Wednesday, January 19, 2005

Question: How much will federal income taxes have to increase by the year 2030 to fund Social Security and Medicare -- if benefits aren't reduced instead?

Answer: More than 60%.

Hey, I wrote this before but some people didn't believe me. Yet the number is simplicity itself to compute, so I'll show it right here.

First, though, why the year 2030?

Well, it's right in the middle of the period in which the Social Security Trust Fund bonds are projected to be being redeemed -- from 2018 to 2042 -- during which so many defenders of the Social Security status quo tell us there will be no problem, all promised benefits are assured.

Also, it's not so far in the future, only 25 years from now. Most people reading this fully expect to be still walking around then. Which means we -- us, you and I -- will either be paying these taxes or depending on somebody else to pay them so that we can get the benefits we've had promised to us and will be depending upon and surely desire.

And, as it's not so far away, there's not a whole lot of uncertainty about it. The "what me worry?" rationalizations that defenders of the status quo produce about 75-year and "infinite" time horizon projections (who knows what will happen? it'll be our grandchildren's problem) don't apply.

Additionally, things get a lot worse after 2030, and I don't want to incite panic and hysteria.

Anyhow, here's how easy it is to figure this number -- although I'll wager you haven't read it anywhere else, not in any newspaper editorials, or in Paul Krugman's column, or from bloggers like Kevin Drum, or anywhere.

Step 1: We look at how much general revenue is spent on these programs today, in terms of GDP.

The Social Security and Medicare Trustees give this number right out (along with the other spending numbers we will use). Currently the amount of net general revenue spending for these programs is 0.36% of GDP.

This consists of -0.56% (a surplus contributing to general revenue) from Social Security, a 0.02% of GDP cost for the Hospitalization Insurance (HI) portion of Medicare, and a 0.9% of GDP cost for the Supplemental Medical Insurance (SMI) portion of Medicare.

Note that both Social Security and Hospitalization Insurance are funded with payroll taxes that have been used to finance Trust Funds that hold federal bonds to finance future benefits. The up-to-15.3% in payroll taxes subtracted from every paycheck consist of 12.4% Social Security tax on the first $90,000 of wages (in 2005) plus 2.9% of HI tax on all wages.

SMI-Medicare in contrast is funded straight from general revenue -- income taxes.

Of course, the redemption of the bonds held in the Social Security and HI-Medicare trust funds to finance future benefits will be financed straight from general revenue -- income taxes -- too, and that's part of the future fiscal rub.

But the starting-point number to remember is that these programs consumed general revenue equal to 0.36% of GDP in 2004.

Step 2: We learn how much general revenue these programs are projected to consume in 2030, in terms of GDP.

The trustees give us this number as well: 5.69% of GDP.

Breaking this down we see it consists of...

Social Security: 1.37% of GDP as the annual cost of redeeming trust fund bonds.

HI-Medicare: 1.06% of GDP as its cost in excess of payroll tax collections (the HI trust funds bonds will have long since been exhausted.)

SMI-Medicare: 3.26% of GDP.

Step 3: Taking the 5.69% of 2030 and subtracting from it the 0.36% of 2004, we find for 2030 an increase in general revenue financing needs of 5.33% of GDP from today's levels.

Step 4: We become able to convert all this into income tax terms by finding the percentage of GDP that income tax collections constitute today.

From the Bureau of Economic Analysis we learn that GDP for 2004 was $11.8 trillion at an annual rate in the third quarter of 2004 (the latest number available, and also the quarter in which the government's fiscal year ends). We also see that total personal and corporate federal income taxes were almost exactly $1 trillion. And thus we see that in our world today federal income taxes equal 8.5% of GDP.

Step 5: Finally, we figure the 5.33% of GDP increase in general revenue needed for these programs that will arise by 2030 as a percentage of the total actual income tax collections of today, 8.5% of GDP, and see the answer is 62.7% -- so we are talking of a 62.7% increase over today's level of income taxation.

Thus, to fund these programs in 2030 income taxes will have to be increased by more than 60% from their current level in the economy, or additional new taxes will have to be introduced as an alternative, or benefits will have to be cut by a corresponding offsetting amount.

QED. Simple.

For the record, here's how that 62.7% increase in needed income tax will be divvied up:

Social Security: 22.7 points of income tax (1.93% of GDP). This consists of 16.1 points of tax (1.37% of GDP) to pay down the Social Security trust fund bonds, plus 6.6 points of tax that the government will have to raise to 'stay even' by making up for the fact that Social Security no longer contributes an equivalent amount (0.56% of GDP) to general revenue after the disappearance of its surplus.

HI-Medicare: 12.2 points of income tax (1.04% of GDP)

SMI-Medicare: 27.8 points of income tax. (2.36% of GDP).

It's worth again remembering that the first two programs, Social Security and HI-Medicare, are financed by trust funds holding US government bonds -- and together they account for 34.9 points of the 62.7 point income tax hike fated for 2030.

Those trust funds are just a great help, eh?

That's our future as it stands, folks.

All this is based on the current best projections of the Social Security and Medicare Trustees. But might the fiscal future be different?

Sure it might. The fiscal condition of Social Security might be modestly better or worse 25 years from now -- but the demographics that drive Social Security are pretty much set over such a short time period, so any great shift from the projections either way is unlikely.

Medicare on the other hand is extremely complex with costs driven by demand. The Medicare Trustees are projecting future growth in expenditures per person that is below the average historical experience, and significant reductions below that seem unlikely. But there is real risk of much greater cost increases due to the uncertain economics of medical technology and potential explosive demand for it (not to mention the inefficiencies of politically directed administration and price setting and so on). Medicare is scary.

The next question is: will we all agree, well before 2030, to pay this 60%-and-steadily-rising income tax increase, to pay ourselves all the benefits we've promised to ourselves then and thereafter?

Or will we find ourselves voting to significantly cut these benefits, well before 2030, to save ourselves some of this tax cost?

Yes, voting even to cut Social Security benefits so early -- as incredulous as the defenders of the status quo and advocates of the trust fund (such as the likes of Paul Krugman and Kevin Drum and their friends and admirers and allies) are at the thought of it.

After all, if we're going to cut something -- maybe in a deal to raise income taxes by only 30% instead of 60% -- why would Social Security be sacrosanct but Medicare not?

If it was your choice, what would you rather lose -- some dollars of walking around money or your health?

And it will be your choice. So think about it now and prepare to lobby for the choice you want -- 2030 isn't so far away.

And while you're at it, you might think about prefunding today some of your Social Security benefits in a private account holding real investments that you own -- so those benefits, at least, won't be a cost to the government available to be cut in 2030.