Tuesday, March 16, 2010

Who Is Our Biggest Creditor? Hint: It's Not Japan or China

There has been debate lately about foreign countries holding our national debt, and particularly whether China or Japan is our largest creditor. The numbers seem large for sure. As of January 1, 2010, China owned $889 Billion and Japan owned $765 Billion of our $12.6 Trillion national debt. But guess what? In the world of national debt holders those countries are mere pikers.

As of January 1, 2010, Social Security taxpayers owned $2.54 Trillion of that debt, more than Japan and China combined. And even those much reviled Federal Employees owned $780 billion of the debt. In fact, of our $12.6 Trillion national debt, over one-third, $4.5 Trillion, is actually inter-governmental borrowings and most of that is borrowed from trust funds like Social Security which have an accumulation of excess tax payments.

A list of these funds and their current account balances can be seen on pages 24 and 25 of this Treasury report.

So why is it that over a third of our national debt is not owed to people who invested in treasury securities but rather to people who have been overpaying taxes and fees to the government for many years? The answer is simple. The United States government has been under collecting income taxes for decades and has been masking the size of the deficit by borrowing money from people who pay Social Security taxes, Medicare taxes, Railroad retirement withholding, federal employee retirement withholding and myriad other taxes and fees .

Now the theory behind what has happened to Social Security and the other trust funds is not bad. For instance Social Security used to be a pay-as-you-go system, where tax payments were received and almost immediately paid out to beneficiaries. Since such a system is not fiscally prudent, in 1983 the program was amended to increase the amount of Social Security taxes paid and lengthen their retirement date in order to develop a reserve of funds they would be available to provide to beneficiaries in the future when the baby boomers retired.

It was fiscally responsible. But this is where the twist comes in. What was the government to do with all this excess money, which as discussed above has now grown to $2.54 trillion. Well, it could invest that money in the stock market, or it could invest it in overseas bonds, or it could simply lend the money to the Treasury and thereby reduce the amount of public borrowing the Treasury would have to do in years when we were running a deficit.

Of course, Congress chose the last option, since that is by far the most prudent. It would not be feasible for the federal government to invest Social Security funds in the stock market without incurring real or imaginary criticism for manipulating stock prices. Moreover, it would not be responsible to do so since Social Security is the safety net for retirees, the guarantee that no matter what else happens to their other investments they will always have a benefit that can be counted on. Similarly it would make no sense to invest in the bonds of other countries rather than our own.

Consequently, every time the treasury took in more Social Security or other trust fund taxes than were to be paid out that year it borrowed those excess amounts. Each trust fund was issued a certificate every time this borrowing took place that show the amount borrowed and the interest rate that would be paid on the instrument.

All of this makes tremendous sense as long as the Congress and, for that matter, the people who pay income taxes, remember that this money has to be repaid. But we never hear discussion of that. Rather, when the Federal government runs huge deficits, all we hear is that we needed to enact "entitlement" reform. What are they saying when they talk about entitlement reform? They are definitely not talking about increasing income taxes to pay back Social Security taxpayers for all the money that has been borrowed. No, they talk about increasing Social Security taxes again or delaying the retirement age again.

According to the 2009 Social Security Trustee's Report, Social Security taxpayers will continue to pay into the Social Security trust fund more each year than is withdrawn from the fund until approximately 2016. (Due to the recession, that will not be the case this year, but excess payments should resume next year.) It should be noted that the 2009 trustees report contained projections that were more pessimistic than in prior years. This is particularly noteworthy because, as a general rule, the trustees have been very conservative in their projections. Their analyses are based on estimates of population growth, inflation, gross domestic product, interest rates, and other factors that influence the amount of money coming in to the Social Security trust fund as well as the amount of money being paid out. Historically they have always made their projections based on very conservative analysis. This is illustrated by the fact that the current projection that the trust fund will not be exhausted until 2037 is almost 2 decades later than the 2018 projection that was made when the 1984 changes were enacted.

Assuming the current Trustee projections are correct, beginning in 2016 Social Security tax receipts will not be enough to make payments to beneficiaries and the Social Security program will have to start redeeming those instruments that were issued by the Treasury. Based on current projections ongoing tax payments plus bond redemptions should be enough to make full payments to Social Security recipients through 2037. At that point there would have to be a 24% reduction in Social Security payments for a period of years before the fund would return to balance. Remember, though, that would not be a reduction from the level of payments made today, but rather the higher inflation adjusted payments that would be made in 2037. The fact that there could be a problem beginning in 2037 may suggest that some minor changes should be made to the Social Security program today to ward off that eventuality. However, before we address the 2037 problem we need to address the 2010 problem.

It should be noted that many Republicans, who have been opposed to Social Security since its inception, continue to lie about Social Security. For instance, Jane Norton, no relation thankfully, who is running for to become a Senator from Colorado, recently called Social Security a ponzi scheme,

"With regard to Social Security, it has turned into a Ponzi scheme. The money that people pay into it should be there for when they are ready to retire."

Well, nothing could be further than the truth, but I guess poor Jane would never let fundamental facts get in the way of her anti-government crusade. Sadly, though, she is not alone. Most people have no idea that Social Security taxpayers have been building a nest egg. It is income taxpayers who have been underpaying taxes.

Some may ask, "well aren't Social Security taxpayers and income taxpayers the same?" The answer is that while there is some overlap they are not the same. Social Security taxes are only paid on wages and they are only paid on wages below $106,800. Moreover, Social Security taxes are paid on wages without regard to the number of dependents you have or whether you are earning the minimum wage. In contrast income taxes are reduced based on the number of dependents you have and the amount of income you earn. In addition all of your income over $106,800 and, more importantly all of your income subject to capital gains taxes is exempt from Social Security taxes. That means the richest Americans pay tiny fraction of their income in Social Security taxes, while the working classes pay a substantial amount.

In fact, the amount of Social Security taxes paid by wage earners is much higher than they realize. The amount of Social Security taxes deducted from your wages is 6.2% and there is an additional 1.45% deducted for Medicare. What most people don't recognize is that your employer matches those amounts. That means a total of 12.4% of your wages is paid for Social Security and 2.9% for Medicare. Most economists agree that if the employer did not have to pay his portion of Social Security or Medicare taxes, those amounts would be added to the employees wages. That is why the real tax rate wage earners pay for Social Security and Medicare is twice what they think it is.

But the wealthy in our society such as the top 400 income earners, don't have to worry about any of this because virtually all of their income comes from capital gains, not wages. Consequently, they pay very little in Social Security taxes as a percentage of their overall income. Additionally, their income tax rate is generally the capital gains tax rate of 15%, which is less than half the top tax rate of 35% paid on wages. That is why the universe of Social Security taxpayers and income taxpayers is very different both in terms of who is in each group and what overall percentage of their income they pay in taxes.

Whenever I hear someone who claims to be concerned about fiscal responsibility that we need entitlement reform but not a word about the income tax deficit, I can do little but shake my head. Approaching our nations fiscal problems that way is akin to a man whose house is on fire and who also has a crack in his basement. Rather than put the fire out, he decides to address the long-term problem by shoring up his foundation. That makes no sense for the homeowner and it makes even less sense for the federal government.

It is time to increase collections of income taxes in order that our tax structure will generate enough to redeemed the Treasury instruments that had been issued to the Social Security and other trust fund programs as needed to pay the beneficiaries of those programs. Only after the Congress and the people have shown the political will to do that should we go after the much longer term problem with Social Security.