Budget Deficit and Entitlements: The Grand Delusion

Henry J. Aaron
Henry J. Aaron The Bruce and Virginia MacLaury Chair, Senior Fellow Emeritus - Economic Studies

October 15, 2003

According to many commentators, the only cure for the current and prospective budget train wreck is to slash spending on “entitlements” (read: Social Security, Medicare, and Medicaid). They point out, correctly, that growth in spending on these three programs accounts for most of the projected increase in government spending over the next few decades. But they go on, incorrectly in my view, to argue that large cuts in these programs are a feasible and necessary component of a prudent program to restore fiscal balance.

Projected budget deficits are indeed terrifying. Largely because of projected increases in spending on Medicare and Medicaid, and to a lesser extent on Social Security, the nation will face formidable deficits even after the economy returns to full employment. The deficits would be large even if the rash, short-sighted tax cuts enacted in 2001 and 2003 were repealed. But, contrary to a prevailing mantra, cuts in entitlement programs are unlikely to play much of a role in closing those deficits. More likely, spending entitlements will exceed current projections. To think otherwise is a grand delusion.

Lets start with Medicare. The current Medicare system is less generous than 80 percent to 90 percent of insurance plans for the non-elderly. It has a deductible for hospital care that is fast approaching $1,000—far above that of all but a few private plans. It has no limit on out-of-pocket costs, no coverage for most out-patient drugs, and no coverage of nursing home care unless it immediately follows hospitalization. Congress is currently debating whether to add a prescription drug benefit that will increase spending by more than $400 billion over ten years. Furthermore, the particular plans Congress is considering contain so many gaps that pressures to increase spending still more will be irresistible. Dealing with Medicares other coverage gaps would cost vastly more.

Requiring the well-to-do elderly to pay more than they now do for Medicare coverage is surely worth considering. Unfortunately, fewer than 8 percent of the elderly live in households with annual incomes in excess of $50,000. The number of well-to-do elderly is too small for increased charges on them to fully offset the formidable costs of modernizing Medicare. In brief, a Medicare system that provides the elderly and disabled with decent coverage would cost more, not less, than the current system does.

Well, what about Social Security? The “you-can’t-be-fiscally-serious-unless-you-slash-entitlements” crowd suggests raising the age at which Social Security benefits can be claimed. Nice try, but simply raising the age of initial eligibility without changing the amounts paid when benefits are actually claimed would save virtually nothing. Those who claim benefits at later ages automatically receive larger benefits that just offset the shorter period that they can expect to receive benefits. Congress set things up this way expressly to encourage older workers to remain in the labor force.

Cutting total benefit amounts paid at each age would save money, but the conservative answer to projected deficits in Social Security—partial privatization—would actually raise total benefit payments, add to government spending, and increase the national debt. The three partial privatization plans put forward by the commission that President Bush appointed, for example, would each add more than $4 trillion to the federal debt by 2040.

The reason is simple. No responsible politician or analyst thinks it is fair to cut pensions for the currently retired or those soon to retire. President Bush made clear that he would never dream of doing such a thing. That means that spending on traditional pensions cannot be cut for many years. To set up individual accounts requires additional contributions to those very same individual accounts. And those contributions add to government spending.

More fundamentally, current Social Security benefits are remarkably parsimonious. The average earner who claims benefits when first eligible to do so at age 62 now receives a benefit that replaces only 31 percent of earnings (after subtracting Medicare premiums, which are automatically deducted). By 2030, under current law, that same worker is projected to receive a benefit net of Medicare premiums that replaces only 26 percent of earnings. Raise the age at which workers can first claim benefits by three years to age 65 and the replacement rate in 2030 under current law would only be 33 percent, and the total cost of the pension program would be virtually unchanged. Is it any surprise that the only way to actually save money—cutting total pension payments—has, and should have, few adherents?

What this means is that cutting entitlements will not be a major part of closing the nation’s very formidable looming budget deficits unless Americans are prepared to renege on the commitment to assure the elderly and disabled basic income and health coverage. Simply raising the age at which Social Security benefits can be claimed would save nothing, and income-testing Medicare would save little. Seemingly antiseptic solutions such as raising the age of pension eligibility or income testing health benefits will not suffice.

The actual choice is stark and simple. Raise taxes—and that means much more than repealing recent tax cuts—or abandon the rather thin and porous social safety net that the United States has crafted over the past seventy years.

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