Sunday, January 08, 2006

Interest on Interest: a threat

The Treasury Bonds in the Trust Fund are real. At least those purchased by current payroll tax dollars. They are the product of actual payroll dollars extracted from real paychecks. And in turn the interest earned on those Bonds is real. The General Fund would have had to pay those same dollars to a bond investor if they didn't have the Trust Fund to borrow from instead.

But the Interest on the Interest is more troubling. It is second order. The General Fund is simply assuming an obligation for the convenience of not reducing the current payroll tax to make it a real pay-go system. Now the decision to raise payroll taxes in 1983 was perfectly necessary, for the most part it just restored paygo, the amount of excess payroll tax over cost actually collected is vastly overestimated by just about eveyone, the Trust Fund did not break the $100 billion mark until 1988. And investing the suplus in Special Treasuries was equally sensible, why set up any elaborate system when the whole Fund would be depleted by 2023 anyway.

But 2023 has now turned into 2041, and given not very extraordinary numbers may begin to stretch out even farther. Now the effect of reinvesting the interest in the Special Treasuries back into Special Treasures starts to bite. The General Fund starts assuming an unfunded liability, one that compounds over time as interest on interest starts to pile up. Now no one who believes in the Full Faith and Credit of the United States (and I certainly do) doesn't agree that that money is owed, the question is whether this is the best way to do it in the interests of all taxpayers in the future.

And the answer is 'No'. Given that the Trust Fund will likely be in surplus well past 2041 and perhaps forever we need to reexamine how we manage it. And the answer is pretty clear: stop reinvesting interest into Treasuries. It doesn't produce real cash flow into the Treasury, it just masks the cost of borrowing. The solution is obvious, interest on existing Treasuries and any excess of income excluding interest over current cost needs to be invested in an alternative economic vehicle. In the short term this means some borrowing pain, in the long term it shifts the reponsibility for redeeming those assets off of the General Fund. Moreover it offers the opportunity for the General Fund to eliminate any responsibility long term. If in addition to taking all interest on the current Trust Fund into other vehicles, it actually start to pay down the current principal it gradually reduces its interest burdens overall.

But given the actual financing of Social Security this means reducing the flow of other income into the system. Which means cutting the tax on Social Security benefits that applies to more affluent recipients (a relatively small amount of income) or cutting or diverting a portion of the payroll tax.

1 comment:

Jim Granitsas said...


You are a smart guy, but I still think it is all a waste of time.