QuickOverview

PAYGO (pay-as-you-go) is a term used to refer to financing where budgetary restrictions demand paying for expenditures with funds that are made available as the program is in progress. Alan Greenspan commonly used the term and encouraged U.S. lawmakers to use the practice so as not to increase the National Debt. His recommendations were often ignored as the yearly budget deficits have been growing since 1998. However, when the Democratic Party came to power in 2007, they adopted the practice in an effort to curb runaway spending.

In budgeting, the term PAYGO refers to the requirement that newly proposed expenditures must be accompanied by commensurate increases in revenue OR a reduction elsewhere in the budget. The goal of this is to require those in control of the budget to engage in the diligence of prioritizing expenses and exercising fiscal restraint.

U.S. Congress

An important example of such a PAYGO system in this first sense is the use of PAYGO rules in the United States Congress. The Congress's PAYGO rules required Congress to pay for any tax cuts with offsetting tax increases or spending cuts.

These rules were in effect from 1990-2002 and are widely seen as having assisted the US Congress in maintaining budget discipline. "Those rules were allowed to lapse in the House and watered down in the Senate, which made it easier for lawmakers to approve President George W. Bush's tax cuts and a Medicare prescription drug plan".

In practice, since spending rarely decreases, increased taxes are required to pay for additional spending. It is assumed that increased taxes will result in increased revenue collection because unintended consequences of tax increases are ignored. Often increased taxes result in less revenue since taxpayers find ways of avoiding the extra tax. Another aspect of PAYGO is that tax decreases must be offset and hence are also rare under such a scheme.

Social Insurance

In social insurance, PAYGO refers to an unfunded system in which current contributors to the system pay the expenses for the current recipients. In a pure PAYGO system, no reserves are accumulated and all contributions are paid out in the same period. The opposite of a PAYGO system is a funded system, in which contributions are accumulated and paid out later (together with the interest on it) when eligibility requirements are met.

U.S. Social Security

An important example of such a PAYGO system in this second sense is Social Security in the U.S. In that system, contributions are paid by the currently employed population in the form of a payroll tax (also called Social Security tax), while recipients are mostly individuals of at least 62 years of age. Social Security is not a pure PAYGO system, because it accumulates excess revenue in so-called trust funds.

Explanation

These kind of PAYGO systems can be implemented quickly, because no reserves are necessary to finance the expenses of the first generation of recipients. However, these windfall gains of the first generation have to be financed by following generations. By paying the expenses of generation t, the following generation t+1 relies on future contributions of generation t+2 to cover its expenses. In this fashion, the windfall gains of the first generations are passed along over generations and, hypothetically, the last generation would have to finance its own expenses and that of the preceding generation. That is why some economists have called PAYGO systems equivalent to (or even worse than) Ponzi schemes, which is albeit a mistaken classification, since PAYGO systems are far from being fraudulent investment schemes.

Controversy

There is much controversy about the way a social insurance PAYGO system (especially one as large as U.S. Social Security) may affect private and national saving. Another issue is the return on contributions to the system, which - depending of the system's design - changes from being extremely large for the first generation of recipients to numbers close to the growth rate of the population in a mature PAYGO system.

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