Social Security and Medicare: Scaling the Problem and Proposed Solutions The Philadelphia Federal Reserve, December 2, 2005 Kent Smetters The Wharton School.

Social Security and Medicare: Social Security and Medicare: Scaling the Problem and Scaling the Problem and

Proposed SolutionsProposed Solutions

The Philadelphia Federal Reserve, The Philadelphia Federal Reserve,

December 2, 2005December 2, 2005

Kent SmettersKent Smetters

The Wharton School & NBERThe Wharton School & NBER

IntroductionIntroduction

Traditional budget measures substantially Traditional budget measures substantially underestimate existing liabilitiesunderestimate existing liabilities

In the past, “brick and mortar” public In the past, “brick and mortar” public goods could be allocated on an annual goods could be allocated on an annual basisbasis

But they have been replaced during past But they have been replaced during past 50 years with long-term liabilities (e.g., 50 years with long-term liabilities (e.g., Medicare; Social Security, etc.)Medicare; Social Security, etc.)

Two Main Problems with Two Main Problems with the Traditional Budgetthe Traditional Budget

1.1. Substantially Substantially underestimatesunderestimates unfunded liabilities by ignoring unfunded liabilities by ignoring long-term liabilitieslong-term liabilities

2.2. Is Is biasedbiased against reforms that against reforms that would reduce these unfunded would reduce these unfunded liabilitiesliabilities

1. Underestimates 1. Underestimates LiabilitiesLiabilities

Budget does not track many unfunded obligations

They’re “off balance sheet”

Examples

Social Security and Medicare

Medicaid

Federal Employee / Military pensions

Instead, the budget focuses on a particular unfunded obligation: public debt

Debt Held by Public Misses Debt Held by Public Misses almost $60 Trillion in almost $60 Trillion in

LiabilitiesLiabilities

Public debt is only one component of Public debt is only one component of government’s true Fiscal Imbalance (FI)government’s true Fiscal Imbalance (FI)

FI = debt held by public + PV of all future FI = debt held by public + PV of all future outlays – PV of all future revenue = $63 outlays – PV of all future revenue = $63 trilliontrillion

In contrast, debt held by public is only $4.4 In contrast, debt held by public is only $4.4 trillion (gross debt is about $8 trillion)trillion (gross debt is about $8 trillion)

2. Reforms are hard2. Reforms are hard

Example 1: An actuarially-fair “carve out”Example 1: An actuarially-fair “carve out” Part of payroll tax invested in personal Part of payroll tax invested in personal

accountsaccounts Future SS benefits reduced in equal present Future SS benefits reduced in equal present

valuevalue

Debt held by the public will increaseDebt held by the public will increase Other unfunded obligations decrease Other unfunded obligations decrease equallyequallyZero impact on Zero impact on totaltotal Fiscal Imbalance Fiscal Imbalance

But focusing on public debt But focusing on public debt federal federal liabilities liabilities appearappear to be larger since the other to be larger since the other unfunded obligations are not being tracked.unfunded obligations are not being tracked.

So even a perfectly neutral reform So even a perfectly neutral reform appearsappears badbad

Example 2: “Carve out” with a “haircut”Example 2: “Carve out” with a “haircut” Part of payroll tax invested in personal accountsPart of payroll tax invested in personal accounts Future SS benefits reduced by slightly Future SS benefits reduced by slightly more more

thanthan the present value of diverted payroll taxes the present value of diverted payroll taxes Similar to Commission’s Model 1Similar to Commission’s Model 1 People might still want a personal accountPeople might still want a personal account

Debt held by the public will still increaseDebt held by the public will still increase Other unfunded obligations decrease by Other unfunded obligations decrease by moremoreTotalTotal Fiscal Imbalance is actually Fiscal Imbalance is actually reducedreduced

Focusing on public debt Focusing on public debt liabilities liabilities seemseem largerlarger

Biases reform debate against reforms that Biases reform debate against reforms that would actually would actually reducereduce the Fiscal Imbalance the Fiscal Imbalance

New budgetary New budgetary frameworkframework

Two main integrated components:Two main integrated components:

““Fiscal Imbalance” (FI) = Debt held by public + Fiscal Imbalance” (FI) = Debt held by public + PV of all future outlays – PV of all future PV of all future outlays – PV of all future revenuerevenue

Similar to open-group liability conceptSimilar to open-group liability concept

““Generational Imbalance” (GI) = portion of FI Generational Imbalance” (GI) = portion of FI on account of current and past generationson account of current and past generations

Similar to the closed-group liability conceptSimilar to the closed-group liability concept

Simple and easy to understandSimple and easy to understand

Both FI and GI are UsefulBoth FI and GI are Useful

Fiscal Imbalance measure needed to Fiscal Imbalance measure needed to address the address the sustainabilitysustainability of policy. of policy. The FI must equal 0 for sustainabilityThe FI must equal 0 for sustainability

Generational Imbalance needed to Generational Imbalance needed to choose among the set of all choose among the set of all sustainable policiessustainable policies Examples: Examples:

New pay-go financed prescription drug benefitNew pay-go financed prescription drug benefit Many options for reforming Social SecurityMany options for reforming Social Security

Key Economic and Key Economic and Demographic AssumptionsDemographic Assumptions

Real annual discount rate, Real annual discount rate, rr = 3.6% = 3.6% Real annual per-capita productivity, Real annual per-capita productivity, gg = 1.7% = 1.7% Excess real growth of health care over Excess real growth of health care over

productivity until 2080, productivity until 2080, hh = 1.0% = 1.0% 2080 – 2100: excess growth reduced linearly to 02080 – 2100: excess growth reduced linearly to 0 After 2100: excess growth fixed at 0After 2100: excess growth fixed at 0

Sensitivity analysis conducted belowSensitivity analysis conducted below

Health Care Assumption, Health Care Assumption, hh The wedge, The wedge, hh=1.0%, is same as Trustees=1.0%, is same as Trustees

Very conservative by historic standardsVery conservative by historic standards 1980 – 2001: actual wedge was 2.3%1980 – 2001: actual wedge was 2.3% Double-digit growth this year; expected to lastDouble-digit growth this year; expected to last

Total spending on Social Security and Total spending on Social Security and Medicare increases from 7.6% of GDP in Medicare increases from 7.6% of GDP in 2002 to 13.1% of GDP by 20802002 to 13.1% of GDP by 2080

  2004 2005 2010

1. Fiscal Imbalance in Social Security 8,006 8,352 10,158

On Account of Past and Living Generations 9,549 9,899 11,676

On Account of Future Generations -1,543 -1,547 -1,518

2. Fiscal Imbalance in Medicare (Parts A, B and D) 60,886* 63,381 75,599

On Account of Past and Living Generations 24,094 25,431 32,289

On Account of Future Generations 36,791 37,951 43,310

3. Fiscal Imbalance in Rest-of-Federal-Gov’t -5,608 -5,805 -6,339

Total Federal Fiscal Imbalance (FI) 63,284 65,928 79,417

Table 2: Fiscal and Generational Imbalances (Selected Years)

(Present Values in Billions of Constant 2004 Dollars; Fiscal Years)

$2.6 trillion $16.1 trillion

* Part D (new Rx benefit ) alone = 24,186

  2004 2005 2010

1. Fiscal Imbalance in Social Security 2.3 2.3 2.5

On Account of Past and Living Generations 2.71 2.74 2.87

On Account of Future Generations -0.44 -0.43 -0.37

2. Fiscal Imbalance in Medicare (Parts A, B and D) 17.3 17.6 18.6

On Account of Past and Living Generations 6.83 7.05 7.94

On Account of Future Generations 10.44 10.52 10.65

3. Fiscal Imbalance in Rest-of-Federal-Gov’t -1.6 -1.6 -1.6

Total Federal Fiscal Imbalance (FI) 18.0 18.3 19.5

Table 2: Fiscal and Generational Imbalances (Selected Years)

(% of Present Value of Uncapped Payrolls; Fiscal Years)

Options for Paying for $63 Options for Paying for $63 TrillionTrillion

Confiscate all physical capital assets in the U.S. Confiscate all physical capital assets in the U.S. (actually does not go far enough!)(actually does not go far enough!)

Increase federal income taxes by 68% Increase federal income taxes by 68% immediatelyimmediately and and foreverforever, assuming no , assuming no reduction in labor supply or savingsreduction in labor supply or savings

Increase the combined employer-employee Increase the combined employer-employee payroll tax from 15.3% to over 32% payroll tax from 15.3% to over 32% andand remove the payroll tax ceiling (but don’t credit remove the payroll tax ceiling (but don’t credit benefits)benefits)

Slash Social Security and Medicare by over halfSlash Social Security and Medicare by over half

Sensitivity Analysis:Sensitivity Analysis:Parameter AssumptionsParameter Assumptions

Policy

Baseline High Low

Discount Rate, r 3.6% 3.9% 3.3%

Productivity Growth Per Capita, g 1.7% 2.2% 1.2%

Health Care Outlay Growth Per Capita, h 1.0% 1.5% 0.5%

Sensitivity Analysis:Sensitivity Analysis:FI as Share of PV of PayrollFI as Share of PV of Payroll

Policy

Baseline High Low

Discount Rate, r 18.0 16.2 20.2

Productivity Growth Per Capita, g 18.0 19.0 16.4

Health Care Outlay Growth Per Capita, h 18.0 21.5 14.9

But are these obligations But are these obligations “real”?“real”?

Yes: the only difference between these Yes: the only difference between these obligations and regular debt is the obligations and regular debt is the policy options available for dealing with policy options available for dealing with them.them.

Options for reducing explicit debt:Options for reducing explicit debt: Monetize it (except TIPS)Monetize it (except TIPS) Increase taxesIncrease taxes Declare bankruptcy Declare bankruptcy

Options for reducing implicit debt:Options for reducing implicit debt: Hard to monetize (since inflation protected)Hard to monetize (since inflation protected) Control outlays, increase taxesControl outlays, increase taxes

Is there a hidden silver Is there a hidden silver lining?lining?

International prospects also gloomyInternational prospects also gloomy Outlook of many European countries Outlook of many European countries

also bad.also bad. That’s bad for the U.S. fixed income That’s bad for the U.S. fixed income

markets!markets! Some hope in Latin America (e.g., Chile)Some hope in Latin America (e.g., Chile)

Will capital deepen as baby boomers Will capital deepen as baby boomers approach retirement?approach retirement?

What about “dynamic scoring?”What about “dynamic scoring?”

Some Glimmer of Hope:Some Glimmer of Hope:Groundwork Being Set for Groundwork Being Set for

ReformReform1.1. New accounting methodology recently New accounting methodology recently

Adopted by Gov’t TrusteesAdopted by Gov’t Trustees For Social Security, starting with 2003 For Social Security, starting with 2003

ReportReport For Medicare, starting with 2004 ReportFor Medicare, starting with 2004 Report They estimate a Medicare + SS FI of $82 They estimate a Medicare + SS FI of $82

trillion!trillion!

2.2. Senator Lieberman has introduced a bill Senator Lieberman has introduced a bill requiring it for government as a wholerequiring it for government as a whole

Easy Fix / Hard FixEasy Fix / Hard Fix

Social Security: The “Easy Fix”Social Security: The “Easy Fix” Smaller problemSmaller problem Nature of problem is also easier since it Nature of problem is also easier since it

is cash payment (e.g., “just” price index)is cash payment (e.g., “just” price index)

Medicare: The “Hard Fix”Medicare: The “Hard Fix” 7 times large (new Rx plan imbalance 7 times large (new Rx plan imbalance

alone is larger than Social Security’s alone is larger than Social Security’s imbalance)imbalance)

Nature of problem is also harder since in-Nature of problem is also harder since in-kind payment and driven by tech changekind payment and driven by tech change

Pension Fund ImplicationsPension Fund Implications

Asset SideAsset Side Long-dated fixed income instruments Long-dated fixed income instruments

risky?risky? Invest in more stocks?Invest in more stocks?

Liability side (won’t talk much about)Liability side (won’t talk much about) Private payments could increase to extent Private payments could increase to extent

that private pensions are integrated with that private pensions are integrated with Social Security (not common)Social Security (not common)

Why Haven’t Fixed Income Why Haven’t Fixed Income Markets Reacted with higher Markets Reacted with higher

interest rates?interest rates? View I: Capital markets don’t View I: Capital markets don’t

understand.understand.

View II: Capital markets believe that View II: Capital markets believe that most of the obligations will be reduced most of the obligations will be reduced by reducing benefits (hard to believe)by reducing benefits (hard to believe)

View III: Term StructureView III: Term Structure

Include More Stocks?Include More Stocks?

Aside: accounting issuesAside: accounting issues

Risk: Liability matching problemsRisk: Liability matching problems

Risk: Demographic issuesRisk: Demographic issues

Source: Poterba (2004), “Population Aging and Financial Markets”

President’s Social Security President’s Social Security Plan Plan

An actuarially-fair carve outAn actuarially-fair carve out Few minor exceptions: pre-retirement Few minor exceptions: pre-retirement

mortality and bequeath-ability of accountsmortality and bequeath-ability of accounts

Won’t have any impact on markets Won’t have any impact on markets (fixed income or not) provided if (fixed income or not) provided if households are not borrowing households are not borrowing constrainedconstrained Intuition Intuition

But, about 50 percent of U.S. households But, about 50 percent of U.S. households don’t hold any equities either directly or don’t hold any equities either directly or indirectly in employer-sponsored DC plansindirectly in employer-sponsored DC plans

Exact reason is important for policy goalExact reason is important for policy goal Rational (correlation between human capital Rational (correlation between human capital

and physical capital returns) or irrational and physical capital returns) or irrational (“fixed costs” associated with learning)(“fixed costs” associated with learning)

If rational, then President’s plan neutralIf rational, then President’s plan neutral

If irrational, then likely small increase in If irrational, then likely small increase in equity values and small reduced bond equity values and small reduced bond pricesprices