Privatization in Action: Reform in Chile

In a meeting with Social Security trustees, President Bush declared that an increase in payroll taxes is off the table as a funding source for Social Security reform. That's too bad, because it would seem to effectively kill Senator Lindsey Graham's plan, which I thought had a lot of merit. So where does that leave us? Seemingly with two choices: raise the retirement age or pay the transition costs through debt. Forget how to pay for it, though, are Private Savings Accounts even the way to go?

For an answer, let's turn to the real world. Pejman Yousefzadeh at Pejmanesque links to this New York Times article by Jose Pinera, Chile's former Secretary of Labor and Social Security. In 1980, Chile did just what we are contemplating: they reformed their system by allow workers to opt out of the government's pension system and contribute to personal retirement accounts. (Actually, this goes far beyond the 2-4 percent payroll tax diversion we are talking about). 10% of a worker's pre-tax wages are deposited in a personal account monthly, and the worker may optionally contribute up to 10% more. The account is tax-free until withdrawal upon retirement.

Much more detail is needed to understand Chile's system in its entirety, so I refer you to the article. However, here are some of the benefits this plan provides the workers of Chile:

• Portability (the account is tied to the worker, not the company or job)
• Flexibility (the worker has several withdrawal options at retirement)
• Preservation of the safety net (if a worker has contributed for 20 years yet his fund is unable to provide a defined 'minimum pension', the government covers the gap)
• Choice (only brand new workers were required to use the private accounts - those already in the workforce were given the option to remain in the government plan)

How did the government confront what Pinera calls a cash flow issue rather than transition costs? And how did the workers make out? Pinera answers:

We used five "sources" to generate that cash flow: a) one-time long-term government bonds at market rates of interest so the cost was shared with future generations; b) a temporary residual payroll tax; c) privatization of state-owned companies, which increased efficiency, prevented corruption and spread ownership; d) a budget surplus deliberately created before the reform (for many years afterward, we were able to use the need to "finance the transition" as a powerful argument to contain increases in government spending); e) increased tax revenues that resulted from the higher economic growth fueled by the personal retirement account system.

Since the system started on May 1, 1981, the average real return on the personal accounts has been 10 percent a year. The pension funds have now accumulated resources equivalent to 70 percent of gross domestic product, a pool of savings that has helped finance economic growth and spurred the development of liquid long-term domestic capital market. By increasing savings and improving the functioning of both the capital and labor markets, the reform contributed to the doubling of the growth rate of the economy from 1985 to 1997 (from the historic 3 percent to 7.2 percent a year) until the slowdown caused by the government's erroneous response to the Asian crisis.

Of course, you can hear the chorus of naysayers: America is not Chile, for example, and that is true enough...but our plan is much more cautious than this (is that a good thing? Stay tuned...). Regardless of the sizes of the relevant economies, though, the idea here is to give workers an opportunity to realize some real capital appreciation in their retirement plans, and thus a greater stake in the economy, and at the same time, begin the first steps of fixing a system that is irretrievably broken (and whose socialistic origins are not indicative of our nation's values). One of the great democratizing forces in recent American history has been the increase in investors due to low minimum investments in mutual funds and online brokerages...how much more so that would be under Chile's plan! (hat tip to bebere)