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Thursday, December 23, 2010

The Social Security Trust Fund Accounting Trick

Over at Dorf on Law, Neil Buchanan has a post raising the prospect that the "payroll tax holiday" might eventually undermine one of the key foundations of political support for social security, the trust fund.  Neil and I basically agree on the descriptive: the Social Security Trust Fund is an illusion, and it is an illusion that is fundamental to protect its political backing.  I suspect we disagree on the normative, whether basing the largest federal program on an illusion is good government policy.  Below the fold, I attempt to explain how this illusion operates.

The reason that the Social Security Trust Fund is an accounting illusion is slightly complicated to explain.  Suppose we have an individual, John Doe, and his wife, Jane Doe.  John earns $60,000 per year, and Jane earns $40,000 per year, so their household income is $100k.  Let us assume also that the Doe household spends $70,000 per year in ongoing expenses like rent, food, and utilities.  Furthermore, they give $40,000 per year to Jane's parents, who are sick and need constant medical care.  Thus, the Doe household runs a $10,000 per year deficit, which is  placed on John's credit card.

So far, so good, and everyone would say that the Doe household runs a $10,000 per year deficit.  They also would have no retirement savings.

Suppose that John and Jane put together the following nice little trick to get some retirement savings.  At the beginning of every month, Jane's income would be put into a seperate Savings Account.  On the second of the month, John would withdraw the entire amount from the Savings Account, and give the money to Jane's parents to pay for their medical care.  At the same time, he will write a promissory note to Jane, promising to pay back the money into the Savings Account in the future, when John and Jane retire.  The Does would then continue to do everything exactly as before: John earns $60k, spends $70k on things other than Jane's parents, and they put $10k on the credit card.

The Does would also go around saying that they are putting $40,000 every year into their Savings Account.  And people would laugh at them, though somehow people don't laugh when Uncle Sam does this.

The reason this doesn't work is because the Does are blatently double-counting the $40,000.  If John's promissory note to Jane is a worthless piece of paper, they have no retirement savings -- the retirement money is being spent on Jane's parents.  If John's promissory note to Jane is a meaningful piece of paper, then the Does do not have a $10,000 annual deficit.  They have a $50,000 annual deficit.

This, in a nutshell, is how the social security Trust Fund works.  Substitute John and Jane for "current working-age taxpayers" and the Savings Account for the Social Security Trust Fund, and there you have it.  If the Trust Fund really is devoted to future Social Security benefits for today's workers, then you must take the payroll tax revenue out of the calculation of the federal deficit, but still keep social security payments to today's retirees (payments to Jane's parents) in that calculation, which would make the deficit explode (the $50,000 in my example).  But if we say that the trust fund is an illusion, a worthless piece of paper like John's I.O.U. to Jane, then we, like the Does, have no retirement savings and still something of a deficit ($10,000 in my example).

Posted by Tun-Jen Chiang on December 23, 2010 at 05:50 PM | Permalink

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Posted by: ContLight | Feb 4, 2011 6:49:02 AM

Brian writes:

The only questions are whether the government has a legal obligation to pay its IOUs to the Social Security Trust Fund (it does)...."

Hmmmm. Under what legal theory does any later Congress have to comply with the statutory command of an earlier Congress? Would not the simple statutory statement --in , say, the form of an appropriations bill declaring that the government will not redeem the earlier Congresses' IOUs -- suffice to repeal pro tanto any earlier statutory obligation contained in the Social Security Act? No contract clause binds the federal government, and, as for the due process clause, it is hard to believe that anyone would have a vested right to the "property" of redemption of the trust fund IOUs. (Individual beneficiaries would not have standing to sue, in any case).

You know the slogan: An earlier legislature cannot alienate the power of a later legislature to change its mind. Vermeule and Posner have an 2002 article in Yale Law Journal arguing against this slogan (Adrian Vermeule & Eric A. Posner, Legislative Entrenchment: A Reappraisal, 111 Yale Law Journal 1665 (2002)), but, under their reasoning, entrenchment of the payment obligation would require Congress to enact a special provision in the original Social Security Act declaring that the Act could not be amended by ordinary legislation. To my knowledge, Congress did not do so.

So what's the basis for saying that Congress has any legal obligation to pay their IOUs to the trust fund? I think that, in the strongest possible sense, the trust fund is a complete legal fiction because Brian's "legal obligation" is fictitious.

Posted by: Rick Hills | Dec 31, 2010 10:40:39 AM

I just feel the need to chime in to note that the line quoted by Brian-- "'the trust fund is an illusion, a worthless piece of paper like John's I.O.U. to Jane,'" is a sentence fragment that begins "But if we say that . . ."

And of course the rest of the paragraph from which the quotation comes argues what TJ has been saying all along-- that we can either treat the promise to pay as worthless or not, but that either choice suggests an error in the current accounting. It seems very odd to see that as a claim that the promise to pay is worthless.

Posted by: WPB | Dec 28, 2010 12:20:30 AM

Brian,

Well, again, you position works if one is consistent. Then the trust fund is not an illusion, because we really are putting money into it, but the deficit doubled. Unfortunately, Uncle Sam is not similarly consistent in his accounting. Besides which, I should note that even Neil Buchanan (no critic of social security) concedes that the trust fund is a "legal fiction."

Posted by: TJ | Dec 27, 2010 2:40:49 PM

Maybe that's right, though from the title of your post to lines like "the trust fund is an illusion, a worthless piece of paper like John's I.O.U. to Jane," it certainly sounded like you were attacking social security, not just making an accounting point about the actual size of the deficit. But, in fact, the trust fund is not an illusion, because Uncle Sam's promise to pay is not like John's, it is not, in fact, a worthless piece of paper.

Posted by: Brian | Dec 27, 2010 2:33:57 PM

O.k., my initial comment may have been a little harsh. Here's why I'm annoyed. In at least one of Buchanan's articles*, he faults others for being unwilling to tell the public the truth about budget deficits (namely that sometimes the benefits will outweigh the costs). In that article Buchanan chides Al Gore for (essentially) lying about Social Security—the "lockbox" ordeal—because he felt it gave Bush support for his Social Security privatization ploy (bad in Buchanan's opinion). More generally, the third part of Buchanan's article is titled "A Noble Deception?," in which he specifically rejects so-called "noble lies" to the public.

So I find it quite annoying to hear Buchanan defending the "legal fiction of Social Security's separate financing," which is basically a noble lie of the sort Buchanan has rejected with strongly-worded rhetoric elsewhere. I think it is time to admit to the general public (out loud) that "Social Security" is a regressive wage tax combined with a transfer payment system to the elderly that distributes benefits via a mildly progressive formula, that lavishly subsidizes the lifestyles of the middle- and upper-middle-class, and even wealthy Americans. Oh, and it is built on the "defined benefit" model that has proven to be unsustainable over the long-run.

If one was worried about cost-benefit analysis, or the progressivity of our tax-and-transfer system, means-testing for Social Security so that well-off people aren't paid an (often 20 or more year) annuity at great public expense should be on the table. But based on Buchanan's political calculation, it seems like he would be opposed to means-testing Social Security, not because paying Warren Buffet Social Security is good public policy, but because he would be worried about weakened political will for our transfer payment program for retired individuals. I think we ought to tell the public the truth.

Buchanan is inconsistent. He thinks lying about budget deficits is bad, but lying about Social Security is o.k. Hence my "by any means necessary comment" above. I retract that comment, but the more important point about Buchanan's inconsistency stands.

*Is it Sometimes Good to Run Budget Deficits? If So, Should We Admit it (Out Loud)?, 26 Va. Tax. Rev. 325 (2006).

Posted by: GU | Dec 26, 2010 11:02:35 PM

Brian,

Thanks for the comments. We have been talking past each other to some extent. You have said nothing about the deficit. I have said nothing about whether John will pay in the future, since I explicitly posit a situation where John has a perfect credit rating and will pay in the future. I take it that your objection to my analogy disappears for that scenario.

Posted by: TJ | Dec 24, 2010 7:43:08 PM

I've been quite consistent. I haven't said anything at all about the deficit (which I think is largely a non-issue, for other reasons). I was just objecting to your analogizing John to the government. Anyway, thanks for your replies.

Posted by: Brian | Dec 24, 2010 7:33:59 PM

Brian,

But it is not a different issue -- and the fact that the "payroll tax holiday" highlights that the social security system is part of the general government budget is what gets Neil worried. The laws of mathematics means that you either have a separate system or a unified system, not both.

Your insistence that the government has a legal obligation to pay the bonds, and that it will pay the bonds, means that you favor thinking of it as a separate system. But then you need to be consistent -- think of it as a separate system in all its applications. Which means that when you talk about the government deficit, it is over two trillion dollars. If you maintain that consistency, there is nothing wrong with your position. It does mean that the pressure to reduce the two trillion deficit (including by cutting the largest federal expenditure) will be considerably more than if the publicized deficit was smaller.

Posted by: TJ | Dec 24, 2010 7:29:35 PM

There are no mathematical laws at issue here and no dispute about math. The only questions are whether the government has a legal obligation to pay its IOUs to the Social Security Trust Fund (it does), and whether there is reason to think it will default on that obligation (it's conceivable, but not very likely for a host of I assume obvious reasons). That is the pertinent difference between the government and John. Would it have been better if Reagan had not started massive borrowing against the Trust Fund to offset his massive deficit spending in the 1980s? Probably so. But that's a different issue.

Posted by: Brian | Dec 24, 2010 7:16:29 PM

To clarify the breakdown even further:

Revenues: $940 billion from payroll taxes (Jane's income); $1,460 from other sources including income tax (John's income).

Expenditures: $1,130 billion social security and medicare payments (Jane's parents); $2,420 other expenditures (Doe household expenses).
--------------------------------------------------------------------
Deficit if Jane's income is considered spent (i.e. promise to pay is worthless): $1,150 billion. Trust Fund: $0.

Deficit if Jane's income is not considered spent (i.e. promise to pay is meaningful): $2,090 billion. Trust Fund: $940 billion.

Posted by: TJ | Dec 24, 2010 5:38:54 PM

Brian,

You are missing the point. I assume your point is that Uncle Sam has a perfect credit rating. But I said nothing about whether John has a good or bad credit rating. If you assume that John's promise to pay is perfect, that works too, but only if you then say the Does have a $50,000 annual deficit.

In more practical terms, the 2010 federal budget consists of this:

Revenues: $940 billion in social security and medicare; $1,460 billion from other sources.

Expenditures: $3,550 billion.

The accounting trick is that we are double counting the $940 billion in payroll taxes. We say we put that in a Savings Account, while at the same time we spend it all by saying that we have only a $1,150 billion deficit. If you assume that John's promise to pay is ironclad, as Uncle Sam's is, then the deficit explodes (almost doubles) to $2,090 billion.

Uncle Sam may have a perfect credit rating, but that doesn't mean he can defy the laws of mathematics.

Posted by: TJ | Dec 24, 2010 5:17:33 PM

Buchanan is a "by any means necessary" sort of guy, so I doubt he cares that Social Security is built on a lie.

[TJC edit: GU, I don't like this type ad hominem attack even when they are sympathetic to my position. Besides which, Neil clearly does care, since he fears that undermining the illusion will undermine political support for social security. It is only that he thinks the benefits of the illusion outweigh the costs.]

Posted by: GU | Dec 24, 2010 1:11:36 PM

Uncle Sam's promise to pay is simply not the same as as John's. You've elided that rather important point, haven't you?

Posted by: Brian | Dec 24, 2010 12:12:06 PM

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