April 11, 2010
The Entitlement Quandary
The Entitlement Quandary—Posner
Although I do not place any weight on long-term economic forecasts, there is no doubt that we face a growing burden of federal and state entitlement spending—"entitlement" signifying that expenditure levels are automatically financed, rather than having to be reauthorized every year as defense expenditures (and indeed all nonentitlement government expenditures) are. Government entitlement spending is concentrated on pensions and elder health care. Both forms of spending increase as a function of the growing percentage of elderly people in the population, and healthcare spending grows additionally because of increases in cost caused by new technologies plus the normal upward-sloping supply curve, implying that increases in demand for health care (because of the increasing number of elderly) cause a rise in average and therefore total costs.
Becker rightly adds to entitlement costs the cost of servicing government debt, since lenders to government have an entitlement to the repayment of their money with interest at the rate specified in the loan. Costs of debt service can easily grow at a compound rate, because the more the government borrows, the higher the interest rate it is likely to have to pay; instead of borrowing $1 billion at 5 percent interest, for a total annual interest expense of $50 million, it might have to pay 7 percent interest to borrow $2 billion, for a total annual interest expense of $140 million—which is more than twice the interest expense on a loan that is twice as large. Because of the United States' huge public debt (the part of federal government debt that the government is contractually committed to repay), interest rates on the public debt are likely to rise, creating the compounding effect that I just illustrated.
I am less concerned about nonfederal government debt than about federal government debt. The nonfederal debt problem centers on public workers' pensions, and public workers are of course a minority of all workers. Moreover, because states and cities cannot create money, and because they compete with other states and cities for businesses and people, they are compelled by market forces to restrict spending. The federal government's entitlement obligations extend to the entire elderly population of the United States. And any commitment to federal fiscal prudence is diluted by knowledge that the United States can always inflate its way out of deficits or borrow at low rates as long as the dollar remains the principal international reserve currency, so that foreign nations have to buy dollars from us, which means have to lend to us.
Deficit projections are pretty worthless. At the beginning of 2007 the Congressional Budget Office, which has an inflated reputation but is at least nonpartisan, projected the federal deficit for fiscal 2010 at $333 billion (it will be at least four times that)—and that was a short-term projection. In 2001 it had predicted a 10-year budget surplus of more than $3 trillion. Its forecasts are largely just extrapolations, which assume that the future will be just like the past. All that can be said about future deficits with an approach to confidence is that if nothing is done they will grow, and that nothing is likely to be done until they grow to a point at which there is a palpable impact on the standard of living.
In 1983, Congress amended the social security act to provide that, for people born in 1938, the age of eligibility for full social security benefits would rise gradually from 65 to 67. (Hence the first effects of the reform were not felt until 2003, when people born in 1938 reached the age of 65, and the full effect will not be felt until 2026, when people born in 1959 reach 67—it is the deferral of the hurt that made the program politically feasible.) It is a sad commentary on our political system that there is no movement today for a similar reform, which would raise the future age of entitlement to full social security benefits to 70 in recognition of continuing increases in longevity, health, and income. We are in ostrich mode so far as dealing with our fiscal problems is concerned, even though the problems are far more serious than they were in 1983.
The basic problem is that our two political parties, although they pretend to be ideologically opposed and certainly do disagree on a number of details of public policy (many of which however are economically inconsequential), are agreed on the basics of fiscal policy: that taxes are bad and government spending is good. The Democrats used to believe that since spending was good, taxes had to be heavy, and Republicans that since taxes are bad, spending had to be limited so that taxes could be low. Eventually the parties discovered from election results that taxes are unpopular and spending popular, so Democrats stopped pushing for higher taxes (except on very high earners) and Republicans for lower spending. Both parties have embraced fiscal irresponsibility.
The Looming Entitlement Fiscal Burden-Becker
The entitlement fiscal burden from projected spending increases on retirement benefits and health care during the next couple of decades is scary for Western Europe, Japan, The United States, and other rich nations. I will concentrate on the US, but the picture is often as bad or worse in these other nations.
In 2010, spending on social security retirement benefits amounted to about 4.3% of American GDP, while Medicare and Medicaid added another 5 ½ %. This gives a total federal spending on health and retirement benefits of about 10% of GDP, which is 40% of overall federal government spending of 25% of GDP. Without incorporating the effects on spending of the new health care bill, and with no further changes in retirement ages and other aspects of social security benefits, the combined spending on these entitlements is expected to rise in twenty years to about 15% of projected GDP. The expected increase in spending on health of the elderly is the biggest component of this increase, although social security payments will also rise significantly.
State and city obligations to retirees are often forgotten in calculating the burden of government commitments to retirement and health benefits, but these too are sizable for many localities. A recent report in the New York Times indicated that a new analysis of California's pension liabilities found a hidden shortfall of more than half a trillion dollars. This is several times as large as the state pension obligations that had been reported, and over six times the size of California's outstanding bonds. Calculations for Illinois and some other states, and also for some cities, also indicate large future pension obligations.
That the retirement obligations of state and local governments are sizable is not surprising since they have early retirement ages for police, firemen, and other government employees. These governments also usually use earnings in the last year or two prior to retirement to determine the level of retirement benefits. Hence government employees nearing retirement have strong incentives to push for higher pay and overtime work since higher earnings then have a multiplier effect on the size of retirement benefits.
Future fiscal problems for the federal government will be particularly challenging not only because entitlements are growing rapidly, but also because the federal debt has been ballooning due to the extraordinary deficits during the past two years. Large deficits are likely also for the next couple of years. The combined cost of interest on government debt, social security benefits, and spending under Medicare and Medicaid will take at least 20% of projected GDP by 2030, even without any sizable increase in the interest rates that creditors demand to hold the much larger US government debt. This percent equals about 80% of current government spending relative to GDP, and is a full 100% of the ratio of federal government to GDP for several decades prior to the financial crisis.
Several reforms could greatly slow the growth in federal, state, and local retirement benefits. The most basic would be to change social security and other retirement systems to defined contribution individual account systems. By that I mean that state and local government employees, and everyone under social security, would accumulate tax free retirement accounts from annual contributions to these accounts, perhaps forced contributions from their annual earnings. Such accounts would be similar to the IRA and Roth accounts that many people already have, although rules might control the allocation of funds in these accounts among stocks, bonds, and cash. This control on asset allocation would be designed to prevent the elderly from taking excessive risks, and then needing to be bailed out by government transfers.
If such a fundamental reform is not politically feasible, then minimum retirement ages to collect social security benefits should be raised to age 70 for the general population in recognition of the actual and projected growing health of older persons. Exceptions would be made for the truly disabled, and for workers in physically demanding jobs, such as firemen and policemen. However, even in these occupations the large majority of employees are capable of continuing to work beyond the young current retirement ages. Indeed, many policemen retire in their fifties with generous pensions to take jobs with private security firms.
Reforming Medicare is even more difficult politically, as seen from the content of the recently passed health care legislation. Among other approaches that could save sizable amounts of public spending on health care (several possible reforms are discussed in our posts of last week on the new health care legislation), the out-of-pocket spending required of the elderly covered under Medicare could be greatly raised from its present quite low level. It could be increased by raising sharply both deductible levels required of most Medicare recipients and their co-pay rates. As a result of the low out-of-pocket expenses under the present system, neither patients nor their physicians have strong incentives to make serious benefit-cost calculations of whether expensive treatments are desirable. Another useful reform would be to extend the minimum age of Medicare coverage to age 70, whereas during recent Congressional discussions of health care bills, opponents had to beat back efforts to lower rather than raise the minimum age at which a person becomes eligible for Medicare.
The burden of entitlements and other government spending depends very much on the growth of GDP since it is the ratio of government spending to GDP that determine the real tax burden. If GDP could grow by ½ percent per year faster than it would otherwise, the effects on GDP and the tax burden of given government spending in twenty and thirty years would be enormous. To achieve such a higher growth rate would require lower, not higher, taxes on both physical and human capital, more, not less, encouragement to entrepreneurial activities, and greater emphasis on competition in labor and product markets instead of bailouts of companies like GM, Chrysler, and Citibank that were badly managed.
All of my suggestions would be met by strong political opposition from entrenched interest groups, such as the elderly, government unions, and poorly managed companies. Yet without these changes, or something comparable, the entitlement and debt burden at all levels of government will grow during the next couple of decades to levels that will become a serious drag on the performance of the American economy. And as I indicated at the beginning, similar, if not larger, problems are confronting Western Europe and Japan.