Mitchell’s Musings 5-29-2017: Creative Accounting

28 May 2017 9:43 AM | Daniel Mitchell (Administrator)

Mitchell’s Musings 5-29-2017: Creative Accounting


Daniel J.B. Mitchell


In June 2011, California governor Jerry Brown faced a problem. He had a budget crisis inherited from his predecessor, Arnold Schwarzenegger. Brown hoped to resolve the problem by extending certain temporary taxes that were due to expire. But he needed a few Republican legislative votes to put the tax issue on the ballot for voters to decide – a two-thirds vote of the legislature would have been required - and no Republicans would go along. However, the budget needed to be passed before the July 1, 2011 start of the new fiscal year, and budgetary rules required a “balanced” budget.[1] So eventually an extra $4 billion in revenue was simply assumed, although it was not specified which tax or taxes would supply the extra revenue. With the assumption of the phantom $4 billion, the proposed budget was balanced on paper and could be passed.


Readers will quickly discern that just assuming more revenue, while it solved an accounting problem, did not address the real problem, insufficient tax receipts. The revenue needed for the proposed budget to be in actual “balance” was not produced by just assuming it would appear, so the true problem was not resolved. If extra revenue is assumed that then doesn’t appear, and if programs are continued absent that extra revenue, someone eventually must pay. In the California case, presumably that someone would be future taxpayers, since state debt will rise. Or perhaps some future programs that would otherwise be in later budgets won’t be undertaken because of that debt.


Essentially, what an accounting trick does is to allow some course of action to go forward. But eventually there will be consequences.


That conclusion from this California anecdote is readily evident. And it can be applied more generally. From time to time, the idea of using a trick to deal with Social Security’s long-term “underfunding” is suggested. Sometimes the trick involves giving recipients less in the future without making it apparent. Fiddling with the cost-of-living provision falls into that category. But sometimes the idea is to protect future recipients from cuts in the future, also without making that goal apparent.


A bit of history: Social Security, when it was enacted in 1935, was made to look like a private pension plan of the type that existed at the time in a few big firms. So it had a mix of employer and employee contributions, a trust fund, and a defined-benefit schedule. The trust fund was invested in U.S. Treasury securities. The fact that it was made to resemble a private pension plan was really for political purposes; such a structure made the plan – a radical innovation in its time – seem more normal. The trust fund was invested in Treasuries rather than in the stock market because in the midst of the Great Depression – which had begun with the market crash of 1929 – putting money into stocks would hardly have been reassuring.


In more recent history, however, the idea of putting some of the Social Security trust fund into the stock market has been raised on the grounds that stocks, over long periods, have earned more than Treasuries. So if you earn more on what is in the trust fund, there is less pressure to raise tax revenue for the program by increasing payroll taxes. But various objections have also been raised. In some cases, the stock market suggestion is combined with the idea of phasing out or diminishing the defined-benefit element of Social Security and substituting individual accounts, basically a variant on IRAs. Conservatives who don’t like Social Security on ideological grounds favor that idea.


But liberals can see earning higher returns via the stock market as a way of preserving the program “as is” and its promised benefits. A recent paper makes just such a case.[2] The paper takes up various objections to diverting money to the stock market and puts them aside. For example, it raises the issue of whether Social Security purchases of stocks would “disrupt” the stock market (not clear what disrupt means) and finds that it wouldn’t be a problem. But the paper misses the macro perspective. Social Security resembles a private pension plan. But as a near-universal federal program, it really isn’t an ordinary pension.

There is a key problem facing Social Security as a system when it is seen as an ordinary pension plan. Viewed that way, it is underfunded. However, Social Security is basically a pay-as-you-go transfer arrangement (today’s taxes pay current benefits). But it also has some savings built up – but not enough – for the demographic bulge created by the baby boom/baby bust. So the trust fund will go to zero before all the boomers have collected what current formulas suggest they will be owed.


Of course, the most obvious solution for preserving the system as it is would be to raise the associated employer and employee payroll taxes. But Washington gridlock prevents that step. So if earnings on the trust fund were raised sufficiently, those extra returns might get the system over the demographic hump.


Now, in theory, you could make those earnings go up by simply raising the interest rate paid on the Treasuries held by the system. In effect, Social Security would become solvent on paper and the national debt would rise to cover the added interest costs. The accounting trick would thus protect future boomer retirees and put the burden of paying for them on future taxpayers. However, the fact that it is a trick is too transparent for such a step to be undertaken. Why should the Treasury pay a higher interest rate to Social Security than to other lenders, folks would ask?


Diverting investment of the trust fund into stocks is a more subtle trick, but it is nonetheless a trick from a macro viewpoint. All that would really happen is that the identity of the holders of Treasury securities and stocks would shift. The trust fund would buy stocks. Those stocks would then not be available for institutions and individuals that otherwise would have bought them. On the other hand, more Treasury securities would have to be sold on the market since Social Security would not be buying them. So those institutions and people that would have bought stocks will end up buying Treasuries. There might be some second-order effects arising from this shuffling of portfolios, but in the end that’s all it is: a portfolio shuffle.


In, say, the year 2040, when the boomer retirement will be at or near its peak, the then-existing GDP will be whatever it is and some of it will be consumed by retirees. The more they consume, the less will be available for anyone and anything else. That is the underlying macro significance of the baby boom demographic bulge. More for the elderly; less for others. Reshuffling the portfolio has no obvious impact on the total size of that future GDP. It doesn’t, for example, raise national saving now which might – through more investment – lead to a higher GDP by 2040. So the trick entailed in diverting the trust fund into the stock market has only one effect. It tends to ensure that future retirees will be fully protected from cuts in promised benefits because the system will be “solvent.” The flip side of that solvency is that the incidence of paying for the demographic bulge will be borne by someone else.


Let’s do some simple examples. Imagine a society in which every year there is one birth at age 0 and everyone dies at their 80th birthday. Persons age 0-19 are “children-dependents.” From age 20 through age 59, they are active workers and parents. From age 60 until they die, they are retirees. Children-dependents are supported by intra-family transfers from parents, not the government. Retirees are supported by a government-operated, pay-as-you-go, tax-based Social Security system.


As we have set up this story, there will be a steady state in which at any time there will be twenty children (aged 0-19), 40 active workers-parents (aged 20-59), and 20 retirees (aged 60-79) in society. Let’s now suppose further that each active worker earns 1 dollar. So total GDP will be $40. The 40 active workers, in producing that GDP, are supporting both their non-working children and non-working retirees. Forty workers, in other words, are supporting 80 people.


If every person receives an equal income, that income will be 50 cents. So the active worker-parents will, through intra-family transfers, divert $10 of GDP to their 20 children (so each child will receive 50 cents). The twenty retirees are supported by Pay-Go Social Security, so $10 will be taxed away from active workers and paid to the retirees (giving each retiree 50 cents). The 40 active workers thus will have $20 left for themselves (50 cents per capita). This steady-state situation is shown on Appendix Figure A1.


Now let’s create a baby boom demographic bulge. Suppose in one year, there are 11 births (10 extra babies) instead of one. Thereafter, the birth rate goes back to one per year. There will be 30 children total in society until, after 20 years, the boomer-children become active worker-parents. Figure A2 show a typical year before the boomers age into the workforce. Let’s assume that parents want to maintain per capita consumption of children at 50 cents. They will have to divert $15 of the $40 GDP they are generating to their 30 kids. The number of retirees is still 20 so $10 will still be taxed away from active workers to support the Pay-Go Social Security system and its promise of a retirement income of 50 cents/retiree. Active worker-parents will receive only 37.5 cents per capita for their consumption, assuming they want to sacrifice to keep their kids at 50 cents per capita.


When the boomers become workers, society faces two choices. It can continue Social Security on a Pay-Go basis, and not put anything away in a trust fund for the eventual retirement of the boomers. Or it can pre-fund the eventual increment of boomer-retirees. Figures A3 and A4, respectively, show the alternatives. In Figure A3, with the number of children back to 20 (baby bust), the intra-family transfer/diversion from the enlarged GDP of $50 is back to $10. There are still only 20 retirees so the tax diversion from the $50 GDP is again only $10. We now have 50 workers supporting 90 people which leaves more income for the active workers than when only 40 workers supported 90 (when the boomers were children) or when 40 workers supported 80 people (before the boomers were born). Boomer-workers have a per capita income of 60 cents if there is no pre-funding.


If there is full pre-funding of the extra boomers’ retirement, we will need to put aside $100 in the trust fund.[3] (The 10 extra boomers will be retired for 20 years and get 50 cents per year; we’re assuming zero interest on the trust fund.) As Figure A4 shows, if we tax the 50 workers $12.50 (instead of the previous $10 with no pre-funding), over the 40 years before retirement of the boomers, the extra $2.50/year will add up to $100). Even so, the 50 active workers will do better than the steady-state and better than when the boomers were children. Their per capita income will be 55 cents.[4]


So what happens when the boomers become retirees? If the tax for Social Security is not raised, the $10 tax taken from the $40 GDP will produce only a per capita income for retirees of 33.3 cents ($10/30), as shown on Figure A5. If, on the other hand, sufficient income in earlier years had been put aside to build the trust fund to $100, as Figure A6, all groups – children, active workers, retirees – get their 50 cents per capita.[5]


What if there is no prefunding and also a decision is made to give the boomer-retirees their promised 50 cents per capita anyway? The money has to come from somewhere. As Figure A7 shows, if the incidence falls entirely on active workers, their per capita income falls to 37.5 cents, assuming they continue to give their children 50 cents per capita. It’s worth noting that this result during boomer retirement is the same as what occurred when the boomers were children. But because no government agency was involved when the boomers were kids (the transfer was intra-family), we didn’t call what occurred a “crisis.” When a government agency is involved, however, we do. Go figure!


Let’s get back to the proposal to put some Social Security funds into the stock market. Which of the various figures is most analogous to that proposal? Figure A7 is the closest analogy. As noted, putting the money in the stock market does not make GDP bigger. And more money has not been diverted from prior GDP to produce an actual reserve of resources.  But putting funds in the stock market does make the Social Security system solvent on paper. Politically, the boomers are thus protected. Still, the incidence has to fall on someone other than retirees, as in Figure A7. That figure assumes the incidence falls on active workers by the mechanism of a higher tax. But it could fall on them through inflation.


The point is that if you have a $40 GDP and 90 people to split it up, the average per capita income has to be less than when you have a $40 GDP and 80 people to split it up. With a $40 GDP and 90 people, you can’t give everyone 50 cents per capita. It’s no more complicated than that. Putting Social Security money in the stock market doesn’t change that logic. It just rigs the game – assuming that stocks do earn more than Treasuries in the future - so that the boomers are not the ones who take a hit (because their system appears solvent). If they don’t take a hit, the incidence has to be on active workers and/or their children.


There is another danger in resurrecting the stock market approach. As noted earlier, that idea has been more associated with dismantling the current structure of Social Security and turning it into individual IRA-type accounts. So re-introducing the dormant stock market argument risks destroying Social Security, not protecting it.

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Footnotes


[1] We are putting aside here what “balanced” might mean. That matter is a separate issue we don’t need to deal with here.

[2] Gary Burtless, Anqi Chen, Wenliang Hou, and Alicia H. Munnell, "What Are the Costs and Benefits of Social Security Investing in Equities?" (Boston College, Center for Retirement Research, May 2017), available at http://crr.bc.edu/wp-content/uploads/2017/05/IB_17-10.pdf.

[3] We are fully funding just the extra boomers, not all retirees.

[4] The gain is due to the baby bust. The 50 active worker-parents are supporting only 20 kids. In the steady state, we had 40 workers supporting 20 kids.

[5] Note that this result does not depend on earnings on trust fund monies, which are zero. At the macro level, what has happened is that in prior years real resources were diverted from GDP consumption, stored, and now paid out. 

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