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A Family-Friendly Fiscal Policy
to Weather “Demographic Winter”
 

 

 

John D. Mueller [1]  

  BIO

Remarks to The World Congress of Families IV Warsaw, Poland, 11 May 2007

I’m honored to be here in Warsaw, among so many old and new friends, to discuss family-friendly fiscal policy. I’ll try briefly to do three things: first, sketch the economics of the family; second, use it to consider why the birth rate is below the replacement rate in most of developed Europe and Asia while hovering near that rate in the United States; and finally, outline two basic fiscal principles necessary for any country (including the United States) to avoid or survive what this Congress has aptly called “demographic winter.”

People and property. I begin by calling to your attention two highly significant features of family economics. The first was pointed out by Aristotle:[2] Household wealth is of two kinds, people and property—or as Theodore W. Schultz dubbed them around 1960, "human and nonhuman capital."[3] Both are “reproducible”; may be tangible or intangible; require maintenance; and depreciate. Just as property compensation is the return on investment in property, labor compensation is the return on investment in people.

Yet there is an important difference: the rate of return on property is the same for everyone in a competitive market, but the rate of return on investment in people varies with the age of the person. For example, at age 20 the average real rate of return in the U.S. on college tuition was estimated at about 16 percent recently,[4] compared with the U.S. stock market’s long-term average of 6 to 7 percent. But after about age 40, that rate fell below the rate in the stock market, and after age 50, the return on further education turned increasingly negative. This first fact accounts for the pattern of lifetime earnings in the following chart, which is generally true of developed countries today:

Lifetime Income and Consumption

Early in life, income is mostly labor compensation, which starts at zero while we spend time learning valuable skills; rises rapidly between childhood and the mid-30s as we enter and gain experience in the labor market; rises more slowly to peak at around age 50; then drops finally to zero in retirement. Property income starts close to zero early in life (for those with little or no inherited property), but becomes increasingly significant as the expected rate of return on investment in human capital falls below the rate on investment in property. And for those who acquire significant wealth from any source—whether inheritance, talent, luck, or hard work—the only practical way to save it is in the form of claims on property (stocks, bonds, etc.).

The central role of intra-family gifts. This leads us to the other essential feature of family economics. Family members acquire their incomes mostly by exchange with those outside the family, but within the family transactions are mostly gifts. We all need to be fed, clothed, sheltered, and transported, whether or not we earn income. Our income therefore typically exceeds our consumption during parenthood and the "empty nest" (i.e. after children have left home), while consumption exceeds income during childhood and old age. This involves extensive gifts, not only from parents to dependent children  but also between husbands and wives and from adult children to aged parents.

The retirement gap. Even with modern private capital markets, an inherent "retirement gap" arises from the fact that for anyone to retire, labor compensation must fall to zero, yet consumption is ordinarily higher than the property income resulting from earlier saving of stocks and bonds. The retirement problem is how to fill this gap without forgoing retirement, suffering a sharp fall in consumption during retirement, or lowering one’s total lifetime earnings and consumption (which would result if early in life one invested more in lower-yielding property and less in higher-yielding human capital).

Positive and negative impact of government retirement pensions. Without government social benefits, the retirement gap could be bridged only by a gift from someone (most often one’s adult children) whose own consumption is thereby reduced. Pay-as-you-go Social Security went a long way toward solving the retirement problem by providing an asset that private financial markets cannot. Starting a well-designed pay-as-you-go system typically boosts the birth rate: for example, the American Baby. However, after such benefits have closed the retirement gap, further expansion comes at the expense of smaller investment in either children or productive property.

Why people have children. This was clear in a recent study,[5] in which I showed that just four factors explain most variation in birth rates among the 50 countries for which data were available (comprising about two thirds of world population). The birth rate is strongly and about equally inversely proportional to both per capita social benefits (see first chart below) and per capita national saving (second chart below), both adjusted for differences in purchasing power.

After taking these economic factors into account, I found that a current or long legacy of totalitarian government was also highly significant, further reducing the birth rate by about 0.6 children per couple.

Finally, the birth rate is strongly and positively related to the rate of weekly worship (third chart, below).

The main reasons, then, for below-replacement birth rates in most of Europe and Asia compared with the United States are per capita social benefits so high as to displace gifts within the family, including fertility; the legacy of communism in Eastern Europe and Russia; and lower rates of religious observance (with the notable exceptions of Poland, Ireland, and a few others).

American demographic exceptionalism? A respected American demographer, Nicholas Eberstadt, has written recently that “U.S. demographic exceptionalism is not only here today; it will be here tomorrow, as well.”[6] However, the conclusion of my own study was far less confident about this.

The U.S. Congressional Budget Office has projected that the share of American national income absorbed by social benefits will roughly double over the next 75 years.[7] If so, the empirical relationships I mentioned suggest that the U.S. birth rate will decline over the next 75 years from the current 2.1 replacement level to about 1.6, even if America’s religious observance does not decline. (I also concluded that the proposed method of funding benefits will likely raise the relatively low U.S. unemployment rate substantially.) However, the United States could still avoid a declining population by ending legal abortion, which has reduced the American birth rate since the early 1970s by about one-quarter (an average of 0.6-0.7 children per couple).

Two basic principles. My conclusion is that two basic principles of family-friendly fiscal policy are necessary for any country, including the United States, to avoid or escape “demographic winter.”

First, the cost of general government consumption of goods and services[8] (i.e. excluding social benefits) should be funded with an income tax levied equally on labor and property income at the lowest possible rate.[9] I have recommended that the simplest method is to do so as part of the cost of goods and services, including investment property, while eliminating all deductions, exemptions and credits, except a single refundable credit based solely on family size, that would rebate both income and payroll taxes on an amount exceeding the poverty level. I estimated that with such a tax base, both the U.S. personal and corporate income taxes could be replaced, without a regressive shift in tax burden, with a single flat tax rate of 16 percent—or 18 percent when combined with the Social Security payroll tax cut I will mention shortly.

Second, each social benefit program should be balanced with payroll taxes on a pay-as-you-go basis, at a level calibrated to prevent the birth rate from falling below the replacement rate. Since the United States is now at the replacement rate of 2.1, this would require that, rather than doubling, U.S. social benefits must not be permitted to increase at all as a share of national income. For many European countries, a decline in the share of national income devoted to social benefits might be required.

Since about 1990, the U.S. Social Security retirement system has been collecting about 25 percent more from workers in payroll taxes than necessary to pay current retirement benefits; as a result, American workers have been subsidizing general government operations that ought to have been paid for with an income tax on both labor and property income. The simplest way to balance U.S. Social Security is to cut retirement payroll taxes immediately by about 25 percent (3 percentage points), thus returning the current trust fund surplus to American working families, to invest without restriction either in raising and educating their children or in stocks and bonds, depending on their family situation. Prospective deficits would be removed at the same time by phasing in a reduction of equal proportion in promised benefits, pro-rated for the number of years the workers received the payroll tax cuts. New episodes of imbalance would then be prevented by automatically adjusting the benefits in inverse proportion to the birth rate and longevity.[10] Government health insurance programs must also be reformed by linking each program’s benefits to prior payroll contributions and maintaining overall annual balance in the same way as for Social Security.

These two reforms would vastly increase fiscal fairness and simplicity, make it far easier for families to have and raise children, and so help assure (as the theme of the fourth World Congress of Families has put it) that demographic winter is replaced with a springtime for the family.

 

Endnotes:

[1] John D. Mueller is director of the Economics and Ethics Program at the Ethics and Public Policy Center, and president of LBMC LLC, a financial market forecasting firm, both in Washington, DC. He was Economic Counsel to the Republican caucus in the U.S. House of Representatives under both Reagan administrations.

[2] Aristotle, The Politics, translated with an introduction by T.A. Sinclair, Penguin Books, 1962; Book I, Ch. 3-4, available in a different translation at http://www.constitution.org/ari/polit_00.htm.

[3] Theodore W. Schultz, “Investment in Human Capital,” American Economic Review (March 1961): 1-17.

[4] Bloendal, S., S. Fickel, N. Girouard, and A. Wagner, “Investment in Human Capital Through Post-Compulsory Education and Training,” Organization for Economic Cooperation and Development (Paris, 2001): 10.

[5] John D. Mueller, “How Does Fiscal Policy Affect the American Worker?” Notre Dame Journal of Law, Ethics and Public Policy Vol. 20 No. 2 (Spring 2006), 563-619; available at http://www.eppc.org/publications/pubID.2671/pub_detail.asp.

[6] Nicholas Eberstadt, “Born in the USA,” The American Interest, Summer 2007, available at http://www.aei.org/publications/filter.all,pubID.25988/pub_detail.asp.

[7] Congressional Budget Office, “A 125-Year Picture of the Federal Government’s Share of the Economy, 1950-2075,” July 3, 2002, available at http://www.cbo.gov/showdoc.cfm?index=3521.

[8] Borrowing would be worthwhile to invest in such government-owned assets as buildings, ships or equipment.

[9] John D. Mueller, The LBMC Plan for Tax Reform, Memo to the National Commission on Economic Growth and Tax Reform, September 26, 1995. For an updated discussion, see John D. Mueller, “Taxes, Social Security & the Politics of Reform,” The Weekly Standard, November 29, 2004, 24-29; available at http://www.eppc.org/publications/pubID.2268/pub_detail.asp.

[10] See James C. Capretta, “Building Automatic Solvency into Social Security: Insights from Sweden and Germany,” The Brookings Institution, 1 March 2006, available at http://www.eppc.org/publications/pubID.2692/pub_detail.asp

 

 

 

 

 

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