The Fourth Entitlement: Interest December 1, 2003
The discussion of entitlement reform is often limited to 3 large social programs: Social Security, Medicare and Medicaid. True, if those programs are not reformed, the next generations will likely face burdensome tax increases, deep benefit cuts, or untenable deficits and debt levels.
However, there is a fourth entitlement that is not so often discussed: Interest on the Public Debt. On the budget's current trajectory, interest is poised to become the largest and fastest growing entitlement over the next 30 years. Balancing the federal budget (or coming close) is the only way to keep the “interest entitlement” under control.
Outline:
Four Large Entitlements: Social Security, Medicare, Medicaid and Interest on the Public Debt
Projecting Future Interest Costs
Consequences of Deficits, Debt, and Interest Costs
Four Large Entitlements: Social Security, Medicare, Medicaid and Interest on the Public Debt: There are two main types of government spending: entitlement or "mandatory" spending, and appropriated or "discretionary" spending.
Entitlement spending is automatic, based on rules for eligibility and payment. For example, Social Security benefits are based on the years of work and wages that people earned. Medicare payments to hospitals and physicians are defined in formulas in the law; eligibility and benefit criteria are also stated in the law. Medicaid spending consists of matching funds paid to states for a variety of health services under highly specified rules.
Of course, those eligibility, payment, benefit, and matching fund rules can be changed by Congress. But if Congress does not act, the rules persist from year to year, and spending based on those rules occurs automatically. These programs are, in effect, on “autopilot.”
Interest on the federal debt is treated in much the same way. The government pays its creditors first, before making any decisions on other spending -- even including ordinary entitlements. Interest payments, then, might be considered as a “super-entitlement.”
The four largest entitlement programs are Social Security, Medicare, Medicaid, and Interest on the Public Debt. Figure 1 shows the relative size of these four entitlement programs as a percent of GDP.
Figure 1.
Social Security is currently the largest entitlement. It currently accounts for about 4.5 percent of GDP. However, as the baby boom generation retires, Social Security spending is projected to grow to 6.4 percent of GDP by 2030.
Medicare is the second largest entitlement. It accounts for about 2.6 percent of GDP at present, and its spending is on track to rise to 6.2 percent of GDP by 2030 with the addition of the drug benefit recently passed by Congress (see Figure 2). The drug benefit alone will likely raise Medicare spending by about 1 percent of GDP by 2030.
Figure 2.
Medicaid currently accounts for 1.5 percent of GDP, and is projected to grow to 3.0 percent of GDP by 2030. Medicaid spending is difficult to project because spending is heavily affected by state actions. However, the fact that Medicaid pays for nursing home care for poor senior citizens (or those who have deliberately "spent down" or divested themselves of assets to gain eligibility) will put tremendous upward pressure on Medicaid spending as the baby boomers begin to age into their 80s (after about 2025).
Interest accounts for about 1.5 percent of GDP currently, down from a recent high of 3.3 percent in 1991. However, on the current budgetary trajectory, which includes large deficits and a dramatic buildup in the federal debt, interest would grow to a staggering 8.0 percent of GDP by 2030.
The four big entitlements currently amount to about 10 percent of GDP, and are projected to grow to almost 24 percent of GDP by 2030 (see Figure 3).
Figure 3.
By comparison, total federal spending is about 21 percent of GDP currently. Therefore, spending for the four largest entitlements currently encompasses about half of the budget. But by 2030, Social Security, Medicare, Medicaid, and Interest would together account for more than the whole current budget.
Projecting Future Interest Costs: These long-term projections of Social Security, Medicare, and Medicaid spending are far from certain, but the basic demographic trend underlying them -- the aging of the baby boom generation -- is undeniable.
The long-term projection of interest costs assumes the federal government continues to run large budget deficits. On the current trend, revenues are projected to rise to about 17.5 percent of GDP as the economy recovers from the recent recession. (The revenue increase isn’t due to tax increases; instead, it assumes that corporate profits and capital gains income will rise as the stock market continues to regain some of its previous levels, and personal incomes rise as a result of bonuses and expanded employment.)
Meanwhile, federal spending is currently about 21 percent of GDP, and continuing to rise (see Figure 4).
Figure 4.
With federal spending so much higher than revenues, large budget deficits are likely to persist throughout the next decade, even before the baby boom generation reaches retirement age.
There are three basic ways the Bush Administration and Congress could bring the budget back into balance: (1) raise tax revenues, (2) change the rules of entitlement programs to reduce their cost, and (3) cut discretionary spending.
At this point, Congress and the President are not seriously considering any of these things.
Tax Increases seem unlikely now, but public sentiment could change very quickly when the federal deficits begin to cause real economic problems.
As the economic and social consequences of large deficits and interest costs become apparent over the next decade, a repeal of tax cuts granted in 2001 or 2002, or a movement toward tax reform is possible. Reforms would expand the tax base by closing loopholes and ending various tax breaks in the current code. But so far, political leaders have not embraced tax increases or reforms to close the deficit and reduce future interest costs.
Entitlement Reform does not look very likely right now either. Medicare reform was essentially an opportunity missed in 2003. Congress chose instead to emphasize new prescription drug benefits in a fairly cynical competition for the senior vote.
Of course, prescription drugs are necessary, and many low- and middle-income seniors desperately need help with the cost.
But the 2003 Medicare bill included few significant financing mechanisms or offsetting benefit cuts to pay for the new drug benefits. The bill does take some precursor steps toward a Medicare reform based on competition and choice by expanding Medicare’s HMO program and offering other new health plan choices. But that is a far cry from Medicare reform: real competition between the traditional government-run program and alternative plans. The 2003 bill will almost certainly need to be re-legislated in the near future, both to tidy up problems with the drug benefit, and to take further steps toward reform.
Social Security reform has dropped out of public attention over the last two years. To his credit, President Bush touched the “third rail” of Social Security policy during the presidential campaign in 2000 and not only survived, but proved that many Americans are open-minded about a serious debate on reform.
The President’s hand-picked Social Security Commission also got off to a good start, with an interim report that clearly explained the issues facing Social Security.
However, the Commission ended up presenting not one, but three reform proposals. To make matters worse, the Bush Administration has never included the cost of Social Security reform in its budgets. That is a further signal that the Administration is not serious about doing the public and legislative groundwork that would be required to actually enact a Social Security reform bill.
In essence, the public debate on Social Security ended when the President’s Commission disbanded. Reform bills have been introduced in Congress, but they have not sparked a thoughtful national discussion beyond the usual political rhetoric: Republicans applauding personal investment accounts and Democrats denouncing any sort of privatization.
Again, sentiment could change quickly as the baby boom generation nears retirement and the deficits become an economic concern. Some press reports indicate the Bush administration hopes to make Social Security reform an issue in the 2004 election campaign. But it is uncertain whether any proposal will pass, or whether such a proposal would do much to restrain costs over the next several decades. For now, then, it seems prudent to project a continuation of deficits rather than large cost-cutting measures within the entitlement programs.
Discretionary Spending usually requires an explicit appropriation by Congress each year. The largest component of discretionary spending is defense outlays, at about 4 percent of GDP (see Figure 5). The non-defense discretionary spending budget includes outlays for transportation, agriculture, justice, research, and non-entitlement social programs, among other things, which altogether comprise an additional 4 percent of GDP.
Figure 5.
Since we can’t know in advance how much Congress will appropriate, all projections of discretionary spending are highly uncertain.
Official budget projections are required by law to assume that discretionary spending only grows as fast as the rate of inflation (currently projected to be about 2.5 percent a year over the next decade), which would imply a reduction in spending as a percent GDP over time.
But discretionary spending has grown much faster than inflation in recent years, and has risen sharply as a percent of GDP since 2001. Some of that reflects a sharp acceleration in defense spending, which will probably not continue.
Nevertheless, there is no indication defense needs will actually abate, and little sentiment in Congress for reductions in non-defense spending. It would be wishful thinking to presume that Congress will reduce discretionary spending as a percent of GDP, and thereby reduce deficits and interest costs.
A more realistic assumption, though still perhaps conservative, is to project that discretionary spending will remain constant as a percent of GDP, rising at the same rate as the economy grows.
Consequences of Deficits, Debt, and Interest Costs: With the U.S. economy remaining at less than full employment, and with continued weakness in the global economy, the U.S. deficits have not thus far had negative economic consequences: high interest rates, a rapidly declining dollar, and so on.
In fact, the sudden swing from budget surpluses into large deficits over the last several years may have helped spur the economy out of recession. Ultra-low short-term interest rates have allowed a boom in auto and home financing. Tax cuts and government spending for defense, homeland security and social programs have propped up the economy.
While the re-emergence of huge deficits may have caused uncertainties about the future, and thereby kept a lid on business confidence and investment, the deficits have probably had a positive net effect on the economy over the last two years.
However, government deficits are almost certain to cause significant economic damage over the next decade. As the global economy recovers, U.S. deficits could cause damaging inflation or a rapid decline in the value of the dollar. Higher interest rates could choke off business investment and consumer purchases of housing or cars.
Even if shortfalls in U.S. saving are filled with capital inflows from abroad, the proceeds of those foreign investments will have to be repaid in the future, with capital income flowing out of the U.S. instead of to domestic investors.
Moreover, deficits may have political consequences on the grounds of generational fairness. Of course, voters like to be told they can have their cake and eat it too. Tax cuts and spending increases are popular. People also believe the deficits were primarily related to the recession, not to the recent tax cuts and spending increases.
But as the deficits persist throughout the next decade and beyond, U.S. voters will begin to associate them not only with economic problems, but also with dysfunctional, irresponsible government. All of the debts must eventually be repaid, and the politicians opposed to deficit spending will increasingly point out that fact.
In the long run, the biggest consequence of deficits is high interest costs. As the U.S. continues to borrow to finance its deficits, interest costs will mount to levels that could crowd out popular spending programs or cause painful tax increases.
Voters don’t like spending cuts or tax increases now. Imagine their anger when they are told that the economy will fall into long-term decline unless they cut spending programs or raise tax rates to pay interest on debt accumulated years ago.
It is one thing to raise taxes to pay for something important. Or to cut a desirable spending program in order to reduce taxes. At least something good comes with the pain.
It will be much more difficult politically to cut spending or raise taxes just to make payments on the accumulated interest entitlement.
Link:
Centrists.Org No-BS Long-Term Budget Baseline Homepage
