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Federal Reserve Bank o f Minneapolis 1993 Annual Report The High Cost of Being Fair by P reston J. M iller Vice President and Monetary Adviser Government interventions in the name of fairness distort the incentive structure. These distortions reduce growth and create the possibility that recipients of the government’ redistribution s schemes eventually would be better off without them: a small slice of a big pie could eventually exceed an equal slice of a small pie. The views expressed in this annual report are solely those o f the author; they are not intended to represent a formal position o f the Federal Reserve System. President’s Message Since the fall of the Ancien Regime, governmental policy makers, especially in democratic societies, have debated values. Looking back at this debate and then bringing it forward to today, it seems that arguments fall roughly into four categories: our highest priority should be an egalitarian world characterized by fairness and equality, or we must seek the greatest utility through efficient decisions, or we must allow markets to operate freely because that will yield the greatest benefit to the most people, or nothing has a higher value than the quality of life so that we must always be mindful of the environment. These competing values have been present in the political consciousness of our lawmakers in varying forms since the early days. As time passes, one value may rise above the others, and then be supplanted by another as the political landscape changes. At all times, though, none has fallen away completely. In the following essay, Preston Miller takes a hard look at an important aspect of the value conflict I have just described. As an economist, his interest brings him to the questions of the marketplace and efficiency. He asks about the costs of consistently favoring one value over another and his answer is clear. There is much to learn from Preston’s examination of free market outcomes in comparison with governmental intervention. And the lessons transfer well to other value clashes like that between development and the environment. As a national policymaker, I have become convinced that the “best solution” seldom means mutual exclusiveness, but rather involves searching for the policy that honors, not necessarily equally, competing values. President Federal Reserve Bank o f Minneapolis 1993 Annual Report The High Cost of Being Fair by Preston J. Miller Vice President and Monetary Adviser It’s been a little over 30 years since Milton Friedman published Capitalism and Freedom. In this book, which was cited in Friedman’s Nobel prize award, he argues pas sionately and cogently in support of free markets. He stresses that government interven tions in markets generally restrict individuals’ freedom of choice and impair the efficiency of the economy. Friedman, and later his critics, pointed out that efficiency is not the whole story. Although free markets generally lead to efficient outcomes, that alone is not sufficient to guide policymaking. Policymakers must be guided by other social objectives—namely, fairness, or equity. Friedman’s critics argued that efficient outcomes are not necessarily fair because some individuals can receive too little of the economy’s goods or services. Policymakers, then, can be viewed as facing a trade-off between efficiency and fairness. According to this common view, increasing government intervention in markets leads to more fairness at the cost of less efficiency. But, because government interventions in the economy have been allowed to expand, the public must view the cost of this lost effi ciency as low. However, a lot has happened since Capitalism and Freedom was published. New knowledge and evidence have accumulated on the relationship between economic perfor mance and government involvement in the economy. These new developments suggest that the costs of government interventions typically are higher than formerly thought. Such interventions not only result in one-time losses in economic efficiency, as is commonly thought, but they typically also reduce growth over time. 2 If the costs of achieving fairness are higher than formerly thought, government interventions to achieve that goal ought to be scaled back. The public must realize that the trade-off between efficiency and fairness is not so favorable when viewed in a dynamic, or growth, context. To make my arguments concrete, I examine just three of the many ways the gov ernment intervenes in markets: trade protection, redistributive taxes and transfers, and social security. (Of course, I could have also included government interventions in health care, agricultural price support policies, industrial policies, and so on.) In each case, I explain why the government has intervened to make things fairer and then show how the new tools and research reveal much higher economic costs to these interventions than has been commonly thought. The case of social security is slightly different. Some government intervention in annuity markets can be defended on efficiency grounds. But actual govern ment operation of the social security system can be defended only on fairness grounds. So the argument here is that once the efficiency concerns are addressed, the costs of govern ment operation of the system are much higher than commonly thought. I begin with the trade-off between efficiency and fairness as it is usually argued. A key reason the standard analysis fails to capture all of a policy’s costs is that it usually considers costs at a point in time rather than costs over time. The difference between the two can be dramatic. Restoring the balance between efficiency and fairness is simple economically, but difficult politically. Economically, the solution is to scale back government interven tions made in the name of fairness by better targeting benefits to the poor and needy. How ever, politically, that is hard to do. Government programs spread benefits widely to low-, middle-, and high-income people in order to buy support for the program. But there is no clear rationale for the government to intervene in the name of fairness and distribute bene fits to middle- and high-income people. People in these income classes must be convinced that such interventions are not in their collective best interests. Until they are, politics sug gests that the government’s role in the economy will continue to grow. The Cost of Government Interventions in Theory . . . The Public Demands Fairness . . . were justified because it would be unfair to cause workers By alm ost any m easure, the governm ent’s role in the in these industries to lose their jo b s or receive less economy has been growing. For example, the ratio of income. Recent changes in the income tax structure are total government expenditures to gross domestic product another example. The Clinton administration’s 1993 tax has risen steadily in the last 30 years, from less than 28 bill was justified on the grounds that it was taking income percent in 1963 to more than 34 percent in 1993. And from those who had profited (unfairly) from the 1980s tax even these figures vastly understate the government’s role cuts and giving the proceeds to the less fortunate. And in the economy because they exclude mandates, regula finally, the greatest expansion in federal governm ent tions, tax subsidies, and other types of interventions. The expenditures over the last number of years was in entitle government’s role has expanded even though economists ments, which exist primarily to give more income or ser since the time of Adam Smith have agreed that, except in vices to the poor or unfortunate; that is, they owe their special cases, private unfettered markets are the most effi existence to the public’s support of the goal of fairness. cient way of delivering goods. So why the expansion? The short answer is that the public wants to be fair. . . . But What’s Fairness? Admittedly, some interventions can be attributed to spe Although policies seek to achieve fairness, there’s a sur cial cases. Examples include interventions in decreasing prising lack of agreement among both economists and cost industries, such as price controls in the cable televi noneconomists on what fairness really means and on how sion industry; interventions because of externalities, such important it is relative to other social goals. Yet most as pollution abatement programs; and interventions in cer defenders of government interventions in the name of tain private information, insurance environments, such as fairness do tend to hold some similar views. They typi the mandate of automobile insurance for all drivers. But cally agree that fairness does not require everyone to get these special cases cannot explain the extent of the expan the same size slice of the economic pie, but they argue sion. Rather, the increase in government interventions that market outcomes are often unfair because some peo reflects a dissatisfaction with the ability of markets to pro ple get too little. Defenders also agree that fairness is not vide fair outcomes. Departures from free trade are one all that counts. They argue that efficiency, or the size of example. Concessions under the North American Free the pie, counts too. However, between two systems pro Trade Agreement (NAFTA) to individual industries such ducing the same size economic pie, they agree that the as sugar beet growers, textile producers, and truckers one with slices of more equal size is better. 4 (CBO) finds that removing the barriers to trade with Mexico would lead to little gain in output in the United States (CBO 1993, p. 23). It follows that the existence of these barriers costs little in terms of lost efficiency. Sim ilarly, another study finds that the tax distortion costs of the U.S. redistributive income tax system are no larger than the compliance and collection costs—a modest 5-10 percent of revenues collected (Slemrod 1992, p. 46). Costs Are Small Initially . . . The defenders have a strong case. Under unfettered mar kets, individuals would be rewarded according to their contributions to the economic pie. The rewards for some, however, would be too small to afford them a minimal standard of living. Changes in the reward system under unfettered markets could also be very harsh. Since indus tries decline as they become obsolete or noncompetitive, workers in those industries would lose their jobs. Since the public appears to demand fairer outcomes, govern ment intervention is seen as a desirable way to bolster the standard of living of low-income individuals and to protect the jobs of individuals in threatened industries. But the defenders of this type of intervention recog nize that interventions incur costs. As economist Arthur Okun (1975) put it many years ago, there is a trade-off between equity and efficiency. Efficiency is generally best served under unfettered markets. In a market sys tem, prices signal how to allocate resources, and rewards provide individuals with the proper incentives. Govern ment interference in markets alters the price and reward structure and causes inefficiencies. The trade-off is easily seen in an extreme case. Sup pose initially that a market economy generates a wide distribution of income. Suppose next that the govern ment intervenes by taxing all individuals earning above the average (or mean) income and transferring the pro ceeds to those whose income is below the average—in essence making everyone’s income the same. Individu als would then have little incentive to work because they would get the same income whether they worked or not. In this case, total income, or the size of the economic pie, would shrink considerably. In actual practice, though, the loss of efficiency from interventions is typically seen as modest. That is a major reason for their proliferation. Okun likened government redistribution schemes to leaky buckets that carry water from the haves to the have-nots. Although some water is lost in transit, the task is still worthwhile because the unfortunate end up with more than they had before (1975, pp. 91-106). Empirical studies generally confirm that the costs of such interventions are small. For instance, a recent study done by the Congressional Budget Office . . . But Huge Over Time Although I have no quarrel with the argument that some government interventions are necessary to provide ade quate income or services to the poor and unfortunate, I do quarrel with the common assessment of their costs. If resources are being taken from one group and given to another based on the income of each, the redistributions necessarily distort. That is, these interventions necessari ly alter the reward structure and thereby alter incentives. The common view of the costs of these distortions to incentives, such as that in the two studies above, is based on an essentially static, or point-in-time, analysis. However, interventions based on fairness not only lead to static distortions, but they also can reduce growth—an effect that can only be measured over time. Such inter ventions typically reduce the rewards to innovation and investment in human and physical capital. The costs of underinvestment in developing new methods, new skills, and new equipment can become staggering. It is possi ble that the recipients of the government’s redistribution schemes eventually would be better off without them: a small slice of a big pie could eventually exceed an equal slice of a small pie. That is essentially what happened under Eastern European socialism, leading to the fall of Communism. Although this brand of socialism was intended to promote fairness, the economic pie in this part of the world became relatively so small that the middle class there became worse off than the poor in capitalist countries. Restraining government interventions made in the name of fairness could lead to more growth by encour aging more innovation and investment. More growth is desirable because it can provide larger slices of the eco nomic pie for everyone in the society. 5 . . . And in Practice The ability to raise both efficiency at a point in time and growth over time by restraining government is not just a theoretical possibility. It’s a real option. The next three sections illustrate how government interventions get competitive in a global marketplace to industries that are experiencing a greater demand for their goods or services. A gainst this tem porary cost, standard economic started, how much damage they actually do, and how they could be scaled back. analysis suggests the need to consider the benefits of a more efficient economy. The efficiency gain is thought to come from comparative advantage (Gould, Ruffin, Trade Protection and Woodbridge 1993, pp. 1-2). The idea of compara tive advantage is that each country is relatively better On many different occasions and in many different ways, the U.S. government has erected barriers to the free exchange of goods and services across its national borders. The governm ent, for example, has placed explicit import quotas on textiles and voluntary import quotas on Japanese automobiles, collected tariffs on liquor and taxes on high-priced autos (the incidence of which falls predom inantly on foreign im ports), and enacted anti-dumping laws to limit Japanese computer chips. The prim ary reason these barriers exist is to maintain the jobs and incomes of those in the protected industries. For instance, Ross Perot [with Pat Choate (1993, p. 29)] argues against NAFTA because it “will accelerate the loss of manufacturing jobs in the United States . . . . Eventually, companies that choose to stay in the U.S. will need to reduce employee wages and bene fits.” Economists point out that Perot’s argument is not balanced. He cites some of the costs but ignores all of the benefits to the U.S. economy from free trade with M exico. Standard econom ic analysis suggests that although moving to freer trade may indeed cause some temporary job displacement, it leads to greater econom ic efficiency. than others at producing some goods or services and so should specialize in producing what it does best and then trading. For example, Canada is better off special izing in growing wheat, exporting it, and using the pro ceeds to purchase oranges rather than growing oranges at home. Under standard analysis, the policy issue is this: Do the benefits of freer trade, in terms of more efficiency, outweigh the costs of tem porary job displacem ent? Although economists using the standard analysis typi cally favor moving to freer trade, empirically it tends to be a close call. The costs of lost jobs and income in some vulnerable industries are readily apparent, while the comparative advantage gains are usually found to be fairly small. Standard analysis, however, understates the costs of protectionism. It fails to consider how barriers to trade impede growth. Thus the standard approach will find only modest advantages to opening U.S. markets. Stan dard analysis considers com parative advantage, but sees only a once-and-for-all efficiency gain. After that is realized, standard analysis suggests there is no rea son why economic growth should be affected. That is because standard analysis assumes that the rate of tech nological advance is unaffected by barriers to trade. New theory and new observations are not consistent with that assumption. They indicate that freer trade p ro m o tes te c h n o lo g ic a l adv an ces and econ o m ic growth. In recent years, m acroeconom ists have becom e in cre asin g ly in te re ste d in why som e c o u n trie s ’ economies grow faster than others. Their studies con clude that differences in economic growth across coun tries cannot be explained simply by differences in inputs Standard economic analysis also suggests that only a minimal connection exists over time between a coun try’s level of employment and the openness of its mar kets. A country can have full employment if it is an island economy that doesn’t engage in any foreign trade or if it is an open economy that is completely free of barriers to foreign trade. The difference in employ ment between the economies would be not in the total number of jobs but in the types of work the jobholders do. This analysis suggests that moving to freer trade can have some temporary costs because workers will be relocated from industries that have become less 6 Barriers to trade can affect growth by slowing down the rate o f technological innovation. Protected industries do not have to discard their outmoded technologies, and this resistance to change can reduce economic growth. i of labor and capital (Lucas 1988 and Schmitz 1993). But economists are not in agreement on what other factors explain differences in economic growth. Some cite vary ing degrees of resistance to adopting new technologies. Such resistance can come from capitalists or workers who have stakes in maintaining old technologies. (See, for example, Holmes and Schmitz 1994.) Others cite dif ferences in human capital, that is, in the education, training, and experience of workers that affect their skills and competency (Lucas 1988). Recent work by economist Robert Lucas (1993) out lines a model that illustrates both of the above explana tions. He begins by examining differences in human capital across countries and finds that they are not due just to disparities in formal education. Countries which are similar with respect to labor and capital inputs and formal education still can have significantly different growth rates. Lucas argues that the essential differences in human capital across countries are due to disparities in leaming-by-doing on the job. Lucas’s theory suggests that economic growth is affected by the amount of leaming-by-doing on the job. It also indicates a route by which trade barriers can lead to lower growth, and recent evidence confirms that this route exists. It follows from leaming-by-doing that a relationship should be observed between the productivity of workers and the length of their experience working with a given technology. Lucas examines how the number of worker hours to com plete a given project varies as worker experience grows. In particular, he refers to a Labor Department study of worker hours needed to produce Liberty ships (cargo-carrying ships built for the United States and its allies during World War II). If that rela tionship (which is input per unit of output) is inverted, a picture emerges of how worker productivity (that is, output per unit of labor input) varies with worker expe rience. The pattern seems intuitive and general. When workers begin a new technology, their productivity is quite low. Everything is new to them. However, after a slow start, their productivity climbs rapidly as they become more familiar with their tasks and learn better ways of carrying them out. Eventually, productivity lev- The Learning-By-Doing Pattern Experience reduces the time workers need to do a job,. . . Number of Worker Hours Needed to Produce One Liberty Ship Monthly, December 1941-December 1944 Source: Searle 1945, p.1135 . . . which means they become more productive. A shift to a new technology reduces productivity — temporarily. In the 1980s and 1990s countries in East Asia and Latin America that opened their markets experienced rapid growth. A study done at the Dallas Federal Reserve finds that “outw ard -o rien ted p o licies are a much stronger conduit for economic growth and advancement than protectionist import substitution policies” (Gould, Ruffin, and Woodbridge 1993, p. 4). It cites an analysis of 29 episodes of trade liberalization which finds that growth increased in manufacturing and agriculture fol lowing the liberalizations (Papageorgiou, Michaely, and Choksi 1991). Other empirical studies, both formal and informal, support the conclusion that freer trade promotes growth. One formal study finds a positive relationship between openness and growth and concludes that els off as workers master the bulk of the necessary skills and procedures. It also seems intuitive that productivity will initially fall as a firm moves up the technology ladder. When a new technology is adopted, productivity initially falls because workers must learn new skills and procedures. However, with the new and improved technology, pro ductivity will eventually surpass what it was with the old one. This pattern of leaming-by-doing suggests that eco nomic growth depends on how fast old technologies are discarded and new ones adopted. If technologies are dis carded too rapidly, economies absorb the initial costs of switching to new technologies but do not exploit the gains from rapidly rising productivity on existing tech nologies. This, in fact, seemed to be the experience of Singapore (Young 1992). However, if technologies are kept for too long, economies are faced with slow pro ductivity growth because workers’ learning-by-doing has plateaued. This, in fact, seemed to be the experience of Great Britain. Thus there is a rate of technological innovation that maximizes growth. Barriers to trade, then, can affect growth by slowing down the rate of technological innovation. Protected industries do not have to discard their outmoded tech nologies. Theoretically, these barriers could promote growth if, without them, a country’s rate of technologi cal innovation were too fast. In contrast, they could lower growth if, without them, a country’s rate were about right or too low. Thus the relationship between growth and trade barri ers becomes an empirical issue. The new observations and new statistical studies strongly suggest that freer trade promotes higher growth. The evidence comes from casual observation, careful historical review, and formal econometric analysis. Since Friedman’s Capitalism and Freedom was pub lished in 1962, many new observations on the link betw een fre e r trad e and econom ic grow th have amassed. During the 1950s, 1960s, and 1970s econo mists persuaded developing countries to erect trade bar riers to protect their infant industries (Edwards 1993). The economies of these countries generally stagnated. when openness and the level of public infrastruc ture are taken into account, physical investment becomes quantitatively more important in the growth process, implying that a better quality of investment is encouraged by a more liberal inter national trade regime and by more government fixed investment. Particularly for the developing countries, investm ent in human capital also becomes more quantitatively important when a more open trading environment and a better pub lic infrastructure are in place. (Knight, Loayza, and Villanueva 1993, p. 536) Similarly, another recent study finds that economic growth was stimulated in France by a freeing of trade within the European Community (Coe and Moghadam 1993). Finally, an extensive survey of historical studies and econometric analyses relating growth and trade pro tection in developing countries was recently published (Edwards 1993). While critical of all of the studies cited, the survey finds a positive relationship between freer trade and growth in almost all of them. The message from the new theory and evidence is clear: trade protection inhibits growth. Thus, in erecting or maintaining trade barriers, the fairness benefit of pro tecting workers should not be weighed against just the one-time cost of lower efficiency due to reduced com parative advantage. It also is necessary to include the cost of lower economic growth. 9 income quintiles. A little less than half the members of the bottom quintile moved up into a higher quintile, and about half the members of the top quintile fell out of that quintile” (Sawhill and Condon 1992, p. 3). A U.S. Treasury Department study (1992) finds that a significant degree of household mobility over time is explained by the life cycle pattern of earnings. In their early years individuals typically invest in acquiring skills and furthering their education and thus earn low incomes. In their later years they earn progressively Redistributive Tax and Transfer Policies Redistributive taxes and transfers is a second area where government interventions made in the name of fairness could be scaled back to promote higher growth. It is generally observed that in the 1980s the rich got richer and the poor got poorer (McKenzie 1992). The govern ment responded with changes to federal income tax and transfer policies (beginning with the 1986 tax reform) to counter this increase in income disparity (CBO 1994, pp. 54-57). In 1993, for example, marginal tax rates were raised significantly on higher-income families and the earned income tax credit was greatly expanded for lower-income families. These changes were defended based on fairness arguments. Standard economic analysis recognizes that these changes, especially to higher marginal tax rates, had costs in terms of lower efficiency. Higher marginal tax rates on the wealthy were seen as distorting investment decisions by encouraging the use of tax shelters. A more progres sive tax system also was seen as reducing the supply of labor, primarily that of households’ secondary income earners. However, these costs were seen by policymakers as low relative to the benefits of a fairer income distribu tion, and so the policy changes were enacted. The standard measure of redistribution costs under state the true costs because they fail to include the cost of lower growth. The costs are m easured under the assumption that the income distribution is static—the same individuals are either unemployed or working at the same jobs year after year. Costs to redistribution, then, are thought of in terms of how they affect individu als in given income classes. (These classes are usually defined by quintiles, which each contain one-fifth of the population.) Recent research indicates that the static assumption is false and provides a new way to think about the income distribution. Suppose income quintiles are hotel rooms and individuals are the occupants (Sawhill and Condon 1992). Standard analysis assumes the same individuals are in the same rooms year after year. But, in fact, recent studies indicate that a significant amount of room-chang ing is occurring over time. It is reported that in both the 1970s and 1980s “some three out of five adults changed higher incomes as they realize the returns to their invest ment in human capital. Thus, for many people, progressively higher marginal tax rates represent reductions in the rate of return to their human capital. In their early adult years they must sacri fice income to invest in their human capital by taking time to study and train. They are willing to invest because they foresee an adequate return in terms of higher future income. Progressively higher marginal tax rates reduce the return to their human capital investment by removing progressively larger chunks of their future income. There is good reason to believe that people’s career decisions are affected by changes in returns; that is, they go where the money is. For example, one study reports that in the 1980s there were large increases in the rela tive supplies of most of the types of workers whose rela tive w ages increased (B ound and Johnson 1992). Another study finds a large enrollment response to a change in the return to higher education (Blackburn, Bloom, and Freeman 1991). These and other studies suggest people respond to rewards as theory and com mon sense suggest. Thus lowering the returns to invest ment in human capital will lower the amount of time and effort people put into training and education. The argum ent that redistribution lowers growth depends on the existence of significant mobility across income classes, as is true in the United States. In the United States, progressive taxes are mainly just higher taxes on the same individuals as they move through their careers, causing them to invest less in their human capi tal. The argument need not hold for other countries which have little m obility across classes. For those countries, taking money from the few rich and giving it 10 The market is signaling higher returns to acquiring skills and education. When these signals are clearly received, individuals are encouraged to develop greater skills, such as computer training, and to acquire more schooling, such as a college degree. Higher progressive taxes mute those signals, however, and they decrease the incentives to invest in these types o f hum an capital. This reduction in investment will slow growth. to the many poor could allow the poor to invest more in their human capital, such as schooling, thus raising total human capital investment and growth. But, again, in the United States, where schooling is available to all and mobility is high, this possibility seems remote. That there is a conflict between fairness, or equity, and growth can be seen clearly in the current U.S. environ ment. By almost all accounts the income distribution has widened, and that in itself has brought calls for a greater use of redistributive taxes and transfers. However, this widening in the income distribution can be traced primari ly to changes in real, or technical, factors. Thus greater redistribution, which mutes the message of markets, limits individuals’ response of either investing in the skills or going to the jobs where the returns are highest. Most studies conclude that the major cause of the widening U.S. income distribution in the 1980s was a growing inequality in real earnings. Tax and other policy changes caused little of the widening. In fact, one study finds that m ost advanced in d u strialized countries showed increases, often large, in wage inequality during the 1980s (Davis 1992). Thus other industrial countries experienced similar income distribution changes as in the United States even though their policy courses were very different. The changes in real earnings, meanwhile, are general ly thought to be due to changes in technology (Bound and Johnson 1992). In the 1980s low-skilled jobs suf fered a decline in real wages, while high-skilled jobs experienced a rise in real wages. The changes in real wages reflect a higher return to education, training, and experience. The most likely explanation for the changes in returns is the use of advanced technology that substi tutes for the work of low-skilled workers and at the same tim e m akes h igh-skilled w orkers m ore productive (Bound and Johnson 1992). One study finds that workers who do use more advanced technology get paid higher wages (Dunne and Schmitz 1992). Another study finds that the evolving use of the computer can explain much of the measured technological advance (Krueger 1993). Since the changes in income distribution were largely technology-induced, the government’s effort to dampen the associated changes in the reward structure certainly will slow growth. The market is signaling higher returns to acquiring skills and education. When these signals are clearly received, individuals are encouraged to develop greater skills, such as computer training, and to acquire more schooling, such as a college degree. Higher pro gressive taxes mute those signals, however, and they decrease the incentives to invest in these types of human capital. This reduction in investment will slow growth. Social Security The social security system is the final example I use to illu stra te my point that scaling back governm ent interventions made in the name of fairness would pro mote growth. Social security serves a valuable function in society by assuring that all older individuals have a modest amount of income when they retire. But flaws in the way the system is designed and administered make it both inefficient and growth-stifling. Correcting these flaws is feasible, and the result would be gains in economic effi ciency and growth. The government’s social security program is financed differently than a private pension system. The program is financed pay-as-you-go: current workers are taxed, and the proceeds are distributed to current retirees. The federal government does not accumulate assets to meet its future obligations as a private pension system does. If it did, social security now would be recording a surplus as a trust fund, while the federal budget with the social security trust fund removed would be in rough balance on a present-value basis. However, current budget pro jections indicate that the federal budget deficit excluding social security will grow steadily from $242 billion in fiscal 1995 to $304 billion in fiscal 1999 (CBO 1994, p. 26). Presumably, this deficit will continue to grow into the next century. The implication is that instead of social security revenues net of expenditures being used to acquire assets, they are being used to finance other gov ernment expenditures. Thus future obligations under social security will have to be financed by taxes on future generations of workers. Because of the way social security is financed, its future appears much less rosy than its past. In the past the program steadily increased payments to retirees and paid retirees many times what they put into the plan. This expansion in benefits was financed by rising social secu income redistribution. It defines benefits for retirees, and rity tax revenues fed by increases in the percentage of the those benefits are only loosely tied to contributions. This workforce paying into the plan and in both the social has allowed the system to redistribute income from the security tax rate and tax base. However, in the future the newer generations to the older generations and among return to retirees looks much less favorable. Since the individuals in the same generations. program now applies to virtually all workers, no substan The social security system, then, can be thought of as tial increases in coverage are possible. Demographics are a mandatory, unfunded pension system and a complicat also turning less favorable. In the 1980s there were five ed tax/transfer system. Because of the fairness aspects of workers supporting each retiree. By 2050 that 5-to-l ratio the system, the governm ent has chosen to operate it. I will fall to 2-to-l. These facts suggest that in the future argue that the United States would be better off with pri- retirees will be getting less back from the plan than they put in (Goodman and Musgrave 1992, chap. 13). This unsettling future gives good reason to consider How Adverse Selection Affects Annuity Markets reforms of the system. Two reforms are readily suggest ed: first, back future obligations with funds of assets, and second, turn over the management of those funds to The adverse selection problem in annuity markets is easy the private sector. Because these reform s would make to see. Suppose an insurance company offers an annuity the system more market-oriented, they would likely lead which pays a fixed sum of money per month to individuals to greater efficiency and higher growth. at age 60 for as long as they live and which charges a pre Under this proposed privatization scheme, the gov mium based on the population's average life expectancy. ernment would still have a role in the social security sys Then individuals who have sound, and in part private, information which suggests that they will live longer than tem. That role is dictated on efficiency grounds. Due to average would have an incentive to buy the annuity. How adverse selection problems (which are explained in the ever, those who expect to live shorter than average would sidebar), unfettered private annuity markets are unlikely have an incentive not to buy the annuity. Thus those who to be able to provide adequate protection to workers. buy the annuity would have life expectancies longer than However, the governm ent can address these problems the population average, costing the insurance company without managing the system. more than it had planned and forcing it to raise its premi um. But then those with poorer health who were willing to Thus the social security example is a little different buy before would no longer want to buy at the higher pre from the previous two. The argument is not that unfettered mium. This adverse selection process could continue until annuity and pension markets are most efficient. In fact, it becomes unprofitable for the insurance company to some government intervention seems necessary for effi offer any annuity at all. This could occur even though the ciency. However, it is not necessary that the government public were better off with active annuity markets. (See, operate the system. The argument, then, is that changing for example, Eckstein, Eichenbaum, and Peled 1985.) The government can help attenuate the adverse selec the g o v ern m en t-o p erated system to a p riv ately run, tion problem. It need only issue two simple edicts: funded system will increase both efficiency and growth. ■ In s u ra n c e co m p an ies ca n n o t d is c rim in a te in The government, o f course, could have opted for a their premiums based on the perceived health of privately run social security system at the outset, but the applicants. instead it chose to operate the system itself. Since it ■ All individuals must buy some m inimal amount could have addressed the adverse selection problem s of annuities. w ithout m anaging the system, it m ust have had other Edicts of this type are common in other types of insur reasons for doing so. It appears that the other reasons are ance. For instance, they are included in the administra based on fairness— fairness dictated a government-run, tion's health care plan to address the sim ilar adverse pay-as-you-go system. The social security system aims for fairness through selection problems in health insurance markets. 13 vate operation of a funded pension system subject to government edicts addressing adverse selection and with an explicit tax/transfer policy targeting income to the older poor. The government-run system is less efficient than the one I am advocating. Under the government-run system, workers view their social security contributions as a tax. In fact, this is a major reason why the CBO (1991, pp. 71-75) argues that social security payments and contri butions should be consolidated with ordinary government expenditures and taxes. Workers view their contributions as taxes because their future benefits are not closely tied to those contributions. Their future benefits are promised, but the government at times changes them. In fact, those benefits depend not only on economic and demographic developments that affect future real income and the size of the future workforce, but also on the willingness of future workers to continue to participate in the plan. In contrast, workers contributing to a private plan would own their pension/annuity and thus be less prone to view it as a tax. Benefits would depend on the amount they contribute and on the return to their investment. Their payoff would be uncertain only because the rate of return to their investm ent would be uncertain. There would be no uncertainty with respect to the willingness of future generations to participate. Society might still want to redistribute income on fairness grounds even with a privately run system. But then the government would have to make explicit the taxes and transfers for carrying out the redistribution. Making the redistribution explicit would likely make it less pervasive and better targeted. The privately run system is likely to lead to greater economic efficiency than a government-run system for two reasons. First, privately run funds would have to compete among themselves and would likely be more efficient than a monopolistic, government-run fund. Sec ond, the redistribution scheme used with a privately run system would likely be more limited, which would lead to smaller disincentives to work and save. Probably more important, though, a privately run sys tem would lead to higher growth. That is because the rate of return to investment in a privately funded system would be greater than the rate of return to contributions in a pay-as-you-go system. In a paper written well after Friedman’s Capitalism and Freedom, economist Martin Feldstein (1987) examines the economic consequences of shifting dollars from an unfunded to a funded system. He finds that an extra dollar placed in a funded system would yield to retirees the pretax rate of return on pri vate capital, which might be expected to lie in the 10-15 percent per year range, as it has in the last 40 years. However, an extra dollar contributed to the unfunded social security system would yield a rate of return equal to the rate of growth of the economy, which most ana lysts now expect to be around 3 percent per year. This suggests that growth would be increased if resources were shifted from the low-yielding social security sys tem to a higher-yielding privately funded system. Although shifting to a privately funded system would increase growth, it would not make every generation better off. The shift requires that society as a whole save more by paying less to current retirees. Thus the current old generation would be made worse off. Feldstein shows that under reasonable assumptions and using stan dard ways of weighting the welfare of different genera tio n s, the gains to the cu rren t young and fu tu re generations would greatly exceed the losses to the cur rent old generation. Nevertheless, current retirees would be hurt by the shift. This suggests that if dollars are shifted out of social security, the shift should be made gradually, and the dollars should be taken from those most able to fend for themselves—the people with high incomes and wealth. This proposal to shift to a privately run social securi ty plan will strike many as unrealistic, if not ridiculous. However, it should be noted that such a shift is being made in other countries. Chile gave workers the option to put their money either in the state-run system or in private funds. Most workers have been choosing the pri vate funds, so the state-run system is gradually being phased out. Moreover, the Chilean plan has proved so successful that other Latin American countries either have adopted similar programs (Mexico and Peru) or are in the process of doing so (Argentina, Bolivia, and Venezuela) (Survey 1993). Growth would increase i f resources were shifted from the low-yielding social security system to a higher-yielding privately fu n d ed system. 15 The task confronting society is to develop systems that target benefits to the poor while interfering as little as possible with the private markets’ ability to foster efficiency and growth. 16 Public Attitudes Must Change My argument that the costs of government interventions made in the name of fairness are costlier than commonly thought does not suggest that they should be eliminat ed. Rather, it suggests that they should be scaled back. Economically, restraining or scaling back government redistributions seems straightforward and easy to do. Politically, it seems difficult. That is why public attitudes toward government redistributions must change first. Economically, all that is required is that programs to redistribute resources be better targeted. The economic rationale for these programs is to provide resources to the poor and needy. No economic rationale exists for providing resources to individuals in the middle- and upper-income classes. Yet that’s where most of the money goes. A study of how federal benefits are distributed across income classes finds that the benefits scarcely redistribute income at all (Howe 1991). In fact, over 40 percent of the 1991 benefits went to households earning over the average (median) cash income, which was three to four times the poverty threshold for a family of two. By making transfers to those who are not needy, the amount of redistribution is much larger than it has to be for fairness. This excess unnecessarily raises the costs to the economy in terms of inefficiency and slow growth. Economically, interventions made in the name of fairness can then be easily restrained by making all benefits means-tested, that is, making sure the benefits go only to people whose wealth and income are below some threshold levels. Politically, this remedy may be hard to apply. The benefits of government redis tributions tend to be spread widely because that is what the public wants. In order to get public support for such programs, politicians find it necessary to distribute their benefits far beyond just the truly needy. Many people have the attitude that if they pay for a program, they deserve some of the proceeds. As long as the public feels this way, there will be little support for reining in government programs and interventions. The public, however, has it dead wrong. If the government is to intervene based on fairness, its role is to redistribute resources from the middle- and upper-income classes 17 to the poor. Period. People in the middle and upper classes would be much better off if the amount of taxes used for their own benefits was eliminated and they used the increase in their after-tax incomes to arrange privately for their benefits. In this way fairness could still be served, but the government’s role and the resulting inefficiencies could be diminished. Milton Friedman was right to stress the advantages of unfettered markets. Yet his critics also were right to point out that some individuals in society cannot attain an accept able level of existence without help. The task confronting society is to develop systems that help the poor while interfering as little as possible with the private markets’ ability to foster efficiency and growth. That means targeting redistributions carefully. It means the public must become aware of the high cost of extending benefits to those who do not truly need them. It also means that failure to change could cause society to pay an increasingly high cost as time goes by. 18 References Blackburn, McKinley L.; Bloom, David E.; and Freeman, Richard B. 1991. Changes in earnings differentials in the 1980s: Concor dance, convergence, causes, and consequences. Working Paper 61. Jerome Levy Economics Institute of Bard College. Bound, John, and Johnson, George. 1992. Changes in the structure of wages in the 1980’s: An evaluation of alternative explanations. American Economic Review 82 (June): 371-92. Coe, David T., and Moghadam, Reza. 1993. Capital and trade as engines of growth in France: An application of Johansen’s coin tegration methodology. International M onetary Fund Staff Papers 40 (September): 542-66. Congressional Budget Office (CBO). 1991. The economic and budget outlook: Fiscal years 1992-1996. 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Uncertain lifetimes and the welfare enhancing properties of annuity mar kets and social security. Journal o f Public Economics 26 (April): 303-26. Edwards, Sebastian. 1993. Openness, trade liberalization, and growth in developing countries. Journal o f Economic Literature 31 (Sep tember): 1358-93. Feldstein, Martin S. 1987. The welfare cost of social security’s impact on private saving. In Modem developments in public finance: Essays in honor of Arnold Harberger, ed. Michael J. Boskin, pp. 1-13. New York: Basil Blackwell. Friedman, Milton. 1962. Capitalism and freedom. Chicago: University of Chicago Press. Goodman, John C., and Musgrave, Gerald L. 1992. Patient power: Solving America’s health care crisis. Washington, D.C.: CATO Institute. Gould, David M.; Ruffin, Roy J.; and Woodbridge, Graeme L. 1993. The theory and practice of free trade. Federal Reserve Bank o f Dallas Economic Review (Fourth Quarter): 1-16. Holmes, Thomas J., and Schmitz, James A., Jr. 1994. Free trade and resistance to change: Increasing the number of battlefronts to win the war. Manuscript. Federal Reserve Bank of Minneapolis. Howe, Neil. 1991. How to control the cost of federal benefits: The argument for comprehensive “means-testing.” Policy Paper 3. National Taxpayers Union Foundation. Knight, Malcolm; Loayza, Norman; and Villanueva, Delano. 1993. Testing the neoclassical theory of economic growth: A panel data approach. International Monetary Fund Staff Papers 40 (Sep tember): 512^11. Krueger, Alan B. 1993. How computers have changed the wage struc ture: Evidence from microdata, 1984-1989. Quarterly Journal o f Economics 108 (February): 33-60. Lucas, Robert E., Jr. 1988. On the mechanics of economic develop ment. Journal of Monetary Economics 22 (July): 3-42. ____________. 1993. Making a miracle. Econometrica 61 (March): 251-72. McKenzie, Richard B. 1992. The “fortunate fifth” fallacy. Policy Study III. Center for the Study of American Business. Okun, Arthur M. 1975. Equality and efficiency: The big tradeoff. Washington, D.C.: Brookings Institution. Papageorgiou, Demetris; Michaely, Michael; and Choksi, Armeane M., eds. 1991. Liberalizing foreign trade. Vol. 7, Lessons o f experience in the developing world. Cambridge, Mass.: Basil Blackwell. Perot, Ross, and Choate, Pat. 1993. Save your job, save our country: Why NAFTA must be stopped—now! New York: Hyperion. Sawhill, Isabel V., and Condon, Mark. 1992. Is U.S. income inequality really growing? Sorting out the fairness question. Policy Bites (Washington, D.C.), no. 13 (June): 1-4. Schmitz, James A., Jr. 1993. Early progress on the “problem of eco nomic development.” Federal Reserve Bank o f M inneapolis Quarterly Review 17 (Spring): 17-35. Searle, Allan D. 1945. Productivity changes in selected wartime ship building programs. M onthly Labor Review 61 (December): 1132— 47. Slemrod, Joel. 1992. Did the tax reform act of 1986 simplify tax mat ters? Journal of Economic Perspectives 6 (Winter): 45-57. 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NBER Macro economics Annual, 1992: 13-54. 19 Federal Reserve Bank of Minneapolis Statement of Condition Earnings and Expenses Directors Officers Federal Reserve Bank of Minneapolis Statement of Condition (in thousands) December 31, 1993 December 31, 1992 Assets Gold Certificate Account Special Drawing Rights Coin Loans to Depository Institutions Securities: Federal Agency Obligations U.S. Government Securities Cash Items in Process of Collection Bank Premises and Equipment Less Depreciation of $42,172 and $39,475 Foreign Currencies Other Assets Interdistrict Settlement Fund $ 243,000 186,000 15,365 4,300 $ 195,000 186,000 15,746 1,400 106,173 7,599,809 84,354 4,597,670 465,435 414,847 43,626 585,294 172,676 (1,003,850) 42,374 565,807 110,165 2,554,661 $8,417,828 $8,768,024 $7,048,384 $7,458,324 676,876 3,642 5,327 721,109 3,656 5,374 Total Deposits 685,845 730,139 Deferred Credit Items Other Liabilities 435,376 66,535 390,367 29,256 8,236,140 8,608,086 90,844 90,844 79.969 79.969 181,688 159,938 $8,417,828 $8,768,024 Total Assets Liabilities Federal Reserve Notes1 Deposits: Depository Institutions Foreign, Official Accounts Other Deposits Total Liabilities Capital Accounts Capital Paid In Surplus Total Capital Accounts Total Liabilities and Capital Accounts 1 Amount is net o f notes held by the Bank o f $1,171 million in 1993 and $733 m illion in 1992 Earnings and Expenses (in thousands) For the Year Ended December 31, 1993 1992 $347,125 32,740 1,749 41,659 129 $255,108 56,066 1,301 40,733 449 423,402 353,657 43,306 10,513 2,728 5,814 500 2,143 2,431 37,950 8,560 2,266 5,738 458 2,074 2,161 866 1,149 1,046 1,440 923 1,244 939 1,167 970 5,130 3,029 3,945 (870) 2,048 687 5,108 2,673 4,131 429 1,752 Current Earnings Interest on U.S. Government Securities and Federal Agency Obligations Interest on Foreign Currency Investments Interest on Loans to Depository Institutions Revenue from Priced Services All Other Earnings Total Current Earnings Current Expenses Salaries and Other Personnel Expenses Retirement and Other Benefits Travel Postage and Shipping Communications Software Materials and Supplies Building Expenses: Real Estate Taxes Depreciation—Bank Premises Utilities Rent and Other Building Expenses Furniture and Operating Equipment: Rentals Depreciation and Miscellaneous Purchases Repairs and Maintenance Cost of Earnings Credits Net Costs (Distributed)/Received from Other FR Banks Other Operating Expenses Total Current Expenses 86,188 (6,893) 3,431 6,643 4,682 228,762 $ 10,875 $ 10,143 $ 79,969 10,875 $ 69,826 10,143 $ 90,844 Transferred to surplus (26,635) 3,739 8,021 5,321 303,003 Net (Deductions) or Additions2 Less: Assessment by Board of Governors: Board Expenditures Federal Reserve Currency Costs Dividends Paid Payments to U.S. Treasury 280,296 (13,148) Current Net Earnings 73,361 344,107 Net Expenses (4,899) 79,295 Reimbursed Expenses' 78,260 $ 79,969 Surplus Account Surplus, January 1 Transferred to Surplus—as above Surplus, December 31 1 Reimbursements due from the U.S. Treasury and other Federal agencies; $1,890 was unreimbursed in 1993 and $1,958 in 1992. 2 This item consists mainly o f unrealized net gains or (losses) related to revaluation o f assets denominated in foreign currencies to market rates. 23 Directors Federal Reserve Bank of Minneapolis Delbert W. Johnson Chairman and Federal Reserve Agent Helena Branch Gerald A. Rauenhorst Deputy Chairman James E. Jenks Chairman Class A Elected by Member Banks Lane W. Basso Vice Chairman Susanne V. Boxer President Houghton National Bank Houghton, Michigan Appointed by the Board of Governors Lane W. Basso President Deaconess Medical Center Billings, Montana Charles L. Seaman President and Chief Executive Officer First State Bank of Warner Warner, South Dakota James E. Jenks President Jenks Farms Hogeland, Montana William W. Strausburg Chairman and Chief"Executive Officer First Bank Montana, N.A. Billings, Montana Class B Elected by Member Banks Appointed by the Board of Directors Federal Reserve Bank of Minneapolis Duane E. Dingmann President Trubilt Auto Body, Inc. Eau Claire, Wisconsin Beverly D. Harris President Empire Federal Savings and Loan Association Livingston, Montana Dennis W. Johnson President and Chief Executive Officer TMI Systems Design Corp. Dickinson, North Dakota Donald E. Olsson, Jr. Executive Vice President Ronan State Bank Ronan, Montana Earl R. St. John, Jr. President St. John Forest Products, Inc. Spalding, Michigan Nancy McLeod Stephenson Executive Director Neighborhood Housing Services Great Falls, Montana Class C Appointed by the Board of Governors Delbert W. Johnson President and Chief Executive Officer Pioneer Metal Finishing Minneapolis, Minnesota Jean D. Kinsey Professor of Consumption and Consumer Economics University of Minnesota St. Paul, Minnesota Gerald A. Rauenhorst Chairman and Chief Executive Officer Opus Corporation Minneapolis, Minnesota Federal Advisory Council Member John F. Grundhofer Chairman, President and Chief Executive Officer First Bank System, Inc. Minneapolis, Minnesota December 31, 1993 24 Officers Federal Reserve Bank of Minneapolis Gary H. Stem President Colleen K. Strand First Vice President and Electronic Payments Product Director John H. Boyd Senior Research Officer S. Rao Aiyagari Research Officer Kent C. Austinson Supervision Officer Scott H. Dake Vice President Robert C. Brandt Assistant Vice President Marvin L. Knoff Supervision Officer Sheldon L. Azine Senior Vice President Kathleen J. Erickson Vice President Marilyn L. Brown Assistant General Auditor Robert E. Teetshom Supervision Officer Ronald E. Kaatz Senior Vice President Creighton R. Fricek Vice President James T. Deusterhoff Assistant Vice President James M. Lyon Senior Vice President Karen L. Grandstrand Vice President Debra A. Ganske Assistant Vice President Arthur J. Rolnick Senior Vice President and Director of Research Caryl W. Hayward Vice President and Electronic Payments Product Manager Jean C. Garrick Assistant Vice President Melvin L. Burstein Executive Vice President, Senior Advisor and General Counsel Theodore E. Umhoefer, Jr. Senior Vice President Peter J. Gavin Assistant Vice President William B. Holm Vice President Linda M. Gilligan Assistant Vice President Ronald O. Hostad Vice President Jo Anne F. Lewellen Assistant Vice President Bruce H. Johnson Vice President Susan J. Mendesh-Fitzgerald Assistant Vice President and Assistant Electronic Payments Product Manager Thomas E. Kleinschmit Vice President Richard L. Kuxhausen Vice President H. Fay Peters Assistant Vice President and Assistant General Counsel David Levy Vice President and Director of Public Affairs and Corporate Secretary Richard W. Puttin Assistant Vice President Paul D. Rimmereid Assistant Vice President Susan J. Manchester Vice President David E. Runkle Research Officer Preston J. Miller Vice President and Monetary Advisor Claudia S. Swendseid Assistant Vice President Susan K. Rossbach Vice President and Deputy General Counsel Kenneth C. Theisen Assistant Vice President Charles L. Shromoff General Auditor Richard M. Todd Assistant Vice President Thomas M. Supel Vice President Thomas H. Turner Assistant Vice President Warren E. Weber Senior Research Officer Mildred F. Williams Assistant Vice President December 31, 1993 25 Helena Branch John D. Johnson Vice President and Branch Manager Samuel H. Gane Assistant Vice President and Assistant Branch Manager Public Affairs Federal Reserve Bank of Minneapolis 250 Marquette Avenue Minneapolis, MN 55401-2171 Designer: Philip E. Swenson Associate Designer: Beth Leigh Grorud Illustrator: Brian Cronin Photographer: Peter Tenzer Essay Editors: Kathleen A. Mack Kathleen S. Rolfe Martha L. Starr