The Tax Cut and Jobs Act of 2017, the “crowning achievement” of Donald Trump’s first year in office, is estimated by the Joint Committee on Taxation and the Congressional Budget Office to add $1-1.5 trillion to the national debt over 10 years. Suddenly, the need to offset this increased pace of debt accumulation has caused Republicans to pivot from a Trump campaign promise to sustain entitlement spending; even Social Security, the country’s most popular government program, is now on the chopping block.
Although Social Security has never missed a payment in more than 70 years, the constant repetition of such falsehoods as “Social Security is broke” or “the trust fund money was stolen” have led many, particularly the young, to fear that Social Security will not be available when it is their time to retire. These assertions reflect a fundamental misunderstanding of a system that is working just as planned. Social Security is not about to explode—not now nor when the bonds in the trust fund run out. Nor is it broken, bankrupt, a Ponzi scheme or any of the other alarming pejoratives often used to describe it.
For most beneficiaries, Social Security constitutes an important part of their retirement income; for 35% of its recipients, it is their only income. Consequently, the program is extremely popular with the electorate. Why is cutting Social Security such a priority now? A little history is in order.
How We Got Here
Franklin D. Roosevelt designed Social Security as a government-mandated retirement insurance program to reduce poverty in old age. The revenue that pays for this coverage comes from a payroll tax, required of most workers. Because program benefits are based on their earnings, voters do not perceive Social Security as “welfare.” As Roosevelt once said: “We put those payroll contributions there to give the contributors a legal, moral and political right to collect their pensions and their unemployment benefits. With those taxes in there, no damn politician can ever scrap my Social Security program.” To this day, any “damn politician” who proposes to curtail any aspect of Social Security can expect to encounter opposition from a huge majority of the electorate.
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In 1983, Ronald Reagan’s Commission on Social Security foresaw the disruption that would occur around 2012 when Baby Boomer retirements would begin. At that time, retirees would markedly outnumber workers, and payroll taxes would have to be dramatically increased. To avoid this, the commission devised a plan that would force Boomers to save more towards their own retirement. Beginning in 1985, payroll tax rates were increased to create a surplus that the Social Security Administration (SSA) invested in specially issued treasury bonds. The accumulation of those bonds is called the “Social Security Trust Fund.” When, in the future, the SSA would need money to augment payroll tax revenues to pay Boomer retirement benefits, it would simply sell these bonds back to the U.S. Department of the Treasury rather than having to increase payroll tax rates.
The key to funding Boomer retirement benefits is economic growth; the commission was hoping that the Treasury would use the cash provided by SSA to foster economic growth by investing in our physical infrastructure and/or by reducing our national debt. This did not happen. Instead, in the 2000 election campaign, voters fell for George W. Bush’s position that the national surpluses (including the Social Security surpluses) were “our money” to be returned in tax cuts. (Al Gore, for his part, demonstrated a similar lack of macroeconomic sophistication by the fact that he neglected to point out that the national debt was “our debt” and that economic growth requires investment. Instead, he mumbled about lock boxes.)
Today, the core problem with Social Security is that the American economy grew more slowly than projected when the Reagan plan was put in place. Government neglect of crumbling infrastructure and huge spending on wars instead of enhancing growth and debt reduction squandered some of the resources that would have enlarged the economy to ease the payroll tax burden on future workers.
A Ponzi Scheme?
Some politicians have likened Social Security to a Ponzi scheme. A “Ponzi scheme” is a white-collar crime in which shares of a fund are sold to successive groups of investors, with no real resources backing up the shares. Each new group pays money into a fund, which is then used to pay the preceding groups. If each successive group is larger than the preceding group, the preceding investor groups gain. Initially, the returns are large, attracting more investors. Eventually, however, it becomes impossible for the succeeding investor groups to keep growing, and the “sure thing” collapses.
In Social Security, unlike a Ponzi scheme, both parties (workers and retirees) benefit: the older generation passes on to the young the physical and knowledge capital of the nation. The immense value of this transfer enables younger workers to produce the national income out of which the retirees take their piece. For example, it is the current retiring generation that built the internet, by which current entrepreneurs are building huge businesses, high paying jobs and great wealth. There is no similar reciprocity in a Ponzi scheme.
Some of the conflation of Social Security with a Ponzi scheme stems from the fact that the first generation of Social Security recipients received a large rate of return on their investments. The first recipient, Ida May Fuller of Rutland, Vt., received her initial check in 1940. Prior to her retirement, she had contributed $24.75. By the time she died in 1975, at age 100, she had collected $22,888.92. Similarly, the rest of that first generation received far more in benefits than they paid in. Of course, this was the same generation that pulled the country through the Great Depression and World War II, thereby contributing mightily to the welfare of the nation. Consequently, there was little fuss made over the extraordinary return on their payroll taxes. Later generations of retirees, of course, have received far more normal returns.
As the Social Security Trustee Report shows, the future of the program is secure with only minor adjustments. The frequently repeated falsehood that it will not be there for future generations fosters inter-generational distrust at a time when we need to be one nation again.
The Falling Worker-Retiree Ratio
Some critics claim that the burden on future workers will rise over time. This argument uses the ratio of workers to retirees, which is falling due to the Baby Boom population bulge. Currently, there are 2.8 workers for each retiree, and this ratio will fall to two workers per retiree over the next 25 years—an alarming and seemingly impossible burden for our children and grandchildren to bear. However, these fears do not account for rising worker productivity of those future workers.
Of course, sustained productivity growth requires sustained investment in the assets that contribute to growth in worker productivity. If that investment slows, the burden on future workers will be greater. The past decade of politicized obstruction of spending, both to invest in economic recovery and to invest in productivity-enhancing infrastructure investments, is the core economic burden on our youth. This failure to invest will leave them with a lower standard of living.
In 2018, the payroll tax is applied to all earnings up to a cap of $128,400. Among the many ideas to strengthen the solvency of the system are proposals to raise or eliminate that payroll tax earnings cap. In fact, the National Academy of Social Insurance reports that 71% of those polled prefer such a “scrap-the-cap” option. While apparently popular with the public, this option poses a potential danger to the program’s continued existence. The benefit payments received by individual retirees are calculated using a “progressive” formula based on how much they contributed. Those who earn less in their life are provided a much higher “rate of return” on each dollar they earn compared to the return that the higher income earners receive on each dollar they earn.
Average monthly earnings are calculated for each applicant for Social Security retirement benefits using earnings from each worker’s top 35 earning years. These past earnings are then adjusted via a wage index to bring them to today’s purchasing power. Under the benefit formula, each dollar of the first $711 of the average monthly earnings adds 90 cents to the benefit check; each dollar of the next $3,517 adds 32 cents; each dollar above that adds a mere 15 cents. Note that, while the benefit amount rises with earnings, the rate of increase drops very fast at the $711 and the $3,517 “bend points.”
This “progressivity” must be considered when assessing the practicality of scrapping the cap. For example, if the current formula for calculating benefits were retained, then each dollar of earnings above the current cap would contribute only 15 cents to monthly benefits. Consequently, higher income people would be taxed heavily while receiving a meager return, rendering it less of an insurance program and more of a welfare program. This would likely create the very divisiveness that Roosevelt adamantly tried to avoid. The negative reaction to “scrapping the cap” would be even more pronounced for the self-employed who are required to contribute as both employer and employee.
Choices for Congress When the Bonds Run Out
The original plan was for the Social Security Trust Fund to last until about 2060, when all but the most persistent Boomers would be dead. However, significant events—such as the terrorist attacks of Sept. 11, 2001, and 2008’s financial meltdown—intervened, causing the economy to grow more slowly than projected, with the result that Social Security purchased fewer bonds. The new prediction is for the bonds to run out in 2033; most Boomers will still be alive and collecting Social Security benefits. What happens then? Here are two of the many choices that Congress will face when the bonds run out:
• Reduce the Benefits
The payroll tax can still support 78% of scheduled benefits. A person retiring in 2040, after contributing the maximum for at least 35 years of working life, is scheduled to receive $41,572; under this calculation, the person would receive only $32,841.
• Pay Full Benefits
Continuation of scheduled benefits would require a change in the law to permit funding from outside the system, meaning the general taxpayer. If Congress decides to make such a change, no increase in Social Security tax rates is required to fully fund the scheduled benefits. Rather, Congress can simply continue with the existing Social Security tax rates in place before the Trust Fund was exhausted and bonds were still being cashed in. No great catastrophe will occur. This is good, because this second option is the most likely one to be chosen by a future Congress since most of the Boomers will still be alive and voting (as will their children, who don’t necessarily want to support their parents or have them move into the spare bedroom).
Understood correctly, Social Security is not a one-way transfer of funds from workers to retirees. Rather, it is a program that recognizes the reciprocity between generations. Current workers are paying their taxes out of income enhanced by the prior work and investments of the retirees. In a market system, with well-functioning capital markets, each generation’s productivity is enhanced by the efforts of preceding generations, and each generation pays a part of that increased productivity in the form of retirement benefits for the generation that made it possible. The young pay the old out of enhanced productivity made possible by the old who invested in infrastructure such as universities when they were young.
