Our long-term budget challenge can be summarized in one word: entitlements. Without Social Security, Medicare, and Medicaid, the budget would be roughly in balance over the coming decades. But with these programs, and without reform, a fiscal crisis is inevitable. To balance the budget over the next 25 years would require an immediate and permanent 30 percent increase in all federal taxes. That is the future we face, and it is a future of our own making.
Entitlements traditionally have paid generous benefits--financed by affordable taxes--to rich and poor alike, because the ratio of workers to beneficiaries has been high. Those days are gone and will not return. Maintaining entitlements in their current form will require either crippling taxes or crippling debt. Alternatively, we can rethink the entitlement philosophy, focusing resources where they're needed most, empowering individuals to make choices and giving them incentives to reduce waste, and buttressing personal retirement savings.
We spend 9.7 percent of GDP on entitlements today, and by 2030 we will spend around 14.4 percent. Two forces bear primary responsibility for pushing entitlement spending upward: population aging and health-care-cost growth.
Population aging is easily understood: The Baby Boom generation is retiring, seniors are living longer, and families are having fewer children. The ratio of workers to beneficiaries, which is now over three to one, will fall to around two to one by 2030. Aging alone will ultimately raise entitlement costs by nearly 50 percent.
As for health-care costs, they are rising for three reasons. First, as incomes rise, the value of health increases relative to that of other goods. (As you make more money, the marginal value of new goods falls, and you would rather live longer with the stuff you have than buy more stuff and die sooner.) Second, technology generates treatments we gladly would have purchased in the past but couldn't, because they didn't exist. Today they do, and we buy them. Third, the falling share of health care that is paid out-of-pocket--47 percent in 1960, 12 percent today--encourages patients to purchase even marginally useful treatments. MIT economist Amy Finkelstein concluded that this factor alone accounts for 40 percent or more of health-care-cost growth.
Income effects and new technologies would increase health-care costs even in a totally free market. But the falling out-of-pocket share, which encourages waste and cannot be shown to contribute much to patient health, is due to government policy.
The political economy of reform is complicated by the fact that the budget automatically allocates funds rather than requiring new congressional appropriations each year. As a result, outlays can grow well out of proportion to our willingness and capacity to fund them. Entitlements are on autopilot, and the autopilot is steering us into the ground.
While traditionally called the "third rail of politics," Social Security--which provides payments to disabled workers, retirees, and retirees' survivors at an annual cost of $700 billion, making it the biggest federal program--might also be known as "the fixable entitlement." It is the program whose problems--and their potential solutions--are best understood.
Social Security's costs are driven primarily by the effects of population aging on the program's pay-as-you-go financing, which redistributes taxes from workers as benefits to retirees. But Social Security's inability to save money is important as well: While the program has a $2.5 trillion trust fund, several econometric studies have shown that policymakers don't actually save its surpluses, but rather spend them or use them to finance tax cuts. As a result, future taxpayers will be no better off than they would have been had the trust fund never existed.
In addition, Social Security paid extraordinarily high returns to early participants, a practice that prevented it from building savings that, had they actually been saved, would have helped it weather the looming demographic crisis. A typical individual retiring in 1965, for instance, received benefits amounting to eight times what he had paid in Social Security taxes. Earlier retirees did even better. Had these participants received only what they contributed, plus interest, the trust-fund balance would today be around $15 trillion higher.
Most Social Security-reform plans tweak tax and benefit formulas so that, over time, revenue aligns with costs. But it would be better to start reform efforts by asking, "What kind of retirement system will someone retiring 50 years from now need?" A Social Security program for the future must do three things: save more money, give people incentives to retire later in life, and target resources where they are needed most.
First, everyone who can save for retirement on his own should do so. President Obama and many Republicans support automatic enrollment in 401(k) and IRA pension plans. If all Americans saved just 10 percent of their wages, the need for Social Security payments would be greatly reduced. And, upon retirement, individuals should convert part of their savings to annuities; perhaps annuitized funds could be withdrawn tax-free while other withdrawals are taxed. For the typical person, these steps alone would accomplish most of what Social Security now achieves.
Second, able-bodied individuals should remain in the workforce longer. In the 1950s, the typical worker claimed Social Security around age 68. Today, despite a longer lifespan and work that is less physically demanding, the median American claims Social Security at age 62. It is an economic, budgetary, and moral mistake for Americans to spend one-third of their adult lives in retirement at the expense of those who work. The early and normal retirement ages for Social Security should be raised.
But we should use carrots as well as sticks. My research has shown that the typical worker nearing retirement age receives only around three cents in extra benefits for each additional dollar he pays into Social Security. To give this worker a good reason to keep working, the Social Security payroll tax should be reduced or eliminated for individuals older than 62.
Third, Social Security benefits for high earners should be reduced. While liberals object that "a program for the poor is a poor program"--a view based on the uncharitable assumption that if Americans know a program is redistributive, they won't support it--the current system gives about $27,000 per year in benefits to every retiree who earned more than $100,000 per year when working. This is a luxury a program facing insolvency cannot afford.
Social Security's benefit formula also needs repair. As my research has shown, most of the redistribution in Social Security is based on factors other than income. In fact, a worker's earnings level is a poor predictor of how generously Social Security will treat him. Single-earner couples do better than dual-earner couples; short working careers produce higher benefits than do longer ones; divorced women whose marriages lasted ten years or longer do better than those who divorced earlier. This means that some low-earning households receive relatively low benefits, while some high-earning households receive relatively generous ones. A flatter, simpler benefit structure would make Social Security more understandable and would more effectively prevent poverty.
The experiences of other countries might teach us something. The United Kingdom is moving to increase its benefits, coupled with automatic enrollment in pension accounts. These accounts will invest an amount equal to 8 percent of workers' earnings, with contributions split between workers, employers, and the government. Australia requires all workers to save 9 percent of their wages in individual accounts; for low earners, it provides a minimum benefit.
Meanwhile, New Zealand offers a flat universal benefit to all retirees, with voluntary "Kiwi Saver" retirement accounts providing additional income. Such a setup would be a significant change from our current system, but would allow us to give the household of every retired and disabled worker a poverty-level benefit with a payroll tax of under 6 percent. A reform that effectively eliminated poverty for retirees and generated income above the poverty level by means of individual savings would be good policy, and might even be good politics.
Reforming Social Security is important not only for its own sake, but to conserve resources for Medicare, where it will be harder to supplant dwindling government benefits with personal savings.
Medicare's fiscal challenge is like Social Security's on steroids. Medicare faces all of Social Security's demographic challenges, and also bears the burden that health expenditures have long been growing faster than the economy.
Medicare costs around $450 billion per year. That's a lot of money, but at least seniors are receiving better health care, right? Actually, it's far from clear. MIT's Finkelstein and Wellesley's Robin McKnight found that Medicare raised seniors' hospital spending by 37 percent in its first ten years (it was created in 1965) without lowering their death rates. It is true that seniors who might otherwise have no insurance now benefit from Medicare, but we could cover them for a fraction of the current cost. Seniors who can afford their own insurance pay less out of pocket with Medicare, but their health isn't much better for it: When at age 65 they shift from private plans to Medicare, they experience no reduction in mortality.
In today's dollars, Medicare will spend $775 billion by 2020 and $1.4 trillion by 2030, according to Congressional Budget Office projections. But Medicare's problem isn't just rising costs; it's also that so much of what we spend is wasted. An entitlement program that refuses no qualified claim, pays on a fee-for-service basis, and charges low deductibles invites disregard for cost effectiveness.
To restrain the rise of costs, Medicare reimburses health-care providers at rates about 20 percent lower than those paid by private insurers. But to compensate, many providers simply conduct extra procedures, according to a recent Department of Health and Human Services study. Others refuse to take Medicare patients: In a 2008 survey, the Medicare Payment Advisory Commission found that 29 percent of seniors looking for new physicians had difficulty finding a doctor who accepted Medicare.
The Obama administration has proposed taking certain Medicare-policy decisions away from Congress, which is politically risk-averse and heavily lobbied by providers, and transferring them to an expert advisory commission. This is a good idea, but the Senate health legislation, which provides for such a commission, renders it ineffectual: It would not be allowed to alter doctor or hospital payments in its first four years, and even afterward could not restrict benefits, increase co-payments or deductibles, or modify eligibility requirements. Worse yet, the commission could make no proposals in years in which overall national health-care expenditures grew faster than Medicare outlays--which means most years.
And congressional Democrats accepted the idea of such a commission only in exchange for the rest of the health-care bill--that is, only to achieve the longtime liberal goal of increasing the federal government's power over the private medical sector. Without this inducement, many Democrats would accept nothing at all.
The recent episode in which a government panel recommended that women not receive mammograms until their 50s shows the limits of the commission approach. The recommendation--exactly the type such panels would make in Obama-style reforms--was immediately attacked by lawmakers, who wrote their rejection of it into their health-care legislation.
If stripping Congress of its Medicare oversight isn't possible or won't work, a consumer-oriented approach might be a viable alternative. One such approach is "premium support": Medicare would provide each beneficiary a fixed supplement, adjusted for age, income, and health status. The Federal Employees Health Benefits Plan operates on this basis, with a government contribution set at 72 percent of the average premium. Using these funds, plus their own money, participants choose from up to two dozen providers.
Since consumers pay any premiums above the government share, and are free to choose between competing plans, they have an incentive to spend efficiently, which in turn gives providers an incentive to provide quality care at an affordable cost. The point of such a policy isn't to design and impose the best plan, but to create a market structure that will find the best plan by means of competition and innovation. And the best plan may not be the same for each person, which is another reason we should empower individuals to make their own health-care choices.
Premium support was politically unpopular when proposed on a bipartisan basis in the 1990s, and it is hard to imagine the Obama administration--which never uses a carrot when a stick is at hand--supporting consumer choice. Rep. Paul Ryan's proposed "Roadmap" reform--which also addresses Social Security, taxes, and private health care--takes a similar approach, which is why he is already being accused of wanting to "privatize" Medicare. But increased Medicare efficiency would reduce the pain of the inevitable cuts in benefits. Medicare savings of even 10 percent would amount to $75 billion by 2020 and $135 billion by 2030. And other solutions are not presenting themselves.
That brings us to Medicaid, a means-tested state/federal program that provides health care to low-income and disabled individuals. Medicaid does not have a single structure; rather, each state runs its own program, consistent with certain federally imposed requirements, and decides how much to spend. About a third of Medicaid spending goes toward long-term care for the elderly. In 2010, Medicaid spending will likely top $500 billion--even more than Medicare outlays--with costs split roughly 60-40 between Washington and the states. Medicaid is responsible for around 15 percent of all U.S. health-care spending, and is the biggest line item in state budgets.
Medicaid spending has grown--and, in consequence, crowded out private insurance--in part because of population aging and rising health-care costs, but also because states have significantly expanded eligibility in recent years. And that is largely because such expansions bring more federal funds to their coffers.
The federal government covers 50 to 75 percent of Medicaid costs, depending on the state's average income. This means that the states can provide $2 to $4 in total benefits for each $1 they spend. Under such terms, even an obviously wasteful benefit extension makes budgetary sense from the state's perspective. And cuts work the same way: Paring Medicaid spending by $4 million would save Mississippi only $1 million, while New York must cut $2 million to save $1 million. The result is a ratchet effect whereby costs increase in good times and hold steady in bad times.
The matching formula also skews Medicaid resources from poor states to rich ones, since only the rich can afford to run large Medicaid programs. Among the largest net beneficiaries of Medicaid funding are New York and Maine, whose average incomes are hardly low by national standards.
As with Medicare, the key to reforming Medicaid is shifting incentives--this time, for state lawmakers. A modest but helpful change would be simply to reduce matching rates as Medicaid spending rises, so that if states choose to expand Medicaid into the middle class they must bear the cost themselves.
A farther-reaching reform would be to fund Medicaid through block grants to the states while expanding the states' flexibility with regard to program design. (A similar approach was part of the 1996 welfare reform.) If a state wished to expand Medicaid beyond what the block grant paid for, it would have to do so with its own dollars.
All Americans should save for their own retirement and health-care needs. Only those whose savings are insufficient should receive supplements. Innovation, competition, and choice, which make American consumer markets the most vibrant in the world, should play a central role. Entitlement-reform policy isn't much more complicated than that.
In entitlement politics, however, it is far easier to play defense than offense. In 2005, when asked when the Democratic party would present a plan to reform Social Security, Nancy Pelosi's answer was: "Never. Is never good enough for you?" Likewise, in this year's health-care debate, Republicans have prospered by opposing, not proposing.
But while voters do not always reward those who make difficult choices, entitlement reform should be seen as its own reward, for without it, America will soon be crushed by either taxes or debt. The true compensation is a prosperous future consistent with our principles.
Andrew G. Biggs is a resident scholar at AEI.