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The Payroll Tax Cut: Effective Stimulus, Phony Accounting

Charles Blahous | 12/08/2010 |

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It’s good news that President Obama and Congressional leaders have reached agreement on a deal to prevent a near-term tax increase on individuals and small businesses. As a public trustee for the Social Security Trust Funds I feel, however, obliged to sound an alarm about one component of the deal: specifically, a double-dose of new government debt, via a proposed accounting maneuver to disguise the effects of the agreement’s payroll tax cut provision.

The basics first, and then the problem. Currently, Social Security is funded by a 12.4% payroll tax on workers. Those taxes are credited to the Social Security Trust Fund, where they establish the program’s authority to make benefit payments. The provision in question would effectively reduce the payroll tax by 2 percentage points, resulting in an estimated $120 billion of tax relief to workers over one year.

Understand, my point here is not to critique the idea of payroll tax relief itself. Economists on both sides of the aisle believe that payroll taxes are a drag on job creation; indeed, one reason that we need Social Security reform is to prevent future payroll tax increases from hindering economic growth. Relative to other forms of stimulus, payroll tax relief introduces a minimum of both bureaucracy and economic distortions.

The problem is not with the tax relief but with an accompanying accounting gimmick: as described, the provision would also issue $120 billion in additional debt (from general revenues) to the Social Security Trust Fund – in other words, changing the government’s accounting to make it appear as though the $120 billion had been collected even though it hadn’t.

This is more than a harmless accounting entry; because Social Security spending is statutorily limited to the amount of assets in the Trust Fund, the accounting maneuver increases the government’s spending authority by $120 billion plus interest to be accumulated over decades to come.

This is, inescapably, double-counting. The $120 billion in question would be retained by workers while the government would credit the same money to the Social Security Trust Fund. Decades from now, hundreds of billions in benefit payments would be authorized based on phantom tax revenues that never appeared on the federal ledger.

Over the years, the accounting integrity of the Social Security Trust Fund has become increasingly compromised. This is a real problem because the very basis for Social Security is as a separate, self-financed program in which benefits are supposedly justified by payroll taxes workers have previously contributed.

Over the last two years gimmicks have been taken to a new level, first with the Making Work Pay tax credit and possibly again now with the payroll tax holiday. If this continues, then at some point (no one can say exactly when) it will become so obvious that the Trust Fund’s balance bears no actual relationship to taxes paid by workers that the rationale for Social Security’s continuing portrayal of “earned benefits” will eventually collapse.

Below is a graph showing the rising amount of debt issued to the Social Security Trust Funds – ostensibly representing the interest-compounded value of past surplus program revenues. In effect, this represents the total amount of benefit payments to which future taxpayers are being committed, above and beyond any payroll taxes they must pay.

(Chart)

These rising debt obligations would not be cause for concern if this amount of workers’ past payroll taxes had actually been collected and dutifully saved. Had that happened, our overall fiscal position would have improved, allowing us to more easily budget for these future benefit payments.

Most empirical analysis has concluded, however, that this money has not been saved. The government has repeatedly spent surplus Social Security taxes even as it has continued to issue additional debt obligations to the program’s trust fund.

While it’s bad enough to have spent surplus Social Security revenues, it’s worse still to record as incoming program revenues taxes that were never even collected. The earned income tax credit (EITC), for example, represents a deliberate federal policy to refund poorer workers’ payroll taxes even as we still credit those taxes toward their benefits via the Trust Fund. And, as Andrew Biggs noted in a recent piece, last year’s Making Work Pay tax credit refunded payroll taxes a second time over to many of these same workers.

We are getting dangerously close to a place where we maintain the notion of Social Security’s solvency and “benefits earned by payroll tax contributions” solely by bookkeeping gimmicks alone. Just imagine, for example, that today we decided to increase the Social Security payroll tax by a full four percentage points, while simultaneously giving every worker a refundable income tax credit exactly equal to that four percent. Obviously, this wouldn’t change total federal tax revenues or worker tax burdens at all, nor would it do anything to finance future Social Security benefits.

Yet by the logic of trust fund accounting, such a shell game would by itself create enormous Social Security surpluses, enough to finance not only the program’s currently projected cost explosion but also to permit us to increase benefits still further. Absurd though this accounting representation would be, it’s only marginally more absurd than the path we are already going down.

As SSA’s former acting deputy commissioner Jason Fichtner has noted, there’s an especial irony in this latest proposal for a 2% payroll tax holiday. Remember President Bush’s 2005 proposal to allow workers to invest a portion of their payroll taxes in personal accounts? The Congressional Budget Office projected that it would have taken four years (2009-12 inclusive) for as much as $120 billion to be redirected from the payroll tax into personal accounts. Opponents of President Bush’s proposal reacted then as though this would have had disastrous fiscal consequences -- even though that money would have been used to reduce otherwise-unfunded future benefit obligations. Yet many are now rallying around a proposal to allow that amount of payroll taxes to be redirected from Social Security in a single year, with the goal of stimulating unrelated spending, with no reduction in Social Security liabilities, and while playing accounting games with the Social Security books.

Now, there is a right way to provide this payroll tax relief if we desire it. Simply provide the tax relief and omit the accounting gimmick of nevertheless issuing $120 billion in debt to the Trust Fund. This would represent the value choice actually being made – that the need for near-term stimulus is so great that it justifies the collection of less revenue for Social Security. Of course, this means that Social Security Trust Fund revenues would be lower. Elected officials might be made uncomfortable by recognizing that reality on the books – but it is reality, nevertheless.

Let’s make this simple: Social Security benefits are funded by payroll taxes. If we want higher Social Security benefits, then we need to collect more payroll taxes. If we want to relieve payroll taxes, then we can finance less in Social Security benefits. Either policy is a valid choice. What is not valid is to refund the payroll tax while still pretending that we are successfully financing higher future Social Security benefits with money we haven’t collected.

These gimmicks embody a huge gamble with the future of Social Security. Millions of baby boomers will eventually be expecting benefits that they will believe they paid for via their payroll tax contributions. Increasingly, we are laying a foundation for future taxpayers to say – and rightly – “No, you didn’t.”

Charles Blahous serves as one of the two public trustees for the Social Security and Medicare programs. He is also the author of Social Security: The Unfinished Work.


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