The rapidly deteriorating financial condition of the Social Security system means that the program cannot continue as it is today. The Social Security actuaries warn that maintaining the currently promised benefits will require raising the payroll tax rate over the next 30 years to 18% from today's 12.4% rate, with a risk that it may have to be substantially higher. Even if real wages were to rise a full 1% a year faster than the actuaries assume, the trust fund will run out unless there is a large increase in the tax rate or cut in benefits.

The fundamental cause of Social Security's problem is that it operates on a pay-as-you-go basis with benefits financed by current taxes. This pay-as-you-go method is in sharp contrast to the way that private pensions and 401(k) plans finance benefits with the earnings of investment funds. Although the Social Security system has been accumulating a small temporary trust fund since the early 1980s -- to help pay benefits to baby boomer retirees after the year 2012 -- all benefits are still being paid out of current taxes. The accumulated value of the fund is less than 10% of the system's future obligations and, according to the Social Security actuaries, it will be exhausted by about the year 2020.

During the 60 years since it began, the Social Security tax has risen to a combined rate on employers and workers of 12.4% from just 2%. That six-fold increase in the tax rate, and the unusually rapid rise in labor force participation, has permitted the Social Security system to pay out much more in benefits to retirees than those retirees had paid in taxes during their working years. Social Security is therefore a wonderful deal for those who got in on the ground floor when the tax rate was low, and who have already retired or will soon retire. The double-digit rates of return that they have earned on their Social Security taxes has given the program enormous political support.

But the days of a high implicit rate of return in an unfunded Social Security program are gone forever. For younger employees today, and for those who will enter the work force in the future, the Social Security program is an enormously inefficient way to provide for retirement. Social Security tax rates will have to rise in the future just to balance the aging of the population and the increasing number of retirees relative to those who are working. Tax rate increases will not produce high rates of return for future retirees.

If Social Security continues to operate on an unfunded pay-as-you-go basis, the implicit return that individuals will get on their Social Security taxes will be limited to the rate of increase in tax revenues that results from rising incomes and an increasing size of the population. On average, that's likely to mean an implicit return of only about 2.5%, far less than previous generations of Social Security participants enjoyed.

So the fundamental problem of the Social Security program goes beyond its financial crisis. The real problem with Social Security today is the low implicit return that individuals receive on the dollars that they pay into the system. That cannot be changed by raising taxes or lowering benefits. It's inherent in the unfunded pay-as-you-go character of the current Social Security program.

In contrast to the 2.5% implicit return on Social Security taxes, funds that are channeled through stocks and bonds into investments in real plant and equipment have earned a real pretax return of more than 9% over the past three decades. Shifting from the current unfunded system to a funded program with individual retirement accounts or 401(k) plans would permit employees to earn that higher rate of return.

A wide range of countries around the world have already responded to this potential gain and switched from unfunded pay-as-you-go social security programs to funded privatized systems. Although these systems differ in detail, the common characteristic is the requirement that employers and employees contribute funds to individual accounts that the employees can then invest in mutual funds or other financial assets. In the official report of the U.S. Advisory Council on Social Security that will soon be released, the idea of privatizing Social Security in the U.S. will be recommended by a substantial minority of the council members.

Privatizing Social Security would cut required contributions dramatically. With the substantially higher rate of return in such a funded individual Social Security account, employees could accumulate the same retirement benefits that are now promised by the Social Security program with a much smaller sacrifice during their working years.

To get a sense of how big this difference would be, think about a 50-year-old employee who earns $40,000 a year. With a 12.4% tax rate, he and his employer now pay $4,960 in Social Security taxes. With the Social Security rate of return of 2.5%, that $4,960 would grow to $9,195 when he is 75 years old. In contrast, in a privatized Social Security account that earns a 9% rate of return, accumulating that $9,195 would require saving only $1,066.

More generally, the retirement annuity that requires a 12.4% payroll tax rate in an unfunded Social Security program could be financed by annual contributions that are only one-fifth as large if they are invested in a funded account that earns a real return of 9%.

By shifting to a privatized funded system, the mandatory Social Security contribution could be cut by nearly 80% without a reduction in retirement benefits. For someone earning $40,000 a year, a funded program would thus mean the equivalent of a tax cut of more than $4,000 a year. That tax cut would be possible because of the difference between the 9% return on a real investment in plant and equipment and the much lower return that a pay-as-you-go system can provide.

The tax cut would not only mean more money in each individual's pocket to spend or to save but would also mean a lower marginal tax rate. Since only one-fifth of the 12.4% current payroll tax would be needed to finance the retirement benefits with a privatized Social Security account, the remaining 10 percentage points of the current payroll tax are now a true tax for which the individual gets nothing back. Shifting to a privatized system would therefore cut the individual's effective marginal tax rate by 10 percentage points. For someone who earns $40,000 a year, that would mean a cut in the combined marginal federal income and payroll tax rate to only 15% from an effective 25% today.

Lowering the marginal tax rate in this way would strengthen the incentive to work and would reduce the distorted incentive to take compensation in a variety of fringe benefits and other untaxed forms rather than in spendable cash. The existing tax distortions reduce the efficiency of the economy and lower real national income. The reduction in these distortions that would result from lowering the marginal payroll tax rate would be equivalent to adding about $50 billion a year to national income, a gain of nearly 2% of the total wages now subject to Social Security taxes.

There can be no doubt that the long-run gain from shifting to a privatized system would be enormous: cutting each individual's cost of providing for retirement by 80% and cutting the total federal marginal tax rate of most employees almost in half.

We cannot achieve these benefits of a privatized system overnight. During the transition to a completely private and funded system, the government must continue to pay benefits to existing retirees while new funds are accumulated and invested through the individual accounts. There are a variety of ways in which this transition to a such a fully privatized system could be managed and financed. None of them need disrupt economic activity or financial markets. The specific combination of changes in government debt, taxes and benefits will determine how rapidly the transition in made and which groups are the winners and losers during the transition. Fortunately, the big difference between the return on real investment and the implicit return on Social Security taxes implies that the cost during the transition need not be large.

The fundamental reform of Social Security has been politically impossible as long as it looked like Social Security was financially sound and was capable of continuing to provide a high implicit return on payroll taxes. But the opposite is now clear. The financial problems of the program will force substantial change. And the poor return that any unfunded program can offer will provide the political support for a shift to a privatized funded program.

There is no more important long-term issue facing the American economy. And there is no better time to start the transition than now.

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Mr. Feldstein , a former chairman of the President's Council of Economic Advisers, is a professor of economics at Harvard.

(See related letter: "Letters to the Editor: Beware Privatizing Of Social Security" -- WSJ April 8, 1996)