Problems with Pay-as-you-go

From the Deseret News, July 16th

The U.S Social Security system is in big trouble.  While the trust fund balance today is just over two and half trillion dollars, this amounts to about four years of benefits payments.  And while the balance on the trust fund has been rising every year since the fund was created in 1987, it will not be long before demographics cause that trend to reverse.  We need to reform Social Security and the longer we wait, the bigger the burden of reform we become.

One of the biggest problems with Social Security - and one of the biggest hurdles to reform - is the way it is structured.  Unlike a retirement pension, hardly any of the revenue collected from workers is put aside as savings.  Instead, the bulk of Social Security taxes collected are immediately spent as benefits for current retirees.  For example, in 2011 $805 billion dollars of revenue was generated, most of that by taxes.  Expenditures were $736 billion, leaving $69 billion to be added to the trust fund.  This type of a system where taxes on current workers pay for benefits to current retirees is called a "pay-as-you-go" system.

Most people think of their social security payments the same way they think of a pension or savings program.  That is, they pay money in while they work, that money is saved and earns interest, and then is withdrawn as retirement benefits are received.  Since Social Security benefits are based on a workers earnings, the more a worker pays into the system the higher that workers benefits will be when he or she retires.  The rules for determining the size of benefits payments are very similar to those that determine the size of a pension benefit payment and periodically the Social Security Administration mails participating workers estimates of what their future benefits payments will be when they retire based upon various ages for retirement.  It is only natural that we think of this system as the equivalent of a pension, since from the worker's perspective it operates exactly as a pension would.

However, since taxes are not accumulated as savings, benefits for that current workers receive when they retire must come from taxes on future workers.  This is what makes reform so difficult.

Consider, for example, what would happen if we switched from a pay-as-you-go system to a fully-funded pension system.  Current workers would need to be double taxed; once to pay for the benefits to current retirees, and then again to pay for the savings needed to fund their retirement pensions.  Since doubling payroll taxes is unappealing to most workers, consider the alternative of lowering benefits.  We could keep taxes constant and put half the money toward a pension and give half to current retirees.  This would amount to cutting Social Security benefits in half, which also seems very unappealing.  Lesser reforms would lessen these burdens, but would still necessarily involve raising taxes or lowering benefits or both.

The flip side of switching from pay-as-you-go to a pension is switching from a pension to pay-as-you-go.  In that case there are windfalls to be had by workers and/or retirees.  These windfalls were indeed paid out when Social Security was first introduced and as its scope was expanded over the years.  However, these windfalls cannot be recouped because the beneficiaries are mostly dead and beyond the reach of government taxation now.

The simple fact is that there is no simple way to reform the system without making either workers or retirees worse off than what the system now promises.  Another simple fact is that those promises cannot be honored in the long run.  The longer we wait for reform and postpone the costs, the larger and more painful those costs will be.