For the first time in its history, America is in danger of breaking its quintessential economic promise: that with hard work and education, each generation will have the opportunity to do better than the one that preceded it. Many Americans sense this danger: According to two polls taken in recent years, a majority are “worried and concerned” about reaching their economic goals and believe that their children will be worse off than they are. Their anxiety is understandable. Despite strong macroeconomic performance, many workers today are not fully sharing in the prosperity of the new global economy and must cope with growing levels of economic risk.

Some on the right continue to respond to these troubling economic trends by arguing that unfettered free markets always produce the best of all possible outcomes and denying that insecurity and inequality are much of a problem. Others, predominantly on the left, argue that the global economy is the ineluctable enemy of the average American worker and that the only way to improve his or her lot is to turn inward and place various government requirements and limitations on industry. But both views are misguided, and they ignore the fact that the disruptive forces of the twenty first century global economy are both a blessing and a curse. These forces bring substantial economic benefits to American families, but they can also cause real economic difficulties. It would be short-sighted to forgo such potential gains, but it would also be unjust and unwise to reject efforts to shore up the social safety net for fear of interfering with market forces.

Rather, what is needed is a new model that acknowledges the two-sided reality of the twenty-first-century economy. Such a model should be guided by an understanding that economic growth is stronger and more sustainable when that growth is broadly shared, and that a robust yet well-tailored government role is necessary both to correct for the market’s limitations and to enhance economic security. As the employer-based system for providing economic security comes under increasing strain from the forces of global competition, this model would not strive to prop up outdated arrangements, but rather it would be built on a new and sustainable social compact among individuals, corporations, and government. Individuals would take primary responsibility for their own economic security and accept certain mandates and default arrangements, but they could rely on employers and government to help manage economic risks that they could not manage alone. Employers would continue to play an important role in facilitating the provision of benefits and paying for a portion of their cost but would not provide such benefits directly. And government would not only set the rules that shape private sector and individual
efforts to manage risk but would also serve as the ultimate guarantor
of a basic level of economic security. Such a New Social Compact would help American workers manage the risks of the twenty-first century economy, while also sharing in its prosperity.

The Era of Growing Economic Insecurity

Americans’ increasing insecurity about their economic futures is a reflection of two worrisome, and by now familiar, trends. First, American families face greater economic risks and lack adequate safety nets during periods of hardship. Second, the nature of economic growth today is far less broad-based than has been the case throughout American history; most Americans’ wages have been stagnant while the inequality gap has widened enormously.

American workers face greater insecurity because many economic risks have been shifted onto individuals and away from employers and the public sector–a shift that the Economic Policy Institute’s Jared Bernstein has labeled “you’re on your own economics.” Proponents of this approach call for policies that rely almost exclusively on the putative benefits of individual incentives, such as reduced marginal tax rates. They pay little attention to market imperfections and limitations–such as those that result from costly and limited information–or to the reality of individual decision-making, which can differ significantly from the perfectly rational behavior assumed in classical economics. They also ignore the absence of markets for various types of insurance, the fact that markets may not provide merit goods (such as health care) to the degree that society demands, and sometimes even the fact that government must set the rules under which markets operate. And “you’re on your own” advocates fail to realize
that their approach can result in significant disparities in economic outcomes, even among those who invest in their education, work hard, and plan prudently for the future. Under a “you’re on your own” approach to economics, those who suffer unforeseen hardship may simply be left behind, while improving economic performance is simply a matter of getting government out of the way.

The embrace of this approach in recent years, coming at the same time that the employer-based benefit model is deteriorating, has resulted in growing individual risk associated with such challenges as health care, retirement security, and job loss. Let’s start with the most urgent source of economic insecurity for many families: health care. As the cost of health insurance premiums has risen–from 8 percent of median family income in 1987 to 17 percent in 2003–fewer firms are offering health insurance, leaving more Americans to fend for themselves. The share of the population with employer-provided health coverage declined from 64 percent in 2000 to 60 percent in 2005. Even firms that have not cut back on their health benefits have shifted the cost of rising premiums to employees in the form of reduced wage growth.

American families also face new uncertainties regarding their pensions, as American businesses move from defined-benefit toward defined-contribution retirement plans. In 1980, more than one-third of private workers were covered by a defined-benefit plan; by 2002, it was only about one-fifth. At the same time, defined-contribution plans have become much more common. In some ways, these plans are advantageous; for example, they provide for a potentially higher rate of return while promoting choice, ownership, and control, which some workers prefer and that may be more compatible with an economy in which people change jobs more frequently. But defined-contribution plans also have significant drawbacks: Increased risk for workers comes with the potential for
greater returns. In addition, the plans are voluntary, mostly relying on worker contributions, and workers often fail to enroll.

What’s more, for American workers who lose their jobs, the average (and median) duration of unemployment has increased, while unemployment insurance is doing less to cushion the blow of job loss. The Government Accountability Office (GAO) found that, in part due to tighter state eligibility requirements, the fraction of unemployed workers who received unemployment insurance benefits fell each decade from about 50 percent in the 1950s to about 35 percent in the 1990s. Unemployed low-wage workers are particularly unlikely to receive benefits.

Underlying all of this is the rapid pace of globalization. Although a variety of academic analyses have shown that trade has played only a modest role in domestic job loss and rising inequality, trade can cause painful and highly visible job dislocations for workers in particular industries, even while it is a net economic benefit. This has heightened anxiety about competition from countries like China and India, which is increasingly targeted at high-skill as well as low-skill jobs. Indeed, a recent poll in Foreign Affairs suggests that
almost nine out of 10 workers worry about their jobs going offshore. And, while noting that relatively few jobs have been lost to offshoring to date, Princeton economist Alan Blinder finds such anxiety warranted in the long run, estimating that 22 to 29 percent of all U.S. jobs may be at risk of offshoring in a decade or two, a fact that greatly magnifies its political impact.

In addition to greater economic risks, levels of household income volatility are high, even as macroeconomic fluctuations in gross domestic product (GDP) and unemployment have declined relative to previous decades. As a result, families face a significant risk of suffering a precipitous drop in their incomes (as well as the possibility of a rise in income, to be sure). According to the Congressional Budget Office (CBO), between 2002 and 2003 about one in five workers saw their earnings fall by 25 percent and about one in seven saw their earnings fall by more than 50 percent (roughly the same shares that saw their earnings rise by those percentages). And though further research is needed about the trend, there is evidence that levels of income volatility have risen over the past several decades as a percentage of household income.

Finally, the insecurity of American workers is also explained by the nature of economic growth today, which is no longer broadly shared among all Americans, as it was for most of our nation’s history. Whereas growth in productivity and real median family income roughly tracked each other between 1947 and 1973, those trends have since diverged. Instead, the gains of economic growth have gone largely to those at the top, resulting in a stunning rise in inequality. The share of the nation’s income going to the top 10 percent was higher in 2005
than at any point since before 1941. As former Treasury Secretary Lawrence Summers recently told Congress, “In 1979 the top 1 percent of the population earned as much as the bottom 27 percent combined; by 2004, the figure was 46 percent.” The tax cuts of 2001 and 2003 have exacerbated the problem, making the after-tax distribution of income even more unequal–when fully in effect, the tax cuts will increase the after-tax incomes of the top 20 percent by 4.6 percent (and the top 1 percent by 6.8 percent), compared with a 0.5 percent increase for the bottom 20 percent of the income distribution.

The Pitfalls of Insurance

Many of these sources of economic insecurity are beyond the ability of most people to control on their own. People generally manage economic risk through the purchase of insurance, and conservatives have often argued that the market, specifically private insurance of all types, can thus help people weather economic storms. But such optimism ignores several imperfections in the nature of an insurance market.

Perhaps the most significant imperfection is that asymmetric information leads to adverse selection. To take the most obvious example, no sensible firm would sell unemployment insurance in the private market, because the individual knows much more than the insurance company about whether he or she is about to get fired. Similarly, health insurance is often prohibitively expensive when
individuals purchase it directly from an insurance company. Because individuals tend to know more about their own health than do insurance companies, the people most likely to find the products financially beneficial will be those with more health risks. Recognizing this, insurance companies will increase the price of the product. The increased price causes a few more individuals to decide the insurance is not worth it, and the pool of people who find the product financially beneficial shrinks even further to include those with even more health risks. The resulting downward spiral means that private markets do not function effectively for many households. For this reason, an effective risk pool needs to be one created around a criterion other than the need to purchase health insurance, such as employment at a company or membership in a union (which is why employer-based insurance has worked relatively well in this regard).

What’s more, some individuals simply do not adequately insure themselves against economic risks, saving too little for retirement, illness, or short-term bouts of unemployment. Notwithstanding what economists view as rational, utility-maximizing behavior, we know from recent work in behavioral economics–the study of how real people actually make choices–that such rationality is far from universal in practice.

Progressives, by contrast, have traditionally recognized the limits of private insurance and addressed them with social insurance programs that include everyone in the risk pool. And through the combination of social insurance and employer-based benefits, government and the private sector together have provided American families with key forms of economic security for decades. However, this model is growing less and less tenable. In the face of growing competitive pressures, American firms are increasingly retreating from their role as a provider of social benefits. What is needed in response is a rebalancing of responsibilities among government, the private sector, and individuals to provide both economic security and economic growth.

Economic Security and Economic Growth

To be sure, many policymakers and analysts, on both sides of the ideological spectrum, have been trained to believe that providing more security to families must come at the expense of economic performance and that these two goals are thus contradictory objectives. Harvard economist and former Chairman of Ronald Reagan’s Council of Economic Advisers Martin Feldstein, for example, has said that social insurance programs “have substantial undesirable effects on incentives and therefore on economic performance. Unemployment insurance programs raise unemployment. Retirement pensions induce earlier retirement and depress saving. And health insurance programs increase medical costs.”
Economist Arthur Okun famously compared using government funds for social programs to a “leaky bucket” because so much is lost in the process of delivering the benefit.

While this traditional view offers an important cautionary note, it misses another salient point about the modern economy: While economic growth can clearly increase economic security, economic security can also increase economic growth. Indeed, growing economic insecurity for American families takes a toll on the economy as a whole and thus leads to a vicious cycle. Insecurity impairs overall growth, which thus increases the likelihood that the stagnation in real median wages will persist, which in turn exacerbates the economic insecurity that American families face.

In particular, this traditional view ignores three key ways in which economic security can bolster economic growth. First, a basic level of security frees people to take the risks–such as starting a business, investing in their own education, or trying an unconventional career–that can lead to growth. For example, empirical evidence suggests that generous personal bankruptcy laws are associated with
higher levels of venture capital; that workers who are highly fearful of losing their jobs invest less in their job skills than those who are more secure; and that investment in education and job skills is higher when workers have key risk protections. With inadequate protection against downside risk, people tend to be overcautious, “fearing to venture out into the rapids where real achievement is possible,” as Robert Shiller of Yale has argued. “Brilliant careers go untried because of the fear of economic setback.”

Second, if hardship does occur, some degree of assistance can provide the resources to help a family thrive again. Families with access to some form of financial assistance, educational and training opportunities, and basic health care are less likely to be permanently harmed by the temporary setbacks that are an inevitable part of a dynamic economy. For families experiencing short-term difficulties, a safety net can be a springboard to a better future and higher productivity.

Finally, and perhaps most importantly, economic security can lessen demands for protectionist policies that hamper overall economic growth. Enhancing security eases the painful job dislocations that globalization can cause in particular industries and reduces anxiety among workers more generally, thereby mitigating calls to keep out the forces of competition that benefit the economy as a whole.

To be sure, the symbiotic relationship between economic security and economic growth is not the only reason we should reduce the likelihood that families will experience economic hardship and help them rebound if they do. If nothing else, there is a moral imperative to provide for the economic well-being of all in society. Moreover, as Harvard economist Benjamin Friedman argued in his recent book The Moral Consequences of Economic Growth, providing for the economic well-being of the vast majority of people encourages social progress outside of strictly economic gains, specifically “greater opportunity, tolerance of diversity, social mobility, commitment to fairness, and dedication to democracy.

Enhancing Growth, Increasing Economic Security

But how do we deliver economic security in a way that enhances economic growth, not stifles it? Considering the economic anxiety that many Americans feel, it is easy to envision fearful and frustrated policymakers and workers calling for heavy-handed government measures that interfere with the workings of the market. Such efforts could involve hiring and firing constraints, anti-trade protectionism like import tariffs or outsourcing restrictions, regulatory protections for certain industries, excessively high living-wage laws that ignore
potential reductions in the quantity of labor demanded, or requirements that businesses spend a certain percentage of their payroll on health care, such as the recent Maryland legislation targeted at Wal-Mart.

Although such measures may appear to provide much-needed temporary relief, the evidence suggests they will ultimately prove futile and harm the economy. As Nobel Prize–winning economist Paul Samuelson put it, “Economic history and best economy theory together persuade me that leaving or compromising free trade policies will most likely reduce growth in well being in both the advanced and less productive regions of the world. Protectionism breeds monopoly, crony capitalism and sloth.” Economic historian Peter Lindert surveyed developed countries since the eighteenth century and confirmed that direct market
interventions impose a steep economic cost across time periods and economies. Even in our own country, although many New Deal innovations greatly helped the economy, many economists have since concluded that the New Deal’s cartelization policies–such as wage-uniformity requirements, minimum prices, and production restrictions–played a role in keeping the economy depressed after 1933. While the economy has changed, economic laws have not. By impairing overall economic performance, such interventions would actually undermine the goals of higher living standards and job security that their advocates seek.

Rather than pursue such a harmful strategy, government policymakers should take steps to increase economic security by investing in critical areas like education and job training, which help people before economic difficulties arise, and by revamping the social insurance system to strengthen health care, pensions, and other benefits, which helps soften the inevitable blows of the global economy. (A more progressive and fair tax system is another important
policy lever to help mitigate economic insecurity and inequality.) In designing such programs, we must act ambitiously but carefully, recognizing that both the form and the amount of economic security can affect economic growth and individual well-being. Government policies must strike the right balance to shore up the social safety net while taking care that government programs themselves do not lead to undue inefficiencies and distortions to economic incentives that can impair overall economic performance. Such a robust yet well-tailored approach will enable government to promote strong economic growth, while also addressing rising levels of insecurity and the collapse of the
employer-based benefit system. Doing so, however, will require redefining the responsibilities of the public and private sectors in the twenty-first-century global economy.

A New Social Compact

What is needed, then, is a New Social Compact that would marry economic growth and security through new and sustainable roles and responsibilities for government, employers, and individuals. Under this New Social Compact, government would provide all Americans with two levels of protection: basic  economic security, through government social programs, and an additional layer, by setting the rules of the game to make it easier for individuals to supplement that basic protection on their own.

At the basic level, the government’s function should be primarily to offer social insurance and make participation mandatory. For example, the government currently provides a basic level of health care and retirement security through Social Security, Medicare, and Medicaid, and it should take the steps necessary to shore up the long-term financial health of these programs. The government also should consider new and expanded ways to provide a core tier of economic security. Long-term care insurance, for example, could finance nursing-home costs for individuals who would otherwise have to rely on private insurance
or Medicaid, which only provides benefits once individuals have largely exhausted their savings. And wage-loss insurance could soften the blow of job loss for those who are reemployed at a lower wage, which is the case for about one-half of long-tenured workers who are displaced from and then reemployed in full-time jobs. (Contrary to recent claims by its opponents, there is no significant evidence that wage-loss insurance would reduce wage levels or subsidize low-wage employers; Canada’s experience with a similar effort suggests that benefits accrue to workers, not employers, raising income levels of reemployed workers above what they would have been otherwise.)

In addition to this basic level of security, there is much government can do through smarter regulations and better-designed incentives. One possibility emerges from the broad behavioral economics literature about the importance of default settings. As CBO Director (and former director of the Hamilton Project) Peter Orszag and others have argued, the government should do more to make it easier for families to increase their economic security by saving more through automatic enrollment in 401(k)s and IRAs, with the option to opt out.
The government should also improve the efficiency and fairness of the subsidies for these activities found in the tax code–for example, by transforming $500 billion in existing deductions and exclusions into universal refundable credits, as proposed by Orszag and his colleagues in a recent article.

Such a robust role for government does not necessarily involve the creation of expensive new programs. Indeed, policymakers should be careful to evaluate evidence about what works and not spend more on failed programs or in poorly targeted ways that fail to help those most in need. Doing so not only squanders scarce resources; it also undermines public faith in government’s efficacy. The goal, according to legal scholar Peter Schuck and political scientist Richard
Zeckhauser, is “target efficiency: directing resources where they do the most good.” In some cases, evidence supports larger government investments, such as in early childhood education. In many others, however, government resources can be better targeted than they are today. For example, many policymakers have recently proposed increasing federal tax incentives to pay for rising higher education costs. Yet while college costs have risen sharply, so have the returns on college attendance. Thus, it may not be the most effective use of government
resources to subsidize the cost of college for the many individuals who will more than recoup their investment. Instead, the key challenge for most families is a liquidity constraint, which government can address by helping students borrow against future earnings. At the same time, rather than redistribute resources to all fortunate enough to attend college, government can better target its resources to assist those who fall significantly short of those average future earnings, which is increasingly likely as the returns to college have grown more varied. This could be done, for example, by expanding the availability of income-contingent loans.

As the employer-based system for providing benefits disintegrates, corporations and other employers in this New Social Compact would be required to serve as conduits for health care and pensions, for example, but would no longer be expected to sponsor health and retirement plans or bear the financial risks associated with those benefits. They would automatically enroll their workers in plans offered by other entities–unions, professional associations, membership organizations like AARP, or even state governments–and provide the administrative support for employee choices. Employers already play such a facilitator role in the administration of our tax system, for example, in which employers provide employees with tax forms and withhold taxes from paychecks, adjusting as necessary if the employee is eligible for tax subsidies. Corporations and other employers would also make a fixed payment for each worker to the health and retirement plan enrolling that worker. And the corporate income tax would be reformed, with the revenue from that tax helping to subsidize benefits for moderate- and low-income workers.

Under the New Social Compact, individuals would have to take some responsibility for supplementing the basic level of protection provided by the government, though that task could be made significantly easier
through smartly designed defaults, regulations, and incentives. In addition, individuals would be asked to accept the government’s initial determination of what defaults and allocations are in their best interest; for example, the government may decide that a portion of their income be set aside for retirement, though they would be free to change these allocations. In other cases, they might be required to participate in broad-based programs, such as through a mandate to purchase health insurance. Finally, individuals would continue paying payroll taxes, as they do today, in order to fund the benefits they receive.

The New Social Compact in Practice

To see how the New Social Compact would work in practice, consider health care access. Firms would be required to facilitate access to insurance pools but would not be in the business of sponsoring health plans themselves. The insurance pools could be sponsored by unions, professional associations, organizations like AARP, and state governments. Firms would also be required to facilitate payroll deduction systems for paying the premiums associated with such health insurance and make fixed and, perhaps most importantly from the firms’ perspective, predictable contributions to workers’ plans. As in the new Massachusetts system, firms would be required to pay a levy if they do
not provide health insurance or enroll their workers in an alternative risk pool.

In this model, government would continue to provide health insurance for the elderly and poor through Medicare and Medicaid. In addition, it would serve as a backstop to the requirement that firms enroll workers in alternative health insurance pools by providing access to such risk pools for individuals not covered by this approach. These government programs could be modeled after the Massachusetts Connector, an exchange that facilitates the buying, selling, and administration of private health insurance coverage. Broadly speaking, it is similar to the Federal Employee Health Benefits Program (FEHBP), which allows individuals to choose from a variety of competing private plans and
keep their plans if they move from one federal employer to another. Small businesses that choose not to provide health insurance can enroll their employees in the Connector and provide a cash contribution to the plan of each employee’s choice. Individuals can also purchase insurance this way.

Additionally, as part of its basic package of health care coverage, government could expand access to cost-effective preventive care. Like the high cost of health insurance for individuals or small firms, America’s current underinvestment in preventive care also stems from a market failure: Because most health spending is financed through health insurance plans, and people typically change insurance plans several times over the course of their careers, the financial benefits of aggressive preventive care do not accrue entirely to the same insurer that makes the investment. Moreover, the current reimbursement
structure means that health care providers find greater profits in caring for a sick person than preventing illness in the first place. Providing individuals with access to alternative risk pools would thus increase the incentives for insurers to promote preventive care, as individuals would be more likely to stay with the same insurance plan even as they switch jobs. To pursue a more comprehensive approach, the government might carve preventive services out of the health insurance system entirely and finance them directly, as recently proposed by Jeanne Lambrew of the Center for American Progress.

To help individuals supplement this basic level of protection, government could transform the current set of inefficient and inequitable financial incentives offered to workers to obtain health insurance and health care. Currently, employer-paid health insurance benefits are excluded from an employee’s income for taxable purposes. As described recently in the pages of this journal by economist (and director of the Hamilton Project) Jason Furman [“Our Unhealthy Tax Code,” Issue #1], this is the single largest subsidy in our tax system, costing approximately $200 billion annually. Because employer-based
insurance benefits are deducted from taxable income, the exclusion is linked to marginal tax rates and thus provides much greater benefits to those with higher incomes. The current exclusion is also inefficient for two reasons: It provides a larger subsidy to those most able to afford health insurance on their own, and it encourages the purchase of more generous health insurance plans than people otherwise would have chosen, which creates little incentive for people to be cost-conscious health care consumers. A better approach would be for the government to replace the current exclusion with a flat-rate refundable tax credit for the purchase of health insurance or health care. President George W. Bush’s recent health insurance proposal–which limits the amount of the tax subsidy and makes it available to people without employer-provided coverage–is, in certain respects, a promising response to these problems. (Though it falls short in critical respects: It would likely cause a shift away from employer-sponsored coverage without providing alternative pooling mechanisms in the
individual market, and it would continue to provide a larger subsidy to those with higher incomes.)

Additionally, the government could use “reinsurance” to make it easier for smaller affinity groups, such as small unions or religious groups, to form alternative risk pools and offer health insurance. By capping the insurer’s potential liability, reinsurance prevents a few high-cost individuals from significantly raising premiums for everyone else in small risk pools. Additionally, as reinsurance reduces the variance in private expenditures, and thus the risk to insurers of the impact of a high-cost individual, insurers would spend less on efforts to avoid offering health insurance to the very sick, thereby reducing
administrative expenses that provide no benefit for society as a whole, benefits confirmed by a 2004 Urban Institute study.

For individuals, by providing access to alternative risk pools, this New Social Compact would mean that their health insurance coverage would no longer be tied to a specific employer, thereby solving the problem of “job lock” associated with the current employment-based system. In exchange, individuals would continue paying payroll taxes and could have their health benefits conditioned on responsible and healthy behavior, such as under West Virginia’s Medicaid plan: Individuals are eligible for enhanced health coverage benefits if they
fulfill responsibilities outlined in a “Personal Responsibility Agreement,” including having preventative screenings, showing up for appointments, and participating in health-improvement programs.

Securing Broad-Based Growth

At a time when American workers and firms face growing competitive pressures from globalization, it may appear attractive to try to save jobs and benefits by intervening directly in the free market and imposing heavy-handed regulations and restrictions on firms. Yet such an approach is ultimately self-defeating. It hurts long-term economic performance and ignores the private sector’s inexorable retreat from providing health care, pensions, and other forms of security. New problems require new responses.

A more growth-enhancing, and thus self-reinforcing, way to promote economic security is for government to fill that void with well-targeted programs that provide a basic level of protection directly and that also make it easier for families to obtain additional levels of protection. As the traditional employer-based model for providing economic security disintegrates, it is time for a New Social Compact that will allow us to fulfill our nation’s promise of upward mobility–the broad-based opportunity for individual advancement that has provided a powerful incentive for industrious activity and thus spurred unprecedented economic growth for more than two centuries.