12/16/2010 01:32 pm ET | Updated May 25, 2011

Cut the Payroll Tax to Save Social Security

One of the highlights of the president's compromise on the tax bill is a temporary payroll tax "holiday" -- something we have long advocated for along with others such as James K. Galbraith and Warren Mosler. The proposed deal would cut the tax by two percentage points from the current 6.2% applied on employment income up to $106,800. The beauty is that it can take effect immediately, raising weekly take-home pay and totaling about $112 billion in fiscal stimulus annually. Since the vast majority of Americans pay more in payroll taxes than in federal income taxes, it provides broad-based tax relief (unlike the original Bush tax cuts that were skewed to high income earners in part because they pay most of the federal income tax). The payroll tax itself is regressive because high income earners escape FICA taxes on most of their employment income, so reducing the federal government's reliance on it should be celebrated. In other words, this holiday is a progressive's dream come true.

Instead of cheers, however, the liberal left is worried about this plan. For example, Heidi Hartmann argues that it puts Social Security at risk because it will be difficult to end the "holiday" by restoring the two percentage points later. She also offers an alternative that would achieve essentially the same tax relief through tax rebate checks, thereby leaving the payroll tax alone. This is offered as a lower risk alternative because it is easier to stop the rebates than to restore payroll taxes, which will be seen as a tax hike. But her defense of the payroll tax is fundamentally misguided.

Indeed, it seems along the lines of presidential candidate Al Gore's promise in 2000 to "lock up" the budget surplus in something akin to a Social Security Trust Fund safe, to be tapped later when baby boomers retire. In retrospect, Gore's idea of a government lock box storing up savings turned out to be as much of a myth as the idea that a Social Security Trust Fund could provide advance funding for a retiring baby boom bulge. What will matter in the future is our capacity to produce real goods and services. Accumulating paper money or electronic charges on computer tapes does not in any way help to take care of the elderly. And when the time comes, government can always make the monetary payments as they come due.

Let us step back from the fray and try to understand just what Social Security is. In truth, it is an inter-generational assurance plan. Working generations agree to take care of retirees, dependents, survivors, and persons with disabilities. Currently, spouses, children, or parents of eligible workers make up more than a quarter of beneficiaries on the Old-age, Survivors and Disability Insurance program (OASDI). A large proportion will always be people without "normal" work histories who could not have made sufficient contributions to entitle them to a decent pension. Still, as a society we have decided they should receive benefits. (For more, see "Social Security: Truth or Useful Fictions?", "Does Social Security Need Saving?" and "The Neocon Attack on Social Security.")

Most discussions of the program get hung up on the relationship between payroll tax receipts and Social Security benefits because those receipts are said to be necessary to "pay for" the benefits. This then leads to "money's worth" calculations (the "return" an individual "receives" on his payroll tax "investment" in Social Security -- as if the program were like an IRA) as well as the "day of reckoning" when total payroll tax receipts will fall short of Social Security spending. Inter-generational warriors love to calculate that Social Security is a bad deal for most of today's workers, who would be much better off if they took their taxes and invested them in Wall Street (whoops, maybe not such a great idea right now). And they read each annual report of Social Security's Trustees to find the precise year for Armageddon: when payroll tax revenues are expected to fall short of Social Security benefit payments. Even without the crisis and recession, that would have happened later this decade. Defenders of the program then trot out their own numbers, proclaiming that Social Security is indeed a great deal for a worker who loses a leg in an industrial accident, rendering her unable to ever work again -- a not entirely successful counterclaim for the average worker who prefers not to think about such a scenario.

Defenders also point to the supposed cushion offered by the Trust Fund, which has trillions of safe Treasury bond assets to keep the program solvent. While it is widely claimed that interest receipts and then Trust Fund bond sales will maintain the program for a couple more decades, Social Security's enemies argue that the program faces calamity much sooner because its Trust Funds are a fiction. As we've long argued, the Trust Funds cannot provide external financing for one of the government's own programs, because this is a case of the government "owing itself", an internal accounting procedure.

To understand the current set-up of Social Security, we need to go back to the Greenspan Commission, which tried to change Social Security from "paygo" (tax revenues equal benefits) to "advance funding" (taxes exceed spending) in 1983. Before the crisis, the payroll tax was set about two percentage points higher than necessary for total revenues to equal benefits paid. So the proposed payroll tax holiday essentially returns the program to "paygo". But in truth, tax revenues never "pay for" benefit payments -- either on an individual level or at the level of the program as a whole. This was well understood at the time the program was originated. However, President Roosevelt feared that Social Security would be seen as welfare or, worse, as socialism. So a fiction was maintained: that there would be both an individual link between taxes paid in and retirement benefits paid out (albeit, a loose one), and that at the aggregate level the payroll tax "pays for" benefits. Later, Greenspan's Trust Fund would provide a buffer stock of "money in the bank" for the inevitable date on which a shortfall would occur. These twin beliefs are what James K. Galbraith would call a "convenient fiction" and over time they became a not so innocent "innocent fraud".

Liberals have come to see that payroll tax fiction, as well as Greenspan's Trust Fund fiction, as necessary to maintaining support for Social Security. Perhaps there was a time when this was true. But the fictions have become an albatross around Social Security's neck. They are forcing left-leaning liberals to oppose tax relief for workers, arguing for a tax rate that is set well above what is required to generate revenues equal to benefits in a growing economy (and thus acting as a fiscal drag on an already suffering economy). Worse, they fuel the fire of Social Security's enemies, encouraging calculations of money's worth and Armageddon day. Inter-generational warriors are able to estimate with some precision the program's budgetary shortfall at something like $10 trillion. Since payroll taxes are already so high as to burden most Americans more than the income tax, virtually no one advocates tax increases to close the shortfall. Hence the debate centers on when, and by how much, benefits must be cut. President Obama has been sucked into this debate, adopting the neocon view that the program is unsustainable because there is a coming shortfall.

Liberals are left proclaiming they will never give up the payroll tax because that would be the first step on the road to dismantling the program. What if there were no payroll tax? What if Social Security were just another program, like defense or corporate welfare or farm subsidies? With no dedicated source of tax revenues, there would be no way to calculate "money's worth" (infinite, just like corporate welfare!) or "unfunded entitlements" (zero, just like farm subsidies!). Government would continue to pay benefits in the same way it pays benefits today: by crediting bank accounts. Indeed, it is the only way a sovereign government ever makes payments. And it taxes by debiting bank accounts. Tax revenues do not go anywhere; they cannot be locked up in boxes and they do not fund spending. They are simply a "negative credit" -- a deduction. If total payments exceed total taxes, the government books a deficit that is equal to the net credits to bank accounts. Proclamations by liberals that they will give up the payroll tax only when their dead fingers are pried from it does nothing to help government's finances. Hartmann says that most Americans report that they do not mind the current payroll tax rate. Ask them if they'd like to see it fall to zero, and ask firms if they'd like to see the cost of hiring workers fall by eliminating it.

In reality, the best way to "save" Social Security would be to adopt policy prescriptions that would make sense even if our society were not aging. That is, adopt those policies that would increase our capacity to produce in the future: 1) more human capital: more years of schooling, fewer dropouts, higher quality schooling, and enhanced apprenticeship and training programs; 2) more public investment: new and improved public infrastructure, better maintenance of existing infrastructure, and reduction of adverse environmental impacts; and 3) more private investment: new and improved private production facilities to enhance growth. The last item will almost certainly require maintenance of high aggregate demand today and over the near future.

Hence, true reform must be geared toward higher employment or increased productivity, which comes down to encouraging more capital formation. Further, the types of investments that can be made today to reduce burdens in the distant future are in human capital and public infrastructure. That is to say, the investments must be undertaken primarily by the government. Yet most self-styled reformers seek to reduce the role of government and increase reliance on the market, which by its very nature is focused on the here and now, not on infinite horizons.

Let us also be clear: the Social Security retirement benefit is not welfare. Retirees have earned their benefits. Not by paying taxes, but rather by working and contributing to the production of the goods and services needed by past and present generations of retirees. Those retiring today and tomorrow should be proud of the contributions they made. And those contributions take the form of the American workers' accumulated annual produce. Many of their contributions are still in evidence and are still being enjoyed: our housing, our schools, our bridges, our educated population, our arts and literature, and our justice system.

The fact that retirees paid payroll taxes is the least of their contribution. Note that we do agree that taxes are one of the two unpleasant inevitabilities (death, unfortunately, is the other). But their purpose is not to raise revenue to fund a government program. From inception, taxes create a demand for our sovereign currency. Working hard for money gives money its value; retirees have worked hard over their careers, giving value to the money that we award them in their retirement. They pass the burden of work on to the next generation of workers, who keep money strong and provide the goods and services the retired generation needs. Social Security is really a social compact among generations. This is something the inter-generational warriors wish to deny. The prudent course of action is to leave Social Security alone until changes have to be made. If it turns out that more of society's output has to be shifted to retirees in 2035, then the most effective and most direct method of achieving that shift of distribution will be to use the tax system in the year 2035 to do so. Cutting benefits over the next few years simply lowers living standards prematurely without in any way reducing burdens on future workers.

So let us have a permanent payroll tax holiday. But meanwhile we need to strengthen our social compact, not by legislating future benefit cuts (which reduce the willingness of today's workers to join the compact), but rather by legislating more generous retirements.

Cross-posted from New Deal 2.0.