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January 12, 1990

Financing Social Security
Although the federal budget is in overall
deficit, the Social Security system has been
running increasing surpluses in recent years.
Projections suggest that this surplus will continue
to rise for at least the next twenty years, as annual
payments to beneficiaries rise less rapidly than
receipts from payroll taxes. To the extent these
surpluses increase national saving and investment, the total output of the U.S. economy will
grow, easing the burden on future workers of
supporting future retirees.
Whether these surpluses do, in fact, lead to
increased saving and investment depends, in
part, on what happens to the deficit in the nonSocial Security portion of the federal government
budget If this deficit rises, saving likely will be
lower than the Social Security surpluses alone
would suggest, and the burden of meeting
obligations to future retirees will be greater.
This Letter describes how Social Security is
financed and discusses how alternative uses
of the Social Security surpluses may affect the
nation's ability to support its rising population
of older citizens in the twenty-first century.

Providing for retirement
All societies develop methods of supporting
the elderly when they cease to earn income. One
approach is for individuals to accumulate savings
during their working lives, which they can use to
support themselves in retirement. If those savings
are invested in productive assets, the total output
of the economy grows more rapidly over time,
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more during their retirement than they had set
aside. Pension funds are an institutional example
of this approach.
An alternative approach is for each generation
to support the generation that came before it. In
extended families, for example, working couples
support their non-working parents. They are willing to do this because they count on their children, in turn, to support them later in their lives.
The U.s. Social Security system, to a large extent,
formalizes this arrangement. While young, each

generation provides benefits to the generation
that came before it, and in turn, receives benefits
from the succeeding generation.

Broadly speaking, this second approach to
providing for retirement represents a pay-as-yougo approach. In the most extreme case, benefits
to Social Security recipients in any given year
come directly from the payroll taxes collected
from workers in the same year. In this case, the
system is a pure inter-generational transfer program, and no net saving occurs. Nonetheless, as
long as the size of each succeeding generation
exceeds the size of the generation before, retirees
will receive more in benefits than they contributed while working, even though payroll taxes
per worker remain constant. Nobel-laureate
Paul Samuelson has described this return as the
"biological rate of interest."
A pay-as-you-go system can run into problems
if population growth slows, since this causes
the ratio of young workers to older, nonworking
persons to decline. In such a circumstance,
higher taxes may have to be imposed on the
young to maintain the same level of benefits to
the old. Moreover, cyclical fluctuations in tax
revenues can cause temporary liquidity problems
for a pay-as-you-go system.
Because of these potential problems with a pure
pay-as-you-go system, the u.s. Social Security
system is organized into trust funds that allow
some mismatch between receipts and disbursemeots iI19_l}y_giy~Il'iear..pCl.YrQILtax~JeyjedQll
workers and their employers, which are officially
termed "contributions," are paid into the OldAge, Survivors and Disability Insurance (OASDI)
Trust Funds. In turn, Social Security benefits are
paid from these trust funds. This trust fund
system was designed to insulate benefit payments from current tax receipts and so assure
participants that their benefits would be paid.
When the system was established in 1935, it was
projected that, over time, the trust funds would
accumulate sizeable reserves, which would

generate interest earnings to pay a significant
portion of the annual benefits. To ensure that
adequate initial reserves were accumulated, no
benefits were to be paid until 1942, although tax
collections were to begin in 1937. At the same
time, however, the system never was intended to
operate like a private pension fund, since benefits also were to be paid directly out of current
tax receipts.
In practice, the trust funds did not accumulate
large balances, because Congress frequently
raised benefit levels and extended coverage to
new groups of recipients. As a result, over most
of its history, the system has operated on a de
facto pay-as-you-go basis, with benefit payments
out of the trust funds each year being financed
mainly from that year's payroll tax receipts. Each
generation of retirees was able to receive in
benefits more than it had contributed, however,
because the working population was growing
steadily and because rising real incomes made it
possible to levy increasing taxes on those working. In addition,for a long period after 1950,
the ratio of the assets of the trust funds to their
annual outlays was allowed to decline.

The coming surplus
By the early 1980s, the ratio of reserves to
annual outlays had become dangerously low. In
1981, the assets of the OASDI trust funds were
sufficient to cover only two months of benefits.
There was concern that if payroll tax receipts
were to fall in any future recession, the trust
funds would be inadequate to meet monthly
payments to beneficiaries. Largely as a result
of this concern, the Congress passed the Social
Security amendments of 1983.

declining to zero in 2050. This reserve build-up
is necessary because the currently-young generation-the baby-boomers-is unusually large and
will place heavy demands on the system when it
retires and begins receiving benefits in the second and third decades of the next century. To
pay those benefits solely from payroll taxes
levied on the next generation would require
sharp increases in tax rates in the future.
A recent study by economists at the Brookings
Institution (Can America Afford to Grow Old?,
by Aaron, Bosworth, and Burtless) estimated that
under pure pay-as-you-go financing, the combined employee-employer payroll tax rate could
be cut to less than 10 percent in 2005, but would
then rise above 15 percent by 2030. Current law,
in contrast, calls for a constant tax rate for the
Social Security portion of FICA of 12.4 percent.
By levying taxes now that are higher than required to meet current benefit payments, the
system will build up reserves that can be used
to finance benefits for the boomers in the future
and, it is hoped, equalize the burden between
the boomers and their children.

Long-run balance
The tax and benefit changes introduced in 1983
were designed to piacethe system in presentvalue, actuarial balance over a 75-year horizon.
However, as time passes and the working (and
tax-paying) population increases more slowly
than the beneficiary population, the longer-run
balance of the system likely will be upset. Projections suggest that without further changes in
taxes or benefits (apart from those already mandated), the trust funds will be out of actuarial
balance for the 75-year horizon beginning in the
year 2000, in the sense that the present value of
tax receipts over that period will fall short of the
present value of benefits.

A modest increase in taxes between now and the
end of this century, followed by further increases
These amendments, which followed the recin about 2020 and 2050, would keep the funds
ommendations of the National Commission on
more or less permanently in actuarial balance.
Social Security Reform (the Greenspan CommisSuch increases also would prevent the funds
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short-run liquidity problem facing the system,
projections are extremely tentative, since they
but also to put it into long-run actuarial balance,
depend on the growth of the economy and of
with the present value of projected future outlays
the population in the very distant future.
close to the present value of future receipts. The
reform involved a series of increases in payroll
Easing the burden
taxes together with changes designed to reduce
Regardless of the way in which the consumpthe future growth of benefits.
tion of the retired, nonworking population is
financed, it is always the case that this consumpAs a resu It of th is reform, the trust funds are
tion must be met from the output of the current
projected to grow sharply over the next thirty
working generation. Building up financial assets
years, reaching a peak in the year 2019, before
in a social insurance fund like Social Security

does not by itself alter the cost of providing
for the elderly. However, the burden of these
demands on the young may be affected by
decisions regarding the way in which Social
Security is financed and its accumulated surpluses are invested.
In particular, these decisions may affect the
shares of GNP that are saved and invested and so
influence how large GNP will be in the future.
For example, if the present generation of workers
reduces current consumption (including government consumption) in response to the recent rise
in Social Security taxes, the increase in Social
Security surpl uses wi II represent an increase
in national savi ng, and more of the nation's
resources will be devoted to productive investment. This will mean that future GNP will be
higher because workers will be equipped with
more capital, and as a result, the future working
generation will be better able to provide for the
elderly. However, this will not be the case if the
Social Security surplus is offset by greater deficits
elsewhere in the federal government budget.
The Brookings study referred to earlier illustrates
how Social Security-related financing and spending decisions can affect the distribution of the
burden of providing for the elderly in the future.
This study compared the implications of two alternative scenarios. Both scenarios maintain the
current Social Security benefit schedu les and
raise payroll taxes whenever necessary to keep
the Social Security system in actuarial balance.
The first scenario uses the surpluses that
accumulate in the trust funds to finance
increases in spending and/or reductions in taxes
elsewhere in the government's budget. Thus, the
combined federal budget deficit remains constant as a share of GNP, and the surpluses do not
add to national saving.

tion means that all of the accumulations to
the Social Security funds represent additions
to national saving and investment.
In both scenarios, the Brookings study assumes
that the proportion of national income that is
saved by the private sector remains constant and
is not affected by the saving of the government
sector. Economist Edward Denison has found
evidence to support this view, although some
economists stili would challenge it.
The results of the Brookings calculations are
striking. Under the second scenario, both the
working population and the retirees enjoy higher
living standards in the next century. Beginning in
about 2010, overall consumption (public and private) is higher by one to three percent and retiree
benefits by three to five percent. Moreover, the
cost to the present generation in the form of
lower private and public consumption is surprisingly small. The second scenario implies an
average level of total consumption between now
and the beginning of the next century that is only
one percent lower than in the first scenario.

Increased saving needed
To the extent that government deficits reduce
national savings, and hence nationaiinvestment,
they transfer the nation's resources to the
current generation and away from future generations. This transfer occurs regardless whether
deficits arise in the Social-Security or non-Social
Security portions of the overall budget. This
suggests that policy makers should focus on the
overall budget, rather than on its components.
At the same time, however, the coming change
in the age distribution of the population suggests
that it may be prudent to try to raise the national
saving rate to ease the burden of supporting the
aging boomer generation. A pol icy that aimed to
hold the deficit in the non-Social-Security part
of the budget constant, despite the growing surpluses in the social insurance funds, might help
to achieve this result.

The second scenario, in contrast, does not allow
the trust fund surpluses to finance larger deficits
elsewhere in the federal budget. Instead, fiscal
policy is adjusted to ensure that the deficit in the
.-----noft=Soeial-5eetlritypart-t)f-the-btidget-femairls---------------- ------- .--constant as a share of GNP. This fiscal assump-

.- -..------Briilfl-Motley------Senior Economist

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San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
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