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Throwing FDR under the Bus?

Sunday, December 18, 2011

What the political class fails to understand about Social Security and the payroll tax.

By advocating and implementing the Social Security payroll tax in the mid-1930s, was President Franklin D. Roosevelt being unfair to the middle class and poor? Of course not—but we certainly wouldn’t be able to discern that by listening to the contemporary debate.

Today, Democrats and Republicans on Capitol Hill and in the White House certainly have their differences, but they seem to be unanimous on one unspoken point: FDR, it seems, was apparently dead wrong about the financial purpose of his Social Security system. He advocated it as an insurance system, in which the benefits paid to an individual were linked to the contributions paid by that individual.

But today we are told that the funding side of Social Security is a “tax”—the “payroll tax.” We are also reminded that it’s a regressive tax—a larger burden to the middle class and poor than the rich—but we are not reminded that it is a “contribution” to a system that will eventually pay out benefits in proportion to each individual’s contribution. Regressive taxes are unfair, the argument goes, because the rich shouldn’t be paying a lower percentage of their incomes than the middle class or poor. So, if Social Security is funded by a regressive “tax,” not an insurance “contribution,” then FDR’s administration implemented one of the most unfair taxes in our nation’s history.

FDR was unfair to the poor and middle class? Is that really what we think? Before we decide, it’s worth a look at the history. It’s also worth a look at what’s mysteriously missing from today’s political rhetoric surrounding the “payroll tax”: the whole truth.

Social Security, according to FDR

Nearly 80 years ago, FDR’s new system was touted as a method of providing a measure of economic security “against several of the great disturbing factors in life—especially those which relate to unemployment and old age.” Back then, the question of how we’d “pay for it” was certain to be a major issue, just as it is today for any new program. Astutely, FDR addressed that concern right up front in the push for his new system:

I believe that the funds necessary to provide this insurance should be raised by contribution rather than by an increase in general taxation.

In other words, Social Security was to be an insurance system, funded not by taxation, but by “contributions” to the system from each eventual beneficiary. It’s the reason the official title for the funding side is Federal Insurance Contributions Act (FICA), as opposed to something different, such as Federal Economic Security Tax for Elderly Retirees (FESTER?). Contributions into the federal government’s new system would earn credits that would, in old age, convert to safety-net income for the “contributor.” According to FDR, old-age benefits were to be linked to an individual’s working-age contributions; it was emphatically not to be a welfare system, by which old-age benefits were based on need, and not linked to previous “contributions” into the system. The contributions would be compulsory and would determine the eventual benefits.

In short, according to FDR, Social Security was to be a contributory insurance system. Therefore, describing its funding as a “tax” was implicitly forbidden:

We must not allow this type of insurance to become a dole through the mingling of insurance and relief. It is not charity. It must be financed by contributions, not taxes.

The only beneficiaries of Social Security who escaped paying the insurance premiums were those who were too old to have contributed anything into the system as of its inception. Everyone else since then has paid premiums into the system prior to collecting proportionate benefits from it.

Social Security today

The system has evolved in several respects, not the least of which is the rhetorical decoupling of benefits paid out from premiums paid in. That decoupling has opened up the floodgates for political word games, starting with the replacement of the word “contribution” by the word “tax.”

According to FDR, old-age benefits were to be linked to an individual’s working-age contributions; it was emphatically not to be a welfare system.

Decoupling the tax from the eventual benefit permits politicians to lament the regressive nature of the tax (the middle class and poor are taxed at higher effective rates) without mentioning the offsetting progressive nature of the benefits (the middle class and poor receive back a higher effective proportion of their lifetime incomes). It permits the politicians to propose payroll tax “holidays” without proposing offsetting future holidays in the benefits to be paid out. It permits them to propose “paying for” the tax holiday by increasing taxes on “the rich” without having to comply with the spirit of the Social Security system by increasing future benefits to those same “rich.”

These word games and political rhetoric were not invented in the current campaign. Four years ago, presidential candidate John Edwards, who was staking his campaign on the “two Americas” theme pitting the rich against the rest, gave us a stark example of the rhetorical games enabled by decoupling Social Security benefits from contributions, effectively throwing FDR’s legacy under the bus:

I don't understand why somebody who makes 50 million a year pays Social Security tax on the first ninety-seven thousand and not on the rest, while somebody who makes eighty-five thousand a year pays Social Security tax on every dime of their income.

If Edwards really didn’t understand it, his problem was one of ignorance of his own party’s history; if he actually did, he was at best misleading his audience. In any case, John Edwards had picked a theme that has staying power—to this day, it is influencing the political debate. The speeches around the “payroll tax holiday” have taken a cue from the John Edwards playbook: why shouldn’t the rich pay more to offset a cut in the regressive payroll “tax” (not “contribution”)?

Should we change Social Security’s funding method?

If evolving the Social Security system away from its original intent as a contributory insurance system towards a more welfare-like, progressively taxed system is what we really want to do as a society, then let’s have an honest debate about it, vote for the required reforms, and implement it. But let’s at least have an honest debate about it.

An honest proposal around the payroll tax might begin as follows:

My fellow Americans, Franklin Delano Roosevelt had good intentions when he advocated and implemented the Social Security system; however, his system has been unfair to the middle class and poor. It’s time to eliminate the unfairness from his program. I propose to do just that by taking two necessary steps: (1) eliminating the regressivity he built into the funding side of his system, and (2) de-linking old-age benefits from working-age taxes paid into the system.

Should we throw FDR under the bus? Maybe it’s time we did that, maybe not; in any case, it’s up to us. Let’s just be honest, and tell the whole truth about what we’re doing.

Steve Conover retired recently from a 35-year career in corporate America. He has a BS in engineering, an MBA in finance, and a PhD in political economy. His website is www.optimist123.com.

FURTHER READING: Conover also writes “The Class Warfare We Need,” “The Fatal Flaws of a Balanced Budget Amendment,” “How Democrats—and the Tea Party—Get Reagan Wrong,” and “The Myth of Middle-Class Stagnation.” Andrew G. Biggs contributes “Social Security Benefits in Context.” Alan D. Viard asks “Social Security and the General Treasury: Who's Raiding Whom?

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