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Journal Article

The Equivalence between State Contingent Tax Policy and Options and Forwards: An Application to Investing the Social Security Trust Fund in Equities

Kent Smetters
The Journal of Risk and Insurance
Vol. 67, No. 3 (Sep., 2000), pp. 351-367
DOI: 10.2307/253833
Stable URL: http://www.jstor.org/stable/253833
Page Count: 17
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Since scans are not currently available to screen readers, please contact JSTOR User Support for access. We'll provide a PDF copy for your screen reader.
The Equivalence between State Contingent Tax Policy and Options and Forwards: An Application to Investing the Social Security Trust Fund in Equities
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Abstract

Government guarantees are often priced by appealing to an analogy with option pricing techniques pioneered by Black and Scholes (1973) and Merton (1973). Of course, in reality, the government does not purchase options in the open market. Instead, barring a Ponzi game opportunity, the government must adjust tax revenue or spending in response to shocks in the value of the asset being insured for the government to maintain its intertemporal budget constraint. Nonetheless, this article derives an exact mathematical relationship between fiscal policy and option pricing. Explicitly deriving the option pricing equivalence from first principles proves that the analogy is, in fact, correct and suitable for use by public finance economists and government officials to estimate the cost of government guarantees. Starting from first principles also has the benefit of showing that an additional mathematical term, which multiplies the option price, is necessary to capture the pay-as-you-go nature of most perpetual government guarantees-a term that is missing in the previous work. The author develops the analysis in the context of a highly relevant example: investing the Social Security trust fund in equities. Advocates of this policy have argued that the higher expected returns would help prefund future benefits and, therefore, would require less of a tax increase on future workers. Several government agencies have "scored" hypothetical legislation and have concluded likewise. The results herein show just the opposite. By focusing on expected returns, trust fund investment creates an instant windfall for current workers and is mathematically equivalent to a tax increase on all future workers, relative to a baseline policy of maintaining the current payroll tax rate. National saving is reduced. The author computes President Clinton's proposal to invest in equities to be equivalent to increasing the future payroll tax by 0.8 percent in perpetuity. A policy recommendation to invest about 40 percent of the trust fund in stocks analyzed recently by the Social Security Administration is equivalent to a 2.1 percent increase in the future payroll tax.

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