How Will We Pay for Social Security and Medicare?

Brief Analyses | Social Security

No. 490
Wednesday, October 13, 2004
by Thomas R. Saving, Ph.D.

Social Security and Medicare are making future promises much greater than the taxes that will be collected at current rates. Unfortunately, some policymakers seem to be intent on making the problem worse, not better. Reforms are needed that create more saving today for retirement and increase the nation's capital stock.

Size of the Problem . The latest reports of the Trustees of Social Security and Medicare calculate the present values of the cash flow deficits for both programs - and the numbers are staggering. Social Security's funding gap for the next 75 years stands at $5.2 trillion. Medicare's unfunded costs come to $28 trillion, including $8.1 trillion added by the new prescription drug benefit. The combined $33.2 trillion shortfall is about three times the current size of our economy.

Bleak as this picture is, over a longer horizon the situation is worse. Consider people retiring 76 years from now. The Trustees' 75-year calculation counts all of the payroll taxes these people will pay but ignores the benefits they expect to receive. To measure what happens after the 75th year and beyond, the Trustees now calculate the unfunded obligations over an infinite horizon. From this long-range perspective:

  • Social Security's long-run cash flow deficit is $11.9 trillion, and the new prescription drug benefit will require $16.6 trillion.
  • The total shortfall of Medicare Part A (hospital insurance, currently paid by taxpayers) and Part B (for doctors' services, three-fourths funded by taxpayers) is $45.3 trillion.
  • After payroll taxes and premium payments by the elderly, the unfunded liability of Medicare and Social Security combined totals more than $73 trillion - about seven times the size of our economy.

Making the Problem Worse . As if these numbers aren't bad enough, there is a movement underway to place additional burdens on taxpayers by reducing retirees' share of the cost of Medicare Part B. Under current law, seniors' premiums are supposed to cover one-quarter of the cost of Medicare Part B, with taxpayers picking up the other three-quarters. The law also prohibits increasing the Part B premium in an amount that exceeds the value of a senior's Social Security cost of living adjustment (COLA).

Part B premiums, which are automatically deducted from Social Security benefit checks, will rise by 17.5 percent in 2005. The standard monthly premium is $66.60, which leads to an increase of about $11.66. (The average Social Security benefit increased from $903 in December 2003 to $922 in January 2004, due to the 2.1 percent COLA.)

In anticipation of a senior backlash, some politicians are seizing the opportunity for demagoguery. Some in Congress want to delay the premium increase for a year. A bill by Sens. Ted Kennedy (D-Mass.) and Debbie Stabenow (D-Mich.) (S. 2780) would limit the increase in the Part B premium for 2005, but allow premiums to return to where they otherwise would have been in 2006.  In other words, seniors will be hit with a big premium increase a year later than under current law. Senate Minority Leader Tom Daschle (D-S.D.) introduced a bill (S. 2754) in July 2004 that would limit future increases in monthly premiums for Medicare Part B and Part D (the new prescription drug benefit) to one-fourth of any senior's Social Security COLA.  If either of these proposals were passed into law, seniors would bear a declining share of the program's cost, while Medicare's cost to taxpayers would increase. The Kennedy-Stabenow proposal - if continued indefinitely - would create a new unfunded liability totaling $6 trillion, more than half the size of Social Security's unfunded liability! Under the Daschle bill, seniors' share of the costs of Parts B and D would decline to 20 percent over the next 20 years from approximately 25 percent today.

Shortfalls Began This Year . Some argue that the financial problems of elderly entitlements will not arise until the distant future. In reality, we are dealing with those burdens right now. This year, for the first time in recent memory, Social Security and Medicare combined will spend more than the programs take in. This will require a transfer from the Treasury of 3.6 percent of federal income tax receipts. That figure will grow rapidly:

  • In just 15 years, in the early stages of the baby boomers' retirement, we will be transferring more than 25 percent of federal income tax revenues to cover the funding needs of Social Security and Medicare.
  • By 2030, if current laws remain unchanged, more than half of all federal income tax revenues will be required to pay projected benefits.
  • By 2040, the figure will be two-thirds, and by 2069, funding shortfalls will exhaust all federal income tax revenues. [See the figure.]
General Revenue Transfers to Social Security and Medicare

We have two clear choices: We must either set aside resources to provide for the promises we keep making to seniors, or we must take away some of those promises. Currently the government collects more Social Security taxes than it needs to pay benefits, credits the excess amount to the Trust fund, then spends the money on other government projects. Would it not be wiser to set aside funds to pay promised benefits by investing them in real market assets?

New Savings Are Needed . It is time to face reality. Current elderly entitlement programs saddle the next generation of workers with increasing implicit debts. We must introduce reforms that capture the earning potential of the baby-boom generation before they escape into retirement and leave the young with a burden that cannot be paid. Unless we increase our level of saving now, we will leave our children and grandchildren strapped with escalating tax rates.

Some have suggested that we can wait and raise taxes or lower benefits when the cash flow crisis arrives, but this is not a problem that can be solved by incremental tweaking. The Trustees forecast enormous future taxes, and cuts that will hurt retirees who depend on benefits. Others have argued that economic growth will ease future taxpayer burden. But the Trustees take into account projected growth in the nation's output. If output rises more rapidly than they project, benefits will also rise proportionally.

Conclusion . Due to changing demographics and rising medical costs, the share of the nation's output consumed by the elderly will rise. It is this rising economic share (financed in large part by Social Security and Medicare transfers) that will drive a growing tax burden. Saving more now for retirement reduces the burden on future taxpayers while at the same time increasing the nation's capacity to produce.

This generation of workers faces a clear choice. Will they tighten their belts a bit and save more? Or will they ask their children and grandchildren to choose between reneging on promises to retirees, going without government services or paying exorbitant tax rates?


Dr. Saving is a public trustee of the Medicare and Social Security Trust Funds, director of the Private Enterprise Research Center at Texas A&M University, and a senior fellow at the National Center for Policy Analysis. An earlier version of this article appeared in the Wall Street Journal.

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