January 21, 2013 9:22 pm

America’s debt dilemma: A looming crisis

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In the first of a series, Robin Harding examines the fiscal challenges that will shape the US in the 21st century
US Dollar©AFP

The US economy is in the doldrums, unemployment is stubbornly high and Social Security, the New Deal-era safety net for older Americans, is running out of money. It is 1981.

To salvage the popular programme, President Ronald Reagan forms a commission. At its head is Alan Greenspan, the man he later makes chairman of the US Federal Reserve.

The commission procrastinates but then, in a model of backroom bipartisanship that is hard to imagine today, a “gang of nine” does a deal. Payroll taxes go up; over time, so does the Social Security retirement age, from 65 to 67.

But as Mr Greenspan recalls today, from his office overlooking Connecticut Avenue in downtown Washington, the fix was not forever. “Funding over a 75-year period was all that the political system would take. What that does is create a very large deficit in the 76th year and forward.”

FT Series

America’s debt dilemma

FT reporters examine the fiscal challenges that will shape the US in the 21st century

The US is once again mired in budget warfare over huge deficits projected for the long term, and Mr Greenspan’s experience illustrates the central reason why: the government pays for retirement benefits out of today’s taxes. There is no pile of assets saved up because in 1939 Congress gave a first lucky generation their pensions for free.

The large baby boom generation paid for the smaller generation of their parents. Now they are retiring and expect to be looked after.

Other countries have a fiscal problem due to ageing (consider Japan) but US ideas about limited government make it uniquely troublesome. Medicine is private, for example, yet Medicare, the health insurance system for retirees, causes most of the fiscal pressure. It is forecast to take an extra 3 percentage points of gross domestic product by 2037 and more after that.

Americas-debt-dilemma-graphic

Americas-debt-dilemma-graphic

As the Obama administration begins its second term this week, the Financial Times explores the real fiscal choice for the US: not the short-term frenzy of cliffs, debt ceilings, deficits and sequesters, but how – or whether – to pay for an older population. The answer will decide the very nature of the US economy in the 21st century.

Down one path, the retirement contract is untouched, but tax levels have to rise by 30 per cent or more; the US would look like a mature European economy. Down the other, taxes stay low, but barring a revolution in healthcare costs, provision for at least some retirees – current or future, rich or poor – must be slashed.

The question is whether a small federal government can endure with an ageing population – and that helps to explain why the political fight is so extraordinarily vicious. The choice is not between a little more tax on the rich or a nasty squeeze on the education budget. It is about what kind of country the US will become.

For Mitch Daniels, governor of Indiana until last week and a leading Republican voice on fiscal policy, only one answer is really conceivable. “My answer would be that only a truly vibrant private economy – of the kind that a giant welfare state crowds out and suppresses and stifles – can generate the kind of growth needed to solve our debt problem,” he says.

For President Barack Obama and the Democrats it is clear that the priority is different. Mr Obama says there should be a balance of tax rises and spending cuts. The alternative, he said last week, “is for us to go ahead and cut commitments that we’ve made on things like Medicare, or Social Security, or Medicaid, and for us to fundamentally change commitments that we’ve made to make sure that seniors don’t go into poverty”.

The scope of this choice is clear from a comparison of projected revenues under Congressman Paul Ryan’s budget plan – one Republican vision of America’s future – with Congressional Budget Office projections of spending under today’s policies.

The budget deficit was about 7 per cent of GDP in the last fiscal year, but even with Republican revenues and Democratic spending the budget would not be too far from primary balance – excluding interest payments – by the end of the decade. Tax revenues should have recovered from the Great Recession, stimulus will have expired, and recently agreed deficit reduction measures will kick in.

It is the 2020s when the big spending will start. The baby boomers, into their 70s, will start getting sick; the Social Security retirement age will stabilise at 67 in 2022; and the CBO is unwilling to assume that certain controls on medical costs will stick for more than a decade. The revenue and spending paths will become irreconcilable. Debt will pile up – and quickly.

Many fiscal proposals in Washington barely address that long-term problem at all: they look at the next 10 years over which the CBO scores their effect on the deficit. The cap on discretionary spending that began in 2011 and the “sequester” looming at the end of February, which will impose across-the-board spending cuts unless Congress reverses it, are two examples.

Plans that do tackle the long-term, such as the Simpson-Bowles proposal that came out of the president’s deficit commission, all mix three elements: spending cuts, tax rises and efforts to get more out of Medicare. The trick is to find a balance.

. . .

Cutting spending to match current revenues – as Republicans prefer – is both the most and least radical solution. On the one hand, it simply keeps government’s share of the economy at its average since the second world war. But doing so as the population ages is only possible by breaking a retirement contract that has stood for almost as long.

For those under 55 today, Mr Ryan’s plan would turn Medicare from health insurance into a partial subsidy to buy private health insurance, and raise the Medicare eligibility age to 67. It would save a lot of money but younger workers would have to pay for baby boomers to enjoy full Medicare without getting it themselves.

An alternative is to restrict benefits now for well-off retirees. Means-testing programmes may undermine public support but they would at least make sure that the baby boomers would not take out more than they put in.

Funding over a 75-year period was all that the political system would take. What that does is create a very large deficit in the 76th year

Such cuts are a hard sell, however, and have little precedent. Rich, ageing populations around the world tend to vote for health spending. Indeed, so strong is the tendency of government spending to rise as countries get richer that Wagner’s Law, as it was christened in 1893, has seldom been broken anywhere.

Nor do spending cuts come without risking programmes that create future growth. All too probably, they would fall on more politically vulnerable investment programmes – in education, infrastructure and research – to make room for spending on Medicare.

“One wants to keep in mind that what tax revenues are used for will affect growth outcomes,” says Jorgen Elmeskov, deputy chief economist of the OECD.

Much higher taxes – the implicit solution of any Democrat who makes Medicare and Social Security sacrosanct – are feasible but not desirable. There is room to raise taxes in the US: consumption taxes, in particular, are low by international standards.

Higher levels of tax would most probably hurt growth to some degree. Joel Slemrod, professor of economics at the University of Michigan, says evidence from overseas comparisons is “still very unclear”. There are fast-growing countries with high taxes, such as Norway, and slow-growing countries with low taxes.

But studies of individuals and companies are easier to read. “A higher tax level reduces incentives for people to do things that make more income,” says Mr Slemrod. “I have a sense that I know what the direction is even if I don’t know the level [of damage to growth].”

There is also ample evidence that badly designed taxes, with high rates and lots of loopholes, are bad for growth. The US tax code is especially baroque. Reform would be good for the economy, even if some taxes rise in the process.

If a big increase in taxes risks the dynamism of the US economy, it is also outright surrender to the baby boomers, and oppressive to younger generations who will pay higher taxes than their parents did.

That leaves a final option: to tackle the problem of Medicare at its source. Bring down the sky-high cost of medical care in the US – or merely control the rate at which it rises – and you have a pain-free, growth-supporting fiscal cure that is broadly fair between the generations.

There are two reasons for the steep trajectory of projected Medicare spending. About half is due to the ageing population. The other half is because the cost per person has consistently risen faster than inflation.

Looked at another way, the US spends 17.4 per cent of total output on healthcare (including more than 8 per cent in the public sector), compared with the OECD average of 9.6 per cent. Simply closing that gap – an option that is not open to any other rich country suffering a demographic budget squeeze – would free up enough resources to solve America’s fiscal problems. The Affordable Care Act, or Obamacare, uses a range of measures to control Medicare costs but the savings go towards expanding health coverage for the poor rather than addressing long-term fiscal imbalances.

. . .

There are many different plans for Medicare reform, with greater or lesser government involvement, but they all boil down to scrapping incentives for patients to demand wasteful treatment or for doctors to give it to them.

“The steps that I think are most promising are really about changing payment methods to reward providers for better health outcomes,” says Mark McClellan, a former administrator of Medicare now at the Brookings Institution think-tank in Washington.

Medicare was created in 1965 on a fee-for-service basis, under which doctors are paid when they treat somebody – giving them every reason to do just that.

The reforms Mr McClellan proposes involve paying doctors instead to make people better, or to deliver preventive care, or just to treat somebody for a year. He points to encouraging results from private sector insurance programmes, which have slowed the rate of cost inflation, and says that so far Medicare has “only taken small steps down this road of payment by results”.

Whether it is truly possible to save that much without rationing or limiting Medicare is hard to predict but it points to an intriguing fiscal option. Congress could set aggressive targets for Medicare cost control and back them up with tax rises or spending cuts – designed to hit existing as well as future retirees – that would kick in if the healthcare reforms faltered.

The fiscal challenge for the US is colossal. But if Washington can get past its obsession with today’s deficit, it can be resolved.

Expenditure: Medicare at the heart of the fiscal problem

Social Security is the national pension system in the US. It began in 1935 with retirement benefits and later expanded to cover disability insurance.

The system is funded by a payroll tax of 6.2 per cent on employees and employers. That tax is paid into the Social Security trust fund but, as the fund only invests in government securities, it is more of an accounting entry than a stockpile of assets.

The Congressional Budget Office says that the cost of Social Security will rise from 5 per cent of gross domestic product now to 6.2 per cent in 2037 and 6.7 per cent in 2087.

Medicare was added to Social Security in 1965 to provide health insurance to those aged 65 or over. It is paid for with a 2.9 per cent payroll tax on employees and employers, plus a range of premiums, deductibles and co-payments for patients. The system pays for medical care delivered, and by law it must not consider the expense of a treatment, so Medicare has suffered constant cost inflation.

Medicare is at the heart of the US fiscal problem. The CBO forecasts that spending will rise from 3.7 per cent of GDP today, to 6.7 per cent in 2037 and 13.3 per cent in 2087 if past cost trends continue.

Medicaid and its parallel programme for children provides health insurance to those on low incomes. It is funded by federal and state governments. A big expansion of Medicaid is in prospect as the Affordable Care Act, or “Obamacare”, goes into effect.

The CBO forecasts that Medicaid spending will rise from 1.7 per cent of GDP last year to 3.7 per cent in 2037 and 5 per cent by 2087.

Discretionary spending is the catch-all term for funds that Congress chooses to spend in its annual budgets. It covers everything from defence to education and the cost of government itself.

Deficit-cutting deals in recent years have concentrated on this. The 2011 debt-ceiling deal set aggressive caps on discretionary spending for the next decade. A “sequester” will impose further across-the-board cuts at the end of February, unless Congress reverses it.

The CBO projects that “other” spending will fall from 11.6 per cent of GDP in 2012, to 7.8 per cent in 2022, which would be low by postwar standards.

For more articles in the America’s Debt Dilemma series go to www.ft.com/usdebt

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