Social Security and Medicare: Scaling the Problem and Proposed Solutions

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

2. Introduction • Traditional budget measures substantially underestimate existing liabilities • In the past, “brick and mortar” public goods could be allocated on an annual basis • But they have been replaced during past 50 years with long-term liabilities (e.g., Medicare; Social Security, etc.)

3. Two Main Problems with the Traditional Budget • Substantially underestimates unfunded liabilities by ignoring long-term liabilities • Is biased against reforms that would reduce these unfunded liabilities

4. 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 1. Underestimates Liabilities

5. Debt Held by Public Misses almost $60 Trillion in Liabilities • Public debt is only one component of government’s true Fiscal Imbalance (FI) • FI = debt held by public + PV of all future outlays – PV of all future revenue = $63 trillion • In contrast, debt held by public is only $4.4 trillion (gross debt is about $8 trillion)

6. 2. Reforms are hard Example 1: An actuarially-fair “carve out” • Part of payroll tax invested in personal accounts • Future SS benefits reduced in equal present value  Debt held by the public will increase  Other unfunded obligations decrease equally Zero impact on total Fiscal Imbalance But focusing on public debt  federal liabilities appear to be larger since the other unfunded obligations are not being tracked. So even a perfectly neutral reform appears bad

7. Example 2: “Carve out” with a “haircut” • Part of payroll tax invested in personal accounts • Future SS benefits reduced by slightly more than the present value of diverted payroll taxes • Similar to Commission’s Model 1 • People might still want a personal account  Debt held by the public will still increase  Other unfunded obligations decrease by more Total Fiscal Imbalance is actually reduced Focusing on public debt  liabilities seem larger Biases reform debate against reforms that would actually reduce the Fiscal Imbalance

8. New budgetary framework • Two main integrated components: • “Fiscal Imbalance” (FI) = Debt held by public + PV of all future outlays – PV of all future revenue • Similar to open-group liability concept • “Generational Imbalance” (GI) = portion of FI on account of current and past generations • Similar to the closed-group liability concept • Simple and easy to understand

9. Both FI and GI are Useful • Fiscal Imbalance measure needed to address the sustainability of policy. • The FI must equal 0 for sustainability • Generational Imbalance needed to choose among the set of all sustainable policies • Examples: • New pay-go financed prescription drug benefit • Many options for reforming Social Security

10. Key Economic and Demographic Assumptions • Real annual discount rate, r = 3.6% • Real annual per-capita productivity, g = 1.7% • Excess real growth of health care over productivity until 2080, h = 1.0% • 2080 – 2100: excess growth reduced linearly to 0 • After 2100: excess growth fixed at 0 • Sensitivity analysis conducted below

11. Health Care Assumption, h • The wedge, h=1.0%, is same as Trustees • Very conservative by historic standards • 1980 – 2001: actual wedge was 2.3% • Double-digit growth this year; expected to last • Total spending on Social Security and Medicare increases from 7.6% of GDP in 2002 to 13.1% of GDP by 2080

12. Table 2: Fiscal and Generational Imbalances (Selected Years) (Present Values in Billions of Constant 2004 Dollars; Fiscal Years) * Part D (new Rx benefit ) alone = 24,186 $16.1 trillion $2.6 trillion

13. Table 2: Fiscal and Generational Imbalances (Selected Years) (% of Present Value of Uncapped Payrolls; Fiscal Years)

14. Options for Paying for $63 Trillion • Confiscate all physical capital assets in the U.S. (actually does not go far enough!) • Increase federal income taxes by 68% immediately and forever, assuming no reduction in labor supply or savings • Increase the combined employer-employee payroll tax from 15.3% to over 32% and remove the payroll tax ceiling (but don’t credit benefits) • Slash Social Security and Medicare by over half

15. Sensitivity Analysis:Parameter Assumptions

16. Sensitivity Analysis:FI as Share of PV of Payroll

17. But are these obligations “real”? • Yes: the only difference between these obligations and regular debt is the policy options available for dealing with them. • Options for reducing explicit debt: • Monetize it (except TIPS) • Increase taxes • Declare bankruptcy • Options for reducing implicit debt: • Hard to monetize (since inflation protected) • Control outlays, increase taxes

18. Is there a hidden silver lining? • International prospects also gloomy • Outlook of many European countries also bad. • That’s bad for the U.S. fixed income markets! • Some hope in Latin America (e.g., Chile) • Will capital deepen as baby boomers approach retirement? • What about “dynamic scoring?”

19. Some Glimmer of Hope:Groundwork Being Set for Reform • New accounting methodology recently Adopted by Gov’t Trustees • For Social Security, starting with 2003 Report • For Medicare, starting with 2004 Report • They estimate a Medicare + SS FI of $82 trillion! • Senator Lieberman has introduced a bill requiring it for government as a whole

20. Easy Fix / Hard Fix • Social Security: The “Easy Fix” • Smaller problem • Nature of problem is also easier since it is cash payment (e.g., “just” price index) • Medicare: The “Hard Fix” • 7 times large (new Rx plan imbalance alone is larger than Social Security’s imbalance) • Nature of problem is also harder since in-kind payment and driven by tech change

21. Pension Fund Implications • Asset Side • Long-dated fixed income instruments risky? • Invest in more stocks? • Liability side (won’t talk much about) • Private payments could increase to extent that private pensions are integrated with Social Security (not common)

22. Why Haven’t Fixed Income Markets Reacted with higher interest rates? • View I: Capital markets don’t understand. • View II: Capital markets believe that most of the obligations will be reduced by reducing benefits (hard to believe) • View III: Term Structure

23. Include More Stocks? • Aside: accounting issues • Risk: Liability matching problems • Risk: Demographic issues

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

25. President’s Social Security Plan • An actuarially-fair carve out • Few minor exceptions: pre-retirement mortality and bequeath-ability of accounts • Won’t have any impact on markets (fixed income or not) provided if households are not borrowing constrained • Intuition

26. But, about 50 percent of U.S. households don’t hold any equities either directly or indirectly in employer-sponsored DC plans • Exact reason is important for policy goal • Rational (correlation between human capital and physical capital returns) or irrational (“fixed costs” associated with learning) • If rational, then President’s plan neutral • If irrational, then likely small increase in equity values and small reduced bond prices