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Backgrounder #1467 on Social Security

August 23, 2001

Ten Deceptive Myths About Social Security, the Budget and theEconomy

By

Rather than debating forthrightly about how fiscal policy can get the economy moving, politicians from both parties are squabbling about which side's fiscal agenda will "raid" the Social Security surplus. This focus is misguided.

It is true that the Social Security program has very serious long-run problems, but these problems will be solved--or not solved--depending on the structural changes that are made in the program. The disposition of the current Social Security surplus has no direct impact on either Social Security's long-term fiscal health or on its ability, or inability, to pay promised benefits. Any surplus in the program after benefits are paid is turned over to the U.S. Treasury, and the way the Treasury uses those funds has no direct impact on the Social Security system.

Some argue that the misleading nature of the current debate is acceptable because "saving the Social Security surplus" and "preserving the Social Security trust fund" are useful tactics to achieve the largest possible budget surplus and the fastest decline in the publicly held debt. And since these people believe that big budget surpluses and debt reduction are the keys to economic growth, this rationale supposedly justifies taking liberties with the truth.

Yet this ends-justifies-the-means approach is a marriage of deceptive tactics and bad economics. There is no evidence that budget surpluses and debt reduction are economic elixirs. Indeed, proponents of this view are confusing cause and effect. Specifically:

  • Budget surpluses tend to be the consequence of good policy, not the cause. When the economy is growing, people have jobs, incomes climb, businesses earn more profits, and there is less pressure to utilize federal government income redistribution programs. This relationship explains why periods of prosperity are associated with lower deficits or larger surpluses.

  • Changes in fiscal balance have almost no impact on interest rates. Some argue that big surpluses will help the economy by leading to lower interest rates, but even big changes in the federal government's fiscal balance are insignificant in a world capital market where trillions of dollars change hands every day.

  • Even if bigger surpluses did lead to lower interest rates, there is scant evidence that this result would trigger growth. Some believe that lower interest rates will stimulate the economy by encouraging more borrowing, but interest rates are just one factor in the demand for credit. Individuals and businesses will not borrow if they do not believe an investment will be profitable, regardless of how low interest rates fall. Moreover, although borrowers may benefit from lower interest rates, this effect will be offset by the fact that the lenders will be earning less interest. In fact, periods of extraordinarily low interest rates--such as in America in the 1930s and Japan in the 1990s--frequently are associated with economic weakness.

  • Fiscal policy can affect the economy. Lower tax rates, especially reductions in individual income tax rates and policies to reduce the tax code's bias against saving and investment, will increase growth rates by improving incentives to engage in productive behavior. Supply-side economic policies, with their emphasis on lowering penalties on working, saving, and investing, successfully accomplish these goals. Higher levels of government spending, by contrast, are likely to reduce economic output since markets allocate resources more efficiently than do politicians and bureaucrats.

Policymakers should focus on proposals that improve the economy's productive capacity and not be sidetracked by misconceptions about the Social Security surplus. This is the reason the current debate is counterproductive. Fixating on Social Security's short-term fiscal status will not help Social Security and will not promote good fiscal policy.

If Members of Congress and the Administration learn to recognize the following common myths promulgated by opponents of both Social Security reform and pro-growth fiscal policy, they will be better prepared to pursue policies that will help boost economic performance, thereby increasing the prosperity and wealth of Americans.

MYTHS ABOUT SOCIAL SECURITY, THE BUDGET, AND THE ECONOMY

Myth #1: Social Security surpluses are being used to hide the government's real fiscal balance.

Fact: Properly calculating deficits or surpluses requires that all spending and all taxes be measured--including Social Security revenues and outlays.

A budget surplus or deficit is supposed to capture the aggregate impact of government on credit markets. A deficit, for instance, should measure how much money government will borrow in a given time period. A surplus is just the opposite. It measures when government collects more than it spends and presumably shows how much debt will be reduced. Arbitrarily removing parts of government from the budget distorts this measurement.

Myth #2: The Social Security trust fund is a source of savings that can be used to pay future benefits.

Fact: The trust fund contains nothing but IOUs--government bonds that represent nothing more than a claim on future generations.

These IOUs have value, but only in the sense that future politicians can "redeem" the bonds by collecting more tax revenue, reducing spending, and/or issuing new debt to the public. These bonds do not reflect real savings. Unlike private-sector pension plans, the IOUs in the trust fund are not assets. Indeed, the Clinton Administration's Office of Management and Budget explained this point very well, writing that

These balances are available to finance future benefit payments and other trust fund expenditures--but only in a bookkeeping sense.... They do not consist of real economic assets that can be drawn down in the future to fund benefits. Instead, they are claims on the Treasury, that, when redeemed, will have to be financed by raising taxes, borrowing from the public, or reducing benefits or other expenditures.1

Myth #3: Social Security has an annual surplus of nearly $139 billion.

Fact: Social Security's annual cash surplus--the difference between the taxes collected and benefits paid--will be about $77 billion this year.

Social Security taxes in 2001 are expected to total $451 billion and Social Security spending is projected to reach $374 billion.2 The difference between these two figures, $77 billion according to the most recent estimate by the Social Security trustees, is the program's real surplus. Some claim, however, that the Social Security surplus is actually almost $140 billion. This assertion assumes that the interest payments credited to the IOUs in the trust fund--more than $60 billion this year--represent real money. Yet these interest payments are nothing more than bookkeeping entries, and, therefore, represent higher taxes, lower benefits, and/or higher debt levels for future generations.

Myth #4: Using Social Security surpluses for tax cuts or new spending will drain the trust fund.

Fact: All Social Security surpluses are given to the Treasury in exchange for IOUs, regardless of how they will be used.

If Social Security surpluses are spent on other government programs, the trust fund gets government bonds. If the surpluses are used for tax relief, the trust fund collects the same IOUs. If the surplus is used to reduce the national debt, the same thing happens. In other words, the trust fund does not change in size, no matter how the surpluses are used. The Treasury Department could put the surpluses in a big pile and burn them every year, and the trust fund would still have the same amount of IOUs. The only way to guarantee that Social Security surpluses are set aside to help provide retirement income is to give younger workers the option of diverting a portion of their payroll taxes into personal retirement accounts.

Myth #5: The Medicare surplus also is being used to mask the government's fiscal balance.

Fact: The Medicare payroll tax is collecting $146 billion a year, far less than the $238 billion that the government will spend on the program this year.3

Some have argued that Medicare has a $29 billion surplus, and that this excess should not be used to "mask" the government's fiscal health. This argument is nonsensical for two reasons. As discussed earlier, the deficit or surplus is supposed to measure the total impact of government fiscal policy on private credit markets. Moreover, Medicare does not have a surplus. Medicare spending this year will exceed revenues by more than $90 billion, though this gap falls by about one-half if the premiums paid by seniors are taken into consideration.4 The $29 billion figure is a make-believe calculation made possible by comparing Medicare tax revenues with the amount of money the program spends only on hospital care (Part A). Yet an analysis of Medicare spending that ignores the money spent on doctor visits (covered by Medicare Part B) is like analyzing the Pentagon budget while ignoring the expenditures of the U.S. Air Force and U.S. Navy.

Myth #6: The recently enacted tax cut is hurting the economy.

Fact: The economy began to soften in the middle of last year, one year before the tax cut was approved.

The economy's performance has been sub-par for about one year. Therefore, it is specious to assert that a tax cut approved just a few months ago somehow is to blame for this development. Moreover, none of the pro-growth elements of the tax cut--income tax rate reductions, IRA expansion, and death tax repeal--have been implemented. The government has been sending out "rebate" checks, but while this "Keynesian" policy may increase consumption at the expense of saving and investment, it will not increase aggregate output. Improving incentives to work, save, and invest--supply-side economics--is the way to boost overall economic growth.

Myth #7: Increasing the size of the surplus will lower real (inflation-adjusted) interest rates.

Fact: Global capital markets, where trillions of dollars change hands every day, determine real interest rates.

Proponents of large surpluses and debt reduction argue that bigger surpluses (or smaller deficits) will result in lower interest rates. They are correct, but the impact is tiny and completely overwhelmed by other factors. Even a $100 billion shift in the federal government's fiscal balance is unlikely to have much effect compared with factors such as the worldwide demand for credit, tax policy, risk, and economic growth.

Myth #8: Lower interest rates will stimulate economic growth.

Fact: Lower interest rates, by themselves, will not boost investment and economic growth.

Interest rates are prices that help the market allocate credit to its most valued uses. Adjusted for factors like risk, interest rates reflect peoples' preference for consumption and/or income today compared with their preference for consumption and/or income in the future. The notion that low interest rates automatically boost growth, however, is misguided. The biggest determinant of investment is after-tax profits. As such, policymakers seeking to boost investment should focus on lowering tax rates and other pro-growth policies. People will not borrow, after all, if they do not think they can earn a profit. Economic history makes this case. Low interest rates did not help the U.S. economy during the Great Depression and low interest rates are doing nothing to boost the Japanese economy today.

Myth #9: The tax cut should be delayed, reduced, or repealed to help the economy.

Fact: Enlarging the tax cut and accelerating when the lower tax rates take effect will spur saving and investment and boost the economy.

The recently enacted tax cut has many good features, including lower tax rates on individual income and repeal of the death tax.5 When fully implemented, these tax reforms will increase incentives to work, save, and invest. Unfortunately, these provisions are now scheduled to take effect years in the future. Instead of deferring or reducing these tax cuts, policymakers should make them bigger and have them take effect as quickly as possible.

Myth #10: The Clinton tax increase boosted the economy in the 1990s and led to a budget surplus.

Fact: The Clinton tax increase delayed the economy's resurgence and had nothing to do with the budget surplus.

Tax cut opponents often claim that the 1993 tax increase helped restore growth and deserves credit for today's budget surpluses. This notion is contradicted by Clinton Administration budget documents. In early 1995, nearly 18 months after enactment of the 1993 tax increase, the Clinton Administration's Office of Management and Budget projected budget deficits of more than $200 billion for the next 10 years.6 Clearly, events after that date--including the 1997 capital gains tax cut and a temporary reduction in the growth of federal spending--caused the economy to expand and the budget deficit to vanish.

CONCLUSION

Some Republicans who want to stop more domestic spending falsely argue that new spending will "drain" the Social Security trust fund, instead of correctly asserting that additional domestic spending will undermine the economy. Some Democrats who want to defer or repeal the tax relief wrongly claim that a lower tax burden will force the government to "dip into" the Social Security surplus, rather than arguing openly that taxpayers should not be able to keep more of the money they earn so that Washington will have more money to spend.

Both sides are doing a disservice to the country. The disposition of the Social Security surplus has no impact on the program's long-run viability. Indeed, misleading assertions about the Social Security surplus or its trust fund are likely to undermine the program since they will make it harder to implement the structural reforms needed to secure a safe and comfortable retirement for future generations.

Some believe that it is acceptable to use these false arguments since the practical result is to make it harder for politicians to increase spending or cut taxes. In other words, this issue is a proxy for maximizing the surplus in order to pay down the national debt. Unfortunately, there is little evidence that surpluses or a balanced budget promote economic growth and even less evidence that debt reduction has an impact on the overall economy. Instead, lawmakers should focus on increasing economic growth and expanding prosperity by lowering tax rates and reducing the size of government. Yet these central matters are the very issues that are being overshadowed by the misleading focus on Social Security's short-term fiscal balance.

Daniel J. Mitchell, Ph.D., is McKenna Senior Fellow in Political Economy in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

Endnotes

1. Office of Management and Budget, Budget of the United States Government, Fiscal Year 2000: Analytical Perspectives (Washington, D.C.: U.S. Government Printing Office, 1999), p. 337.

2. See Social Security Administration, 2001 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds , March 19, 2001, at http://www.ssa.gov/OACT/TR/TR01/index.html. The Congressional Budget Office and the Office of Management and Budget have slightly different estimates of annual spending, revenue, and interest payments. Regardless of the numbers used, however, the definition of what comprises Social Security's annual cash surplus is the same.

3. Congressional Budget Office, "The Budget and Economic Outlook: Fiscal Years 2002-2011," available at http://www.cbo.gov/showdoc.cfm?index=2727&sequence=0&from=1.

4. Ibid.

5. Assuming, of course, that lawmakers make the tax cut permanent.

6. Office of Management and Budget, Budget of the United States Government: Analytical Perspectives: Fiscal Year 1995 (Washington, D.C.: U.S. Government Printing Office, 1994).

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