EVENTS

Date:	Friday, May 9, 2003
Time:	9:30 AM -- 12:00 PM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

May 2003
Time Bombs in the Federal Budget

Future budget projections show a remarkable increase in the percentage of the federal budget dedicated to social insurance programs. At a May 9, 2003, forum on the federal budget, three panels discussed why this is occurring and possible reform measures.

Jagadeesh J. Gokhale
AEI

With the coming retirement of the baby-boom generation, the federal budget will be increasingly devoted to social insurance programs, the most important of which are Social Security and Medicare. Because these programs promise future benefits, it makes sense to evaluate their effect on the long-term fiscal position of the United States government. However, current measures such as debt held by the public, the annual budget deficit, and seventy-five-year actuarial deficits are inadequate because they either understate the prospective financial shortfall or give a preference to measures which improve the short-term financial situation but actually worsen the government’s long-term fiscal position. This introduces a bias in policymaking against Social Security and Medicare reforms which would make them more fiscally sustainable.

In my paper I propose the use of two new measures which will more accurately describe the effect of reforms on the long-term fiscal outlook. The first is the fiscal imbalance, which is the present value of all future outlays projected under current policy plus the current amount of debt minus the present value of all future receipts projected under current policy. This measure in essence shows how many dollars are needed today to make today’s policy sustainable. The fiscal imbalance shortfall is an unfunded obligation for past, living, and future generations and shows how far current policy is from being sustainable.

The second measure, the generational imbalance, gives the amount of the fiscal imbalance attributable to past and living generations. Thus, it can be used in combination with the fiscal imbalance to display the amount of the fiscal imbalance attributable to past and current generations and that which will be borne by future generations. The fiscal imbalance-generational imbalance composite measurement has unique benefits. It is forward looking, calculated in perpetuity, comprehensive, based on current fiscal policy, and easily communicable.

Using current OMB projections, the fiscal imbalance in 2002 dollars is $45 trillion, of which $7 trillion is from Social Security and $38 trillion is from Medicare. To restore the fiscal imbalance to zero would require an immediate permanent increase in wage taxes of 16.7 percent, or an immediate permanent increase in personal income taxes of 69.3 percent.

There is cause for optimism. Administration officials and others recognize the need for change in the ways we measure the fiscal impact of entitlement programs. In my view, the need for new budget measures is urgent enough that I recommend legislation formalizing adoption of the fiscal imbalance-generational imbalance composite measure in official budget reports.

Richard Jackson
Concord Coalition

The fiscal imbalance-generational imbalance composite measure is a definite improvement over the ten-year cumulative budget balance, which ignores demographic effects beyond the ten-year horizon. The generational imbalance measure provides an important contribution by capturing the generational tilt of entitlement programs and proposed reforms.

But perhaps the composite measurement claims too much. It tells us nothing about the time path of the budget deficit or the time path of the total debt held by the public. For example, a reform could be passed which would restore fiscal balance, but suppose it did so by legislating painful reforms which would take effect eighty years in the future. It is possible we might drown in debt in the intervening time. Furthermore, annual budget deficit projections are still important because they serve as powerful ammunition for those who seek to limit excessive indebtedness.

Another problem is that the comprehensive nature of the fiscal imbalance measure treats all programs equally into the future and ignores likely future changes in some programs. It makes sense to use the fiscal imbalance measure on certain parts of the budget which we are reasonably sure will remain in their promised form in the future. This is the case for Social Security, which has special legislative and political protection. However, since Medicare is financed partly by general revenues, it is unsound to use the fiscal imbalance measure to evaluate it, since it is highly likely that the program will change in the future.

John Sabelhaus
Congressional Budget Office

It is almost certain that once the baby-boom generation starts to retire Social Security will face a financial shortfall. Funding this shortfall will impose a burden on some group at some point in time. But it is difficult to analyze the distributional effects of different reform measures because risk characteristics vary between different proposals.

To analyze different proposals designed to distribute the costs of maintaining Social Security solvency, my paper uses a Monte Carlo approach that incorporates both the expected outcomes and the risk premiums associated with various proposals. Because there is considerable uncertainty regarding crucial demographic variables such as mortality rates, fertility rates, and immigration, I constructed probability distributions to describe the relative likelihood of possible effects under various reform measures. Thus, the model predicts how aggregate Social Security finances will change as economic, demographic, and policy rules change. This model can compare reforms with different risk characteristics. As shown in the analysis of different proposals, the distributional outcomes between generations could vary significantly.

If no changes in current policy are made, the resources in the trust fund will be exhausted sometime in the two decades after the first baby-boomers begin to retire. At that point, a combination of benefit cuts and tax increases will have to take place to ensure that the system remains solvent. This will reduce the internal rates of return for all current and future generations, but the difference in the change in internal rates of return will not be the same across all generations. Enacting reforms now to avoid drastic tax increases or benefit cuts in the future will improve the fiscal health of Social Security, but also will have varied effects on the rate of return among different generations.

Maya MacGuineas
New America Foundation

Including both financial and risk analysis makes the model detailed and precise. The strength of this model is that it successfully integrates economic, demographic, and market risks in a systematic fashion. The paper is able to show the relative risks of different proposals versus the baseline of doing nothing to change current policy.

There are three issues that need to be addressed. First, you choose to model the internal rates of return of different proposals, but many people say that internal rates of return are an inappropriate measure because Social Security is fundamentally a social insurance program. Second, you measure possible policy changes against the baseline of doing nothing to change current policy. But current policy is unacceptable, so is it the appropriate baseline to pick? Maybe you should use more than one baseline to measure against. And third, assuming the fail-safe options to be benefit cuts or tax increases fails to note the political nature of the Social Security system, which will force changes before the trust fund is completely exhausted.

The model demonstrates that the internal rates of return will fall in all reform scenarios, as well as the baseline situation of doing nothing. There is no free lunch in Social Security reform. Given this, the proposal to let individuals invest part of their Social Security benefits in private equities is the best option as it minimizes the pain which will come with reform of the Social Security system.

Eugene Steuerle
Urban Institute

The projections for Social Security and Medicare deficits are right. The essential problem is that the benefits promised in the future far exceed the tax revenues that will be realized. A couple set to retire in 2030 will receive about $1 million in Social Security and Medicare benefits under current policy, but will have paid only one-half that in taxes. Predetermined spending through entitlements constrains the spending choices available to future generations. This is a process problem which takes decisionmaking power away from the public.

Michael O’Grady
Joint Economic Committee of the U.S. Congress

The projections are believable, but convincing Congress is sometimes difficult. It is politically easier to justify subsidies to low-income groups, but charts on proposed entitlement reforms typically do not show distributional effects across income groups. The system is not sustainable in its current form, and there are serious problems ahead as Congress is considering adding a prescription drug benefits plan to Medicare, which would go to people who have not prepaid for it. It is hard to make changes to current entitlement programs because they are excellent political issues on which to campaign. However, there has been enough time to think intelligently about Medicare reform and last year’s proposals have been improved. The question is on which proposals can Congress get enough consensus to move forward?

Jeff Lemieux
Progressive Policy Institute

Entitlement programs currently represent 11 percent of GDP. That number will rise by between 4 and 9 percentage points by the year 2030. In the current environment on Capitol Hill there is no sense of shared sacrifice, particularly among Democrats. The partisan political framework is worrisome because it will make it very difficult to solve long-term entitlement problems. The surplus made it hard to reform Medicare, and this week for the first time since the mid-1990s Congress will have to make tough choices. There is a small chance that Medicare costs can be controlled, through competition among different plans in Medicare along the lines of the Federal Employees Health Benefits Program and case management, which may cut the costs of treating people with chronic illnesses.

AEI research assistant Dane Swango prepared this summary.