Family-Friendly Fiscal Policy to Weather "Demographic Winter"

Published May 11, 2007

Fourth World Congress of Families

**Remarks prepared for delivery to the Fourth World Congress of Families Palace of Culture and Science, Warsaw, Poland.**

I’m honored to be here in sunny Warsaw, among so many old and new friends, to address the fourth World Congress of Families about family-friendly fiscal policy. (I will go beyond taxation because, for reasons I will explain, family-friendly fiscal policy must address social benefits as well as the taxes that typically pay for them.) I will try to do three things: first, briefly sketch the economics of the family; second, use it to explain why the birth rate has fallen below the replacement rate in most of developed Europe and Asia while hovering near the replacement rate in the United States; and finally, outline two basic principles of family-friendly fiscal policy that are necessary for any country (including the United States) to avoid or survive what has aptly been called “demographic winter.”

People and property. I’ll begin by calling to your attention two highly significant features of family economics. The first was pointed out by Aristotle back in the 4th Century, B.C. : Household wealth is of two kinds, people and property — or as University of Chicago economist (and later Nobel laureate) Theodore W. Schultz dubbed them around 1960, “human and nonhuman capital.” Both are “reproducible”; both may be tangible or intangible (e.g. our bodies vs. education, a machine vs. a patent); both require maintenance to remain productive; and both depreciate in use. Labor compensation is the return on previous investment in people, while property compensation is the return on previous investment in property.

Yet there is an important difference: the rate of return on property is the same for everyone in a competitive market (other things, like risk, being equal); but the rate of return on investment in people varies with the age of the person. For example, the average real rate of return in the U.S. on college tuition at age 20 was about 16 percent recently,  compared with the U.S. stock market’s long-term average of 6 to 7 percent. But the same study found that after about age 40, the rate of return fell below the average rate in the stock market; and that after age 50, the return on further education turned increasingly negative. (The main reason is that four years of college roughly double average annual earnings, but as we get older we can realize those earnings for fewer years before death.)

These basic facts account for the pattern of lifetime earnings in the following chart, which I believe is universally true of developed countries today:

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 important fact about family economics. Though family members acquire their incomes mostly by exchanging services or products with those outside the family, within the family transactions are mostly gifts, not exchanges. 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 requires extensive gifts, not only from parents to dependent children (whose rearing depends almost entirely on such gifts); but also between husbands and wives (men’s labor market earnings typically average about twice women’s); and from adult children to their 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 evenly distributed consumption is ordinarily higher than the property income that could typically result 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. While a financial account is essentially a claim on property, a pay-as-you-go Social Security retirement pension amounts to a share in a diversified human capital mutual fund. Social Security makes it possible for workers, by pooling a fraction of their current labor income, in effect to transfer labor compensation from their working years to retirement, and to surviving spouses and dependents after their deaths, with a higher rate of return than on low-risk government bonds. Starting a well-designed pay-as-you-go system typically boosts the birth rate: for example, the parents of the American Baby Boomers were the first generation covered throughout their working careers by Social Security. However, it is important to recognize that after such benefits have closed the retirement gap, any further expansion necessarily comes at the expense of smaller investment in either children or productive property.

Why people have children. This was clear in a recent study,  in which I showed that just four factors explain most variation in birth rates among the 50 countries for which data were available (which comprise 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 past 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). On average, a couple that never worships will have about 1.4 children in their lifetimes — too few to replace themselves — while those who worship every week average about 3.4 children, or about 2.1 more than those who don’t. (I found relatively little variation by religious denomination.)

The study showed, I believe, that couples around the world have children for basically two reasons: either because they love the children for their own sakes, or because they love themselves and expect some advantage from the children. Both per capita social benefits and private saving are inversely related to the birth rate because they measure the average adult’s provision for his (or her) own future well-being. But the rates of worship and fertility are positively related because both acts devote scarce resources like time and money to another person (whether God or a child) for that person’s sake rather than our own advantage. Both require us to raise the other person and lower ourselves in our scale of preference for persons: the Two Great Commandments (to love God and neighbor) are empirically linked — lending support to the thesis of my colleague at EPPC, George Weigel.

The main reasons, then, for below-replacement birth rates in Europe and Asia compared with the United States are: per capita social benefits that are so high as to displace gifts within the family, including fertility; the legacy of communism in Eastern Europe and Russia; and relatively low 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. It is by no means beyond the realm of the possible that America’s demographic profile will look even more exceptional a generation hence than it does today. If the American moment passes, or U.S. power in other ways declines, it won’t be because of demography.”  However, the conclusion of my own study was far less confident about the demographic future of the United States.

The U.S. Congressional Budget Office has projected that the share of American national income absorbed by social benefits (mostly Social Security, Medicare, and Medicaid) will roughly double over the next 75 years.  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 concluded that the proposed method of funding benefits will likely raise the relatively low U.S. unemployment rate substantially. 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). So could Russia, which has a total fertility rate of about 3.1 before and 1.3 after legal abortions. But abortion rates are inversely correlated with religious observance.

Two basic principles. My research indicates that two basic principles of family-friendly fiscal policy are necessary to avoid or escape “demographic winter.” I will describe their specific application to the United States, but believe they are also applicable to any other country.

Income tax reform. First, as I suggested in 1995 to the National Commission on Economic Growth and Tax Reform,  general government operations (that is, the cost of current government consumption of goods and services  excluding social benefits) should be funded with an income tax levied equally on labor and property income at the lowest possible rate. I recommended that this be done by eliminating all deductions, exemptions and credits, except for a single refundable credit based solely on family size, which would rebate both the income and payroll taxes on an amount exceeding the poverty level. For administrative simplicity, the tax would be collected as part of the cost of goods and services purchased (including new investment property) rather than on the same income when received by workers and owners of productive property. The flat income tax would therefore work about the same as a typical value-added tax, except that investment property would not be exempt from taxation. In this way, the income tax could be collected from only several million businesses and other employers, rather than separately from more than 130 million households.  I estimated that with such a tax base, both the U.S. personal and corporate income taxes could be replaced, without a regressive tax burden, with a single flat tax rate of 16 percent (or 18 percent when combined with the 3 percentage-point Social Security payroll tax cut that I will mention shortly).

Reform of social benefits. Second, each social benefit program must be balanced with payroll taxes on a pay-as-you-go basis, at a level of social benefits as a share of national income calibrated so as 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, this would require a decline in the share of national income devoted to social benefits, all of which ultimately are paid from families’ labor income.

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. Over the next couple of decades the situation is expected to reverse, so that annual benefits exceed payroll tax revenues by a similar proportion. Democrats have proposed to “solve” this problem by raising taxes on individual and corporate income, capital gains and estates, thus forcing property owners to pay for worker’s benefits. But as I showed in the same study mentioned earlier, this necessarily raises the cost of hiring and so the unemployment rate, as in most of Europe. My fellow Republicans, meanwhile, have sought to divert the surplus payroll taxes to subsidize property ownership with tax-advantaged financial retirement accounts. By further reducing families’ after-tax labor income, this could only further reduce the birth rate, as in Europe and Asia.

I suggested that 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.

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. Rather than allowing current spending per recipient to drive the programs’ shares of national income, the calculation must be reversed by starting with the target share of social benefits in national income and dividing by the number of beneficiaries.

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 this Congress has put it) that “demographic winter” is replaced with a springtime for the family.

— John D. Mueller is author of Redeeming Economics: Free Markets and the Human Person (ISI Books), director of the Economics and Ethics program at the Ethics and Public Policy Center, and president of LBMC LLC, a financial-market forecasting firm.

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