The Heritage Foundation

Executive Summary #1864 on Social Security

June 23, 2005

June 23, 2005 | Executive Summary on Social Security

Executive Summary: Social Security Reform Is Crucial for Small-Business Entrepreneurs

With a national discussion underway about reforming Social Security, it is timely to consider the impact of possible changes on the nation's small busi­nesses and entrepreneurs. Well-crafted reforms could aid this vital sector, but a survey of economic research shows that quick fixes like payroll tax hikes could be extremely damaging-not only to entrepreneurship, but also to the economy's ability to generate the jobs and growth needed to sustain Social Security.

Principles for Reform. Taken together, the studies reviewed here suggest five important prin­ciples for retirement policy and Social Security reform:

  1. Efforts to expand pension coverage are unlikely to succeed unless the coverage is significantly tax-advantaged and easily administered, employer contributions are minimized, and the overall economic climate is positive.
  2. Simply providing new opportunities to save will not solve the retirement income dilemma. Indi­viduals already have many attractive ways to save for retirement. These opportunities are underutilized by many middle-income and lower-income citizens, who say that they do not have enough money left to save for retirement after they pay for their basic needs.
  3. Social Security benefits are likely to be a more important source of retirement income for entrepreneurs and those who work in smaller companies than for other Americans.
  4. Some way must be found to sustain and, if pos­sible, increase retirement benefits-one that does not increase payroll taxes and does not assume that voluntary contributions will be made to a savings plan simply because that plan exists.
  5. Raising taxes on entrepreneurs is not the way out of the dilemma. If Congress tries to "solve" Social Security's financial problems by raising marginal tax rates, there will be fewer entrepre­neurs. If there are fewer entrepreneurs, there will be fewer new jobs created and slower eco­nomic growth. With fewer jobs and slower growth, Social Security's problems will become far worse.

The Best Reform Option for Entrepreneurs. Of all the Social Security reform proposals cur­rently being discussed, the one that best fits all of these criteria is diverting a portion of existing pay­roll taxes into personal accounts that workers would own and control themselves. There are sev­eral key reasons for this.

  • Personal accounts that are developed from exist­ing payroll taxes would likely increase Social Security benefits while avoiding payroll tax increases. This meets two of the entrepreneur's needs simultaneously. It could decisively improve the rate of return that entrepreneurs would achieve for their own retirements, and it could help to avoid marginal tax increases that would create an unfavorable economic climate for entrepreneurial activities. Both factors would create strong incentives for entrepreneurship.
  • The personal account option would not require the entrepreneur, as an employer, to increase the contribution level for employee pensions or savings funds. Yet personal accounts would likely offer those employees a better rate of return than they could expect from the existing Social Security system. This would make work­ing for an entrepreneurial business-even one without a pension plan-a more attractive option for potential employees.
  • The personal account option directly addresses the two key structural flaws in the current sys­tem: the demographic squeeze of fewer work­ers supporting more retirees for longer periods of time and the huge unfunded liability. Payroll tax increases would not fundamentally address either structural problem. Under a personal account system, benefits would rise as the value of investments rose. The benefits would not depend on the forbearance of workers under ever-heavier tax burdens or on some unlikely spurt of population growth. Moving toward pre-funding Social Security and paying down unfunded liabilities are important steps in reducing the downstream pressure for higher taxes.
  • Since personal accounts would create assets that could be passed on to heirs, the number of individuals receiving inheritances would rise. This would aid the retirement income pros­pects of the next generation. Research has also shown that individuals receiving inheritances are far more likely to engage in entrepreneurial activities than is the population as a whole. Thus, personal accounts, in and of themselves, would indirectly increase entrepreneurship.
  • Because entrepreneurs focus on economic risks, they are likely to make informed choices about whether or not to choose personal accounts and to convey their thinking to their employees. This kind of constructive scrutiny will be good for the system. However, entrepre­neurs will also understand, and be accepting of the fact, that some people may choose the "known" of the traditional Social Security sys­tem over the relative "unknowns" of personal accounts.
  • A personal account system would help to cur­tail the current practice of having the Treasury Department cover its borrowing from the Social Security system by issuing non-publicly traded government securities (IOUs) to that system. In contrast to this practice, personal account funds would be invested in private and public equities markets, where money is substantially more transparent and fungible. Over time, therefore, personal accounts would likely increase the capital available for entrepreneur­ial ventures.

Conclusion. Personal accounts offer two funda­mental advantages for small business: actions that the government would not have to take (unnecessar­ily raising taxes or cutting Social Security benefits) and results that the private sector would generate (enhanced entrepreneurship, strengthened capital markets, and improved retirement incomes). In the end, empowering entrepreneurs in this way would benefit the entire nation as additional jobs were created and economic growth was sustained.

James Morrison, Ph.D., has specialized in small business and entrepreneurship policy for over 20 years. He is a trade association executive in Washington, D.C.

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