Social Security and Medicare Are Funded by Payroll Taxes, Paid Equally by Employees and Employers; There is a $2.5 Trillion Surplus But That Money Was Spent a Long Time Ago to Fund Government Operations

Social Security 'Reforms' Are Never Far Away

March 19, 2013

U.S.News & World Report - Social Security is never far from the Congressional budget ax. Although it's been spared actual cuts to date, program defenders have already lost their battle to keep it from being considered for cuts. The battleground thus will be moving to specific reform proposals.

Depending on who's talking, Social Security is either a runaway fiscal disaster that needs to be overhauled or a healthy program that has done its job and needs only a tweak or two.

With the spin doctors in high gear, here are factual answers to key statements about the program.

First, a little background. Social Security is funded by payroll taxes, paid equally by employees and employers. Since 1990, each has paid 6.2 percent of covered wages up to a ceiling, which is currently the first $113,700 in annual earnings. This tax supports the Old-Age, Survivors, and Disability Insurance (OASDI) program, which has two parts--Old-Age and Survivors Insurance (OASI) and Disability Insurance (DI)--paying monthly benefits to retirees and their families and to disabled workers and their families.

There is also a payroll tax for Medicare that is 1.45 percent each for employees and employers; there is no earnings ceiling for Medicare taxes.

The total tax for both programs for most taxpayers is thus 15.3 percent. Self-employed wage earners must pay this entire amount.

The health reform law has tacked on higher Medicare taxes for wealthier taxpayers. They will rise another 0.9 percent on wage incomes above $200,000 in 2013 ($250,000 for couples). These same income limits are also being used to trigger a 3.8 percent annual tax on net investment income. 

Here's the history of Social Security taxes.

The last time Social Security was "reformed," in the early 1980s, payroll taxes were raised to make the program self-supporting, and big surpluses began to accrue. By law, Social Security must place its surpluses in a special issue of U.S. Treasury securities, and the interest on these securities is added to Social Security revenues. The program is also credited with some of the tax revenues that the IRS receives from income taxes on Social Security benefit payments.

Every year, the trustees of the Social Security program issue a detailed annual report on the program's financial outlook. According to the 2012 report, Social Security will be able to pay all obligations in full until the year 2033--50 years after the last round of reforms was enacted. After that, it would be able to continue paying about 75 percent of its obligations for retirement and disability benefits. However, the DI component of the program will totally exhaust its funds by 2016, so something needs to be done soon.

The trustees' report contains lots of variables that administrators admit are uncertain: multiple employment, inflation, economic growth, population, and health and longevity projections, just to name some big categories.  

Social Security is spending more money in benefits than it's taking in. It's broke.  

Social Security is not broke, regardless of how you define the term. Program expenses do exceed the amount of payroll taxes taken in by the program. However, the program is still in the black if you include its interest and other income.

We can't afford Social Security.  

Affordability ultimately comes down to whether you think current payroll tax rates are too steep, benefits are too big, or some combination of the two. There has been nearly no discussion that payroll tax rates should come down, so the affordability question hinges on benefits. There has been some talk of trimming future benefits for higher-income wage earners and perhaps trimming the annual cost of living adjustment (COLA). Studies show that lower-income workers wind up receiving more from Social Security than they paid in taxes, while the opposite is true for higher-income wage earners.

Social Security is adding to the deficit. 

The deficit was a contentious Social Security topic even before Al Gore's infamous "lock box" statements during the 2000 presidential race. Narrowly speaking, Social Security is distinct from the rest of the federal budget and its defenders say it can neither add to nor reduce the federal deficit. It has its own dedicated tax and relies solely on that tax and the income it earns from investing surplus tax collections.

During 2011 and 2012, the employee payroll tax was reduced from 6.2 to 4.2 percent. But this economic stimulus was intended to put more money in consumers' hands. The Social Security program happened to be an effective way to accomplish this goal. Social Security was made whole for the cuts and its overall financial position was not affected. Did this stimulus add to the deficit? Yes, but that's not the same thing as saying Social Security did so.

This issue becomes murkier, however, because of the legal requirement that Social Security place its excess money into U.S. Treasury securities. It's not as if the feds are holding the program's $2.5 trillion surplus in, well, a lock box. They spent that money a long time ago to fund government operations and gave Social Security an I.O.U., just as they do to everyone else who owns U.S. Treasury debt.

Under this view, when Social Security must begin cashing in its U.S. Securities to fund its operating deficits, Uncle Sam will have to go out and find the real dollars to repay Social Security. How will it find those dollars? Of course, it will need to sell more U.S. Treasury securities, adding to the national debt and to the deficit. In this indirect way, at least, Social Security's looming shortfalls would add to the deficit. The villain in this story, if there is one, would seem not to be the Social Security program itself but overall government fiscal policy.

Proposed changes to Social Security will hurt current retirees.  

Generally, major reform proposals issued so far would have little effect on people 55 and older, and would not change benefits for retirees for upwards of 20 years. This primarily involves raising the retirement age and any specific proposals that would affect benefits. An exception could be if the annual cost of living adjustment (COLA) were made less attractive. That might take effect sooner, although opening up the COLA for discussion will also bring out lots of proposals to increase it, particularly to reflect sustained inflation in healthcare costs.  

Another likely reform measure would raise the annual ceiling on taxable earnings, but this would affect workers, not retirees. There will also be proposals to means-test Social Security benefits, which could affect payments to more affluent retirees. The key there will be the effective date of any changes.

We're all living longer, so raising the retirement age is a logical and easy fix. 

Yes, and no. Wealthier people are certainly living longer. People in white-collar jobs may be living longer. Poorer people are not living longer. The longevity revolution has not worked its magic on them. Many lower-income Americans take early retirement, at 62, because they are worn out by physically demanding jobs. Suggesting these people work until they're 70 is not realistic. Extending the full retirement age (now at 66 and headed to 67 for people born after 1959) thus may have its greatest impact on these early retirees.

Most proposals that raise the retirement age can only pay for themselves by reducing the relative level of benefits for early retirees. Social Security has analyzed the major reform proposals and assessed their impact on the program's long-term sustainability.

Twitter: @PhilMoeller