Rebuilding Social Security: The labor elasticity effect

In the debate over Social Security, Nobel Laureate Edward C. Prescott has been a strong voice for a shift away from the current pay-as-you-go model — in which current workers pay for current retirees — to a mandatory personal saving plan, in which workers' savings are put into low-cost, highly diversified funds. The personal saving approach would guarantee financial security for retirees in a country where the ratio of worker to retiree is declining, Prescott says, and would help boost the country's overall economic performance as well.

Surveys are reporting that about a third of Americans support President Bush's plans for Social Security. Count in that number a man who shared the 2004 Nobel Prize for Economics, Edward C. Prescott. A professor of economics at the W. P. Carey School of Business and a senior monetary advisor at the Minneapolis Federal Reserve Bank, Prescott makes the case for rebuilding the 70-year-old program.

Prescott advocates a shift away from the current pay-as-you-go model — in which current workers pay for current retirees — to a mandatory personal saving plan, in which workers' savings are put into low cost, highly diversified funds such as those permitted by the Federal Government Thrift Plan and by otheroptional retirement plans.

The personal saving approach would guarantee financial security for retirees in a country where the ratio of worker to retiree is declining, Prescott says, and would help boost the country's overall economic performance as well.

Proponents of the traditional Social Security plan — like Mark Weisbrot, director of the liberal Washington, D.C. think tank Center for Economic and Policy Research — argue that Social Security does not need any tinkering. "Social Security was good for nearly half a century without any changes at all," Weisbrot says. In fact, he has described the notion that Social Security is in trouble as "an urban legend" promoted by Republicans intent on undoing the New Deal program for ideological reasons.

But supporters of traditional Social Security undersell the virtues of a savings system, Prescott says. He says that his research and that of many other macroeconomists on how labor markets function finds that diverting some of the payroll tax into mandatory savings accounts would make the country richer.

It would increase the fraction of people that work in the market sector, he says. More importantly, he adds, it would also enhance the welfare of the people. By his calculations, the value of the additional consumption made possible by working more hours is twice as big as the value of the time that would have been spent on vacation or in retirement.

"In the U.S., how much you get back if you work an extra year or two is zero because the benefit formula depends on only 35 years of earnings," Prescott said in a telephone interview. Changing the structure would encourage workers to spend less time on vacation and to put off retirement for a few more years. In addition, it would also encourage more married women to go to work.

The reason is a concept Prescott calls labor supply elasticity — a theory that suggests that people's choices about whether they get a job and how much they work at that job depends on the tax structure. His Exhibit A: Until the 1970s, Europeans and Americans worked roughly the same amount of hours. Now, labor-market statistics from the Organisation for Economic Co-operation and Development (OECD), show that on a per-person basis, Americans aged 15 to 64 now work almost 50 percent more than the French, and about the same amount more as the Italians and Germans.

In the 1970-1995 period hours worked in the market sector fell by nearly 50 percent in Western Europe while they increased by 10 percent in the United States. Why the change? Prescott notes that participation fell in Western Europe because of the large increase in the marginal tax rate there. Participation in the labor market grew in the United States because flatter taxes increased the fraction of the increase in income associated with having a second earner in the household, Prescott says.

Nor is the U.S. an isolated case. "In 1998, Spain flattened its tax rates in similar fashion to the U.S. rate cuts of 1986, and the Spanish labor supply increased by 12 percent," he wrote in an essay on the topic. "In addition, Spanish tax revenues also increased by a few percent."

The shift, Prescott says, is not really in the number of hours worked, but the number of taxable hours worked. The Italian government, for instance, estimates the underground labor generates about 25 percent of the country's entire economic product, he says.

While a job market with zero taxation might sound like the most efficient kind of all, Prescott says underground or informal jobs typically aren't very productive. The lack of contracts reduces efficiency, as does the need to hide from the taxman. "A lot of times you do things in a less efficient way in order to hide the activity," he explains.

Prescott says he believes a mandatory saving plan would have a number of other advantages as well. A system of mandatory personal accounts would:

• Lower the risk of demographic surprises. Prescott believes that with a system set up on private accounts, there is less risk of demographic shifts catching administrators by surprise. "You don't have to be a great forecaster," he says.
• Make the poor less poor. Greater labor participation would tend to bring up the living standards of the poorest families, he says.

Provide a better future for the poor. By creating a small nest egg, poor couples would have a chance to build some capital either to leave for their children if they don't spend it all in their retirement or to create better financial opportunities in their own lives. It would help in another way as well, if Prescott had his way: he suggests that people should be able to borrow against that money, to use for a house down payment or as seed capital for a family business.

Yet one aspect of the current system Prescott would leave untouched. In shifting from a pay-as-you-go system to a system of personal saving for retirement, Prescott advocates no change in the U.S. Survivor and Disability Program which is run by the Social Security Administration. This is a mandatory insurance plan that should not be changed. He supports public provision out of general tax revenues for unfortunate people who can not work.

Prescott believes that mandatory personal saving accounts offer a solution to the healthcare crisis as well.

In the U.S. health care system, most costs are paid through third-party insurers, Prescott says, and as a result, people have no incentive to keep their costs down. "With third party payments, there's moral hazard," he explains. Insurance plans are structured in such a way that consumers have no incentive to keep an eye on their health costs, so they consume more health care services.

Like private investment accounts in Social Security, Prescott argues that health savings accounts change the incentive structure. Cash balance plans give people a reason to obtain health care at the high-quality, low-cost providers. Indeed, he estimates that households would receive more health-care services with this system and receive them at lower cost to society. At the very least, a move toward personal retirement accounts is all but inevitable, Prescott believes.

"All the responsible governments in the world are moving in that direction," he says.

"Twenty-five have. This includes Mexico, our neighbor, as well as a number of other American economies, Sweden and most of the former Communist countries of Eastern Europe." He charges that politics motivates those who want to stall progress toward a beneficial new policy. It's not an honest disagreement based on the facts of the case, he said, but a cynical ploy of those with a vested interest in a bad system to cling to power. "They want to maintain the welfare state, which is their power base," he says.

Although he believes history is on the side of the mandatory personal savings accounts to provide for health care and retirement, Prescott is clear-eyed about the prospects for a change in Social Security this year. "This time around, my betting odds is it won't make it," he says. "You can only do it if there's bipartisan support for it — and it should only be done if there is."