The United States’s Social Security trust funds are set to run out in a few years, according to the Congressional Budget Office. The CBO projects that following current trajectories for revenue and outlays, the trust funds will hit zero in 2033. Should we care?

I’ve been mulling this question over, along with a separate but related one: Is the total US federal debt $31,460,917,912,000.64, including Treasury debt held by the Social Security trust funds and other federal entities? Or is it “only” the $24,641,815,856,835.50 held by the public? (Both numbers reflect the balances reported by the Treasury as of March 30.)

The trust funds exist because for a while, Social Security tax receipts and other revenues were larger than Social Security payments. (In the US, Social Security taxes mostly come from a payroll tax.) Social Security used the extra revenues to buy Treasury debt. Now there are fewer workers, more retirees, and more generous benefits, so Social Security tax revenue is smaller than payments. Social Security uses the assets in its trust funds to cover the difference. It would be easy to conclude we’re in trouble when the trust funds run out.

But that’s not how it works at all. Treasury debt is not an asset like a stock or bond or Uncle Scrooge’s pool of gold coins—a claim to something real outside the government. Treasury debt is a claim against future income taxes. Cashing in Treasury debt just means paying for benefits with income taxes.

The ups and downs of the trust funds simply reflect a change in how we finance Social Security spending. When payroll taxes are greater than Social Security spending, which was the case until 2007, payroll taxes are financing other spending. When payroll taxes are less than Social Security spending, income taxes or increases in debt are financing Social Security spending, which has been the case since 2008. (See the graph below.) The trust funds just add up this change over time. Exhausting the trust funds is, in this view, really irrelevant.

Why there’s trouble even before the trust funds run out

Before 2008, payroll taxes were higher than spending on Social Security benefits. The difference was invested in Treasury debt, effectively funding other government spending. But with payroll taxes now lower than spending on benefits, fiscal adjustments have to be made ahead of the trust funds’ projected depletion in 2033. 

That doesn’t mean we can all go to sleep, for two reasons. First, when payroll taxes are lower than Social Security outlays, and the trust funds are winding down, income taxes or additional public debt must finance the shortfall. The government has to spend less on other things, raise income tax revenues, or borrow, which means raising future taxes. And, per the graph, the numbers are not small. One percent of GDP is $230 billion. The extra strain on income taxes, other spending, or debt does not wait for the trust funds to run out. It happens right now, when the trust funds are positive but decreasing.

Zero matters only because by law, when the trust funds go to zero, Social Security payments must be automatically cut to match Social Security tax revenue. That’s the sudden drop in the graph. The program was set up as if the trust funds were buying stocks and bonds, real assets, and would not lay claim on income tax revenues. But they were not; Social Security taxes were used to cover other spending, and now income taxes must start to pay Social Security benefits.

What happens when the trust funds run out, then? Congress has a choice: automatically cut benefits, as shown, or change the law so that the government can pay Social Security benefits from income taxes, or issue ever more debt, at least until the bond vigilantes come. (Or raise payroll taxes, or reform the whole mess.) I bet on change the law.

So what’s the right measure of debt? It’s conventional to look only at debt in public hands. But there is a case to look at the total debt, i.e. to include the trust funds. Those are the total claims against the income tax. Looking at it this way, however, one could also go on and count unfunded future Social Security benefits as a debt—the present value of the difference between the two lines in the graph, which leads to immense numbers, per the research of Boston University’s Laurence Kotlikoff.

I have usually not considered the present value of unfunded promises as “debt,” because Congress can change the law that defines benefit payments at any time. Changing debt repayment to the public is a default, with financial and legal consequences; changing Social Security benefits is legislation. You can’t sell your future Social Security benefits as you can your Treasury debt. The trust funds are halfway between the two.

The funds’ cash-flow problems point to two larger issues. First, paying off the existing debt is not the US’s central fiscal problem. The central problem is vast unfunded future pension and healthcare promises. Defaulting or inflating away current debt would do nothing to fund those promises.

Second, incentives are as or more important than budgetary costs of entitlements. Social Security initially moderated its disincentives, and secured its political support, by mirroring a savings program: the more you put in, the more you got out. Most “reforms” add disincentives: higher taxes on high earners with no increased payout, the taxation of benefits, and means testing. Working more or harder benefits you less. Means testing of other programs has resulted in most low- to middle-income Americans effectively facing a 100 percent marginal tax rate: earn an extra dollar, lose a dollar of benefits. The disincentive there is pretty clear, and mirrored in the steady decline of labor-force participation.

John H. Cochrane is a senior fellow of the Hoover Institution at Stanford University and was previously a professor of finance at Chicago Booth. This essay is adapted from a post on his blog, The Grumpy Economist.

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