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Why the Social Security Tax Fight Is Stupid

The fight this week in Washington over how to pay for an extension of the Social Security tax cuts is just stupid.

Republicans want to pay for the tax cut by freezing the pay of civil servants, raising public employee pension contributions, cutting back on health-care spending, raising fees charged by Fannie Mae and Freddie Mac, and cutting off unemploymentbenefits for wealthy people. The Democrats want to tax millionaires more.

Perhaps some of these things should get done regardless of what happens to payroll taxes. None of them need to get done to pay for the tax cut, however, because the tax cut shouldn’t be paid for at all.

The reason why politicians in both parties think they need to pay for the tax cut is that they don’t understand the Social Security system.

The most sophisticated minds on Capitol Hill believe that the government uses payroll tax money to fund current expenditures, and gives the Social Securitytrust fund an IOU for the money. You’ve probably heard some version of this.

It’s not even technically correct — and it’s far from functionally correct. At a technical level, the government doesn’t raid the trust fund. Instead, the funds collected by the taxes are invested in a kind of Treasury bond called a “special issue” that is only sold to the trust funds.

When the Social Security taxes were cut, the trust funds collected less money. This, in turn, meant that they purchased fewer special issue Treasury bonds. This meant that the government collected fewer revenues from the sale of bonds to the trust funds.

Because politicians believe that they can only spend money that is collected through taxation or raised in bond sales, the U.S. Treasury had to issue more bonds to the rest of the world. The federal government’s debtdidn’t change at all — it just changed who it sold the bonds to.

The great fear in Washingon, D.C., is this will speed up the insolvency of Social Security. After all, there are far fewer Treasury bonds in the trust funds. When the baby-boom retirement wave begins to hit, the Social Security trust funds will want to sell those bonds back to the government. If they have too few of them to sell — that is, if after they sell all their special issue bonds, they cannot pay out all of the Social Security payments due — then they will be insolvent.

So does this mean Social Security would have to come to an end? Of course not.

Once the trust funds run out of special issue bonds, they will just have to be funded without canceling bonds. There is no danger at all of the tax cut underfunding Social Security.

Think about it this way. What is the difference between the government making payments for Social Security benefits based on the redemption of a special issue bond and the government making payments for Social Security benefits when there is not special issue bond?

If you guessed "nothing" then you are correct.

The contents of the Social Security trust funds are completely irrelevant. All that really matters is how many elderly people will need to draw on Social Security.

Cutting the taxes that fund Social Security does not increase the deficit. It just changes the mix of regular Treasury bonds and special issue bonds. At a time when Americans are suffering from a lack of money in the private sector and a surplus willingness on the part of savers to buy government bonds, taxing for Social Security makes no sense at all. Why not let people do what they actually want to do: Let the debt-burdened use more of their income to pay down their debt, and let savers use their income to buy government bonds?

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