Mandatory retirement savings calculations

A Mandatory Retirement Security Solution

A reasonable policy to tackle the retirement long-term financial problem is to mandate private retirement accounts and to provide tax relief to help finance them. Mandatory private accounts will increase national savings and provide an investment complement to social insurance. Relief would come from allowing employee Social Security taxes to be deductible from taxable income, a measure that would reduce marginal tax rates and significantly lessen the financial burden of the obligatory retirement savings. This deduction would amount to an income tax deferral targeted to Social Security taxpayers.

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Increased savings for own-retirement is the best way to counter the inexorable trend of ever fewer workers and ever more retirees, the main flaw in the financing of the current system. Private accounts should be part of a broad-based retirement policy strategy, not an election which carries the offset of a reduction in Social Security benefits, and not on top of a mandatory “progressive” reduction of benefits. Mandatory accounts would level the tax field and simplify the incentives for retirement savings. Voluntary, tax-advantaged retirement accounts, such as IRAs and 401(k)s, are inherently unfair to those who cannot afford to save for any purpose or whose employers do not have retirement plans. Voluntary accounts do not provide a clear-cut complement to Social Security.
A sensible policy would be to require that two percent of all wages, salaries and net profit of self-employed persons be contributed to a personal retirement account. To illustrate what saving two percent of wages could mean for a taxpayer, I will borrow the example given by the President’s Commission to Strengthen Social Security for a “scaled medium earner” (earning $35,000 in 2001). At retirement, she or he will own an expected portfolio worth more than a half million dollars. A two-earner family could easily have an expected net “cash” worth of $1 million (Final Report, p. 9). The Commission assumed a portfolio choice 50 percent corporate equity, 30 percent corporate bonds, and 20 percent U.S. Treasury bonds.

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Social Security taxes are 12.4 percent of wages up to $90,000; one half is deductible as an expense to the employer. The other half paid by the employee is not deductible, with the consequence that salary income is taxed twice: immediately by Social Security and later, after deductions, by income tax. That is certainly not a worker-friendly tax policy. Double taxation of income, either salaries or dividends, is undesirable.
Deductibility of Social Security taxes would operate as an across-the-board 6.2 percent reduction in marginal income tax rates. However, in practice the marginal tax rate reduction would be larger for the first, 10% income tax bracket, then would decline as salary and other income grow, and become negligible for the sixth and highest, 35% income tax bracket. This result is due to the personal standard deduction being fixed in dollar terms, the $90,000 limit on 2005 wages subject to Social Security tax, and the dollar amounts where the tax brackets are positioned.
The incentive of income tax deductibility of Social Security taxes would compensate a significant part of the mandatory savings. Deductibility would help finance the required contribution to a retirement account in the order of 31 percent for the 10% bracket, 47 percent for the 15% bracket, 77 percent for the 25% bracket, and then decline to only 19 percent of the 35% bracket. In my calculations, I considered for simplicity a single wage earner who takes the standard deduction of $5,000 and has taxable income at the top of the bracket.

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Making Social Security taxes deductible for income tax purposes will tend to increase the fiscal deficit. Current income tax revenue would decline for the duration of the deferral period, and would increase as retirees start withdrawing from their private retirement accounts. This medium-term shortfall can be wisely managed by curtailing, as necessary to reach fiscal neutrality, existing voluntary retirement accounts, whose contributions and earnings are tax deferred (personal IRAs and employer-sponsored retirement plans such as 401(k)s and Keogh’s) or those whose earnings are tax free (Roth-IRAs). All those voluntary programs should be curtailed because their key rationale is tax deferral for those few who can afford to save. Tax deferral for all taxpayers is also the essence for the mandatory private accounts proposed here, based on ownership of retirement assets.

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This solution would leave Social Security insurance intact, warts and all. The inexorable demographics indicate that the program’s solvency cannot be easily fixed. The known solvency solutions of reduced benefits or higher taxes are not palatable; increased retirement age is cruel punishment to the short lived.
Reduced benefits, such as using price indexing instead of wage indexing, would quickly yield a negative rate of return on investment. The President’s Commission in 2001 wrote: “for a single male worker born in 2000 with average earnings, the real annual return on his currently-scheduled contributions to Social Security will be only 0.86 percent.” (For workers who earn the maximum amount taxed the real annual return is already negative.) Reduced benefits applied to everybody, if and when inevitable in AD 2041, would be acceptable then when everybody has a personal retirement account. That fateful year, pay-as-you-go would be a reality. Instead of waiting for a 26 percent reduction of payable benefits in 2041, benefits can be scheduled for gradual reduction to give time to the private accounts to accumulate tangible property.
Tax increases now (raising the payroll tax or the amount subject to it) to shore up future Social Security are counterproductive; it would be throwing money to preserve intact a program, however popular, which needs to change, because of demographics. In the next ten years the government will have to sell 2.2 trillion dollars worth of bonds to Social Security; during that period more taxes would just mean more spending. Social Security bonds redemption after 2017 would necessitate tax increases then. Family history suggests my passing at 66, thus I cannot favor increasing the retirement age: I want it rolled back to 65.