Yes, Social Security Affects Long-term Deficits. And Here's How to Change That

Defenders of Social Security say all the time that this program has nothing to do with the deficit, and thus cuts to Social Security shouldn't be part of any long-term fiscal deal.

In fact, though, Social Security's future costs will drive future deficits, and that reflects a monumental blunder by Washington that can still be corrected.

Here's the deal: As I explained last week, the Social Security trust funds are filled with $2.6 trillion worth of IOUs from the U.S. Treasury—a big pile of make-believe-money, not actual assets, in the form of special federal bonds the program will begin redeeming as the Boomers retire. The Treasury will pay for those redemptions out of general revenues, and this expense is categtorized as interest on the national debt. Looking ahead, over the next 25 years, the CBO reports that interest on the debt will be the fast growing part of the federal budget—and a key driver of future deficits.

In the next decade alone, interest payments will climb from around $224 billion this year to $857 billion in 2023. From there, interest payments will rise much higher, to well over $1 trillion a year. 

Mostly, our elected leaders won't be able to do a thing as interest payments soar; debts simply have to be repaid. But there is one category of interest payments that Congress can control—and that's redemptions of bonds by the Social Security and Medicare trust funds. If we raised the payroll taxes, cut benefits, or squeezed more efficiency out of these programs—or some combination of the three—the trust funds wouldn't have to cash in so many bonds and the U.S. Treasury wouldn't have to pay out so much money. This would mean lower future deficits. So that's why the Social Security debate can't be removed from the deficit debate. 

But it should never have been this way. Social Security and Medicare ran surpluses for decades, and that money should never been lent to the U.S. Treasury to cover the government's daily operating costs. It should have been stashed away in the "lockbox" that Al Gore advocated and, even better, invested in a mix of stocks and bonds that would have greatly increased the value of the surpluses, so they'd stretch much further into the future than is now projected. 

While the big damage has already been done, it's not too late to revive the lockbox—or to better invest the trust funds.

Consider the following scenario: Congress agrees to raise the payroll tax cap on Social Security to bring it more in line with historic norms, and Social Security continues to generate modest surpluses for another decade or so. These surpluses are not scooped up by the Treasury in return for yet more IOUs, but instead are invested in a savvy fashion—the way that universities and endowments invest, not to mention the sovereign wealth funds of other countries. 

Meanwhile, instead of wating until the 2020s to start redeeming the bulk of its Treasuries, Social Security begins to so immediately (which would drive up deficits) and then turns around and also locks away that money in investments that will bring a greater return. 

I haven't run the numbers, but the net result of this plan would be to spike deficits in the short term, but greatly expand the size of the main Social Security trust fund over time, depending on investment returns. This could make the whole issue of cutting benefits moot. 

Let me say that again: By modestly raising the payroll tax and shifting Social Security's trust funds into better investments, Congress could avoid any cuts to benefits and extend the program's solvency. And all it needs to do is accept higher deficits in the near-term, when federal borrowing costs are at a historic low. That sounds like a good deal to me.