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The End of Social Security Self-Financing: What Next?

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The End of Social Security Self-Financing: What Next?

October 10, 2012

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Today the Mercatus Center is releasing my study entitled, “The End of Social Security Self-Financing: What Does it Portend for Social Security’s Future?” The piece explores the implications of the Obama Administration and Congress having recently cut the Social Security payroll tax and financed benefit payments from the general government fund, thereby ending decades of bipartisan commitment to FDR’s original vision for Social Security -- that it be a self-financing program in which total benefits were limited by the amount of worker contributions. This financing change has the potential to fundamentally transform the future Social Security debate, possibly affecting important policy choices ranging from its rate of benefit growth, to whether a contribution-benefit link is maintained, to how eligibility ages are set, to whether formal means-testing is adopted.

News reports indicate that the payroll tax cut will be allowed to expire at the end of this year. There are, however, no indications that lawmakers will reverse the substantial general revenue subsidies that were deposited in the Social Security Trust Funds to compensate for it. Approximately $217 billion in such subsidies have been provided to Social Security. These subsidies do not reflect any incoming tax collections and their costs are simply being added to the national debt. Moreover, because these transfers to the Trust Funds earn interest, by 2033 they will have compounded to require future taxpayers to subsidize roughly $600 billion in Social Security benefit payments beyond what beneficiaries paid for. It remains to be seen what effect this policy change will have on public perceptions that Social Security is an “earned benefit.”

My study details the following aspects of the policy change:

The Long History of the Self-Financing Principle: A foundational idea underlying Social Security historically was that it was not supposed to be welfare. In a welfare program it’s not required that tax contributions and benefit payments balance, individually or collectively. One individual might receive benefits despite having never paid taxes, whereas another might contribute taxes but draw no welfare benefits. FDR wanted Social Security to be different. He insisted that it be financed under contributory insurance principles, with total benefits limited to the amount of worker contributions plus interest. The perception that workers had -- at least as a group -- paid for their benefits was FDR’s means of safeguarding the program’s political support. As he put it:

We must not allow this type of insurance to become a dole through the mingling of insurance and relief. It is not charity. It must be financed by contributions, not taxes. . . I expressed my opinion that full solution of this problem is possible only on insurance principles. It takes so very much money to provide even a moderate pension for everybody, that when the funds are raised from taxation only a “means test” must necessarily be made a condition of the grant of pensions.

For decades a strong bipartisan majority remained firmly committed to FDR’s vision. The political right valued the contribution-benefit link as ensuring critical fiscal discipline, whereas the left valued it for protecting benefits from having to compete annually with other programs for funding. Social Security Advisory Councils over the decades repeatedly endorsed self-financing, on up to and including President Clinton’s 1994-96 council, which unanimously opined that Social Security should be financed “without other payments from the general revenue of the Treasury.”

Cracks in the Consensus: This consensus commitment to self-financing first began to erode in the late 1990s. In 1999 President Clinton proposed transferring general revenues to the Trust Funds to “save the surplus” for Social Security. In the following decade many other left-of-center advocates suggested breaking the program’s contribution-benefit link by having higher-income taxpayers contribute additional taxes to the program without earning associated benefits.

As the commitment to Social Security self-financing ebbed in some quarters, there arose a parallel desire to cut low-income workers’ payroll tax burdens. This occurred for several reasons. 

  • One was a misperception that the payroll tax was “regressive.” Actually, Social Security net tax burdens (taxes net of benefits) are quite progressive as figure 1 shows. The misperception that its financing system is regressive is based on viewing only one side of the equation; the payroll tax assessments but not the benefits they create. Because the Social Security payroll tax would clearly never have been established without accompanying benefits, this one-sided view is incomplete at best.

Figure 1 (Source: Social Security Administration Office of the Actuary)

  • Second, Social Security benefits have steadily risen to levels requiring higher tax burdens than lawmakers remain comfortable assessing throughout good times and bad. See Figure 2.

Figure 2: Annual Social Security Cost Burdens Relative to Worker Wages (Source: Social Security Trustees’ Report)

  • Third, policy makers intermittently wish to provide “tax relief” to workers who pay no income taxes – a contradiction often resolved by mis-portraying refundable tax credit payments as payroll tax relief (even when policy makers had no intention of actually cutting income to the Social Security Trust Fund, nor the benefits these payroll taxes finance). 

  • Finally, some (especially younger) left-of-center advocates now take it for granted that Social Security’s ongoing political support will remain strong even if the historical self-financing principle is abandoned.

The rising desire to replace Social Security’s contributory payroll tax financing with general fund subsidies was by no means shared by all left-of-center Social Security policy advocates. Some, such as Nancy Altman, strongly criticized the recent payroll tax cut out of a conviction that Social Security’s self-financing principle remained the cornerstone of its future viability and political strength.

Abandoning Self-Financing: In 2011-12 lawmakers cut the Social Security payroll tax to its lowest level in decades. The legislation included the following language:

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.

Overnight this provision transformed Social Security from a program in which general revenue financing had historically been negligible, to one that relied significantly on subsidies from the general fund. By the end of this year only 28% of the Social Security Trust Funds balance will reflect prior surpluses of Social Security tax income over expenditures. See Figures 3 and 4.

Figure 3: Components of the Social Security Trust Funds, End of Year 2010

Figure 4: Components of the Social Security Trust Funds, End of Year 2012

Potential Policy Implications: There are essentially four possible future courses for Social Security policy given the recent incorporation of substantial general revenue subsidies.

  1. Continuation. Social Security continues to receive substantial subsidies from the general fund while its historical ethic of self-financing is tacitly abandoned.
  2. Recurrence. The current general revenue subsidies are allowed to terminate on schedule, but a precedent is established whereby lawmakers feel few inhibitions about resuming such subsidies whenever they believe other policy considerations warrant doing so.
  3. Termination with Lasting Policy Effects. The general revenue subsidies terminate on their current schedule and are not revived, but public perceptions of Social Security’s role are significantly affected by awareness that benefit payments have been subsidized from the general fund.
  4. Termination with No Lasting Policy Effects. The general revenue subsidies terminate on their current schedule, public awareness of the subsidies remains limited, and lawmakers henceforth treat the 2011–12 practice as a one-time exception to longstanding policy.

There is no way to know which course will be taken, but under three of these four scenarios Social Security’s future is likely to be quite different from its past. Historically programs financed from the general fund have been treated very differently from Social Security. These differences reflect a dynamic in which general fund financing induces many lawmakers to value the interests of income taxpayers on a par with those of beneficiaries.

Benefits in general-fund-financed programs have historically been much more changeable than Social Security’s, with revisions of eligibility criteria and means tests being particularly frequent. Moreover, certain features of current Social Security benefit growth (such as wage-indexing of its initial benefit formula) are extremely atypical of other federal programs, which are usually indexed to grow more slowly. Finally, if it is no longer required that Social Security tax collections be sufficient to finance its benefit payments, the historical pattern of payroll tax rate and base increases may well discontinue.

The following table summarizes possible changes to Social Security policy in the post-self-financing era:

Possible Changes to Historical Social Security Policy Principles under General-Fund Financing

Policy Factor  Historical Principle  Possible Change 
Payroll taxes  Raise periodically as necessary to finance scheduled benefit obligations. Argument for future payroll tax increases weakened; acceptable for payroll tax collections to fall short of benefit obligations. 
Means testing  Full benefit eligibility for all contributors regardless of non-Social Security income. Eligibility based in part on need in the manner of other general revenue–financed programs. 
Wage indexing of initial benefit formula Benefits indexed to remain a constant share of preretirement wages.  Benefits grow with price inflation in the manner of other general revenue–financed programs.
 Contribution-benefit link Benefit entitlement a reasonably direct function of individual payroll tax contributions. Formula redrawn to provide limited safety-net benefit for all, irrespective of individual tax contributions.
 Eligibility Ages Set to ensure that vast majority can withdraw old-age benefits.  Raised to target benefits on those most at risk of outliving preretirement savings .

A fuller discussion of why general revenue financing may lead to these specific policy changes is included in my study.

In sum, the recent policy of cutting the Social Security payroll tax and financing the program from the general fund represents a fundamental departure from its longstanding financing basis and a philosophical break with the vision of FDR. The long-term policy implications are not yet clear. To the extent, however, that the current general-fund subsidies are either precedential or undermine perceptions of Social Security as an earned benefit, they could mean an end to political dynamics that historically have rendered Social Security unique, prompting renewed consideration of policy options traditionally applied only to what have been popularly thought of as welfare programs.

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.

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