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Thursday, January 6, 2011

Federal Entitlements and Impending Deficits

The United States is heading towards a fiscal train wreck.  The looming fiscal crisis is being driven by an aging population and rising healthcare costs. If left unchecked the promises made to past and future generations, through Medicare, Medicaid and Social Security, will bankrupt the US government. According to the CBO’s worst case projections Medicare, Medicaid and Social Security will grow to consume over 25.7% of annual GDP, while all other federal expenditures are expected to be held constant as a percentage of GDP. (5)  This outcome is far from certain, however to better understand how this fate could be avoided we need to better understand what are the core drivers of these projections.  This analysis will attempt to provide the reader with a better understanding of the entitlement issues facing the country.

Let me first start by breaking out the various components of the problem into their individual pieces.  The principle cause of the projected fiscal scenario is the growth of entitlement programs.  Entitlement programs consist of various government social welfare programs.  For simplicity sake I will focus on the big 3, as they are known, Medicare, Medicaid and Social Security.  These three represent the largest entitlement programs and collectively account for the vast majority of the projected growth in federal spending.  The CBO has provided several forecasts, taking into account various spending and revenue policy assumptions. The CBO provided projections involve all programs carrying on as the law currently is written including, the Bush tax cuts, which are schedule to expire in 2010 and the Medicare Part D, prescription drug benefits, this projection is called the Extended Baseline Scenario.  The CBO provides an alternative set of projections called the Alternative Fiscal Scenario, which take into consideration congressionally mandated patches to Medicare physician reimbursements and the indexing of the AMT to inflation.  I consider the alternative fiscal scenario more likely as such I will base my analysis off of the Alternative Fiscal Scenario assumptions.  My analysis also follows the CBO’s projections on healthcare cost growth.

Medicare and Social Security are programs principally targeted to Americans over the age of 65 years old.  In 2009, 20.9% of the U.S. population is over the age of 65.  (5) By 2029 this number will have rise to 34.1% and by 2084 to 42.7% of the population.  (5)  This vast number of retirees’ dependant on federal resources for retirement income and healthcare coverage will lead to unsustainable budget deficits.  By looking at the each program individually, we can begin to unravel the root causes.  Social Security is funded through payroll taxes.  The Social Security trust fund currently accrues a surplus as there are more workers paying into the trust than retirees taking out. In 2007, Social Security spending consumed 4.3% of GDP.  Social Security taxes account for 4.87% of GDP and Social Security ran a surplus of 0.58% of GDP or roughly $68 billion dollars. (7) Social Security outlays are expected to grow steadily until reaching 6.4% of GDP in 2082.  Social Security revenues are expected to average 5.07% of GDP from 2008 through 2082, while outlays are expected to average 5.45% of GDP from 2008 through 2082, with a deficit averaging 0.38% of GDP from 2008 through 2082. (7)  This represents a deficit, in real 2008 dollars, of $6.6 trillion from 2008 through 2082 or $89 billion per year. Although this is a large deficit, it is certainly not so large as to account for the tremendous growth in deficits expected from years 2008-2082.   Bear in mind that this analysis does not take into consideration debt owed by the federal government to the Social Security Trust Fund, thus it is not fully reflective of true fiscal reality. 

I will now turn my attention to Medicare and Medicaid.  Medicare and Medicaid have both experienced more rapid growth due to raising healthcare costs, economy wide.  Medicare has experienced considerable growth rising from .7% of GDP in 1970 to 2.7% of GDP in 2005.  This represents an annual compound growth rate of 18.4%.  Medicaid has grown from just .3% of GDP in 1970 to 1.5% of GDP in 2005, representing an annual compounded growth rate of an astonishing 22.3%.  These two programs are expected to experience further explosive growth through the year 2082.  Under the alternative fiscal scenario, outlined above, Medicare and Medicaid expenses grow to consume 18.5% of GDP by 2082 from a starting position of 4% of GDP in 2008. (3) Of the two Medicare is expected to grow from 2.7% of GDP in 2007 to 15.6% of GDP in 2082, whereas Medicaid grows from 1.4% of GDP in 2007 to 3.7% of GDP in 2082.  (3) It is clear entitlement programs are on a path that is unsustainable.  The big 3 are anticipated to collectively consume 25.7% of GDP by 2082.  To put this into proper perspective, consider that for the past 50 years all US government expenditures, including Social Security, Medicare, Medicaid and Defense, have only average 20% of GDP. (3)

Now that the numbers are clear it is important to look at the underlying reasons behind the rapid growth in entitlement spending.  We have seen that the country is aging however this alone cannot account for all of the growth in entitlement expenditures.  Aging is a primary factor contributing to the rise in Social Security expenditures, however Social Security expenditures increase by only 55% from 2008 to 2082 while the number of beneficiaries increases nearly 104% by 2082.  By the CBO’s estimates, the age profile of the U.S. accounts for only 20% of the estimated rise in entitlement spending, when Medicare, Medicaid and Social Security expenditures are averaged, by 2082. (3) It is clear that the answer lies in the faster rate of cost growth in the healthcare entitlement programs.  Since 1975 Medicare has grown 2.7% faster than GDP, while Medicaid has growth 2.2% faster than GDP. (3) This excess cost growth is the leading cause of the anticipated growth in total Medicare and Medicaid spending.  Furthermore, growth in healthcare expenses reduces government revenues as most private sector healthcare benefits are pre-tax.  As healthcare expenses grow faster than GDP, and private sector healthcare benefits come to represent a larger share of employee income, federal income tax revenue declines proportionally.

Now that we have a better understanding of where the expenses will come from lets look at the revenue side of the equation, for the past 50 years total federal revenues have averaged between 16.1% and 20.9% of GDP.  Revenues are projected to average between 20% and 25% of GDP over the next 73 years.  Real GDP during this time period is projected to rise from $12.4 trillion in 2009 to $56.1 trillion in 2082, representing an increase of 316%.

During this period deficits are expected to rise from an average of 1.1% of GDP a year, in years 2009-2019, to an average of 14.8% of GDP a year from years 2072-2082.  The rapid rise of entitlement spending is directly linked to the rapid rise in deficit spending.
To meet the increased costs of entitlements individual income taxes are expected to rise from the current level of 8.7% of GDP to 12.2% of GDP in 2082.  Due to growing healthcare costs and their effect on pre-tax benefits as a percentage of total compensation, payroll taxes decline from the current level of 6% of GDP to 5.4% of GDP in 2082.   The CBO projects that private healthcare costs will rise from 12% of GDP in 2007 to 30% of GDP in 2082. (3)  This growth is projected to reduce income tax revenue by 1.6% of GDP in 2082 and reduce payroll taxes by 0.7% of GDP that same year. (3)  Taken collectively, the reduction in income coupled with exploding entitlement liabilities further emphasizes the unsustainable nature of looming federal budgets deficits.  Under the CBO’s alternative fiscal scenario the federal debt is expected to increase exponentially from 35.7% of GDP in 2009 to an astonishing 858% of GDP in 2082. (3)  This is an increase in the federal debt of 2,351% even as GDP has grown 316%.  Aside from the dramatic growth in entitlement spending, compounding interest expenses are what drive the federal debt higher exponentially.  By 2050 interest costs on the debt would absorb 80% of all federal revenue and will account for 13.7% of GDP. (4)  At this point the federal government will have to continue to borrow just to pay the interest on the existing debt similar to when a consumer uses a credit card to pay the balance on another credit card.  As any consumer who has had the misfortune of experiencing this situation will tell you, it does not work.

            We have seen that the federal government’s budget is not projected to be healthy in the years ahead, but what does that mean to the economy as a whole?  Well growing government indebtedness affects the economy in several ways.  First government borrowing, certainly on the scale projected, crowds out private investment.  As the government competes for scarce financial resources the cost of borrowing increases economy wide.  According to the CBO’s projections government deficits by 2082 will reduce capital stock by 40% and reduce the GDP by 25%.  (3) This reduction in capital stock will lead to slower growth as fewer resources are available for capital investment in productivity enhancing technologies and training.  This would lead to a steady decline of worker productivity and wages.  This trend if sustained could cause continued decline in economic activity leading to a lower standard of living.  Overtime creditors may lose faith in the capabilities of the federal government to continue to service the debt.  As the government reaches it borrowing limits its ability to react to a natural or man-made crisis could be severely constrained.  Furthermore, debt must be paid back, this will require that the government drastically cut services and/or raise taxes, further lowering citizen’s quality of life.  In order to avoid drastic cuts to services or increases in taxes the government may turn to simply printing the necessary funds to meet its obligations, this process would lead to higher inflation and potentially hyper inflation, which would further destroy the economy and lifestyles of citizens.  The outlook under this scenario is bleak, however it is not unavoidable.

            The scenario outlined above represents a worst case scenario, and it is by no means a certainty.  There are several painful but relatively simple solutions, which could allow the U.S. to avoid this fate entirely.  The simple answer would be to cut benefits and raise taxes.  Each of these will be politically difficult.  The question then becomes what is the right mix of cuts and tax increases and what programs to cut and how.  As Medicare/Medicaid represents the largest single expected expense in future budgetary forecasts I will start there.  The broad consensus is that the least painful way to reign in Medicare and Medicaid costs is to slow the growth in medical costs.  This would dramatically affect the outlook of the long-term budget in two ways.  First, it would reduce the size and scale of government funded medical expenses, second, it would increase government revenue by reducing the amount of income paid as pre-tax healthcare benefits.  The most common suggestions for reducing the growth in healthcare costs are the introduction of electronic medical records or EMRs.  Electronic medical records are software systems which digitalize the healthcare process.  It is assumed that through the adoption of EMRs medical costs would be reduced through the reduction of duplicate testing and medical errors.  Furthermore, EMRs hold the promise of instant data availability on the success rates of treatments across vast patient populations.  This information will allow the government to measure the effectiveness of not only treatments but also healthcare professionals and reward them accordingly.  This is a process know as pay for performance (P4P), pay for performance initiatives increase the reimbursement rates of physicians that keep their patients healthy and thereby prevent expensive emergency treatment and chronic conditions.  According to the CBO the elderly and disable account for just 25.1% of all Medicare/Medicaid recipients but collectively account for 67.7% of all costs.  (3)  By effectively leveraging technology to drive down costs, eliminate expensive medical mistakes and utilize data to reward healthy behavior it is estimated that EMRs can lead to saving of 4% of total healthcare expenses. (8) In 2005 dollars, this represents a total $80 billion dollars annually. (2)

            Additional options to reduce the cost of Medicare/Medicaid include decreasing reimbursement rates to physicians, eliminating or replacing Part D, the prescription drug benefits and increasing the eligibility requirements. The Heritage Foundation believes that a prescription drug card which provided Medicare/Medicaid recipients with partial subsidies for drugs while requiring the recipient to cover a portion of the expense could sensibly reduce the long term cost of Medicare/Medicaid while still providing substantial benefits to recipients. (9)  The Heritage Foundation projects that through the introduction of the drug card and the elimination of Medicare Part D the federal government could save $8.1 trillion over the next 75 years.  (9)  The Heritage Foundation also recommends that the federal government change the reimbursement structure to states from a straight percentage of expenses, currently 57%, to a block grant type structure.  This would align the states with the federal government in the collective interest of cutting costs.  (9) A further suggestion is to tackle fraud and abuse as well as cut overpayments to insurance companies, according to the Heritage Foundation Medicare overpayments top $12 billion annually. (9) All told the combined affect of incremental change in federal practices coupled with increased use of health information technology and result driven preventative medicine, economy wide, could be substantial. 

            By my calculations Social Security has far fewer problems than either Medicare or Medicaid.  Social Security could be fixed easily by a few simply changes.  One easy change would be increasing the age of eligibility.  According to the Concord Coalition the first recipients of Social Security lived an average of 12 years for men and 13.4 years for women after retirement.  Today’s boomers are expected to live 16 years for men and 19 years for women after retirement. (1) Another simple solution would be to change the formula by which benefits are indexed to wage growth to one in which benefits are tied to the consumer price index.  A third option would be to decrease benefits for wealthy retirees.  These simple solutions could go a long way toward ensuring Social Security remains solvent for the next 75 years. 

            The above referenced solutions will all help to address the expected fiscal imbalance.  That said it is impossible to address the coming projected deficits through cuts, technology and accounting methods alone.  The simple fact is revenue must increase.  Due to the miracle of compounding interest, the sooner the government raises taxes, cuts spending and utilizes every technological and accounting method available to fix the problem, the easier it will be. The CBO projects if the current laws as they are written regarding the AMT were enforced while Medicare costs were held to 4% and 6% of GDP, the fiscal train wreck could be avoided entirely. (3)  This would require that some 75% of the U.S. population would fall into the higher AMT tax bracket by 2082; this would mean that the majority of working citizens would be paying taxes ranging between 26%-28% not including FICA tax, which adds an additional 8%. (3)  Both scenarios seem unlikely.  Given the difficulty of the task it is likely that deficits will rise while taxes and benefits will be cut.  The exact make-up of the final solution is hard to predict.  It is likely that the solution will require the use of all options including several outside the box ideas, such as increased immigration.

            What is clear is that the current path is unsustainable, only through shared sacrifice will the worst be avoided.  It is clear that benefits for current retirees are far too generous and that the baby boomer generation must postpone retirement and accept hire taxes during the years of employment remaining.  The government must also learn to live with less.  Core functions need to be rethought and those functions that can be done by the private sector should be privatized.  

Works Cited

1) Bixby, Robert . "The Future of Social Security." The Concord Coalition 1 (2007): 10.

2) Federico, Girosi, Robin  Meili, and Richard  Scoville. "Extrapolating Evidence of Health Information Technology Savings and Costs." RAND 1 (2005): 55.

3) Holtz-Eakin, Douglas. "Congressional Budget Office." The Long Term Budget Outlook 1 (2005): 70.

4) Kogan, Richard, Kris  Cox, and James Horney. "The Long Term Fiscal Outlook is Bleak." Center on Budget and Policy Priorities 1 (2008): 16.

5) Orszag, Peter . "Congressional Budget Office." The Long Term Budget Outlook 1 (2007): 62.

6) Orszag, Peter. "Spratt Fiscal Gap." Congressional Budget Office 1 (2008): 10.

7) Orszag, Peter. "Updated Long Term Projections for Social Security." Congressional Budget Office 1 (2008): 45.

8) Pan, Eric. "The Value of Healthcare Information Exchange and Interoperability." Center for Information Technology Leadership 1 (2004): 45.

9) Riedl, Brian. "The Five-Step Solution: Cutting the Budget Deficit in Half by 2009 While Extending the Tax Cuts and Rebuilding Iraq and Afghanistan ." Backgrounder 1833 (2005): 9.

10) Walker, David. "America's Fiscal Future." Government Accountability Office 1 (2007): 49.

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