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September 17, 2009
What We Can Learn from Social Security: Why Regressive Taxes Are Used to Fund Progressive Entitlements
Joseph J. Thorndike

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As Congress gets serious about healthcare reform, money remains a stumbling block. Lawmakers have yet to agree on how to foot the bill for expanded coverage, and with the weather cooling down, arguments are sure to heat up. Besieged on every front, supporters of reform will cast about for new answers to an old question: What's the best way to pay for a major new entitlement?

The history of Social Security can shed light on that question. For almost three-quarters of a century, this New Deal creation has defined the scope and shape of the American welfare state. In some respects, Medicare may seem the more appropriate analogue for the current debate over healthcare finance. But Social Security established enduring norms that crucially shaped Medicare funding. If we want to understand the best way to finance healthcare, we need to start by looking at the way we chose to finance retirement security.

Why, Franklin, Why?

The central question in the history of Social Security finance can be posed as a puzzle: Why did Franklin Delano Roosevelt, progressive hero, choose a regressive levy to finance his most enduring contribution to the American welfare state?

To some degree, this question is misguided. As historian Mark Leff pointed out in his 1983 article, "Taxing the 'Forgotten Man,'" it presumes that Roosevelt was always and everywhere opposed to regressive taxation. If that was the case, then the payroll tax stands out as an aberration from the New Deal norm. But in fact, FDR's antipathy toward regressive taxation was not complete. True, he didn't much care for taxes that burdened the poor, and he dearly loved progressive levies on the rich. But he was willing to tolerate regressive taxes when they proved necessary or expedient.

But why did Roosevelt insist on using payroll taxes as the sole funding mechanism for Social Security? He certainly had options. Most other countries offering public pensions combined payroll taxes with contributions from general revenues. As historian William Leuchtenburg observed, "In no other welfare system in the world did the state shirk all responsibility for old-age indigency and insist that funds be taken out of the current earnings of workers."

Meanwhile, domestic champions of old-age insurance -- people like Francis Townsend, a physician activist who mobilized a vocal constituency to support his plan for generous public pensions funded by a national sales tax -- were hardly agreed on the desirability of a payroll levy. Neither, for that matter, were political leaders at the state level, where contributory taxes were not used to finance pensions.

More important, many of Roosevelt's own advisers were disinclined to rely exclusively on payroll taxes, or even to insist that retirement pensions pay for themselves. Harry Hopkins and Rexford Tugwell, both close to the president, were united in opposing the tax on fairness grounds. The Treasury Department, meanwhile, worried that a payroll tax would shrink aggregate purchasing power at a time when "underconsumption" was already getting blame for causing the Great Depression.

Indeed, early Social Security proposals, including those prepared by FDR's handpicked advisers, did not rely exclusively on the payroll tax to fund pensions. Instead they made room for contributions from general revenue (which in those days came from a roughly equal mixture of excise and income taxes). Roosevelt quickly nixed this idea, insisting that the program be entirely self-financing and contributory. He sent his advisers back to the drawing board, and they reluctantly drew up a new version of the program hewing closely to the president's restrictive guidelines.

Economic or Political Genius?

So why the intransigence from the White House? Two explanations seem most plausible: fiscal conservatism and political genius.

Generally speaking, "fiscal responsibility" always ranked near the top of FDR's list of political priorities, right after "end the Depression" and "reform American society." For most of the 1930s, items 1 and 2 sucked all the air from most policy debates, suffocating budget concerns in the process. But FDR's commitment to a distinctive strain of fiscal conservatism did survive the spending and regulatory onslaught of the early New Deal. Kept alive by the support of Treasury Secretary Henry Morgenthau, it surfaced at odd but crucial moments.

One such moment occurred during the Social Security debate. Roosevelt was genuinely committed to the notion that old-age pensions be self-supporting. As he said in 1937, "as regards social insurance of all kinds, if I have anything to say about it, it will always be contributed, both on the part of the employer and the employee, on a sound actuarial basis. It means no money out of the Treasury."

Indeed, it meant money into the Treasury, since workers would begin paying payroll taxes immediately, while benefits would not begin for several years. These revenues would diminish the size of the federal deficit and limit the amount of borrowing necessary to fund government operations. This revenue potential was feared by many economists, who worried that the tax would be deflationary. But for Roosevelt the would-be fiscal conservative (and actual fiscal spendthrift), smaller deficits would be a welcome change.

Of course, the economists were right -- payroll taxes were deflationary. And when the recession of 1937-1938 plunged the nation back into the economic abyss, many critics fingered Social Security taxes as the leading culprit. Under pressure from Congress, the administration agreed in 1939 to delay a scheduled increase in the payroll tax, while also accelerating some benefits. These changes weakened the program's long-term viability, dispensing with the notion of self-contained financing and accepting (implicitly, at least) the need for eventual contributions from general revenues.

Nevertheless, Roosevelt was genuine in his commitment to keeping the program solvent -- and limited. By insisting, at least initially, that it be self-financed, he hoped to check the congressional impulse toward unrestrained spending. Absent such a constraint, he worried that lawmakers would simply spend the country into oblivion. The payroll tax was certainly designed to be a money machine, financing a grand, enduring social program. But it was also meant to serve as a check on that program, ensuring that new spending came with a certain amount of pocketbook pain.

The Ownership Entitlement

If the payroll tax quickly lost its claim to fiscal conservatism, it retained its political justification as a bulwark for social democracy. From the start, Roosevelt was committed to the "insurance" model of old-age pensions, in which payroll taxes were akin to premiums and pensions were an "earned" benefit of having paid those premiums.

Roosevelt was deeply attached to this conceptual scheme, and he used it repeatedly to defend the payroll tax specifically and Social Security more generally. Payroll taxes, he insisted, would protect the program from its enemies. He famously declared to Luther Gulick, a critic of the payroll tax:

    I guess you're right on the economics, but those taxes were never a problem of economics. They are politics all the way through. We put those payroll contributions there so as to give the contributors a legal, moral, and political right to collect their pensions and their unemployment benefits. With those taxes in there, no damn politician can ever scrap my social security program.

This quotation has been trotted out many times and by many people to explain the distinctive funding scheme established for Social Security. But the statement is not without its problems, at least as a piece of historical evidence. Leff has pointed out that the quotation comes from the recollection of an associate, recorded some six years after FDR decided on a payroll tax. By then the payroll tax had already come under attack, with lawmakers seeking (successfully) to limit and delay scheduled increases.

Roosevelt, then, might actually have been trying to protect the tax from its critics by draping it in the popularity of the associated program, even though the quotation seems to make precisely the opposite link. In any case, Roosevelt was speaking with the benefit of hindsight. "Knowing how the system had come out," Leff observes, "he was in an excellent position to claim foresightedness. Of such stuff, accurate historical memory is not made."

Implications for Today

Fair enough. But whether FDR insisted on the payroll tax for all the right political reasons, or whether he later made his decisions comport with political reality, is really a question of purely historical interest. From the perspective of current policymakers, the decision to use a payroll tax was clearly a functional masterstroke -- deliberate, inadvertent, or otherwise.

Does the history of the payroll tax offer guidance for those trying to design a healthcare program? Probably not healthcare reform as it's shaping up on Capitol Hill this fall. By rejecting the notion of a single-payer healthcare system, Congress has weakened the argument for using a broad-based tax to fund a broad-based program. A VAT -- endorsed by many as the best way to finance healthcare -- would function as a Rooseveltian premium only if it went to pay for some sort of universal benefit. With most Americans still getting health insurance from their employers, it's unclear how a VAT could be defended using the Social Security-as-insurance model. On the other hand, if this round of healthcare reform fizzles out, then using a VAT to pay for more universal, government-provided insurance might make political sense.

But the history of Social Security financing seems likely to get another turn in the limelight. President Obama has promised to make Social Security reform a high priority once healthcare reform is finished. And he also seems likely to revamp its funding mechanism by lifting the cap on individual payroll taxes. Critics have already decried the move as a breach of faith, a repudiation of the connection between taxes (premiums) and pensions (benefits).

FDR might even agree with that point. But he and other lawmakers who presided over the creation of Social Security proved none too faithful to that connection. The tax freeze and benefit increase enacted in 1939 broke the connection just four years after it was first made. Breaking it again would simply reopen an old debate, not repudiate a cherished faith.

Reference List

    Leff, Mark Hugh, "Taxing the 'Forgotten Man': The Politics of Social Security Finance in the New Deal," 70 Journal of American History (1983).

    Leuchtenburg, William Edward, "Franklin D. Roosevelt and the New Deal," 1932-1940 (1963).

    Lowenstein, Roger, "A Question of Numbers," The New York Times Magazine, January 16, 2005.

    Patashnik, Eric M., and Julian E. Zelizer, "Paying for Medicare: Benefits, Budgets, and Wilbur Mills's Policy Legacy," 26 Journal of Health Politics, Policy and Law (2001).