How we actually pay for Social Security, Medicare
If you receive Social Security and Medicare, you’re taking food from the mouths of your grandchildren. But didn’t you pay for Social Security and Medicare with taxes withheld from your paycheck while you were working? No, you didn’t.
It’s a common misconception to believe that somewhere in Washington is an account with your name on it into which the government deposits your taxes so they’ll be available to pay for your Social Security and Medicare when you retire. In fact, no such accounts exist.
Social Security is a pay-asyou-go system with payments to current retirees coming from taxes paid by current workers. It’s been that way from the beginning. In January 1940, Ida Mae Fuller became the first person to receive Social Security. The total tax withheld from her paychecks while she was working was $24.75. The total payments she collected during her retirement? $22,888.92.
Social Security and Medicare are financed by the payroll tax (formally called the Federal Insurance Contribution Act tax). This is a highly regressive tax. Unlike the federal personal income tax, which is not paid by low-income workers, the payroll tax is paid by everyone, beginning with the first dollar of wage income earned. The payroll tax rate is 15.3%. Congress has directed half to be taken from workers’ paychecks and half to be paid by employers. That’s not how it actually works. Try as it often does, Congress is unable to repeal the laws of economics.
Tax incidence measures who actually pays a tax, in contrast with who the government says should pay the tax. Take, for instance, the gasoline tax. The tax is levied on the sellers of gasoline, not the buyers. You aren’t required to keep receipts for all your gasoline purchases and then mail a check to the government for the amount of the tax. Yet studies have shown that sellers of gasoline pass almost the whole of the gasoline tax on to buyers by increasing the price of gasoline by nearly the amount of the tax.
Similarly, research has shown that employers shift the whole of the burden of the payroll tax on to workers by paying them lower wages. So workers don’t pay 7.65% of their income in payroll taxes, as Congress ordained; they pay the whole 15.3% tax. Young, low-income families have to scrimp and do without because 15% of their income is taken by the government and used to pay for grandpa and grandma’s retirement.
The original sin here is Franklin Roosevelt’s (one of his many sins). He wanted to start a government-funded old age pension but realized that in those days people didn’t like the idea of the federal government just handing out money. (People also smoked a lot back then and men wore hats; fashions have changed.) So he came up with the payroll tax rigmarole that persists to the present.
But the pay-as-you-go system was vulnerable to blowing up if population growth slows. That’s exactly what’s happened, leaving us with more and more retirees having their retirement funded by fewer and fewer workers.
The funding shortfall facing the Social Security and Medicare systems is a staggering $100 trillion.
But never fear, President Biden and Congress are hard at work on a plan to fix the problem. (Pause here for raucous laughter from the audience.) In fact, of course, there is no serious plan before Congress and the chance that Biden, as he prepares to run for reelection, will spend the political capital necessary to fix Social Security and Medicare is approximately zero.
If I were king (I’m available if the position opens up), here’s what I’d do. I’d replace the current system with one in which the federal government collects a percentage of each person’s wages. This time your money actually would go into an account with your name on it and be invested in ways you control. In other words, the federal government would be running something like a 401(k) plan. We could leave everyone over 50 in the current system and guarantee a minimum benefit to those who worked only irregularly or for very low wages. Beneficiaries would run the risk of the stock market declining just as they retired, shifting to them some of the burden young families bear under the current system.
President George W. Bush proposed a baby step in this direction. His plan immediately took 10 torpedoes amidships and sank without a trace. Obviously, my approach would never get through Congress.
Given the politics, the best we can probably do is to kill the payroll tax and just pay for Social Security and Medicare out of general government revenues. The change would make the systems actuarially sound but would require a substantial tax increase on middle income households. No matter what we do, Social Security and Medicare will remain an enormous redistribution of income from the young and middle-aged to the elderly.