I may have been too hard on Congressman Martin’s Sabo suggestion to increase the interest rate on Treasury bonds in the Social Security trust fund in this post. I realized this as I re-read the brilliant critique of the recommendations of the Bush Social Security commission from Peter Diamond and Peter Orszag. Page 26 of their Reducing Benefits and Subsidizing Individual Accounts: An Analysis of the Plans Proposed by the President’s Commission to Strengthen Social Security has a box entitled Subsidizing the Individual Accounts Through a Low Interest Rate on the Liability Accounts:
By charging an interest rate on the liability accounts that is lower than the rate the Trust Fund earns on its balances, Models 2 and 3 impose costs on the Social Security system and subsidize the individual accounts. To see this, imagine $100 that is diverted from the Trust Fund into an individual account under Model 2. The $100 diverted into the individual account would trigger an entry of $100 in the worker’s liability account. Model 2 charges an interest rate on the liability accounts of 2 percent per year (after inflation). If the worker were 40 years away from retirement, the interest charges would cause the $100 entry to grow to $221 (in constant dollars) by the end of the worker’s career. If the $100 had been retained by the Trust Fund, however, it would have grown to $326 by the time the worker retired. The difference between the amount in the liability account ($221) and the amount that would have accrued in the Trust Fund ($326) represents a subsidy to the individual account and a loss to the Trust Fund. Such a subsidy arises whenever the interest rate on the liability account is below the interest rate the Trust Fund earns on its reserves.
What’s going on with these two very different proposals? The Federal government can be thought of as two divisions: the Social Security Trust Fund and the General Fund (OK, the latter has many subdivisions). If the government is thought of as some multinational enterprise with multiple divisions, then the intercompany interest rate could diverge from the arm’s length rate as defined by section 1.482-2(a) of the U.S. Treasury regulations.
Multinationals could potentially set non-arm’s length interest rates. At times, they think appealing to the “safe harbor” of the Applicable Federal Rate (AFR) curtails the IRS from challenging non-arm’s length rates. One should note, however, that the AFR is set to track market rates.
In a similar fashion, President Bush’s commission advocated having below market rates paid to the Trust Fund, which would clearly worsen any alleged shortfall. Why would the White House want to do so? Because they have no will to address the General Fund deficit besides raiding our retirement benefits.
Sabo on the other hand wants an above market rate paid to the Trust Fund. On Feb. 23, William Polley sensibly noted:
Anyway, back to Rep. Sabo’s plan. His plan would simply shift the financing from the pay-as-you-go Social Security system to the general fund… until (at least) 2080. He’s talking about doing exactly what I would try to avoid… for 40 years. This is more than just a counterpoint to the “raiding the trust fund” argument. This would institutionalize a long run imbalance in the pay-as-you-go Social Security system–a long period of deficit without a corresponding surplus. In my rank ordering of approaches to the Social Security issue, this ranks right below doing nothing.
Simply put – the General Fund has a very serious long-term shortfall even if it is not asked to bail out the more modest Social Security Trust Fund. Bottom line – we could set non-arm’s interest rates between these two divisions, but I’m not sure if either Bush’s version or Sabo’s version would be a wise policy change.