|Retirement Policy Outlook logo 130||
No. 2, September 2010
The 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. Left unreformed, however, entitlement costs will become so wildly out of step with revenues that a fiscal crisis will be inevitable. Balancing the budget over the next twenty-five years would require an immediate and permanent 30 percent increase in all federal taxes. Over longer periods, the prognosis is even grimmer. The alternative is to rethink the entitlement philosophy by focusing resources where they are most needed, sharpening incentives to reduce waste, empowering individuals to make choices, and buttressing Americans' own retirement savings.
Key points in this Outlook:
- Rising entitlement costs are largely responsible for the long-term budget deficit and are leading the United States toward a fiscal crisis.
- Social Security reform should encourage individual savings, extend the working years, and reduce benefits to high earners.
- Medicare reform should use "premium support" plans to increase efficiency and reduce costs.
- Medicaid reform should reduce states' incentives to waste government money.
We have been warned for decades by Social Security and Medicare trustees, bipartisan commissions, government agencies like the Congressional Budget Office (CBO) and Government Accountability Office, and independent experts. Yet administrations of both parties have expanded entitlements even as unfunded obligations piled up by the trillions. Entitlements traditionally paid relatively generous benefits to rich and poor alike, financed by affordable tax rates, but those days are gone and will not return.
While the Left sometimes blames the fiscal gap on tax cuts, tax revenues would rise relative to gross domestic product (GDP) even if the Bush tax cuts were made permanent. Over the past forty years, personal income-tax revenues have averaged 8.2 percent of GDP. The CBO projects that even if the Bush tax cuts were made permanent and the Alternative Minimum Tax were indexed to inflation, income-tax revenues would exceed the historical average by 2013 and top 10 percent by 2030. A shortage of tax revenue is not what is driving the fiscal gap.
The simple problem is spending: today, we spend 9.7 percent of GDP on entitlements, while by 2030 we will spend around 14.4 percent. In contrast, the federal government spent only 6.7 percent of GDP on entitlements in 1990 and 4.0 percent in 1970. Two forces push entitlement spending upward: the aging population and rising health care outlays per beneficiary. More retirees collecting higher benefits means higher costs
Population aging is easily understood: the baby-boomer generation is retiring, seniors are living longer, and smaller families leave fewer workers to support them. The ratio of workers to beneficiaries, which is now over 3 to 1, will fall to almost 2 to 1 in 2035. Aging alone will ultimately raise entitlement costs by nearly 50 percent in coming decades.
Health care costs are rising for three reasons. First, as incomes rise, the value of health increases relative to other goods; individuals would rather live longer with the stuff they have than buy more goods and die sooner. Second, technology generates treatments we gladly would have purchased in the past, but could not since they did not yet exist. Today they exist and we buy them. Third, the falling share of health care paid out-of-pocket--from 47 percent in 1960 to 12 percent today--encourages patients to purchase even marginally useful treatments, since they are mostly spending other people's money.
The effects of these incentives are difficult to quantify, but the RAND Corporation health experiment of the 1970s and '80s found that working-age individuals who paid 25 percent of health costs out-of-pocket spent around 20 percent less than those with no cost sharing. Individuals with the equivalent of health savings accounts spent around 30 percent less. Importantly, all classes of patients had similar health outcomes. MIT economist Amy Finkelstein goes further, concluding that 40 percent or more of the increase in health costs in recent decades is due to the way we pay for health care.
Technology and the rising value of health would increase health outlays even in a totally free market. But the falling out-of-pocket share, which generates cost and waste and contributes nothing to patient health, is due to government policy choices. Tax preferences for employer-provided health insurance encourage employers to shift compensation from wages to more health coverage, as the choice is between providing one dollar in health coverage or one dollar minus taxes in wages. Moreover, the fact that health premiums are tax-deductible while copayments and deductibles generally are not encourages health provisions in which premiums are high and deductibles low, an "all-you-can-eat restaurant" model that increases both the number of uninsured and the amount of wasteful provision for those who do have insurance. Medicare and Medicaid are consistent with this model and suffer from the same shortcomings.
As a result, the problem with Medicare and Medicaid is not necessarily the growth of their costs. It is that they cost so much--and are so wasteful--in the first place. Reforms that focus on cutting waste and improving cost-effectiveness will be more successful than those that focus simply on cutting some arbitrary trend rate of cost growth
The political economy of reform is complicated by the fact that the budget automatically allocates funds rather than requiring congressional appropriations. As a result, outlays can grow well beyond our willingness and capacity to fund them. Entitlements are on autopilot, and the autopilot is steering us into the ground. As my AEI colleague Joseph Antos points out, we should always think in terms of entitlement "spending," not entitlement "costs." Entitlements are a choice we have made, but those choices can, must, and will be altered in years ahead. Pretending that we have no options only deepens the reluctance to act.
While traditionally termed the "third rail of politics," Social Security might also be called "the fixable entitlement," the program whose problems and potential solutions are best understood. Social Security is the biggest federal spending program, the largest tax paid by most workers, and the principal source of income for most retirees. Reforms to Social Security, which provides payments to retirees, disabled workers, and survivors at an annual cost of over $700 billion, would impact the budget and Americans' lives simply by virtue of its size.
Social Security's costs are driven entirely by the effects of population aging on the program's pay-as-you-go financing, which transfers taxes from workers into ben-efits for retirees. Larger numbers of beneficiaries and relatively fewer workers implies higher costs per worker. Moreover, Social Security's $2.5 trillion trust fund will not do anything to reduce costs for the taxpayer. Several econometric studies conclude that policymakers dissipate Social Security surpluses through increased spending or reduced taxes rather than saving them. As a result, future taxpayers will be no better off than they would have been had the fund never been accumulated.
But Social Security's problem is not simply changing demographics. The program also paid extraordinarily high returns to early participants, preventing the system from building savings that would help it weather future demographic changes. A typical individual retiring in 1965, for instance, received eight times more in benefits than he paid in taxes. Earlier retirees did even better. Had these participants received only what they paid in, plus interest, the trust-fund balance would be around $15 trillion higher today.
Most Social Security reform plans tweak tax and benefit formulas so that, over time, income aligns with costs. A better approach, however, might be to start with the goal, by asking, "What kind of retirement system would a person retiring fifty years from now need?" To operate successfully in the future, a reformed Social Security program should do three things: encourage savings, extend working years, and target resources where they are needed most.
First, everyone who can save for retirement should save. President Barack Obama and many Republicans support automatic enrollment in 401(k) and IRA pension plans. If Americans saved 10 percent of their wages, the need for Social Security payments would be far lower. At retirement, individuals should convert part of their accounts to annuities to protect against destitution in old age; perhaps annuitized funds could be withdrawn tax-free while other withdrawals might be taxed. For the typical person, these steps alone would accomplish most of what Social Security does.
Second, able-bodied individuals should remain in the workforce longer. In the 1950s, the typical worker claimed Social Security around age sixty-eight. Today, despite longer life spans and less physically demanding work, the most common age at which Americans claim benefits is sixty-two. It is an economic, budgetary, and moral mistake for Americans to spend one-third of their adult lives in retirement, financed by those who work. The early and normal retirement ages for Social Security should increase along with life expectancies, but we should use carrots as well as sticks. My research has shown that the typical individual nearing retirement age receives only around three cents in extra benefits for each additional dollar of taxes paid into Social Security. To sweeten the deal, the Social Security payroll tax should be reduced or eliminated for individuals over age sixty-two.
Third, Social Security benefits for high earners should be reduced. While liberals object that "a program for the poor is a poor program"--based on the uncharitable view that Americans would not support a program if they knew it was redistributive--paying $27,000 per year in benefits to a person who earned over $100,000 per year cannot be our highest priority. As evidence of the program's importance, liberals often cite the fact that even middle and high earners rely heavily on Social Security for income in retirement; but it is also evidence that many Americans who could afford to finance their own retirements have ceased to do so, relying on the government instead. High earners would rather receive lower benefits than pay higher taxes; policy reforms should oblige them.
Social Security's benefit formula also needs repair. As some of my work has shown, most of the redistribution in Social Security is based on factors other than income, such that an individual's earnings level is actually a poor predictor of how he or she fares under the program. Single-earner couples do better than dual earners; short working careers produce higher benefits than longer careers; divorced women whose marriages lasted ten years do better than those who divorced earlier. As a result, some low-earning households receive relatively low benefits while some high-earning households receive relatively generous benefits. A flatter, simpler benefit structure would make Social Security more understandable to participants and better prevent poverty.
Experiences overseas may have something to teach us. The United Kingdom is moving toward a strengthened safety net coupled with automatic enrollment in pension accounts that invest 8 percent of earnings, split among workers, employers, and the government. Australia requires all workers to save 9 percent of wages in individual accounts, with a means-tested minimum benefit for low earners. More radical still, New Zealand provides a flat universal benefit to all retirees, with voluntary "Kiwi Saver" retirement accounts providing additional income. Moving to a noncontributory base pension would be a significant change from Social Security, which has always relied on the precept of "earned benefits"; but Washington already provides a means-tested retirement benefit through Supplemental Security Income. For less than 6 percent of payroll, we could provide every retired and disabled household a poverty-level benefit. A radical reform that effectively eliminated poverty for retirees but generated income above the poverty level from individual saving might be both good policy and good politics.
Almost any form of income redistribution hurts incentives to work and save, but an explicit guarantee would not necessarily be more harmful than what we already have. Moreover, negative incentives would be focused on the very lowest earners, making effects on overall economic output small. Retirement income is the area where individual savings can most easily replace lost government benefits, and building individual savings will conserve resources for Medicare--where such tradeoffs are more difficult.
Medicare faces all the demographic challenges of Social Security, with the added burden that health spending per person has been rising faster than the growth of the economy. The resulting fiscal challenge is Social Security on steroids. Medicare will spend $775 billion by 2020 and $1.4 trillion by 2030 (in today's dollars), according to CBO projections. Liberals consistently counter efforts to fix Social Security by arguing that the real crisis lies elsewhere: "Social Security is not the big problem," wrote New York Times columnist Paul Krugman. "It's Medicare and Medicaid." But once in power, congressional Democrats proceeded to do next to nothing about it except use Medicare cuts to fund their proposed health reform bill.
Yet the problem with Medicare is not just rising costs, but 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 automatically generates disregard for cost-effectiveness. Medicare today costs around $450 billion per year, and seniors are not necessarily receiving better health care. MIT's Finkelstein and Wellesley's Robin McKnight found that Medicare raised seniors' hospital spending by 37 percent in its first ten years of exist-ence without improving death rates. Likewise, even today there is no reduction in mortality as people turning sixty-five shift from the supposed jungle of private insurance to the universal coverage supplied by Medicare. Low-income seniors benefit from Medicare, but we could cover these individuals at a fraction of what we pay today. Medicare's biggest effect is on seniors' pocketbooks, with Finkelstein finding significantly lower costs paid out-of-pocket.
In addition to providing patients with treatments they may not really need, some providers bill Medicare for treatments they have not provided at all. The federal government estimates that around $65 billion is lost to Medicare fraud each year, one dollar in every seven spent by the program. Outside researchers believe totals could reach $100 billion annually. False billing and the provision of unnecessary treatments allow bogus providers to scam millions from the system. In contrast, private-sector insurers have incentives to combat fraud, and they devote significantly larger shares of their administrative costs to tracking fraudulent claims.
Furthermore, Medicare and Medicaid impose significant administrative burdens on providers. Medicare alone has over 110,000 pages of regulations, while Medicaid adds thousands more. An American Hospital Association survey found that providers spent a half hour complying with Medicare paperwork for each hour spent delivering care. Time spent on paperwork has a cost just as overtreatment and outright fraud do. Moreover, despite talk about combating health care fraud, the antifraud provisions in both recent health reform bills were so vaguely worded that even Medicare's own actuaries could not estimate the cost savings they might produce.
To hold back rising costs, Medicare reduces provider reimbursements to around 20 percent below private rates. In response, some providers simply conduct more pro-cedures. A 2008 Department of Health and Human Services study stated that "declining payments . . . were partially to blame for physicians' attempt to make up in procedure volume what they were not compensated for during regular office visits." Other providers leave Medicare rather than swallow these cuts. A 2008 survey found that 29 percent of seniors looking for a new physician had problems finding one who accepted Medicare. The reasons doctors leave Medicare, according to the New York Times, are that "reimbursement rates are too low and paperwork too much of a hassle."
The Obama administration has proposed shifting some Medicare policy decisions away from Congress--which is politically risk averse and lobbied heavily by providers--to an expert advisory commission. While this would be a good step, the Senate health legislation rendered the commission largely toothless. It could not touch doctors or hospitals for its first four years, and even afterward could not restrict benefits, increase cost sharing,or modify eligibility. Worse yet, the commission could make no proposals in years in which overall national health expenditures grew faster than Medicare outlays--that is, most years. Congressional Democrats accepted this modicum of outside control only in exchange for realizing the long-time liberal goal of increased federal power over private-sector health care. Lacking these inducements, many Democrats would accept nothing at all.
The recent episode in which a government panel recommended that women not begin mammograms until their fifties shows the limits of this approach. The decision--exactly the type such panels would make in Obama-style reforms--was immediately attacked by lawmakers, who wrote their rejection into the health reform legislation. This illustrates the practical difficulty that even a nominally independent panel will have in reducing health outlays in a politicized environment.
At the end of the day, Medicare is neither government fish nor free-market fowl. It lacks the power to set both prices and quantities that a system like Britain's National Health Service possesses, but it also lacks any market mechanism by which cost-efficient treatments and providers necessarily supplant the less worthy. While political forces would find it difficult to, say, shift resources from a hospital in one congressional district to a hospital in another based on performance, market forces already do so with neither pain nor protest. To be solvent, Medicare must head either toward greater government control or greater market control. This is one reason why political compromise on Medicare has so far proved impossible.
If Americans are unwilling to tolerate more command-and-control from the government, a consumer-oriented approach might be more acceptable. Most economists believe that health insurance should cover little or none of the initial costs but have no limit for catastrophic costs. Medicare often works opposite to this: initial costs are covered in full while there are limits on maximum costs. Reversing this approach would likely reduce costs for Medicare while improving beneficiaries' protections against catastrophic costs.
One market-based approach is so-called premium support, in which Medicare would provide each beneficiary with a fixed supplement, adjusted for age, income, and health status. The Federal Employees Health Benefits Plan operates on a similar basis. The government contribution is set at 72 percent of the average plan premium. Using these funds, plus their own contributions, participants choose from up to two dozen national and local insurance providers.
Since the federal contribution is capped and individuals pay any premiums above the government's share, consumers have the incentive to seek quality and plans have the incentive to provide it. Under a premium-support model, all flavors of health insurance would compete for seniors' dollars. A managed-care plan might compete against traditional fee-for-service plans and high-deductible plans, including health savings accounts. The point is not to impose the best plan but to find the best plan, through experimentation and competition. And that best plan may not be the same for everyone.
Premium support failed to achieve political support when proposed on a bipartisan basis in the 1990s, and it is hard to see the Obama administration--which never uses a carrot when a stick is at hand--supporting consumer-based cost controls. Representative Paul Ryan's reform plan relies on a similar approach and is already being accused of "privatizing" Medicare. But increased Medicare efficiency would reduce the pain of cost cuts. Medicare savings of even 10 percent would generate annual savings of $75 billion by 2020 and $135 billion by 2030. While this solution may not be popular, other solutions are not presenting themselves.
Medicaid is a means-tested state-federal program for low-income and disabled individuals, with about one-third of spending going toward long-term care for the elderly. That said, there is no single "Medicaid"; rather, each state runs its own program, consistent with certain federally imposed requirements, and decides how much to spend. Medicaid spending in 2010 likely will top $500 billion, even higher than Medicare, with costs split roughly 60-40 between Washington and the states. Medicaid represents around 15 percent of all U.S. health spending and exceeds education as the biggest line item in state budgets.
While Medicaid spending rises with population aging and health care costs, states also have significantly expanded eligibility in recent years. Today, 60 million individuals are covered by Medicaid, including 25 percent of American children, as the program expands into the middle class in some states. The middle-class elderly, especially, rely on Medicaid for long-term care when their assets are exhausted (or, in many cases, disposed of to qualify for the program). With assisted living in the Washington, D.C., area costing over $57,000 per year and nursing home care costing over $91,000, it is not surprising that more retirees are relying on Medicaid. But these costs do not disappear; rather, they are simply transferred to taxpayers. Recent health reform legislation would further expand Medicaid to cover 15 to 20 million currently uninsured Americans.
Although Medicaid expansions crowd out private insurance and drive up costs, federal matching formulas make expansions a virtual no-brainer for state lawmakers. States decide how much to spend on Medicaid, but the federal government covers from 50 to 75 percent of the costs, depending on the state's income. When states expand Medicaid, they receive $1 to $3 in federal assistance for each $1 they spend themselves. Under these terms, even an obviously wasteful benefit extension makes perfect sense; after all, it is not wasting the state's money.
The matching formula also means that cutting Medicaid is a poor way to raise revenues. Cutting Medicaid by $4 million would save Mississippi only $1 million; 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. While the formula is progressive, only richer states can afford to run large Medicaid programs. Among the largest net beneficiaries of Medicaid funding are New York and Maine, states that are hardly low income.
As with Medicare, the key to Medicaid reform is shifting incentives--this time, for state lawmakers. A modest reform might simply reduce match rates as spending rose, such that basic spending would receive a higher federal match while Medicaid expansions to the middle class would be paid by the states. A more far-reaching reform would transform Medicaid funding into state block grants. States could be given increased flexibility in program design, such as that granted under the 1996 welfare reform law. But with a block grant, a state that chooses to expand Medicaid does so with its own dollars. The point is not necessarily to shift costs to the states overall; it is to shift costs at the margin, so that the policymakers who decide on program expansions bear the costs of doing so. An additional dollar of state resources would be dedicated to Medic-aid only if it brought at least one in perceived benefits.
The Politics of Reform
Entitlement reform must focus on what programs are really supposed to accomplish, get the incentives right, and limit government activity to what government does best. Government is good at mandating things, but not so good at carrying them out. Government is good at redistributing wealth, but not so good at insuring that resources are spent wisely. All Americans must save to cover their retirement income and health care needs. Those whose savings are insufficient should receive supplements. Innovation, competition, and choice--which make American consumer markets the most vibrant in the world--must play an important role. It is not much more complicated than that.
In entitlement politics, it is far easier to play defense than offense. Representative Nancy Pelosi's answer in 2005 when asked when the Democratic Party would present its own Social Security plan was "Never. Is never good enough for you?" Likewise, in this year's health debate, Republicans benefited politically by opposing, not proposing.
It is unclear whether a comprehensive reform such as Representative Ryan's Roadmap plan, which addresses Social Security, Medicare, taxes, and private-sector health care, is more viable than incremental reforms. Also unclear are the benefits of a bipartisan reform commission, which would likely endorse significant cost reductions but also significant tax increases. While compromise is important, commissions are geared toward splitting the difference rather than proposing the comprehensive reforms that are necessary.
In the end, we must choose between larger programs financed by higher taxes or better, more targeted plans that focus resources where they are needed most. Reforming entitlements should be seen as a virtuous act if only because virtue, as it is said, is its own reward. The political party that reforms entitlements will not likely be rewarded at the ballot box for doing so. However, that party will secure an America consistent with its vision for decades to come.
Andrew G. Biggs (firstname.lastname@example.org) is a resident scholar at AEI. A version of this Outlook appeared in the March 22, 2010, edition of National Review.
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3. Social Security Administration Board of Trustees, The 2009 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds, 111th Cong., 1st sess. (Washington, DC, May 2009), table IV.B2, available at www.ssa.gov/OACT/TR/2009/lr4b2.html (accessed September 2, 2010).
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8. There is also an interactive effect between low marginal costs and new technologies, as the former encourages investment in the latter, even if it is not cost-effective in terms of total costs.
9. On this topic, see John Sabelhaus, "Will the Slowdown in U.S. Health Cost Growth Continue? A Factor Market Perspective" (working paper, Social Science Research Network, March 2008), available at http://ssrn.com/abstract=1105033 (accessed September 2, 2010). Sabelhaus decomposes health care cost growth into growth in the health care labor force and growth in health care workers' wages, suggesting a more complex view of future health cost growth than is suggested by a simple extrapolation of past trends.
10. Social Security Administration Board of Trustees, The 2009 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds, table VI.F8.
11. Andrew G. Biggs, "What Does It Mean to ‘Save the Surplus'?" available at http://andrewgbiggs.blogspot.com/2008/03/what-does-it-mean-to-save-surplus.html (accessed September 2, 2010).
12. Dean Leimer, "Cohort-Specific Measures of Lifetime Social Security Taxes and Benefits" (ORES Working Paper 110, Social Science Research Network, December 2007), available at http://papers .ssrn.com/sol3/papers.cfm?abstract_id=1217123 (accessed September 2, 2010).
13. Social Security Administration Office of Retirement and Disability Policy, Annual Statistical Supplement 2008 (Washington, DC, 2008), table 6.B5, available at www.ssa.gov/policy/docs/statcomps/supplement/2008/6b.html (accessed September 2, 2010).
14. Ibid., table 6.A4.
15. Gayle Reznik, David A. Weaver, and Andrew G. Biggs, "Social Security and Marginal Returns to Work Near Retirement" (Social Security Issue Paper 2009-02, Social Science Research Network, April 15, 2009), available at http://papers.ssrn.com/sol3/papers.cfm? abstract_id=1434508 (accessed September 2, 2010).
16. Social Security Administration Board of Trustees, The 2009 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds, table VI.F10.
17. Andrew G. Biggs, "Will Your Social Insurance Pay Off? Making Social Security Progressivity Work for Low-Income Retirees," AEI Retirement Policy Outlook (January 2009), available at www.aei.org/ outlook/29198.
18. Paul Krugman, "Good Sense from the CBO," New York Times, November 9, 2007.
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22. Grace Arnett, Jonathan Emord, Laurence Huntoon, and Robert Charrow, "How Medicare Paperwork Abuses Doctors and Harms Patients," Heritage Foundation, May 11, 2000, available at www.heritage.org/Research/Lecture/How-Medicare-Paperwork-Abuses (accessed September 2, 2010).
23. Melinda Buntin, Stephen Zuckerman, Robert Berenson, Anant Patel, and Teryl Nuckols, "Volume Growth in Medicare--An Investigation of Ten Physicians' Services" (Working Paper WR-6310-ASPE, RAND Health, December 2008), available at http://aspe.hhs.gov/health/reports/08/medicarevolume/report.pdf (accessed September 2, 2010).
24. Julie Connelly, "Doctors Are Opting Out of Medicare," New York Times, April 1, 2009.
25. Joshua Gordon, "Save the Medicare Commission," Concord Coalition, December 1, 2009, available at www.concordcoalition.org/ tabulation/save-medicare-commission (accessed September 2, 2010).
26. Federal Long Term Care Insurance Program, "Results for the Cost of Care in D.C.," available through https://www.ltcfeds.com/ltcWeb/do/assessing_your_needs/costofcare?action=costofcare (accessed September 8, 2010).
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