Don’t Allow Another Payroll Tax Accounting Gimmick

During his Monday evening address to the nation on the budget negotiations, President Obama repeated his call for an extension of the current one-year Social Security payroll tax cut. Whether or not this extension is agreed to as part of a larger budget deal, it is vital that Congress not permit a repeat of a costly accounting gimmick implemented when the temporary tax cut was enacted last year. The gimmick results in real additional costs and additional debt, and undermines the accounting integrity of the Social Security Trust Funds.

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:

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:

1. 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. 
2. 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. 
3. 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. 
4. 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. 
5. 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.”

This view of the Trust Fund’s bonds as having been “purchased with worker contributions” is widely held but it is increasingly belied by federal policy. Less than half of the current Trust Fund balance now actually consists of surplus payroll taxes paid by workers. A great deal of it consists of interest credits to the Trust Fund (though most observers would acknowledge the money was never saved – again, an issue beyond the scope of this article); some of the balance derives from revenue from benefit taxation; and some of it now consists of general revenue contributions. In fact, the $105 billion in general revenue transfers this year is greater than the amount of surplus payroll taxes paid by workers in any previous year, as seen on the graph below. To the extent that such accounting maneuvers fill the Trust Fund with debt issued from the general funds, we falsify the portrait painted before the American public of Social Security benefits purchased with worker contributions.

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.