What's In the Social Security Trust Funds, Or: Why Continuing the Payroll Tax Cut Could Eventually End Social Security as We Know It
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Most Americans do not know all of the details of Social Security finances. They do, however, retain a strong sense that Social Security participants somehow paid for their benefits, and that the program’s Trust Funds represent “their money” in a way that the financing for other government programs does not. This sense gives Social Security benefits an extra political protection relative to other programs. It would likely end if we abolished the Social Security payroll tax, did away with its trust fund, and funded the program with general budget revenues.
The proposed payroll tax cut extension would take a major step toward ending this longstanding special status. There’s no way to know where exactly the tipping point is, but it will come sooner than most observers now realize. Continuing and expanding this policy would likely soon turn bipartisan perceptions of Social Security into something more like welfare or at least like Medicare Part B: that is, benefits continually open for political renegotiation because they’re known to be subsidized from the general fund -- that beneficiaries themselves did not really pay for them.
As I’ve previously written, even under a “no action” scenario Social Security risks an eventual merger into the general budget (ending the special separation originally envisioned by FDR). A recent Ralph Bristol column persuasively argues that continuing to cut the payroll tax will make it inevitable even sooner that Congress “will formally adopt a ‘reform’ that is least disruptive by simply transferring a large portion of the legal liability for Social Security benefits to (the general fund) ‘where it will have been for the past many years anyway.’”
A detailed inspection of the Trust Funds and their income sources may help explain how rapidly the payroll tax cut might end the “earned benefit” rationale for Social Security.
The picture above divides Social Security’s $2.68 trillion Trust Fund balance (projected for the end of this year) into three pieces:
A: Surpluses of past program tax collections over expenditures;
B: Subsidies from the general government fund;
C: Interest credits.
Each of these three financing categories bears differently on the question of whether Social Security is a self-financed, earned benefit program.
Category A is the piece unambiguously consistent with the principles of self-financing. Whenever Social Security generates more in tax income than it spends on benefits, the surplus is deposited in its Trust Funds. If the program later draws on these funds to meet its benefit obligations, it is clearly just drawing on income it previously generated.
The vast majority of the money in Category A (98% over Social Security’s history) comes from the payroll tax, and the remainder from benefit taxation. Both tax sources contribute positively to the U.S. Treasury, and both thus contribute to the program’s self-generated income.
Category B, by contrast, is unambiguously inconsistent with the idea that Social Security benefits are earned and that the program is paying its own way. By the end of this year only 5% of the total Trust Funds balance will be attributable to such subsidies from the general fund. The lion’s share of this amount is in turn attributable to this year’s payroll tax break.
Category C – interest credits – is where fierce analytical arguments take place. Interest payments to the Trust Funds are made from the general fund, and viewed narrowly do not represent net additional income to the U.S. Treasury generated by Social Security. There are, however, two possible attitudes one can take towards these interest payments:
Attitude #1: The government’s ability to borrow from Social Security reduces the amount of other borrowing it must do, and thus its interest owed. Payments of interest to the Social Security Trust Funds thus represent actual net income generated by past program surpluses.
Attitude #2: Surplus Social Security taxes were spent rather than used to reduce government debt service. Payments of interest to the Social Security Trust Funds thus do not represent actual income generated, but are instead simply a further liability facing subsequent income taxpayers.
If one takes Attitude #1, one could justify grouping the interest payments in C with category A – that is, as consistent with the principles of self-financing. If one takes Attitude #2, then we would group C with B, because the interest credits would be an additional subsidy to Social Security provided by income taxpayers.
It’s beyond the scope of this article to explore this issue at length, but it has often been studied within academia and the evidence consistently supports Attitude #2. That is, the interest payments in category C represent, like category B, a further extent to which income taxpayers subsidize Social Security. But unlike category B, the question is arguable – that is, if the evidence pointed the other way one would reach the opposite conclusion.
One important additional technical point before moving on. Occasionally some commentators argue that interest payments to Social Security simply represent the repayment of money it previously loaned to the general fund -- that everything is “made even” once the money is repaid with interest.
This is incorrect. The reason it is incorrect is that the generations who must make the interest payments are not the same ones who borrowed the money. Basically, when one generation uses its surplus payroll taxes to buy additional government services for themselves, no additional money flows into the Treasury. When that same generation later receives Social Security benefits funded in part by credits of interest from the general fund, it is receiving a pure subsidy financed by younger income taxpayers.
It should also be remembered that while most interest earned by the Trust Funds to date is based on past tax surpluses, a small piece of it is attributable to general revenue transfers. This piece is another unambiguous subsidy from the general fund.
To sum up:
It is unequivocal that piece A represents an extent to which Social Security participants have paid for benefits.
It is unequivocal that piece B undercuts the view that Social Security is self-financing.
Piece C is arguable: one could construct a theoretical argument either way, though the empirical evidence favors the view that it is, like piece B, a subsidy from the general fund.
So where does this leave us? At the end of 2011, we will in effect be “a little bit pregnant.” That is, our enforcement of Social Security’s self-financing ethic will have been breached somewhat, but the total general fund subsidy to date would still be much smaller than net tax surpluses contributed by program participants. (Most of the Trust Funds would consist of interest credits, which are surrounded by analytical ambiguity.)
Now let’s look forward. Suppose that the President’s proposed policy were adopted of extending and deepening the current payroll tax cut. By the end of 2012, the Trust Fund balance would look like this:
This picture differs from the previous one in a very important way: already, subsidies from the general fund are beginning to compete in size with past net tax surpluses. Indeed, by the end of 2012 fully 37% of the Social Security Trust Funds’ non-interest balance would be attributable to general fund subsidies.
At what point would perceptions of Social Security being an “earned benefit” be irretrievably changed? Two approaching milestones might be worth noting:
- If the President’s proposed policy were adopted and then later extended, then by June 2013 the share of the Trust Funds attributable to general revenue subsidies would actually exceed the share attributable to past net surpluses of tax income over expenditures (i.e., B > A).
- If, hypothetically, the policy were adopted and extended indefinitely, by early 2015 the entire $3 trillion balance of the Social Security Trust Funds would be attributable to general revenue subsidies and interest credits (i.e., A < 0).
There’s no way to know. But one thing is certain: further continuation of the policy of replacing payroll taxes with income taxes will test perceptions of Social Security as an “earned benefit” to a degree that they have never been tested before.
Charles Blahous is a research fellow with the Hoover Institution, a senior research fellow with the Mercatus Center, and the author of Social Security: The Unfinished Work.
The Jobs Bill: Pretending to Fund Social Security
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Before this legislation is seriously considered, there needs to be greater understanding that it would take a major step toward transforming Social Security from what it has long been -- an earned benefit, funded by separate worker payroll taxes -- into an income-tax based system more akin to welfare.
A former colleague of mine has astutely observed that sometimes the most consequential policy decisions happen simply because too few realize that they are being made. In 1983, for example, Social Security faced an immediate financing crisis, which legislation was said to resolve for decades to come. What the public wasn’t told, and which too few policy makers recognized at the time, was that the solution would produce enormous annual Social Security imbalances going forward – big surpluses in the near term, followed by even larger deficits in the long term. And so for decades after the 1983 reforms, mounting Social Security surpluses allowed elected officials to mask deficits elsewhere in the federal budget, without meaningfully amassing resources to pay for the looming costs of the Baby Boomers’ Social Security benefits. So here we sit in 2011, with Social Security still technically “solvent” but running an annual $150 billion deficit of tax income relative to costs, and holding $2.6 trillion of debt in its trust funds that the general government is hardly in position to redeem.
We are now in danger of enacting another transformative change to Social Security, and a potentially disastrous one. Cutting the payroll tax isn’t just a stimulus measure; it’s a decision to fundamentally alter how Social Security is financed.
The payroll tax is Social Security’s lifeblood. If it continues to be significantly cut, then only one of two things can happen:
- Social Security’s insolvency is accelerated, or;
- Social Security must be financed by general (read: income tax) revenues.
Either choice undercuts Social Security’s future ability to operate as it has in the past.
So far, the Administration has quietly made choice #2: to convert Social Security into a general revenue-financed program.
The payroll tax cut enacted last December was accompanied by a provision to funnel roughly $105 billion in general revenues into the Social Security Trust Funds. This year’s “American Jobs Act” aims to cut payroll taxes by a further $240 billion in next year alone. The bill text recently submitted to Congress contains language funneling an offsetting $240 billion in general revenues into the program to make up for the uncollected taxes. That sums to a full $345 billion of general revenue (income tax) commitments just over 2011-12, to support Social Security benefit payments.
This is not a small change to Social Security; it is transformative. Consider this: in 2005, President George W. Bush proposed that workers be permitted to invest part of their Social Security contributions in personal accounts. The Congressional Budget Office then projected that this would result in roughly $323 billion in payroll tax revenues being redirected from the Trust Funds to personal accounts over the following ten years. Though all of that money would have been saved to finance future Social Security benefits, policy opponents voiced strong concerns about the supposedly-ruinous “transition cost” of personal accounts.
Just two years of payroll tax cuts now embraced by the Obama Administration, however, would shift more payroll tax revenue away from Social Security than CBO found President Bush’s proposal would over ten. Even more importantly, unlike President Bush’s proposal, none of this payroll tax cut would be saved to finance future Social Security benefit payments. The revenue would be “replaced” by new debt issued from the general government accounts – to be paid for decades from now with our children’s income taxes.
This transformation of Social Security financing warrants opposition both from self-identified progressives and conservatives. The reason that progressives should oppose it is straightforward: because cutting the payroll tax straightforwardly undermines our ability to finance benefits. This is why 61 House Democrats wrote the President on July 21 to express firm opposition to a further payroll tax cut extension.
Cutting the payroll tax is clearly also an attack on the progressive vision for Social Security’s future. Many progressives argue that the solution to Social Security’s shortfall is to raise taxes by increasing the wage base subject to the payroll tax. But the case that Social Security might be rescued with significant future tax increases is fatally undermined if elected officials conclude that the current payroll tax is already too high to sustain during a recession. Passage of the AJA would take the progressive solution to Social Security’s shortfall completely off the table.
Conservatives should also oppose the proposal with equal vigor, though for different and more complex reasons. For conservatives the problem lies primarily not with cutting payroll taxes but with issuing general revenue transfers to the Social Security trust funds. These transfers create legally binding debt that future taxpayers must redeem. Simply put: they convert Social Security into a program that requires higher income taxes to fund.
A temptation on the conservative side is to simply say, “The Trust Fund doesn’t mean anything anyway, economically. Why should I care if additional debt is issued to it?” This instinct is both naïve and substantively wrong. Though debt held by the trust funds may not have the same economic significance as debt borrowed in the public markets, it has the clear political meaning of authorizing additional spending, and the legal meaning of explicitly obligating the federal government to produce the required funds.
If you doubt this, consider that even in 2011 Social Security will spend $150 billion more than it collects in tax revenue. And yet there is no discussion of whether that $150 billion gap should be closed even in part with spending reductions. Why? It is entirely because the debt held by the Trust Funds gives the program permission to spend money, no questions asked. If the Social Security Trust Funds were now depleted, there would be a negotiation now ongoing over how to correct the balance of spending and taxes. Every time more debt is issued to the Trust Funds, that matter is decided wholly in favor of higher spending.
Conservatives should vigorously oppose this policy because it essentially requires that income taxes (rather than payroll taxes) must be raised in the future, to redeem Social Security Trust Fund debt and to pay benefits. This would convert Social Security into something more like welfare, for which the funding is provided – not by contributions from all covered workers – but preferentially from those subject to the income tax.
In sum, choking off Social Security’s tax revenue and issuing debt in its place is a terribly short-sighted policy, both for Social Security and for the general budget. Social Security faces challenges enough without being the source of funds for yet another round of fiscal stimulus. Leave it alone, or beneficiaries, taxpayers and the program itself will face dire consequences.
Charles Blahous is a research fellow with the Hoover Institution, a senior research fellow with the Mercatus Center, and the author of Social Security: The Unfinished Work.
Don’t Allow Another Payroll Tax Accounting Gimmick
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Background: Social Security is represented to the public as a self-financing program, designed to pay its own way. The idea is that workers fund their Social Security benefits via a separate payroll tax. The program has its own dedicated Trust Funds and can only make benefit payments from those Trust Funds. Surplus Social Security taxes in any year that they appear (3% of which come from taxation of benefits) are credited to the Trust Funds, which accumulate with interest.
Whether the amounts in Social Security’s Trust Funds represent real saving is a constantly-debated issue, and beyond the scope of this article. The main point for our purposes is that the basic ethic of Social Security financing is straightforward. On the one hand the program is not supposed to spend more on benefits than it generates in revenues. On the other, beneficiaries are to be assured that the assets in Social Security’s Trust Funds are fully available to be spent only on their benefits (and on small administrative expenses). Without that essential link between incoming taxes and outgoing benefits, Social Security would be just like any other federal program: funded from the general budget with no reason for a separate Trust Fund account.
Last December, Congress temporarily cut the employee share of the Social Security payroll tax rate from 6.2 percent to 4.2 percent. This was reportedly done to reduce the cost of, and thereby stimulate, job creation. At first glance, this might seem like a standard counter-cyclical government action in the face of recession: the government collects less revenue and accepts an increase in publicly-held debt in an effort to stimulate the economy. But tucked away in the legislation establishing this payroll tax cut was the following text:
“There are hereby appropriated to the Federal Old-Age and Survivors Trust Fund and the Federal Disability Insurance Trust Fund established under section 201 of the Social Security Act (42 U.S.C. 401) amounts equal to the reduction in revenues to the Treasury by reason of the application of subsection (a). Amounts appropriated by the preceding sentence shall be transferred from the general fund at such times and in such manner as to replicate to the extent possible the transfers which would have occurred to such Trust Fund had such amendments not been enacted.”Translated into English this basically means, “The government will continue to credit the Social Security Trust Fund as though the worker share of the payroll tax rate were still 6.2 percent, even though in reality it will only collect 4.2 percent from workers.”
The practical effect of this accounting gimmick is the issuance of roughly $105 billion in additional debt to the Social Security Trust Funds in 2011. This added debt will earn interest over time resulting in the obligation of hundreds of billions of dollars in future benefit payments -- benefits that no one has yet actually paid for. The new debt will ultimately be financed the way that all government debt is financed: out of the general treasury as yet another burden carried by our kids and grandkids, likely via higher income tax assessments.
There are several reasons why this accounting gimmick is damaging, costly and should not be repeated if Congress agrees to extend the current payroll tax cut:
- It’s unnecessary and irrelevant to any stimulus purpose. The argument for the payroll tax cut is that it provides near-term stimulus. But the accompanying general revenue transfer has absolutely nothing to do with stimulus. Its effect is only to avoid recognizing what would otherwise be transparent: that cutting the Social Security payroll tax affects the program’s Trust Funds as well as the government’s larger ability to finance Social Security benefits.
- It contradicts the ostensible purpose of ongoing budget/debt negotiations. Policy makers are currently engaged in discussions aimed at reducing federal deficits and the growth of federal debt. It’s one thing to support a payroll tax cut in this context, even though to a first approximation this increases deficits and borrowing from the public. But the accompanying general revenue transfer embodies a second round of debt issuance to the Social Security Trust Funds, resulting in a double dose of gross federal debt. This gross debt is essentially the debt subject to statutory limit, concern over which is the animating purpose of existing negotiations. In this context, it can only worsen public cynicism if policy makers engage in accounting gimmicks that balloon the very debt they are supposedly trying to constrain.
- It costs real money. Policy wonks argue endlessly about the economic meaning -- or lack thereof -- of the Social Security Trust Funds. But additional debt issued to the Trust Funds unquestionably results in real additional spending. This is true on its face, as the program’s authority to finance benefits is defined by the amount of assets in its Trust Funds. But it is also a phenomenon caused in part by political economy realities. Currently Social Security is bringing in roughly $151 billion less in taxes than it is paying out in benefits, yet there are virtually no calls to cut benefit payments to today’s seniors by anything resembling that amount. Why? Because of the positive balance in Social Security’s Trust Funds. The Trust Funds give Social Security permission to spend money in a way that few politicians can safely challenge, even in an urgent fiscal environment. In both technical and political senses, therefore, the issuance of over $100 billion in annual additional debt to the Trust Funds, and the accumulation of interest on that debt, will eventually result in hundreds of billions of dollars in further spending.
- It shifts Social Security’s financing basis from payroll taxes paid by today’s workers to higher income tax burdens on our children. Whenever we collect payroll taxes, we both increase the balance of Social Security’s Trust Funds as well as bolster the government’s ability to finance benefits. But when we simply issue general-revenue-financed debt to the Trust Funds, we increase the program’s authority to pay benefits without increasing the government’s actual ability to pay. Such increased debt owed by the general funds will be paid largely from future income taxes. No doubt some would prefer to have a Social Security system financed by income taxes rather than worker payroll taxes. But this is a fundamental policy change that should be publicly debated and transparently decided rather than accomplished by under-the-radar accounting changes.
- It
belies the public representation that the Social Security Trust Funds
consist of payroll taxes paid by workers toward their eventual benefits. Expressing the way many Americans think about the Social Security Trust Funds, one member of Congress recently stated:
“Americans have built up a $2.6 trillion dollar surplus in their Trust Fund. American workers know that their Social Security contributions are real – they see the amount deducted from their paycheck every week.”
For some perspective on the picture above, consider this. At the start of this year, Social Security’s Trust Funds held roughly $2.6 trillion. The vast majority of the nominal growth of the Trust Funds has taken place since the inauguration of the first President Bush (41), when they held only about $100 billion. Of that $2.5 trillion in subsequent growth, about $843 billion consists of surplus annual payroll tax payments, the remainder deriving from interest payments, benefit taxation, and now general revenue subsidies. That $843 billion attributable solely to surplus payroll taxes breaks down as roughly $133 billion during Bush 41, $308 billion during the two Clinton terms, and $496 billion during the Bush 43 terms, with payroll taxes later falling short of annual expenses by about $94 billion during the first two years of the Obama Administration.
The current aggregate shortfall of payroll taxes relative to expenses since 2009 will widen to a full $267 billion this year due to the current payroll tax cut, bringing the total net payroll tax surpluses since 1989 down to about $670 billion, or barely one-quarter of the total Trust Fund balance. What’s more: if the payroll tax cut is further extended through 2012, the total payroll tax shortfall since 2009 will rise to about $390 billion, reducing the net nominal contribution of payroll tax surpluses to the Trust Fund since 1989 down to about $550 billion, or less than one-fifth the total balance of the Trust Fund.
At that point, far from the Trust Fund mainly representing contributions made by workers, the vast majority of it would merely represent ongoing annual interest payments from the general fund, financed by the government with still more public debt. It would actually only take 3-4 years of repeating this year’s accounting gimmick until the general revenues committed to the Trust Fund were actually greater in nominal value than all the net surplus payroll taxes paid by workers since 1989. Granted, this is a current-dollar measure and not the best way to compare dollar amounts over long spans of time. It’s nevertheless clear that continuing the policy of cutting the payroll tax -- and depositing general revenues in its place -- renders the notion of a Trust Fund built up mostly by worker payroll taxes a thorough fiction in short order.
Some persist in saying that Social Security is not now adding to the deficit even though its 2011 tax income is a full $151 billion less than benefit payments, and even though this shortfall is now being made up with general revenue transfers and interest payments, neither of which cushion against its deficit impact. It can only further public cynicism for elected officials to again cut the Social Security payroll tax, issue additional debt to the Social Security Trust Fund, and yet claim that none of this activity adds to our deficits and total debt.
Whether the current payroll tax cut should be continued beyond 2011 is a matter warranting serious debate. But cutting the payroll tax has inevitable implications for Social Security financing, implications that government accounting should transparently acknowledge. In any event, under no circumstances should we repeat the accounting gimmick employed last time around.
Charles Blahous is a research fellow with the Hoover Institution and the author of Social Security: The Unfinished Work.
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