July 23, 2012

Social Security And Medicare How Is It Funded

And Will It Still Be Around For The Next Generation?

By Melvin J. Howard

If you look at your pay-stub you will see two deductions for FICA taxes. Ever wondered what it means? Well FICA stands for Federal Insurance Contributions Act and covers two basic benefits for retirees and disabled persons:
Social Security:

Labeled as FICA-OASDI or Old Age and Survivors Insurance and Disability Insurance. This provides pension benefits to retirees, survivors and disabled persons.

Labeled as FICA-HI or Health Insurance. This provides medical insurance for retirees, survivors and disabled persons.

Some of you may be aware that the amount of money the government collects from employees and employers as the FICA taxes has exceeded the government's obligations in Social Security and Medicare payments for the past three decades. This has been true since FICA taxes were increased under the Reagan administration in 1983, at a time when other Federal Income Taxes were reduced. Then the question is "What has the government done with that excess money?" Its all been spent on other things. About $2.2 Trillion of Social Security and Medicare Surpluses - all spent elsewhere by the US Treasury. Lets see why this is. Many people are upset because they think the government should have "saved the money" for the future and often they are misled to believe this through the existence of what are called the Social Security and Medicare Trusts, or sometimes know as the Lock Boxes. In what form could the government save the money?

* Keep it as US dollars or deposit it in a bank,
* Invest in the private sector, or
* Buy government bonds. I.e. write IOUs to oneself.

Let's look at the first possibility. If the government keeps the money as US dollars this is tantamount to the Treasury intervening in monetary policy, which is the job of the Federal Reserve. The Treasury would be essentially holding large sums of money out of the economy for many years, which would not make sense at all. The Treasury could instead decide to deposit the savings in a bank thereby making the funds available for use in the economy and draw on its deposits later as benefits fall due. But the banking system is backed up by the government itself, so the promises of the bank to make good on depositors funds is ultimately the promise of the government to itself. So why bother with all the banking fees?

It makes more sense for the government just to write a note to itself - "I owe to my self $x trillions of dollars", which is essentially what happens. A similar argument applies to investing the funds in the non-government guaranteed private sector. The private sector depends for its success on the stability and financial security of the State. If the State collapses so does the private enterprise defined by the rules of the State. If certain private enterprises collapse it shouldn't affect the State, except if there is massive widespread collapse like the recent banking crisis and then the State would step in to provide as many guarantees as possible. 

So some ultimate risks are still born by the State. The main point is that investing in the private sector carries with it higher risks than holding a government obligation. And the main point of Social Security is to pass risk from those that can least bear it over to those that can. Private investing without government guarantees completely removes this risk transfer feature of Social Security and places private sector investment risks onto those who can least afford it.

Therefore, as nonsensical as it sounds, so long as there is a surplus collection, the most sensible thing to do is for the Social Security and Medicare funds to pass over the excess funds they collect each year to the Treasury for it to spend back into the economy. The Treasury then writes an IOU to the trust fund to pay back the amount it just spent on something else. Basically the Government is writing an IOU to itself. Then they put the IOU in a box, lock it up and call it a safe "lock box" or trust fund. 

Whether intentional or not, what effectively happened to the Social Security and Medicare surpluses generated by the Reagan Era FICA tax increases and reductions in benefits, helped fund Reagan's big military build-up of the eighties. With a Federal Income Tax Cut, but an increase in FICA taxes, the tax burden was less progressive, and the loss in tax revenues in the general Treasury account was somewhat offset by Social Security Surpluses. 

This shifting of funds also enabled the government to replace borrowing from the private sector (the markets), which it cannot default on without dire consequences to the economy, with a promise to "pay back" the funds to Social Security and Medicare many years in the future when needed. This is a much less serious promise than issuing debt to the private sector because future governments may very well get away with reducing publicly funded social security benefits if they argue it effectively enough.

However the government cannot default on debt issued to the private sector else it will send the markets into a tailspin (since it is the most risk-free asset) and thus send the world's economy crashing. 

The Bush tax cuts and the recent extension of those cuts has compounded this trend of borrowing from Social Security and Medicare to make up for lower general revenues and thereby fund other government expenditures, and substitute borrowing from the markets with borrowing from 

Social Security/Medicare. Only time will tell if this was the right move or will promises be broken.