Government Spending on the Elderly: Social Security and Medicare

Studies | Federal Spending | Health | Social Security

No. 247
Friday, November 30, 2001
by John C. Goodman and Matt Moore


Executive Summary

Because the payroll tax revenues that fund Social Security and Medicare currently exceed the amount paid in benefits, these two programs are generating annual budget surpluses.

But by the time the first of the baby boomers begin to retire, Social Security and Medicare will begin paying out more in benefits than they collect in payroll tax revenues. As a result, taxes will have to rise.

  • In contrast to the current 15.3 percent (FICA) tax rate, spending on Social Security and Medicare Part A combined will swell to 23.8 percent of payroll by the time today's teen-agers reach retirement age in 2050, according to the Social Security Administration's intermediate forecast.
  • If federal subsidies for the Medicare Part B program and health care benefits funded through programs such as Medicaid and the Veterans Affairs system are also expressed as a percent of taxable payroll, the mid-century burden climbs to 32 percent.
  • Thus to keep its promises to people entering the labor market today, the federal government will have to claim almost one-third of the income of future workers - most of whom are not yet born.

Nor is this the worst that can happen. The Social Security and Medicare actuaries also make a forecast based on pessimistic assumptions:

  • When today's 18-year-olds reach retirement age, Social Security spending will equal 21.7 percent of payroll - more than twice the current burden.
  • When Medicare and other elderly health programs are included, spending in 2050 will equal 54.4 percent of taxable payroll.
  • If this projection proves true, we have already pledged more than half the incomes of future workers just to cover benefits for the elderly already included under current law.
  • This burden will be even greater if Congress tacks on a new Medicare prescription drug benefit or a long-term care benefit.

Moreover, even the pessimistic projection is by no means the worst that can happen. After 1997, the Medicare trustees made a dramatic and unexplained change in their assumptions, wiping out almost one-third of Medicare's unfunded liability in one fell swoop. Without this sudden surge of optimism, elderly benefits will consume about two-thirds of worker income by mid-century, based on the pessimistic forecast!

Despite all the recent attention paid to Social Security's long-term fiscal insolvency, Social Security is not our biggest problem. Health care is. Indeed, health care spending will outpace Social Security spending by the time today's teen-agers reach the retirement age, according to intermediate assumptions. If the pessimistic projection proves to be true, health care spending will surpass spending on Social Security during the baby boomer retirement years.

The reason for the financial crisis in America's elderly retirement programs is that they are based on pay-as-you-go finance. All payroll tax revenues are spent - the very minute, the very hour, the very day they are received by the U.S. Treasury. Most of these revenues are spent on benefits for current retirees. Any additional amount is spent in other ways or, more recently, to pay down the national debt. But there is no funding of future benefits. No money is being stashed away in bank vaults. No investments are made in real assets. Pay-as-you-go means taxes taken from today's workers pay for benefits government provides to today's retirees. When today's workers reach the retirement age, their benefits will be paid only if higher taxes are collected from the next generation of workers.

What about the trust funds? Unfortunately, these funds have an accounting function, but not a financial function. The funds do not collect taxes. Nor do they disburse benefits. Every payroll tax check sent to Washington is written to the U.S. Treasury. Every Social Security benefit check is written on the U.S. Treasury. Moreover, the Social Security trust fund exists within the U.S. Treasury - not as an independent entity. Thus the issuer of the trust fund's bonds (the U.S. Treasury) and the holder of the bonds (the Social Security trust fund) are the same entity. As a result, the trust fund's special-issue bonds are actually nothing more than IOUs the government writes to itself. To redeem the IOUs in the trust fund, the government will have to raise taxes, increase borrowing or cut other government spending. Ironically, these are the same choices we would face if the trust fund did not exist.

What can be done to save Social Security? Some have suggested "patchwork reforms" that tinker at the margins of the system. These reforms would either cut benefits or raise taxes or both. But they would maintain the pay-as-you-go structure of the current system.

An alternative approach is to move quickly to replace the current system with a funded system. Under this approach, workers would make deposits to funds that invest in interest-earning assets - that can be sold to pay benefits in future years. Under this approach, worker benefits are not dependent on the willingness of future generations to pay taxes.

Instead, each generation would pay its own way.


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