Center for Business & Public Policy
Collaborative blog exploring the relationship between market forces and public policy.

Here is the third in a series of blogs that I started on May 18.  The first was called “Why YOU may LIKE Government ‘Theft’”.  In it, I listed four possible justifications for government to act like Robin Hood, taking from the rich to give to the poor.  The point is to think about whether the top personal marginal tax rate really should be higher or lower than currently, as currently debated these days in the newspapers.

However, perhaps we should also remember what is wrong with government using high marginal tax rates to take from the rich in order to help the poor.  The problem is that a higher personal marginal tax rate distorts individual behavior, particularly labor supply and savings behavior, by discouraging work effort and investment.  Since those are good for the economy, high marginal tax rates are bad for the economy!  In fact, economic theory suggests that the “deadweight loss” from taxation may increase roughly with the square of the tax rate.  In other words, doubling a tax rate (e.g. from 20% to 40%) would quadruple the excess burden of taxes – the extent to which the burden on taxpayers exceeds the revenue collected.

The point is just that we face tradeoffs.  Yes, we have four possible reasons that we as a society may want higher tax rates on the rich in order to provide a social safety net, but we also have significant costs of doing so.  Probably somewhere in the middle might help trade off those costs against the benefits, but it’s really a matter of personal choice when you vote: how much do you value a safety net for those less fortunate that yourself?  And how much do you value a more efficient tax system and economy?

In the first blog on May 18, I listed all four justifications, any one of which may or may not ring true to you.  If one or more justification is unconvincing, then perhaps a different justification is more appealing.  In that blog, I put off the last three justifications and mostly just discussed the first one, namely, the arguments of “moral philosophy” for extra help to the poor.   As a matter of ethics, you might think it morally just or fair to help the poor starving masses.  That blog describes a range of philosophies, all the way from “no help to poor” (Nozick) in a spectrum that ends with “all emphasis on the poor” (Rawls).

In the second blog on July 13, I discussed the second justification.  Aside from that moral theorizing, suppose the poor are not deemed special at all: every individual receives the exact same weight, so we want to maximize the un-weighted sum of all individuals’ “utility”, as suggested by Jeremy Bentham, the “founding figure of modern utilitarianism.”  His philosophy is “the greatest happiness of the greatest number”.   Also suppose utility is not proportional to income, but is instead a curved function, with “declining marginal utility”.  If so, then a dollar from a rich person is relatively unimportant to that rich person, while a dollar to a poor person is very important to that poor person.  In that case, equal weights on everybody would still mean that total welfare could increase by taking from the rich to help the poor.

The point of THIS blog is a third justification, quite different in the sense that it does NOT require making anybody worse off (the rich) in order to make someone else better off (the poor).  It is a case where we might all have nearly the same income and same preferences, and yet we might all be better off with a tax system that has higher marginal tax rates on those with more income, and transfers to those with little or no income.  How?  Suppose we’re all roughly equally well off in the long run, or in terms of expectations, but that we all face a random element in our annual income.  Some fraction of us will have a small business that experiences a bad year once in a while, or become unemployed once in a while, or have a bad health event that requires us to stop work once in a while.  To protect ourselves against those kinds of bad outcomes, we might like to buy insurance, but private insurance companies might not be able to offer such insurance because of two important market failures:

1. Because of “adverse selection”, the insurance company might get only the bad risks to sign up, those who are inherently more likely to become unemployed or to have a bad year.
2. Because of “moral hazard”, insurance buyers might change their behavior and become unemployed on purpose, or work less and earn less.

With those kinds of market failure, the private market might fail altogether, and nobody is able to buy such insurance.  Yet, having such insurance can make us all better off, by protecting us from actual risk!

Potentially, if done properly, the government can help fix this market failure.  Unemployment insurance is one such attempt.  But the point here is just that a progressive income tax can also act implicitly and partially as just that kind of insurance:

In each “good” year, you are made to pay a “premium” in the form of higher marginal tax rates and tax burden.  Then, anytime you have a “bad” year such as losing your job or facing a difficult market for the product you sell, you get to receive from this implicit insurance plan by facing lower tax rates or even getting payments from the government (unemployment compensation, income tax credits, or even welfare payments).

I don’t mean that the entire U.S. tax system works that way; I only mean that it has some element of that kind of plan, and it might help make some people happier knowing they will be helped when times are tough.  But you can decide the importance of that argument for yourself.

Next week, the final of my four possible justifications for progressive taxation.

I find myself bemused by the sheer number of commentators that have labeled vice presidential candidate Paul Ryan a “radical” because of his views on the federal budget.  His core view – that we ought to keep federal spending as a share of GDP at a level approximately equal to where it has been for the entire lifetimes of most Americans – strikes me as far less radical than the current policy status quo.

Let’s start with some basic facts.  In the post-war period in the U.S., federal spending has averaged just under 20 percent of GDP.  (You can confirm this for yourself by going to the White House OMB site and downloading Table 1.2).  There have clearly been some ups and downs over this period for a variety of reasons, but it has never exceeded a quarter of GDP except for 2009 – the depths of the Great Recession – when outlays reached 25.2% of GDP.

In other words, for 60 years – through military conflicts great and small, through booms and busts, through the creation and demise of countless government programs, and through tectonic shifts in the global economic landscape, the U.S. has found it possible to keep government at about 20% of GDP.  And throughout this period, the economic engine of the U.S. remained the envy of the world, even now in the aftermath of the Great Recession.

Absent substantial changes to our public policies, however, U.S. government spending as a share of GDP is projected to rise at an unprecedented rate.  According to the CBO’s “extended alternative fiscal scenario,” which they describe roughly as a continuation of current policies, spending as a share of GDP is projected rise to 35.7% of GDP in just the next 25 years.  This seems to me to be prima facie evidence that our future fiscal problems are being driven by rising spending, rather than a lack of revenue.

Given this, what sounds more radical?  Suggesting that we make cut the growth rate of spending to keep the ratio of government-to-GDP near historical levels, as Paul Ryan has suggested?  Or allowing government to grow from 20% to over 35% of GDP?

Google’s definition of radical is “affecting the fundamental nature of something.”  A failure to change policy course would affect the fundamental nature of the U.S. economy.  Now that is radical.

If we want to avoid this, then we need to re-think the role of government.  Most of the future projected growth of government is due to a rising health care costs and an aging population.  One cannot slow rising health care costs and population aging simply by cutting spending, as any serious student of the budget – of which I consider Paul Ryan to be one – already knows.  Nor is it obvious we really want to stop all those trends – at least some of the rise in health spending brings new health benefits, and most of us are quite happy to live longer.

What we can do is recognize that our programs need to change with the times.  Remaining life expectancy today, conditional on reaching age 62, is about 50% longer than it was in the 1960s.  Yet we continue to encourage people to exit the labor force early.  Even worse, we have created a mentality where most Americans seem to believe that they have a God-given right to have their retirement income and health care expenses paid for by taxpayers after they reach age 62 or 65.  At a minimum, we should recognize that if people are living both longer and healthier lives than they were in decades past, we ought to make them wait longer to start receiving benefits.

There are good reasons to have Social Security and Medicare.  But we need to recognize that the fiscal burden they are placing on taxpayers is going to grow rapidly in the years to come, and that the best way forward is to reform them to make them sustainable for future generations.  Paying for these rapid cost increases through an inefficient tax system that depresses investment, discourages entrepreneurship, penalizes work, and retards economic growth is the real “radical” solution – and the one that should work hard to avoid.

I’ve written over the past couple of weeks about public pensions in Illinois.  Short version: they’re a possibly-unfixable mess.  Since the state constitution forbids reducing promised benefits for current employees (or increasing contributions) and the state has failed to plan for their pension promises in a timely manner, the state is stuck between the proverbial rock and a hard place.

With this in mind, over the past few days I’ve been trying to think of unconventional ways in which the state can save money.  This is a bit tricky, since in the case of public employees the state pays their salary when they’re working AND their pension when they retire.  It’s the overall cost that matters.  So, for example, when the University of Illinois had an early retirement program last year, the University stopped paying them and SURS, the state university retirement system, started paying them.  But since both are ultimately using state dollars (but less-so in the case of the University, whose state appropriation as a fraction of overall cost has fallen drastically in recent years), this is really just a reshuffling of which pocket the money comes from.  The state is still on the hook.

Thinking outside the box leads to some crazy ideas.  And here’s one of them.  I make no promises about whether it will work in practice.  But it does point to some of the strange features of state finance.

Here’s the idea: to help the state’s pension system’s finances, the state should pay its workers more as they near retirement.  That’s right.  More.

As I started to play around with the idea, I had a dim recollection of reading something related.  It turns out that a couple of weeks ago, Andrew Biggs wrote in the Wall Street Journal about how cutting the Social Security payroll tax for workers nearing retirement could actually help the system’s finances.  The idea is simple: if older workers get to keep more of their wages, they’ll work longer.  And, if they’re working, they’re not collecting Social Security.  Lowering the payroll tax pushes back retirement, and this helps the system’s finances.  The idea is also related to my post from two weeks ago, where I discussed research showing that retiree health benefits induce early retirements.  If the state can’t pay retirees less and can’t ask them to contribute more, the only thing it can do to reduce pension costs is induce them to retire later, and it needs to do so in a way that costs less than the potential savings from delayed retirement.

So, how does it work?  Consider a worker near retirement age who has been working for the state his whole career, or at least long enough to reach the earnings cap on the state’s retirement system.  This worker, let’s call him Charlie, will earn 80% of his final salary after retirement.  And, assuming this worker was actually fulfilling a necessary function (e.g., teaching students finance), that worker will have to be replaced after retirement by a new worker.  Let’s call him David.  New workers tend to earn less than senior workers, so David will earn less than Charlie did.  Maybe David earns 80% of Charlie’s final salary.  But, essentially, after Charlie retires the state will be paying both Charlie and David – two people – to do work that could be supplied by one person.  While the state paid 100% of Charlie’s salary for that work before retirement, it pays 160% of Charlie’s salary after retirement!

So, the state has the potential to save a lot of money overall – 60% of Charlie’s salary per year – if it can induce Charlie to delay retirement.  Due to the non-impairment clause, a lot of the ordinary ways of doing this such as increasing the full retirement age are off the table.  One thing the state can do is increase Charlie’s salary.  This could be done through an actual wage increase or, as Biggs suggests, by reducing the 8% of wages that Charlie must pay into the retirement system as he nears retirement.

It is easy to see how it might be worth it to the state to spend more money on Charlie’s wages in order to delay his retirement.  But, let’s make up some simple numbers.  I’m going to ignore things like the fact that pension payments increase 3% per year and other details of the retirement system. They don’t change the basic insight, and the uncertainty involved with the other numbers that I’M JUST GOING TO MAKE UP is a much bigger deal than details like this.  I’m illustrating – not proposing policy.

So, suppose that increasing Charlie’s wage by 10% per year leads him to delay retirement by 3 years.  Suppose Charlie makes $50,000 per year and has maxed out his service so he’ll earn 80% of that ($40,000) after he retires.  Assume that David will earn $40,000 after he’s hired.

There are two things that should be taken into account.  If Charlie’s wage goes up, the basis for his pension will go up as well.  Roughly speaking, pensions are based on average earnings over the last four years of work.  Over these years, Charlie earns 50,000 for one year (the year before he gets the raise) and 55,000 for three years (after he gets the raise).  His final pension is 80% of the average, or 0.8 * 53,750 =  $43,000 per year.  Again, there are subtleties to the formula, but too many details obscure the main idea.  And, if Charlie works additional years, he will pay an additional 8% of salary into the pension system.  This would seem to be money that the state gets back.  But, as far as I can tell, these “excess contributions” are refunded to the employee at retirement.  So, in the case of a worker who has maxed out his pension, there would be no additional benefit to the state.  (For a worker who has not maxed out their pension, the state would receive additional contributions from the worker who delays retirement, but it would also have to pay an additional 2.2 percent of final earnings for each additional year of work, so it is unclear that this would benefit the state.)

Total 10 year cost if Charlie retires now:

Total 10 year cost if Charlie retires in 3 years:

So, the total savings over 10 years from my COMPLETELY MADE UP numbers is $54,000, or 6.75% of the cost under the current system.  And, this savings occurs in the first three years from not having to pay David.  Although I’ve ignored the time-value of money to keep things simple, the fact that the savings come up front would favor giving Charlie the raise if there were a positive interest rate.

Whether a scheme like this could actually save money would depend on a lot of things.  Among them are how much more near-retirees need to be paid to delay retirement, how long the delay retirement for, the relative cost of replacement workers, the length of time over which retirees draw pensions, and the time-value of money. Again, for the purposes of illustration, I COMPLETELY MADE UP THE NUMBERS ABOVE.  Economists invest a lot of time and energy in estimating quantities like these, though, and they’d need to do so before anything like this could go forward.

One crucial factor would be how well the state can target workers who are really on the margin of whether or not to retire.  While a wage increase across the board would be extremely unlikely to save the state money, one that is targeted at workers who are thinking about retiring and induces them to delay retirement just might.  One thing’s for sure: it wouldn’t run afoul of the non-impairment clause!

My own research area is environmental and natural resource economics, which others often call “sustainability”.  That’s actually embarrassing, because I don’t know what it means.  For a renewable resource like timber, it seems pretty easy:  you just plant trees, let them grow, cut them down, and then plant trees again.  For a nonrenewable resource like oil, it’s impossible: once a barrel of oil is consumed, it’s gone forever.  The only way to make oil “sustainable” is not to use it, which does not make any sense, because oil has no value at all if it can’t be used.

So, sustainability is either obvious or impossible.  The concept seems to be of no use whatever.  So I turn to people smarter than me, to get some answers.  By “smarter than me”, in this case, I mean (1.) Nobel-Prize winning economist Robert Solow, and (2.) whoever writes for Wikipedia.

Way back in 1991, Robert Solow wrote “Sustainability: An Economist’s Perspective”, in which he says:  “It is very hard to be against sustainability. In fact, the less you know about it, the better it sounds.”   He says he has seen various definitions, but they all turn out to be vague.  So his essay is an attempt to make it more precise.  “Pretty clearly the notion of sustainability is about … a moral obligation that we are supposed to have for future generations.”   But you can’t be morally obligated to do something that is not feasible!  He notes UNESCO’s definition:  “… every generation should leave water, air, and soil resources as pure and unpolluted as when it came on earth.”   But taken literally, that injunction “would mean to make no use of mineral resources; it would mean to do no permanent construction, … build no roads, build no dams, build no piers.”  That is neither feasible nor desirable!

Instead, he suggests that sustainability might be both feasible and desirable if it is defined as “an obligation to conduct ourselves so that we leave to the future the option or the capacity to be as well off as we are.”   In the final analysis, what that means is that we don’t necessarily have to leave all the oil in the ground, if we leave something else of equal or greater value, some other investment that can be used by future generations to produce and consume as we do, and which they can leave to other generations after them.  It is a holistic concept, both simple and operational.  We only need to add the value of all assets, subtract all liabilities, and make sure that the net wealth we bequeath is not less than we inherited. 

We can use oil, but we should not simultaneously be running huge government budget deficits that reduce the net wealth left to our children and their children.  The measure of “net wealth” should include the value of ecosystems, fresh water supplies, biodiversity, and oil, as well as productive farmland, infrastructure, machinery, and other productive assets.   All those values are extremely difficult to measure, but at least the concept is clear.

Has that message been adopted since 1991?  It certainly does not seem to be part of the thinking of the U.S. Congress and the rest of our political system.   What are they using for guidance?

Wikipedia says  “Sustainability is the capacity to endure. For humans, sustainability is the long-term maintenance of responsibility, which has environmental, economic, and social dimensions, and encompasses the concept of stewardship, the responsible management of resource use.”  Okay, well, that’s still pretty vague, by Solow’s standards.  Let’s see if they make it more specific: “In ecology, sustainability describes how biological systems remain diverse and productive over time, a necessary precondition for the well-being of humans and other organisms. Long-lived and healthy wetlands and forests are examples of sustainable biological systems.”

I’m sorry, that kind of specificity does not make it more operational.   They haven’t read Solow.  In fact, the whole entry seems to read like it is intended to maximize the number of times it can link to other Wikipedia entries!

“Moving towards sustainability is also a social challenge that entails, among other factors, international and national law, urban planning and transport, local and individual lifestyles and ethical consumerism. Ways of living more sustainably can take many forms from controlling living conditions (e.g., ecovillages, eco-municipalities and sustainable cities), to reappraising work practices (e.g., using permaculture, green building, sustainable agriculture), or developing new technologies that reduce the consumption of resources.”

Actually, the only phrase in the whole entry that really struck me was “more sustainably.”  Now, I REALLY do not know that THAT means.  Our current trajectory is either sustainable, or it’s not!  If future generations can live forever, how can they live longer than that?  And if not, well, …

Yesterday, the Trustees of the Social Security and Medicare Trust Funds issued their annual report on the financial status of these entitlement programs.  These annual reports have been published for decades, and are generally recognized as the most credible, unbiased, and objective assessment of the long-run financial situation facing these programs.  I am going to focus on the Social Security program in this post.

Interest groups and policy analysts from across the political spectrum immediately issued press releases trying to spin the findings of the report.  Here are the first two that crossed my virtual desk yesterday:

The National Academy of Social Insurance (of which I was a member for many years before finally resigning over frustration at their defense of the status quo) issued a release spinning the report in the most positive light possible:  “The 2012 Trustees Report shows that Social Security is 100 percent solvent until 2033, but faces a moderate long-term shortfall. In 2011, Social Security had a surplus – revenue plus interest income in excess of outgo – of $69 billion. Reserves are projected to grow to $3.1 trillion by the end of 2020 … While the trustees’ projections indicate that major changes are not needed, modest changes should be made in a timely manner and can bring Social Security into long-term balance.”

In sharp contrast, the Committee for a Responsible Federal Budget issued a release stating:  “Today, the Social Security and Medicare Trustees released their 2012 report on the financial status of Social Security and Medicare, showing that reforms will be needed soon to make these programs sustainable … Social Security as a whole is on an unsustainable path … Social Security’s financial status has deteriorated significantly since last year’s report … Currently, Social Security is adding significantly to unified budget deficits. Not counting the payroll tax holiday this year and last year, the program is projected to run a $53 billion deficit in 2012 and $937 billion from 2013 through 2022.”

Both NASI and CRFB are highly respected organizations, yet the pictures they paint could not be more different.  So, who is right?  Is it possible to reconcile these two views?

Like last week’s post, in which I tried to cut through the rhetoric over the cost of the Affordable Care Act, this post tries to cut through the rhetoric over Social Security’s finances by using a fictitious debate.  And just like last week, the answer to “who is right?” is “It depends …”

Let’s focus on what appears to be a factual disagreement.  NASI says “In 2011, Social Security had a surplus.”  CRFB says “Social security is adding significantly to unified budget deficits.”

How can the program be running both a surplus and adding to the deficit?

The answer is that it depends on whether you think about interest on the Social Security trust funds as being income or not.  One’s views about the Trust Funds also help shed light on whether we should view Social Security as being in financial distress now (the CRFB view), or whether we still have two decades before we have any real problems (the NASI view).

How does the Trust Fund work?  (For this post, I am going to ignore the distinction between the retirement and disability trust funds – implicitly, I am assuming that Congress will simply re-allocate the payroll tax revenue across the two programs, as they have done in the past when needed).

Let’s go back a few years to the pre-financial crisis, say, 2007.  Suppose you earned $50,000 that year.  You and your employer each paid 6.2% of payroll into the system, for a total of 12.4%.  This was approximately $6,200 that the U.S. Treasury collected, and this money was designated for the Social Security Trust Fund.

Social Security took most of that $6,200 (just to keep that math easy, let’s say they took $5,200 of it), and paid it out to current retirees and other beneficiaries (such as disabled workers, widows, etc).  The remaining $1,000 was not needed in that year, so it was handed back to the U.S. Treasury.  In return, the U.S. Treasury issued a $1,000 special-issue U.S. Treasury bond to the Social Security trust funds.  Like other U.S. Treasuries, this one was backed by the full faith and credit of the U.S. government.

Now, back in 2007, like in most years in recent history, the U.S. government was running budget deficits.  Thus, the Treasury department basically took your $1,000 and used it to finance the government spending that we were doing in excess of the income tax revenue we were bringing in.  They did not actually invest the money in financial securities – rather, they spent it.  Of course, they still owe the $1,000 to the Social Security trust fund.

This has been going on for about three decades.  As a result, the Social Security trust fund now owns several trillion dollars’ worth of government bonds.  And the U.S. Treasury pays the trust funds interest on these bonds.

Today, to a first approximation, the entire $6,200 that a $50,000 per year worker and her employer pay into the system is all going to pay benefits.  So there are no more new deposits to the trust fund.  But the balance of the account is quite large, and is spinning off interest.

So here is the key question.  Should the interest that Treasury is paying to the Social Security trust funds be counted as income?  Here is how a discussion might go between NASI and CRFB representatives.  (Any misrepresentations of views are mine alone).

NASI: “Of course the interest should count as income.  The interest grows the trust funds, and the trust funds represent a legal claim by the trust funds that will be backed by the full faith and credit of the U.S. government.”

CRFB: “Yes, but while these bonds – and their interest – represent an asset to Social Security, they are a liability to the U.S. Treasury.  And because the Treasury spent that money rather than saving it, it is crazy to think that we should count this as income.  The interest payments are just an accounting fiction, not a real flow of money into the government as a whole.”

NASI:  “Ah, but the trust funds do represent real savings.  If the Treasury had not issued this debt to Social Security, they would have had to increase public borrowing.  So the Trust Fund balance represents money that the U.S. did not have to borrow – and that is a form of saving.”

CRFB: “But for decades, Congress used the Social Security surpluses to hide the deficits in the rest of the government.  As a result, Congress spent more money over the past few decades than they would have if they had not been able to hide the true cost of their profligacy behind a unified budget framework.”

NASI: “There is no way to know for sure that the Social Security surpluses led to increased spending by Congress.”

CRFB: “Ah, but there is – at least two academic studies (here and here) have shown that this is exactly what happened.”

NASI: “Academic studies aside, there is no question that we should count this interest.  And if we do count it, it is clear that Social Security is running a surplus.  It is also clear that the program can pay 100% of promised benefits at least until 2033.”

CRFB:  “But that is a narrow perspective.  We care about the government budget as a whole – not just the narrow question of the Trust Funds.  From that perspective, what we know is that the amount of money we are collecting in payroll taxes today is no longer enough to cover the payments to beneficiaries.  The days of cash flow surpluses are gone.  And because interest on the trust fund is just one arm of government (Treasury) making a paper transfer to another arm of government (the Trust Funds), this does not represent real income to the government as a whole.  As such, the program is in dire straits, and needs to be fixed now.”

That fictitious debate roughly captures the economic disagreement underlying these two very different assessments of the latest Trustees’ Report.

I happen to support the CRFB view that the problem is serious, that we need to address it sooner rather than later, and that there is no pain-free solution.  But at the end of the day, it is impossible to fully refute the NASI view because we cannot go back in time and re-run an alternate history to know how spending would have responded in the absence of past Social Security surpluses.

Regardless of which view one holds, it is becoming increasingly difficult to deny the existence of a financing problem.  Even if you take the NASI view that we do not have a problem until the trust funds run dry in 2033, it is worth noting that this date is quite a bit earlier than what has been previously estimated.  Furthermore, 21 years is not a very long time when we are talking about a retirement program.  After all, nearly half of today’s 65-year olds will still be alive in 2033 and relying on Social Security benefits.  Today’s 46-year olds will reach their normal retirement age in 2033.  And today’s college students will be nearly half-way to their own retirement age.  We need to make changes now – so that we have time to phase-in the changes gradually and to allow individuals to adjust.

So, regardless of one’s views about the trust funds, it seems obvious to me that the real story behind the release of the Trustees’ Report is that the problem is real, it may be larger than we previously thought, and that it is not going to go away on its own.

As posted on Forbes yesterday …

In 1941, President FDR explained why he chose to fund Social Security through a payroll tax in as follows:

“We put those payroll contributions there so as 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”

For more than seven decades, FDR’s strategy has proven effective.  Talk to someone in or near retirement – even people who consider themselves small government conservatives – and you will often hear them state that they have a right to their Social Security benefit because they paid for it over their working life.

President Roosevelt knew that the key to the political sustainability of Social Security was the establishment of an entitlement mentality, and the key to establishing an entitlement mentality was the linkage between payroll contributions and benefits.  If Social Security were structured as a means-tested welfare-style program – that is, it if were financed by a progressive income tax rather than through payroll contributions – it might have never lasted this long.

Given this, it is important that President Obama and Congress have just agreed to extend the payroll tax cut and to continue to use budget gimmickry to turn Social Security into a partly general-revenue-financed program.

Here is how it works.  The 2% payroll tax cut reduces revenue to Social Security by about 15 percent.  But Social Security does not have a spare 15 percent of revenue lying around: rather, it is currently running quite close to break-even on a cash flow basis, and faces enormous long-run deficits.  To get around this, President Obama and Congress have decided to replace the lost payroll tax revenue by transferring money from general revenue (which derives primarily from the income tax) into the Social Security trust funds.

This budget gimmick has the short-term political benefit of making the Social Security trust funds seem unaffected by this tax cut.  But it also means that we are deviating substantially from FDR’s vision of a retirement program being paid for (on a pay-as-you-go basis) by participant contributions.  By moving down the path of general revenue financing of Social Security, we achieve the short-term “progressive” aim of increasing the degree of income-based redistribution (because income tax rates rise with income, whereas payroll tax rates do not).

But in the long-run, this has the potential to erode political support for the program.  By shifting the funding burden onto the income tax, the program starts to look more like a welfare program than a contributory social insurance program.

I am not the first to notice the irony of this.  My very good friend Chuck Blahous, who served eight years in the National Economic Council for President George W. Bush, and who was appointed by President Obama as one of two Public Trustees for Social Security, just released a paper explaining why this payroll tax cut is bad policy.  Among the seven reasons he provides is that doing so destroys the “historical Social Security compact.”  In a Washington Post article back in December, Dr. Blahous stated that these budget gimmicks are “a grave step for Social Security.”

This view is not limited to experts on the Republican side: the other Public Trustee of Social Security (a Democrat) – Robert Reischauer, the highly respected president of the Urban Institute — agrees with Dr. Blahous.  While Reischauer was more sympathetic to the tax cut, he also noted that it “could, if it continues for a substantial period of time, undermine one of the foundational arguments that makes the Social Security program inviolate.”

Perhaps the most succinct summary of the irony comes from Jason Fichtner, a Senior Research Fellow at the Mercatus Center and former Chief Economist and (acting) Deputy Commissioner for the Social Security Administration.  He summed it up the situation quite succinctly in an email to me by noting that “in 15 years we might look back on this time in history and discuss how President Obama, as a Democrat, was the president that started the path to killing Social Security.”

So, maybe President Obama really is the Damn Politician that FDR was worried about?

At the Republic debate in Myrtle Beach, SC last night, in response to a question by Gerald Seib of Wall Street Journal, three of the candidates weighed in on Social Security reform.  Their responses revealed strikingly different approaches to economic policy.

Governor Romney took the practical approach.  After pointing out that he would protect everyone over the age of 55, he laid out two very specific changes to the benefit formula that would substantially reduce Social Security expenditures in the decades to come.  The first change would change the way that initial retiree benefits are calculated.  Under current law, benefits from one cohort of retirees to the next rise with average wages in the economy.  Governor Romney suggested, instead, a plan similar to what Social Security policy experts call “progressive price indexing.” This would continue to index starting benefits to wage growth for those at the bottom of the income distribution, but would index benefits at the top end of the income distribution to price inflation instead.  Because prices tend to rise less quickly than wages, this would reduce expenditures relative to current law.  The impact would be gradual – and thus the short-term cost savings would be limited, but over many decades can be quite substantial.  Second, Governor Romney indicated a willingness to increase the full retirement age by one or two years.  Importantly, increasing the full retirement age does not actually require that anyone work longer: rather, it simply moves the age at which one receives “full” benefits back by one to two years.  Variants of both of these reform proposals have been floating around Washington over the past decade.  In essence, this is a fiscally responsible approach that recognizes there is no pain-free way to fill in the fiscal gap.  While this is good fiscal policy, whether or not it is good politics remains to be seen.

In sharp contrast to Romney’s “eat your spinach” approach to reform, Speaker Gingrich suggested that we follow the “all dessert” approach to Social Security.  Rather than being upfront about the need for politically difficult changes to taxes or benefits, Speaker Gingrich suggested that the government can guarantee retirees that they can receive full promised benefits without paying a dollar more in taxes, despite the existence of a multi-trillion dollar shortfall.  How does he propose we do this?  By allowing workers to shift 100 percent of the employee payroll tax contribution (currently 6.2 percent of payroll) into personal accounts, leaving the 6.2 percent employer contribution going into the existing system.  Citing the examples of Chile and Galveston, Speaker Gingrich argues that people will not have to sacrifice any benefits.  As I discussed last week, however, he fails to acknowledge the huge implicit liability he is imposing on taxpayers by essentially guaranteeing that stocks will perform close to their average historical values.  They might, but to guarantee this without acknowledging the real economics cost is both fiscally reckless and intellectually dishonest.

Former Senator Rick Santorum used most of his response to correctly point out another fact about the Gingrich proposal: namely, that by diverting 6.2 percent of payroll into the personal accounts, we will have to borrow additional money to back-fill the missing payroll tax revenue, nearly every penny of which is now going to pay current retirees.  And the Speaker’s statement that we can somehow fill this gap by eliminating the overhead associated with consolidating anti-poverty programs is mathematically ridiculous.  Those numbers don’t even come close to adding up.

This is quite a different situation than we faced a decade ago when the President’s Commission to Strengthen Social Security (on whose staff I served) recommended personal accounts at a time when Social Security was projected to have another 15-plus years of surpluses.  One of the key rationales for personal accounts a decade ago was to ensure that those surpluses were saved, rather than redirected to underwrite other government spending.  The Commission plans also envisioned smaller accounts, further reducing the need to fund a transition investment.  Even so, the plan still had to come up with substantial short-term revenue to cover the transition, an aspect that contributed to the proposal’s demise.  Unfortunate, “carve-out” personal accounts – which I have supported in the past – is an idea whose time has come and gone.

Aside from criticizing Speaker Gingrich, Senator Santorum offered few specifics.  He did endorse means-testing, noting that we should reduce or eliminate benefits for the 60,000 retirees who earn over $1 million per year.  This is a perfectly reasonable suggestion, albeit with two problems.  First, if high earners receive no benefit whatsoever for paying into Social Security, then this converts the 12.4 Social Security payroll contribution into a pure tax, with all the associated efficiency losses.  Second, the money saved is a “drop in the bucket” compared to the size of the projected Social Security shortfalls.  Assuming that every one of those 60,000 millionaires gave up 100 percent of their benefits, this would save only a few billion dollars a year.  This is real money, but when one looks at the size of the expected annual Social Security shortfalls that we will face in another 20 years, we need dozens – if not a hundred – money saving ideas of this magnitude.

Thus, what we have witnessed are three fundamentally different approaches to Social Security reform.  One candidate who puts forward real meaningful solutions and is therefore criticized for not being sufficiently bold, one candidate who promises a free lunch at taxpayer expense, and one candidate who appears not to have put together a plan sufficient to the task ahead of us.  Only time will tell how voters respond to these three different narratives.

Disclosure: Over the past few weeks, I have begun to offer informal, unpaid advice to the Romney campaign’s policy staff on issues related to Social Security.  All opinions expressed in this blog, however, are mine alone.

This blog is cross-posted, with permission, at www.forbes.com

Here is an interesting article, in the Washington Post, entitled “Payroll tax cut raises worries about Social Security’s future funding“.  It points out that the recent payroll tax cuts are intended for short term stimulus, but they muck with the way that social security benefits are funded.  Instead of coming frm payroll taxes, that money now will haveto come from general revenue. 

As it points out: “For the first time in the program’s history, tens of billions of dollars from the government’s general pool of revenue are being funneled to the Social Security trust fund to make up for the revenue lost to the tax cut. Roughly $110 billion will be automatically shifted from the Treasury to the trust fund to cover this year’s cut, according to the Social Security Board of Trustees. An additional $19 billion, it is estimated, will be necessary to pay for the two-month extension.” 

As it goes on to say, “The payroll tax cut changes that. Instead being a protected program with its own stream of funding, Social Security, by taking money from general revenue, becomes more akin to other government initiatives such as Pentagon spending or clean-air regulation — programs that rely on income taxes and political jockeying for support.”

The Budget Control Act of 2011 established a joint congressional committee (the “Super Committee”) and charged it with the responsibility of reducing the deficit by $1.2 trillion over 10 years.  If the Super Committee fails to reach an agreement, automatic cuts of $1.2 trillion over 10 years are triggered, starting in January 2013.  These are said to be “across the board”, but they are not.   They would apply $600 billion to Defense, and $600 to other spending.  Entitlements are exempt, including the Supplemental Nutrition Assistance Program (SNAP, formerly food stamps) and refundable tax credits such as the Earned Income Tax Credit and child tax credit.  These entitlements are exempt from the cuts because anyone who qualifies can participate (that spending is determined by participation, not by Congress).

In addition, the Bush-era tax cuts are set to expire at the end of 2012, so doing nothing means that tax rates would jump back to pre-2001 levels.  That combination might be the best thing yet for our huge budget deficit.

The Federal government’s annual deficit has been more than $1 trillion since 2009.  Continuation of that excess spending might create a debt crisis similar than the one now in Europe.

The Center on Budget and Policy Priorities estimates that the trigger would cut $54.7 billion annually in both defense and non-defense spending from 2013 through 2021.  Meanwhile, U.S. defense spending is around $700 billion per year, with cuts of about $35 billion per year already enacted, so the automatic trigger would reduce defense spending from about $665 billion to about $610 billion.  Some may view that 10% cut as draconian, but the simple fact is that the U.S. needs to wind down its spending on two wars.  Congress and voters are fooling themselves if they think the U.S. can continue to spend the same level on defense, not raise taxes, and make any major dent in the huge annual deficit.

The same point can be made for automatic cuts in Social Security, which in its current form is unsustainable.  Since it was enacted in 1935, life expectancy has increased dramatically, which means more payouts than anticipated.  Birth rates have declined, which means fewer workers and less payroll tax than anticipated.  The system will run out of money in 2037.  Congress either needs to raise taxes or cut spending.  But they won’t do either!  The only solution might be the automatic course, without action by Congress!

For further reading, see “Why doing nothing yields $7.1 trillion in deficit cuts”.

With all the argument in Washington about how to balance the budget, a reminder is worthwhile that none of these numbers make any sense at all!  What “should” be the meaning of the government budget?  And, does any number provided by anybody actually have that meaning?

In general, a budget deficit is supposed to mean that one’s current consumption exceeds income, which would indicate a decrease in wealth.  Indeed, that’s the problem with a deficit – drawing down our wealth (which could even turn from positive to negative!).  The U.S. Federal budget numbers fail to provide such a meaning, for several reasons.

First, the Federal budget includes ALL spending, not just consumption.  Some of that spending is actually investment, such as new spending on buildings, bridges, roads, airplanes, and any long-lived military equipment.  The budget does not show the breakdown between what we really use up this year, and what spending is really investing in the future.

Second, Social Security is “off-budget”, unless you are looking at a unified budget.  Okay, I said that in a way that is intentionally confusing!  The basic problem here is that social security is SUPPOSED to run a surplus, so that we can set aside some funds from those now working to pay them when they are retired.  If it does not run a surplus to save for the retirement of the baby boom generation, then we’ll be in big trouble when the baby boom generation retires!  The current social security surplus is too small for that.  Then, however, the big problem is that the unified budget mixes the social security budget with the rest of federal spending.  So when you see a deficit in that account, it’s really worse than it looks, because it includes the small social security SURPLUS that’s already not a big enough surplus for social security to break even!

Third, the U.S. Federal Budget is confusing about what is a “Tax Expenditure” and what is government “Spending”.  A tax expenditure is really ‘spending via tax break’, as when a taxpayer gets a special credit or deduction for doing some particular activity.  The Congress could instead have accomplished the exact same thing by an ACTUAL spending program, providing subsidy to the same set of eligible individuals for doing the exact same activity.  So it really does not make much sense to say you want to cut spending and not raise taxes, because eliminating one of those tax breaks is really the same as eliminating an equivalent spending program.

Fourth, a Federal “mandate” might require a certain kind of spending by a firm.  To take a simple example, suppose some safety regulation requires construction firms to provide a hard hat to all workers.  That’s really equivalent to a tax on that firm, equal to the amount they have to spend on hard hats, where the revenue of that “tax” is spend by government on the provision of hard hats.  But then the problem is that mandates are so pervasive.  Some ‘true’ measure of the size of government would be HUGE, if we counted the dollar cost of all mandates as a “tax”, as if it were in the government budget.