By Cameron Smith

During the discussion of the debt limit issues facing the United States, entitlement reforms have been suggested by the right and reviled by the left. Unfortunately few Americans understand exactly how the debt limit interacts with Social Security, what the future holds for the program, or even how Social Security works in the first place

Many Americans believe that the taxes they pay for Social Security go directly into a trust fund that will eventually provide for their benefits. While Social Security does have a trust fund of sorts, it is not filled with tax dollars accumulated over the generations. In fact, the trust fund holds no cash at all. That may come as a shock to taxpayers who have been paying a portion of their wages into the program for decades. As the fiscal condition of the United States continues to deteriorate, what Americans do not know about Social Security may come back to haunt them.

With the exception of special legislation this year that lowered payroll tax rates, most Americans have paid 6.2 percent of their earnings into Social Security since 1990. Currently the Social Security tax only applies to the first $106,800 of earnings. Using these numbers, the maximum Social Security tax bill is $6621.

Social Security tax revenues are received by the Treasury Department and immediately invested in special issue government securities. These securities bear interest rates historically ranging from 15.250 percent to as low as 2.125 percent. For 2009 and 2010, the interest on these obligations averaged less than three percent. The tax revenues exchanged for the securities are deposited in the general fund of the U.S. Treasury to be spent by the federal government. As of 2010, the Social Security Trust Fund held about $2.6 trillion in special securities “backed by the full faith and credit of the United States.”

That backing is precisely where the debt limit impacts Social Security. If the government does not have sufficient general fund resources or the ability to borrow money when the Social Security Trust Fund redeems these special securities, there is no money to pay beneficiaries. The truth is that generations of Americans have paid into Social Security, and every last dime has been spent by legislators from both ends of the political spectrum who failed to exercise fiscal restraint.

For the first time since 1983, Social Security paid out more than it received in revenues in 2010. In every deficit year, more special securities must be redeemed to pay out benefits than are issued to the trust fund by the Treasury. Unfortunately, deficits are projected far into the future, with all the assets of the Social Security trust fund exhausted in 2036. At that point, payroll tax income would only be able to support about three-quarters of anticipated benefits.

Americans should also consider whether Social Security as it is currently structured is the bargain many believe it to be. An individual making $40,000 a year paying the 6.2 percent tax for 40 years will have paid almost $100,000 to the federal government. From 1950 to 2010, the S&P 500 produced an annualized return of 7.16 percent, when adjusted for inflation. If the Social Security tax on $40,000 were invested in the S&P 500 over 40 years at the same rate, the compounded value would be more than $550,000. Because the average American lives about 79 years, Social Security would have to pay more than $3800 per month to match the S&P’s rate of return.

But for retiring individuals looking to redeem their investments recessions or depressions, average returns over 40 years could be of little comfort. So then the question is how much is the “stability” of Social Security worth? According to the Social Security Administration’s online benefit calculator, the estimated monthly Social Security payment for the individual making $40,000 a year for 40 years and retiring in 2012 is $2023. Additionally, Social Security beneficiaries making more than $34,000 per year could see as much as 85 percent of their benefits taxed. The individual making $40,000 a year who decides to keep working while eligible for benefits could see almost $430 cut from his or her monthly Social Security check.

The U.S. must borrow money or seriously cut spending in other areas to pay its Social Security obligations in the coming years. Even with that borrowed money, the program will be unable to pay promised benefits in less than 25 years. Oddly enough, the most ardent supporters of Social Security are those who unwilling to reform the program now in order to preserve its future.

Reasonable minds may differ about the merits of Social Security, but the current fiscal practices of the federal government and the existing flaws in the program mean that changes must be considered for the program to be preserved. Rather than villainizing every proposed change to Social Security, proponents of the program must evaluate each idea on its merits, including the impact on current beneficiaries as well as the fiscal future of Social Security. Americans would be wise to look past the political dogma and insist that legislators provide real solutions grounded by the sobering challenges facing the nation.

Cameron Smith is General Counsel for the Alabama Policy Institute, a non-partisan, non-profit research and education organization dedicated to the preservation of free markets, limited government and strong families, which are indispensable to a prosperous society.