Freeman

ARTICLE

Why Social Security Is Popular

The Conditions That Make Social Security Popular Are Temporary and Rapidly Disappearing

SEPTEMBER 01, 2001 by HUGH MACAULAY

Hugh Macaulay was Alumni Professor of Economics Emeritus at Clemson University.

Polls show that people under 40 believe they are more likely to see an unidentified flying object than a penny of benefits from Social Security. Those 40 to 65 think they may see some return on the Social Security taxes they have paid. But expenditures will exceed receipts beginning in 2015, and even the fictional Trust Fund is supposed to run dry by 2035. So their returns are uncertain and likely to be very low. Those about to receive benefits or who have just begun receiving them are told that the annual return on the taxes they paid will be under 2 percent, much less than they could have gotten anywhere else.

Yet despite all these marks against Social Security, it has been so popular that, at least until recently, any politician who suggested a change in the program was described as having touched a deadly third rail. (President Bush has recommended that people be able to invest a small portion of their payroll tax in private retirement accounts, and has set up a commission to propose a specific plan to that effect.)

Social Security is a “social insurance” program: retired people are not supported by returns on money they contributed in the past. Rather, they are supported with taxes paid by current workers, who, in return, will be supported in retirement by workers from the next generation. As fast as money flows into the Social Security coffers from taxpayers, it gushes out to beneficiaries and is consumed.

This is the same principle that is used in chain letters and Ponzi schemes, both of which are universally ridiculed and usually outlawed.

How can we explain this enthusiastic support for Social Security given the sorry past and the bleak outlook for so wide a group of voters?

There are several reasons why the present program is so popular. The early retirees were big-time winners in this lottery. Take 100 workers who each work 50 years, from ages 15 to 65, as was common when the program began in 1937, and expect to live five years after retirement. With the annual wage income of white males in 1939 equal to $1,112 and women and blacks earning much less, we can conservatively assume that each contributes $10 a year while working and expects to draw $250 a year during his retirement. Those sums appear outlandishly low today, but they approximate the amounts applicable at the outset of the program. Each worker thus puts in $500 over 50 years of work and draws out $1,250 in five years of retirement.

Suppose that at the end of the first year of operation, two workers turn 65 and retire. Each has put in only $10, but each is now set to draw $250 a year for five years. At the end of the second year two more workers reach 65 and retire. Each has contributed $20 total and will also draw $1,250 over five years. If we were to ask these people if they think Social Security is a good idea, the hosannas could be heard in the next state.

As a real-world example, consider Ida May Fuller of Ludlow, Vermont, the first recipient of Social Security benefits. She had paid in a total of $24.75 over three years, and her first month’s benefit was $22.54 in January 1940. She lived to be 100 and drew $22,888.92, or 924 times what she put in. While this is an extreme case, someone who received only two, ten, or 100 times what he contributed would have felt he hit the jackpot. This was at a time when interest rates were 3 percent a year.

Young Workers’ Contributions

Had nothing changed since the program’s inception, the youngest workers who turned 15 in 1940 would put in $500 over their 50 years of work, ending in 1990, and withdraw $1,250. Workers older than 15 in 1940 would have contributed for a shorter period and would have gained even more. Since we are now over 50 years beyond 1940, this level of gain should be the most any worker could expect. But Congress has used several policies to keep the gains growing.

First, Congress has periodically expanded the list of those covered. Only workers in private industry were covered at first, but then at later random intervals, Congress added farmers, self-employed workers, employees of nonprofit and charitable institutions, members of the armed forces, and government workers. Whenever a new group was added, the game started over again, with big winners at first, just as explained above. Those winners have always been enthusiastic supporters.

Second, note that in the early years, when each new group began to contribute and there were few retirees, much more money came into the pot than went out to retirees. Congress has been reluctant to see idle funds sitting in its honey pot, so it has periodically increased benefits for current as well as future retirees. In 1950 and 1952 Congress increased the benefits, doubling the amount that had been promised. Instead of $1,250, retirees would receive $2,500. In later years Congress again increased promised benefits, and in 1972 it tied the benefits to the consumer price index with “cost of living allowances” (COLAs) beginning in 1975. Thus retirees were protected against the ravages of inflation, a provision notably lacking in private retirement plans. Observe that with new groups being added periodically, there would be many new workers paying into Social Security and few newly qualified retirees to receive benefits from it. Again, is it any wonder that retirees believe if they have not found a fountain of youth, they at least have found a fountain of money?

Third, as life expectancy grows, the retirees receive payments for a period longer than that for which they paid. Using our earlier example, instead of paying in $500 and receiving $1,250 during five years of retirement, if the retiree lives only one year longer, he will receive benefits for six years. This is a 20 percent increase in his retirement benefits, which would rise to $1,500. With improvements in nutrition and medical care, life expectancy has continued its march. The gains here have been much greater than in this example. Life expectancy for white males in 1935 was only 61 years. Thus many, if not most, workers would never see any benefits. If life expectancy had been 66 years in 1940 and 75 in 2000, total benefits received would be ten times what was earlier expected. Instead of anticipating a benefit of $500 for only one year, a retiree would expect benefits of $5,000 over ten years, all for the constant level of contributions. Santa Claus has come again.

A fourth benefit has come from the baby-boom generation. When this large population joined the tax-paying labor force in the late 1960s, much more money again poured into the Social Security Trust Fund, and Congress again increased the benefits of those retired and about to retire.

This last benefit increase will turn into a burden when these boomers reach retirement age, beginning about 2010. Then that large generation will depend for its benefits on the smaller Generation X and the good times will be over. Members of Congress and the president have a two-, four-, or six-year time horizon, so they want to do what will heap praise and re-election on themselves today. Future politicians will bear the burden, but that is their problem.

Overstating the Cost of Living

A fifth source of benefits is inflation, which has added to the misperception. As noted, starting in 1975 Congress indexed Social Security benefits to the Consumer Price Index. When prices rose, benefits rose by an equal percent. Economists have long noted, however, that such an arrangement overstates the true cost of living for those so benefited by about 1.5 percent per year. After seven years of retirement the typical beneficiary has had his real benefits raised by an effective 10 percent. Another six years and he is 20 percent better off in real terms. This means his standard of living is not constant, but rises each year. Note how many senior citizens travel extensively, though they never did so while working nor expected to do so when retired.

Another change constitutes a sixth reason for the system’s popularity. Just as new groups were added to the system, so were new benefits added. From 1954 through 1960 disability benefits were added and extended to survivors and dependents. While an added premium was levied for this benefit, those already retired did not have to pay anything for it and those nearing retirement did not pay its full cost. In 1965 Medicare was added to the benefits, and once again those at or near retirement got full benefits for less-than-full payment of premiums. Another 40–50-year game of gain got underway.

There is an additional gain to Medicare recipients. The program is divided into two parts: hospitalization and physician care. Payroll contributions finance, again on a money in-money out basis, the hospital-care portion. The physician’s care portion is financed by voluntary payments by retirees, plus an additional contribution from general tax revenues. At present, Social Security recipients pay approximately 25 percent of the cost of their medical care; the other 75 percent is paid by general taxpayers. Who would want to abandon a system whereby others pay 75 percent of his medical bills? Not the present Social Security recipients.

A seventh reason for the popularity of Social Security is due to our asking only the ones who are alive and have benefited or think they will benefit. Many workers contributed for a lifetime and then died just before or after becoming eligible to collect. They do not get to express an opinion, which might well be highly negative.

For most retirees, benefits have far exceeded costs for the reasons cited. But what about these costs? The government has raised the use of smoke and mirrors to an art form in hiding the true cost of Social Security. Here’s how:

First, remember that present retirees are receiving money from present workers, so any increase in costs is not of concern to retirees. The current push by retirees to have Medicare cover the cost of pharmaceutical drugs is an excellent example of this principle. They expect to gain from this new program, though they have never contributed a cent to finance it. And when Social Security contributions are raised, those already retired care not at all. Someone else will pay these taxes.

Second, when Congress arranged to finance the plan, it required the worker to pay half the amount and his employer the other half. The worker sees only his explicit half of cost. But as any economist will explain, the full cost falls on the employee because the employer’s payment will come from money that would have gone to wages. The employee sees the government providing him with this wonderful plan at low cost and his employer as a mean-spirited capitalist who is not giving him the wage he so fairly deserves.

Third, the employee’s low-cost tax (which the Social Security Act formally calls a “contribution”) has been withheld from his wages since World War II. He never sees that money and thus parts with it with minimal pain. It is truly a hidden tax.

Originally retirement benefits were not taxable income. But in the 1980s and 1990s increasing portions of these benefits were included in retirees’ income subject to the income tax. The sums collected, however, do not go into the general revenue but go instead to the Social Security trust funds. The sums collected are thus hidden Social Security taxes, another concealed cost of the program.

For the first 13 years of the system, the maximum tax paid by the worker each year was 1 percent of his wages up to $3,000, or $30; employers “paid” another $30. Today a worker pays 7.65 percent on wages up to more than $76,000, or over $5,800 a year, with an equal sum from his employer, reducing his nominal salary by that amount. The worker’s maximum tax of $60 in 1937 has now risen to $11,600, or over 190 times as much. The cost of all those increased benefits has now come home for future beneficiaries. The enchantment with the program is likely to decline commensurately in the future.

The most serious cost of Social Security, however, is its social-insurance method of financing. Under a private plan, workers produce, save, invest, produce more goods, and finally retire and consume from this increased store of goods their investment has created. Under social insurance, employees work and pay taxes, and retirees receive these funds immediately and consume. There is no investment or increased output. Consumption is merely transferred from the young to the old. Is it any wonder that old people love Social Security?

If the approximately $600 billion annually contributed to Social Security were invested in ways that produced a 14 percent return, a rate that approximates that realized by manufacturing corporations for the past two decades, there would be $84 billion of additional goods each year. Over the 40 or 50 years when workers are employed, between $3.3 and $4.2 trillion of additional goods would be produced and available at retirement. This would provide an added $12,000 or $16,000 in goods for every man, woman, and child in the United States. These estimates are based on static analysis, meaning that we assume nothing changes in the future. If, however, productivity, incomes, and population rise, as they are sure to do, the gains will be even greater. Under the present system, no new goods will be produced and workers will be poorer by the sums just cited. Social insurance sounds good, but the result is fewer goods than with free-market insurance.

The reasons cited help explain why Social Security is so popular. But these conditions are temporary and rapidly disappearing. When they are gone, the house of cards will come tumbling down. If we cannot see beyond 15 years and change the system to include private savings and benefits, young and middle-age workers today will receive the paltry benefits they so richly deserve.

ASSOCIATED ISSUE

September 2001

comments powered by Disqus

EMAIL UPDATES

* indicates required
Sign me up for...

CURRENT ISSUE

July/August 2014

The United States' corporate tax burden is the highest in the world, but innovators will always find a way to duck away from Uncle Sam's reach. Doug Bandow explains how those with the means are renouncing their citizenship in increasing numbers, while J. Dayne Girard describes the innovative use of freeports to shield wealth from the myriad taxes and duties imposed on it as it moves around the world. Of course the politicians brand all of these people unpatriotic, hoping you won't think too hard about the difference between the usual crony-capitalist suspects and the global creative elite that have done so much to improve our lives. In a special tech section, Joseph Diedrich, Thomas Bogle, and Matthew McCaffrey look at various ways these innovators add value to our lives--even in ways they probably never expected.
Download Free PDF

PAST ISSUES

SUBSCRIBE

RENEW YOUR SUBSCRIPTION