Measuring the Cost of Unfunded Federal Spending Promises
By Jeff Lemieux
July 14, 2003

By any measure, the future cost of federal spending needs and promises -- especially for entitlement programs like Social Security and Medicare -- will be huge.  However, there is a debate about whether not it would be easy or hard to collect higher revenues as the baby boomers retire.  A new paper by economists Alan Auerbach, William Gale, and Peter Orszag disputes the earlier contention of Prof. Michael Boskin that the revenue share of GDP will rise significantly (as much as 3-6 percent of GDP) and painlessly when the baby boom generation cashes in its tax-deferred savings. 

There are many reasons to discount the size of any such "Boskin effect."  The most obvious reason is simple politics:  retiring baby boomers will likely demand cuts in tax rates to compensate for the extra taxes they would pay as they redeemed tax-deferred accounts.  They would echo current taxpayer demands that revenues should not be allowed to rise as a share of GDP.  Moreover, even assuming tax rates weren't reduced, the up-to-date projections by Centrists.Org demonstrate that the gap between revenues and outlays will probably remain huge, even with a hypothetical Boskin effect that raised revenues by 4 percent of GDP.  Perhaps the most obvious flaw in Boskin's work is that the underlying projections of revenues and outlays used in his calculations are dangerously out of date.  Even if the Boskin effect produced added revenues with a present value of $12 trillion (as claimed), the present value of our unfunded deficits is probably now more than twice that amount.

For years, economists have predicted that the retirement of the huge baby boom generation will force the federal government into serious budget problems.  The growth in the number of the working age taxpayers will slow, and the cost of entitlement programs like Social Security and Medicare will balloon.

The Congressional Budget Office (CBO) has produced a consistent set of long-term projections showing that entitlement spending will continue to rise as a share of GDP and of the federal budget.   By CBO's estimates, unless taxes are raised far above historic norms, the next generation will almost inevitably face massive deficits, especially after 2020. 

Centrists.Org has updated those CBO projections with realistic political assumptions.  Assuming revenues do not grow as a share of GDP via a Boskin effect, the budget outlook is very grim.



Measuring the problem a different way, economists Jagadeesh Gokhale and Kent Smetters compute the present value of the total unfunded liability of the federal government's spending promises at a staggering $44 trillion.  For technical reasons, Gokhale and Smetters overestimate the share of that shortfall attributable to the Medicare program.  (The Medicare program was never intended to be fully self-financing -- general revenues were explicitly made a large [now 75 percent] source of "Part B" Medicare funding.  Gokhale and Smetters incorrectly calculate the Medicare share of the unfunded liability as if it were a self-financed system.)  But regardless of how the shortfall is apportioned, the total number -- $44 trillion -- remains unthinkably high.

When they use similar technical assumptions, Auerbach and his colleagues compute the magnitude of the problem as roughly equivalent to Gokhale and Smetters.  They also calculate the shortfall in a slightly different ways:  the amount by which spending would have to be cut or taxes raised to maintain a steady debt/GDP ratio when the baby boomers retire, and also afterwards.  By that measure, they calculate the permanent "fiscal gap" at about 7.5 percent of GDP.

Meanwhile, Michael Boskin has produced a highly publicized (and perhaps politicized) paper arguing that the unfunded liability may be manageable, without draconian tax increases or spending cuts.  He assumes that revenue inflows will surge when baby boomers cash in their tax-deferred savings and pay taxes on the income.  By his calculations, the fiscal shortfall might be very small.  The obvious political conclusion is that additional tax cuts or spending increases (such as those proposed by the Bush Administration and both parties in Congress) are not so worrisome from a budgetary point of view.

Boskin's results appear to be based on a sort of economic leverage:  that a dollar of public savings (debt reduction) is worth a lot less to the economy than a dollar of private savings.  However, that conclusion may be far too simplistic.  Moreover, Auerbach and his colleagues question whether Boskin's figures downplay the extent to which tax-deferred savings is already included in standard long-term revenue estimates (they argue that 85 percent of any so-called "Boskin effect" is already in the standard baselines used by policymakers).

Therefore, supposing that any Boskin effect is quite small, both for political reasons and based on Auerbach and his colleagues' critique, the budget outlook remains very bad.  A revenue bump of 1 or 2 percent of GDP as the baby boomers retired -- even if politics allowed it materialize -- would do very little to solve the looming budgetary crunch.  Certainly, additional long-term tax cuts or spending increases would make the budget picture worse.

One credibility-building feature of the Auerbach research is that it uses realistic baselines, showing a continuing likelihood of large deficits even before the baby boomers retire.  By contrast, Boskin's work appears discordant, with graphics showing the national debt being reduced in absolute terms this decade -- an outcome that now looks extremely remote.



Links:
Congressional Budget Office A 125-Year Picture of the Federal Government's Share of the Economy:  1950-2075 (Revised July 3, 2002)

Alan Auerbach, William Gale, and Peter Orszag Reassessing the Fiscal Gap:  Why Tax-Deferred Saving Will Not Solve the Problem Brookings (July 14, 2003)

Jagadeesh Gokhale and Kent Smetters Fiscal and Generational Imbalances:  New Budget Measures for New Budget Priorities AEI Pamphlet (12th draft, revised April 26, 2003)

Michael Boskin Deferred Taxes in the Public Finances (January 2003)

Centrists.Org No-BS Up-To-Date Budget Baseline Homepage

Centrists.Org What if Prof. Boskin Is Right? (June 30, 2003)