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would not strive to prop up outdated arrangements, but rather it would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.