Technical Paper Series

Macroeconomic Analysis and Tax Analysis Divisions 

Congressional Budget Office

Washington, DC

SOCIAL SECURITY PRIVATIZATION:

WHAT ARE THE ISSUES?

Randall P. Mariger

Visiting Scholar

Congressional Budget Office

August 1999

1999-8

Technical papers in this series are preliminary and are circulated to stimulate discussion and

critical comment. The views expressed in this paper are those of the author(s) and should not

be interpreted as those of the Congressional Budget Office. References in publications should

be cleared with the authors. Papers in this series can be obtained by sending an email to

techpapers@cbo.gov.
Social Security privatization is now receiving much attention in policy circles. Proposed

privatization plans range from modest changes in the mix of assets held by the Social Security

trust fund to the phased-in replacement of all Social Security benefits and taxes with mandatory

Individual Retirement Accounts (IRAs).

Much of the current interest in privatization stems from the realization that any reform of

Social Security that is financially feasible and that maintains the program’s current structure

would not be a good deal for current and future workers. These workers would receive benefits

that represent lower than market rates of return on taxes paid. On the surface, therefore, it would

seem that Social Security can be made more valuable by somehow tapping higher market rates of

return. This simple reasoning suggests that privatization offers the possibility of a “free lunch”

where nearly everyone is made better off.

A major objective of the paper is to demonstrate that the free lunch arguments for

privatization are false. My purpose, however, is not to argue against (or for) privatization. My

purpose is to help redirect the privatization debate toward what I regard as the pertinent issues. 

These issues concern possible political impediments to prefunding retirement incomes in

government accounts--which would argue that prefunding can only take place in private

accounts--and on the implications of privatization for how capital income risk is shared by

individuals. 

The paper begins by analyzing the current Social Security policy dilemma in the context

of a simple model in which people live for two periods. This model helps elucidate an important

truth: Social Security has already accumulated an implicit debt that cannot be fully revoked. 
-2-

Hence, any Social Security reform that is financially sound in the long run effectively levies a net

tax on current and future workers to service that debt. This accounts for the below-market rates

of return that Social Security can promise to current and future workers. 

I then demonstrate that substituting mandatory IRAs for traditional Social Security

benefits and taxes would not relieve Social Security’s implicit debt burden. This is done by

showing that retirement systems based either on mandatory IRAs or on traditional publicly

administered defined benefits can be designed so as to have similar implications for national

saving and for the adequacy of overall retirement incomes. 

The paper then turns to two issues that truly distinguish retirement systems that include

mandatory IRAs from those that do not: the distribution of capital income risk, and the

possibility that prefunding of retirement consumption can occur in private accounts but not in

public accounts. I show that introducing mandatory IRAs would enable individuals who are

currently liquidity-constrained to take on a larger share of capital income risk. With regard to

prefunding, I argue on both efficiency and equity grounds that substantial prefunding is desirable,

and that there is a very real possibility that prefunding can only occur in private accounts. I also

point out that mandatory IRAs would most effectively prefund retirement consumption if

investments were limited to one centrally managed investment fund so as to minimize

administrative costs.

Finally, the paper considers arguments for investing all or part of the Social Security trust

fund in equities. Again, the free lunch argument is rejected: I show that trust fund equity

investments can increase the generosity of Social Security only to the extent that they reduce the
-3-

( ) /( ) ( ) / ( ). 1 11 PURETAX

g

SSTAX

g

SSBEN

g

R B

g

W

g

R B

g

= − += − + τ η R B

returns earned on the private sector’s portfolio. Also analyzed is the possibility that trust fund

equity investments would lead to a more efficient allocation of risk bearing. While this outcome

cannot be ruled out, I conclude that undesirable outcomes are more likely. 

WHY SOCIAL SECURITY IS NOT A GOOD DEAL FOR CURRENT AND FUTURE

WORKERS

The basic nature of the current Social Security system can be understood in the context of

a simple model where each individual is certain to live two periods, a working period and a

retirement period. Each young person of generation g (young at time g) pays social security taxes

of SSTAXg = 2gWg, where 2g is the payroll tax rate and Wg is wage income. Letting g be the

implicit rate of return received on social security taxes for generation g, social security benefits

received by each member of generation g when retired at time g+1 are SSBENg =2gWg (1+g).

As shown in table 1, this social security system can be interpreted in terms of mandatory

implicit government bond purchases and a “pure tax” that can be positive or negative. Letting

the real return on government bonds be denoted RB, each dollar of bonds purchased by workers

yields 1+RB dollars at retirement. Hence, generation g’s promised social security benefits could

be secured with an implicit bond purchase of BIg = SSBENg/(1+RB)2gWg (1+g)/(1+RB). The

pure tax is the difference between total social security taxes and the implicit bond purchase, or

To verify that this interpretation of Social Security implies the correct cash flows, note that the 

sum of the implicit bond purchase and the pure tax adds up to total taxes; and that the proceeds
-4-

on the implicit bond, (1+RB)BIg = (1+g )2gWg, equals the social security benefit amount,

SSBENg. For ease of notation, and without loss of generality, I assume that the real government

bond rate does not vary over time.

Social security’s pure tax rate on wages, 2g (RB-g)/(1+RB), can be positive or negative. 

If the implicit return earned on social security taxes is less than the return on government bonds, 

then social security taxes work effort. Otherwise, social security subsidizes work effort. 

Because individuals earn a fair return on forced implicit bond purchases, only the pure tax

portion of total social security taxes should be regarded as true taxes.

In some contexts, it is useful to refer to social security’s pure taxes as wealth transfers. 

Negative pure taxes are positive wealth transfers, and positive pure taxes are negative wealth

transfers. Also, social security taxes that are not pure taxes will be referred to as “contributory

taxes.” These taxes purchase implicit bonds, and are a fair “contribution” made in exchange for

social security benefits.

Feasible Wealth Transfers

A social security system is viable if it does not cause the stock of government debt to

become so large as to make repayment impossible. This condition puts limits on the set of

feasible wealth transfers (pure taxes) that a viable social security system can convey. To

determine these limits, it is necessary to determine the time path of government debt as a

function of social security’s pure taxes. 

To allow for the possibility of both a funded and an unfunded social security system, I

suppose that the social security system begins with a tax levy at time 0 that might be zero, and
-5-

D N SSBEN N SSTAX RB t t g

g

t

gg g

t g = − += −

=

−

−

−

∑( )( ) , ( , ,...), 1

0

1

1 1 12

( )

D RB N SSBEN RB SSTAX RB

N SSBEN N SSBEN RB t

t

t

g

g

t

g g

g

t t

t

=+ + − +

+ − +=

=

−

−

− −− −

−

( ) [ { / ( ) }( ) ∑

( ) ], , ,... .

1 11

1 12

0

1

1 11 1

( ) ( ) ( ) , ( , ,....). 2 1

0

1

1 1 1 D 1 2

t

R B t N

g g

t

PURETAX

g

R B g N

t

SSBEN

t

=− + t

=

−

∑ + − − − − =

benefits commencing at time 1. (Taxes are zero at time 0 if the system is completely unfunded.) 

In this case, government debt at the beginning of time t attributable to the social security system

is

where Ng is the number of generation g members. (Note that SSBENg are benefits paid to

generation g at time g+1, (g=0,1,...).) This is conveniently rewritten as:

Noting that SSBEN-1 = 0 and -{SSBENg/(1+RB) - SSTAXg} is the pure tax that the social

security system assesses each member of generation g (see (1)), government debt attributable to

the retirement system at time t can be written:

If government debt is repayable at some time t, then it must also be repayable at all

previous times. Hence, a necessary and sufficient condition for the retirement system to be

viable is that debt not be too large relative to GDP at an arbitrarily distant future date. Assuming

that the growth rate of real GDP averages less than RB, the requirement that the debt-to-GDP

ratio at an arbitrarily distant future date be bounded from above requires that:
-6-

() ( ) . 3

0

N 1 0

g

PURETAX

g g

R B g

=

∞

∑ + − ≥

That is, the present value of pure taxes assessed on all generations must be no less than zero. 

Stated in terms of wealth transfers rather than pure taxes, the present value of wealth transfers

can be no greater than zero. Hence, any gain that a viable social security system conveys to one

generation must be at the expense of other generations. 

Funding Possibilities

A social security system is entirely prefunded only if the system's viability does not

require that any pure taxes be levied on future generations. This can be true at all times only if 

there are no intergenerational wealth transfers (pure taxes), in which case the social security

system reduces to forced implicit government bond purchases that are backed up with

accumulations of government wealth. As seen from (2), if pure taxes are always zero, social

security’s contribution to explicit government debt at each point in time is negative (a positive

trust fund balance) and equal to promised benefits. 

Typically, however, social security systems pay much higher benefits to early generations

of retirees than would be warranted by market rates of return and taxes paid. In this case, pure

taxes are negative for early generations and, for the viability condition (3) to hold, it must be true

that pure taxes are positive for at least one later generation. The social security system would

effectively transfer wealth to early generations from later generations, and, at least initially,

would not be entirely prefunded.
1. If the growth rate of aggregate real wages always exceeds the real government borrowing rate, then the

present value condition on pure taxes (3) does not hold. In this case, it is possible that the economy is

dynamically inefficient and a collective choice to decumulate capital by issuing public debt or introducing

an unfunded social security system would make all generations better off. Samuelson (1958) shows that

the economy is dynamically inefficient if the real return to capital is certain and the time-averaged growth

rate of aggregate real wages exceeds the time-averaged real return on capital (also the real return on

government bonds). The reality, however, is that the real return to capital is much higher on average than

the growth rate of aggregative real wages. The more realistic case of an uncertain real return to capital is

investigated by Abel et. al. (1989); they derive sufficient conditions for dynamic efficiency, and argue that

these conditions are satisfied in the United States and other major OECD economies. 

-7-

Of course, an unfunded or partially unfunded social security system can become

completely prefunded. For example, social security could transfer wealth from generation 1 to

generation 0, and levy no pure taxes on later generations. In this case, the system would be

entirely funded after time 1, but not at earlier dates.

A Familiar Case

The conclusion that the present value of Social Security’s wealth transfers cannot exceed

zero might seem overly pessimistic. It is well known that a purely pay-as-you-go social security

system with constant tax rate pays each generation a real rate of return on social security taxes

equal to the growth rate of aggregate real wages (Samuelson, 1958). In this case, it might seem

that the wealth transfers social security can convey are larger the larger is the growth rate of

aggregate real wages, and that the zero present value condition for wealth transfers is therefore

invalid.

However, close scrutiny of the simple pay-as-you-go model reveals that the present value

of pure taxes is indeed zero provided the real return on government bonds exceeds the growth

rate of aggregate real wages.1

 This model assumes that the social security tax rate is constant at

2, that all social security taxes are paid immediately to the old, and that the growth rate of
-8-

aggregate real wages is constant at !. Assuming the social security system starts at time 1,

generation 0 receives benefits of 2N1W1 and pays no taxes. Its pure tax is negative, and equal to

N0PURETAX0 = -2N1W1/(1+RB). All later generations earn an implicit return ! on social

security taxes; hence, from (1), generation g , (g=1,2,.....), pays pure taxes that are positive and

equal to 2NgWg(RB-!)/(1+RB). Simple algebra verifies that the present value of these positive

pure taxes is precisely equal to the transfer received by generation 0 for all values of ! less than

RB.

The intuition for this result is straightforward. Generation 0 creates an implicit public

debt 2N1W1/(1+RB) that future generations must service by paying pure wage taxes at rate 

2(RB-!)/(1+RB). The faster wages grow, the smaller is the pure tax rate. However, because the

tax base is larger the faster wages grow, the absolute burden that generation 0 imposes on future

generations is independent of wage growth.

Social Security’s Implicit Debt Burden

As in this simple pay-as-you-go model, the current Social Security system has

accumulated an implicit debt that must be serviced by current and future workers. This has

occurred for two reasons. First, as in the simple model, benefits were paid to early generations

who paid little tax. And, second, there have been several legislated increases in Social Security

benefits and taxes, where again higher benefits were paid to individuals who paid higher taxes

for relatively few years. 

Figure 1 gives estimates made by Leimer (1994) of wealth transfers the current-law

Social Security program has conveyed or will convey to cohorts born between 1876 and 2050. 
-9-

The reported wealth transfers are adjusted for the time value of money using estimates of actual

government borrowing rates, and are measured in 1989 dollars. For example, the 1900 cohort is

estimated to have received transfers worth $136 billion in 1989; this means that if this cohort’s

transfers were financed with government debt that was continuously rolled over until 1989, then

the debt would have accumulated to a total of $136 billion at that date.

All cohorts born between 1876 and 1937 are estimated to receive positive transfers. 

These transfers total $5.5 trillion 1989 dollars. Only a very small share of these wealth transfers

could possibly be revoked, as the recipients are now either dead or age 62 or older. It follows

that generations born after 1937 must pay pure taxes (suffer negative wealth transfers) that

service all, or nearly all, of the $5.5 trillion (1989 dollars) implicit debt that was accumulated by

the earlier birth cohorts. If the Social Security system is to be self-financing, these pure taxes

take the form of Social Security benefits that have a lower present value than Social Security

taxes paid.

Figure 1 shows that current law levies substantial pure taxes on cohorts born after 1937. 

Nevertheless, pure taxes are not large enough to fully service Social Security’s implicit debt. The

sum of pure taxes paid by cohorts born between 1938 and 2050 is estimated at $1.7 trillion 1989

dollars, only 44 percent as large as the implicit debt accumulated by earlier cohorts. This is why

actuaries at the Social Security Administration estimate that the current Social Security system

cannot meet its long-term financial commitments. Hence, any viable Social Security reform plan

--whether it be a wholly public system, a wholly private system, or some combination--must

assess pure taxes on current and future workers that are larger than those defined by current law. 
2. Mariger (1997) and Geanakoplos et. al. (1998a, 1998b) also make this point. Social Security’s implicit

debt is growing, a fact that may have contributed to some analysts’ mistaken belief that privatization offers

unique opportunities to improve Social Security’s finances (e.g. Feldstein, 1996b). To the contrary, the

change in Social Security’s implicit debt has two components: interest on already-accrued implicit debt,

and newly-accruing implicit debt. Newly-accruing implicit debt is negative, as current and future workers

receive negative wealth transfers from Social Security. Interest on already-accrued implicit debt will

accumulate regardless of whether privatization occurs. 

-10-

Much of the impetus for privatization derives from the perception that the low rates of

return that Social Security can promise to current and future workers reflects some inherent

inefficiency that can be curtailed by phasing the program out (eg. Feldstein, 1996b). This is not

the case. Social Security’s low rates of return reflect an implicit debt that cannot be revoked, and

that must be serviced even if the program is privatized.2

 

WHY MANDATORY IRAS WOULD NOT RELIEVE SOCIAL SECURITY’S

IMPLICIT DEBT BURDEN

The existence of Social Security’s implicit debt gives important intuition for why rates of

return than might be earned in mandatory IRAs are not pertinent to the privatization debate. 

Below, this intuition is validated with a formal analysis showing that retirement systems based

either on mandatory IRAs or on traditional publicly administered defined benefits can be

designed so as to have similar implications for national saving and the adequacy of overall

retirement incomes. 

The analysis is done in two steps. First, the case where mandatory IRAs must be invested

exclusively in indexed government debt is analyzed. In this case, I show that introducing

mandatory IRAs accomplishes nothing that cannot be accomplished with simple changes to

Social Security benefits and taxes. Then, in the second step, I show that expanding the menu of

mandatory IRA investment options only serves to change the distribution of capital income risk
-11-

( ) ( ) / ( ). * 5 1 DMTAX W RB RB g gg g = −+ τ η

( ) ( ) / ( ), 4 11 B W RB g gg g =++ τ η

across individuals. Hence, even if mandatory IRAs that substitute for traditional taxes and

benefits were certain to earn high returns, they would not facilitate an increase in the “average”

individual’s retirement income.

The analysis ignores issues concerning the cost of administering Social Security. As is

discussed later in the paper, to the extent that mandatory IRAs increase the cost of administering

Social Security, they are a less effective vehicle for prefunding retirement consumption than are

traditional Social Security benefits and taxes.

Mandatory IRAs Invested Exclusively in Indexed Government Debt

A Neutral Privatization Scheme

It has been established that a social security system can be interpreted as mandatory

implicit government bond purchases and pure taxes (see table 1). This observation suggests an

obvious means of privatizing a viable social security system in the two-period model introduced

above. Suppose, for example, that the original social security system is such that generation 0

benefits at the expense of later generations (PURETAX0 < 0 and PURETAXg > 0, (g=1,2,......)). 

Then, for generation 1 and each succeeding generation, privatization could be accomplished by

eliminating social security taxes and benefits, and requiring that the young buy explicit indexed

government bonds

and pay a tax that is precisely equal to social security’s pure taxes
3. These findings rely on two assumptions that are not entirely realistic: that individuals know social

security’s implicit rate of return at the beginning or working life, and that securities exist promising a

certain real return on pre-retirement saving. Relaxing these assumptions does not compromise the major

point of this section, which is that mandatory IRAs do not offer any unique opportunities for making Social

Security more generous or for improving government finances. However, as is discussed later in the paper,

relaxing these assumptions does lead to the conclusion that mandatory IRAs would alter the allocation of

risk bearing across individuals. 

-12-

For reasons that will become apparent, the tax (5) will be referred to as a “debt management tax.” 

Note that this scheme simply diverts social security’s contributory taxes to mandatory IRAs,

relabels social security’s pure taxes as debt management taxes, and eliminates traditional social

security benefits.

As shown in table 1, cash flows of individuals would be precisely the same under this

privatization scheme as would have been the case under the original social security system. The

only difference is that explicit government debt would be substituted for implicit government

debt (promises to pay retirement benefits) in individual portfolios. (Note that implicit debt

associated with a traditional social security system is denoted by BI, whereas explicit debt is

denoted by B.) And, with individual portfolios essentially unchanged, rates of return would also

be unchanged.3

But would the supply of government debt be sufficient to accommodate all mandatory

IRA investments? The answer is yes. This is most evident at time 1 when the privatization is

initiated. At that time, government debt is higher by the amount of tax revenue that is diverted

into the mandatory IRAs of generation 1 members. Otherwise, the assets available to the private

sector would be unchanged. In the first period after the program change, therefore, mandatory

IRA balances would equal the increase in the supply of government debt.
-13-

Mandatory IRA balances would equal the increased supply of public debt in later periods

as well. This can be seen by identifying all sources of period-to-period changes in public

borrowing, and verifying that each source is matched by an equivalent change in mandatory IRA

balances. There are three sources of changed public borrowing: reduced tax revenues, increased

debt service costs, and reduced outlays for traditional social security benefits. Each of these

sources of changed public borrowing corresponds to an equivalent change in mandatory IRA

balances. First, reduced tax revenues are matched by new contributions to mandatory IRAs. 

Second, increased debt service costs are matched by income earned in mandatory IRAs. And,

finally, reduced outlays for traditional social security benefits are matched by retirement account

withdrawals that maintain baseline levels of retirement income. 

This privatization scheme is clearly feasible provided the baseline social security system

is feasible. Relative to the baseline, the increase in explicit government debt, equal to mandatory

IRA balances, is always finite as a share of GDP. 

This special case--where mandatory IRAs are invested exclusively in government

securities--makes it readily apparent that substituting mandatory IRAs for contributory taxes and

retirement benefits leaves the time path for national saving and national wealth unchanged. 

Mandatory IRA balances represent an increase in private sector wealth that is equal to the

increase in publicly-held debt. Hence, the increase in explicit private sector wealth is offset by a

decrease in explicit public sector wealth. The time path for national saving and national wealth is

unchanged. 
4. Many believe that Social Security’s pure taxes would be made more efficient if mandatory IRAs were

substituted for some or all of Social Security’s taxes and benefits. The argument hinges on possibility that

individuals overestimate pure taxes levied by the current Social Security system, but would accurately

estimate pure taxes levied under a system with mandatory IRAs (Kotlikoff, 1995).

-14-

() ( ) , 6

1

1 0 0 N

g

DMTAX

g g

R B g N PURETAX

=

∞

∑ + − = −

Privatization per se does not make the viability of fiscal policy less reliant on wage

growth. The explicit debt created under privatization imposes an absolute dollar burden on

future generations just as does the implicit debt outstanding in the baseline; in both cases, this

absolute burden is easier to shoulder the more rapid is wage growth. Likewise, privatization does

not necessarily decrease so-called "political risk," as debt management taxes would probably be

subject to as much political uncertainty as are social security’s pure taxes.

Also, this privatization scheme would have no effect on work incentives. With public

pensions, pure taxes drive a wedge between retirement contributions and retirement income. 

Under privatization, these taxes must be collected to service the increased stock of explicit public

debt.4

 

Non-Neutral Privatization Deriving From Non-Neutral Debt Management Taxes 

The debt management taxes given in (5) are chosen so that privatization has no real

consequences for any generation. More generally, the debt management taxes need only satisfy

the condition that their present value equal the wealth transfer made to generation 0:

which is true if DMTAXg = 2g Wg(RB-g)/(1+RB) as in (5). 

There are clearly many possibilities for the debt management taxes, each one of which

yields a different distribution of resources across generations. But to achieve any particular
-15-

DMTAX ( ) gDMTAX

g g

= += g

* δ , , ,.... , 1 2

distribution of resources across generations, it is not necessary to privatize the social security

system. To see this, suppose the social security system is privatized as above except that the debt

management taxes satisfying (6) are

where DMTAXg

*

, (g=1,2,...), are the neutral debt management taxes given by (5) and the present

value of the deviations from neutral debt management taxes (the /’s) is zero 

(/g(1+RB)-g = 0). Then the distribution of resources across generations yielded by this

privatization scheme could be achieved by leaving social security benefits unchanged and

changing social security taxes by /g on each member of generation g, (g=1,2,...). 

Several studies show that privatizing a viable social security system can increase GDP

and economic welfare in the long run (e.g., Feldstein, 1995; Kotlikoff, 1995; Kotlikoff, Smetters,

and Walliser, 1998). This can be achieved by bringing forward the time path of debt

management taxes relative to those that would be neutral with respect to resource allocation. 

Such a reallocation of the tax burden across generations induces increased national saving

(increased prefunding), lower living standards for older generations, and improved living

standards for younger generations. As has been demonstrated, the same ends can be achieved by

bringing forward the time path of social security’s pure taxes and leaving the basic structure of

social security unchanged.
-16-

Non-Neutral Privatization Deriving From Non-Neutral Mandatory IRA Contributions

The mandatory IRA contributions given in (4) are chosen so that the privatization scheme

leads to no change in real retirement incomes. Of course, a privatization plan would involve

substantive change if mandatory IRA contributions differed from (4), in which case debt

management taxes would necessarily differ from those given in (5). But it is clear that these

substantive changes could be implemented by simply adjusting social security benefits and taxes.

Privatizing a Non-Viable Social Security System 

Any meaningful analysis of the advantages of privatization must define a viable public

social security system as a standard for comparison. It is nevertheless instructive to imagine

privatizing a non-viable social security system. In particular, if such a system were privatized as

in (4) and (5), the implied time path for explicit government debt would precisely equal the

infeasible time path for explicit and implicit government debt under the original public social

security system. It follows that privatization by itself cannot turn an infeasible public retirement

plan into a feasible private plan without putting the rest of government out of balance. 

Expanding the Menu of Investment Options

It has been established that introducing mandatory IRAs invested exclusively in indexed

government debt does not offer any unique opportunities for making Social Security more

generous or for improving government finances. 

But would this conclusion hold up if mandatory IRAs could be invested in risky assets

promising high expected returns? To answer this question, imagine starting from a situation

where mandatory IRAs are invested exclusively in government securities and then expanding the
5. Mariger (1997) investigates the implications for national saving of the changed allocation of capital income

risk, and concludes that it would be small.

-17-

menu of investment options. Clearly, some individuals would want to exchange some of their

government debt holdings for riskier assets, say private equities. But not everyone can take on

more risk. For every seller of government debt, there must be a buyer. And for every buyer of

private equities, there must be a seller. Hence, expanding investment options would result in no

direct change in national saving, national wealth, or national income. 

This is not to say that expanding mandatory IRA investment options would have no

macroeconomic effects. The allocation of capital income risk across individuals would be

changed, which could lead indirectly to changes in labor supply and consumption decisions. 

However, any such changes in aggregate variables would probably be modest, and are certainly

not a rationale for privatization.5

Privatization and Hidden Reductions in Socially-Mandated Retirement Incomes

Often privatization plans are designed to maintain baseline levels of socially-mandated

retirement income under the assumption that mandatory IRAs increase private sector wealth in

accordance with mandatory IRA balances, and that mandatory IRAs earn returns higher than

those paid on government debt. In actuality, however, these plans reduce socially-mandated

retirement incomes. And, because Social Security is made less generous, government finances

are improved. 

To be more specific, consider a privatization plan that allows some portion of Social

Security taxes to be diverted to mandatory IRAs, and that reduces Social Security benefits by the
-18-

projected annuity value of future mandatory IRA balances under the assumption that mandatory

IRAs earn the government borrowing rate plus one percentage point. Then this plan would

certainly reduce socially mandated retirement incomes, and would certainly improve long-run

government finances. 

To understand this result, recall the neutral privatization experiment in which Social

Security benefits are eliminated and Social Security’s contributory taxes (those that are not pure

taxes) are diverted to mandatory IRAs invested exclusively in government debt. In this case, the

private sector’s consolidated portfolio is unchanged except for the increased supply of

government debt, and mandatory IRA balances are equal to the increased supply of government

debt. And expanding the menu of mandatory IRA investment choices has no direct effect on

private sector wealth; hence, the increase in private sector wealth attributable to privatization is

certain to equal to mandatory IRA balances in the hypothetical case where they are invested

exclusively in government debt. 

The privatization plan described reduces socially mandated retirement incomes because it

makes two assumptions that together must be false: that mandatory IRAs earn a return higher

than the government borrowing rate, and that the increase in private sector wealth is equal to

mandatory IRA balances. As a consequence of these false assumptions, the plan invokes a

reduction in traditional Social Security benefits that is larger than would be consistent with a

neutral privatization. Hence, the end result is a certain cut in socially mandated retirement

incomes and a certain improvement in long run government finances.
-19-

THE PERTINENT ISSUES REGARDING MANDATORY IRAs

Mandatory IRAs have no inherent advantages over traditional social security taxes and

benefits with regard to wealth creation. Prefunding retirement consumption in the Social

Security trust fund, if that is politically possible, has the same economic implications as

prefunding retirement consumption in private accounts. 

However, there are four major issues that do distinguish retirement systems that include

mandatory IRAs from those that do not. First, mandatory IRAs would have unique implications

for the allocation of risk bearing. Second, political constraints might make it impossible to

prefund retirement consumption in government accounts, in which case introducing mandatory

IRAs would indirectly lead to a more austere overall government fiscal policy and smaller

government liabilities. Third, mandatory IRAs could have implications for how government

policy redistributes wealth. Lastly, some designs for mandatory IRAs could significantly

increase the cost of administering the Social Security system, which could severely limit their

efficacy for prefunding retirement consumption. Each of these issues is explored below.

Mandatory IRAs And The Allocation of Risk Bearing

Substituting mandatory IRAs for traditional Social Security benefits and taxes would

inevitably change the allocation of risk bearing. Whether this would be good or bad is not clear. 

Mandatory IRAs might allow risk to be shifted to the individuals who are best able to absorb it. 

On other hand, mandatory IRAs could enable some individuals to take excessive risks.

Individuals that are likely to take on more capital income risk as a result of mandatory

IRA investments are individuals who currently would like to borrow for the purpose of investing
-20-

in risky assets but cannot. Such individuals are said to be liquidity constrained, and tend to fall

into two groups: young individuals with little privately-managed wealth, and individuals with an

unusual tolerance for risk.

In addition, the defined-benefit nature of traditional Social Security benefits and taxes

allocate capital and labor income risk in subtle ways that are not captured in the two-period

model presented above, and which would be difficult to mimick in a retirement system based on

private accounts. 

Reallocation of Capital Income Risk Between Young and Old

It has been established that a neutral privatization has no effect on the allocation of risk

bearing if mandatory IRAs are invested exclusively in government debt. Hence, the effect of

mandatory IRAs on the allocation of risk bearing can be understood by starting from a situation

in which mandatory IRA investments are restricted to include only government debt, and then

analyzing the effects of lifting that restriction. 

If mandatory IRAs must be invested exclusively in government debt, then most young

people would have portfolios that are made up almost entirely of government debt. Many of

these individuals would be unable to diversify into riskier assets because of borrowing

constraints, and would gladly exchange part of their holding of government debt for riskier assets

if the restriction on mandatory IRA investments were lifted. 

 Most older individuals, on the other hand, would have significant wealth outside of their

retirement accounts. These individuals would tend to be indifferent to the requirement that their

retirement accounts be invested in government securities, as they could balance safe assets held
-21-

in retirement accounts with risky assets held outside of retirement accounts. Absent a change in

rates of return, therefore, older individuals would tend not to reallocate their portfolios if

retirement account investment options were expanded to include assets other than government

securities. 

To summarize, relaxing the restriction that retirement accounts be invested in government

securities would affect the young and the old differently. At initial rates of return, young

individuals would tend to sell government debt and buy private equities, while older individuals

would tend to leave their portfolios unchanged. This situation would be untenable, as the supply

and demand for assets would not match. There would be an excess supply of government debt,

and an excess demand for private equities. As a result, the return on government debt would rise

so that older individuals would be willing to trade some of their holdings of private equities to

young individuals in exchange for increased holdings of government debt. 

When all is said and done, portfolios held by young individuals would tend to be riskier

and promise higher expected returns, and the portfolios of older people would tend to be less

risky and offer lower expected returns. This arguably makes good economic sense, as young

individuals are better able to adjust to unexpected changes in their financial circumstances than

are older individuals. 

The increase in the government borrowing rate that would likely accompany a changed

allocation of risk would increase government debt service costs. Depending on the nature of

offsetting fiscal policy adjustments, the distribution of wealth across generations could be

affected. If it is, then there would be implications for national saving and GDP.
-22-

Reallocation of Capital Income Risk between Individuals with Different Preferences for Risk

In addition to redistributing capital income risk across individuals of different ages,

mandatory IRAs would enable liquidity constrained individuals with unusually high tolerance for

risk to take on a larger share of total capital income risk. Some individuals, particularly lowincome individuals who are effectively insured against some capital income risk by government

benefit programs for the low-income elderly, undoubtedly would choose riskier portfolios than is

generally considered prudent. This possibility might argue for some limitations on mandatory

IRA investment choices.

Minimum Return Guarantees and the Allocation of Capital Income Risk Across Generations

Some Social Security reform plans provide for a minimum return guarantee on 

mandatory IRAs. Such a guarantee would affect the allocation of risk bearing in a manner that

would probably also affect the distribution of wealth across generations (Smetters, 1998). This

would occur if taxes are levied on workers to finance minimum return guarantees paid to the

elderly. These wealth transfers are analogous to those at the start-up of a pay-as-you-go social

security system. National saving and GDP would probably be reduced relative to a baseline that

did not include minimum return guarantees.

Risk Allocation Implications of Substituting Defined Contributions For Defined Benefits

The analysis thus far does not incorporate some real-world uncertainties that generally

make it impossible to design a neutral privatization scheme in which mandatory IRAs yield the

exact same retirement income does the current Social Security system. (See “A Neutral

Privatization Scheme” above.) In particular, the implicit real return earned on Social Security
6. On this score, Merton (1983) and Bohn (1998b) argue that the wage indexing formula determining Social

Security benefits under current law increases opportunities for sharing labor productivity risk across

generations. Of course, mandatory IRAs would not have this feature. 

-23-

taxes, g, (g=0,1,2,....), is not known at the beginning of working life because real benefits

depend on a lifetime average for “indexed” covered wages, where the index factors pertain to

economy-wide average wages. Also, with indexed government securities available only for

limited maturities, assets do not exist that guarantee a real return on pre-retirement saving. 

Because of these considerations, the portion of Social Security taxes that a neutral

privatization would divert to mandatory IRAs must be selected so as to maintain the baseline

level of expected retirement income. While it would remain true that a “neutral” privatization

would not change expected retirement incomes or expected government finances, it would

change the risk characteristics of retirement incomes and government finances for reasons quite

apart from those discussed above. It is very difficult to know whether these considerations are a

net plus or a net minus for privatization.6 

Possible Political Constraints That Would Argue For Private Accounts

I have demonstrated that diverting Social Security taxes to mandatory IRAs and reducing

benefits in a manner that leaves long run government finances unchanged merely substitutes

explicit government debt in private portfolios for benefit promises (implicit government debt). 

True government liabilities would be unchanged, but voters and elected officials might come to

view the government’s fiscal stance very differently. If so, then privatization could lead to more

austere fiscal policies than would otherwise occur. In this case, privatization would indirectly

reduce true government liabilities. 
7. More generally, if Social Security surpluses do not cause larger non-Social Security deficits, then the

Social Security surplus in a given year measures the amount by which Social Security reduces the overall

unified budget deficit. This reduction has two parts: the excess of Social Security taxes over Social

Security benefit payments directly lowers the unified deficit, and the reduction in net interest payments

attributable to the lower level of debt held by the public indirectly lowers the unified deficit. The second

component of the reduction in the unified deficit corresponds to trust fund interest earnings. 

-24-

This possibility is closely related to the question of whether a legislated increase in Social

Security trust fund accumulations would add to national wealth. This is a difficult question to

answer. If tax increases or benefit reductions boost Social Security surpluses, and if these

surpluses do not result in higher levels of spending, or lower taxes, outside of Social Security,

then the resulting increase in the trust fund balance each year measures the amount by which

federal debt held by the public is reduced.7

 The smaller is the amount of federal debt held by the

public at any point in time, the larger is the share of domestic private wealth that represents

domestically-owned real capital and claims on foreigners–assets that, unlike government debt,

contribute to national income.

On the other hand, political constraints might make it impossible to prefund retirement

consumption in government accounts. Some past attempts to prefund Social Security benefits by

building up a large Social Security trust fund appear to have been thwarted by new legislation

that increased benefits and expanded Social Security eligibility (Cogan, 1998). Perhaps more

troublesome is the possibility that Social Security surpluses encourage larger federal deficits (or

smaller federal surpluses) outside of the Social Security accounts. If this is the case, Social

Security surpluses are neutralized by non-Social Security deficits, and are not truly saved. 

There are probably similar but much less severe political impediments to prefunding in

private accounts. It might be that any political pressure put on elected officials to invoke policies
-25-

that prevent or neutralize Social Security trust fund accumulations would also be felt with regard

to policies that allow individuals access to funds in mandatory retirement accounts for special

non-retirement needs like college tuition or a home purchase. However, the personal costs

associated with drawing down the Social Security trust fund would probably be less obvious to

voters than would be the personal costs of drawing down individually-owned retirement funds

early. If so, voters would be less likely to support early access to mandatory retirement account

balances than they would policies that limit or neutralize asset accumulation in the Social

Security trust fund. Moreover, it is unlikely that individuals would take near to full advantage of

opportunities to draw down mandatory retirement accounts early. This is because individuals

must save their mandatory account monies in order to make up for their loss of traditional Social

Security benefits. 

I conclude that if substantial prefunding is desired, and if political constraints make it

impossible to prefund in government accounts, then prefunding in private accounts would be a

viable option. But is substantial prefunding desirable? I argue below that it is.

Why Prefund? 

The present value of Social Security’s pure taxes must equal Social Security’s current

implicit debt. The essential question Social Security reform must address, therefore, is how and

on whom these taxes should be levied. 

How Social Security’s pure taxes are allocated across generations helps determine the

degree to which retirement consumption is prefunded. The larger the share of these taxes that are

paid by early generations, and the smaller the share paid by future generations, the larger is
8. Advocates of progressive tax rates might favor pure tax rates that rise in tandem with projected real wage

growth. However, the extent to which pure tax rates can rise with real wages is limited by the loss of

efficiency that such a policy would entail. Moreover, some might argue that it would be unethical to

impose a disproportionate share of Social Security’s implicit debt burden on generations that have no input

into current political decisions. 

-26-

prefunding. Increased prefunding, therefore, benefits future generations at the expense of current

generations. 

Efficiency considerations would argue for fairly uniform marginal pure tax rates across

generations (Chari, Christiano, and Kehoe, 1991). For example, if pure taxes are to be levied on

wage income, it would be most efficient if each generation paid more or less the same percent of

wage income as pure taxes at the margin. This is so because raising a tax rate causes the excess

burden of the tax to increase much more rapidly than does tax revenue. Hence, any deviation

from uniform pure tax rates harms generations paying high pure tax rates more than it benefits

generations paying low pure tax rates. 

Most people would probably regard a uniform pure tax rate across generations as roughly

fair as well as efficient. Hence, this policy is a useful benchmark that would probably be close to

most peoples’ preferred policy.8

If Social Security’s pure tax rates were constant over time, and set at a level that fully

services Social Security’s implicit debt, then prefunding would be substantial. With a constant

pure tax rate, all generations would be asked to prefund the same share of their own sociallymandated retirement income. Because the baby boom generation is extraordinarily large,

prefunding would be extraordinarily large as a share of GDP as the baby boom enters retirement

and the ratio of retirees to workers rises.
-27-

Nevertheless, if pure tax rates were to be constant over time, then Social Security would

always carry an implicit debt and retirement consumption would always be partially unfunded. 

This is a straightforward implication of the fact that Social Security needn’t levy any pure taxes

when and if Social Security has no implicit debt.

Summary

Both efficiency and equity considerations argue that Social Security should become

substantially prefunded as the baby boom approaches retirement. In principle, prefunding could

occur in public or private accounts. However, if political constraints preclude the possibility of

prefunding in public accounts, then the case for some privatization is compelling.

Mandatory IRAs and Wealth Redistribution

Thus far, it has been assumed that Social Security levies the same pure tax on all

members of a given generation. In reality, of course, Social Security’s pure tax rates tend to rise

with lifetime income (e.g. Steuerle and Bakija, 1994). The progressive nature of the system

causes marginal pure tax rates on earnings to exceed average pure tax rates, thereby worsening

work disincentives. 

It would also be possible to redistribute wealth in the context of a privatized Social

Security system. This could be done in any number of ways. If mimicking wealth redistribution

under the current Social Security system is desired, it could be done by redistributing retirement

account balances at retirement on the basis of lifetime earnings (but not on the basis of returns

earned in mandatory IRAs). As with the current system, such redistribution would cause each

individual’s marginal pure tax rate on work effort to exceed his or her average pure tax rate.
-28-

Mandatory IRAs and Social Security’s Administrative Costs

Mandatory IRAs could significantly increase the costs of administering Social Security. 

In 1997, Social Security cost $16 per person (workers and beneficiaries) to administer, or $10 per

person excluding the estimated cost of administering the disability program (National Academy

of Social Insurance, 1998). How much mandatory retirement accounts would increase these

administrative costs is extremely uncertain, and would depend on the level of services that are

offered and how the system is organized. Services could vary in a number of ways, including the

frequency of retirement account deposits, the number of alternative investment options available,

the frequency of interfund transfers that are allowed, the frequency of reporting on accumulated

balances, and the amount of investment education that is provided to workers. 

A recent study analyzed a plan for mandatory retirement accounts that offers a medium

level services would increase Social Security’s per-person administrative costs by between $25

and $50, a two to three-fold increase over the cost of administering the current retirement and

disability programs (National Academy of Social Insurance, 1998). The plan would have a

government agency act as an intermediary between participants (workers and employees) and

providers of investment services; would limit investment options to a small number of mutual

funds; would make deposits and fund transfers, and report fund balances, on an annual basis; and

would provide no investor education beyond distributing information pamphlets.

The costs of administering mandatory IRAs would be much smaller if all individuals

were required to invest mandatory IRA contributions in one centrally administered fund. Such a
-29-

plan would prefund retirement consumption more effectively than a plan that allows more

investment services, as administrative costs absorb resources that could otherwise be saved. On

the other hand, plans that allow more investment choices could lead to a preferable distribution

of capital income risk across individuals. 

PRIVATIZING TRUST FUND INVESTMENTS

To date, the Social Security system has taken in more taxes than it has paid in benefits. 

The cumulative difference between taxes and benefits as of the end of 1998, the value of specialissue government securities held in the Social Security trust fund at that time, was about two

times as large as Social Security benefits paid in 1998. This trust fund accumulated because the

baby boom generation is prefunding part of its own retirement, albeit less than would be called

for if Social Security were solvent and pure tax rates were constant over time. (As is discussed

above, however, trust fund accumulations might not truly contribute to national wealth. ) 

Several plans have been put forward recently to invest a portion of the Social Security

trust fund in equities. Often, these plans are touted as means of improving the government’s

finances at no cost to the private sector–a free lunch. Below it is demonstrated that a free lunch

cannot materialize: trust fund equity investments can improve the government’s finances only to

the extent that returns earned on the consolidated private sector portfolio are reduced. 

As with the introduction of mandatory IRAs, trust fund equity investments would change

the allocation of risk bearing. Some analysts argue that these investments would make possible a

more efficient sharing or risks between individuals that are currently liquidity constrained and
-30-

those that are not. While this possibility cannot be ruled out, I argue that undesirable outcomes

are more likely. 

No Free Lunch

Investing a dollar of the trust fund in private equities, while leaving taxes and

expenditures unchanged, requires that the government issue an additional dollar of debt to the

public. Hence, investing the trust fund in private equities amounts to an asset swap: the private

sector accepts government debt in exchange for private equities of equal value. Hence, absent a

change in private consumption, this asset swap would improve government finances only to the

extent that it reduces private sector investment returns.

This conclusion is usefully illustrated for a special case where taxes are frequently

modified to reflect the trust fund's investment performance, where there are no liquidity

constraints, and where individuals are rational and well informed. In this case, I show that trust

fund equity investments are of no real consequence, as all individuals would hedge the

government's equity investments so that after-tax incomes and market rates of return are

unchanged.

Starting from a feasible baseline in which the government owns no equities, suppose the

government at time 0 issues $X of additional debt and buys $X of equities, and changes taxes

each year so as to maintain the baseline time path for government net financial wealth (equity

minus debt). Consider the effect of this change on an individual who pays the share . of federal

taxes. In year 1, this individual's taxes change by his share . of the government's year-1 portfolio

loss (perhaps negative):
9. For simplicity, this exposition ignores the effect of taxes levied on private sector capital income. Allowing

for these taxes does not change any conclusions. 

10. If everyone hedges the government’s equity investment, then there would be no net change in the demand

for assets and rates of return would remain unchanged. This can be seen by noting that a person who pays

the share . of federal taxes reduces his or her demand for equity by .X and increases his or her demand

for government bonds by .X. In the aggregate, therefore, the private sector decreases its demand for

equities by X and increases its demand for government bonds by X. These changes in asset demands are

balanced by equal changes in assets supplied to the private sector.

-31-

∆TAX RE RB X 1 11 =− − ( ), α

where RB1 is the certain nominal return on government bonds and RE1 is the uncertain return on

equities. However, suppose this person had increased his or her debt holdings by .X and

decreased his or her equity holdings by .X in response to the government's equity investment. 

Then his or her capital income in year 1 changes by:

∆INCOM E RE RB X 1 11 = − ( ), α

which exactly offsets the change in taxes.9 The same logic applied to future years implies that

the change in taxes plus the change in capital income would be identically zero in all years for an

individual who consciously hedges the government's equity investment.10

 But would investors hedge the change in the government's portfolio? For someone who

owns risk-free assets in the baseline or is able to borrow at the risk-free return, and who is

rational and well-informed, the answer is yes. In the baseline, such an individual chooses a mix

of debt and equity that best suits his or her tastes. The government's equity investment, if not

hedged, would upset this mix; effectively, it would increase the individual's equity holdings and

decrease the individual's debt holdings. The individual has the means to neutralize this change,

and would rationally do so. 
11. In addition, trust fund equity investments could be a means of allowing future generations to share in the

income and risk of current-vintage capital. Bohn (1998) argues that this would be a desirable risk sharing

arrangement. 

-32-

Possible Changes in the Distributions of Wealth and Capital Income Risk

This example illustrates some basic principles, but is not realistic. While trust fund

equity investments would have no direct effect on total capital income, they would inevitably

alter the allocations of wealth and capital income risk across individuals. This can be seen by

examining the implications of assumptions that differ from those in the example. 

Changes in the Wealth Distribution

The example assumes that each individual shares equally in the upside and downside

risks of trust fund equity investments. This is extremely unlikely. For example, a particularly

troublesome possibility is that Social Security benefits might be increased quickly in response to

better-than-expected returns earned by the trust fund, whereas taxes would be increased after a

long lag in response to worse-than-expected returns. If so, the size of the Social Security

program, and the amount of wealth transfers extracted from unborn generations, would ratchet up

over time.

Changes in the Allocation of Capital Income Risk

The example assumes that all individuals can borrow and lend at the risk-free interest

rate. Alternatively, if some individuals are borrowing-constrained, then trust fund equity

investments might facilitate a more efficient sharing of capital income risk.11 The idea is that

Social Security benefits could be tied to the returns on equity investments, which would enable

young borrowing-constrained individuals to trade in safe promises of modest Social Security
-33-

benefits for Social Security benefits that are less certain, but that are more generous in an

expected value sense. In effect, young peoples’ overall portfolios, portfolios that include

promises of Social Security benefits, would be invested in riskier assets with higher expected

returns. 

If young individuals are to take on more capital income risk, older individuals must take

on less. To see how this would occur, recall that each dollar the government invests in private

equities requires that an additional dollar of government debt be sold to the public. The private

sector gives up equities in exchange for government debt of equal value. Because young

individuals currently hold relatively little equity, it would tend do be older individuals that would

make this exchange. Hence, older individuals would have portfolios more heavily weighted

toward safe government debt.

Shifting some capital income risk from the old to the young could enhance efficiency. 

Many young individuals have little privately managed wealth, and are without access to

borrowing. These individuals might judge that their current portfolios are too safe, as they are

dominated by one asset–the promise of relatively safe Social Security benefits. This asset is

purchased with contributory taxes, the part of Social Security taxes that are not pure taxes. 

Alternatively, if part of the trust fund is invested in private equities, and if Social Security

benefits are adjusted to reflect equity returns, then young individuals are effectively allowed to

swap promises of Social Security benefits for equities. Many young individuals would

undoubtedly welcome this opportunity to take on more capital income risk. And, because older
-34-

individuals would willingly trade some of their equities for government debt, they would be

made no worse off.

However, the scenario just described is unlikely to accurately describe actual fiscal

policy. To begin, the scenario assumes that Social Security benefits are continuously adjusted to

offset unexpected changes in the value of the trust fund so that the higher expected returns of

trust fund equity investments benefit the same individuals who bear the risk deriving from these

investments. This is easy to do in a two-period model because all workers and retirees are

homogeneous with respect to age. (See, for example, Diamond and Geanakoplos, 1999.) In the

real world, however, this would be difficult. Hence, even if policymakers attempt to allocate upside and down-side risk to individuals in equal proportions, they would not have the proper

instruments to do so. 

Moreover, it is not improbable that policymakers would not attempt to allocate up-side

and down-side risk to individuals in equal proportions. In particular, as discussed above, trust

fund equity investments could become a vehicle for making wealth transfers from unborn

generations to currently-living generations. 

Finally, any supposition about how trust fund equity investments would affect the

allocation of risk bearing would be impossible to verify. Verification would require knowing

how Social Security taxes and benefits would be adjusted for every contingency with respect to

returns earned on trust fund investments. Unless these contingencies are specified in advance,

trust fund equity investments would redistribute wealth across individuals in ways that are both

unplanned and unknowable.
-35-

CONCLUSIONS

Mandatory private retirement accounts are not a panacea. Diverting Social Security taxes

to mandatory IRAs and reducing benefits in a manner that leaves long run government finances

unchanged merely substitutes explicit government debt in private portfolios for benefit promises

(implicit government debt). Alternatively, mandating that individuals contribute to retirement

accounts and not changing Social Security taxes or benefits would add no more to national

saving and aggregate retirement incomes than could be achieved with a judicious increase in

Social Security taxes and benefits. 

 Current misperceptions regarding privatization tend to derive from a basic

misunderstanding of the nature of a pay-as-you-go social security system. Such a system is often

likened to an investment that yields a rate of return. This conceptualization gives the incorrect

impression that Social Security can be made more valuable by somehow tapping higher market

rates of return. To the contrary, the reason Social Security’s rate of return is low is that Social

Security conveyed substantial wealth transfers to cohorts born prior to 1937, transfers that must

be financed with pure taxes paid by later generations. 

On both efficiency and equity grounds, it would be reasonable to maintain a fairly uniform

Social Security pure tax rate over time. In this case, the baby boom generation would accumulate

substantial wealth to prefund part of its retirement consumption. In principal, this wealth could 

accumulate in the Social Security trust fund. However, political constraints might make it

impossible to prefund in public accounts. If so, the case for some privatization would be

compelling. 
-36-

Mandatory IRAs could have important implications for the allocation of capital income risk

across individuals. Capital income risk might to be shifted to the individuals who are best able to

absorb the risk. On other hand, mandatory IRAs could enable some individuals to take excessive

risks. 

If the goal of mandatory IRAs is simply to prefund retirement consumption, that can be

done most effectively with a bare-bones plan that limits investments to one centrally managed

fund and keeps administrative costs to a minimum. On the other hand, plans that allow more

investment choices could lead to a preferable distribution of capital income risk across

individuals. 

The case for investing the Social Security trust fund in equities is tenuous. Absent a change

in private consumption, this policy would merely reshuffle claims to a fixed amount of capital

income. And, while simple models suggest that trust fund equity investments could improve the

allocation of capital income risk between those that are currently borrowing- constrained and

those that are not, it is doubtful that policymakers have the proper instruments or the will to

achieve this outcome.
-37-

REFERENCES

Abel, Andrew B., N. Gregory Mankiw, Lawrence H. Summers, and Richard Zeckhauser, 

“Assessing Dynamic Efficiency,” The Review of Economic Studies, January 1989.

Advisory Council on Social Security, Report of the 1994-96 Advisory Council on Social Security,

Washington D.C.: Social Security Administration, 1997.

Bohn, Henning, “Should the Social Security Trust Fund hold Equities? An Intergenerational

Welfare Analysis,” Mimeo, November 1998a.

Bohn, Henning, “Risk Sharing in a Stochastic Overlapping Generations Economy.” Mimeo,

December 1998b.

Chari, V.V., Lawrence J. Christiano, and Patrick J. Kehoe, “Optimal Fiscal and Monetary Policy:

Some Recent Results,” Journal of Money, Credit, and Banking, August, part 2, 1991.

Cogan, John F., Testimony Before the House Committee on Ways and Means, 

November 19, 1998.

Diamond, Peter, “Macroeconomic Aspects of Social Security Reform,” Brookings Papers on

Economic Activity, 2, 1997.

Diamond, Peter, and John Geanakoplos, “Social Security Investment in Equities I: Linear Case,

Mimeo, April 1999.

Feldstein, Martin, "Would Privatizing Social Security Raise Economic Welfare?" NBER

Working Paper 5281. September 1995.

Feldstein, Martin, and Andrew Samwick, "The Transition Path in Privatizing Social Security,

NBER working paper 5761, September 1996a.

Feldstein, Martin, “The Missing Piece in Policy Analysis: Social Security Reform,” American

Economic Review, May 1996b.

Geanakoplos, John, Olivia S. Mitchell, and Stephen P. Zeldes. “Would a Privatized Social

Security system Really Pay a Higher Rate of Return?” In Framing the Social Security Debate,

Eds. Douglas Arnold, M. Graetz, and Alicia Munnell. Washington D.C.: National Academy of

Social Insurance and the Brookings Institution, 1998a.
-38-

Geanakoplos, John, Olivia S. Mitchell, and Stephen P. Zeldes. “Social Security’s Money’s

Worth,” Working paper 98-9, Pension Research Council, August 1998b.

Kotlikoff, Laurence J., "Privatization of Social Security: How it Works and Why it Matters,"

NBER working paper 5330, October 1995.

Kotlikoff, Laurence J., Kent Smetters, and Jan Walliser, "Privatizing Social Security in the U.S.,:

Comparing the Options,” Technical Paper Series, Macroeconomic Analysis and Tax Analysis

Divisions, Congressional Budget Office, November 1998.

Mariger, Randall. “Social Security Privatization: What It Can and Cannot Accomplish,” Federal

Reserve Board Working Paper 1997-32, June, 1997.

Merton, Robert. “On the Role of Social Security as a Means for Efficient Risk sharing in an

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Pension System, edited by Zvi Bodie and John Shoven. Chicago and London: University of

Chicago Press, 1983.

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December 1998.

Samuelson, Paul, “An Exact Consumption Loan Model of Interest With or Without the Social

Contrivance of Money,” Journal of Political Economy, December, 1958.

Smetters, Kent, "Investing the Social Security Trust Fund into Equities: An Option Pricing

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Congressional Budget Office, August 1997.

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Technical Paper Series, Macroeconomic Analysis and Tax Analysis Divisions, Congressional

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-39-

 

TABLE 1

TWO INTERPRETATIONS OF SOCIAL SECURITY’S NET PAYMENTS 

FOR GENERATION g

______________________________________________________________________________

 Conventional Interpretation

Taxes when young (SSTAXg) 2gWg

Benefits when retired (SSBENg ) 2gWg (1+g)

 Alternative Interpretation

When young

 Forced Implicit Bond Purchase (BIg) 2gWg (1+g)/(1+RB)

 plus Pure Taxes (PURETAXg) 2gWg(RB - g)/(1+RB)

 equals Net Cash Outflow 2gWg

When retired

 Implicit Bond Proceeds 2gWg (1+g) 

______________________________________________________________________________

Notes: 2g is the Social Security tax rate, Wg is the wage, g is Social Security’s implicit real rate

of return, and RB is the real return on government bonds.

______________________________________________________________________________
-40-

FIGURE 1. Social Security’s Wealth Transfers by Birth Cohort Adjusted for the 

 Time Value of Money (Billions of 1989 Dollars)

Source:Leimer (1994).