The Coming Financial Collapse of Social Security; P. Ferrara

Consequently, by the end of the year, Congress and President Carter dramatically increased Social Security taxes and trimmed benefits. Payroll tax rates increased repeat edly through 1990,for a total increase of 30 percent. Moreover, the maximum income to which this tax rate applied was increased sharply from $16,500 at the time, and in dexed to increase every year thereafter. Today this maximum taxable income is $57,600. The American people were assured over and over by President Carter, the Social Security Administration, and the rest of the Washington political establishment that these changes guaranteed the financial soundness of Social Security' 'for the rest of this century and well into the next one." 1 But by 1980 Social Security was already in deep financial trouble again. The governMr. Ferrara is afel/ow at the Heritage Founda tion. He is the author of Social Security: Pros pects for Real Reform (Cato, 1985).

ment's annual financial report for the pro gram showed that without a change in the law, the program might not be able to pay its promised benefits as early as 1981.2 To address this second financial crisis, a bipartisan commission headed by Alan Greenspan developed a package of tax in creases and benefit cuts enacted early in 1983. The truth is that if the economy had continued to perform as it had in the 1970s, with high inflation and periodic sharp reces sions, the system would have collapsed again within four years. But price inflation was sharply reduced in the 1980s, and the economy continued to grow for about eight years after 1982 without a recession, and then slid into a relatively shallow slump. Consequently, another quick collapse was avoided. But Social Security's long-term financial problems are another question. A key strat egy of the Greenspan Commission was to develop a large surplus in the Social Secu rity trust funds from 1990 to about 2010, to be used to help finance the retirement of the huge baby boom generation starting after 2010. However, the latest government pro jections show the expected surplus shrink ing into relative insignificance. Moreover, the so-called Social Security trust funds in any event are not a store of financial re438 serves that can assure the future ability of the program to pay its promised benefits.

Repeated financial crises are an inherent feature of the Social Security system. The Social Security trust funds are essentially a sham that cannot assure future financial security. Today's young workers will never receive the benefits currently promised to them by the program. An Inherent Problem Most people seem to imagine that Social Security operates like a traditional fully funded retirement program. In such a sys tem, the tax payments of current workers are saved and invested to finance their own future benefits. As a result, a huge financial reserve is built up sufficient to finance ac crued benefits at any point in time. This reserve is used to finance benefits during retirement years, while current workers at that time will be building up their own re serves to finance their own future retirement. Social Security, by contrast, fundamen tally operates on a pay-as-you-go basis. The tax payments of current taxpayers are not saved and invested to finance their own future benefits. Rather, most current tax payments are immediately paid out to fi nance the benefits for current retirees. Fu ture benefits for present taxpayers are to be paid out of the future tax payments of future workers when today's taxpayers are in re tirement. Consequently, large cash reserves to finance benefits are never developed in such a system.

Such a pay-as-you-go system is quite vulnerable to any adverse development that may upset the delicate balance between expected future taxes and expected bene fits. If unemployment rises, revenues from the payroll tax willfall from expected levels. Ifprice inflation accelerates, indexed benefit payments willincrease faster than expected. If retirees live longer than expected, benefit expenditures will again grow faster than projected. If the birth rate drops, fewer workers will be available to pay promised benefits in the future that are already paid for and relied on by current workers. These 439 and many other possible developments can quickly tip a pay-as-you-go system into financial crisis, leaving it without sufficient funds to pay promised benefits. None of this is a concern in the first generation under a pay-as-you-go system. When such a system is begun, a full gener ation of taxpayers begins to pay taxes, but there are no beneficiaries entitled to benefits based on past tax payments. In a fully funded system, these initial tax payments would have to be saved and invested to finance the future benefits of current work ers. But, of course, these initial tax pay ments are not saved and invested under a pay-as-you-go system. Consequently, in the start-up phase of such a system, there is no concern over bankruptcy, or the inability of the program to pay promised benefits. To the contrary, the system is awash in un claimed funds, and the only issue is how much to payout in virtually free windfall benefits to early retirees. Since the first retirees pay little or nothing for their bene fits, it is easy to pay them only what can be comfortably paid out of the initial incoming revenues. The beneficiaries will be grateful for the windfall benefits they receive.

After the first generation under such a system, however, this situation completely reverses. The retiring generation will then have paid taxes for an entire lifetime and will have built up enormous benefit claims. At this point, there are no more unclaimed surpluses and no more free benefits to pass out. The issue instead becomes whether taxes from current workers will be sufficient to finance promised benefits. If not, then Congress must raise taxes or cut benefits, in stark contrast to the vote-buying spending sprees of the first generation. During its first 40 years, Social Security was in its start-up phase, and short-term financial solvency was not an issue. Instead, free windfall benefits were paid out to retirees. But by the mid-1970s, sufficient benefit obligations had accrued to make financing a problem. Adverse economic developments soon developed to tip the system into finan cial failure. Inflation soared in the 1970s, 440 THE FREEMAN • NOVEMBER 1993 sharply increasing benefit payments in dexed to inflation. At the same time, peri odic sharp recessions caused unemploy ment to rise and wage growth to fall, sharply reducing expected revenues. The combina tion of these economic difficulties caused the first two financial crises of the system described above. The primary cause of the third wave of financial collapse of Social Security, however, will be demographic, as discussed further below.

The Trust Fund Fraud Even if Social Security attempted to de part from the principle of pure pay-as you-go financing and developed a substan tial trust fund reserve, future benefits would not be any more assured because of the essentially fraudulent nature of the Social Security trust fund system. Any remaining Social Security revenues after benefits are paid are lent to the federal government in return for new, specially issued government bonds which are held by the Social Security trust funds. The federal government then spends the borrowed Social Security reve nues on other programs. The Social Security trust funds hold no assets other than these government bonds. When Social Security revenues are insuf ficient to finance current benefits, the gov ernment bonds held by the trust funds are to be turned into the federal government for the cash needed to finance the benefits. But the government holds no cash or other assets to back up the Social Security bonds.

The trust fund assets are claims against the federal government, government IODs which will have to be financed out of in creased federal taxes or increased federal borrowing. In other words, the trust funds are part of the national debt which must be paid when Social Security needs the money. As a practical matter, these Social Secu rity trust funds are nothing more than a statement of the amount that Social Security is legally authorized to draw from general federal revenues in the future, in addition to payroll tax revenues. Therefore, if the So cial Security trust funds hold $1 trillion at some point, that statement even if true, would not mean that the Social Security system is financially sound. Quite to the contrary, it would mean that Social Security .would have an additional $1 trillion claim against the taxpayers, in addition to the claim against them for payroll taxes. Because the Social Security trust funds do not hold any real assets, just a claim against future tax revenues, a growing trust fund by itself does not mean that paying for the retirement of future generations will be any easier economically. It just means that more of this burden will be met out of income taxes and federal borrowing rather than payroll taxes.

The inherent financial problems of Social Security could be successfully addressed if the system were changed so that it accumu lates reserves in a fully funded system and those reserves are invested in productive assets in the private sector. But that would require the government to own so much of the private sector through the Social Secu rity trust funds that it would fundamentally change our entire economic system in an unacceptable way. Consequently, financial problems of Social Security can be solved only by shiftirig to a private system of decentralized investment accounts con trolled by workers individually or through voluntarily organized groups. The Looming Retirement of the Baby Boom Generation As indicated above, the primary cause of the next foreseeable financial crash of Social Security is a destabilizing demographic problem. The huge baby boom generation is now entering middle age. Around 2010, this huge generation will start to retire, causing Social Security benefit expenditures to rise.

This generation will continue to have a major effect on Social Security spending for the following 40 years. But something has happened to make matters worse. Starting in the early 1960s, after the development of the birth control pill, birth rates in the United States declined precipitously. With the legalization of aborTHE COMING FINANCIAL COLLAPSE OF SOCIAL SECURITY 441 tion in the 1970s,the fertility rate, or lifetime births per woman, fell below 2.0 in the early 1970s. It continued to decline to a low of about 1.7 per woman, eventually stabilizing at these low levels until the end of the 1980s. As a result, the baby boom was followed by a baby bust. This means that at the same time the huge baby boom generation will be retiring, causing benefit expenditures to soar, the generation of workers that is sup posed to finance their retirement payments out of current taxes will be relatively small.

The devastating impact of this demo graphic double whammy on Social Security is shown by the Social Security Adminis tration's own long-range financial projec tions. We can examine these projections under the most widely cited intermediate set of assumptions. Table 1(on the following page) shows the results under these projec tions if we combine all three trust funds financed by the payroll tax-the Old-Age and Survivors Insurance trust fund (OASI), the Disability Insurance trust fund (DI), and the Hospital Insurance trust fund (HI). These three trust funds together are referred to as the OASDHI trust funds. With the huge baby boom generation entering its peak-earning middle-age years, and paying Social Security taxes on its earnings, the program should be doing quite well financially right now. Indeed, as indi cated previously, the government's plan is for Social Security to depart somewhat from its usual pay-as-you-go policy during this period and accumulate some substantial trust fund "reserves" to help finance the retirement of the boomer generation.

But Table 1 shows that under the' 'inter mediate" assumptions, tax revenues for all three trust funds combi~ed start to fall short of benefit promises in 2005, only twelve years from now. The federal government must cover these deficits by raising taxes, cutting other spending, or increasing the total federal deficit and federal borrowing. Besides tax revenues, the Social Security trust funds receive imputed interest income on their trust fund bonds. But since the federal government must pay the interest on the bonds, which it does by issuing addi tional bonds to Social Security in the amount of such interest, that interest does not help the government pay its promised Social Security benefits. To finance these benefits, the federal government must come up with the full amount of cash needed to close the deficit between Social Security taxes and Social Security expenditures. Ef fectively, the Social Security trust funds must begin redeeming some of their bonds for cash to cover these deficits, though counting the additional bonds received for interest each year the total trust fund assets may continue growing for a few more years.

As shown in Table 1, this annual Social Security deficit grows to almost $40 billion per year in constant 1993dollars by 2010. By 2015,this annual deficitgrows to $120billion in 1993dollars. By 2020,the annual deficit is an incredible $226.5 billion in 1993 dollars. The federal government again must either raise taxes, cut other spending, or increase the total federal deficit and federal borrow ing by these amounts in order to pay all promised Social Security benefits, even be fore the Social Security trust funds are exhausted. The financial impact of the long term Social Security financing crisis will start to hit less than a dozen years from now. But that is not all. The federal government finances about 75 percent of Medicare Part B, also called Supplementary Medical In surance (SMI), out of general revenues rather than payroll taxes. SMI pays doctors' bills and other health expenses, while Medi care Part A, or Hospital Insurance (HI), which is financed entirely by payroll taxes, provides coverage for hospitalization.