Lies about the Payroll Tax

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For me at least, one of the frustrations about the debate over extending the cut in the payroll tax is extent to which politicians have tried to exploit the public's lack of understanding about how the Social Security system works.

The first lie is the Republican claim that extending the payroll tax will somehow deprive the Social Security system of funds and jeopardize the retirement security of seniors.

Democrats have responded not with the truth but with the claim that the revenue losses from the extension will be offset by "general revenue."

Understanding why both of these claims are untrue requires some background knowledge of how Social Security works.

Social Security is a pay-as-you-go system where current retirees are supported by the payroll tax payments of current workers.  When I pay payroll taxes, they do not go into some account with my name on it, they go to my mother-in-law.  Every year since 1984, the payroll tax revenues plus interest on the SS Trust Fund's holding of treasury notes has exceeded the benefits paid out.  The Trust Fund then exchanges this surplus for more treasury bills and the federal government spends it.  

In 2010, the Trust Fund surplus was $94 billion or about 16% of the benefits paid.  That is about the same size as the revenue short fall from the 2 point reduction in the payroll tax rate (the SS Trustees estimate a loss of about $90b for 2011).  So even with this loss, payroll taxes and interest will cover the benefits paid.  So one of two things will happen.  The Treasury will actually give $90b to the Trust Fund.  But because it is surplus, the Trust Fund will give it right back to Treasury in exchange for government debt.   Or it could be handled the easy way:  Treasury would just give the Trust Fund $90 billion in Treasury notes.

The important point is that the effect of the payroll tax cut on the balance sheet of the Social Security Trust Fund is exactly zero.  With or without the cut in 2011, the Fund would increase its holding of U.S. government debt by over $90 billion.  Even if the government did not give the Trust Fund the $90 billion worth of debt, the effects would not be felt until around 2035 when the Trust Fund is expected to be exhausted. 

Thus the Republican claims have no merit.  

I'll admit the Democratic shading of the truth is less egregious.  It is easier to say that general revenue will cover lost payroll tax revenue than it is to explain that the government will only promise to pay it back later by issuing more debt.  But I do think, the Democratic rejoinder is problematic on two accounts.

First,  it seems to suggest that the current funding of Social Security is more perilous than it really is.  It would have been more comforting to point out that the system takes in so much money that it could pay out all promised benefits even with the lost revenue.

Second, the Democrats missed an opportunity to raise the public's understanding of the longer-term problems with Social Security.  The years of surplus will come to an end at some point.  Already (and independent of any payroll tax cuts), benefit payments exceed payroll tax revenues so that the surplus is being generated by interest on government debt.  At some point in the next decade, tax revenues plus interest will no longer be enough and the system will have to start redeeming its $2.5 trillion stash of Treasury notes.  At this point, general revenues will indeed start flowing out to Social Security recipients, placing increasing strain on the federal budget that will also be coping with escalating Medicare costs.

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Actually, the Republican claims and Democrat claims are both correct and your claims are incorrect. Let me explain how you are wrong.

Since 1983, Social Security (SS) revenues from the payroll tax have exceeded Social Security payments to beneficiaries. Excess SS revenues were spent by the federal government and in return the Social Security Administration (SSA) would receive a special issue non-marketable treasury note from the Treasury. The SSA then takes the special issue non-marketable treasury notes and put them in a filing cabinet called the “lock box”. In addition to this, the Treasury would also provide additional special issue non-marketable treasury notes on the interest income accrued by the SSA.

In 2010, the SS revenues from the payroll tax fell short of the amount needed to pay the SS beneficiaries by the amount of $49 billion and the SSA trustees estimate a $46 billion deficit in 2011. Now, interest accrued to the SSA exceeded the 2010 $49 billion deficit, but remember, interest income is paid from the Treasury to the SSA by means of special issue non-marketable treasury notes and simply makes the trust fund larger.

So, this is where the rubber meets the road. Payroll tax revenues fell short of the needed expenditures by $49 billion in 2010, so how did the SSA make up the short fall? Did it mail the special issue non-marketable treasury notes that it received in interest from the Treasury, which exceeded its deficit, to recipients to cover the shortfall? No, it took those interest payments and put them in the lock box with all the other special issue non-marketable treasury notes it has accumulated over the years. The SSA met the $49 billion shortfall in revenue by redeeming some of its special issue non-marketable treasury notes to the Treasury. And where does the Treasury come up with revenue to pay-off the treasury notes presented to it by the SSA? Why the Treasury has a bunch of money it pulls in each month in taxes called general revenue. So, the Treasury takes some of the general revenue and gives it to the SSA so the SSA can pay the beneficiaries.

The Republicans are correct because a reduction in payroll tax revenue will mean an even greater amount of IOUs will have to be presented by the SSA to the Treasury to meet the shortfall in revenues. This will deprive the SS system of funds by drawling down the trust fund and at an even greater rate than before.

The Democrats are also correct because the shortfall in payroll tax revenues will be covered by general revenues. But even more general revenues will be used to pay the SSA IOUs than would otherwise be the case if more payroll taxes were collected.

And your claim that general revenues are not being used and will not be used until sometime in the next decade to pay the shortfall in SS income is false. Because of interest income, the SS Trust Fund will continue to grow even while general revenues are used to meet the SS deficits that began in 2010 and will continue in to the future. The reason why the Trust Fund is growing while general revenues are being used to pay the SS deficit is because the interest income is in the form of special issue non-marketable treasury notes that cannot be used to pay recipients directly and can only be redeemed by the Treasury from general revenues.

I was very clear that my claim was that pay roll tax revenues plus interest payments exceed benefit payouts (and I understated my case by not including the taxation of benefits which are also revenues to the SSA). I don't see any argument as to why the interest income of the SSA should be ignored in this debate. In this time of deficits, most interest payments are essentially funded by new debt so I don't see a difference when publicly-held debt is substituted for SSA-held debt.

Your claim that payroll tax revenue plus the interest received from the Treasury is greater than the expenditures paid to beneficiaries is correct. What is incorrect is your claim that general revenues are therefore not needed to pay beneficiaries currently and will not be needed until some point in the next decade. The reason why your claim is incorrect was spelled out above. In short, although the interest income earned by the SSA exceeded the $49 billion deficit in 2010, the interest income paid to the SSA is in the form of IOUs from the Treasury. And just like the other $2.5 billion in IOUs held in the SSA trust fund, interest income represents a claim on general revenues from the Treasury. So, the interest income can be used to pay the shortfall in the payroll tax revenue by only by means of redeeming the IOU with general revenues.

In addition, regarding your other point, the Treasury can raise general revenues by essentially two main ways. One is through the collection of taxes and the second way is through selling Treasury bonds and bills on the open market. Swapping special issue non-marketable treasury notes from the SSA trust fund for marketable Treasury bonds and bills would be no different than if the Treasury itself sold the bill or bond to the public and used the those revenues to redeem SSA IOUs. In both cases you are reducing the amount of general revenues the government has to fund other programs.

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