Home > Economics, Politics, What's Wrong With U.S. > Social Security is NOT a Ponzi Scheme, It’s Just A Socially Regressive Tax Used To Fund A Mandatory Insurance Scheme

Social Security is NOT a Ponzi Scheme, It’s Just A Socially Regressive Tax Used To Fund A Mandatory Insurance Scheme

Lots of talk in the blogosphere about Social Security: is it a Ponzi scheme? Yes, no, maybe so…

I started writing this article thinking “of course its a Ponzi scheme”, then I went to thinking it wasn’t, then back to it was, and finally, I have settled on the conclusion that it is not a Ponzi scheme, “definitely not”, and I’m actually kicking myself for not realizing it sooner.

The short reason why Social Security is not a Ponzi scheme is because Social Security is not an investment scheme; instead it is a mandatory insurance scheme (akin to Obamacare).

First, I’m going to recognize that most of the recent discussion has been inspired by the GOP debates, and the allegations of several candidates/attention trolls (who don’t deserve to have their names in print) that Social Security is indeed a Ponzi Scheme. This has politicized the entire discussion, and now if you are a good liberal, you HAVE to believe that it isn’t a Ponzi scheme, and the good conservatives HAVE to believe it is one. Both sides are scrambling for whatever evidence that is in agreement with them, overlooking all evidence that is not, and at the end of the day it all boils down to semantics more than anything else: What exactly is a Ponzi scheme?

If we are using the classic definition of a Ponzi scheme, it is an investment scheme where old investors are paid off from cash inflows coming from new investors, instead of actual returns from the supposed investment itself. The schemes go belly-up after the cash outflows increase faster than the inflows, so any Ponzi scheme manager has to be very aggressive in recruiting new investors.

I want to go off on a tangent for a paragraph because I want to talk about projections. I am about to link you to what I like to call a “dirty projection chart”. You see these charts everywhere: politicians and budget wonks love to whip them out, especially when talking about government entitlement programs or taxes. I don’t take any of these charts seriously, and you shouldn’t either . Budget projections are the devil’s candy and can be used and abused to show or “prove” anything (Paul Ryan’s charts from the Heritage Foundation take the cake for the best example of my point). The Economist has a great one in this article, with projections all the way to 2085 using the super scientific “let’s draw a straight line with some minor wiggles in it” approach (I hope that isn’t what they did, but they didn’t tell us, so it might as well be). It’s pretty much garbage, and there is certainly no way to take it seriously without knowing the methods use to arrive at these projected numbers, but that’s never stopped the media and politicians from using them. Back to our main task:

The Economist article I just mentioned goes onto explain that Social Security is somehow not a Ponzi scheme because:

NO PONZI scheme in the history of the world has ever lasted 75 years. Ponzi schemes depend on garnering an ever-increasing pool of new investors to pay out returns to prior investors. When the potential pool of new investors runs dry, they collapse. This will occur when the scheme runs up against the natural limits of its recruitment strategy; in the ultimate case, it can’t keep going past the point where the entire population is already subscribed.

This should provide us with a hint as to why, as Kevin Drum writes (rebutting Shikha Dalmia), Social Security is not a Ponzi scheme.

Social Security doesn’t need to worry about marketing and recruitment, because it has the benefit of mandatory enrollment and the threat of imprisonment if you don’t pay your social security taxes. The only constraint faced by the social security scheme, or any Ponzi scheme for that matter, is a collapse in new cash inflows. Lucky for the government, it can just raise SS taxes to pay for any shortfalls.

So that led me to read Drum’s article, which at first seemed to me to be an entirely semantic argument that Social Security isn’t a Ponzi scheme because it is just a balancing act between taking in enough taxes to match the benefits it pays out. I say it is a semantic arguement because I think that what most people really mean when they say that Social Security is a Ponzi scheme is really that most people will not get out what they put into Social Security, with the exception of the earliest “investors”. To ignore this point is to miss the entire argument, and while Drum is technically correct in his assessment, I think he missed the most fundamental point to make against the Ponzi-accusations.

Essentially, Drum’s article relieved me of the notion that social security is some type of retirement program. It is, and always has been, an insurance policy against becoming unable to work, and it is just a coincidence that all people eventually become unable to work, and so are eventually entitled to a benefit. You and I are essentially fools for thinking we were ever going to get out more than we put in: insurance remains a profitable industry because it doesn’t pay out as much as it takes in from premiums.

The only reason we came to think of SS as a retirement programs is because of the huge benefits people have been receiving since its inception relative to their contributions, and also the fact that the Social Security Trust Fund was invested in securities that generated a real return. It had all the look and feel of a pension fund or 401K, and I am sure that is how politicians originally described it back in the day. I also vaguely remember Bush II and Co. implying that Social Security was some type of investment scheme when they were trying to privatize it (I am sure the Democrats joined them in supporting this charade).

Today’s newly retired will probably be the last generation to actually get a positive return on any of the contributions/taxes they have paid into it, and for my generation it just becomes another reason why we are screwed, a 12.4% stealth tax on our wages (here’s a cute table showing how little the interwar generation had paid into the system)(and yes, it is 12.4% tax; I know your employer pays for half of it, but your employer considers it part of your wages, and if the tax ended tomorrow, that money could be in your pocket without affecting your employer’s bottom line)(and all annual wages over $106,800 are exempt… is this possibly the most regressive tax in the US?).

So Liberals: be outraged that social security is not some income redistribution program designed to right the social injustices inflicted upon the lower classes by the rich (this should have been obvious to you from the cap on taxable wages).

Conservatives: continue to be outraged for much the same reason as before, because even though it isn’t a Ponzi scheme, it is paid for with a dirty, dirty, tax on your income, and we all know that taxes are STEALING and stealing is BAD (it’s in the Bible somewhere…)!

I personally would like the option to opt out of social security. I’m not sure if I would or not, I’d have to see what kind of premiums I would pay for similar insurance from the private market, but I know that Ron Paul wants to create an opt-out option. I am not sure why many liberals are opposed to the idea, perhaps they just haven’t thought about it enough or are somehow smitten with the narrative of Social Security being some sort of redistribution plan or retirement account.

EDIT: Here is Alex Tabarrok channeling Paul Samuelson and Paul Krugman to arrive at a essentially the same conclusion. Wish I would have read this first, would have saved me a lot of time.

  1. Preston Madison
    September 12, 2011 at 5:48 am

    Why insist on a classic definition for Ponzi Scheme while disregarding the nature of Social Security when the Social Security Act was signed into law? A bit of consistency would be nice.

    You’re taking the words “It’s a Ponzi Scheme” too literally. While Social Security isn’t technically a Ponzi Scheme, it has the essential Peter-robbing-Paul element to it, what I consider to be the crux of a Ponzi Scheme. And, given that FDR indeed said when he signed the Social Security Act into law that it would provide pension benefits upon retirement, it’s hard for me accept your coincidence notion. (qr.net/e345)

    I started considering the FICA taxes paid by my employer to be part of my wages around 1976, when Congress pissed off a lot of us by opting themselves out of paying FICA taxes. It was obviously the way to go in the mid-1970s if you were able to do so. Congress’s opt-out lasted about 10 years, until it became politically untenable for them to remain opted-out. (Now that I think about it, I’ll bet Congress managed to hide an effective pay raise with the “employer-paid” portion.) Check out how well Harris County, Texas, employees who were able to opt out of FICA taxes did with their investments — yes, investments.

  2. September 12, 2011 at 12:14 pm

    I totally agree with you that it’s basically a semantic argument whether it is a Ponzi scheme or not… there are enough “Ponzi game aspects”, to borrow Krugman’s phrase, that it doesn’t really matter if it is an insurance or investment vehicle: it still has the element of taking one person’s money to give another. I am reminded of something that looks and quacks like a duck, but someone is trying to say it is another variety of water fowl. The main reason I wanted to use the “classic” cut and dry definition is because that is what they used in the articles I linked to, so I wanted to provide consistency for those readers and let them know that I wasn’t disagreeing with Drum per se, but I do note that he misses the point in being so technical.

    Nice link to FDR’s words: I assumed that SS was originally sold to the public that way, but I have never read or seen any of the rhetoric used by its original proponents. One of the bigger issues I try to explore with my blog is the how elected officials are often just idea marketers for the rich, privileged, and powerful. They are elected by the people, but they are really spokespersons for the corporate interests who sponsor their candidacies. Political parties are all just theater, designed to make us think we have some sort of choice as voters. In this way, I don’t take anything an elected official says at face value, particularly at the national level. They say what they need to in order to move “the agenda” along. I think if you read between the lines of what FDR says: “to act as a protection to future administrations of the Government against the necessity of going deeply into debt to furnish relief to the needy”… the rich didn’t want to bail out the poor again (that’s what the Great Depression had seemed like to them), so they started a program to tax poor people and give them mandatory insurance.

    RE: congressional FICA opt-outs: I didn’t know about that chapter in history, or Harris County… very interesting, thank you for bringing it to my attention!

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