Recast Federal Entitlements, Fight Tax Hikes

This is the last in a four-part series by Heritage Foundation Vice President of Government Relations Mike Franc, discussing an agenda for the new Congress, balancing the need for bipartisan cooperation against the temptation to veer too far leftward on domestic and international policy issues.

When historians look back on our present time, there’s a good chance they will judge President Bush and the current generation of lawmakers by the adequacy of their response to the overriding domestic policy question of our era: Did they exhibit the political courage required to meet the fiscal challenge presented by the aging of the baby boom generation?

On Jan. 1, 2008, less than one year away, the members of the post-World War II generation will celebrate their 62nd birthdays, opt for early retirement, quietly deposit the first Social Security checks issued to Boomers into their bank accounts, and the long national fiscal nightmare will begin. Three years later they will turn 65 and enroll in Medicare, the fiscal equivalent of riding downhill with no brakes.

Curbing Explosive Costs

By now, all serious lawmakers and policy experts understand our fiscal situation:

  • Between now and 2030, the number of Americans age 65 and over will nearly double, from 40 million to 78 million.
  • Thanks to this completely foreseeable demographic development and the equally foreseeable breakthroughs in medical technology that will continue to increase our life expectancies, spending on our three big entitlement programs — Medicare, Medicaid and Social Security — will explode. Medicare will grow at an annual rate of 9%, Medicaid at 8%, and Social Security at 6%. This trend, in the prescient words of United States Comptroller General David Walker is simply “unsustainable.”
  • With no changes in current law, total federal spending will double as a percentage of our Gross Domestic Product (GDP), reaching 40% of GDP within the next 30 years. This is almost entirely attributable to the exploding ranks of soon-to-be-senior Boomers. If we assume that state and local spending stays at current levels (12% of GDP), then we are looking at a future where total government spending will soon lay claim to more than half of the new wealth created each year.
  • Most alarmingly, the single largest expenditure is likely to be the annual interest due on our national debt.

These sobering facts should ring like clanging alarms in the ears of every lawmaker, regardless of party affiliation, committee assignments or ideological inclination.

Last year, President Bush’s top budget official told a congressional panel that within a decade “deficits stemming largely from entitlement programs such as Social Security and Medicare will begin to rise indefinitely. No plausible level of spending cuts in discretionary programs [everything from education to housing and highways to national defense] or tax increases could possibly solve this problem.”

Last year, Joe Antos of the American Enterprise Institute and Tracey Foertsch, my colleague at the Heritage Foundation, took a long, hard look at the fiscal condition of just one of these programs — Medicare. Medicare’s financial woes, they found, are no longer a distant theoretical threat. They are now a clear and present danger.

To pay for the Medicare benefits promised to current and future retirees over just the next 10 years, Antos and Foertsch calculated that Congress would have to impose an economically debilitating $2.7-trillion tax increase on American workers and businesses. That tax hike would require the equivalent of an immediate and permanent 4.3 percentage-point increase in all personal income tax rates. A milder, but still significant, increase in the payroll tax that workers pay for their Medicare benefits would also be required.

What are the economic consequences of these tax hikes? More than 920,000 private sector jobs would be lost, and GDP would plummet by more than $116 billion.

Covering the entire Medicare shortfall envisioned by the program’s trustees through 2079 (a much more daunting challenge) would necessitate even larger tax increases and much larger job losses (2.3 million), which would lead to a decline in GDP of more than $190 billion.

Of course, because lawmakers must also address the unsustainable paths of Social Security and Medicaid, the scope of the economic Armageddon could be even worse.

The Coming Tax Increase

The findings of Antos and Foertsch set off even more alarm bells when viewed in the broader context of our current tax policy. Why? Not only have lawmakers put a fiscal Armageddon into current law, they have also added hellish automatic tax increases into the recipe as well.

Imagine if conservative lawmakers had devised a way 25 years ago to cook a surreptitious annual tax cut into the tax code. Liberals would be furious with the implications of such a change. Not enough money for vital government programs, they would argue, and too much in the hands of the “rich.”

Sadly, the reality cuts in precisely the opposite direction. Three aspects of the tax code — the insidious Alternative Minimum Tax, the bracket creep that comes when pay raises push workers into higher tax brackets and the planned expiration of the Bush tax cuts beginning in 2010 — set in motion a second and equally unsustainable dynamic, an annual tax increase. Measured as a percentage of our GDP, that tax increase will shift one-tenth to one-quarter of one percent of GDP from the productive side of the economy to government each and every year for as far as the budget eye can see. Translation: a tax increase of between $14 billion and $40 billion in today’s dollars, annually and forever.

According to the Congressional Budget Office, the tax burden will jump quickly once the Bush tax cuts expire from approximately 18% of GDP today to 19.2% in 2013 and then to 19.7% in 2016. Then the rate of increase flattens out slightly, but continues its merciless rise — to 20% of GDP in 2018, 21.1% in 2026, 21.7% in 2031, 22.3% in 2036, and finally to 23.3% in 2046.

These are not just abstract numbers. In 2006, GDP stood at $13.3 trillion. Each percentage point of GDP, therefore, represents more than $130 billion in economic activity. Should lawmakers allow these tax increases to occur, it will be the equivalent of increasing our current tax burden by an unfathomable $700 billion (in 2006 dollars) every year.

Congress and the President should immediately begin to address these twin trajectories. Specifically, they should consider the following options immediately:

  • Rethink the principle of social insurance. It is no longer feasible to promise a defined benefit (whether it is health coverage or a pension) to everyone, regardless of their need or ability to pay. Spending on programs like Medicare, Social Security and veterans’ benefits should be redirected to those who need them the most.
  • Restructure the Medicare drug benefit by replacing it with a targeted benefit for low-income seniors, or by modifying co-payment rules and other provisions.
  • Expand means-testing rules for all of Medicare, allowing seniors with more income to remain in Medicare by paying higher premiums.
  • Establish a new Medicare Premium Support program for baby boomers retiring in 2011 modeled directly after the Federal Employees Health Benefits Program, allowing any retiree with private or employer-based coverage to carry their health plans into retirement with a government contribution to offset their costs.

Many lawmakers may view these reforms as beyond the reach of an evenly divided and bitterly partisan Congress. But these initiatives should be seen as only a modest piece of the heavy-duty reform package Congress will need to enact to get our nation’s fiscal house in order. To solve the looming fiscal crisis, Congress and the President should:

  • Restructure Medicaid. Shift this health program for the poor to a defined contribution system and increase coverage choices for enrollees. Give states greater flexibility in designing plans, and create alternatives for long-term-care coverage.
  • Restructure Medicare. Move the financing of Medicare services to a defined contribution basis as well. Every senior should be able to pick and choose the kind of health plans and benefit packages he or she wants, at the prices they wish to pay. This would require every health plan to compete directly for consumers’ dollars.
  • Reduce the unfunded obligations of Social Security. This will require realistic and cost-effective changes, such as reducing benefits for younger workers to more reasonable levels, while also giving them the tools necessary to make up the difference through personal savings and investment earnings.
  • Change the tax treatment of health insurance. Congress should gradually replace the existing tax breaks for health insurance with a limited national tax credit system. At a minimum, Congress should cap the tax exclusion for employer-sponsored insurance and enact an individual health care tax credit for individuals and families who do not or cannot get health insurance through the place of work. This would create a level playing field between employment- and non-employment-based health insurance, expand coverage dramatically and eliminate the existing inequities in the health insurance markets that today hurt low-income working people trying to secure affordable health coverage.
  • Reject debilitating tax hikes. The coming fiscal crunch should not tempt lawmakers to walk down the blind alley of massive tax increases. As noted above, tax hikes are already “on the table.” They’ve been cooked into our tax code and are too massive for our economy to sustain. The answer is to overhaul our tax code to maximize two things: economic growth and the increased revenues that such growth generates. Congress should concentrate on lowering income tax rates and eliminating the double taxation of income.