More of This = Less of That

The fundamental defect of American politics is its inability to deal with the concept that more of something usually means less of something else. The winner in any election will probably be the candidate who promises most persuasively to suspend this basic law of nature, or at least to ignore it. But politicians are not solely to blame. In their daily lives, citizens are sharply aware that all economic choices have their costs. But when voting, they succumb to the fantasy of something for nothing.

President Bush has declared two big domestic policy ambitions for the start of his second term. One is tax reform, with an emphasis on simplification. The other is Social Security reform, including some form of privatization. In the coming weeks and months, we will hear a lot about how Washington is about to deliver more-of-something. Keep your eye on the unheralded less-of-something-else.

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TAX REFORM

There is no doubt that the tax code is too complex. But every complexity is there because someone benefits from it. Everyone says, and many may even believe, that they would be happy to trade their loopholes for simplicity and lower tax rates. The question to ask yourself is: Would you favor tax reform if it meant higher taxes for you? If the new system is going to raise as much money as the old system, every dollar someone doesn’t have to pay because of reform would have to be paid by someone else. Who is that someone else?

Enthusiasts for tax reform say a simpler tax code with lower rates would cause an explosion of productivity generating as much tax revenue as the old system, or even more, without raising anyone’s tax rate. This isn’t a complete fantasy. Our current mess of a tax system does create costly inefficiencies and disincentives. But any tax reform that simply assumes a huge productivity payoff as an excuse to lower somebody’s taxes without raising somebody else’s would be the height of irresponsibility when the federal deficit is already half a trillion dollars a year.

In judging whatever tax reform the White House comes up with, it will be important to isolate three different concepts: tax simplification, a flat tax and a tax cut. If past Republican efforts are any guide, the Bush proposal will purposely muddle these elements in order to make another tax cut for the rich look like a favor to the middle class.

A “flat tax” would eliminate the various tax brackets and tax everyone at the same rate. That may sound like simplification, but it isn’t. Multiple tax rates are not what make doing your taxes so complicated. Once you know your taxable income, finding your rate and figuring your tax are child’s play. The complications and the loopholes in the tax code are about defining taxable income. If we close some of the loopholes, we can cut tax rates and still bring in the same amount of revenue. That is real tax simplification, and it’s a good idea.

If the tax reform is designed so that no one, or almost no one, gets hit with a tax increase, then it is not just tax reform: There is a tax cut stirred into the stew. And what’s wrong with that? First, this country doesn’t need and can’t afford a tax cut. Second, if we want a tax cut, we can have one without “reform.” And if we want reform, we can have it without a tax cut. Combining the two is just a way to hide the cut and disguise the true nature of the reform.

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SOCIAL SECURITY

Bush’s Social Security reform will include some version of privatization, which means allowing people to invest part of their Social Security payments themselves instead of turning it all over to the government. The premise is that people can achieve a better return by investing the money themselves than they get from the government.

This premise is probably true. Even if the government makes good on its promises to people who are now paying into Social Security, the return on their “investment” would be less than if they had put the money into government bonds, let alone more glamorous opportunities.

This is true even though Social Security payments actually are invested in government bonds. But this does not make them an investment for individual participants. The government sets the Social Security tax rate and the size of benefit payments. The tax revenue goes into the Social Security trust fund, and the benefit payments come out of it. Your tax payments are not earmarked for your own retirement, and your benefits are only vaguely related to how much you personally put in.

A huge contingent of boomers at their peak earning levels are now paying into the trust fund, and a smaller collection of retirees is drawing from it. As a result, the trust fund is growing, and the annual surplus helps to reduce the deficit being run up by other parts of the government.

Politicians of both parties generally have it both ways about whether the money collected in Social Security taxes but not paid out in Social Security benefits is net revenue to the government, or whether it is being held in a sacrosanct “trust fund” for the benefit of future retirees (i.e., the very people who are currently paying the money in). The latest official Congressional Budget Office figure for the 2004 federal deficit, for example, is $422 billion. If it weren’t for a $153-billion “off-budget” surplus in the trust funds for Social Security and other purposes, that deficit figure would be $574 billion. But the $153 billion will be needed someday to pay Social Security benefits, and woe betide the budget official who reminds people that we actually used it to buy down the deficit back in 2005.

At some point as boomers age, the annual Social Security surplus will turn into a deficit (the projection is about 2022). Social Security, instead of painlessly making the overall government deficit smaller, will start to make it larger. Next, the trust fund will actually run out (current projection: 2034).

There are only two ways out of this problem. One is to increase revenues and the other is to cut benefits. Privatization is sometimes presented as a third way. But even its most enthusiastic advocates admit there are “transition costs.” Because most of today’s Social Security tax revenues are used for today’s Social Security benefits (only a quarter of 2003 revenues went into the trust fund), this money must be replaced before tax revenues can be diverted into private investment accounts. But the amount of money needed for this transition -- $2 trillion according to some estimates -- would render moot any talk of the system facing insolvency. It’s as if someone tells you he’s got a magic trick that will wipe out your $1,000 credit card bill -- and all he needs is $1,000 from you to start the magic working.

And then there’s the magic itself: Private investment, particularly in stocks, pays a better return than the government bonds in the Social Security trust fund. Privatization proponents are often vague about what happens to this extra profit. Do more fortunate participants benefit from their wise investment choices, or will their payments from the non-privatized part of Social Security be trimmed to help cover any shortfall to the overall system? More important: It is hard to see how this extra profit will actually materialize. Let’s say it’s true that the typical person with a private retirement account can do better than the payoff on the government bonds in the Social Security trust fund. This raises the interesting question of why anyone would ever voluntarily buy a government bond, although many do. But put that aside. Every dollar in the trust fund is helping to finance the national debt, and every such dollar that is deflected from the trust fund into private investment accounts has to be replaced with a dollar the government borrows on the open market. As a result, despite privatization, the total amount of government borrowing and the economy’s overall level of private investment remain precisely the same as before.

So where will the privatization payoff come from?

There are only two possibilities. Either the return to all competing investors in the private economy will be smaller, or the total investment return in the economy will be larger. Privatizers would not relish the first possibility, and we can think of no reason to expect it. So we are left with the second possibility: that the same amount of investment capital will produce a higher return when more of it is in the hands of millions of small investors, many of them with little investment experience.

You may believe that if you wish. There is a theory, cited by privatizers, that having more individual decision-makers produces a better allocation of capital in the economy. Or you may believe that resting the solvency of the nation’s most important social program on the ability of small investors to beat the market is, to use the technical term, nuts.

Which leads to one final question: Why are they trying to do this? Answer: Partly blind zealotry for anything called privatization. Partly because the statism of the Social Security program genuinely offends them. But mainly because it’s a way to offer more of this while hiding the less-of-that in a maze of confusion.