Social Security Surplus Raises Questions : Payroll taxes: A plan to cut reserves causes concern over the system’s future. Here is a look at proposed changes and what they might mean.

WASHINGTON —  Nothing the federal government does touches Americans like Social Security. For most of the 40-million elderly and disabled Americans who receive benefits, Social Security is all that stands between them and destitution--making the system a sacred totem of U.S. political life.

And more than 110 million people, or nearly every person in the nation who works, pay taxes to support the system. Indeed, nearly one-third pay more in Social Security taxes than they do in income taxes. When the employer’s matching share of the Social Security tax is counted, nearly three-fourths of Americans contribute more in Social Security taxes than in income taxes.

But now Social Security is embroiled in a new controversy: a proposal by Sen. Daniel Patrick Moynihan (D-N.Y.) to cut the payroll tax in order to eliminate a burgeoning surplus--a surplus created by tax rates approved only a few years ago to assure the system’s future soundness. Although Moynihan’s proposal was made as part of a complex political maneuver over the federal deficit, it has stirred alarm and uncertainty about Social Security itself.

“The public is confused and misinformed,” says Henry Aaron, a Brookings Institution economist. “That goes for the politicians, too.”

There are few clear-cut answers in the emerging debate over Social Security’s growing reserves and how to deal with its temporary embarrassment of riches. Almost everyone has an ax to grind.

In an attempt to sort out the confusion, here are answers for a number of important questions about the current controversy swirling around Social Security.

Question: What happens to the money I pay in Social Security taxes?

Answer: Most of it is used to pay the benefits of current retirees. There is no individual account set aside for your contributions that allows them to build steadily for your retirement.

By law, nearly all employees are required this year to pay into the system at a rate of 7.65% on their earnings up to $51,300. Of that, 1.45% finances the Medicare program. The other 6.2% goes toward the Social Security program. The employee’s tax is matched by employers, and self-employed individuals are required to pay the full amount themselves. Only the first $51,300 will be taxed this year, an amount that grows each year with inflation.

Last year, workers and employers paid more than $263 billion in Social Security payroll taxes to the federal government, roughly one-quarter of the government’s total revenues. After paying benefits, the Social Security system had about $36 billion left over.

Q: So what happens to the cash that is not used to pay benefits?

A: The Social Security trust fund hands the money over to the Treasury in return for special government bonds. These are like IOUs from one part of the government to another. The Treasury has promised to pay back the money, with interest, in the future.

In the meantime, the Treasury uses the cash it receives from Social Security to help pay for all the other normal operations of the government, such as buying weapons, paying salaries, building sewers and operating national parks. The cash from Social Security reduces the amount of money the Treasury must borrow from private investors to cover the government’s massive deficit.

Q: But if the rest of the budget is in deficit, isn’t it “thievery,” as Moynihan says, to use the Social Security surpluses to mask the size of the deficit?

A: A lot of people think so, but there is nothing inherently fraudulent about the practice. Social Security trust fund surpluses provide real deficit reduction. Without them, the government would have to borrow that much more to cover the deficit.

Nonetheless, many officials complain that it is wrong to rely on Social Security tax reserves to help pay for the current operations of the government. Particularly disturbing to some is that Social Security taxes hit low-income workers harder, taking a bigger chunk of their earnings, than those who earn more than the $51,300 ceiling.

Moynihan and some other politicians believe that if the government had to report the size of the deficit without the Social Security surplus, it would force action on proposals to narrow the budget gap by cutting spending or raising other taxes.

Q: So we should take Social Security “off budget?”

A: Paradoxically, that might make the situation even worse. Taking the surplus out of the calculation of the federal deficit would reveal $200-billion deficits in the rest of the budget. Faced with such large deficits, many analysts believe Congress would be paralyzed and would simply throw up its hands at the difficulty of ever closing such a wide gap.

Moreover, if Social Security were no longer subject to the discipline of deficit reduction, that would not only exempt the huge retirement program from a broad deficit accord, but it could also allow politicians to tap the “surplus” funds to satisfy demands for expanded benefits.

Q: Can’t we do anything to save the Social Security surplus for the future?

A: Not directly. Even if the government were operating an overall surplus, the money would be “saved” in exactly the way it is today--invested in Treasury securities. There is no safer place to put it.

Q: What’s wrong with investing the Social Security surplus in Treasury bonds?

A: Probably nothing, so long as the government collects enough tax revenue in future years to pay back the Social Security fund. And that depends on the future health of the U.S. economy as a whole. The most important thing the government can do is to follow policies that foster economic growth.

Q: If nothing changes, how big will the Social Security surplus get?

A: The yearly excess of income over outlays is expected to peak at about $160 billion in 2009. By 2018, when Social Security will again start spending more than it takes in from taxes, the annual surpluses are estimated to add up to $3 trillion. That money will be earning interest, and at its peak, the Social Security system should have a cumulative surplus worth up to $12 trillion.

But it is only the $3 trillion in actual extra cash that will be available to help offset deficits elsewhere or to reduce some debt. The interest earnings of $9 trillion in Treasury IOUs in the Social Security trust fund really represent nothing other than an intragovernmental accounting transaction--a promise by the Treasury to tax or borrow enough in the future to make good on its obligations.

Q: If Social Security doesn’t need the money, why are the surpluses so large and growing?

A: For most of its history, Social Security has operated on a pay-as-you-go basis, attempting to take in roughly the same amount in revenues each year that it pays out in benefits, with a little left over in case the economy turns sour.

But after the back-to-back recessions of the early 1980s, the Social Security system was in terrible shape. So Congress approved a plan that raised Social Security taxes and cut back on future benefits.

Taxes were pegged at a rate that was designed to cover current benefits and to begin accumulating some savings for use when the baby boom generation begins retiring in 2011. The baby boomers will put such a burden on the Social Security system that the $12-trillion surplus will be exhausted, according to reasonable economic projections, in about 2050.

Q: What is Sen. Moynihan’s solution?

A: It adds another twist to the debate. Moynihan proposed to roll back the Social Security tax rate to 5.1% in 1991. (He would leave the Medicare tax rate alone.) He did so chiefly because he is angry that the Republicans who have controlled the White House for a decade have refused to go along with higher federal taxes as part of a deficit reduction package. In hopes of forcing the issue, he wants to spread the alarm that the government is relying more and more on regressive Social Security taxes to finance its operations.

Moynihan wants to shift more of the burden of taxation to income taxes instead of payroll taxes. He and many other Democrats do not think it is fair that a wealthy taxpayer pays only a 28% income tax and no additional Social Security tax on each additional dollar of income, while someone with a middle income faces an effective tax rate of at least 35%.

Q: If the Moynihan proposal becomes law, will that reduce the chances that Social Security benefits will still be available when the baby boomers retire?

A: Not necessarily, but it could. Returning Social Security to a pay-as-you-go basis would mean that taxes could be cut to the level Moynihan recommends for about 25 years. Some people think that would be a good idea because, otherwise, Congress would spend the Social Security reserves for other purposes.

But in future years, when fewer workers will be supporting more retirees, the tax rate would have to jump sharply for most of the rest of the 21st Century in order to maintain benefits.

That could create an environment for huge political battles between harder-pressed workers and a large cohort of retirees over whether taxes should be raised or benefits cut. That’s one reason that many economists think it is a better idea to build up reserves as the best way to deal with the demographic bulge and America’s low savings rate.

Q: What would be the effect of turning Social Security into a private pension system, as proposed by Rep. John Porter (R-Ill.)?

A: Porter’s proposal, which President Bush says should be considered as an alternative to the Moynihan plan, would allow each worker to contribute Social Security taxes directly to an individual account and control his or her own funds. It offers the advantage that funds could be invested in vehicles other than Treasury bonds. More than that, the government could not alter an individual’s benefits by future policy changes. But unlike today’s system, in which lower-income workers receive more benefits in proportion to their contributions than higher-income employees do, Porter’s plan would eventually do away with the progressive features that have helped lift millions of the elderly out of poverty.