Eric Patashnik
Professor of Politics, University of Virginia
"Social Security and Medicare in the New Era of Budget Deficits"
June 5, 2003

In my talk today I'm going to focus on 3 topics. The first is: The Bush tax cut and the return of budget deficits. Second, a question that I know is on the mind of many of you, Is social security being raided? and finally, what both political parties don't want you to know about the US budget.

Well let me begin then by talking about the actual legislation that was recently passed. I think that this package is a complex package and it has a variety of features, some are good, some are bad, and some are downright ugly. On the good side, it delivers a short-run jolt to the economy. The bad, many stand to benefit little ; no positive long-term impact on the economy. And, the ugly uses gimmicks to hide long term costs of the package. And let me elaborate a little bit on each of those three points.

The good side, short run stimulant. And this package will, according to most projections, give a bit of a lift to an economy that is recovering but still needs help. Our economy has been in the doldrums, we've had very aggressive monetary policy, interest rates are quite low, and most of what's important for getting our economy going from a policy standpoint will come from the Fed, but fiscal policy can add something. Although the package was not designed primarily as a stimulant package, that was not its primary attempt, if it were it would have been designed differently. It will, I think, according to most projections give something of lift the economy, particularly next year when some of its provisions phase in. Some projections suggest that it may improve GDP by .5%, that's not a huge amount, but that's not nothing either. Along with low interest rates and the weak dollar, which helps the exporting sector of the American economy, this fiscal stimulus offers some insurance against another recession in 2003-2004, in the near term. That's certainly a positive factor for many Americans who are looking for jobs, for people who want the economy to be strong.

On the negative side, its clear that this package, this new tax framework, it not going to deliver large cuts to many people. Because, as you've seen in the newspapers, the cuts are so concentrated on a portion of the taxpaying public, it means that certain sectors of Am society will receive only small benefits. And in particular, what's happened here, because the term average, the average tax cut that's being described in the press, the term average is a very misleading term. It doesn't mean, necessary, the typical person. For example, I was in a bar sitting by myself, and all of a sudden Ralph Samson walked in the room, the average height of the people in the bar would have increased a lot, but I'm not any taller. And, if bill gates joined us, the average wealth of the customers in the bar would have shot up dramatically, but I'm not any richer. The use of the term average can be quite misleading as a guide for the typical experience.

And if we look, for example, at different categories of tax payers: couples, families with kids, and elderly households, what we see is that there are many people who receive significantly less than the average. I'm relying here on figures from the Center for Budget and Policy Priorities, which is a liberal oriented Washington research group, but I think that its numbers are usually seen as very objective and reliable. couples, the average benefit for all married couples receiving tax cuts is $1,786 but 75% of all couples will receive less than the average amount, and 24.5%, nearly 1/4 in married couples, will receive 100$ or less from the tax cut. Families with kids, average benefit is $1,549 but 77.8% will receive less than the average, and almost 1/3, 31.3%, will receive $100 or less. Finally, elderly households, the average benefit going to the elderly is $1,401, but 89.4% of the elderly will receive less than the average amount, and 6.3% will receive $100 or less. One reason is because dividends, there are elderly people who receive a lot of income in dividends, but most elderly are not in that category. The dividends that are received by the elderly are disproportional held by a small proportion.

In highlighting these figures I want to be clear that I'm only talking about this package, not saying necessary that any one of these segments of society are mistreated over all by public policy at the federal level, there are a lot of public policies that serve these groups, but in this particular package they aren't benefiting too much. Also on the negative side of the legislature, long-term view, a number of private forecasters predict that the package will have a slightly negative impact on economic growth in the long run because, it will increase budget deficits and reduce national savings. Overtime, to the extent that the positive effect of the package on the economy, which comes from the incentives for new investment and growth, that's on the positive side, but to the extent that this package leads to larger deficits and reduces savings, that will have a negative impact on economic growth according to some very reliable Wall Street private forecasters, these are not just numbers picked by partisans in D.C., these are private economic forecasts.

Finally, gimmicks hide costs. The bill is described as a $350 billion package, but many of the new tax cuts in the bill, like the capital gains cut, some of the child care tax credits, are scheduled to "sunset" after a few years. This was done to hide the true long term cost of the bill. If these tax cuts are considered permanent, which is a reasonable assumption, because its quite likely that congress will not be desiring to raise these taxes even if they are in sunset, then the cost of the package over time increases dramatically, by nearly a trillion dollars. In other words, the package could have a far larger impact on the US budget than it would appear based on the $350 billion price tag.

As a result of this tax cut and the previous ones, we are now in a new era of returning to budget deficit. Of course, this is not an entirely new era, budget deficits are not a new experience for the US. Between 1979 and 1997, the federal government ran a budget deficit each year. Between 1998 and 2001, it ran a budget surplus each year. It was really the period of budget surplus that was the historical anomaly. That was different. Having budget deficit at the federal level, that's normal American politics.

Well how was the budget balanced in 1998 to 2001? How did we get there? How did we finally slay the deficit monster. It's probably a good idea… let me start from the bottom of this figure because we're going up in order of importance, I think. One factor is that health care inflation, which has been a major driver for federal spending and a major cause for the deficit, temporarily subsided for a brief period. The rate of inflation in the medical sector decreased. There has been a lot of discussion as to why that is, it doesn't appear to have been a permanent phenomenon. There may have been policy changes in 1997 Medicare reforms, things were going on in the manage care sector, but there was a brief episode where health care cost, the escalation of health care cost, subsided. That helped us.

Second factor to allow us to balance the budget: taxes were raised. Bill Clinton raised taxes, and also George Bush I also raised taxes. Taxes went up, and that helped reduce the deficit.

Federal spending was restrained. this was the era when were dealing with the end of the cold war. The defense sector, we were able to get some money out of the defense sector that had previously gone there. Other parts of the budget were also temporarily restrained.

The stock market, obviously, boomed which meant that capital gains taxes rose dramatically, and a new source of revenue began flowing into federal coffers.

And I think that the most important factor, though, is that the economy performed extremely well. Policy made a difference in slaying the deficit, it made a difference especially in avoiding the creation of new expensive spending promises, or avoiding tax cuts, that was especially important, but the main credit, I think, for the elimination of the deficit has to go to the economy. The economy performed extremely well.

But why are deficits back? Why are we back in a world of budget deficit? originally, in 2001 when the deficit came back, and this is what President Bush argued, it's absolutely true, I think it's very true, primary cause was the economy. Just as the economy was the main reason why the deficit disappeared, so to was the economic slowdown in 2001 was the main reason why deficit reappeared. We had a recession, and also, the fall out from September 11 created new costs. This was the main short term cost.

But if you look at the long run deterioration in the fiscal outlook at the federal level, the main cause, now, looking ahead, is not the slowdown of the economy, it's rather explicit policy choices, especially tax cuts. That's the main reason why we're heading towards deficits now. And, this is an extremely complicated graph but I just wanted to call attention a couple of things, because it helps put some of these long term trends into perspective. What this is a graph of shows this is the federal budget from 1962 projecting all the way to 2013. And, the two lines I want to first call your attention too are these straight lines. The first one shows the average level of spending at the federal level over this entire period. What this is, is a measure of the Gross Domestic Product (GDP), which is basically the size of the economy. how much money of the US economy is going to the federal government? Historically, the average is about 20.5%, about 20 cents of every dollar that's generated by the U.S. economy is going into the federal government. of course, this fluctuation, it goes up and down, having to do with the business cycle, having to do with whether you have a democrat in office or a republican.

Taxes, historically, over this period, have been about 18.5% of GDP. That's why we have had deficit, we've spent more than we've taken in. And again, we have fluctuations. You see taxes go up here under Jimmy Carter. This is Reagan coming in, taxes down. This is taxes up, beginning under George Bush Sr. Clinton, and now George Bush. So partisan party makes a difference, but this is long term trend. As over the long run we've spent about 20 cents out of a dollar and taken in about 18.5. What's different now, in the current year, we are no longer at our historic average of 18.5%, the most recent figures I've seen, we're actually at, we may end up 2003 at 16.5% GDP. This is a dramatic change. Now part of it has to do with the economic slowdown, but it's also policy shifts. In other words, we are no taking in a level of revenue at the federal level that is lower at any time, we would have to go back to 1959, we would have to go back to the Eisenhower administration. That's before Medicare, before Medicaid, before food stamps, before the creation of the EPA, before all the programs of the great society, that is the level of taxation we are no generating. It will go up if the economy improves, but we're not going to quickly hit back to our historic average in the next year or two.

Now, today's deficits are different are different than the deficits of the 80's or 90's. First of all, you're hearing in the newspapers about historically large deficits, the biggest ever, they're misleading. The reason is they're giving you the deficit figures in dollar as opposed to standardizing them to the size of the economy. The proper way to measure deficits, or almost anything in the budget, is as a share of the economy. As a share of GDP, the deficits we're running now are not historically largest deficits. certainly not like the deficits we ran during World War II, they're not even at the level of the peak deficits during the Reagan administration, which was about 6% of GDP. We're at about 4% of GDP, we may be going a little higher, and that's not trivial but we're not at the historically largest deficit level, even at this modern period.

Another big difference is that interest rates are obviously lower than they were in the 80's and 90's. That makes it easier to finance these deficits and less worrisome about their impact to the economy. On the other side, we are also 20 years close to the retirement of the baby boomers. And, the private savings rate, how much individuals save in the private economy, is much lower, even than it was in the 90's. We're saving almost nothing now as individuals.

Now, why is this so worrisome? We look ahead, we're in 2030, as a percentage of GDP the three big programs of Medicaid, Medicare and Social Security are going to go from about 7% of GDP to 15% of GDP according to projections. And why is Medicaid going up so much? We often think of that as just a program for the poor. Of course, Medicaid also covers long term care, because Medicare does not cover much long term care. As we age as a society, more and more seniors are going to be relying on Medicaid. And so when you look at a situation where we're collecting less revenue than we've had since the Eisenhower administration, and we look ahead to these kinds of entitlement cost, you can see that we're definitely in for some fiscal stress.

People might say, we don't need to worry so much about these entitlement costs. After all, social security and Medicare are financed by trust funds. well, where's the money? Are the trust funds being raided? Let me talk for a few minutes now about how trust funds really work, what it means to save trust fund surpluses, why the lock box idea (that we've heard so much about) was overblown but not totally crazy.

How a federal trust fund works: Federal trust funds are dedicated accounts in the U.S. treasury. And, the trust funds have economic implications, they are primarily political institutions. One of the main reason for our confusion. We keep thinking they are identical to private sector trust funds, and they're not. There are similarities, but they are different creatures. The major purpose of the federal trust funds is to make long term budget promises more credible. Here we see FDR signing the social security bill in 1935. he explicitly wanted a design based on year-marked taxes, payroll taxes, and the trust fund to make the promises harder to reverse. To give people confidence that the programs would be there when they needed them. That was a very conscious political move on his part.

Some nuts and bolts. Payroll taxes, premiums (like part B premiums) and other income are credited to the trust accounts. So you have government money flowing into the trust fund accounts. Trust fund income not needed in the current year to pay benefits is invested in special Treasury securities. When the government collects more money than it needs to cover currents, or securities or Medicare costs, the trust funds receive investments.

Now, by law, these securities held by the trust funds earn interests at market rates. Of course, investing the money in other assets, like stocks, would bring higher returns but there would be more risk. There's no free lunch. The actual cash generated by the excess of thrust fund income over outlays goes into the Treasury, where it becomes part of the government's pool of operating funds. So, for example, if the government collects 10$ in payroll taxes, but it only needs 9$ for current benefits, that dollar goes to the treasury and it does what it needs for money, what ever the bills come and do. Defense bills, EPA bills, whatever the bills are at that time.

In sum, the trust funds loans the Treasury money t does not currently need. In return, the trust is credited with securities that serve as claims against the government - claims on which the U.S. treasury has never defaulted. And so what's confusing is that these securities have a double life. To the programs themselves they're assets, for social security managers, these are assets they can call upon. But from the perspective of the government budget as a whole, they are liabilities, they are claims against the government.

Now until the mid 1980's, the accumulation of trust fund reserves was not a major concern because Social Security operated on "pay-as-you-go" basis. Meaning they only took in about as much as they needed every year to cover benefits. in the late 1970s and early 1980s, the Social Security Trust Fund ran deficits. Changes in taxes and benefit schedules were made to keep the program solvent. program was on the brink of exhaustion, politicians made choices to keep the program solvent. There were major reforms made in 1983 that made changes to benefit schedules, retirement for younger works, delay in cost of living adjustments, accelerating payroll taxes, subjecting portions the social security benefits for certain people to the income tax. As a result of all these changes, social security began accumulating large, but temporary, annual surpluses. It's only then that we begin thinking about where the money is going.

This is a chart that shows social securities income and outlays. the blue line including interest on its previous trust funds surpluses, the dotted line is outlays, and the redline is income excluding interest. And because the blue line is above the dotted line right now, that's why we're building up supposes in the trust account. but obviously, this is not going to last forever, and at some point we're going to cross over and the trust fund will have to be drawing down its prior reserves.
in fact, here is the latest forecast from the government. Social Security will continue to take in more taxes than it spends until the year 2018. The first year when spending will exceed taxes plus interest is 2030, and according to current projections the trust fund will be exhausted by 2044. that doesn't mean that there wont be any money coming in. After all, the government will still be collecting payroll taxes from current workers, it just wont have enough to cover currently promised benefits. Medicare finances, part A, are in a little bit worse shape. Until 2013, taxes will exceed outgo. Until 2018 taxes and interest will exceed outgo, and the trust fund is projected to be exhausted in 2026.
Well, where's the money in the trust fund? The $64,000 dollar question. We've been building up these surplus, where did the money go? Both political parties accuse the other of raiding the money in the trust funds. And the clear implication is that Social Security funds are somehow being stolen. now the parties can accuse one another of fiscal mischief because the true situation is complicated. It's like what is usually the case, in my view, of politics. the politicians aren't totally lying, they're just telling you part of the truth and they're simplifying things so much so that things become distorted. There are real issues here, but they are a bit distorted.

I n reality, no money is being stolen. there is no direct effect on current or future Social Security benefits. nor do the loans affect the balance of the trust fund. The trust fund gets the same amount of securities. However, and this is where there is the real issue, that is being oversimplified in political discussion: there are indirect effects of this trust fund issue. how the government uses the social security surpluses can influence the economy and the budget in ways that will affect Social Security indirectly. So there's a connection, it' just much less tangible and direct that you would realize given the political rhetoric.Lets step back for a minute and look at the big picture. Is Social Security going to be there for you, for Medicare, for you. ultimately, in the long run, the nation's willingness to fund Social Security in the future depends on basically three basic factors. First, the political resources of seniors, which are incredibly impressive. Seniors vote, seniors write letters, seniors give campaign contributions. Social security and Medicare are important issues to seniors. seniors are a powerful lobby, this is democracy and powerful lobbies have lot of power.
secondly, how non-seniors feel towards their elders. After all, non-seniors vote too. They feel pretty warmly, surprisingly. There's no sense of younger people being resentful of seniors. The idea of war between generations does not seem to be showing up in the public opinion polls. There's a lot of supports for seniors and seniors programs amongst Americans generally.

I t will also depend on the future state of the U.S. economy. Which, we're in America here, can never be good enough, we always want the economy to be better. though her is the tie into Social Security. How do we improve the economy in the future? After all, we're going to have all those baby boomers retiring. They're going to be drawing on their benefits. one idea is that we could save. if the government uses Social Security surpluses to retire more public debt than it would normally do, national saving swill increase, all else being equal. Now if we increase savings, this should increase private sector investment and the rate of economic growth. Because the U.S. economy in 2030 would be somewhat larger from us having done that now, then the burden of supporting retirees-- a burden that cannot be avoided -- would be a bit easier for future workers to bear. If they economic pie is larger, than the slice that the economy gives to seniors in the future will be easier to doll out. we'll have a bigger pie, it will be easier to be generous.
The lockbox. In the late 1990s, Congressional Republicans came u with the idea of putting Social Security in a "lockbox." this actually was an effort to trump President Clinton, who originally came up with the idea of Save Social Security first, when unified budget surpluses emerged as a way of blocking GOP demand for tax cuts. The GOP, one up from President Clinton, said we're going to put all of the Social Security surpluses in a lock box. It was a way of scoring points with the senior lobby, making them look quite fiscally responsible. And there was also, again, some indirect economic logic to it. it wasn't a totally symbolic issue.

Democrats embraced the idea. Al Gore made it a center piece of his presidential campaign. Now remember what I said: this is indirect, this is not just putting money on the ground. Its' complicated. The lockbox idea required the government to balance the non- Social Security part of the budget, allowing the Social Security surplus to buy down debt. That's basically the idea of it. The kind of pressure that we're going to see from Social Security is actually quite modest compared to the budgetary pressure for Medicare and medicate.

What both political parties don't want you to know about the budget. The Republicans prefer not to mention that permanently keeping federal taxes below 19% of GDP, in other words, permanently keeping taxes at the level that they currently are, implies either large deficits or significant cuts in promised social benefits. The Republicans also prefer not to stress that economic growth, if the economy grows at a moderate pace, maybe not as quickly as the boom years of the 1990s but say better than during the slow years of the 1970s, if it grows at that pace than future economic growth will enable future workers both to enjoy rising living standard and to pay the pay the added taxes necessary to sustain existing programs. One way of looking at it is that our kids are going to be a lot richer. If their taxes are going to go up, they can afford it.

Finally, the Republicans don't like to mention that privatizing Social Security entails high transition costs- and that the disappearance of the budget surplus means there is no money to pay for them. Basically, to go form today's public collective system to a private system of individual retirement account, we face what's called a double payment problem. We're going to have keep the current system, which needed to make good the promises already made to seniors. Then we need new money to set up new individual retirement accounts. W ell, you can't use the same dollars twice. In an accounting sense, in federal budgeting you can. But in the real world you can't, and there's going to be costs to that. When we had budget surpluses, some people said, aha, there's free money in Washington, now we can do this. but with the disappearance of the budget surplus it means that the only way we can do that is by cutting other programs, raising taxes, or taking large loans which adds to the deficit.

On the Democratic side, they prefer not to mention that avoiding entitlement cutbacks implies significant tax hikes -- tax hikes most Democrats are reluctant to propose. We can't possibly fund all those things (Medicare, Social Security and Medicaid) if we're going to do anything else, if we're going to have a defense, a military, a state department. we can't do it on our current dollars, taxes are going to have to go up.

The Democrats also prefer not to mention that seniors will be largely protected under any politically feasible GOP Social Security reform plan. Republicans who want to change Social Security are not going to make current retirees, or are on the brink of retirement, suffer dramatic changes. The people who would have to bear the cost of for the most part are much younger workers, but Democrats, Politically, would rather paint those changes as tax on seniors because it would get a much larger reaction. It's a little bit different on the Medicare side because its more complicated and their could be more impact for current participants. But on the Social Security side, I'm pretty confidant that even republicans who want to privatize the program dramatically, are not going to make current retirees bear large changes. They also don't want to say, democrats, that many younger Americans have more trust in the private sector than they do in the federal government.

The conclusion to wrap up is, there are fundamental economic and value tradeoffs at stake in our budget debates, but neither liberals or conservatives have been willing to owe up to them.