by Jurgen Brauer and Nick Anglewicz, March 2005
Copyright: J. Brauer. No reproduction without permission.

Part of the Social Security Trust Fund problem is that the federal government essentially runs two budgets. To finance its regular, normal operations, the federal government levies taxes on income, profits, imports, and other categories of economic activity. This pays for the departments of defense, agriculture, transportation, justice, and so on. Most years, expenses exceed tax receipts and the federal government budget shows a budget deficit. To fill the gap, the federal government borrows. Much of the borrowing came (and still comes) from the second "budget" the federal government runs: the Social Security Trust Fund.

In the late 1930s, the federal government introduced a new tax, the so-called payroll tax. Employees and employers started paying taxes into a Trust Fund. Money paid in by current workers is paid out immediately to retired workers (a "pay-as-you-go" system). Because the people paying in were so much more numerous than the people drawing money from the Fund, the Fund generated large surpluses. In exchange for a stack of I.O.U.'s, these Trust Fund surpluses were "hi-jacked" by the federal government to fill the gaping deficits in its regular operations budgets. The accumulated surpluses thus hi-jacked now have reached the sum of about 1.3 trillion dollars.

If the Trust Fund had been run by a private company, instead of by the federal government, the surpluses would still have been lent to someone (to earn interest or dividends) but with two distinct advantages. First, the accumulated surplus would now probably stand at about $2.3 trillion on account of higher rates of return from investing in private market opportunities instead of investing exclusively in lower-yielding government bonds. Second, in the absence of being able to dip into the Trust Fund surpluses, the federal government would have been compelled either to borrow more from the private markets or reduce the deficits of its regular budget by cutting regular spending or raising regular taxes (or both). Instead of "hiding" the real size of its regular deficits, government would have to have been more honest about the state of its finances.

Private accounts, as President Bush proposes, do not solve the problem.

Private accounts, as President Bush proposes, do not solve the problem. To the contrary, they actually advance the day of reckoning. If you currently pay 6.2 percent of your monthly gross income into the Fund, the private account proposal will require workers to pay in a smaller amount, say, 4.2 percent, leaving the remaining 2 percent to be placed into your "private" account. (The details are still in discussion.) Obviously, this reduces the monthly payments into the Fund so that its current monthly surplus falls while the current monthly benefit payments remain unchanged. So the day when the Fund needs to call in the accumulated I.O.U.'s will arrive earlier than otherwise, and the federal government won't be able to pay up.

The logical consequence is that the federal government will have to resort to four "tricks." First, increase the payroll tax; second, lower the retirement benefits; third, raise regular taxes to pay off the accumulated I.O.U.'s; and fourth, reduce regular federal government outlays. The only question now is one of generational fairness: which generation – the old, or the young – shall bear the burden of earlier government's excessive spending that created all these federal government budget deficits?

Suppose you were born in 1895. At age 20, by 1915, you fought in World War I. At age 42, in 1937, you started paying into the newly created Trust Fund. Twenty-three years later, at age 65, you started drawing retirement benefits. Having paid into the system for 23 years, you might have died by 1965, aged 70, having received benefits for five years. Those born in 1925 fought in World War II in 1945 and paid into the system their entire work lives. In 1990, at age 65, retirement benefits were "taxed" (i.e., reduced; benefit taxation started in 1983), but with an average life expectancy of 78 years, you would have drawn benefits for 13 years, until 2003. The baby boomers, born as from 1946, reach age 65 in 2010. Having paid in a lifetime as well, their benefits will have to be cut as well to account for even higher life expectancy, or else their children, born as from the mid-1960s, will have to pay higher payroll taxes.

To address the problem, some generation will have to pay twice, once via payroll taxes for its immediate predecessor generation (its parents), and once via private accounts for its own retirement.

An alternative is for the federal government to start running a hefty surplus on its regular budget and use it to restock the surplus of the Trust Fund. This requires regular budget spending cuts (financing fewer wars, for example) or raising taxes on income, profits, and the like. But in this case, the current generation pays twice as well, via higher regular taxes, rather than via higher payroll taxes.

Eventually, a transition from pay-as-you-go to pay-into-your-own-account will have to be made. The inevitable consequence of this is that some generation will have to pay twice, once via payroll taxes for its immediate predecessor generation (its parents), and once via private accounts for its own retirement. There is no way around: the only options are to cut spending or benefits, and to raise regular or payroll taxes.