Resident Scholar Alan D. Viard
In a recent article, Profs. James E. Wheeler, Jeffrey D. Gramlich, Dennis J. Gaffney, and Ed Outslay advocate a massive diversion of general revenue into the Social Security Trust Fund. Their primary argument for the proposal--the claim that Social Security currently subsidizes the remainder of the federal government--is incorrect. More important, the proposal would result in burdensome tax increases and spending cuts outside the Social Security system and would probably reduce national saving.
The authors' contention that Social Security currently subsidizes the remainder of the federal government rests on two complaints, neither of which is well founded.
The authors reach a contrary conclusion by using a conceptually flawed baseline for the income tax system, one featuring complete deduction of Social Security taxes combined with full exemption for Social Security benefits.
The authors first complain that Social Security is spending less than its tax revenue and that the extra revenue is transferred to the rest of the government. In fact, there is no such transfer in the relevant present-value sense, because the trust fund is credited with the surplus revenue and interest thereon. As compensation for spending less than its revenue from 1984 through 2016, the trust fund will be allowed to spend more than its revenue thereafter. Specifically, under the latest projections, it will be allowed to pay promised Social Security benefits in full from 2017 through 2040, even though its tax revenue will be insufficient to cover the benefits in each of those 24 years.
The authors next complain that the Social Security Trust Fund is shortchanged by the current accounting for the interaction between Social Security and the income tax system. In reality, the remainder of the government subsidizes Social Security, since the interaction between Social Security and the income tax system produces a net revenue loss for which the trust fund is not charged. To see this point, it is necessary to examine the income tax treatment of Social Security benefits and Social Security taxes and how that treatment affects the trust fund.
First, consider the treatment of Social Security benefits. The authors' statement that "the income taxes on up to 85 percent of Social Security benefits should be included in the Social Security Trust Fund" misleadingly suggests that the trust fund currently does not receive income taxes collected on benefits. It is unclear why the authors do not explain that the majority of those taxes already go to the Social Security Trust Fund and that none of them go to the general treasury.
When Congress enacted what is now Internal Revenue Code section 86(a)(1) in 1983, taxing up to 50 percent of Social Security benefits for some recipients, it earmarked the resulting revenue to the Social Security Trust Fund. When Congress enacted section 86(a)(2) in 1993, taxing up to an additional 35 percent of benefits for a subset of those recipients, it earmarked that revenue to the Medicare Part A Trust Fund. Under those provisions, in 2006 the Social Security Trust Fund received $17 billion of income taxes collected on Social Security benefits and the Medicare Part A Trust Fund received the other $10 billion.
Now, consider the treatment of Social Security taxes. Since individual income tax is imposed on employee compensation net of employer payroll tax payments, employer payroll taxes--half of all payroll taxes--are effectively deducted from individual income tax. As the authors note, there is no deduction for the other half, the employee payroll taxes. In an (imperfectly designed) attempt to provide parity to the self-employed, section 164(f) allows half of self-employment taxes to also be deducted. A rough estimate suggests that the deductions for employer payroll taxes and half of self-employment taxes reduced income tax revenue by $63 billion in 2006. Since the trust fund was not charged for that revenue loss, Social Security received a $63 billion subsidy from the general treasury, far exceeding Social Security's $10 billion subsidy to Medicare Part A.
The authors reach a contrary conclusion by using a conceptually flawed baseline for the income tax system, one featuring complete deduction of Social Security taxes combined with full exemption for Social Security benefits. They insist that the trust fund be "compensated" for any treatment that is less favorable than this asymmetrical benchmark, such as the nondeductibility of employee payroll taxes. The authors do not explain why the income tax system should allow a deduction for Social Security taxes with no corresponding inclusion for Social Security benefits.
The authors also fail to mention that the Social Security Trust Fund has received numerous other transfers from the general treasury. (To be fair, most of the transfers have not been large.) General- revenue financing has been provided for some special benefits paid to individuals who reached age 72 before 1968 without qualifying for regular benefits and for noncontributory military wage credits. In 1998 the trust fund was allowed to retain excess interest paid by the general treasury due to an error in applying the statutory interest formula. Other laws have provided indirect transfers to the trust fund by using general revenues to finance income tax credits that offset payroll or self-employment tax liability. For example, the 1983 Social Security Amendments offered temporary credits to offset increases in payroll and self-employment tax rates and the 1993 deficit- reduction law enacted the permanent section 45B credit for some employer payroll taxes on tip income.
The accounting discussion above establishes that the authors' proposal would not correct an imagined Social Security subsidy to the remainder of the government, but would instead increase the preexisting subsidy in the opposite direction. Accounting cannot tell us, however, whether such a subsidy increase would be desirable. To address that question, we must examine the proposal's economic effects. While the proposed financial transfer would offer highly visible gains, it would also impose quite painful, though less visible, costs.
The gains are obvious. By averting benefit cuts and tax increases that would otherwise be required to maintain solvency, the proposal would lead to higher Social Security benefits and lower Social Security taxes than would otherwise occur. Since the transfer would not increase the government's total resources, however, the resources added to Social Security would be lost to the remainder of the government. The government's long-run budget constraint requires that total noninterest outlays (including Social Security benefits) not exceed total revenues (including Social Security taxes) in present discounted value. Accordingly, the higher Social Security benefits and lower Social Security taxes would have to be financed by lower spending or higher taxes elsewhere in the budget.
The remainder of the government faces a financial shortfall considerably more daunting than that facing Social Security. Large spending cuts or tax increases will be required in the remainder of the budget even without the proposed financial transfer. Should those measures be made still more stringent to avert even the most modest benefit cuts or tax increases in the Social Security system? Is preserving the current-law level of Social Security benefits a higher national priority than ensuring an adequate defense, providing income support to the young and middle- aged poor, and avoiding crushingly high marginal income tax rates?
On a particularly troubling note, the proposed financial transfer would probably reduce national saving. To begin, the proposal would steer future spending restraint away from Social Security benefit cuts that might encourage people to save more for their own retirement. It would also steer future revenue increases away from the Social Security tax system, which generally exempts the returns to saving, and into the income tax system, which taxes the returns to saving.
Transferring money between budgetary accounts is a shell game, not a solution. To address the looming fiscal imbalance, tough decisions will be necessary in all parts of the budget. Rather than robbing the general treasury's Peter to pay Social Security's Paul, let's start making those decisions.
Alan D. Viard is a resident scholar at AEI.
- "Social Security Subsidizes the Federal Government," Tax Notes, Mar. 3, 2008, p. 1027, Doc 2008-2932 [PDF], 2008 TNT 43-42 .
- No transfer occurs even if (as is likely) the existence of the Social Security surplus spurs tax cuts or spending increases elsewhere in the budget. Because the trust fund is credited with the surplus revenue and interest, any such tax cuts and spending increases reduce the future resources available to the remainder of the government, not the resources available to Social Security.
- The 2007 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds, p. 8.
- P.L. 98-21, section 121(e), 97 Stat. 83.
- P.L. 103-66, section 13215(c), 107 Stat. 476.
- Trustees Report, supra note 3, at 25.
- The 2007 Annual Report of the Boards of Trustees of the Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds, p. 5.
- In 2006 the Social Security Trust Fund received $626 billion of payroll and self-employment taxes, Trustees Report, supra note 3, at 25. The estimate in the text assumes that half of those taxes were deducted at an average marginal income tax rate of 20 percent.
- 42 U.S.C. section 428(g).
- 42 U.S.C. section 429(b).
- Daniel Tyson, "Social Security Safe From Treasury Multibillion-Dollar Miscalculation," Tax Notes, Dec. 28, 1998, p. 1594, Doc 98-37944, 98 TNT 245-3.
- P.L. 98-21, section 123(b), 97 Stat. 88, allowed a credit of 0.3 percent of taxable wages in 1984. Section 124(b) of that law, 97 Stat. 89, allowed a credit of 2.7 percent of taxable self-employment earnings in 1984, 2.3 percent in 1985, and 2 percent in 1986 through 1989.
- P.L. 103-66, section 13443(a), 107 Stat. 568.
- Congressional Budget Office, The Long-Term Budget Outlook, December 2007, describes the scope and nature of the long-run fiscal challenge.