Buttonwood’s notebook | Paying for social benefits

The “I’ve paid in all my life” fallacy

Social benefits are often sold as insurance-based schemes. But they don’t work that way

By Buttonwood

SOCIAL security is often described as the “third rail” of American politics—touch it and you die. Britain’s prime minister has just tied herself into a tangle over the way to fund long-term care for the elderly.

The problem is made more difficult because of the way that such benefit schemes were established and marketed to the public—as insurance schemes in which what you receive in benefits relates to what you put in. When pension schemes were set up by Franklin Roosevelt (pictured, left) in the 1930s or in Britain, by David Lloyd George (pictured, right) in the Edwardian era, the insurance notion was something people could easily grasp (private schemes already existed) and could be seen as fair.

This was fine in the early years of such schemes when the number of people contributing was far greater than the number of people taking benefits. But as our societies age, the costs rise and the inadequacy of the “insurance approach” is made clear. When television or radio shows do a vox pop, people will often say “I’ve paid in all my life so why should my benefits be cut” or “why should my taxes rise” and so on.

The problem with this thinking is threefold:

  • What people pay in individually is not related to what they get out
  • What people have paid as societies, in aggregate, is not enough to meet the benefits they have been promised
  • In effect, despite the smokescreens, these schemes operate on a “pay as you go” basis in which benefits are met out of current revenues

To start with the first, state pension schemes usually require some minimum level of contributions before benefits can be paid (ten years in the case of Social Security, for example). But the benefits then don’t have much link to what people pay in. While higher-earners do get a higher pension under Social Security; they get a lower proportion of their final earnings. The top earners get around a quarter of their final salary, the lowest earners a half. Even though higher earners live for longer, a careful study of the system concludes that it is a progressive tax; transferring income from rich to poor. In Britain, national-insurance contributions are paid as a proportion of earnings; the state pension is a flat rate paid to all who qualify. The Office for National Statistics reckons the pension makes the greatest contribution to the progressivity of the benefits system. All this is to be applauded. But it does mean that for many, rather than getting back what they paid in from the pensions system, they may be getting more.

On the second point, in both America and Britain, there is a “fund” from which benefits are paid. The inverted commas are there to show that this is not like a company pension fund, or a sovereign wealth fund like Norway’s, where the money has been invested in outside assets. In both cases, when there is a surplus of income over benefits, the money is placed in government bonds; in other words, a claim on future taxpayers’ income. At best, this approach means the government can keep track of the long-term cost of its promises. If benefits were being properly financed, then the size of the trust fund should be roughly stable in near terms; after all, this is a never-ending commitment. But instead the latest Social Security report shows that benefits will exceed revenues as of 2020, and that the fund will run out in 2034. In Britain, as Frances Coppola spells out, the National Insurance fund regularly runs a deficit in recessions; it is set to run out in 2035. We have not been paying in what we need to.

Pensions are of course just one claim on the public purse; since both the American and British governments are running budget deficits and have seen a rising debt-to-GDP ratio, it is also true to say that citizens of both societies have not paid in full for the services they receive; they are, by implication, leaving future taxpayers to foot part of the bill.

The final point is the crucial one. The existing structures mean that current benefits are paid for largely by current taxpayers. To the extent that part of the benefits are funded with interest on government bonds, current taxpayers are providing the revenues to meet those interest payments. Either future taxpayers will meet any shortfall or future benefits will have to be cut.

So the vox pop quote could well be rephrased to say “I haven’t paid in enough all my life so would like my kids to pay more” or “Since I haven’t paid in enough all my life, I accept I won’t get as much pension as expected.”

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