The Budget meets the Boomers: America’s most famous generation approaches another milestone

Barry P. Bosworth and
Barry P. Bosworth Nonresident Senior Fellow - Economic Studies

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

September 1, 1996

The aging of America presents the federal budget with long-term challenges that dwarf those raised by the current effort to balance the budget by 2002.

The three federal programs that serve the pension and health care needs of the elderlyþSocial Security, Medicare, and Medicaidþhave replaced national defense as the dominant category of federal budget outlays. They now account for just over 40 percent of federal program outlays but will claim 60 percent by 2025, if maintained in present form. Growth in Social Security spending will claim an additional 1 percent of GDP by 2025. Increased spending on health care for the elderly will claim another 5.1 percent of GDP. Without offsetting tax or expenditure actions, the budget deficit will balloon to 10 percent of GDP.

Contrary to common perception, the problem of aging in America is due not so much to an acceleration in the growth of the over-65 population, as to a slowdown in growth of the workforce. The growth in the number of elderly Americans averaged 2 percent annually between 1960 and 1995. In the next 15 years it will actually slow to a 1 percent annual rate before accelerating to 3 percent between 2015 and 2025 when most þbaby-boomers” will be retired. But annual growth in the number of workers, which also averaged 2 percent during the past three decades, is projected to slow steadily to only 0.1 percent annually by 2025.

To date, most discussion of the retirement needs of the elderly has centered on a bleak tradeoff between scaling back the benefits of retirees or raising the taxes on workers. Butþthough it would require uncommon vision and determination on the part of policymakersþit is possible to prepare for the increased future costs of retirement through a third option: increased saving today. Funding a portion of the future retirement costs with added saving would increase the resources out of which future retirement needs would be met and thus head off what could be a wrenching and divisive debate between the young and the old.

Social Security

Although the projected deficit in the Old Age, Survivors, and Disability Insurance (OASDI) system has attracted the greatest public attention, it is only a small part of the future budgetary problem and, in many respects, the most manageable.

Social Security covers more than 95 percent of the labor force. Its trust funds are financed by a þat-rate employment taxþnow 12.4 percent equally split between employers and employees up to a ceiling (equal to $61,800 in 1995)þand a partial taxation of benefits under the income tax.

Social Security revenues currently exceed costs. The annual surplus, $70 billion in 1996, is projected to exceed $80 billion (1996 prices) in 2005. Accumulated reserves are projected to reach a maximum of $1.3 trillion in 2020, after which the intermediate projections of the Social Security actuaries indicate the costs will begin to exceed annual revenues. According to projections, accumulated reserves will be exhausted by 2030.

Over the 75-year horizon used in Social Security actuarial projections, costs exceed revenues by 2.2 percent of payroll, resulting in a deficit equal to about 14 percent of benefits. Although immediate benefit cuts or tax increases equal to 2.2 percent of payroll would restore the system to actuarial balance over the 75-year horizon, they would lead to enormous surpluses early in the projection period and enormous deficits later on. To keep projected deficits from reemerging and to maintain balance over successive 75-year periods, either the tax rate would have to be increased or benefit payments cut by about 0.5 percentage points every 10 years.

Medicare and Medicaid

Although the costs of Social Security and Medicare are driven by similar demographic forces, spending on Medicare will far exceed that on Social Security, largely because of continued increases in the cost of health care per person. Whereas OASDI benefits per retiree are limited to increases in average wages, the cost of medical care has far outstripped income growth.

Medicare and Medicaid account for the vast bulk of federal health care outlays. Medicare serves roughly the same population as Social Securityþpeople over age 65, the disabled, and those with end stage renal disease. Part A of Medicare, hospital insurance, financed through an employment tax on OASDI workers, currently 2.9 percent, but without a ceiling on taxable wages. Part B, supplemental medical insurance, is voluntary; about 25 percent of financing comes from a tax beneficiaries, the remainder from general budget funds. It covers physician fees, outpatient hospital services, and some prescription drugs. Many retirees also have a supplemental private plan to provide services not covered by Medicare and to finance deductibles and co-insurance charges.

In addition, many elderly people in need of nursing home care can qualify as indigent and receive assistance under the Medicaid program for the poor, which is currently operated with joint federal and state financing. Medicaid accounts for about half of nursing home financing and pays the Medicare premiums for the indigent elderly. In total, the elderly account for about 30 percent of Medicaid outlays.

According to the most recent actuarial projections, the hospital insurance fund will be exhausted in 2001. Annual outlays already exceed income, and the fund has begun to draw down its reserve. Over a 75-year horizon, the actuarial deficit is estimated at 4.5 percent of payroll, twice that of Social Security.

Proposals for Reform

The discussion of potential changes in pension and medical support for the aged to alleviate the projected financing problems has been far-reaching, ranging from simply delaying action until a cash flow crisis necessitates benefit cuts or tax increases all the way to proposals to dismantle the public programs and replace them with private retirement and health care plans.

There are three basic means of responding to the future budgetary problems. The two obvious optionsþbenefit cuts and tax increasesþhave dominated the public discussion to date and have kept the focus on how to divide a fixed amount of future resources between the young and the old. The broader question of what determines the total amount of those resources has not often been raised.

The third optionþadvance funding of a portion of future costsþwould increase the future resources out of which the consumption needs of both workers and retirees are financed. Current workers could increase their saving to financed an increased portion of their own retirement. That added saving and capital formation would not only directly raise future capital income of retirees, but also increase the wages and taxes of future workers out of which the retirement benefits could be paid.

Such a program could be undertaken under public or private auspices. The current surplus of the existing public retirement system could be expanded, either by increasing the contribution rate or reducing current benefits, with the surplus set aside to add to national saving. Or the increased saving could take place within private retirement or pension accounts. The crucial issue is that the increased saving actually translate into an increase in national saving and not be offset by reduced saving in other public or private accounts.

How Much New Saving?

Saving in the United States, both private and public, has fallen of sharply over the past decade. The national saving rate in 1995 was less than half that of the 1960s. The net private saving rate has dropped from an average of 9-10 percent of net national product during 1950þ80 to 7 percent in the 1990s. At the same time, the public sector deficit rose to in excess of 4 percent of NNP in the early 1990s. Although Congress has recently made progress in reducing the deficit, private saving is still far below its historical norm.

How much would saving have to grow to financed the coming increase in the elderly’s pension and health care needs? Although spending on the elderly is slated to grow by 6.1 percent of GDP by 2025, the Congressional Budget Office projects that decreased spending in other areas means that total federal program outlays will grow by 5 percent of GDP, from 19 percent in 1995 to 24 percent in 2025. To fund that increase at no cost to future workers, the United States would need to increase its capital stock enough over the next 30 years to raise income 5 percent. Since 1960, the real return on physical capital in the United States, net of depreciation, has averaged about 6 percent, suggesting the need to raise the capital stock by an additional 80 percent of output. For purposes of comparison, the national wealth of the United States in 1995 was about $19 trillion or 2.8 times GDP.

In practice, the situation is somewhat more complex. First, if all the added saving is invested in the United States, the return on both new and existing capital will fall. Part of the decline is not a problem from a national perspective since total labor compensation would increase as the capital stock rises. But the incremental gain to national income from an additional unit of investment can be expected to fall gradually if capital formation accelerates. This fact further increases the required addition to the capital stock.

The decline in the return to capital could be moderated if some of the increased capital were invested abroad. U.S. residents now earn returns on foreign investments comparable to domestic yields. Thus, some of the decline in the rate of return could be avoided by investing in a larger global economy. Foreign investment, however, raises another problem. Such a strategy would require the United States to convert its current account deficit with the rest of the world into a substantial surplus. Initially, U.S. terms of trade would deteriorate. In other words, export prices would need to fall and import prices to rise to affect the reallocation of trade flows. Thus, only some of the decline in the rate of return can be offset by access to a larger global economy.

The bottom line is this: if national saving is increased by about 5 percent of GDP, the added saving should boost growth enough to raise GDP by the increase in government spending projected over the next 30 yearsþabout equivalent to the decline in saving over the past three decades.

Public or Private Funding?

Funding of the coming increase in the nationþs future obligations to retirees could be accomplished either by continuing the current Social Security and Medicare programs or by converting them to private plans. With both the public and the private options the essential question is whether the increment to funding would really add to national saving and capital formation.

Advanced funding would be easiest to implement within the existing public programs because it would leave accrued benefit claims intact. It would require only some combination of an increase in the contribution rate or reduction of benefits to create a reserve, and a firm commitment to set the surplus aside from other government accounts. From the perspective of the economic benefits to the nation, it also matters little whether the reserve is invested in public or private securities. The economic benefits flow from the increased investment in real capital. If the Social Security fund purchased government debt, a larger proportion of private saving could go to financed investment. If it chose to buy private debt, more of the private saving would be used to cover the public sector budget deficit.

Investment in private securities might help in two respects, however. First, it would diminish the risk that the retirement saving would simply be appropriated to financed spending in other government accounts, as happened with the balanced-budget Constitutional amendment proposed by the congressional Republicans in 1995. Investing the fund in private securities, as is done with state government retirement funds, might help distance its operation from the budget. Second, if the fund restricts itself to government securities, most of its economic benefits will be concentrated in private incomes. And though the added capital formation would raise the incomes of future workers, they would be unlikely to perceive their gains as being the result of increased saving and investment by the prior generation. Thus they could remain as opposed as todayþs workers to any tax increase. By raising the investment return of the fund, a mixed public-private portfolio eliminates much of the need for future tax increases. Furthermore, concentrating all of the retirement saving in public securities fails to take advantage of the benefits of portfolio diversification. While the fund would face none of the risks of failure associated with private investments, it would be highly exposed to political risks.

Some observers oppose public management of the retirement fund because they doubt that the managersþ decisions would be guided solely by investment criteria. They also doubt that the public and its representatives could be educated not to use the reserve to offset deficits in other government accounts. Thus, they support partially privatizing the existing system by moving to individual retirement accounts to reduce the political risks surrounding the current retirement system and allow individuals to manage their own investments. In event, they propose to move to a two-pillar system: a smaller public component that provides a more minimal poverty-level benefitþperhaps a þat benefit or one related to number of years of participationþand a second defined-contribution pension with no redistributional element. Participantsþ funds in the individual accounts would be invested in a range of capital market assets, presumably directed by the individual contributors. The plan resembles one introduced in Chile in the early 1980s.

Critics worry that the explicit separation of the redistributional component would result in inevitable pressures to eliminate it, much like the current opposition to welfare programs. Thus, they doubt that the program would provide adequate support for workers with low lifetime earnings. Low-wage workers may also be poorly equipped to make investment decisions. Individual accounts also raise the problem about how to manage the conversion to annuities at time of retirement. It would also be necessary for the government to issue bonds indexed to the CPI to provide a private market means of providing indexed benefits. Many small individual accounts are also likely to increase administrative costs.

Individual retirement accounts have an obvious appeal to well-to-do workers, and they have attracted increased political support in an era when Americans increasingly oppose the redistributional elements of government tax and transfer programs. Since they are effectively defined-contribution pension programs, they eliminate any concern about the public sector costs of the retirement programsþbenefits are determined by contributions and market interest rates. But they raise concerns about the consequences for low-wage workers. Most recently, the concept has been carried even further in suggesting that much of the Medicare program should be converted to individual pre-funded accounts.

Will the Opportunity Be Lost?

The expected future costs of the programs for the elderly are high, but if the nation plans ahead they would be manageable. The greatest problem for the United States is that these future liabilities are mounting in the face of a decreased propensity for Americans to save, both publicly and privately. The most effective means of addressing the financing problem would be to shift toward a partial funding of the retirement programs to raise todayþs saving in anticipation of greater consumption needs in the future.

The controversial aspect of a shift to partial funding is whether it can be done within the current framework of a general public program in which costs and risks are shared or whether it necessitates a shift to a private program where workers own and control their own retirement accounts. Objections to a funded public program spring from doubts that trust fund surpluses would be truly saved, add to national saving, and increase national wealth in future decades. To many, privatization reduces the risk that politicians would appropriate the nest egg for other purposes.

But a public system has many advantages that make it worth a major effort to save. It is progressive in offering larger benefits relative to lifetime earnings for low earners than for high earners, while maintaining a proportionate wage. Its administrative costs are lower than private plans, and it can offer benefits that are indexed for inflation. These features are hard to duplicate in a private system. Privatization has always had an appeal to those who disliked the redistributional aspects of the public program; but recent interest in the funding of future retirement costs has also stimulated interest in privatization.

The likelihood that the United States will adopt a program of partial funding, whether public or private, is low. Thus far, political leaders have been unwilling to confront issues that extend beyond the next elections. It is far more likely that they will ignore this one until the financing problems become more pressing. By then, the option of funding will have passed, and the political battle will return to the divisive one of benefit reductions and tax increases.