Maintaining Social Security Benefit Payments Once the Trust Fund is Depleted Will NOT Increase the Government Deficit

Posted on July 17, 2024, 12:18 pm by aneconomicsense

A. Introduction

As many are aware, based on the most recent forecast and if nothing is done, the Social Security Trust Fund is expected to be fully depleted by 2035. Under current law that sets the operating rules for the Social Security system, benefit payments made to retirees and the disabled would then have to be scaled back to a level that would match the Social Security taxes being paid into the system each year. This would mean a reduction of about 16% (based on current forecasts) from the payments that retirees and other beneficiaries of the system would have otherwise received in 2035.

That would be catastrophic. Retirees and others depend on their monthly Social Security checks, and slashing those by 16% would mean a dramatic fall in the living standards of many. In the aggregate, the cut in payments would amount to about 1% of GDP. Even if one were to ignore the impact on the retirees who depend on their Social Security checks, a sudden scaling back of those payments by 1% of GDP could very well throw the economy into a recession.

What would happen if Congress were instead to fund that shortfall through the regular federal budget? The amount is certainly large, at 1% of GDP or, in terms of the GDP forecast for 2035, about $425 billion. How much would the federal deficit (and federal borrowing needs) then increase relative to what it would have been before the Trust Fund was depleted?

The answer is: Nothing. None. Zero. Zilch. Nada. Not a dime.

There would be no impact on the deficit. Government borrowing in the financial markets would be exactly the same as before. It is true that the deficit would fall if Social Security payments were slashed by 16% from one day to the next. Leaving aside the resulting disruption this would cause for the economy – as a sudden cut in payments of 1% of GDP would certainly depress output and increase unemployment – the fiscal deficit would indeed be smaller if Social Security payments were reduced. But compared to what it was the day before the Trust Fund was depleted, keeping up the Social Security payments in their promised amounts by covering this through the regular federal budget would have no impact on the deficit nor on federal borrowing needs.

Many may not realize this, and I have not seen a discussion of this point in the media or in other accounts of what might happen when the Social Security Trust Fund is depleted. To be honest, I had not really thought this through before myself, and had operated on the (incorrect) assumption that maintaining Social Security benefit payments at their scheduled levels once the Trust Funds had been depleted would add to the federal deficit and borrowing requirements. But it would not. That is important, but I have not seen any discussion of it nor its policy implications.

This post will examine how the Social Security Trust Fund works, its history over the last half-century and its prospects, and briefly on why it is now expected to be depleted by about 2035. The mechanics of the Social Security Trust Fund operations will then be examined in the context of the federal fiscal accounts, showing why it is an accounting mechanism but one that does not itself affect the federal fiscal deficit nor the federal government’s borrowing needs in the markets. It will be seen that maintaining Social Security benefit payments as currently scheduled and promised in 2035 and after would not add to the deficit nor to government borrowing needs. Some of the policy implications will then be considered.

But before starting, some of the terms should be clarified. My references to the “Social Security Trust Fund” (or simply “Trust Fund”) are to the combined Old Age Security (OAS) and Disability Insurance (DI) trust funds. Formally these are two separate trust funds, but they are commonly combined and referred to as the OASDI Trust Fund. Payments from Social Security taxes have on more than one occasion (most recently in 2016 to 2018) been shifted between the OAS and DI accounts as a short-term fix when one of the funds was getting close to depletion (the DI fund in the 2016 to 2018 case). In reports, the OAS and DI funds are often aggregated as if there were one OASDI fund, and I will treat them that way here as well.

Also, the more formal name for the taxes that go into the Social Security accounts is FICA (for Federal Insurance Contributions Act) taxes. FICA taxes are applied on wages (i.e. not on other earnings) at current rates for the worker and the employer together of 10.6% for the OAS and 1.8% for the DI accounts – a total of 12.4%. While these are formally “paid” half by the worker and half by the employer, all analysts agree that these payments in fact all come out of the worker’s wages. The tax applies up to a ceiling on wage earnings of $168,600 in 2024, after which the tax rate is zero. In addition, there are also FICA taxes of 2.9% for Medicare Hospital Insurance (with no ceiling on wage earnings). The Medicare funding will not be addressed here, and when I refer to “Social Security taxes” I will be referring to the 12.4% for the OAS and DI trust funds (OASDI together).

B. How the Social Security Trust Fund Works

Each year, there are workers who are paying Social Security taxes on their wages (at the 12.4% rate) and retirees (and other Social Security recipients, such as spouses, dependents, and the disabled) who are receiving benefit payments from Social Security. The taxes paid go into the Social Security Trust Fund and the benefit payments made are drawn out of it. When the tax payments going in are greater than the current benefit payments going out, the excess accumulates in the Trust Fund. And in those years when the tax payments in are less than the current benefit payments out, the Trust Fund redeems a share of its assets to cover the difference.

The Trust Fund is invested in specially issued US Treasury obligations – essentially special US Treasury bonds. The Trust Fund earns interest on those US Treasury holdings at a rate set by law to equal the weighted average yield observed in the markets as of the last business day of the prior month on US Treasury bonds that are not due or callable for 4 years or more. That interest is added to the Trust Fund. The Trust Fund also receives income taxes paid by certain retirees on their Social Security benefits (from retirees with incomes above a certain threshold). There are also some other, generally minor, transfers to the Trust Fund.

The resulting accumulated balances in the Social Security Trust Fund, as of the end of each year and expressed as a share of GDP of the year, are shown in the chart at the top of this post. It has varied over time, and one can see that the Trust Fund came close to being depleted before – in the early 1980s. Before that, the Social Security system had been managed in a more ad hoc way, with benefit levels, eligibility, tax rates, the income ceiling on which Social Security taxes were due, and more frequently adjusted by Congress. Indexing for inflation was only introduced in the 1970s.

By 1981, the forecast was that the Social Security Trust Fund would be fully depleted by 1983. In response, President Reagan with Congress appointed a commission in 1981 chaired by Alan Greenspan (and subsequently usually referred to as the Greenspan Commission) to provide recommendations for what would return the system to viability. The Commission issued its recommendations in early 1983, with a combination of higher tax rates, adjustments to benefit levels, an increase in the retirement age for full eligibility, and numerous more minor changes. Congress approved these in 1983.

The Greenspan Commission recommendations were based on forecasts of what changes would be needed to lead to the Trust Fund remaining solvent (i.e. not depleted at any point) for at least 75 years. Starting in 1982, the 75 years would carry the forecasts through to 2057. This did not mean that the Trust Fund would be brought to zero in the 75th year, but rather that it would still be solvent at that point. They did not try to look beyond that.

Knowing that the large Baby Boom generation was then in its prime working-age years and that they would be retiring starting around 2010, the changes were designed so that the Trust Fund would be built up in the 1980s, 90s, and 2000s, and then begin to be used to pay out benefits on a net basis as the Baby Boomers retired. This produced the large “hump” seen in the chart at the top of this post with the Trust Fund growing from less than 1% of GDP to 17 1/2% of GDP in 2009, after which it began to decline.

The decline as a share of GDP was planned. However, under the forecasts of the Greenspan Commission in 1983, the Trust Fund would not have been fully depleted by 2035. While it is often stated in the media that this is a consequence of the Baby Boomers reaching retirement age and of longer life expectancies, that is not in fact true. The Greenspan Commission was well aware of how many Baby Boomers would be reaching retirement age in those years – they had already been born. And the issue is not whether life expectancies have been rising, but whether life expectancies have been rising by more than what the Greenspan Commission assumed in their forecasts. And it has not. Indeed, life expectancy in the US has actually been decreasing since 2014 (and then plummeted in 2020/21/22 due to Covid), is well below that enjoyed in comparable countries, and is well below what the Greenspan Commission forecast.

As was discussed in an earlier post on this blog, the Social Security Trust Fund is now expected to be depleted well before the Greenspan Commission anticipated not because of the Baby Boomers nor because of life expectancies growing longer, but rather because the Greenspan Commission did not anticipate that wage inequality would grow so dramatically following Reagan. This matters, because it led a higher share of wage earnings to be drawn above the ceiling on which Social Security taxes are paid, where they are not taxed at all. The Greenspan Commission’s assumption that the share of wages that would be subject to tax would remain where it was (at about 90% of total wages) was not unreasonable at the time, as that share had remained fairly steady in the post-World War II period up to the early 1980s. But then it deteriorated sharply in the subsequent decades.

Due to that increase in wage income inequality, the Trust Fund is now forecast to be depleted in 2035. In my earlier post on this issue, I calculated that had the share of wages subject to Social Security taxes remained at the 90% share (and taking into account what this would also mean for higher benefit payments for the high-income wage earners who would then still be paying into the system), the Trust Fund would have been forecast to last until 2056. The calculations assumed that all else would then be as it was historically when my forecasts were made in 2016, or as the Social Security then forecast in the years from 2016 onwards.

But wage inequality rose in the decades since 1983 and the Social Security Trust Fund is now expected to run out by 2035. Under the current law that governs the Social Security system, Social Security benefits would then be scaled back to a level that would match amounts being paid into the Trust Fund by the workers in those years. This would require a scaling back of benefits of about 16% based on current forecasts. This would be devastating for many. In a biennial report issued by the Social Security Administration (last issued in 2016 with data for 2014 – it appears the Trump administration stopped it, and it has not been restarted), it was estimated that Social Security benefits accounted for 100% of the income of 20% of the population aged 65 or older, and for 90% or more of the income of a third of the population. Saying that again, one-third of Americans aged 65 or older depend on Social Security for 90% or more of their income.

Furthermore, not only do a high share of those over 65 depend on their Social Security checks for almost all of their income in their old age, but the checks themselves are not that high. As of June 2024, the average monthly benefit was only $1,781, or $21,372 on an annual basis. And most of those who especially depend on their Social Security checks also receive well less than these average payments.

A high share of those aged 65 or older in the US depend critically on Social Security. A sudden cut of 16% would be devastating.

C. Federal Borrowing Before and After the Trust Fund is Depleted

As described above, when the amount being paid into the Social Security Trust Fund in Social Security taxes exceeds what is being paid out in Social Security benefits, the excess is invested in interest-earning US Treasury obligations. That excess will reduce what the US Treasury will need to borrow from the markets to cover whatever the federal deficit might be from all of its other revenues less expenditures (i.e. everything other than from Social Security revenues and expenditures). The Social Security Trust Fund will, in such years, be built up as it was from 1983 to 2009.

The opposite happens in years when Social Security tax revenues fall short of what Social Security is paying out in benefits. In those years, the Social Security system will redeem a portion of the US Treasury obligations it holds and from this receive the cash it needs to pay the scheduled benefits. When it does this, the US Treasury will then need to borrow in the markets the amount required to cover the US Treasury obligations that the Social Security system has redeemed. That is, as the Social Security Administration redeems a share of the US Treasury obligations that it holds in the Trust Fund, the Treasury will need to issue new debt to the public to obtain the cash it needs to pay to Social Security for those redemptions.

Now suppose the Trust Fund has been fully depleted, and it no longer holds any balance of US Treasury obligations. This is the forecast for what will be faced in 2035. It no longer has US Treasury obligations that it can redeem. Under the current law for the Social Security system, it would then be required to scale back benefit payments to the amount it is then receiving from Social Security taxes being paid by those then working. The current forecast is that this would require a scaling back of 16%. (Note that this is not 100%, as some people appear to believe. Social Security is not being shut down in some kind of “bankruptcy”. Rather, Social Security payments would continue – just not at the scheduled benefit levels.)

But what would happen in terms of federal government borrowing requirements if, instead of scaling back benefits by 16%, the government instead funded those payments in full from the general budget? The amount would be far from small, at a forecast 1% of GDP to cover that 16% shortage. But what would then happen to what the US Treasury would need to borrow from the public?

The answer is nothing. There would be no change at all. As explained above, when the funds come out of the Social Security Trust Fund holdings of US Treasury obligations, the Treasury will need to borrow from the public whatever is redeemed by the Trust Fund. That is where the cash comes from. When the Trust Fund no longer has any holdings of the US Treasury obligations, then the cash needed to cover the 16% Social Security payment gap from the general budget will be exactly the same. That is, the amount the US Treasury will need to borrow from the public will be the same whether it needs the cash to cover redemptions of US Treasury obligations from the Trust Fund, or to cover the 16% gap in what is needed to pay Social Security benefits in full.

The fiscal deficit will also be the same, whether the full Social Security payments are made out of redemptions from the Trust Fund or are made out of transfers from the general government budget. Social Security taxes (i.e. FICA taxes) are included as revenues going to the government, the same as personal income taxes or other sources of government revenues. Similarly, payments for Social Security benefits are treated as government expenditures – whether or not they are covered by redemptions from the Social Security Trust Fund.

To illustrate with numbers from FY2023 (and using the recent, June 2024, budget figures from the Congressional Budget Office), and expressed as a share of GDP: Outlays for the Social Security system (for retirees and their dependents, as well as for the disabled) was 5.0% of GDP. Payroll taxes for Social Security (the 12..4% on wages) was 4.4% of GDP, leaving 0.6% of GDP to be obtained by drawing down the Social Security Trust Fund. This accounted for part of the overall fiscal deficit in FY2023 of 6.3% of GDP. If the 0.6% of GDP gap had been covered by direct fiscal transfers from the general government budget instead of by redemptions from the Social Security Trust Fund, the overall fiscal deficit (6.3% of GDP) as well as government borrowing requirements (whether to fund the deficit or to cover the Trust Fund redemptions) would have been the same.

(Note: I have left out here the relatively much smaller amounts coming from the transfer of income tax revenues arising from taxation of Social Security benefits in households meeting certain income thresholds, and the interest earned on Trust Fund assets during the year. These are both covered elsewhere in the fiscal accounts.)

It is in this sense that it is accurate to describe Social Security as a “pay-as-you-go” system. While it is not always clear what is being referred to when speakers refer to Social Security as pay-as-you-go (different speakers appear to be referring to different things), it would be accurate to say that this is the case from the point of view of the government’s fiscal accounts and of its borrowing requirements in the markets. What Social Security pays out in benefits in any given year will match what Social Security obtains as revenues in that year (primarily from the Social Security share of the FICA taxes) plus what is provided to the system from the US Treasury. Whether those amounts transferred from the US Treasury are matched by a drawdown on the Treasury obligations in the Social Security Trust Fund, or come directly from the budget, the overall fiscal deficit as well as the Treasury’s borrowing requirements in the market will be the same.

D. Policy Implications and Conclusion

Recognizing this, what does it imply for what should be done in 2035 (or whenever the Social Security Trust Fund is fully depleted)? Under current law, and what is repeatedly stated in the media, is that scheduled Social Security benefit payments would have to be scaled back drastically (by about 16% in the current forecasts). If that is done, that would indeed be a disaster for many given their dependence on the Social Security checks they receive.

But as explained above, there would be no impact on the deficit, nor on government borrowing requirements, if the scheduled benefit payments were kept in full and not scaled back from the scheduled levels, but rather with the gap covered instead by appropriations from the regular budget. Congress could approve this if they wished.

Seen in this perspective, the question then becomes how best to fund the Social Security system along with all other government programs in the budget. One should not restrict consideration only to adjustments in the payroll taxes that are currently tied to the Social Security system, nor to possible reductions in benefit levels by, for example, raising the normal retirement age. Consideration should thus be given to possible other changes in the overall tax system – for example in personal income taxes and/or corporate income (profit) taxes. The payroll tax is regressive, with a flat 12.4% on wages (and only wages) and only up to a ceiling ($168,600 in 2024). Greater reliance on progressive income taxes is an attractive alternative to a regressive payroll tax.

One should therefore take a more holistic view as to what the tax system should be and not treat the issue as one for Social Security taxes in isolation. While there could very well be political advantages to defining a trust fund for Social Security into which certain taxes are paid and from which benefit payments are then made, one should recognize that fundamentally this is only presentation. Covering a portion of the Social Security benefit payments through the general budget, and hence through the overall system of income and other taxes, could well be preferred to exclusive reliance on payroll taxes.

Note also there is precedent for this. Medicare taxes are also paid on wages (at a 2.9% rate, but with no ceiling on the wages subject to tax) and go into a trust fund, plus there are direct monthly premia paid for Medicare coverage. However this funding does not suffice to cover all of what Medicare now costs. The difference is made up by direct fiscal transfers. It is certainly a major government expense, but no one argues Medicare payments should be limited to whatever is paid in Medicare taxes and premia.

As noted, sustaining payments once the Social Security Trust Fund has been fully depleted would require a change in the law that governs the Social Security system. That law has been changed numerous times in the past, and could certainly be changed on this. The real problem is that with Congressional gridlock, obtaining approval for such a change may well be difficult. Republicans have been opposed to Social Security ever since its origin in the Social Security Act of 1935 under Roosevelt. As Social Security became popular and demonstrated its success in reducing poverty among the elderly, that political criticism became less overt but has remained. And those opposed to Social Security will likely use the imminent prospect of the Trust Fund being depleted by 2035 as an opportunity to scale the system back. A reduction in expenditures of 1% of GDP would be huge.

But as examined above, maintaining Social Security benefit payments at scheduled levels once the Trust Fund is depleted would have no fiscal effects in itself. Government revenues, expenditures, and borrowing requirements would be the same the day after the Trust Fund was depleted as it was the day before.

Trump’s Attack on Social Security

Posted on August 16, 2020, 4:47 pm by aneconomicsense

Trump famously promised in his 2016 campaign for the presidency that he would never cut Social Security. He just did. How much is not yet clear. It could be minor or it could be major, depending on how he follows up (or is allowed to follow up) on the executive order he signed on Saturday, August 8 while spending a weekend at his luxury golf course in New Jersey. The executive order (one of four signed at that time) would defer collection of the 6.2% payroll tax paid by employees earning up to $104,000 a year for the pay periods between September 1 and December 31 (usefully straddling election day, as many immediately noted).

What would then happen on December 31? That is not clear. On signing the executive order, Trump said that “If I’m victorious on November 3rd, I plan to forgive these taxes and make permanent cuts to the payroll tax. I’m going to make them all permanent.” He later added: “In other words, I’ll extend beyond the end of the year and terminate the tax.”

The impact on Social Security and the trust fund that supports it will depend on how far this goes. If Trump is re-elected and he then, as promised, defers beyond December 31 collection of the payroll tax that workers pay for their Social Security, the constitutional question arises of what authority he has to do this. While temporary deferrals of collections are allowed during a time of crisis, what happens when the president says he will bar the IRS from collecting them ever? The president swore in his oath of office that he would uphold the law, the law clearly calls for these taxes to be collected, and a permanent deferral would clearly violate that. But would repeated “temporary” deferrals become a violation of the statutory obligations of a president? And he has clearly already said that he wants to make the suspension permanent and to “terminate the tax”.

There is much, therefore, which is not yet clear. But one can examine what the impact would be under several scenarios. They are all adverse, undermining the system of retirement benefits that has served the country well since Franklin Roosevelt signed the program into law.

Some of the implications:

a) Deferring the collection of the Social Security payroll taxes will lead to a huge balloon payment coming due on December 31:

The executive order that Trump signed directs that firms need not (and he wants that they should not) withhold from employee paychecks the 6.2% that goes to fund the employee share of the Social Security tax. But under current law the taxes are still due, and would need to be paid in full by December 31.

Suppose firms did decide not to withhold the 6.2% tax, and instead allow take-home pay to rise by that amount over this four-month period straddling election day. Unless deferred further, the total of what would have been withheld will now come due on December 31, in one large balloon payment. For those on a two-week paycheck cycle, that balloon payment would have grown to 54% of their end of the year paycheck. It is doubtful that many employees would be very happy to see that cut in end-year pay. Plus how would firms collect on the taxes due on workers who had been with the firm but had left for any reason before December 31? By tax law, the firms are still obliged to pay to the IRS the payroll taxes that were due when the workers were employed with them.

Hence most expect that firms will continue to withhold for the payroll taxes due, as they always have. The firms would likely hold off on forwarding these payments to the IRS until December 31 and instead place the funds in an escrow account to earn a bit of interest, but they would still withhold the taxes due in each paycheck just as they always have (and as their payroll systems are set up to do). This also then defeats the whole purpose of Trump’s re-election gambit. Workers would not see a pre-election bump up in their take-home pay.

b) But even in this limited impact scenario, there will still be a loss to the Social Security Trust Fund:

Thus there is good reason to believe that Trump’s executive order will likely be basically just ignored. There would, however, still be a loss to the Social Security Trust Fund, although that loss would be relatively small.

Payroll taxes paid for Social Security go directly into the Social Security Trust Fund, where they immediately begin to earn interest (at the long-term US Treasury rate). Based on what was paid in payroll taxes in FY2019 ($1,243 billion according to the Congressional Budget Office), and adjusting for the fewer jobs now due to the sharp downturn this year, the 6.2% component of payroll taxes due would generate approximately $40 billion in revenue each month. Assuming the $160 billion total (over four months) were then all paid in one big balloon payment on December 31 rather than monthly, the Social Security Trust Fund would lose what it would have earned in interest on the amounts deferred. At current (low) interest rates, the total loss to Social Security would come to approximately $250 million. Not huge, but still a loss.

c) If collection of the 6.2% payroll tax is deferred further, beyond December 31, the losses to the Social Security Trust Fund would then grow further, and exponentially, and become disastrous if terminated:

Trump promised that “if re-elected” he would defer collection by the IRS of the taxes due further, beyond December 31. How much further was not said, but Trump did say he would want the tax to be “terminated” altogether. This would of course be disastrous for Social Security. Even if the employer share of the payroll tax for Social Security (an additional 6.2%) continued to be paid in (where what would happen to it is not clear), the loss to Social Security of the employee share would lead the Trust Fund to run out in less than six years. At that point, under current law the amounts paid to Social Security beneficiaries (retirees and dependents) would be sharply scaled back, by 50% or more (assuming the employer share of 6.2% continued to be paid).

d) Even if the Social Security Trust Fund were kept alive by Congress acting to replenish it from other sources of tax revenues, under current law individual benefits would be reduced on those who saw their payroll tax contributions diminished:

There is also an issue at the level of individual benefits, which I have not seen mentioned but which would be significant. The extent of this impact would depend on the particular scenario assumed, but suppose that the payroll taxes that would have come due and collected from September 1 to December 31 were permanently suspended. For each individual, this would affect how much they had paid in to the Social Security system, where benefits are calculated by a formula based on an individual’s top 35 years of earnings (with earnings from prior years adjusted to current prices as of the year of retirement eligibility based on an average wage inflation index).

The impact on the benefits any individual will receive will then depend on the individual’s wage profile over their lifetime. Workers may typically have 20 or 25 or maybe even 30 years of solid earnings, but then also a number of years within the 35 where they may have been not working, e.g. to raise a baby, or were unemployed, or employed only part-time, or employed in a low wage job (perhaps when a student, or when just starting out), and so on.

There would thus be a good deal of variation. In an extreme case, the loss of four months of contributions to the Social Security Trust Fund from their employment history might have almost no impact. This would be the case where a worker’s income in their 36th year of employment history was very similar to what it was in their 35th, and the loss in 2020 of four months of employment history would lead to 2020 dropping out of their employment top 35 altogether. But this situation is likely to be rare.

More likely is that 2020 would remain in the top 35 years for the individual, but now with four months less of payroll contributions being recorded. One can then calculate how much their Social Security retirement benefits would be reduced as a result.

The formulae used can be found at the Social Security website (see here, here, and here). Using the parameters for 2020, and assuming a person had earned each year the median wages for the year (see table 4.B.3 of the 2019 Annual Statistical Supplement of Social Security), one can calculate what the benefits would be with a full year of earnings recorded for 2020 and what they would be with four months excluded, and hence the difference.

In this scenario of median earnings throughout 35 years, annual benefits to the retiree would be reduced by $105 (from $17,411 without the four months of non-payment, to $17,306 with the four months of the payroll tax not being paid). Not huge, but not trivial either when benefits are tied to a full 35 years of earnings. That $105 annual reduction in benefits would have been in return for the one-time reduction of $669 in payroll taxes being paid (6.2% for four months where median annual earnings of $32,378 in 2019 were assumed to apply also in 2020 despite the economic downturn). That is, the $669 not paid in now would lead to a $105 reduction in benefits (15.8%) each and every year of retirement (assuming retirement at the Social Security normal retirement age).

The loss in retirement benefits would be greater in dollar amount if the period of non-payment of the payroll tax were extended. Assuming, for example, a scenario where it was extended for a full year (and one then had just 34 years of contributions being paid in, with the rest at zero), with wages at the median level throughout those now 34 years, the reduction in retirement benefits would be $316 each year (three times as much as for the four-month reduction). Payroll taxes paid would have been reduced by $2,007 in this scenario, and the $316 annual reduction is again (given how the arithmetic works) 15.8% of the $2,007 one-time reduction in payroll taxes paid.

All this assumes Social Security would continue to pay out retiree benefits in accordance with current law and assumes the Trust Fund remained adequate. The suspension of these payroll taxes would make this difficult, as noted above, unless there was then some general bailout enacted by Congress. But any such bailout would raise further issues.

e) If Congress were to appropriate funds to ensure the Social Security Trust Fund remained adequately funded, the resulting gains would be far greater for those who are well off than for those who are poor:

Suppose Congress allowed these payroll taxes to be “terminated”, as Trump has called for, but then appropriated funds to ensure benefits continued to be paid as per the current formulae. Who would gain?

For at least this part of the transaction (the origin of the funds is not clear), it would be the rich. The savings in the payroll taxes that would be paid in order to keep one’s benefits would be five times as high for someone earning $100,000 a year as for someone earning $20,000. The tax is a fixed 6.2% for all earnings up to the ceiling (of $137,700 in 2020, after which the tax is zero). The difference in terms of the benefits paid would be less, since the formulae for benefits have a degree of progressivity built-in, but one can calculate with the formulae that the change in benefits from such a Congressional bailout would still be 2.3 times higher for those earning $100,000 than for those earning $20,000.

One might question whether this is the best use of such funds. Normally one would want that the benefits accrue more to the poor than to those who are relatively well off. The opposite would be the case here.

f) Importantly, none of this helps those who are unemployed:

Unemployment has shot up this year due to the mismanagement of the Covid-19 crisis, with the unemployment rate rising to a level not seen in the US since the Great Depression. Unemployment insurance, expanded in this crisis, has proven to be a critical lifeline not only to the unemployed but also to the economy as a whole, which would have collapsed by even more without the expanded programs.

Yet cutting payroll taxes for those who have a job and are on a payroll will not help with this. If you are on a payroll you are still earning a wage, and that wage is, except in rare conditions, the same as what you had been earning before. You have not suffered, as the newly unemployed have, due to this crisis. Why, then, should you then be granted, in the middle of this crisis where government deficits have rocketed to unprecedented levels, a tax cut?

It makes no sense. Some other motive must be in play.

g) This does make sense, however, if your intention is to undermine Social Security:

Trump pushed for a cut in the payroll taxes supporting Social Security when discussions began in July in the Senate on the new Covid-19 relief bill (the House had already passed such a bill in May). But even the Republicans in the Senate said this made no sense (as did business groups who are normally heavily in favor of tax cuts, such as the US Chamber of Commerce), and they kept it out of the bill they were drafting.

The primary advisor pushing this appears to have been Stephen Moore, an informal (unpaid) White House advisor close to Trump. He co-authored an opinion column in The Wall Street Journal just a week before Trump’s announcement advocating the precise policy of deferring collection of the Social Security payroll tax. Joining Moore were Arthur Laffer (author of the repeatedly disproven Laffer Curve, whom Trump had awarded the Presidential Medal of Freedom in 2019), and Larry Kudlow (Trump’s primary economic advisor and a strong advocate of tax cuts).

Moore has long been advocating for an end to Social Security, arguing that individual retirement accounts (such as 401(k)s for all) would be preferable. As discussed above, the indefinite deferral of collection of the payroll taxes that support Social Security would, indeed, lead to a collapse of the system. Thus this policy makes sense if you want to end Social Security. It does not otherwise.

Yet Social Security is popular, and critically important. Fully one-third of Americans aged 65 or older depend on Social Security for 90% or more of their income in retirement. And 20% depend on Social Security for 100% of their income in retirement. Cuts have serious implications, and Social Security is a highly popular program.

Thus advocates for ending Social Security cannot expect that their proposals would go far, particularly just before an election. But suspending the payroll taxes that support the program, with a promise to terminate those taxes if re-elected, might appear to be more attractive to those who do not see the implications.

The issue then becomes whether enough see what those implications are, and vote accordingly in the election.

What a Real Tax Reform Could Look Like – II: Social Security

Posted on January 2, 2018, 1:17 pm by aneconomicsense

A. Introduction

The previous post on this blog looked at what a true tax reform could look like, addressing issues pertaining to corporate and individual income taxes. This post will look at what should be done for Social Security and the taxes that support it. Our federal tax system involves more than just income taxes. Social Security taxes are important, and indeed many individuals pay more in Social Security taxes than they do in individual income taxes. Overall, Social Security taxes account for just over a quarter of total federal revenues collected in FY2017, and are especially important for the poor and middle classes. With a total tax of 12.4% for Social Security (formally half paid by the employee and half by the employer, but in reality all ultimately paid by the employee), someone in the 10% income tax bracket is in fact paying tax at a 22.4% rate on their wages, someone in a 15% bracket is actually paying 27.4%, and so on up to the ceiling on wages subject to this tax of $128,400 in 2018. They also pay a further 2.9% tax on wages for Medicare (with no ceiling), but this post will focus just on the Social Security side.

And as is well known, the Social Security Trust Fund is forecast to be depleted by around 2034 if Congress does nothing. Social Security benefits would then be automatically scaled back by about 22%, to a level where the then current flows going into the Trust Fund would match the (cut-back) outflows. This would be a disaster for many. Congress needs to act.

A comprehensive tax reform thus should include measures to ensure the Social Security Trust Fund remains solvent, and is at a minimum able, for the foreseeable future, to continue to pay its obligations in full. Also, and as will be discussed below, Social Security benefit payments are embarrassingly small. Cutting them further is not a “solution”. And despite their small size, many now depend on Social Security in their old age, especially as a consequence of the end of most private company defined benefit pension schemes in recent decades. We really need to look at what can be done to strengthen and indeed expand the Social Security safety net. The final section below will discuss a way to do that.

B. Remove the Ceiling on Wages Subject to Social Security Tax

As was discussed in an earlier post on this blog, the Social Security Trust Fund is forecast to run out by around 2034 not because, as many presume, baby boomers will now be retiring, nor because life expectancies are turning out to be longer. Both of these factors were taken into account in 1983, when following recommendations made by a commission chaired by Alan Greenspan, Social Security tax rates were adjusted and other measures taken to ensure the Trust Fund would remain solvent for the foreseeable future. Those changes were made in full awareness of when the baby boomers would be retiring – they had already been born. And while life expectancy has been lengthening, what matters is not whether life expectancy has been growing longer or not, but rather whether it has been growing to be longer than what had earlier been forecast when the changes were made in 1983. And it hasn’t: Life expectancy has turned out to be growing more slowly than earlier forecast, and for some groups has actually been declining. In itself, this would have lengthened the life of the Social Security Trust Fund over what had been forecast. But instead it was shortened.

Why is it, then, that the Trust Fund is now forecast to run out by around 2034 and not much later? As discussed in that earlier post, the Greenspan Commission assumed that wage income inequality would not change going forward. At the time (1983) this was a reasonable assumption to make, as income inequality had not changed much in the post World War II decades leading up to the 1980s. But from around 1980, income distribution worsened markedly following the Reagan presidency. This matters. Wages above a ceiling (adjusted annually according to changes in average nominal wages) are exempted from Social Security taxes. But with the distribution of wages becoming increasingly skewed (in favor of the rich) since 1980, adjusting the ceiling according to changes in average wages will lead to an increasing share of wages being exempted from tax. An increasing share of wage income has been pulled into the earnings of those at the very top of the income distribution, so an increasing share of wages has become exempt from Social Security taxes. As a direct consequence, the Social Security Trust Fund did not receive the inflows that had been forecast. Thus it is now forecast to run out by 2034.

Unfortunately, we cannot now go back in time to fix the rates and what they covered to reflect the consequences of the increase in inequality. Thus what needs to be done now has to be stronger than what would have been necessary then. Given where we are now, one needs to remove the ceiling on wages subject to the Social Security tax altogether to ensure system solvency. If that were done, the depletion of the Social Security Trust Fund (with all else unchanged, including the benefit formulae) would be postponed to about 2090. Given the uncertainties over such a time span (more than 70 years from now), one can say this is for the foreseeable future.

The chart at the top of this post (taken from the earlier blog post on this issue) shows the paths that the Social Security Trust Fund to GDP ratio would take. If nothing is done, the Trust Fund would be depleted by around 2034 and then turn negative (not allowed under current law) if all benefits were continued to be paid (the falling curve in black). But if the ceiling on wages subject to tax were removed, the Trust Fund would remain positive (the upper curves in blue, where the one in light blue incorporates the impact of the resulting benefit changes under the current formulae, as benefits are tied to contributions).

As discussed in that earlier blog post, the calculations indicate the Social Security Trust Fund then would remain solvent to a forecast year of about 2090. That is over 70 years from now, and the depletion at that time is largely driven by the assumption (by the Social Security demographers) on how fast life expectancy is forecast to rise in the future. This could again be over-estimated.

Lifting the ceiling on wages subject to Social Security tax would also be equitable: The poor and middle classes are subject to the 12.4% Social Security tax on all of their wages; a rich person should be similarly liable for the tax on all of his or her earnings. And I cannot see the basis for any argument that a rich person making a million dollars a year cannot afford the tax, while a poor person can.

C. Apply the Social Security Tax to All Forms of Income, Not Just Wages, and Then Raise Benefits

But I would go further. In the modern era, there is no reason why the Social Security tax should be applied solely to wage earnings, while earnings from wealth are not taxed at all. As one of the basic principles of taxation noted in the previous post on tax reform, all forms of income should be taxed similarly, and not with differing rates applied to one form (e.g. 12.4% on wages) as compared to another (e.g. 0% on income from wealth).

Broadening the base would allow, if nothing else is changed, for a reduction in the rate to produce the same in revenues. We can calculate roughly what that lower rate would be. Making use of IRS data for incomes reported on the Form 1040s in 2015 (the most recent year available), one can calculate that if Adjusted Gross Income (line 37 of Form 1040) was used as the base for the Social Security tax rather than just wages, the Social Security tax rate could be cut from 12.4% to 8.6% to generate the same in revenues. That is, taxing all reported income (including income from wealth) at an 8.6% rate (instead of taxing just wages at 12.4%) would generate sufficient revenues for the Social Security Trust Fund to remain solvent for the foreseeable future. This would be a more than 30% fall in the taxes on wages, but also, of course, a shift to those who also earn a substantial share of their income from wealth.

[Note: There would also be second-order effects as Social Security benefits paid are tied to the taxes paid over the highest 40 years of an individual’s earnings, there is some progressivity in the formulae used, and taxes on all earnings rather than just on wages will shift the share of the taxes paid towards the rich. But the impact of these second-order effects would be relatively small. Also, the direction of the impact would be that the break-even tax rate could be cut a bit further to allow for the same to be paid out in benefits, or a bit more in benefits could be paid for the same tax rate. But given that the impact would be small, we will leave them out of the calculations here.]

The 8.6% tax on all forms of income would generate the revenues needed to keep the Social Security Trust Fund solvent at the benefit levels as defined under current law. But Social Security benefit payments are embarrassingly small. Using figures for September 2017 from the Social Security Administration, the average benefit paid (in annualized terms) for all beneficiaries is just $15,109, for retired workers it is $16,469, and for those on disability it is $12,456. These are not far above (and for disability indeed a bit below) the federal poverty guideline level of $13,860 in 2017 for a single individual. And the average benefit levels, being averages, mean approximately half of the beneficiaries are receiving less.

Yet even at such low levels, Social Security benefits account for 100% of the income of 20% of beneficiaries aged 65 or higher; for 90% or more of the incomes of 33% of those aged beneficiaries, and 50% or more of the incomes of 61% of those aged beneficiaries (data for 2014; see Table 9.A1). And for those aged 65 or older whose income is below the federal poverty line, Social Security accounts for 100% of the income of 50% of them, for 90% or more of the income of 74% of them, and for 50% or more of the income for 93% of them (see Table 9.B8). The poor are incredibly dependent on Social Security.

Thus we really should be looking at a reform which would allow such benefit payments to rise. The existing levels are too low to serve as an effective safety net in a country where defined benefit pension plans have largely disappeared, and the alternative approach of IRAs and 401(k)s has failed to provide adequate pensions for many if not most workers.

Higher benefits would require higher revenues. To illustrate what might be done, suppose that instead of cutting the Social Security tax rate from the current 12.4% to a rate of 8.6% (which would just suffice to ensure the Trust Fund would remain solvent at benefit levels as defined under current law), one would instead cut the tax rate just to 10.0%. This would allow average Social Security benefits to rise by 15.8% (= 10.0%/8.6%, but based on calculations before rounding). One can work out that based on the distribution of Social Security benefit payments in 2015 (see table 5.B6 of the 2016 Annual Statistical Supplement), that if benefits were raised by 5% for the top third of retirees receiving Social Security and by 10% for the middle third, then the extra revenues would allow us to raise the average benefit levels by 45% for the bottom (poorest) third:

Annual Social Security Benefits	Avg in 2015	% increase	New	Difference
Bottom Third of Retirees	$8,761	45%	$12,733	$3,972
Middle Third of Retirees	$16,010	15%	$18,411	$2,401
Top Third of Retirees	$23,591	5%	$24,771	$1,180

Overall for Retirees	$16,044	15.8%	$18,574	$2,531

This would make a significant difference to those most dependent in their old age on Social Security. The poorest third of retirees receiving Social Security received (in December 2015 and then annualized) a payment of just $8,761 per year. Increasing this by 45% would raise it to $12,733. While still not much, it would be an increase of almost $4,000 annually. And for a married couple where both had worked and are now receiving Social Security, the benefits would be double this. It would make a difference.

D. Conclusion

Conservatives have long been opposed to the Social Security system (indeed since its origin under Roosevelt), arguing that it is a Ponzi scheme, that it is unsustainable, and that the only thing we can do is to scale back benefits. None of this is true. Rather, Social Security has proven to be a critically important support for the incomes of the aged. An astonishingly high share of Americans depend on it, and its importance has only increased with the end of defined benefit pension schemes for most American workers.

But there are, indeed, problems. Due to the ceiling on wages subject to Social Security tax, and the sharp increase in inequality starting in the 1980s under Reagan and continuing since, an increasing share of wages in the nation have become exempt from this tax. As a consequence, and if nothing is done, the Trust Fund is now forecast to run out in 2034. This would trigger a scaling back of the already low benefits by 22%. This would be a disaster for many.

Lifting the ceiling on wages, so that all wages are taxed equally, would resolve the Trust Fund solvency issue for the foreseeable future (to a forecast year of about 2090). Benefits as set under the current formulae could then be maintained. Furthermore, if the base for the tax were extended to all forms of income (including income from wealth), and not limited just to wages, benefits as set under current formulae could be sustained with the tax rate cut from the current 12.4% to a new rate of just 8.6%.

But as noted above, current benefits are low. One should go further. Cutting the rate to just 10%, say, would allow for a significant increase in benefits. Focussing the increase on the poorest, who are most dependant on Social Security in their old age, a rate of 10% applied to all forms of income would allow benefits to rise by 5% for the top third of retirees, by 15% for the middle third, and by a substantial 45% for the bottom third. This would make a real difference.

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