Chapter Seven
Social Security (and Medicare)
Social Security is the largest government expenditure program in the world, with expenditures of $523 billion in 2005. That figure includes only the cash retirement benefits paid. Social Security’s companion policy that covers medical expenses of the elderly, Medicare, had expenditures of another $299 billion. Taken together, the federally financed retirement benefits amounted to $822 billion.
Despite its vast size, and the fact that it affects almost everyone each year of their lives, the Social Security system is probably the most poorly understood government policy of all. The jargon alone is incomprehensible; we hear of unfunded liabilities, infinite and 75 year time horizons, AIME and PIA, trust funds and lockboxes, wage-indexing versus price-indexing of benefits, bend points in the benefit formula, carve-outs and add-ons, replacement rates, covered and uncovered earnings, and on and on. There is, however, probably no policy more important to understand because the consequences for the way we live, and how well we live, are monumental.
This chapter will focus on what I believe to be the fundamental issues surrounding the design of a system to provide retirement benefits to the elderly. We will begin by explaining how Social Security works.
Social Security Basics
The retirement benefits provided to the elderly by Social Security (and Medicare) each year are financed by taxes on the earnings of workers. The benefits received by those now retired do not come from a fund they accumulated by paying taxes during their working years. The taxes they paid in earlier years were all spent on providing benefits to those then retired. Similarly, the taxes paid by workers today do not go into a fund to finance their own retirement; they are spent providing retirement benefits to those retired now. Social Security is thus an income transfer program, with income transferred each year from workers to retirees.
But, you will say, what about the trust funds we hear about all the time; doesn’t the money go into the trust funds? It is true that there are trust funds, but they play a minor, even negligible, role in the operation of Social Security. They are temporarily playing a somewhat larger role right now than they did in the past or will in the future, but it is a minor factor even today. (In 2005, 84 cents of each dollar in workers’ taxes were immediately paid out as retirement benefits; only 16 cents went into the trust funds.) We will discuss the trust funds later, but we can get a clearer understanding of how Social Security operates by first ignoring them.
A retirement system that finances retirees’ benefits by taxing younger workers’ earnings (as Social Security does) is said to be run on a pay-as-you-go basis. There is no fund being accumulated on behalf of the taxpayers, so this arrangement is also sometimes called an unfunded system. I will use the pay-as-you-go terminology or PAYGO for short.
A PAYGO system bears an eerie resemblance to a Ponzi scheme (also known as a pyramid scheme), named after Charles Ponzi who apparently first utilized the device to swindle investors. In 1920, Ponzi began borrowing money from investors, promising them a return of 50 percent after only 45 days. (On an annual compound basis, this is comparable to a return of 2500 percent!) He paid off the early investors by using the funds provided by later investors (as Social Security paid off early retirees by taxing later retirees, i.e., young workers); he did nothing with the funds to actually generate such fantastic returns (as Social Security does not invest the taxes paid by workers). Like most pyramid schemes, it collapsed leaving the later investors with nothing since their funds had been used to pay off the early investors. The entire swindle lasted less than a year, with Ponzi pleading guilty to mail fraud and spending four years in jail. Since that time, pyramid schemes have been illegal.
Unless they are run by the federal government, as with Social Security. But there are differences between privately operated Ponzi schemes and publicly operated PAYGO retirement programs which enable Social Security to be a viable system for providing retirement benefits. Notably, the government can force current and future workers to “invest” (by collecting taxes from them), so that retirees can always be assured of incoming funds supplied by younger workers.
By the year 2000, Edwardson finds that the adjusted rate of return to Social Security is negative, implying that retirees at that time got back less in Social Security benefits than the costs they bore as workers (taxes and lost earnings). All later generations are estimated to receive negative returns as well. Since Edwardson’s study does not include Medicare, and is based on an ultimate reduction in GDP of only 8 percent, actual outcomes from the system are likely even worse than he estimated.
Is Social Security a good deal? Our analysis suggests that the answer to this fundamental question is: it was a good deal for early retirees, but for present and future retirees it represents a very bad deal. Put differently, with PAYGO Social Security, early retirees gained at the expense of all later generations. This result, it should be emphasized, is the consequence of the PAYGO nature of the Social Security system. With a funded system of providing retirement benefits, as with private saving supporting retirees, future generations do not lose out.