“Not only it’s not right, it’s not even wrong.” Wolfgang Ernst Pauli
Maybe Wolfgang Paul was being prescient in commenting on the moves by Congress to use the Social Security payroll tax cut to stimulate the economy for a second year running. A more easily recognizable analogy would be “stealing from Peter to pay Paul.” As much as I enjoy my taxes being cut, one has to look at the consequences of these decisions and sadly I have to be a really negligent father to be excited by these cuts.
Social Security is a mandatory (with some exceptions) defined benefit pension plan and pays citizens who participate for a minimum number of years a pension, through death with some survivor benefits, based on average lifetime income. It is one part pension system and one part wealth redistribution as low-income earners get a slightly higher pension replacement rate than higher earners. Because the first generation of retirees were paid a pension without ever having contributed (lending some credence to Rick Perry’s Ponzi scheme quote), the funding principle underlying Social Security is termed “Pay-As-You-Go” or PAYGO. For such a system to work efficiently, the commitment every future generation is making to the previous generation is to produce more children (so that more folks are taxed) and/or grow the economy, especially as life expectancy increases. Social Security is not a pure PAYO because in the 1980s, Alan Greenspan headed a commission that recognized that this social contract was being violated, raised the payroll tax to the current rate of 12.4% and all excess contributions over pensions were placed in a “Trust Fund” that would earn an artificial rate of interest. Unlike a typical corporate or public pension plan, this Trust Fund was not segregated from the US Government’s other revenues and were plundered to finance budget deficits under the Reagan Administration (leading George W Bush to make the accusation that Social Security did not have assets but just some IOUs).
In 1997, the Late Prof. Franco Modigliani and I started to evaluate Social Security, and we projected that Social Security was headed for a crisis because PAYGO was not a sustainable funding approach given the future demographic imbalance and low projections for economic growth. We tried to argue with President Clinton’s Administration (some of whom are now with President Obama) that the budget surpluses needed to be diverted to the Social Security Trust Fund to convert Social Security into a partially funded pension system—much like traditional pension funds—and have assets invested under the oversight of a Blue Ribbon Board—much like the Canadian Pension Plan—and with a clear target return. Inaction by President Clinton on Social Security and President Bush taking care of the surpluses with two wars ensured that real Social Security reform was endangered. Moreover, President Bush was totally focused on privatization, which only privatizes risk as opposed to saving Social Security and, by the time we wrote a book in 2004, the key projections, assuming no reform, were as follows: (a) by about 2014 pensions would exceed contributions and gradually deplete the Trust Fund; (b) by about 2042 the Trust Fund would be exhausted; and (c) when that happened, contributions (essentially that our children would be paying) would have to rise from 12.4% to 17.8% and on to 19% or benefits would need to be cut by about a third. We argued instead that increasing contributions by approximately 1.1% and investing the Trust Fund responsibly could preserve contributions at 13.5% permanently. This 1.1% increase was already higher than our estimate had the Clinton Administration undertaken it (approximately 0.7%) as delaying reform only increases the cost.
Enter President Obama and a collapsing economy. An easy source of bipartisan support to stimulate the economy was to waive 2% of the total 12.4% contribution to Social Security to “give citizens more spending money” so as to stimulate the economy. But what did these moves do to Social Security finances? In short, the payroll tax cuts in 2010 deprived Social Security of about $120 billion in contributions. These moves happened to coincide with the first of the Baby Boomer generation starting to receive pensions and the simple finances of Social Security now have the following profile: (a) in 2010, pensions already exceeded contributions and while they are estimated to be marginally positive from 2012-2014, they are firmly negative thereafter; (b) more telling, the Trust Fund is now depleted 6 years earlier in 2036; and (c) contributions in 2036 will have to jump to 17% from the 12.4%. Thus, any additional moves by Congress to extend the payroll tax cut is only going to worsen this profile and deplete the Social Security Trust Fund earlier, raise the taxes on our children earlier, and basically sacrifice our children’s welfare and economic growth for the present.
Imagine if you were the chief investment officer of a pension fund that is poorly funded and likely to be depleted and the decision of the sponsor is to reduce future contributions. Beyond the initial unhappiness of such a decision, one can rationalize this by the assumption that at some point the sponsor will have to pay a higher tab and this mitigates one’s frustration. However, with Social Security, the government’s only source of revenue is future taxes, and these taxes are levied on our children.
In “Honey I Shrunk the Kids” the struggling inventor shrinks his and his neighbor’s kids through a machine malfunction and then accidentally sweeps them up and dumps them in the trash. No such accidental motive can be attributed to what we are doing to our children’s wellbeing and wealth with payroll tax cuts and inaction on Social Security reform, and we are unceremoniously dumping them in the trash.
Maybe these latest moves by Congress validate the poor opinion that Americans have of their representatives in Washington DC.
Dr. Arun Muralidhar is Chairman of Mcube Investment Technologies LLC (www.mcubeit.com), and CIO of AlphaEngine Global Investment Solutions (AEGIS). Arun is the author of A SMART Approach to Portfolio Management: An Innovative Paradigm for Managing Risk (Royal Fern Publishing LLC, 2011) and three other books. He has worked as a plan sponsor, asset manager, and supplier of investment and risk management technologies. He holds a Ph.D. in Managerial Economics from MIT.