Democrats Are Right to Attack Obama Tax-Cut Deal

Dec. 14 (Bloomberg) -- Liberal Democrats are attacking not only the rates in the White House-Republican tax-cut compromise but also the plans for Social Security. The deal would trim the payroll tax to 4.2 percent from 6.2 percent for one year.

This reduction is supposed to stimulate growth. These Democrats don't care. They don't want to mess with the retirement program.

"This is a grand plan of starving Social Security so you can then privatize Social Security," Representative Jackie Speier, a Democrat from California, said Dec. 10. "I'm very disappointed. He's out-Bushed Bush."

She is right, though not in the way she means. The payroll tax break of 2011 encapsulates what's wrong with our entire tax system. This one piece of the compromise plan also explains why growth after next year is likely to be weaker, not higher, than the current optimistic predictions.

The problem is the nature of that growth. In the past century both parties and the economists behind them have focused on the business cycle, their theory being that for the country to grow, that cycle must be managed, preferably by them. But economic growth requires something else: trust that deals and contracts will be honored by all, including governments. Pensions are contracts, even public pensions like Social Security.

Hard-core property rights lawyers would reject the idea of Social Security being a contract. They see the program as a government mugging dressed up as a contract. Nonetheless, the framers of Social Security, including President Franklin Roosevelt, viewed the benefit contractually. In various drafting discussions, Roosevelt talked about Social Security as a pension, or an annuity, not a tax arrangement.

Public Faith

The program is grand because it is the original, the showcase contract between Americans and their government. The New Deal itself used contract as a theme. That is why the New Deal was called the New Deal and not, the "New Demand Management Payment."

When a showcase contract like Social Security is compromised, citizens' faith in other contracts, public or private, begins to fray. Their willingness to invest or hire weakens.

Roosevelt and others doubtless believed that the Social Security contract complemented their plans to make the business cycle less bumpy. After all, in the 1930s, millions of elderly in the U.S. languished in poverty. Feeding them was smoothing the business cycle in the most crucial way.

When Payments Began

But in 1937, the first year of Social Security's implementation, that strategy was challenged. That's when Americans began making payments into the system; the government's take amounted to 2 percent when you include the employer side. As Francois Velde, an economist at the Federal Reserve Bank of Chicago, pointed out in a paper published in the fourth quarter 2009, the amount taken represented 10 percent of all federal receipts that year.

Next, came the Depression within the Depression of 1937 and 1938, in which industrial production dropped a third in six months and unemployment moved into the high teens.

Other forces were far more important in causing that Double Dip. One was monetary and banking policy, another was Washington's hostility to business. (Roosevelt actually told the country that he would prove to Wall Street that he was "their master.")

Cool Tool

But the sequence of the Social Security tax followed by recession made a deep impression. American leaders' takeaway from the mistake of 1937 was that the payroll tax was a nifty tool for demand management. They liked the thoughts of Marriner Eccles, the Fed Chairman. Eccles believed that Social Security's payment schedules should be so flexible so that authorities might raise it during strong growth, to prevent "overheating," and lower it during recessionary periods.

That playing with the heads of taxpayers in this way might be disconcerting didn't seem to occur to anyone. The payroll tax cut for 2011 takes the idea of Social Security as fiscal tool to Eccles-level extremes.

The retirement system faces long-term shortfalls, regardless of growth. Our economy is not, currently, shrinking. If in a non-crisis our leaders are willing to widen that Social Security debt by one penny, then, logically, they will be willing to trash the program more dramatically should a 1930s-style double dip take place.

They will also be willing to adjust other contracts, even private ones. In its Social Security component the new tax deal honors the precedent set when the federal government sacrificed bondholders and creditors to unions in the recent auto bailouts. It seems any deal or promise is subordinate to servicing the general economy and its managers.

Low Expectations

One might argue that when it comes to Social Security nothing is lost since the program was already a joke to most Americans. Younger people expect no payout anyhow. So, the argument goes, the policy now should be to get the economy growing through reform, tax and other changes to the retirement system, and only later to rebuild American trust in our institutions.

But that is backward. Enduring growth comes when there is more trust in contracts. Certainly foreign investors, who buy bonds and currency, view the U.S. that way.

Social Security is a relatively easy fix, as contracts go; it could be put back in balance in an afternoon. To do that would be to send an important signal that other imbalances will be addressed.

The latest tax-rate compromise sends no such signal. It therefore jeopardizes U.S. growth in the longer run.

(Amity Shlaes, senior fellow in economic history at the Council on Foreign Relations, is a Bloomberg News columnist. The opinions expressed are her own.)

To contact the writer of this column: Amity Shlaes at

To contact the editor responsible for this column: James Greiff at

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