Political Economy

Getting the Facts Straight: Payroll Tax Edition

Joshua Tucker Dec 22 '11

From Princeton political scientist Nolan McCarty’s blog:

For me at least, one of the frustrations about the debate over extending the cut in the payroll tax is extent to which politicians have tried to exploit the public’s lack of understanding about how the Social Security system works.

The first lie is the Republican claim that extending the payroll tax will somehow deprive the Social Security system of funds and jeopardize the retirement security of seniors.

Democrats have responded not with the truth but with the claim that the revenue losses from the extension will be offset by “general revenue.”

Understanding why both of these claims are untrue requires some background knowledge of how Social Security works.

Social Security is a pay-as-you-go system where current retirees are supported by the payroll tax payments of current workers. When I pay payroll taxes, they do not go into some account with my name on it, they go to my mother-in-law. Every year since 1984, the payroll tax revenues plus interest on the SS Trust Fund’s holding of treasury notes has exceeded the benefits paid out. The Trust Fund then exchanges this surplus for more treasury bills and the federal government spends it.

In 2010, the Trust Fund surplus was $94 billion or about 16% of the benefits paid. That is about the same size as the revenue short fall from the 2 point reduction in the payroll tax rate (the SS Trustees estimate a loss of about $90b for 2011). So even with this loss, payroll taxes and interest will cover the benefits paid. So one of two things will happen. The Treasury will actually give $90b to the Trust Fund. But because it is surplus, the Trust Fund will give it right back to Treasury in exchange for government debt. Or it could be handled the easy way: Treasury would just give the Trust Fund $90 billion in Treasury notes.

The important point is that the effect of the payroll tax cut on the balance sheet of the Social Security Trust Fund is exactly zero. With or without the cut in 2011, the Fund would increase its holding of U.S. government debt by over $90 billion. Even if the government did not give the Trust Fund the $90 billion worth of debt, the effects would not be felt until around 2035 when the Trust Fund is expected to be exhausted.

Thus the Republican claims have no merit.

I’ll admit the Democratic shading of the truth is less egregious. It is easier to say that general revenue will cover lost payroll tax revenue than it is to explain that the government will only promise to pay it back later by issuing more debt. But I do think, the Democratic rejoinder is problematic on two accounts.

First, it seems to suggest that the current funding of Social Security is more perilous than it really is. It would have been more comforting to point out that the system takes in so much money that it could pay out all promised benefits even with the lost revenue.

Second, the Democrats missed an opportunity to raise the public’s understanding of the longer-term problems with Social Security. The years of surplus will come to an end at some point. Already (and independent of any payroll tax cuts), benefit payments exceed payroll tax revenues so that the surplus is being generated by interest on government debt. At some point in the next decade, tax revenues plus interest will no longer be enough and the system will have to start redeeming its $2.5 trillion stash of Treasury notes. At this point, general revenues will indeed start flowing out to Social Security recipients, placing increasing strain on the federal budget that will also be coping with escalating Medicare costs.