Academic journal article Independent Review

The Anatomy of Social Security and Medicare

Academic journal article Independent Review

The Anatomy of Social Security and Medicare

Article excerpt

Social Security in the United States is the largest government expenditure program in the world, with expenditures of $823 billion in 2005. That figure includes only the cash retirement benefits paid. Social Security's companion policy that covers the elderly's medical expenses, Medicare, had expenditures of another $299 billion. Taken together, the federally financed retirement benefits amounted to $822 billion.

Despite its vast size and its effects on almost all Americans each year of their lives, the Social Security system is probably the most poorly understood government policy of all. The jargon alone is incomprehensible: we hear of unfunded liabilities, infinite and seventy-five-year time horizons, average indexed monthly earnings and primary insurance amounts, trust funds and lockboxes, wage indexing versus price indexing of benefits, bendpoints in the benefit formula, carve-outs and add-ons, replacement rates, covered and uncovered earnings, and so on. Probably no policy, however, is more important to understand because its consequences for the way we live and for how well we live are monumental.

In this article, I focus on the fundamental issues surrounding the design of a system to provide retirement benefits to the elderly. I begin by explaining how Social Security works.

Social Security Basics

The retirement benefits provided to the elderly by Social Security (and Medicare) each year are financed by taxes on workers' earnings. The benefits received by those persons now retired do not come from a fund they accumulated by paying taxes during their working years. All the taxes they paid in earlier years were spent on providing benefits to those retired then. Similarly, the taxes paid by workers today do not go into a fund to finance their own retirement; they are spent in providing retirement benefits to those retired now. Social Security is thus an income-transfer program, with income transferred each year from workers to retirees.

But, you may ask, what about the trust funds we hear about all the time? Doesn't the money go into the trust funds? It is true that there are trust funds, but they play a minor, even negligible, role in the operation of Social Security. They are temporarily playing a somewhat larger role right now than they did in the past or will in the future, but it is a minor factor even today. (In 2005, eighty-four cents of each dollar in workers' taxes were paid out immediately as retirement benefits; only sixteen cents went into the trust funds.) I discuss the trust funds later, but we can get a clearer understanding of how Social Security operates by first ignoring them.

A retirement system that finances retirees' benefits by taxing younger workers' earnings (as Social Security does) is said to be run on a pay-as-you-go (PAYGO) basis. Because no fund is being accumulated on behalf of the taxpayers, this arrangement is also sometimes called an unfunded system.

A PAYGO system bears an eerie resemblance to a Ponzi scheme (also known as a pyramid scheme), named after Charles Ponzi, who apparently first utilized this scheme to swindle investors. In 1920, Ponzi began to borrow money from investors, promising them a return of 50 percent after only forty-five days. (On an annual compound basis, this is comparable to a return of 2,500 percent!) He paid off the early investors by using the funds provided by later investors (as Social Security paid off early retirees by taxing later retirees--that is, younger workers); he did nothing with the funds to generate such fantastic returns (as Social Security does not invest the taxes paid by workers). Like most pyramid schemes, Ponzi's system collapsed, leaving the later investors with nothing because their funds had been used to pay off the earlier investors. The entire swindle lasted less than a year. Ponzi pleaded guilty to mail fraud and spent four years in jail. Since that time, pyramid schemes have been illegal. …

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