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Sebastian Mallaby, Columnist

The Flaw in Bush's Plan

By Sebastian Mallaby
Monday, February 14, 2005; Page A17

The Bush budget policy continues to be awful. But the recent proposal for personal accounts in Social Security is at least half-excellent. If the administration can show the flexibility to recant one key error, it may deserve to win the coming battle in Congress.

First, what's excellent? Unlike many versions of pension privatization, the Bush personal accounts are not a giveaway to Wall Street. The government would administer the personal accounts and control the short list of investment options, so salesmen would get no opportunity to push junk funds with enormous hidden fees onto unwary workers.

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The Bush plan is not a giveaway to account holders, either. Pension privatization in Britain, and the leading reform proposal from the Social Security commission in President Bush's first term, involved taxpayer subsidies to those who opted for personal accounts: A policy that was supposed to fix the future budget hole actually wound up enlarging it. The new Bush proposal, by contrast, is intended to be roughly budget-neutral (although more on this later). The new proposal also takes a decent shot at protecting investors from their own folly. Unless workers explicitly demanded otherwise, their savings would go into a "life cycle" account that shifts money from stocks to bonds as they get older. That way they're protected from a possible stock market crash on the eve of their retirement. Admittedly, some high-rolling 64-year-olds will still punt on equities and get burned. But millions of poor workers who accepted the default life-cycle option would retire richer.

So much for the excellent Bush stuff. Now consider the big error.

The leading reform proposal in Bush's first term said that individuals could set aside 4 percent of their pay (up to the payroll tax cap, currently $90,000) in personal accounts, but that the maximum anyone could set aside per year was $1,000. In his new proposal, however, the president added a promise to phase out that $1,000 cap. This may sound like an innocent change. But it turns a plausible plan into a crazy one.

The phaseout kills the progressivity in personal accounts. Under the old proposal, a worker earning up to $25,000 could divert 4 percent into his account, whereas a worker on $90,000-plus could divert just over 1 percent; the opportunity to earn superior investment returns was to be concentrated among workers who most needed it. But if Bush phases out the $1,000 cap, that progressivity will ultimately be eliminated.

This might be okay if you could create extra, compensating progressivity in the residual Social Security system. But Bush's cap phaseout makes that almost impossible.

Why? In an uncapped system, high earners get big personal accounts; in return, they accept commensurately big cuts in their traditional benefits. According to Jason Furman of the Center on Budget and Policy Priorities, by 2075 high earners' traditional benefits might be reduced -- get this! -- to zero. Fully 100 percent of their Social Security benefits would come from the new personal accounts. That would rule progressivity out. You can't cut high earners' traditional benefits in order to help low-income workers if the high earners already get nothing.

Furman's projection also dents Bush's intended budget-neutrality. Because high earners' traditional benefits would zero out, you can't push them down enough to compensate the Social Security trust fund for their diverted payroll taxes. Full compensation might require a high earner to accept a traditional benefit reduction of perhaps $32,000 per year. But if the traditional benefit is worth only $22,000, the high earner will pocket a subsidy of $10,000 a year at the expense of the budget and of poorer workers.

But the scariest implication of Furman's projection is political. If high earners were to draw nothing from the traditional Social Security program, it would not be sustainable. The high earners would be paying 4 percent of their payroll-eligible earnings into personal accounts and doing very nicely, thanks; meanwhile, they would still be shelling out a payroll tax of 8.4 percent to the government, which would be perceived to purchase nothing. How long would the residual Social Security system survive under these political conditions?

The administration may try to phase out the $1,000 cap extremely slowly, putting off its evil consequences. If it could overcome its anti-tax scruples and inject new money into the system, it could create room to preserve a benefit for high earners, budget responsibility and progressivity. But the best fix for the $1,000 cap problem would be simply to put it back on the table. Junking the cap was a fateful mistake in an otherwise promising proposal.


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