Social Security Is A Ponzi Scheme

Last week, Alex Tabarrok wrote a post at Marginal Revolution titled, “Is Social Security a Ponzi Scheme?”

His answer is yes.

That reminded me of what I wrote about Social Security in my 2001 book, The Joy of Freedom: An Economist’s Odyssey.

Here’s the start of the chapter.

I say we scrap the current [Social Security] system and replace it with a system wherein you add your name to the bottom of a list, and then you send some money to the person at the top of the list, and then you . . . Oh, wait, that IS our current system.

—Dave Barry, “Election could come down to who kisses most orifice,” Miami Herald, September 24, 2000

In 1991, one of my students, Stephen Banus, wrote to the Social Security Administration requesting information about the Social Security taxes he had paid and the benefits he could expect to receive. In the form letter he got back, Gwendolyn King, the commissioner of Social Security wrote:

I want to assure you that Social Security is built on a sound financial foundation. Social Security benefits will be there when you need them.

A prudent man and a good planner, Banus sent a similar request in 1995. This time, the message in the form letter was different. The commissioner of Social Security, Shirley Chater, wrote:

The latest report of the Social Security Board of Trustees says the Social Security system can pay benefits for about 35 more years. This means there’s time for Congress to make the changes needed to safeguard the program’s financial future.

In just four years, the commissioner had scaled back the blanket assurance that the benefits would be there “when you need them” to “about 35 more years.” What happened between 1991 and 1995?

Actually, nothing much happened in those four years except that the Social Security Commissioner in 1995 was perhaps less dishonest than her counterpart in 1991. The fact is that Social Security was never on a “sound financial foundation.” Contrary to the Social Security Administration’s official propaganda, there is no real trust fund. Roughly 80 percent of the payroll taxes collected from current workers today are sent out to current retirees, with only a brief stayover in Washington. The government spends the rest of the money on other items. The so-called trust fund contains bonds that the government has created. These bonds are simply IOUs from one branch of government to another. Chris Jehn, an associate director of the Congressional Budget Office, compares these bonds to notes that you write every year and put in a box for your child’s college education. The note says, “I owe $5,000 to my daughter’s college fund.” After 18 years of such saving, when your child turns 18, you open the box and out comes, not $90,000, but 18 worthless pieces of paper.

Those who retired in the early 1940s got huge benefits in return for paying low payroll taxes for only a few years. But as the system has “matured,” so that current retirees have been paying Social Security taxes for virtually their whole working lives, these retirees have received a much lower return.

A private citizen who set up such a financial chain letter would go to prison. In fact, he did. His name was Charles Ponzi, and he was arrested in 1920 for promising investors that they could double their money in 90 days and using the proceeds from later participants to keep his commitments to earlier ones. Thus was born the term “Ponzi scheme.”

There are two main differences between Ponzi’s original scam and the Social Security system. The first difference is that Social Security is run by government and, whatever its constitutionality and its questionable ethics, is legal. The second difference follows from the first: Whereas Ponzi had to rely on suckers, the government can and does use force. It’s true that the government refers to the Social Security payroll taxes—a hefty 10.6 percent (an extra 1.8 percent is for disability insurance and a further 2.9 percent, levied on all income from work, is for Medicare) of every worker’s earnings up to $80,400 in 2001—as “contributions.” But just try not “contributing.” That’s what Valentine Byler, an Amish farmer in New Wilmington, Pennsylvania, did in 1961. His religion taught that its members should care for each other and he tried to act on his religious beliefs by not paying Social Security taxes. The Internal Revenue Service responded by seizing three of his horses and selling them to collect $308.96 in unpaid taxes.

The Social Security Administration’s new line is that the fund is solvent until 2037. What the government officials who say that really mean is that by 2037, the last of the special federal government bonds that the Social Security Administration has bought and kept in the Social Security “Trust” Fund will be sold off to the U.S. Treasury. This “sale” of bonds is simply a transfer between the government’s left and right hands. To free up the cash to pay for these bonds, the Treasury will have to float new bonds, increase taxes, or cut other spending.

The more relevant date, therefore, is when the government’s benefit payments start to exceed its income from payroll taxes and from interest on these bonds—because that’s when the bonds will first be sold and the government will have to come up with extra cash. That date, the Social Security Administration now projects, will be 2024, about two-thirds of the way through the retirement of the baby boomers.

In the late 1990s, the government’s own actuaries estimated that, to maintain promised benefits, the tax rate would have to rise over the next decades from its current level of 12.4 percent to more than 18 percent. At an 18 percent rate, Social Security taxes would be about 7.5 percent of overall GDP. But total federal revenues from all sources, not just from the Social Security payroll tax, have stayed within a narrow range of 18 to 20 percent of GDP since the early 1950s. If this historical constant held, then the Social Security program alone would take about 40 percent of the total tax revenues collected by the federal government, leaving the remaining 60 percent to pay for Medicare, interest on the debt, defense, and everything else the federal government does. That doesn’t seem likely, which means that the odds of raising the Social Security tax rate substantially are, fortunately, fairly small. At some point in the future, therefore, benefits will have to be less than promised.