U.S. Chamber of Commerce: An Update on Entitlement Threats

00_ECON_DollarsAndSense_April2014_800x533The near-term budget outlook brightened a bit when the Treasury Department announced that the budget deficit fell to a still astounding $483 billion in 2014 from $680 billion in 2013. While encouraging, the Congressional Budget Office (CBO) suggests that the 2015 deficit will be comparable to 2014’s, but the fiscal outlook will gradually deteriorate thereafter. By 2024, the deficit is projected to rise to $960 billion and will be on an upward path. If deficits rise faster than the nominal growth in the economy as CBO projects, publicly held debt will accumulate. Debt is projected to rise from just under $17 trillion in 2013 to more than $26.6 trillion in 2024. As the debt accumulates, there will be a risk of successfully managing the debt servicing costs as interest rates rise.

Our long-term challenges are largely driven by mandatory, rather than discretionary, spending. Outlays for Social Security and Medicare are projected to about double in 2024 to $1.5 trillion and $1 trillion, respectively.

Across political aisles there is a growing understanding of the severity of the problem, and the U.S. Chamber has advanced an educational effort to build support for reform. In 2013, Chamber Executive Vice President for Government Affairs Bruce Josten gave an address, 10 Truths About America’s Entitlement Programs, highlighting the challenges we face. The need for meaningful and comprehensive entitlement reform was also a central component of Chamber President and CEO Tom Donohue’s State of American Business address earlier this year announcing the organization’s Jobs, Growth, and Opportunity Agenda.

The nature and magnitude of our nation’s future fiscal troubles were emphasized by the Social Security and Medicare Trustees when they released their updated projections on the health of the respective programs this summer. It is illuminating and concerning to review their results.

Social Security

The Social Security system provides benefits to retired workers, of course, but it also provides benefits to dependents, spouses, widows and widowers, and people with disabilities. Benefits are drawn from two primary components. Payments to individuals who are unable to work as a result of a serious medical condition are paid out of the Disability Insurance (DI) trust fund. The other beneficiaries are processed through the Old-Age and Survivors Insurance (OASI) trust fund. The combined account is referred to as Old-Age and Survivors Insurance and Disability Insurance (OASDI).

The two components are financed through payroll taxes, with 10.6% allocated to OASI and 1.8% to DI. The total tax is split between employers and employees or paid in full by the self-employed, although most economists assume that employees bear the burden of the tax. Of the two programs, DI faces the more immediate challenge. The latest Trustees Report projects that the DI trust fund will deplete in the fourth quarter of 2016. At that point it will only be able to pay 81% of scheduled benefits.

The DI trust fund faced a similar financing problem in 1994. The shortsighted response then was to reallocate a greater portion of the combined OASDI payroll tax to meet the growing costs of disability insurance. This wrongly suggested that the problem was one of resource allocation, not an excess of benefits promised compared with resources available. Before the reform, 11.2% of total payroll taxes were allocated to OASI. That was ultimately lowered legislatively to 10.6%, where the share remains today. While this temporarily fixed the shortfall in the DI trust fund, it did so at the retirement program’s expense.

In 1994, policymakers engaged in a classic case of kick the can, and there is good reason to be even more cautious of this approach today because OASI faces a greater actuarial shortfall than does DI. Diverting funds would exacerbate this problem.

The Trustees project that Social Security will meet its current obligations using revenues and interest until 2019, at which point Treasury will begin to redeem trust fund asset reserves to pay some benefits. Redemptions will continue until all reserves are exhausted in 2033, at which point payroll tax income would be sufficient to cover 77% of scheduled benefits. In other words, absent fundamental reforms, the default option is for every Social Security beneficiary to receive a 23% benefit haircut beginning in 2033.

Medicare

Medicare is the second-largest social insurance program in the United States after Social Security, but it will surpass Social Security in a few years. The financial status of the Medicare program is less apparent because different components are financed by different methods.

The Hospital Insurance (HI) trust fund (Part A) accounts for slightly less than half of Medicare spending. Like Social Security, this portion of Medicare is financed through payroll taxes. In the latest report, the Trustees project HI insolvency in 2030, which is four years later than last year’s estimate largely owing to a recent and unexplained reduction in health care cost inflation.

Payments for physician services and other outpatient services (Part B) and prescription drugs (Part D) are allocated from Medicare’s Supplementary Medical Insurance (SMI), which is projected to be adequately financed into the indefinite future. Current law automatically provides financing through general funds (e.g., individual and corporate income taxes) and premiums paid by beneficiaries. As a result, there is no shortfall in spending for these components, though costs are projected to rise from 1.9% of GDP in 2013 to 3.3% of GDP in 2035 and then to 4.5% in 2088.

Demographic Challenges

The Trustees Reports project cost and income based on projections of future demographic changes. One of the primary challenges of financing the trust funds is the growing mismatch between the numbers of beneficiaries per worker.

In 1950, there were 16.5 covered workers per OASDI beneficiary. In 2013, the ratio declined to only 2.8 workers per beneficiary. Under the Trustees’ most plausible forecast, the ratio would decline to 2.1 in 2035 and 2.0 in 2070.

For Medicare, every beneficiary in 2013 had about 3.2 workers to pay for his or her HI benefit. Paralleling Social Security, this ratio is projected to decline to only about 2.3 workers for each beneficiary in 2030.

The key demographic variables behind the Social Security and Medicare projections are total fertility rates, mortality rates, and levels of net immigration. The fertility rate is particularly important for understanding the looming financial challenges. The baby boomer generation—those born between 1946 and 1964—reflected a temporary surge in the birth rate following WWII. The baby boomers began to retire in 2007, and costs have since risen for both Medicare and Social Security.

The most imminent challenge is the projected depletion of the DI trust fund. However, it is not the greatest challenge we face. Projected long-run shortfalls for Social Security and Medicare run into the tens of trillions of dollars and will require legislative action. There has been much fear-mongering over the dangers of reform, but the biggest threat to the well-being of these programs is inaction. The Trustees Reports effectively refute suggestions that these programs are more or less fine as they are or assertions that reforms will never happen. To the contrary, these reports affirm unequivocally that reforms in each of the programs are certain. The only question is whether the reforms will be enacted sooner, later, or by default.

Many proposals have been offered to restore these programs to sound financial shape. One important takeaway is that there are sound, thoughtful proposals available to strengthen these programs. All that is lacking is political will in Washington.

A second takeaway is that the longer we wait the fewer relatively easy options we will have. By acting earlier, changes may be more modest and would give younger workers and at-risk populations adequate time to adapt. Our entitlement programs have been reformed many times over the years to meet changing financial and demographic challenges. We should capitalize on the recent spirit of bipartisanship to advance the entitlement reform debate.

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