An often-repeated assertion in the debt-ceiling negotiations was that entitlement programs, including Social Security, must be cut if the long-run deficits are to be reduced. This raises many questions among those who have contributed to the program all their working lives and who have long expected an unquestioned return on that investment. They resent being told that they are living at the expense of the taxpayer like some welfare recipient receiving an "entitlement."
Isn't Social Security a separate program? After all, it has its own revenue source — the payroll tax — and its own spending formula based upon total taxes paid during the recipient's work life. Why is Social Security on the chopping block as if it were just another program in the federal budget? If it is separate from the rest of the budget, how can cuts in Social Security help reduce the deficit? What's the connection?
Although not a perfect analogy to private insurance, Social Security is an insurance program that takes in premiums and pays out benefits that insure beneficiaries against an unwanted event: poverty in old age. Of course, unlike the premium on a private insurance policy, the payroll tax is involuntary; participation in Social Security is required of most workers and the "premium" is the payroll tax. This mandate restricts freedom, of course, but the resulting universal coverage greatly reduces the program's administrative costs, and it forces the profligate to save.
For most beneficiaries, Social Security is an important component to retirement financing, and for 35 percent of the recipients, Social Security checks are their sole retirement income. Consequently this insurance program is extremely popular with the electorate. Given this popularity and the existence of a separate financing formula, why is Social Security part of the negotiations to bring greater balance to the federal budget?
In part, it is ideology. Apparently, to those who favor a reduction in the size of government regardless of how that is accomplished, anything that is expensive and operated by the federal government is fair game. They strongly believe in the supremacy of the private sector in providing all but a few services such as national defense. For these people, it does not matter that Social Security has much lower administrative costs than its private sector counterparts. Even when it is shown that Social Security has other advantages, such as the progressive benefit scheme — in which higher income payroll taxpayers cross-subsidize the lower income payroll tax-payers — still its opponents prefer to cut the program.
Would such cuts save money? Social Security was designed as a "pay-as-you-go" system in which current workers pay for current retirees in the expectation that when they retire, future workers will pay for them. As such, each generation invests in the next generation in a spirit of reciprocal responsibility to one another. This is not a one-way transfer from young to old; each generation inherits the physical and knowledge capital from the preceding generation. This worked fine for 75 years. Until the baby boom.
When the system was established in 1935, there was no way to forecast the baby boom that would follow the end of World War II. But in 1983 the Reagan administration did the math. They calculated that within a few decades a large number of boomers would retire and the payroll tax as then scheduled would be an insufficient source of revenue to pay the scheduled retirement benefits.
As a result, the plan put in place by President Ronald Reagan included an increase in payroll tax rates, creating a surplus of cash which enabled Social Security to buy special U.S. Treasury bonds. These bonds would be held in reserve, that is, in the "Trust Fund," representing an obligation of the nation as a whole to the Social Security System.
This reserve was to build to over $2.2 trillion worth of bonds. When needed, these bonds would be sold back to the Treasury by Social Security in exchange for cash to supplement the payroll taxes to pay the retirees their checks on schedule. The bond fund was the safest investment the boomers could make because it is backed by the full faith and credit of the nation itself. Reagan's economists estimated that the bond sales, or "redemptions," would begin to be required about 2018.
Due to the severe recession in 2008-09, the payroll tax revenue became insufficient eight years earlier than planned; the system ran deficits in 2010 and 2011 and consequently had to start redeeming the bonds. Where did the Treasury get the cash to redeem these bonds? Answer: the same place the Treasury gets any of its money — taxes and borrowing. So it is through the bond redemption part of the Reagan plan that Social Security impacts on the federal budget today.
Only by slowing down the rate at which the bonds are being redeemed can changes in Social Security help reduce the federal deficit. The slower the bond redemptions, the slower the annual amount of cash the Treasury must pay to redeem the bonds. This reduction in the rate of bond redemptions can be achieved either by increasing the payroll tax rate (shifting the burden of bond redemptions from the nation as a whole to the current generation of workers) or by raising the eligibility age for full benefits and/or by employing a less generous inflation adjustment formula. All these options are political minefields.
Charles O. Kroncke is associate dean in the University of South Florida College of Business. William L. Holahan chairs the department of economics at the University of Wisconsin-Milwaukee.