Frankly About Social Security

Despite the fact that the ceiling on social security contributions was removed and the rate was increased by three percentage points as of January 1, 2000, the social insurance fund (in Lithuania called Sodra) is still in shambles. The problems that plague the system fall heaviest on pensioners, whose pensions are pathetically small and constantly delayed, and on employees, whose payments into the system are continuously increasing. The only way by which Sodra can balance its money flows is to borrow and cover the deficit with bank loans. In February 2000, Sodra’s expenditures exceeded revenues by 79 million litas.
It is highly unlikely that the near future will bring any changes for the better. This is because the economic policy that the government of Lithuania has pursued so far has only worsened the business environment and added to the rise of unemployment. Bearing in mind that social security contributions are paid from labour-related income, no work means no income and thus no payments to social security.
Sodra’s deficit and its constant problems were inevitable from the outset. They came as no surprise to those who understand the principle on which the system is based. State social insurance is an ineffectual system that has a nice start but a very sad end. Contrary to popular belief, a state insurance pension is neither earned nor saved, as is the case with pension funds; nor is it bought, as is the case with genuine insurance. Though unfortunate, this is a fact. A public pension is a government’s obligation to the current retirees that is fulfilled at the expense of all working individuals.
Phasing out the pay-as-you-go scheme is the only way to solve these problems. This is an uphill task, as the p-a-y-g system is “unique” in that the only people who benefit are those who were of retirement age at the time when the system was introduced.
Let us image that there is no state social insurance and people themselves have to take care of their retirement income. When the state introduces a social insurance tax, retirees receive additional, guaranteed income out of a blue sky.
The opposite happens when the social insurance system is dismantled. Individuals who have paid social insurance contributions lose their right to receive a public pension when they retire. A public social insurance system is a perfect illustration of how reckless decisions of bureaucrats allow the manipulation of people’s lives by unexpectedly benefiting some people and unfairly impoverishing others.
There is no other option but to dismantle the public pension system. The state social insurance is in its death throes in countries throughout the world. Today we must figure out how to ameliorate the situation in a way that would have the least negative effect on society. First of all, as long as Sodra exists, it is necessary to make its work as effective as possible. Five years ago, the Lithuanian Free Market Institute proposed to unify the mechanisms for collecting social security contributions and income taxes. This project got off the ground only recently. It was a necessary step, given that social security contributions are paid from the same income that is subject to income tax.
Tax inspectors who administer the income tax could just as easily manage social security contributions. At present, however, we have an ineffective system that duplicates the administration of similar taxes throughout the whole country. Think of the cost of installing multiple computer systems that perform the same tasks, or doubling the demand for premises and employees, or the burden that is placed on enterprises by forcing them to deal with several institutions for tax reasons. The administration of social security contributions should have been delegated to tax authorities a long time ago. If this had been done, the losses would have been much smaller. Today, restructuring of the system will only yield results if it is more than merely changing Sodra’s name.
Restructuring the administration of social security contributions is crucial, but it is not sufficient in itself. The pay-as-you-go scheme should gradually be replaced with voluntary, private insurance. Every individual should realise that old age is not an accidental occurrence and that it is inevitable. The state’s duty is to create conditions in which every individual is able to save for his retirement.
However, in order for people to be able to save money, they must have sources to save from. It is unlikely that people will have enough money to save for their retirement as long as state social insurance exists and as long as they have to surrender 34 percent of their income in social security contributions, 33 percent in income tax, plus a 18 percent VAT and a whole range of other taxes. More than that, many people are jobless, so they hardly have any income at all to live on, much less to save for their retirement. In order for an individual to be able to take care of himself, he should be relieved of the duty to take care of others. Easing the tax burden ensures that a larger share of an individual’s income will remain in his hands. Lower taxes will also create more jobs or allow people to start their own businesses.
As always, the question is what will be done with the current retirees. Additional funds are needed in order to end the state social insurance system in a way that will not harm existing or would-be pensioners. Obviously, the tax burden cannot be increased, as this would impoverish the rest of society and reduce their ability to take care of their own retirement. Regrettably, an official task force that has developed a conceptual framework for pension reform has also proposed to increase income and other taxes. Income received from privatisation of state assets could be used to offset the shortfall of funds that would result from a reduction of social security contributions for working individuals. It is therefore critical that proceeds from privatisation are not squandered on dubious economic welfare programmes. These funds should instead be used to bring about an effective reform of the pension system.
It has not yet been decided how the state social insurance system will be restructured. The reform proposal that is now being debated entails some unnecessary steps to the side, rather than ahead. These are the introduction of a national, or first-pillar, pension. The government is contemplating the introduction of mandatory and voluntary fully-funded pension insurance, which is a much needed solution. However, it seems that the government’s efforts will focus on the first pillar, or a partial modification of the Sodra pension, which essentially is not a reform at all.
The best plan would be to create a pension system based on mandatory and voluntary fully-funded private pension insurance. Every individual would have to put aside a share of his income for retirement. This income would be invested and paid back when an individual reaches a retirement age. The pension would be saved and would continue to grow for the future benefit of the pension holder, rather than be paid out at the expense of others. Those who would be unable, for various reasons, to participate in mandatory insurance, or whose benefits would be too low, would be entitled to social support.
The current public pension system should be redesigned gradually, while simultaneously expanding fully-funded private pension funds. To that end, people should be divided into categories according to their date of birth. Then the level of involvement in the old and new systems should be defined for each category. Those who are closer to the retirement age should remain in the current system. The younger the individual, the larger the share he will save and the smaller the share he will contribute for current pensioners.
Some say that pension reform will be possible only in some two years. But the problems of the current pension system continue to remind us that pension reform must be implemented without further ado.