Commentary

Gaping entitlement imbalance

By Jagadeesh Gokhale and Kent Smetters
This article originally appeared in the Washington Times on March 28, 2004.
The U.S. Social Security and Medicare Trustees’ Reports recently released show new “present value” measures of financial imbalances in the nation’s entitlement programs.

The measures show very large financial imbalances. Social Security faces an imbalance of $10.4 trillion, while Medicare’s imbalance is 6 times larger at $61.6 trillion — for a combined shortfall of $72 trillion.

These numbers confirm our own calculations for the president’s 2004 budget — widely reported in the news last year — were, if anything, quite conservative. Indeed, the president later signed a prescription drug bill the trustees estimate will cost nearly another $17 trillion in present value.

This eye-popping $72 trillion shortfall will not be immediately obvious to some readers of the Trustees’ Reports. The Reports officially claim Social Security and Medicare face a combined imbalance of $32 trillion because they assume Medicare will receive $40 trillion from general revenue.

To be sure, the law commits Congress to fund a large portion of Medicare using general revenue. But Congress has not actually allocated this money, and so the true financial strain of these two programs is $72 trillion.

The present value approach now adopted by the Social Security Trustees discounts (that is, reduces) future cash-flow shortfalls to recognize that preparing to pay $1 owed in the future requires putting aside less than $1 today because the sequestered amount can earn interest in the meantime.

Thus, the new approach places present and future dollar flows on an equal footing (that of the present) before adding them. The trustees’ calculations project shortfalls in America’s entitlement programs so massive that, even after reducing them at the government’s interest rate, they total a whopping $72 trillion today.

The new estimates show the amount of funds the government would have to “set aside” today to finance future shortfalls. Of course, the government cannot set aside $72 trillion immediately. Indeed, this imbalance is almost double the value of America’s total wealth, including the value of all companies, homes, autos, durable goods and everything else.

Instead, this shortfall must be met from increasing revenues or cutting costs over many years. No doubt, these policy reforms will require sacrifice. But they will be less burdensome if we act immediately rather than postpone action.

Although many economists from different political persuasions agree on the need for present value analyses of programs with significant long-term implications, the new shortfall estimates have opponents.

Critics argue making projections even over a few years is fraught with uncertainty: So how could we be confident about estimates incorporating shortfalls well into the distant future?

This criticism, however, is misplaced. First, ignoring the future is not the correct response to uncertainty. Second, the problems facing Social Security and Medicare are driven by relatively stable and predictable long-term demographic trends. Indeed, predicting next year’s budget deficit is relatively harder because it is subject to more volatile short-term economic shocks that average out over a longer horizon.

Finally, our own study has shown the range of policy changes needed to place the nation’s entitlement programs on a sustainable course are not very sensitive to changes in most underlying assumptions — with one very important exception.

That exception is the assumed growth rate in future health-care outlays. In their calculations, the trustees assumed federal health-care outlay growth will exceed growth in gross domestic product (GDP) by just 1 percentage point during the next several decades. However, historical experience shows overall medical expenditures outpaced GDP by about 2.3 percentage points during the last 20 years.

In fact, Medicare’s imbalance could be twice as large if the growth in health care costs over the next few decades were assumed to be closer to its historical average. In other words, the trustees’ estimate of Medicare’s $61.6 trillion imbalance is, if anything, on the low side.

Not only do the new measures adopted by the trustees constitute fuller and more honest measures of shortfalls in U.S. entitlement programs, they are also better guides for policy decisions. Conventional budget measures fail to fully consider burdens passed on to future generations because these measures are based on a limited time horizon. That makes it easy for present generations to spend beyond their means and leave large financial burdens for future ones.

The next step is for the Office of Management and Budget and the Congressional Budget Office to extend the present value approach to all federal operations. Indeed, the nation’s Medicaid program, which provides health care to poor, is growing rapidly as well. But its costs are currently estimated only five to 10 years into the future.

The longer-term costs of defense, highway construction and maintenance, education, federal retirement, welfare and all other spending and revenue programs also need to be officially analyzed on a present value basis.

Toward that end, Sen. Joe Lieberman, Connecticut Democrat, has just introduced the Honest Government Accounting Act in the U.S. Senate. If enacted, the bill would require the federal government to adopt a more appropriate long-term perspective in making future budget estimates and policy decisions.

The good news is a fuller airing of the imbalances in America’s entitlement programs has begun — thanks to the Social Security and Medicare trustees. We hope the new estimates provoke a vigorous debate on reform options before the next presidential election.

Jagadeesh Gokhale is a senior fellow at the Cato Institute. Kent Smetters is a professor at the Wharton School and a research associate of the National Bureau of Economic Research.