Senator Ron Johnson claims Social Security is Ponzi scheme, that it is broke, and that in order to "save it" the program should be re-evaluated and re-authorized annually. Actually, it is this set of assertions that needs a closer look.
THE BEST DEFENSE IS UNDERSTANDING HOW THE PROGRAM WORKS
To defend Social Security it is essential to know how the amount of individual retiree benefit checks are determined and how they are paid for. Two published formulas (at ssa.gov) constitute very specific promises of Social Security benefits made to workers in exchange for very specific tax payments.
The Benefit Formula
The retiree benefit formula determines the amount of the retiree's first monthly check; all subsequent checks are equal to that amount, adjusted annually for inflation, with monthly payments continuing until death of the retiree or the end of eligibility of a designated beneficiary. The formula that determines the amount of that first check adds the individual's payroll tax payments made during the top 35 earnings years, then adjusts for past inflation since those years, labor productivity growth, and a means-test factor (an upward adjustment of the payment to the lowest-income contributors).
The Financing Formulas
The revenue to pay for those Social Security benefits comes from two sources. The first is the familiar payroll tax, or FICA (Federal Insurance Contribution Act) withholding from earnings up to a cap (which this year is $147,000).
The second source of revenue is proceeds from the sale of Social Security bonds. This source is more complicated than the first and designed to address the financial burden of the baby-boom retirement. The "Post-War Baby Boom" was 77 million people born in the 18 years between 1946 and 1964. In the subsequent 18 years only 47 million people were born, a "Baby Bust." Because of this population boom and bust sequence, an undue burden would have been imposed on the "busters" if the sole source of revenue for boomers' retirement benefits had been the payroll tax on worker income.
To prevent that burden, the baby boomers were forced during their working years, beginning in 1985, to pay a higher payroll tax rate than required at that time to pay the retirement benefits of those then retired. That difference, or " surplus" cash, was invested in Social Security Bonds bought from the Treasury. These special bonds are not issued to the world financial markets but instead are traded back-and-forth between the Social Security Administration and the Treasury Department. In those years when the payroll tax generates a revenue surplus net of retiree benefits, bonds are bought from Treasury by Social Security; in those years when there is a revenue deficit, bonds are sold by Social Security back to Treasury.
FOLLOW THE MONEY AND FOLLOW THE BONDS
In effect, these special bonds act as a loan mechanism. During their working years, the boomers were forced to loan money to the country and the country would repay the loan with interest during their retirement years. This loan mechanism was a savings vehicle for the boomers and a debt obligation for the country. The Social Security Administration acted as agent of the workers while Treasury acted as agent for the country; the electronic record of these bonds is known as the "Social Security Trust Fund."
Are the Bonds "Worthless" or "Pro-growth?"
Senator Johnson has asserted that the bonds are "worthless" because they are traded between one branch of government and another. The economic concept behind this financial mechanism proves otherwise. The plan was to boost savings by the boomers and invest in the public-sector assets of the economy and then pay a portion of retirement benefits out of that enlarged productivity. In other words, it relied on a reciprocal relationship between generations: the young would pay for the retirement benefits of the old out of the greater wealth made possible by the old when they were young. The Treasury Department, at the direction of the Congress, would invest in long-neglected public sector assets including bridges, roads, harbors, clean-up of chemical dump sites, broadband, research and development, and other public-sector complements to the market economy. The plan rested on one of the most important and least understood principles of economics: a market system requires a strong public sector to do those things that the market needs for optimum performance but will not produce for itself.
If all that had worked out as planned the bonds would have run out in 2060, 75 years after the boomers began their forced savings. Because the economy grew more slowly than planned there was a slower growth of the surplus and of the bond purchases by Social Security on behalf of the boomers. Consequently, the bond fund will not run out in 2060, when all but the most persistent boomers will be dead, but instead, under current estimates, will run out in in 2035, when nearly half of the boomers would still be very much alive.
WHAT HAPPENS WHEN THE BONDS RUN OUT?
After the bonds run out -- i.e., after Social Security has sold all of its bonds back to the Treasury in exchange for cash -- the payroll tax revenue will be enough to pay 75% of the scheduled benefits. When that happens, Congress will face two choices. The first choice is to reduce benefits by 25% so that payroll tax revenue would be sufficient to cover that level of expense. This is unlikely because Members of Congress like to keep their jobs; it would be very difficult to explain to retirees and workers close to retirement that Congress plans to renege on the annually published promises of benefits they earned by paying FICA taxes during their working years.
The second choice is to continue honoring the benefit schedule in full, deriving the 25% supplement from general taxes and borrowing, i.e., the same place where Treasury got the money to buy back the Social Security bonds before the bonds were all gone. Moreover, the amount required will be determined the same way: the supplement needed to meet the scheduled benefit formula. Since the amount of money needed is equal to 25% of the retiree benefits whether there are bonds to be redeemed or not, no increase in taxes or borrowing will be required for Treasury to provide the supplementary funds to Social Security.
Social Security is not a Ponzi scheme; it is not broke; it is not facing bankruptcy when the bonds run out; the bonds not worthless because one agency of government exchanges the bonds with another agency. Moreover, the system has been reviewed regularly and an annual report issued to the Congress and the public. In addition to the large change made due to the Baby Boom, this long-standing process of steady review and reevaluation has led to several other changes. For example, because life expectancy has increased, the age of eligibility has been increased; in 2027 that gradual increase will settle at age 67 for full schedule benefits (lesser benefits available at age 62). Finally, the benefits schedule includes a means test.
The arithmetic is in sharp contrast to the notion that Social Security is in deep trouble and in need of major overhaul. The greatest threat to Social Security is misunderstanding how it works.
William L. Holahan is Emeritus Professor and former Chair of Economics at the University of Wisconsin-Milwaukee.
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