What drives the long-term budget deficit -- spending increases or falling taxes?

Find the answer over at AEI's online magazine, The American.
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IBD: Social Security Math Understates Scope of Funding Problem

Jed Graham writes for Investors Business Daily that the costs of fixing Social Security may be higher than commonly understood, since it's likely that we'll borrow most of the money needed to repay the Social Security trust fund. In following years, we won't merely need to address Social Security's annual shortfalls – which themselves will be in the hundreds of billions of dollars – but the interest costs on debt accumulated up to that point.

Crunching the numbers in the 2009 trustees' report, including economic projections, shows that the extra interest costs from redeeming the trust fund bonds alone would average 1.6% of GDP from 2037 to 2083, assuming that interest payments are paid for with more borrowing.

If the government were to pay all unfunded benefit promises in 2037 and beyond while covering interest costs on the trust fund-related public debt, that would soak up 2.9% of GDP, on average, from 2037 to 2083.

Click here to read the full story.

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Fortune: The next great crisis: America's debt

Sean Tully writes for Fortune magazine:

Normally Paul Krugman, the liberal pundit and Nobel laureate in economics, and Paul Ryan, a conservative Republican congressman from Wisconsin, share little in common except their first names and a scorching passion for views they champion from opposite political poles. So when the two combatants agree on a fundamental threat to the U.S. economy, Americans should heed this alarm as the real thing. What's worrying both Krugman and Ryan is the rapid increase in the federal debt - not so much the stimulus-driven rise to mountainous levels in the next few years, but the huge structural deficits that, under all projections, keep building the burden far into the future to unsustainable, ruinous heights.

Click here to read the whole story.

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What is the debt-to-GDP ratio if we include the Social Security and Medicare trust funds?

As deficits rise and the Baby Boomers retire, the burdens of government spending on the economy are becoming more obvious. The most common measure of where we are and where may be going is the ratio of debt to gross domestic product. This ratio, more so than the simple dollar value of the debt, indicates the economy's capacity to support government borrowing.

But an important question is how to measure the debt to GDP ratio. All measures include the publicly held government debt, which means Treasury bonds held by everyone from Wall Street investors to ordinary folks saving for retirement. However, it's not clear whether we should includes intragovernmental debt, which is primarily composed of the Social Security and Medicare trust funds.

Many on the left don't like to count the Social Security and Medicare unfunded obligations – which total in the tens of trillions of dollars – as true "debt." That's fine. As some have correctly pointed out, future Social Security and Medicare benefits in excess of what the trust funds can finance are obligations, not liabilities, and can be changed at any time. (It's ironic that many on the left don't wish to change them, but that's another story.) That is, implicit debt isn't the same explicit debt.

But folks on the left are also adamant that the Social Security and Medicare trust funds are true debt – as good as any debt issued to Wall Street, as (say) Dean Baker argues. Ok, that's fine.

But if so, shouldn't we count Social Security and Medicare debt when we calculate debt-to-GDP ratios? I can't see why not. And when we do, it tells a very different picture about the evolution of public finance in the U.S. The chart below is drawn from OMB historical data from 1940 through 2007. It shows both publicly held debt – the kind we usually think about – as well as intragovernmental debt, which includes the Social Security and Medicare trust funds as well as other government trust funds (the highway trust fund, etc.).

As of 2007, publicly held debt equaled 37 percent of GDP. Not a problem, except that CBO projects that the recession and financial crisis coupled with President Obama's spending plans, by 2018 the publicly held debt could more than double, to 82.4 percent of GDP. Most people would consider that a problem.

But then add to that the intragovernmental debt that many people insist must be treated as just as "real" as publicly-held debt. There don't seem to be good projections of future intragovernmental debt, but let's just assume that the ratio to GDP remains the same. (This isn't implausible; while the Medicare trust fund is winding down, the larger Social Security trust fund is projected to peak in the 2020s.)

In that case, by 2018 total government debt will reach 111 percent of GDP. That level would put us somewhere between where Sudan and Jamaica are today, and fifth from highest globally. While there isn't a strict threshold at which debt becomes unsustainable – what matters is the growth rate of nominal debt relative to the growth of nominal GDP – even the IMF and World Bank's debt sustainability framework adjusted for a strong country like the U.S. would frown on debt at that level.

Moreover, the total debt level as of 2018 would be only slightly lower than the historical peak of 121 percent in 1946, when we had just finished fighting a war around the globe. But unlike the debt issued to fight World War Two, this debt won't be incurred in the cause of freedom but in the cause of political convenience – a fight not to defeat foreign enemies, but political opponents who say that long-term spending must be reined in.

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Fiscal child abuse

Courtesy of the always-interesting Carpe Diem:

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Judd Gregg role on entitlement reform?

One reason Republicans regretted New Hampshire Sen. Judd Gregg's acceptance of President Obama's nomination as Commerce Secretary is that the Senate would lose one of its strongest voices for long-term budget and entitlement reforms. Gregg was a leading sponsor of the so-called Gregg-Breaux Social Security Reform Act, which was co-sponsored by Sens. John Breaux (D-LA), Chuck Grassley (R-IA), Bob Kerrey (D-NE), Chuck Robb (D-VA), Craig Thomas (R-WY) and Fred Thompson (R-TN). More recently, Gregg has teamed up with Budget Committee chairman Sen. Kent Conrad to sponsor a commission to take on long-term tax and spending challenges, including entitlement reforms. These are big shoes to fill.

But it appears all is not lost. A story in Politico today contains the following note:

In something of a surprise, the fiscally conservative Gregg noted that Obama selected him "especially" for his work on entitlement reform. "If our credit is going to be good and our dollar is going to be strong, we have to address entitlement reforms," the Republican said.

While the Commerce Department has not before played a strong role on entitlement reform, Gregg's will be a strong voice within the administration for restraining the growth of entitlement spending and putting the nation's long-term books in order.

Update: The Manchester Union Leader weighs in here.

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Michael Kinsley on Entitlement Myths

Michael Kinsley argues in Time Magazine that we should reconsider our views of the "entitlement crisis." While always interesting, I'm not sure Kinsley's arguments really hold up to scrutiny – but see my comments below and judge for yourself.

The Peter G. Peterson foundation, a new and welcome arrival on the national scold scene, announced in a December press release that the U.S. is bankrupt. Not the government but the whole country and everyone in it. As of Sept. 30, the PGP folks reported (using figures from the Federal Reserve), the value of everybody's assets was $56.5 trillion. The value of our liabilities (public and private) was $56.4 trillion. Given what has happened to real estate and the stock market since Sept. 30, it seems certain that we now owe more than we are worth.

It seems certain, that is, if the PGP folks are correct. Now, I'm all for doom 'n' gloom--they've done very well for me in the journalism business over the years--but this struck me as too bad to be true. And on closer examination, it is. About $40 trillion of PGP's $56 trillion in liabilities is its calculation of future Medicare and Social Security benefits ($34 trillion of it is Medicare alone), which Congress has promised to future senior citizens but has made no provision to pay for. This is the entitlements nightmare we hear so much about. Trouble is, the PGP folks seem to have forgotten about this $40 trillion of dubious promises when totting up the assets of people who will (or possibly won't) get the benefits. If these entitlement promises are real government debts, they are also real assets for the people who will enjoy them. If (as we gloomsters suspect) they aren't real for the future recipients, then they aren't real for the government either.

American families may have borrowed irresponsibly, and may have elected politicians who borrow even more irresponsibly on their behalf, but the typical American family is not bankrupt. The average couple age 65-74 has accumulated a net worth (not counting entitlement promises as either assets or liabilities) of $691,000, according to the Federal Reserve in 2004. Shortly thereafter, of course, they start to die in large numbers. And what happens to the $691,000? Generally it goes to the children and grandchildren.

It's often said, on the subject of underfunded entitlements, that we are "robbing future generations." This is not completely true. You can't literally steal, say, a vacation home from the year 2050 and plant it next to a beautiful lake in 2009. Nor can you beg, borrow or steal money in 2050 and spend it in 2009. But you can reduce your savings rate in 2009, spend the money instead and leave a less prosperous country in 2050. And if you borrow money from foreigners in 2009, as we have been doing more and more, they can indeed come knocking in 2050 and demand their money back. With interest.

Meanwhile, though, families--middle-class families, not just rich ones--are passing hundreds of thousands of dollars on to the next generation in their wills. Fair enough, if they worked for the money and saved it. In fact, wonderful. But much of this generosity, it turns out, is made possible by Social Security and Medicare. How much? Hard to say. What is easier to say with certainty is that most people today and in the future will get more back from these entitlement programs in retirement than they put in during their working lives.

Medicare and Social Security are supposed to be insurance against the perils of old age: poverty and illness. They are not supposed to be gifts or subsidies to the children of retirees. Yet that is what, in large part, they have become. The reason for insurance is that you can't predict the future. If an elderly woman has diabetes and her husband needs heart surgery, then dies anyway, leaving her impoverished, Medicare and Social Security should be there for her. And if it all costs far more than she ever put into the system, that's O.K. too.

But if our elderly woman dies with $691,000 in the bank, it's evident that she didn't need the government money to pay for her health care or to avoid plunging into poverty. She wasn't lying or cheating--she might have been legitimately worried--but her worries turned out to be unnecessary. And society, having kept its promise to her, should get at least part of that money back. Oh, yes, designing a system to achieve this would be a nightmare--maybe impossible. The incentive for old folks to squander their savings would be enormous. Maybe it can't work. But the point is worth keeping in mind as we enter President Obama's "new age" of "hard choices."

And the children? Let them rob their own children, just as their parents did.

Some thoughts: First, while Kinsley's point regarding the Peterson Foundation's account seems correct – a debt to someone has to be an asset to someone else – transferring massive amounts of resources through Social Security and Medicare entails significant efficiency losses. Social Security contributions are regarded as taxes by workers in ways that contributions to personal saving are not, and therefore reduce incentives to work. So while the accounting may net out, there are economic costs in getting from here to there.

Second, Kinsley may exaggerate the size of inheritances that will be passed on to Baby Boomers and younger cohorts. This paper by Kotlikoff and Gokhale concludes that the bequest boom is likely overstated.

Third, even if households continue to pass on significant bequests to their heirs, this won't be – as Kinsley claims – due to the generosity of Social Security. For early generations of beneficiaries, Social Security provided benefits well in excess of contributions, which – assuming seniors didn't just consume this extra income – allowed for larger inheritances. But as this memo from the SSA actuaries shows, Social Security can afford to pay a typical couple retiring in 2008 benefits and interest equal to only around 75 percent of the taxes the couple paid in over their lifetime. Social Security imposes a net tax on current and future retirees and, if anything, reduces the amount of wealth they'll have to leave to their kids.

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Ross Perot on Social Security Reform

The New York Times Freakonomics blog has a Q&A feature with Ross Perot where the billionaire budget reform answers reader questions on a number of topics, including Social Security reform.

Q. How do you believe Social Security can be reformed (or abolished, if you believe this) to benefit my generation (I'm 17 years old) as well as the current generation?

A. Plans such as Rep. Paul Ryan's (R.-Wis.) "Roadmap for America's Future" contain several ideas for reforming Social Security that deserve serious consideration. The challenge is to preserve the benefits for retired citizens and those nearing retirement age, say 55 and older, while strengthening the retirement benefits for the remaining workers. This would include ensuring the solvency of the Social Security system with changes to the retirement age.

Contrary to conventional wisdom, the current financial crisis offers the perfect time to face this problem. The record deficit spending that has already been approved is sure to place enormous burdens on our children and grandchildren for years to come. Taking steps now to solve the Social Security dilemma (as well as the more pressing problems posed by Medicare and Medicaid) will help to bring clarity to the long-term outlook for our nation's financial future.

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A correction and clarification on aging and health care cost growth

Recently I authored a Health Policy Outlook for AEI that looked at the relative roles of aging and per capita health care cost increases – called 'excess cost growth' – in driving increases in overall entitlement spending. The piece took on a increasingly common view that excess cost growth is really the only player in the entitlement game, making Social Security reform and policy issues regarding population aging seemingly irrelevant. New York Times columnist Paul Krugman, for instance, wrote that "the whole Beltway obsession with the fiscal burden of an aging population is misguided." Krugman and others cited a November 2007 CBO report as evidence; the report contained a chart showing that over the next 75 years almost 9 out of every 10 dollars in increased Medicare and Medicaid spending would be driven by excess cost growth, not population aging. This graph got my attention when it was featured in a blog post from Mark Thoma entitled "It's Not Social Security."Here's my recreation of the original CBO Medicare/Medicaid chart.

Now, for the correction: in my article, I quoted an op-ed from CBO Director Peter Orszag that appeared in the Wall Street Journal in December, 2007 in which he said "The fiscal gap does not arise, as many believe, primarily from the coming retirement of the baby boomers. Rather, the rate at which health-care costs grow will be the primary determinant of the nation's long-term budget picture." In my article, I pointed out that you could not infer this conclusion from the November 2007 CBO study because it did not include Social Security and did not express cost increases in present value form. However, in subsequent conversations it was pointed out to me Orszag's op-ed was referring to CBO's December 2007 Long Term Budget Outlook, in which the fiscal gap for the entire government, including Social Security, was calculated. This mischaracterization was an error on my part which I should have caught, and I regret not doing so.

That said, the fiscal gap calculations in the December Long-Term Budget Outlook shared the principal shortcoming of the November 2007 analysis, which was that interactions between aging and excess cost growth were attributed entirely to excess cost growth, not shown separately (as CBO has done in subsequent papers) or divided proportionatley between aging and excess cost growth (as I did in my paper). In addition, CBO used a technique for accounting for the effects of aging and excess cost growth on GDP – the denominator in the costs/GDP calculation – that tends to increase the share attributable to excess cost growth. (See CBO's May 2008 policy brief.) An equally plausible approach, I argued, showed a somewhat higher share deriving from population aging. (In the May policy brief, CBO's preferred method is called "approach 1" while I have used "approach 3.")

Here's a chart that attributes to aging and excess cost growth their proportionate shares of the interactions between the two, and uses CBO's "approach 3" from their May policy brief to account for effects on GDP.

Now here's an additional chart using the same methods, except that it adds to aging's share cost increases attributable to Social Security. As you can see, this is moving away from the original chart from which outside commentators drew so many conclusions.

This final chart expresses total Social Security, Medicare and Medicaid spending increases due to aging and excess cost growth in present value form. This discounts future cost increases at a 3 percent real interest rate, and more closely resembles methods used for Social Security and Medicare actuarial accounting as well as for calculations of the fiscal gap. You can see here that the roles of aging and excess cost growth are practically equal. (In this instance, aging is very slightly larger than excess cost growth, at 51%-49%, using CBO's "approach 1" for handling interactions with GDP, aging's share is 42% of the total.)

The point of these calculations isn't to show that aging is the primary cost driver of future entitlement spending; rather, it is simply to rebut the argument that aging is a bit-player in total entitlement spending – in other words, to show that concern over an aging population isn't misguided. Moreover, these numbers don't lead to the conclusion that we need less research on health care cost growth. Population aging, and the potential policy responses to it, have been much-studied and are well understood, why the drivers of health care cost growth and the relationship between health care cost and quality are much less well understood. What the results do show, which is what I argued in the original piece, was that we need continued research and policy work on both fronts.

Click here to download a spreadsheet containing these figures.

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Arnold Kling blogs on Aging vs Health Care

The always-interesting Arnold Kling at EconLog has a short post drawing attention to my recent AEI paper comparing how population aging and health care cost inflation will contribute to the long-term fiscal gap. (Hint: aging plays a much bigger role than many say.)

Here's Arnold's thoughts:

From my perspective, the health care cost issue is a bit of a red herring. If you had government out of the health care financing business, you would not worry about what health care costs are doing. If my fellow citizens choose to spend more of their money on their health care, that's not my concern. It's the prospect of my fellow citizens spending more of my money on their health care that has me worried.

A good point. There are good reasons to spend more on health care – rising incomes make health care more attractive than other good, and new technologies make new treatments available – but there are also a lot of reasons we shouldn't be spending so much. While I'm not a health care expert, I do believe that if customers saw more of the bill they were paying there would be greater pressure for efficiency in the health care sector.

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Trailer for IOUSA

So this weekend I found myself at the theater watching the new Batman film – a bit dark for my tastes; I prefer my non-stop action and senseless violence to be more optimistic and life-affirming – but before the movie started we got to see the trailer for the new documentary IOUSA, which focuses on the work of the Concord Coalition and former GAO head David Walker in promoting long-term entitlement reform. The Peter G. Peterson Foundation, which Walker now heads, is promoting the film which will open across the country later in August.

Here's the trailer:

Several weeks ago my wife and I were lucky enough to attend a pre-screening here in Washington, which we enjoyed very much. It doesn't have as many explosions as Batman, but it's twice as scary.

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GAO: Long-term still unsustainable

The Government Accountability Office released an update to their long-term fiscal outlook. GAO illustrates taxes and spending under two baselines:

The first is “Baseline Extended,” which follows the CBO’s January baseline estimates for the first 10 years and then simply holds revenue and spending other than large entitlement programs constant as a share of gross domestic product (GDP). The second is the “Alternative simulation” based on historical trends and recent policy preferences. Under these alternative assumptions, discretionary spending grows with the economy rather than inflation during the first 10 years, Medicare physician payments are not reduced as in current law, and revenues are brought down to their historical level.

The following table summarizes the fiscal gap under the two baselines.

So we have a choice between a 17% increase in federal taxes or reduction in spending under the optimistic baseline, or a 36% increase in taxes or reduction in spending in the other. As with other analyses, most of this is driven by cost growth in health care, with smaller contributions from Social Security and other programs. Sobering stuff. Read more!