April 15th is a day we contemplate our financial relationship to government. It thus provides a suitable occasion to reflect on the distinction between Social Security contributions and income taxes. In discussions of Social Security, many disagreements stem from the fact that we view its funding from within different paradigms, namely some of us see these payments as insurance contributions, others as just another form of income tax. On this year’s Tax Day, this post considers the historical origins of this conceptual distinction, arguments for each of the two paradigms, and their implications for strategies of fiscal reform.
Historical Origins of the Two Paradigms
First, income taxes. Today’s Internal Revenue Code stems from 1913, the year in which the Sixteenth Amendment authorized federal income taxation. Income taxes were introduced because the federal government needed more revenue, given that its traditional sources of revenue, tariffs and excise taxes, were insufficient to fund a modern central government.
Second, contributions. Historically, social insurance funds are descendants of late medieval guilds’ funds for sickness, disability, old-age and survivors. These mutual aid societies were occupation-specific, and had their own contributory funds for various purposes. These had nothing to do with government or the tax system. They were private, cooperative insurance funds financed by members’ contributions. The contributory social insurance schemes that emerged in the late 19th century in Germany, Austria and other Continental European countries were state-run reincarnations of these late medieval corporatist self-help arrangements. U.S. Social Security was based to a large extent on these European models, and introduced a similar form of contributory social insurance for workers (as reflected in the term “FICA” – “Federal Insurance Contributions Act”).
Merits to Each Paradigm
Despite the contributory, off-budget origins of the system, today, many economists and budget experts find a fungible-tax or unified-budget frame more compelling, i.e. one which treats the general fund and the Social Security Trust Fund as if they were one entity and essentially fungible. There are two main arguments for this paradigm. First, this perspective is necessary when considering macroeconomic policy, for it discerns the net effects of government taxing and spending patterns on the national and global economy and credit markets. In the early years of the program, Social Security’s taxing and spending were so small as to be largely irrelevant in macroeconomic terms. But in recent decades, as the program has grown in scope, no economist would dispute its macroeconomic relevance. Second, the unified budget frame is an important long-term budgetary planning too. It forces us as a society to consider how much taxation we can – or want to – afford in the future (and how much we want our children or grandchildren to have to pay).
In turn, four justifications are put forward by those who subscribe to the “contributory” paradigm, which views the OASDI trust funds as distinct from the federal budget (“off-budget”). These arguments are based respectively on legislative intent, equity claims, the insurance principle, and fiscal responsibility concerns. First, they note that the legislative intent of Title II, Section 201 of the Social Security Act of 1935 is clear: Social Security contributions can be invested in the general fund via Treasury Bonds, but these must bear interest (payment of which is credited daily), be redeemed on their maturity dates, and used when needed to pay benefits. Second, the off-budget school makes the equity claim that social insurance contributions are flat-rate and disproportionately targeted to low and middle income Americans, applying only to income below an annually adjusted income threshold of $106,800 in 2010, whereas income taxes are levied against all Americans. This regressive taxation is justified because of the progressive benefit, but if the boundary between the Trust Fund and the general fund is blurred, and all taxes are fungible, payroll taxes are grossly inequitable. Third, any insurance fund requires reserves in order to meet its fiduciary obligations over the long-term. If the Social Security program is not allowed to accumulate secure reserves on which it can draw at will and without political interference, it cannot perform successfully. Fourth, from a budget hawk perspective, if the OASDI trust fund is analytically thrown together into one pot with the rest of government (the general fund and the Medicare [HI] and Supplementary Medical Insurance [SMI] trust funds), this alleviates pressure on Congress to balance the general fund or the HI and SMI trust funds. Rather, unified budget metrics can be used both as targets and as budgeting instruments, taking solvency pressure off the more deficitary portions of the federal budget.
Implications for Fiscal Reform Strategies
What are the implications of the contributory (off-budget) and ‘fungible tax’ (unified-budget) paradigms for our country’s fiscal reform policies going forward? The contributory paradigm treats the Social Security Trust Fund as a distinct entity that has to be solvent over the long term and must have annual balanced budgets, without recourse to borrowing. This is the Social Security solvency issue which the annual Trustees report addresses, and over a 75-year horizon it amounts to a shortfall which is equivalent to about two percent of taxable payroll. This frame sees the nation’s fiscal crisis as centered in the $13 trillion general-fund debt and the interest payments this debt necessitates, as well as in the projected long-term rise in health care expenditures which will challenge the solvency of both the general fund and the Medicare trust funds. It tends to consider any potential contribution increases needed to balance the Social Security Trust Fund to be analytically distinct from the income-tax or other levies that the general fund and Medicare trust funds will require to remain solvent.
Advocates of a unified budget frame point out that from a macroeconomic perspective, this approach is highly problematic. The unified budget frame tends to view Social Security solvency not in terms of the OASDI Trust Fund alone, but in terms of the unified budget. In this frame, rising Social Security expenditures for the baby boomers in the coming decades appear to be a crushing fiscal burden: the unified frame does not perceive the Trust Fund surplus as money saved up for this purpose because macroeconomically, the notion of inter-year (much less inter-decade) transfers is not meaningful. Here, those $2.4 trillion in Treasury Bonds (the OASDI Trust Fund surplus, which is projected to approach $4 trillion by the end of the decade) are not perceived as obligations which should be redeemed solely based on programmatic criteria, i.e. the Social Security benefit formula; rather, the generosity of Social Security benefits should be weighed against the fiscal needs of other branches of government, as well as against the sustainable tax burden for the economy as a whole. Most (but not all) arguing from this paradigm maintain that given our unified budget crisis, Congress should cut Social Security program expenditures (by raising the retirement age, means-testing benefits, etc.), making the program as cash-flow neutral as possible over the long term so as to delay (perhaps indefinitely) repayment of the bonds.
Much of the disagreement in the Social Security debate stems from the existence of two different paradigms which lead experts and other observers to come to different conclusions about the fiscal status of the program, while citing the same numbers. The challenge for policy intellectuals in the budget reform discussion will be to find a language for mediating between these two paradigms and for adjudicating their claims.
Benjamin Veghte is Income Security Research Associate at the National Academy of Social Insurance. He can be reached at bveghte[at]nasi.org or at (202) 452-8097.