Friday, September 05, 2008

Can economic growth head off the coming Medicare/Social Security entitlement funding crisis? 

Government spending on Medicare, Social Security and Medicaid is scheduled to explode over the next 25 years. Taxes are not.

The result by arithmetic is a future explosion in the size of annual budget deficits and the national debt -- at such a rate that Standard & Poor's projects the credit rating of the United States and its Treasury bonds will to plunge to "junk" by 2027 on current law.

This is a big issue -- or should be. There is even a motion picture about it playing in a theater near you, IOUSA.

Alas, there seems to be no happy, easy way to escape this fiscal future.

Government spending on Medicare, Social Security and Medicaid is projected to increase by 6.1 points of GDP by 2030, from 2007's level, says CBO -- this increase is equal to 30% of the size of the entire federal government today (20% of GDP).

In 2007 the federal budget deficit was 1.2% of GDP. Adding 6.1 points to that creates a deficit of 7.3% of GDP, which in 2007 would have been a little more than one trillion dollars. With deficits of this size (and growing indefinitely thereafter!) adding to the national debt annually, and interest compounding on it all, we can see what S&P is concerned about.

Well ... this destruction of the nation's credit rating won't happen because it can't be allowed to happen. The entitlement funding gap will be closed because it must be. (If the nation's credit rating is allowed to be destroyed, the funding gap will still be closed by the government's obligations going unpaid. Since this is the worst possible outcome for everybody, we can confidently predict the political actors will finally agree to close the funding gap before then, as a less bad option).

The question is: how will the funding gap be closed? There are three possible alternatives, by arithmetic...

#1) Tax increases. In 2007 all income taxes (personal and business) were 11.2% of GDP. As 6.1 / 11.2 = 54%, if the projected spending increases were to be paid by income taxes, it would require an across-the-board income tax increase of 54% in GDP terms by 2030.

A 54% across-the-board income tax increase (or equivalent, such as a new national Value Added Tax [.pdf] )will not make taxpayers happy. Nor will it be easy to enact.

#2) Benefit cuts. Of the 6.1 points of GDP increase in spending, 1.8 points are for Social Security, 3.2 points for Medicare, and 1.1 for Medicaid. Total spending for these programs in 2030 is projected to be 6.1, 5.9, and 2.5 points of GDP respectively. Thus, eliminating these spending increases would cut promised Social Security benefits by 30% ... cut Medicare benefits by 54% ... and cut Medicaid benefits by 44%.

Benefit cuts on this scale will not make seniors happy, nor please advocates for the poor who are served by Medicaid. Nor will they be easy to enact.

#3) Both tax increases and benefit cuts. Cutting the baby in half Compromise is the essence of conflict resolution in politics. A plausible political compromise is to cut the funding gap for entitlements 50% with tax increases and 50% with spending cuts. (This is just what Congress did in the 1983 Social Security reform which saved that program from imminent insolvency.)

This would result in a 27% across-the-board income tax increase. If the projected increase in spending for each program was cut in half, Medicare benefits would be cut by 27%, Social Security benefits by 15% and Medicaid by 22%. Needless to say, such a combination would make pretty much everybody unhappy -- and consequently not be easy to enact.

For perspective on just how difficult even this "50-50 compromise" would be to enact, consider...

* The tax increase is almost four times larger in GDP terms than the Clinton tax increase of 1993 that passed the Democratic Senate only on the tie-breaking vote of vice president Al Gore, and passed the Democratic House by only a single voter.

* The benefit cuts for seniors are ... totally unprecedented. (Perhaps the closest precedent to consider is the well remembered by Congress "stoning of Dan Rostenkowski" by enraged seniors who attacked him on the street after the powerful Democratic Congressional leader shepherded a bill through Congress that actually called on them to pay a modest amount for government-provided long-term care health insurance -- a provision immediately thereafter repealed by Congress.)

No, nothing is easy or happy about those three options. Yet the Iron Laws of Arithmetic tell us these are the only possible ways to close a funding gap: either get (tax) more money to spend ... or spend less ... or some combination of both. So one of these options must come true in our future.

But wait ... perhaps there is a fourth option ... make the economy larger.

After all, if the economy grows large enough, it can cover any amount of increased government spending in dollar terms without the government increasing taxes in percentage-of-GDP terms.

For instance, being that the increase in entitlement spending by 2030 is projected at basically 6 points of GDP compared to today's total income tax collections of 18 points of GDP -- or one-third of taxes collected -- if GDP in fact proves to be one-third larger than expected in 2030, tax collections would be one-third larger too, and on the face of things be sufficient to cover the increased spending with no tax increase in GDP terms.

(This is keeping everything back-of-the-envelope simple, ignoring all feedback relationships, such as how Social Security and Medical benefits increase as economic growth accelerates due to wage-indexing and other factors.)

Well, that's a believable, simple and easy solution, and a happy one too! Make everyone richer enough and these programs pay for themselves, all their larger benefits become practically free.

And why shouldn't we suppose future economic growth will be fast enough to make this happen?

Why do the experts speaking in IOUSA not even consider the "growth option" as a possibility, and analysts such as CBO not consider its likelihood? Why, even more than a decade ago, did Alan Greenspan dismiss the growth solution as "beyond the reach of credibility"?

This is a question that is asked seriously by many on the political left in defense of entitlements, and by some on the right in defense of low taxes.

Indeed, the fact that a growth solution isn't even considered by the experts begins to appear sinister to some when they notice that the experts actually project future GDP growth rates to fall -- in large part "creating" the entitlement funding crisis.

(Is there some hidden plot among actuaries and economists to destroy Medicare and Social Security? I've seen it suggested on the AARP discussion boards -- at least about Republican actuaries and economists.)

For instance, the Social Security Trustees in their economic projections anticipate that the future GDP growth rate will decline from an average of 3.1% for the last 40 years to only 2.1% by 2025 and the long-term thereafter. That's a 32% drop!

Is that rate not too low? Unrealistically low compared to historical experience? Can this decline be justified?

Yes, it can be justified. Here's how:

GDP growth is composed of three components: Total employment growth ... times growth in hours worked per worker ... times growth in productivity per hour. As the Trustees Report explains, over the last 40 years the growth rate of these three components averaged about 1.6%, -0.3%, and 1.7% annually, giving the total 3.1% average growth rate number.

Going forward, the Trustees "intermediate" projection basically assumes historical experience carried forward. It assumes future productivity growth at the 40-year historical average rate of 1.7%, and sets the annual change in hours worked to 0% (an increase!).

But it also projects by 2025 a decline in the growth rate of the work force to only 0.4% annually, from the 40-year historical average rate of 1.6%. This decline in the growth rate of employment is what produces all the decline -- in fact, more than all the decline -- in projected future GDP growth.

How is this decline in the growth rate of employment justified? Very simply: by noting the retirement of the "baby boomers" and counting heads. Future employment levels are projected to continue the 40-year average of the past adjusted for demographic changes in the population. Most obviously, as the rate of growth of the retiree population accelerates, and the rate of growth of the working age population declines, the rate of growth of the work force drops ... to 0.4%

In short, the projected decline in the GDP growth rate actually is simply a projection of the averages for the last 40 years carried forward, adjusted for future changes in the population -- which are easy to project 25 years ahead, because all workers and retirees who will be age 25 or older then are alive today.

Now, let's take another look at the "growth solution".

The year 2030 is only 22 years away. For the economy to then be 33% larger than currently projected will require that the GDP growth rate average 1.3 points more than projected over that period. That is a 42% increase over the average growth rate for the last 40 years, and a 62% increase over the rate projected for 2025 and after. An increase that is non-trivial!

But the "growth solution" faces a bigger challenge than that. Increasing the size of the working population by making people work extra years, and having them work longer hours during them -- two of the three components of GDP growth -- is not the happy solution "growth solutionists" generally imagine. They put their faith entirely in increasing productivity, the factor that gives people "more for less."

Productivity growth over the last 40 years averaged 1.7%, and that's the average rate projected by the Trustees for the future. For the entire needed 1.3 points of increased growth rate in the future to come from accelerating productivity requires a permanent increase in average long-term productivity growth rate of 76% -- nontrivial indeed! The rate must rise to a permanent 3%.

Unfortunately, there is no known economic formula for increasing productivity growth in a developed economy. For the 10-year periods 1966-76, 1976-86, 1986-96, and 1996-2006, productivity grew at average annual rates of 2.0% 1.3% 1.2% and 2.1%. The highest of those covered only 30% of what the growth solution discussed here requires: only 0.4 of 1.3 points.

If you have a policy prescription for increasing the long term growth rate of productivity, which has escaped the note of the world so far, make your suggestion known! We need it!

If not, then we all are well advised to take seriously what the historical record tells us about our most probable fiscal future -- something the political system today is not doing.

BUT STILL ... Could the future nonetheless be brighter than pictured here, with GDP growth significantly greater? Can't we at least hope?

Certainly. It's a near sure thing that future GDP growth will be either better or worse than today's "intermediate" and "base line" projections by the Social Security Trustees, CBO and others. The Trustees report in fact includes a stochastic analysis to measure the uncertainly in projections. It is comprised of 5,000 projections of the future based on all plausible economic assumptions in different combinations.

OK. So is it possible that -- even if only through great good luck -- unexpectedly high GDP growth could cover future spending promises without us all incurring tax increases larger than have been seen in all historical experience?

Stochastic analysis says: "damned unlikely".

And remember, the future could be worse than today's projections as well.

So the answer to the original question is: Don't expect any "free lunch" regarding entitlements courtesy of a magically lucky increase in economic growth any more than you expect to hit the Powerball lottery. The luncheon bill will be served.