The Congressional Budget Office last week released its long term budget forecast for the next 50 years, which showed that if nothing was done (and taxes automatically rose substantially from their present level through “bracket creep”) the Federal deficit would total 17 percent of gross domestic product by 2050, and Federal debt held by the public would exceed 200 percent of gross domestic product. In other words, fiscal collapse.
According to the CBO projections, two factors are likely to worsen the U.S. government’s fiscal position by 2050, social security and Medicare/Medicaid. There will be one offsetting item, the behavior of tax yields if tax laws are kept at their present level.
The CBO outlined six possible scenarios, under 3 different assumptions for cost increases (primarily in Medicare) and two assumptions for tax yields. The outcome under these scenarios varies from huge government surplus to national bankruptcy; the high-tax, high-spending bankruptcy above is Scenario 4. (Scenario 1, low-tax, high-spending, is even faster bankruptcy!)
To take the offsetting factor first, CBO has tax yields increasing from 16.5 percent of GDP currently, past the 18.2 percent that is the average of the last 50 years and the 20.5 percent that is the postwar high (in 2000, because of huge capital gains tax yields) to around 25 percent of GDP “provided tax laws remain unchanged.” The catch is that tax laws remaining unchanged would preserve all the idiotic “sunset” provisions of the 2001 and 2003 tax laws, by which the tax reductions of those years revert to zero in the years ahead, the estate tax is restored to its full pre-2001 level, etc. In addition, this scenario assumes that nothing is done to reform the Alternative Minimum Tax, the temporary reforms to which also expire, so that by 2050 70 percent of U.S. taxpayers are subject to this nightmare impost.
This is unrealistic; it is also unrealistic to assume that you could increase the Federal government’s tax take from 16 percent of GDP to 25 percent, the highest in U.S. history, without a serious adverse effect on the U.S. economy — the French Disease would simply move in. Thus the “high-tax” scenarios 4, 5 and 6 can be dismissed, however much they may appear to simplify the spending tradeoffs.
Unfortunately, if nothing is done to curb spending, the “high spending” part of Scenarios 1 and 4 is only too realistic.
Defense spending, and discretionary non-defense spending, do not appear avenues for major savings. The CBO has already made very favorable assumptions in both areas, with these items declining as a percentage of GDP, despite remaining constant in real terms. In both cases, this appears optimistic — defense because the rundown of the 1990s has already left U.S. capabilities very tightly stretched in the current difficult situation, and discretionary non-defense spending because Congress in the past decade has not shown itself capable of controlling it. Hence, from these sources, even the CBO’s alarming spending forecasts may be too low.
The two areas where spending must be addressed, if the CBO’s nightmare scenarios are to be avoided, are social security and Medicare/Medicaid.
According to CBO projections, social security is the less dangerous of the two. If nothing is done to “reform” it the CBO estimates it will increase from 4.2 percent of GDP in 2010 to 6.2 percent of GDP in 2050, with most of the increase coming before 2030, as the baby boomers retire.
Medicare and Medicaid, on the other hand, are much more serious problems. Even in the CBO’s “intermediate” case (which itself requires cost restraints substantially more effective than any seen so far) Medicare/Medicaid spending increases from 4.8 percent of GDP in 2010 to 11.5 percent of GDP in 2050 with the rate of increase being more or less constant. On the high spending path, Medicare/Medicaid spending rises to 21.5 percent of GDP, a figure clearly unsustainable by any means.
There are three reasons social security spending is destined to increase as a percentage of GDP: rising longevity (and thereby, longer retirements), the “bulge” from the retirement of the baby boomers and the automatic escalation of past years’ earnings by average earnings rather than by prices when calculating benefits payable.
Since real earnings increase by an average of 1.3 percent per annum, the earnings link is expensive. It is also unfair; for example auto and steel workers, whose wages were driven up by union bargaining to levels far above the market in the 1960s and 1970s, then have those inflated earnings increased still further in real terms, in line with overall earnings growth over the last 30 years, when calculating social security benefits. Thus the earnings figures used for their social security benefits calculations are highly artificial, far above those earned today, in the 1970s or at any other period of history. This discriminates in favor of those with strong unions and high temporary bargaining power.
The CBO looked at three options for restraining the growth of social security spending: raising the retirement age, removing this artificial earnings link and replacing it with a prices link, and constraining the annual cost of living adjustments to 1 percent below the rate of inflation.
Limiting cost of living adjustments would reduce the pension of a 95 year old by 28 percent, just when his exceptional longevity, feeble condition and high medical costs had made his financial position most difficult. This is thus an unattractive option.
According to the CBO, removing the pre-retirement earnings link, thus removing the automatic 1.3 percent per annum annual average cost increase in social security, would reduce outlays to 4.1 percent of GDP in 2050, 34 percent below present law. In addition, raising the retirement age to 70 and then indexing it to average longevity would reduce the cost by a further 19 percent, to 3.3 percent of GDP — significantly below the current level of 4.2 percent of GDP, although there would be a “baby boomer” bulge around 2030.
It is interesting that removing the earnings link saves more money than delaying the retirement age. However, if Medicare costs are included, the effect of delaying the retirement and Medicare availability age is increased.
Three factors cause the cost of Medicare and Medicaid, particularly Medicare, to be a far larger problem than the cost of social security, and potentially an overwhelming one. One is the increase in longevity, and the failure to adjust the Medicare availability age, which has remained at 65 even as the social security entitlement age has been raised to 67. The second is the genuine quality improvement in medical care, so that new treatments are continually being found, the majority of which should be provided under Medicare/Medicaid, but all of which cost money, generally (but not always) more money than the therapy they replace. The third is medical cost inflation itself; it has grown 3.0 percent per annum faster than GDP since 1970, slowing to 1.7 percent per annum faster than GDP since 1990.
In a notable omission, the CBO did not address directly how much of this excess cost growth was due to new and improved therapies, and how much to slippage in program requirements, growth in bureaucracy, growth in fraud, and growth in legal malpractice costs.
The CBO projected three different Medicare cost trends, the high, medium and low spending scenarios, with costs rising annually 2.5 percent, 1 percent and zero faster than GDP, to produce a level of spending on Medicare/Medicaid in 2050 of 21.3 percent, 11.5 percent and 6.4 percent of GDP. If the eligibility age for Medicare were increased in line with the proposal above for social security, the cost saving would be around 9 percent of total cost (taking account of the offsetting corresponding increase in the cost of Medicaid.) That would reduce the overall cost of Medicare/Medicaid under the three scenarios to 19.4 percent, 10.5 percent and 5.9 percent of GDP.
The third of those estimates, if combined with early retirement for social security, is clearly financeable, even given a “steady state” tax policy and possibly a little relaxation in the CBO’s draconian assumptions about government spending. It corresponds closely to the CBO’s Scenario 3, in which the Federal budget in 2050 is in small surplus and Federal debt is declining as a percentage of GDP. Unfortunately its central assumption, of zero excess growth in medical costs, appears unrealistic unless draconian action is taken.
The middle estimate, of Medicare spending with later eligibility of 10.5 percent of GDP, and social security expenditure with later eligibility and price indexing down to 4.2 percent of GDP, is approximately 3 percent of GDP per annum more favorable than the CBO’s Scenario 2, or maybe 2 percent more favorable than Scenario 2 when the CBO’s optimistic assumptions about other spending are taken into account.
That doesn’t sound like much, but over 47 years it would have an enormous effect; primary spending in 2050 would be 21.4 percent of GDP, and Federal debt would remain below 100 percent of GDP, or lower if modest tax increases reflecting the nation’s greater wealth were instigated.
With later eligibility for Medicare and social security, and price indexation for social security, the long term budget problem will remain manageable, provided Medicare/Medicaid do not expand their coverage (in terms of the percentage of people covered, and the percentage of costs paid by the government) and medical costs increase by no more than 1 percent per annum above the growth in GDP.
Even to achieve this will be difficult, given that in the 1990s, a period of tight medical cost containment, medical costs increased by 1.7 percent above the growth in GDP. However, over a 50 year period, there are a number of tools that can be used to restrain cost increases:
— Payment by the recipient of the service. By setting up medical savings accounts, possibly with a government cash subsidy for the poor, we could move to a system where all but catastrophic medical costs were borne directly by the patient. In containing costs and removing bureaucracy, this would be an enormous advance.
— Cap on medical charges to individual patients at say 25 percent above the lowest cost offered by the provider to an insurance company or government agency. Currently, because Medicare/Medicaid and the insurance companies are able to drive a tough bargain on costs, the uninsured may pay 2 or even 3 times what the insurance company pays. Thus forces people into collective schemes, while any savings are eaten up by insurance company or state bureaucracy. Appallingly wasteful.
— New patent law whereby (i) U.S. consumers of drugs don’t subsidize those in other rich countries, whose costs are subject to price controls and (ii) companies are not incentivized to produce endless marginally differing remedies for common but not very serious ailments, while neglecting research on life-threatening rare diseases (particularly those that affect tropical countries.) The concept of property rights in an invention is essential to progress; the current payment and registration system for those rights is a historical accident.
— Remove the up-front cost imposed by trial lawyers. When it costs $100,000 per annum for a doctor to get malpractice insurance, that doctor needs very quickly to earn $250,000 per annum or more in order to make a living and pay off debt. This huge fixed cost greatly increases the financial risk and cost of entry into medical practice, and by forming yet another barrier to entry, drives up the fees that practitioners charge. A legally mandated “workmen’s compensation” system for medical malpractice, funded by doctors according to their level of activity, and preventing malpractice suits in all but the most heinous of cases, would provide appropriate recompense for medical errors, without allowing a class of wealthy parasites to inflate medical costs.
— Major simplification and rationalization of the Medicare and Medicaid reimbursement systems, with the aim of reducing bureaucratic costs both in government and in the service providers.
This combination of reforms would be highly politically unpopular, offending a number of major interest groups that provide huge funding to the political system. Nevertheless, only by carrying out such reforms, over the next 10-15 years, can the explosion in medical costs be contained, and long term budget stability be achieved.
And, as outlined above, the baby boom grandpas, and their Generation X successors, are going to have to work till 70!
-0-
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.