Economic Diversification: Hedging Against Families' Risk without Harming the Economy

Ripon Forum | December 2007 / January 2008


Harry Markowitz’s 1952 essay Portfolio Theory broke new ground in developing ways to diversify financial portfolios. By the time he won the Nobel Prize nearly four decades later, countless financial innovations to help spread risk had been introduced, making the risks associated with investing more acceptable — particularly to the American middle class. Sure the markets are taking a hit now, but those with diversified portfolios are certain to weather this downturn better than those without.

U.S. economic public policy would benefit from a similarly innovative approach to managing risk. The economy is facing growing pains that go deeper than just the current financial market turmoil. Despite progress in bringing down international trade barriers and an impressive period of economic growth, we are facing unprecedented levels of income inequality and a host of new economic risks — everything from disappearing pension plans to entire industries moving abroad. If the economy turns down as it appears to be doing, these challenges will only become more pronounced. Unfortunately, views on how to deal with this issue are polarized and neither side has a viable strategy for dealing with the more tumultuous side of the modern economy.

There are the rosy eyed optimists who focus on the strengths of the new economy while ignoring the pitfalls. Their interpretation does not fit the facts: the top 20 percent of U.S. households now earn well over 50 percent of all income while the top 5 percent earn close to a third.  There have been mass layoffs at the kinds of companies once considered the backbone of the U.S. economy, including Hewlett Packard, Boeing, Procter and Gamble, and Sears. Laid-off workers who find new employment often end up in jobs that pay far less than what they were earning before. Even for families who have health insurance, a serious injury or illness can send them tumbling towards financial hardship. The success of this country was never based on guaranteeing economic outcomes, but we need to acknowledge that many families that play by the rules still run the risk of economic ruin.

On the other side, there are those who have focused on the problem, but too often ignore the critical contributions of economic growth, suggesting stale ideas that are more likely to harm than help the economy.  They’ve honed in on free trade and the Bush administration’s tax cuts as the major culprits of economic inequality, turning to the tired favorites of protectionism and repealing the tax cuts for the wealthiest Americans in favor of new targeted tax cuts for the middle class as remedies. Neither will work.  The first would diminish the large economic gains available from trade. The Institute for International Economics estimates that globalization has increased the standard of living in the US by $1 trillion a year and that further economic integration could lead to increases of another $500 billion per year. The second approach would worsen both the budget deficit and economic incentives. The outcome would be to undermine the building blocks of a stronger economy.

Instead, the goal should be to ensure that the benefits of a growing economy are spread more fairly.  A multi-pronged approach focusing on investment, a more progressive and efficient tax code, and most importantly, economic diversification to create a “hybrid economy” where all workers have access to income from a variety of sources would help insulate them from the swings and potential pitfalls that appear to be a permanent condition of the modern-day economy. 

Investments and Tax Reform

Much of the growing income gap can be attributed to higher returns to higher-skilled workers. Thus, one of the most important things we can do is to invest in the education and skills of the U.S. labor force, expanding investments in life-long education—starting at pre-K and continuing through the working years. However, the payoffs from education will be slow to trickle into the economy, and it is not enough to say that one or two generations from now the gap will close. A more immediate fix is also in order.

Fundamental tax reform can make the tax code both more efficient and progressive. Switching from an income tax to a “progressive consumption tax” for instance, where taxes are levied on consumption through progressive rates, would lead to higher levels of saving — stimulating economic growth — while allowing more progressive rates to help those who have not fared so well in the recent economic boom. Also, the $800 billion worth of targeted tax cuts that run throughout the tax system (including everything from the home mortgage interest deduction, to the deductibility of employer-provided healthcare, to tax breaks for vacation homes, fertilizer, and film productions) should be dramatically scaled back.

These tax expenditures are inefficient, regressive, they often pay people to do what they would be doing anyhow, and ironically, they drive up the cost of the goods that we are trying to make more accessible, such as housing and health care. 

Reforming the tax base would be a huge step to making the tax code both more fair and helping the economy to prosper. Another interesting proposal by Robert Shiller of Yale University, would index tax brackets and tax rates to income inequality.

As the gains from economic growth became more (or less) concentrated, tax burdens would be adjusted accordingly.  

Economic Diversification

Calls for higher levels of investment and fundamental tax reform are nothing new. The most important contribution in helping workers deal with the risks and inequities of a more competitive economy would come from an updating of the country’s social contract to help broaden the economic streams available to families.

Our current social contract—consisting mainly of the major health and retirement entitlement programs for the elderly—focuses on the risks in retirement of outliving ones savings or not having health insurance. But while those were the major risks of decades ago, they are not today. Retirees have become one of the more financially secure cohorts. Meanwhile the insecurity of working families and children has risen.  For too many workers their income remains primarily, if not purely, “wage-based”. This is less problematic when wages are growing steadily along with the economy; more so when, like now, wages are at historic lows as a share of GDP. The global economy will continue to put downward pressure on wages in many areas, leaving wage-dependent families vulnerable.

As any financial adviser will tell you, the key to dealing with risk is diversification — managing risk exposure through multiple investments. In order to increase economic security, we need to diversify personal economic situations just as the titans of Wall Street do their portfolios.

Moving past wages - mandatory saving

The first step is to expand capital ownership. Returns to capital have outweighed labor returns in recent years, leaving workers without investment portfolios at a disadvantage.  Attempts to increase personal saving levels in the U.S., however, have not been successful.  Our patchwork savings policy relies on tax preferences for various forms of saving—from 401(k)s, to IRAs, to targeted saving for education, health, or other tax subsidized activities. The government has spent trillions of dollars trying to encourage people to save, with a dismally low personal saving rate to show for the effort. One reason efforts have not been successful is because our current system of social insurance causes workers to believe they will be cared for in retirement through government programs—never mind that we have no plan for how to actually pay for these promises.

A better approach than providing tax-carrots and unsustainable promises is to rely more on personal responsibility. All workers should be required to save a percentage of their annual earnings to build a pool of personal savings. From an economic perspective, 10 percent might be desirable; realistically, something between 2 and 5 percent is more likely.  Workers’ savings would build up and, over time, they would accumulate significant levels of capital with which to generate an alternate income stream. The expansion of asset ownership for many individuals would help smooth out economic fluctuations. Assets could be drawn down during periods where wage income would otherwise be insufficient to meet a family’s needs, such as during a period of unemployment, time off from work, or retirement.

Recognizing how difficult it is to save for families who are barely getting by as it is, individual saving should be supplemented through progressive matches for moderate and lower-income savers. And since minimum wage workers can hardly be expected to live on less than they are already earning, the Earned Income Tax Credit, a government program that is used to augment low worker’s wages while maintaining positive work incentives, should be expanded to a “Super EITC”.  

Real insurance for real risk

The social insurance system of the past half-century has focused on supplying benefits for likely occurrences such as routine medical costs in old-age and retirement. What we need in the more turbulent economic environment is real insurance for the many things that are not certain to occur but would be devastating if they did.   While millions of people are insured for things like contact lenses purchases, they lack coverage for calamitous unanticipated events — anything from cancer to Katrina — that can cause unlucky families to fall off track into financial catastrophe and never find their footing again.

Employers, who have traditionally been in the business of supplying many of these basic insurance benefits, are scaling back because of rising costs. This in fact, gives us the opportunity to update the employer portion of the social contract out of necessity. Moving more towards an individual-based system is likely to improve on the current system which leaves gaping holes in coverage, hides the real costs of these benefits, and creates multiple problems concerning portability, flexibility, and proper targeting of benefits. A new partnership between individuals and government is needed, with workers held responsible for purchasing their own insurance along with sliding-scale subsidies from the government for those who cannot afford the additional costs.

With the recent advances in financial and insurance instruments, the risks of job loss, wage decreases, catastrophic injury or illness, disability, or asset depreciation are all potentially insurable. Vacation insurance is already available.  Housing bubble insurance has potential as well. Robert Shiller has developed a real-estate index that allows homeowners to hedge against the risk of the housing market turning down—or for that matter, renters from the risk of it not. Or we could create estate tax insurance: rather than repealing the estate tax, small business owners and family farms could purchase insurance to cover any estate tax liability their heirs might face down the road.  These new financial instruments make hedging against all types of potential loss more manageable. Some of these insurances, such as health and long-term care, should be mandatory and government-subsidized; others such as wage, disability insurance should be highly encouraged through automatic default mechanisms; and still others such as estate tax insurance should be totally voluntary and purchased depending on an individual’s personal needs.

 A well-targeted safety net

But even with a more balanced combination of wage income, capital income, and a mixture of insurances, some workers will inevitably fall on hard times. No level of diversification can eliminate economic risk completely. This new system of risk diversification should be paired with a guaranteed government-financed social safety net to provide minimum levels of income, health care, and retirement payments to the people in greatest need.

The most obvious way to do this, again, comes from updating the current social insurance system. Many of the government’s unaffordable programs such as Social Security and Medicare will have to be reformed regardless of other changes. Given the choice between cutting benefits for everyone and cutting benefits for those who need them least, the choice is clear. Transforming the current system of social insurance away from a universal program to a strong safety net would save needed resources while putting the government in the more appropriate role of the insurer of last resort. 

While there is sure to be resistance to transforming the current social insurance system from a universal program to a more targeted means-tested system, it has to be acknowledged that the existing system is already on the decline: there are many types of risks that are not covered, the universal system diverts hundreds of billions of dollars to recipients who do not need them, creating a perverse subsidy from poor to rich, and the major government programs that constitute social insurance are unsustainable.  Shifting some resources away from the most well-off in society to help give economic security to those who need it is most appropriate in this time of growing income inequality.  

Nothing Comes for Free

Revamping the social contract to increase economic security will not come without a cost.  Upper-middle-class earners and the well-off would be required to pay for more of their own benefits by shouldering the costs of the new savings and insurance mandates. Government programs would be scaled back for those who don’t need the help so that resources could be diverted to those who do. The elimination of many current regressive tax breaks could easily generate $200 billion a year. And another $200 billion could be saved by scaling back benefits that go to well-off citizens in programs ranging from agriculture subsidies to Social Security to Medicare.

The need to rethink the United States’ social contract provides us with the opportunity to give it a much-needed facelift. A new system consisting of a diversified economic portfolio of wage supports, mandated saving, new insurances targeted at real risk, and a strong safety net will both help to counter negative trends in income inequality and provide a new level of individual economic security. Last century’s social programs were aimed at helping retirees; this century’s should be aimed at increasing the opportunity and security of workers and their families.                                  RF 

Maya MacGuineas is the Director of the Fiscal Policy Program at New America Foundation.

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