Defaulting on Social Security Trust Fund Would Mean Massive Upward Transfer of Wealth

For Immediate Release: January 27, 2005

Contact: Debi Kar, 202-387-5080

Many proponents of privatizing and/or cutting Social Security benefits have implied or explicitly asserted that the Social Security trust fund does not exist. While it is true that the trust fund is "an accounting entry" and consists of "IOUs," this is true of most stores of wealth in a modern economy. The world is long past the day when wealth was primarily held as a physical asset, such as gold.

An implication of the claim that the trust fund does not exist is that the bonds held by the trust fund should not be repaid. In effect, this would mean defaulting on U.S. government debt. Such a default would have substantial redistributive consequences, shifting income from Social Security beneficiaries, most of whom are middle and lower income workers, to the mostly higher income taxpayers who are liable for the tax revenue that would be needed to repay these bonds.

Dean Baker, the co-director of the Center for Economic and Policy Research (CEPR) examined the distributional implications of such a default in 2001, when the leaders of President Bush's Social Security commission implied that a default was a possibility. The study, entitled "Defaulting on the Social Security Trust Fund Bonds: Winner and Losers," examined the distributional effects arising from what would be an unprecedented default on $6 trillion in government bonds.

The taxes collected to buy the government bonds held by the trust fund came primarily from the payroll taxes of low- and moderate-income workers. The Social Security payroll tax is a regressive tax on wages. It does not apply to interest and dividends and other forms of capital income. It is also capped at $90,000 so that high-end wage earners pay a smaller share of their income in taxes. The regressive nature of the tax is offset by the progressive nature of Social Security's benefit formula. However, this progressive benefit formula would become irrelevant if the government defaults on the bonds accumulated by the trust fund.

In the event of a default, it would be necessary to raise revenue through the regressive Social Security tax revenue that would have otherwise been provided by payments of interest and principle from the bonds held by the trust fund. Assuming that benefits are held constant, the default implies a large increase in the payroll tax, compared to a situation where the government honored its commitment to the trust fund. Alternatively, benefits could be cut, in which case workers pay for the default through reduced benefits.

While typical workers will lose if the government defaults on the bonds held by the Social Security trust fund, those wealthy individuals who pay most of the individual and corporate income taxes will gain. They will retain the money that otherwise would have been used to repay the bonds in the trust fund.

Based on the Congressional Budget Office's model of tax incidence, this study estimated that a default in 2002 would have lead to a net transfer of nearly $370 billion from households in the bottom 95 percent of the income distribution to the households in the top 5 percent. Further, the richest 1 percent of households would have a net gain of more than $270 billion, or an average of $300,000 per household. The net loss from default to households in the bottom eighty percent of the income distribution would be approximately equal to 10 percent of a year's income.The upward redistribution from a default increases if the trust fund is allowed to continue to accumulate bonds prior to the default, with the default occurring at the point when Social Security is first projected to need revenue from these bonds in 2018. In this case, the redistribution from the bottom 80 percent of households to the richest 5 percent would exceed $1 trillion (in 2001 dollars).