Shifting towards equity markets increases interest rates.

Another method to maintain a solvency in the Social Security system is to shift Social Security Trust Funds to the equities market. As the model above suggests, this reform causes equity returns to decrease and interest rates to increase and necessitates an increase in income taxes to maintain a constant fiscal stance. Clearly, under this reform, equity holders are hurt, bondholders benefit, taxpayers are hurt, current workers are left unaffected (to the extent that under the benchmark their payroll taxes were not affected as they are under the "shifting funds" reform), and future recipients benefit (to the extent that under this reform their benefits are left unchanged compared to being cut under the benchmark case). Under this reform, income transfers from taxpayers and equity holders to bondholders and future recipients (and current workers, as compared to the "increasing payroll tax" reform).

To the extent that all bonds and equities are domestically held, the choice of reform is determined by which groups (equity holders, bondholders, current workers, future Social Security recipients) the government favors. If all groups are weighted equally, then the government should be indifferent between the reforms (the problem would be reduced to having one infinitely lived representative agent, from the government's point of view). If all bonds and equities are not domestically held, then income transfers will occur between domestic residents and foreigners. For example, under the "increase payroll taxes" reform, a redistribution from U.S. workers (paying higher payroll taxes) to foreigners holding U.S. equities will take place since the return on U.S. equities increases following this reform. Furthermore, following this type of reform, income would transfer from foreign bondholders (holding bonds paying a lower interest rate) to U.S. taxpayers (paying lower income taxes because the interest expense portion of government spending is reduced).

Alternatively, under the "shift funds" approach an income redistribution occurs from foreigners holding U.S. equities to U.S. workers. In this case, foreigners holding U.S. equities would lose because they are earning a lower return on their equity holdings but not receiving any benefits from the Social Security system, effectively subsidizing U.S. workers' retirements. The effects of this type of reform are further complicated by the fact that foreigners hold a substantial portion of the U.S. government's debt (approximately one-third of publicly held debt). This creates a political dilemma in which there is a redistribution of income from U.S. taxpayers (paying higher income taxes) to foreigners holding U.S. bonds (paying higher interest rates).

According to the latest CBO budget, the government is expecting to run total surpluses in the amount of $5.6 trillion over the next decade. The surpluses are divided between Social Security ($2.5 trillion) and the rest of the government ($3.1 trillion). Therefore, the arguments presented above concerning increased interest rates, increased interest payments, and tax increases could be modified in light of these projected surpluses. As stated above, the necessary tax increases are for a constant fiscal stance. If the government wants to continue to run a $3.1 trillion surplus over the next decade, then the above arguments still hold. These tax increases are relative to the government's fiscal position. Clearly, the government could absorb higher interest payments and not increase taxes, but the resulting surpluses would decrease by the amount of the increased interest payments. Alternatively, the tax cut that the government could offer in light of the surpluses would partially be offset by higher interest payments. On net, higher interest payments may not seem as painful in an environment of budget surpluses, but only to an irrational individual who does not see that higher interest payments cause taxes to be cut by a smaller amount than they otherwise would be.

The shifting of Trust Funds from Treasury securities to equities has generally been sold to the public as a painless cure for the salvation of Social Security, but this article has shown that this is not so straightforward. In fact, shifting funds to the equities market could actually be a more painful solution to the problem (from the standpoint of U.S. taxpayers) if a net income redistribution to foreign bondholders occurs. The change in the total tax burden under these alternative plans should be an integral part of any discussion of Social Security reform.

SUMMARY AND CONCLUSION

Several proposals have been developed to reform the Social Security system to ensure that it is fully funded. These proposals include investing a portion of Social Security funds in equities instead of increasing Social Security payroll taxes. A general equilibrium model is developed in this research to demonstrate some of the effects of these reform proposals. The model shows that investing a portion of Social Security funds in equities will increase interest rates on bonds. We demonstrate that shifting funds into the equities market is equivalent to a change in the size of the Social Security Trust Fund times an adjustment factor. Using historical data, we show a significant relationship between interest rates and the size of the Social Security Trust Fund. From this empirical relationship, we then demonstrate that interest rates could increase if a portion of the existing Trust Fund is invested in equities. Furthermore, while the Trust Fund will have a higher expected return, other taxes may need to be increased to maintain an equivalent budget position. An interesting extension of this model is to examine the alternative reform proposal of increasing the payroll tax. Intuitively, if the payroll tax is increased, this would increase the size of the Trust Fund, decrease the amount of debt the government must market to the public, lower interest rates, and allow for a reduction in taxes. The stark contrast with investing a portion of the Trust Fund in the equities market stresses the importance of this issue when considering alternative proposals.