At the signing ceremony for the new Medicareprogram in 1965, President Lyndon Johnson said,“No longer will young families see their own incomes,and their own hopes, eaten away simply because theyare carrying out their deep moral obligations to theirparents.” But taxes to support growth in Medicareand Social Security will severely eat away at youngpeople’s income in coming years unless those pro-grams undergo fundamental reforms.

In the 20th century politicians replaced per-sonal savings, family obligations, and private char-ities with giant centralized transfer systems tosupport the elderly. The main programs for theelderly, Social Security and Medicare, are primari-ly funded by taxes on the young. That fundingmechanism has set the nation on a financial colli-sion course as the number of elderly will soar 116percent by 2040 while the number of workers sup-porting them will grow just 22 percent. Withoutreforms, the combined cost of Social Security andMedicare Part A is expected to rise from 13.8 per-cent of taxable wages today to 24.2 percent by2040. Adding in projected spending on Part B ofMedicare pushes up the total projected costs ofthe two programs to 30 percent of wages by 2040.

Congress is considering making the loomingfiscal crisis much worse with a costly and unfund-ed prescription drug program. But increasing thealready high transfers from the young to the old isneither economically sound nor fair. Considerthat, on average, the elderly used to consume lessthan the young, but now they consume more.Also, the elderly today are in better physical shapeand better able to earn income to support them-selves than before. Major entitlement reforms areneeded to reduce taxpayer costs and head off agenerational war between the old and the young.

A wide range of reforms is needed to deal withrising entitlement costs. Social Security and Medi-care should be turned into savings-based systemswith payroll contributions funding personalhealth care and retirement accounts. Taxes on sav-ing should be sharply reduced so that Americanscan put more money aside for their own future.Medicare reforms should reduce health care costsby increasing competition and relying more onout-of-pocket payments. Centralized redistribu-tion systems for the elderly need to be replaced bypersonal savings and greater individual responsi-bility for retirement in the new century.

War between the GenerationsFederal Spending on the Elderly Set to Explode

by Chris Edwards and Tad DeHaven

_____________________________________________________________________________________________________

Chris Edwards is director of fiscal policy studies and Tad DeHaven is a research assistant at the Cato Institute.

Executive Summary

No. 488 September 16, 2003

Introduction

At the signing ceremony for the newMedicare program in 1965, President LyndonJohnson said, “No longer will young familiessee their own incomes, and their own hopes,eaten away simply because they are carryingout their deep moral obligations to their par-ents.”1But unless Medicare and Social Securityare reformed, young people’s incomes will beeaten away by skyrocketing taxes to support afederal government of unprecedented size.

The nation is on a financial collision coursebetween young and old as demographicschange dramatically in coming years. By 2040the number of workers will have risen by only22 percent, but the number of elderly (thoseaged 65 and older) will have risen by 116 per-cent.2 Jagadeesh Gokhale and LaurenceKotlikoff, leading experts on the comingchanges, note that, as baby boomers begin retir-ing later this decade, it “will mark the beginningof an enormous conflict over resources. Indeed,it is probably no exaggeration to say that we areapproaching generational warfare.”3

The government has made overly generouspromises to future retirees without any planto pay for those promises. As a result, currentpolicies “are generating a huge implicit debtthat future generations will have to pay off.”4

Looking forward, Social Security and Medi-care’s promised benefits exceed available taxesby $18 trillion, expressed in today’s dollars.5

Another recent estimate placed the financialimbalance of Social Security at $7 trillion andthat of Medicare at $37 trillion.6

Those enormous liabilities suggest thattomorrow’s young workers face a huge taxthreat as entitlement spending soars.Already, the federal government spends 35percent of its $2.2 trillion budget on benefitsfor the elderly.7 Spending on Social Securityis estimated to be $471 billion in fiscal year2003, making it the largest federal program(Table 1).8 Spending on Medicare (net of pre-miums) is estimated to be $244 billion inFY03. Medicare is set to grow even faster thanSocial Security in coming decades.

That programs for the elderly are a fiscaltime bomb is widely recognized, but policy-

2

Tomorrow’syoung workersface a huge tax

threat as entitlement

spending soars.

Table 1Main Programs for the Elderly in the Federal Budget, FY03

Social Security—old age, survivors, and Funded by 12.4 percent tax on wages up todisability insurance (OASDI) $87,000. Outlays of $471 billion.

Medicare Part A—hospital insurance (HI) Funded by 2.9 percent tax on all wages. Outlays of $151 billion.

Medicare Part B—supplementary medical Funded 25 percent by participant premiumsinsurance (SMI) and 75 percent by general tax revenues.

Outlays of $93 billion, net of premiums.

Medicaid—elderly benefits Funded by general tax revenues. Benefits for the elderly are about 29 percent of Medicaid spending ($162 billion), or $47 billion.

Other elderly benefits, such as civil service Outlays of about $100 billion.retirement and veterans' health care

Sources: Mid-Session Review, Budget of the United States Government, Fiscal Year 2004 (Washington: GovernmentPrinting Office, July 2003); and Congressional Budget Office, "Federal Spending on the Elderly and Children," July28, 2000.

3

Federal discre-tionary outlaysrose 8.4 percentannually betweenFY98 and FY03.

makers were lulled into a false sense of secu-rity during the late 1990s as growth in enti-tlement spending moderated. That was justthe calm before the storm. The number ofSocial Security beneficiaries grew 14 percentduring the 1990s but will grow 30 percentduring the decade beginning in 2010, caus-ing spending to explode.9

This study discusses the long-term outlookfor taxpayers if entitlement spending is notreformed, examines the rising share of the fed-eral budget going to the elderly, discusses therising income and consumption levels of theelderly, looks at the generational accountingmethod for understanding the entitlementcrisis, and concludes with policy options thatcan be implemented to avert the crisis.

The Federal Government in2040 without Reform

The coming demographic tidal wave willforever alter the federal budget. As the babyboomers begin to retire in 2008, the costs ofSocial Security and Medicare will escalate.More retirees, longer life spans, and risinghealth costs will thrust a huge tax burden onfuture workers unless major spending reformsare implemented. The Congressional BudgetOffice and other authorities have repeatedlycalled attention to the huge long-term costincreases in the entitlement programs, butCongress has not yet heeded calls for reform.

Congress was complacent about the needfor spending cuts in the 1990s when the eco-nomic boom caused government revenues tosoar and pushed the budget into temporarybalance. Also, growth of spending on the threemain entitlements (Social Security, Medicare,and Medicaid) slowed during the late 1990s.Average annual Social Security growth slowedfrom 5.4 percent (FY91–FY96) to 4.3 percent(FY96–FY01); Medicare growth slowed from10.9 percent to 4.5 percent; and Medicaidgrowth slowed from 11.9 percent to 7.2 per-cent.10

Today, the revenue boom has ended andentitlement spending is rising rapidly once

again. Medicaid spending jumped 14.7 per-cent in FY02 and is expected to grow 9.5 per-cent in FY03.11 Social Security and Medicarespending will accelerate rapidly when the babyboomers begin retiring in 2008.

CBO baseline projections show that thesum of Social Security, Medicare, andMedicaid spending will almost double from8.4 percent of gross domestic product todayto more than 15.6 percent by 2040.12 Thus,without reform, the government would haveto almost double the share of income that istaxed to pay for promised benefits.

The left-hand column in Figure 1 showsCBO figures for federal outlays as a percentageof GDP in 2003. The right-hand column pro-vides a scenario for 2040 if policymakers donot make any entitlement reforms. It usesCBO projections for Social Security, Medicare,and Medicaid but assumes that outlays for allother programs stay the same size relative toGDP that they are today. In that case, federalspending would rise from 20.2 percent ofGDP to 27.4 percent—a 36 percent expansionin the government’s fiscal command over theeconomy. If such a 7.2 percentage point costincrease were thrust on today’s taxpayers, itwould be equivalent to a $774 billion annualtax hike. By comparison, President Bush’sincome tax rate cuts saved taxpayers about$100 billion per year.

Long-term projections from the CBO fre-quently present a more optimistic picture ofoverall federal spending. For example, CBOfigures often assume that discretionary spend-ing, interest, and other federal spending willfall relative to GDP in coming decades to part-ly offset the increase in entitlement spend-ing.13 Such reductions would entail largespending reforms by Congress and many pro-gram eliminations. That would be a neededand refreshing change in policy. However, fed-eral discretionary outlays rose 8.4 percentannually between FY98 and FY03, represent-ing a rapidly increasing, not decreasing, shareof GDP. Also, current projections do notinclude the costs of a prescription drug bene-fit or other new programs that Congress mayadd in coming years. Thus, the right-hand col-

umn in Figure 1 and CBO’s long-range spend-ing projections are probably low-end, opti-mistic estimates unless policymakers changecourse and make major spending cuts.

The economic damage done by the spend-ing increase shown in Figure 1 would be enor-mous. The cost to taxpayers will not be just theextra income handed over to retirees.Harvard’s Martin Feldstein points out that atax-financed rise in entitlement spending willcreate large “deadweight losses,” or inefficien-cy costs, to the economy.14 Those costs rise astax rates increase because taxpayers reducetheir productive activities, such as work andentrepreneurship, and increase their unpro-ductive activities, such as tax avoidance.Feldstein estimates that deadweight lossesfrom higher tax rates to pay for entitlementspending would create added costs equal toabout two-thirds of the tax increases them-selves. Thus, he estimates that, if the payrolltax to fund Medicare were increased by 9.0percentage points of wages, it would createadditional costs to the economy equal to 6.2percentage points of wages.15

Feldstein points out another problem oftennot considered when estimating the future taxhikes needed to fund unreformed entitlementprograms. As tax rates rise, the tax base shrinksas productive efforts decline and tax avoidanceincreases. Those feedback effects of highertaxes would require that government raise taxrates much higher than static calculations indi-cate in order to fund cost increases. For exam-ple, if a simple static calculation indicated thatpayroll taxes needed to be 9.0 percentagepoints higher, Feldstein estimates that the gov-ernment would actually need to hike the pay-roll tax rate by 14.3 percentage points to get allthe revenue that it wanted.16

To avoid crippling tax burdens on the nextgeneration, a wide range of major spendingreforms will be needed. Not only must entitle-ment programs be overhauled, Congress mustbegin cutting or terminating discretionaryspending programs. If large cuts are not made,the federal government will expand to anunprecedented peacetime size and America’spowerful economic engine will be smotheredunder European-sized tax burdens.

4

To avoid crippling tax

burdens on thenext generation, a

wide range ofmajor spendingreforms will be

needed.

1.4% 1.4%

7.5% 7.5%

4.4% 6.2%

6.0%1.5%

3.4%

2003 Estimated 2040 Projected

Interest

Discretionary

Other

Social Security

Medicare

Medicaid19.9%

27.1%

Sources: Authors’ assumptions and entitlement projections from Douglas Holtz-Eakin, Congressional Budget Office,“The Economic Costs of Long-Term Federal Obligations,” Testimony before the House Committee on the Budget, July24, 2003.

Figure 1Federal Spending in 2040 without Reform (percent of GDP)

2.6% 2.6%

2.5%

20.2%

27.4%

Federal Spending on theElderly to Soar

Spending on entitlement programs is con-suming an ever-increasing share of the totalfederal budget. Figure 2 shows that combinedspending for Social Security, Medicare, andMedicaid rose from 27.8 percent of the budgetin 1980 to 41.3 percent in 2000. Lookingahead, suppose that entitlements are notreformed but the overall size of the federal gov-ernment is limited to today’s 20 percent ofGDP. Figure 2 indicates that nearly all otherfederal programs will be squeezed out as SocialSecurity, Medicare, and Medicaid explode tonearly 80 percent of the budget by 2040.

The share of each program’s spendingthat goes to elderly beneficiaries has beenestimated by CBO.17 The share of outlaysgoing to the elderly was 76 percent for SocialSecurity, 87 percent for Medicare, and 29 per-cent for Medicaid in 2000. The analysis alsoincluded spending on civil service retirementand other programs to calculate total spend-ing on benefits for the elderly. All in all, CBOcalculated that federal spending on pro-

grams for the elderly averaged $17,688 perelderly person in 2000.

CBO found that total federal spending onthe elderly rose from 24 percent of total fed-eral outlays in 1980 to 35 percent in 2000,and the share will rise to 43 percent by 2010and continue rising thereafter.18 Should thatoccur, the elderly will elbow aside all othercitizens as they seize the bulk of the federalbudget. Clearly, if Americans want to keeptheir government from growing even largerthan it already is, let alone reduce its size,then budget costs for the elderly must be rad-ically cut. If entitlements are not reformed,young families will be laboring under a hugetax burden and receiving very little in return.

Demographic Changes Make Status Quo

UnsustainableUnavoidable demographic changes during

the next few decades will force Congress tomake large changes to entitlement programsfor the elderly and the entire federal budget.

5

The elderly willelbow aside allother citizens asthey seize thebulk of the federal budget.

78.0%

56.5%

27.8%

41.3%

20%

30%

40%

50%

60%

70%

80%

1980 2000 2020 2040

Sources: Authors’ assumptions and entitlement projections from Douglas Holtz–Eakin, Congressional Budget Office,“The Economic Costs of Long–Term Federal Obligations,” Testimony before the House Committee on the Budget,July 24, 2003.

Figure 2Social Security, Medicare, and Medicaid as a Share of Total Federal Spending (futuretotal spending fixed at today’s 20% of GDP)

The economy will experience a huge transitionas the baby boomer generation (those bornbetween 1946 and 1964) begins retiring in2008. As the number of elderly people rises,taxpayers and the federal budget will be severe-ly squeezed without major program cuts.

Figure 3 shows that by 2020 the number ofelderly citizens will increase by 51 percent, butthe number of working-age Americans willincrease only 16 percent. By 2040 the numberof elderly people will have risen 116 percent butthe number of working-age people will haveincreased only 22 percent.19 In addition to thebaby boomers’ retirement, increased longevitywill cause the number of the elderly to swell.Life expectancy for males at 65 will increasefrom 15.9 years today to 18.3 years by 2040,according to the Social Security trustees’ inter-mediate scenario.20 Numerous experts believethat the trustees’ intermediate scenario under-states likely increases. For example, the 1999Social Security Technical Panel recommendeda four-year increase in age assumptions, butonly a one-year change was implemented.21

Similarly, many experts believe that theMedicare trustees intermediate projections aretoo optimistic.

As the number of elderly persons soars, thenumber of workers available to support themwill not keep up as the U.S. birthrate stag-

nates. Birthrates averaged three children perwoman when the baby boomers were beingborn but are projected to be less than two inthe future.22 The number of Social Securitybeneficiaries as a percentage of the number ofworkers paying taxes to support them will risefrom 30 percent today to 49 percent by 2040.23

The general direction and size of the comingdemographic changes are unambiguous. Thosechanges will cause a financial crisis unless poli-cymakers begin making changes soon.Policymakers should particularly focus on theless optimistic projections from the SocialSecurity and Medicare trustees—it would bebetter for future generations to receive a posi-tive financial surprise than to get hit with unex-pected tax hikes or benefit cuts. Either way,near-term reforms will create a much better dealfor future taxpayers and retirees.

High Consumption by theElderly Funded by the

YoungThe fiscal problems caused by the increasing

number of elderly Americans are exacerbated byhigh and rising levels of consumption by theelderly, much of which is supported by govern-ment transfers. Today’s elderly consume far

6

By 2040 the number of elderly

people will haverisen 116 percent

but the numberof working-age

people will haveincreased only 22

percent.

12% 16% 18% 22%

116%

51%

13%

96%

0%

25%

50%

75%

100%

125%

2010 2020 2030 2040

Age 20-64Age 65+

Source: Authors’ calculations based on 2003 Social Security Trustees Report, p. 82.

Figure 3Growth of U.S. Population by Age Group (percent change from 2000)

more relative to the young than ever before, andyoung taxpayers are financing much of thatconsumption. It used to be that the elderly con-sumed less than the young, on average. But ris-ing federal transfers have reversed that situationand now the elderly consume more than theyoung.

Jagadeesh Gokhale, Laurence Kotlikoff,and John Sabelhaus examined changes in lev-els of consumption by the elderly and thenonelderly in recent decades.24 They calculat-ed that in the early 1960s an average 70-year-old consumed about one-third less than anaverage 30-year-old. But by the late 1980s, anaverage 70-year-old consumed about one-fifthmore than an average 30-year-old (Figure 4).Rising health care consumption throughMedicare is a key cause of the change. But theeconomists found that the elderly have greatlyincreased their non–health care consumptionas well. In the early 1960s, 70-year-olds con-sumed 63 percent of what 30-year-olds did innon–health care goods and services. By the late1980s they consumed 91 percent of what 30-year-olds did. Similarly, 60-year-olds con-sumed 81 percent of a typical 30-year-old’snon–health care goods and services in theearly 1960s; they now consume slightly more.

High and rising consumption by the elder-

ly can be funded from three main sources: cur-rent earnings, personal savings, or govern-ment transfers. Today’s elderly retire earlierthan before and thus have reduced currentearnings. Although the elderly have enjoyedrising levels of personal savings, those savingshave not been enough to fund their rapidlygrowing consumption. As a result, transfersfrom the young have funded much of therapid rise in consumption by the elderly.Stanford University’s Victor Fuchs has studiedthe funding sources for consumption by theelderly and concluded that 56 percent of the“full income” of the elderly today comes fromgovernment transfers from the young; only 44percent comes from their own resources.25

(Full income refers to the sum of personalincome plus health care expenses not paidfrom personal income.)

That most consumption by the elderly isfunded by taxing the young rather than per-sonal savings or current earnings is the resultof government policy. The elderly haveresponded to policy incentives to work less,consume more, and reach retirement withinadequate savings. Government has createda vicious cycle wherein high taxes are used tofund retirement programs and expand gov-ernment in general, leaving less money avail-

7

Most consump-tion by the elderly is fundedby taxing theyoung.

71%

118%

63%

91%

0%

50%

100%

150%

Early 1960s Late 1980s

TotalNon–Health Care

Figure 4Average Consumption of 70–Year–Olds vs. 30–Year–Olds

Source: Jagadeesh Gokhale, Lawrence Kotlikoff, and John Sabelhaus, “Understanding the Postwar Decline in U.S.Saving: A Cohort Analysis,” National Bureau of Economic Research Working Paper no. 5571, May 1996.

able for young families to save for their ownretirement. Indeed, the promise of expansivegovernment benefits during retirement hascreated a strong disincentive for the young tosave for their own retirement. Meanwhile, thegovernment has thrown up large tax barriersto personal savings with high income taxesand restrictions on retirement savings vehi-cles such as 401(k) plans and individual retire-ment accounts (IRAs).

Without major reforms, this vicious cycle willget worse. Rapidly rising costs for Social Securityand Medicare will tempt policymakers to raisepayroll and income taxes even higher, whichwould leave families with even less cash andfewer incentives to save. If politicians choosethat path, Americans will lose even more eco-nomic independence as the young have more oftheir earnings taxed away and the elderlybecome even more dependent on government.

The vicious tax and transfer cycle causedby unreformed entitlements will also causeU.S. economic growth to decline. The growthin entitlements for the elderly has been a fac-tor behind the decline in the nation’s savingsrate. Resources have been shifted from theyoung to the old, who have a much lowerpropensity to save. Gokhale, Kotlikoff, andSabelhaus conclude that “anemic rates of U.S.saving will spell anemic rates of U.S. domesticinvestment, labor productivity growth, andreal wage growth. This, unfortunately, is thelegacy of the uncontrolled intergenerationalredistribution from young savers to oldspenders that has been fueling ever higherrates of U.S. consumption.”26 To escape fromthis economic death spiral, policymakersneed to remove barriers to greater individualsavings and reduce government intergenera-tional transfers.

Accounting forGenerational Inequity

To shed further light on the long-range eco-nomic problems caused by the graying ofAmerica, economists have developed “genera-tional accounting.” The technique was pio-

neered by economists Laurence Kotlikoff, Jaga-deesh Gokhale, and Alan Auerbach. Generation-al accounting estimates are complementary toregular federal budget data and are occasionallyincluded in federal budget documents.27

Generational accounting data show taxescompared to government transfer benefitsthat Americans at each age may expect to payand receive in their remaining lifetime.Transfer benefits include Social Security,Medicare, Medicaid, welfare, and other pro-grams. Some transfer programs benefit theyoung, but the bulk of transfers goes to theelderly. Future benefits and taxes are summedand expressed in present value terms. A life-time net tax figure based on the differencebetween taxes and benefits may be calculated.

Those calculations shed light on the rawdeal politicians have set up for the young com-pared with the old. For example, recent esti-mates by Gokhale and Kotlikoff show thatunder current policy a male reaching 65 yearsof age today can expect to receive $238,000 inSocial Security, Medicare, and other transfersduring the rest of his life in present valueterms (Figure 5).28 Since he will pay $167,000in taxes the rest of life, he will secure a net gainof $71,000 from the government. That netgain comes at the expense of the young. A 25-year-old male today can expect to receive$202,000 from transfer programs in thefuture, but pay $524,000 in taxes during hislifetime, for a net loss of $322,000.

Net tax rates are calculated for each gener-ation as taxes less transfer benefits received,divided by projected lifetime labor income.Net taxes pay for all government spendingother than transfers. Gokhale and Kotlikofffind that net tax rates will rise from 18 per-cent of lifetime income for a person born thisyear to 36 percent, on average, for future gen-erations.29 Thus, unreformed transfer pro-grams will impose a tax cost on future tax-payers that is twice as high as the tax costthose programs impose today.30 Rising nettax rates indicate that current federal fiscalpolicies are unsustainable and that transferprograms are shifting large costs to futuretaxpayers.

8

The vicious taxand transfer cycle

caused by unreformed

entitlements willcause U.S.

economic growthto decline.

Gokhale and Kent Smetters recently pro-duced another set of estimates that highlightthe long-term imbalances of today’s budgetpolicies. Those “fiscal and generational imbal-ance” estimates measure the gap betweenfuture tax revenues and federal spending basedon current entitlement promises. In presentvalue terms, Gokhale and Smetters find thatSocial Security has a $7 trillion imbalance andMedicare has a $37 trillion imbalance.31

Gokhale and Joseph Antos have calculated thatthe current prescription drug bill wouldincrease the Medicare imbalance by $7 trillionto $12 trillion.32

These sorts of long-term projections rely onnumerous assumptions, so they are not carvedin stone. However, they clearly indicate the fis-cal crisis that Congress has set up for the coun-try with its expansive and unfunded entitle-ment programs. The estimates also raise funda-mental issues of generational fairness. Federalpolicies have transferred enormous resourcesfrom the young to the old. Seniors have receivedSocial Security and Medicare benefits far inexcess of the taxes they paid for those pro-grams.33 Although past inequities cannot be

changed, policymakers can reform the pro-grams now to avoid even larger intergenera-tional government transfers in the future.

Do the Elderly Need SuchLarge Budget Transfers?Today’s elderly are in a much different situ-

ation than those in prior decades when SocialSecurity and Medicare were created. Generallevels of well-being, measured by lifespan,health, wealth, and income, all point to muchhigher living standards for today’s elderly. Theelderly are working less than before and enjoy-ing higher consumption levels. That is goodnews for the elderly, but it is creating a bigproblem for the young who are financing alarge share of consumption by the elderly.

Labor force participation by the elderlyhas declined markedly in the past half centu-ry. The share of men 65 and older who are inthe labor force fell from 46 percent in 1950,to 27 percent in 1970, to just 18 percent in2002.34 (However, participation by the elderlyhas been fairly stable or trending up slightly

9

The elderly areworking less thanbefore and enjoying higherconsumption levels.

$(100,000)

$-

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000

Age 25 Age 65

Tax Payments

Government Benefits

Net Taxes

Source: Jagadeesh Gokhale, Laurence Kotlikoff, and John Sabelhaus, “Understanding the Postwar Decline in U.S.Saving: A Cohort Analysis,” National Bureau of Economic Research Working Paper no. 5571, May 1996.

Figure 5Generational Accounts for Average 25- and 65-Year-Olds

Aver

age

Pers

on’s

Fut

ure

Taxe

s an

d B

enef

its

since the mid-1980s). Early retirement cre-ates an economic strain as fewer workers areadding to the nation’s GDP and fewer arepaying payroll taxes to support the entitle-ment programs.

The dramatic decline in the number ofelderly workers has occurred despite a declinein the rate of disability among the elderly.35

The share of the elderly with chronic disabil-ities fell from 26 percent in 1982 to 20 per-cent by 1999.36 By the mid-1990s, 72 percentof the elderly reported their health to be goodor excellent.37 Improved health means thatmore elderly people are capable of workingtoday and providing for themselves. Yet fewerare working because the government is hand-ing them large transfer benefits.

Not only has the physical condition of theelderly improved, so has their financial con-dition. Social Security was created partly inresponse to the substantial share of the elder-ly population who lived in poverty and wereunable to care for themselves. Census Bureaufigures show that 35 percent of the elderlylived in poverty in 1959, compared to 27 per-cent of the overall population.38 But sincethen poverty has plummeted, as shown inFigure 6, and there has been a reversal in the

relative position of the elderly and the gener-al population. The percentage of the elderlyliving in poverty has steadily declined; it wasjust 10 percent in 2001, compared to 12 per-cent for the overall U.S. population.39

Other Census data also support this pictureof the relative prosperity of the elderly. TheCensus classifies the elderly as in poverty or hav-ing “low,” “medium,” or “high” income. Thedata show that the share with low income fellfrom 35 percent in 1974 to 27 percent in 1998,the share with medium income increased from33 to 35 percent, and the share with highincome increased from 18 to 28 percent.40

Federal Reserve Board wealth data also showthat the elderly are in a better position today.41

Figure 7 shows that between 1989 and 2001 thenet worth (measured in constant 2001 dollars)of the elderly increased much faster than that ofthe young. For example, the median net worthof families with a head of household aged 65 to74 increased from $105,000 to $176,300 duringthis period, while median net worth for the 35to 44 age group increased only slightly from$77,000 to $77,600.

Since the elderly today are in much betterfinancial shape relative to the young, it isunfair to continue expanding government

10

Improved healthmeans that more

elderly people arecapable of

working todayand providing for

themselves, yetfewer are working

because the government ishanding themlarge transfer

benefits.

35.2%

24.6%

15.7%

10.1%12.2%

0%

5%

10%

15%

20%

25%

30%

35%

40%

1959 1970 1980 1990 2001

Figure 6Percentage of the Elderly Living in Poverty

Source: Bureau of the Census, Historical Poverty Tables, www.census.gov/hhes/poverty/histpov/hstpov3.html.

transfers from the young to the old. VictorFuchs finds that “although today’s elderlyare on average healthier and wealthier thanany previous generation in the nation’s histo-ry, their desires and expectations regardinglife in retirement are outpacing the ability ofsociety to fulfill them.”42 To fulfill thoseexpectations, the elderly should work more,entitlement programs should be turned intosavings-based systems, and the taxation ofsavings should be reduced to allow familiesto build bigger retirement nest eggs.

Reforming entitlements can create concernsamong those lower-income Americans whoassume that current programs are highly pro-gressive, or disproportionately helpful to thepoor. But entitlements for the elderly may be lessprogressive than is usually thought.43 Lower-income Americans tend to die younger; thusthey receive fewer years of Social Security andMedicare benefits than do others. Also, SocialSecurity tends to transfer income from singleworkers to more financially stable married cou-ples through spousal benefit provisions.

Higher-income recipients tend to live longerand incur higher annual health care expenses

than poor recipients. Some analyses have foundthat Medicare can be neutral, or even regressive,in overall impact. For example, a 1997 study byeconomists Mark McClellan and JonathanSkinner concluded, “Medicare has led to nettransfers from the poor to the wealthy.”44

Social Security and Medicare reforms can bestructured to benefit all Americans if theyreduce inefficiencies, create faster economicgrowth, and increase choice and financial secu-rity. Partial privatization of Social Securitycould be very progressive with the poorest ben-efiting relatively more than those with higherincomes.45 By contrast, research has found thatnot reforming Social Security would be highlyregressive.46 That is because payroll taxes wouldskyrocket to pay for promised benefits and thusimpose a heavy burden on average workers.

Policy Solutions

The pay-as-you-go entitlements of the20th century will create a major policy crisisin the 21st century unless Congress beginsreforms soon. Numerous workable proposals

11

Social Securityand Medicarereforms can bestructured tobenefit allAmericans if theyreduce inefficiencies, create fastereconomic growthand increasechoice and financial security

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

$140,000

$160,000

$180,000

$200,000

Under 35 35-44 45-54 55-64 65-74 Over 75

1989 2001

Source: Ana Aizcorbe, Arthur Kennickell, and Kevin Moore, “Recent Changes in U.S. Family Finances: Evidence fromthe 1998 and 2001 Survey of Consumer Finances,” Federal Reserve Bulletin, January 2003, p. 7.

Age Group

Con

stan

t 200

1 D

olla

rs

Figure 7Median Family Net Worth, 1989 and 2001

for entitlement reform have been advanced inrecent years. Yet Congress has hesitated onreform, perhaps waiting for a perfect andpainless solution. But there is no perfect solu-tion. Instead, averting a war between the gen-erations will involve numerous reforms thatCongress can begin pursuing immediately inincremental steps.

The first step is creating more personalsaving. Workers should be given the oppor-tunity to direct a portion of their payrolltaxes into private accounts to fund their ownretirement. A thick layer of voluntary savingsshould be built on top of those payroll con-tributions by sharply reducing taxes on sav-ing. Next, disincentives for greater workforceparticipation by the elderly should beremoved. Meanwhile, both entitlement andnonentitlement programs need to be cut tomake way for higher costs as the number ofelderly citizens soars. For example, Medicarecosts can be cut by requiring more costs to bepaid by beneficiaries out-of-pocket, andmany programs in the $858 billion discre-tionary federal budget should be terminatedor privatized.

Social Security ReformSocial Security is the largest federal pro-

gram, accounting for 21 percent of the feder-al budget in 2003. Under its pay-as-you-gostructure, hundreds of billions of dollars areredistributed each year to the elderly frompayroll taxes on workers. The pay-as-you-gostructure will become unsustainable in futuredecades because growth in promised benefitsfar exceeds the program’s tax revenues.

The key to understanding Social Securityis to focus on the system’s cash flows ratherthan the “trust fund.” The Social SecurityTrust Fund does not represent money savedfor the future and does not affect the level oftaxes needed to support future retirees.Social Security assets invested in governmentbonds do not shield future generations fromhigh taxes. That has been understood byexperts for decades, but it continues to causeconfusion among politicians and the public.In 1939 Life magazine ran a special on Social

Security and noted the mirage of a govern-ment reserve fund:

The most criticized feature of the Acthas been its scheme for financing old-age insurance, under which it wasplanned to pile up a fantastic 47-billion-dollar reserve by 1980. The joker in thisis that the Government has been spend-ing Social Security tax money for ordi-nary expenses and putting its ownI.O.U.’s in the reserve fund. Thus, whenthe time came to pay old-age annuitiespartly out of the interest on the bonds,the money could be raised only by tax-ing the people a second time.47

In 1939 those concerns led to amend-ments to Social Security that set the programon a pay-as-you-go basis that is still in placetoday. The trust fund became a small contin-gency fund or bookkeeping entry of no realimportance.

The Social Security problem is best under-stood by looking at future cash-flow short-falls. By 2018 Social Security expenditures willbegin exceeding revenues, according to theprogram’s trustees.48 By 2040 Social Securitytaxes will fund just 75 percent of benefits. If noreforms are made, that gap will be closed byeither huge tax increases or huge benefit cuts.

The solution is to begin filling that futurecash-flow gap today, which can be achievedwith a funded system built on personal sav-ings accounts. Funded retirement systemsbuild up large pools of private capital fromwhich future benefits are paid. Those pools ofprivate capital will fuel higher business invest-ment and growth, which make paying futureretirement claims easier. A funded systemallows members of each generation to pay fortheir own retirement through savings accu-mulated during their working years.

Numerous plans for a partially funded SocialSecurity system have been proposed. The 1997Social Security Advisory Council report sup-ported moving toward a funded system.49 In2001 a bipartisan commission appointed byPresident Bush supported adding a system of

12

The SocialSecurity TrustFund does not

represent moneysaved for the

future and doesnot affect thelevel of taxes

needed to support future

retirees.

personal savings accounts to Social Security.The President’s Commission to StrengthenSocial Security proposed three reform options.50

Option 1 was designed to illustrate the benefitsof accounts funded by 2 percent of wages.Option 2 would redirect 4 percentage points ofthe 12.4 percent Social Security payroll tax intoprivate accounts (with the contributions cappedat $1,000 annually). Option 3 would redirect 2.5percentage points of the payroll tax into privateaccounts (capped at $1,000) and would requirethat workers pay another 1 percent of wages tothe accounts.

Under Options 2 and 3, traditional bene-fits would be reduced, but overall retirementincome would generally increase. Privateaccounts would have various investmentrestrictions and minimum benefit guaran-tees in case investments did poorly. Theaccounts would be held until retirement, atwhich point benefits would be taken in theform of annuities or minimum withdrawals.

All in all, the President’s Commission’sproposals were quite timid. A number ofreform plans introduced in Congress in the1990s called for higher payroll carve-outs forprivate accounts in the range of 6 to 10 per-centage points.51 Nonetheless, the commis-sion made a strong case for personal accountsand addressed the concerns of a broad con-stituency. Enactment of any of the proposalswould be a big step forward. After all,Congress need not design accounts perfectlyfrom the outset. Once the public gains experi-ence with private accounts, Congress couldadjust and improve them. For example,accounts could begin with a 4 percent payrollcontribution and then be expanded asAmericans gained trust in them. In addition,there are unknowns with regard to the bestmethod of account administration. Suchdetails could be fine-tuned as the public andfinancial institutions gained experience.

Americans are more ready than ever forthe responsibility and security that personalSocial Security accounts would provide.Consider that when President Rooseveltintroduced the system in 1930s only 10 per-cent of Americans held stocks.52 Today the

popularity of mutual funds has given morethan half of all households experience withinvestment accounts.53 It would be an excit-ing project to introduce the other half ofAmericans to the growth potential and secu-rity of private investment accounts.

The President’s Commission noted thatmore than 20 other countries have movedtoward retirement systems based on individ-ual accounts. Personal accounts have numer-ous advantages over pay-as-you-go systems.They provide higher rates of return, createprotection against the political risk of benefitcuts, stimulate economic growth, creategreater economic freedom, and ensuregreater fairness for beneficiaries by allowingbequests to heirs. Those advantages havebeen discussed in great detail elsewhere.54

Another advantage of moving to a SocialSecurity system with private accounts wouldbe the reduction in deadweight losses thatwould occur.55 If a portion of current payrolltaxes were diverted into personal accounts, itwould essentially act as a tax cut, thus reduc-ing deadweight losses.56 Work incentiveswould be strengthened as individuals noticedthat taxes on their pay stubs were convertedinto true savings in private accounts. Thatwould spur growth and give workers a muchstronger interest in building a secure futurefor their families.

Medicare ReformUnless reformed, Medicare will be a bigger

time bomb for future taxpayers than SocialSecurity. Not only are Medicare costs growingas the number of the elderly increases, butcosts are being pushed up by health care infla-tion caused by new medical technologies andunrestrained demand.57 Although new tech-nologies and expanded treatment are greatfor the elderly, those benefits are coming at alarge cost to the taxpayers footing the bills.

Medicare Part A (Hospital Insurance) isfinanced by a payroll tax of 2.9 percent on allwages. The combined expenditures of SocialSecurity and the HI part of Medicare areexpected to rise from 13.8 percent of taxablewages today to 24.2 percent by 2040, and

13

More than 20other countrieshave movedtoward retire-ment systemsbased on individualaccounts.

thus grab a 75 percent larger share of work-ers’ wages.58 Adding in projected spending onPart B of Medicare pushes up the total pro-jected costs of the two programs to 30 per-cent of wages by 2040.59

Medicare Part B (Supplemental MedicalInsurance) is financed 25 percent by user pre-miums and 75 percent by general federal rev-enues. Most general revenue for Part B comesfrom the nonelderly through income taxa-tion.60 Part B represents about 42 percent ofgross Medicare spending and is growing fasterthan Part A.61

Like Social Security, Medicare is financedon a pay-as-you-go basis, creating a largetransfer from the young to the old. In bothentitlement programs, early generations ofrecipients received large benefits comparedto the small amount of taxes paid. By con-trast, future generations will receive low ratesof return unless the programs are reformed.62

Indeed, in a 2000 study, economists DavidCutler and Louise Sheiner found that “theMedicare system is shifting a greater share ofthe burden on future workers than is SocialSecurity.”63 Unfortunately, Congress is con-sidering making that problem worse with ahuge unfunded prescription drug benefit.

Options for Medicare and Social Securityreform share some common ground. In bothcases, reforms should create partially fundedbenefits for the elderly based on defined-con-tribution personal savings accounts. Thatcompares favorably to current entitlementsystems, which are unfunded defined bene-fits. Medicare’s unfunded defined benefitexposes taxpayers to whatever uncontrolledcost explosions occur in the program. By con-trast, a defined-contribution plan wouldlimit taxpayer liability and create incentivesfor cost control.

Under a partially funded Medicare system,workers would deposit a portion of their pay-roll tax into personal accounts that would beinvested in debt and equity securities. Thoseaccounts would be used to buy health careinsurance upon retirement. Martin Feldsteinhas calculated that retiree health care savingsaccounts financed by an average 1.4 percent of

wages would be enough to make up the futurefunding shortfall of Medicare.64 (To coverfunding for the transition to the new accounts,other federal programs should be cut.)Feldstein concludes that private health careaccounts “would eliminate the need for mas-sive taxes that would otherwise reduce the dis-posable income of low and middle incomeworkers by 20 percent and impose an extradeadweight loss equal to more than six percentof existing wages.”65

When people retired, balances in their per-sonal health care savings accounts would gotoward purchasing a health insurance policy.Seniors would choose among competinginsurance providers with various coverageoptions, including an option for catastroph-ic coverage with a high deductible. Leftoverbalances in Medicare savings accounts wouldgo toward covering various out-of-pockethealth expenses.

Baby steps were taken toward a savings-based health care system in 1996 with the cre-ation of medical savings accounts (MSAs).66

MSAs need to be reauthorized by the end of2003, and various proposals to expand andimprove them have been introduced. MSAs,which combine a high-deductible insuranceplan with tax-favored savings accounts for out-of-pocket health expenses, can be used by indi-viduals of any age. If mandatory health careaccounts funded by the payroll tax were creat-ed, MSAs would provide a voluntary and com-plementary add-on to cover health expensesduring both working and retirement years.

Congress should liberalize MSAs andmake them permanent. Currently, MSAs areunderused because of their many restric-tions. Congress limited MSAs to the self-employed and small companies, limited thetotal number of MSAs, and imposed limitson deductibles and other items. If liberalized,MSAs can begin moving health care awayfrom today’s system dominated by third-party payment through the government andinsurance companies, which pushes uphealth care costs. An MSA-based systemcould reduce health care costs by increasingcompetition between providers and making

14

Like SocialSecurity,

Medicare isfinanced on apay-as-you-go

basis, creating alarge transfer

from the young tothe old.

consumers more responsive to cost tradeoffs.In addition, an MSA-based system couldreduce high administrative costs becausemany payments would be made immediatelyupon patient treatment rather than throughthird-party billing.

Certainly, Medicare reform involves manycomplex problems. That is partly due to thecurrent top-down regulatory structure that hascreated detailed lists of mandated benefits,price controls on some 7,000 specified services,and 110,000 pages of regulations.67 Congressshould revisit the proposals made by the 1999Bipartisan Commission on the Future ofMedicare. The commission proposed movingin the direction of greater patient choice andmore market competition to keep costs down.Medicare would be moved away from pricecontrols toward choice and competition, withgovernment support aimed at helping financeindividual insurance premiums.

The Bush administration supports encour-aging greater competition in the provision ofMedicare services. For example, it has sought toexpand the Medicare+Choice program begun in1997 to provide retirees choice among compet-ing health providers while reducing costs. Underthe program, private insurers contract with thegovernment to provide Medicare benefitsthrough a health maintenance organization, apreferred provider organization, or some otherform of benefit delivery. The program has nothad much success because the governmentimposed a mass of regulations and distortedfunding formulas, thus discouraging participa-tion.68 Nonetheless, with reforms, this approachcould produce long-run cost efficiencies.69

Top-down Medicare regulations should beremoved as the system moves toward a com-petitive, savings-based structure. For example,regulations that prevent providers from offer-ing stripped-down health insurance optionsshould be removed. Medicare benefits thatprovide full coverage without substantialdeductibles should be ended. Also, regula-tions on medigap policies should be changedto allow for high-deductible coverage (medi-gap policies are supplementary private insur-ance plans).70 Under a reformed system, con-

sumers could have broader insurance cover-age with higher deductibles. Savings in healthcare accounts could be allocated to meet theexpenses that individuals believe are mostimportant.71

Asking the elderly to pay more expensesout-of-pocket makes economic sense becauseit would keep health costs down. It is also rea-sonable from a fairness perspective, giventhat out-of-pocket expenses for health carefor the elderly are currently quite small. In1998 elderly households had annual out-of-pocket health expenses ranging from 9 per-cent to 16 percent of their total householdexpenditures depending on income level.72

Given that transfers from the young alreadycover 75 percent of the cost of health careconsumption by the elderly, the systemshould move back toward a user-paysapproach.73

One way to reduce third-party paymentwould be to change the rules so that medigapproviders offered high-deductible coverageinstead of today’s first-dollar coverage. TheCBO finds that first-dollar coverage causescost inflation and that policyholders end upconsuming 25 percent more services thanthey would if they had to pay initial costsout-of-pocket.74 If medigap plans did not paythe first $1,500 of enrollees’ costs, it wouldsave taxpayers about $98 billion over 10years, according to the CBO. To offsetenrollees’ added costs, the CBO believes thatmedigap premiums would fall.

Another reform would be to increase Part Bpremiums to cover Medicare cost increases.Younger workers pay for most of Part Bexpenses through income taxes.75 Part B pre-miums were originally intended to cover 50percent of program costs, but premiums coveronly about 25 percent of costs today. Thatdecline in costs paid through premiums hascome at the expense of the young. The CBOestimates that raising the premiums for Part Bmodestly to 30 percent of costs would savetaxpayers about $75 billion over the first 10years.76

Prescription drug benefits should be han-dled within the context of overall Medicare

15

Asking the elder-ly to pay moreexpenses out-of-pocket makeseconomic sensebecause it wouldkeep health costsdown.

reform. Unfortunately, the drug situation isbeing falsely portrayed as a crisis to pushCongress into adding benefits without anyreal reform. The average out-of-pocket costof prescription drugs for Medicare enrolleesin 2003 is a reasonable $999 per year; just 5percent of enrollees have costs of more than$4,000.77 Those figures do not indicate anypressing need to add drug benefits. Adding adrug benefit would just make Medicare’sfinancial problems worse.

Tax Reform to Eliminate Bias againstSaving

In addition to moving Social Security andMedicare toward savings-based systems, pol-icy reforms should remove barriers to indi-vidual saving in general. Personal savingsprovide individuals with financial securityand independence and allow for reduceddependence on government. Savings are thefuel that stokes economic growth by provid-ing the capital that businesses need to investin new and better equipment and technology.

It is generally recognized that SocialSecurity and Medicare reduce workers’ abilityand incentive to save for retirement. Pay-as-you-go entitlement programs crowd out pri-vate savings, although the magnitude of thiseffect is subject to a range of estimates.78 Asystem of personal accounts financedthrough mandatory payroll contributions islikely to increase overall national savings.79

To complement mandatory retirementaccounts, private savings can be increased byreplacing the income tax with a consump-tion-based system to eliminate the current taxbias against saving. President Bush’s taxreforms have moved in that direction by cut-ting the dividend and capital gains tax rates to15 percent. That cut should be made perma-nent and further pro-saving reforms pursued.

One promising reform route is to continueliberalizing personal savings vehicles, particu-larly IRAs. Regular IRAs allow an up-frontdeduction for savings but subject withdrawalsto tax. Roth IRAs provide for savings depositsfrom after-tax income, but qualified with-drawals are tax-free. To encourage greater sav-

ing, contribution limits should be increased,eligibility restrictions repealed, and withdraw-al restrictions eased. Withdrawal restrictionsreduce account liquidity and dissuade individ-uals from using the accounts to begin with.

President Bush proposed reforms alongthose lines in his FY04 budget.80 His planwould create lifetime savings accounts (LSAs)based on a Roth IRA structure. LSAs wouldbe savings accounts for all income and agegroups. They would allow contributions ofup to $7,500 per year and allow withdrawalsat any time with no taxes or penalties.

It is true that some lower-income familiescannot afford to save more for their retire-ment, but research shows that many can.Although savings rates generally rise asincome rises, savings rates also vary widelywithin income groups, even at lower incomelevels.81 Examining the data on income andsavings, Victor Fuchs has concluded that“most low income elderly could have savedmore prior to age 65.”82 That suggests thatremoving barriers to saving by reducing taxesand liberalizing rules on personal savingsvehicles can help Americans at all income lev-els build larger nest eggs for their retirement.

Remove Barriers to Work Participationby the Elderly

In recent decades retirement has becomemuch more of a voluntary decision than aphysical necessity. As the health of the elder-ly has improved, the workforce has shiftedaway from blue-collar work toward less stren-uous white-collar work. As a result, retire-ment has become more of a discretionarychoice for seniors today, which makes publicpolicy incentives more important. If theelderly work more and pay for a greater shareof their high consumption, the future bur-den on taxpayers can be reduced.

Despite steady improvements in thehealth and longevity of the elderly, there hasbeen a long-term trend toward earlier retire-ment. Today, the average annual work hoursfor those at age 65 is just 701 for men and423 for women, compared to a standardwork-year of 2,000 hours.83 Thus, there

16

Removing barriers to savingby reducing taxes

and liberalizingrules on personal

savings vehiclescan help

Americans at allincome levels

build larger nesteggs for their

retirement.

appears to be plenty of room for greater workeffort by the elderly to support their high lev-els of consumption.

A key policy problem is that Social Securityand Medicare encourage workers to leave thelabor force too early when they become eligiblefor benefits.84 A detailed new study by econo-mists Jonathan Gruber and David Wise con-cludes that government retirement programsin the 12 countries they examined, includingthe United States, clearly affect retirementdecisions.85 For example, the countries withthe largest government benefits have thestrongest early retirement trend.

Although Social Security provides reducedmonthly benefits for early retirees andincreased benefits for late retirees, many ofthe elderly are eager to receive benefits as soonas they are eligible at age 62. Indeed, a largespike in retirement occurs at 62.86 Anotherlarge spike occurs at 65, the normal retire-ment age for Social Security and the eligibili-ty age for Medicare. Similar effects occur inother countries. For example, Gruber andWise find a spike in retirement at 60 in Francewhen benefits become available. In a largereview of the evidence, Feldstein and Liebmansimilarly conclude that “Social Security sys-tems do appear to have important impacts onretirement behavior.”87

Those findings suggest that Congresscould increase work participation of seniorsby raising the eligibility ages for Social Securityand Medicare. Simulations by Gruber andWise find that raising the eligibility age forretirement benefits by three years wouldreduce the share of men aged 56 to 65 notworking by between 23 and 36 percent, a bigimprovement.88

Moving to a retirement system based onpersonal accounts would provide incentivesfor seniors to continue to work. By working,seniors would be able to keep adding to theirsavings balances or pass on larger legacies toheirs. Congress should also assess whetherlabor regulations and other policies createroadblocks to greater work participation bythe elderly. After all, the elderly have a life-time of skills and experience that the

American economy will need more than everin the decades ahead.

Cutting Federal SpendingThe magnitude of growth of entitlement

spending in future years poses a challenge topolicymakers to find large savings across theentire $2.2 trillion federal budget. All elsebeing equal, unreformed entitlements willpush federal spending up from about 20 per-cent to more than 27 percent of GDP by2040. That would represent a massive gov-ernment expansion. If Americans want tolimit the government to its current size rela-tive to the economy, let alone cut it, entitle-ments must be reformed and large cuts madeto discretionary spending.

Unfortunately, Congress has been going inthe opposite direction in recent years.Discretionary spending growth averaged 8.4percent annually between FY98 and FY03.89 Inhis first two years in office, President Bushpresided over huge defense and nondefenseoutlay increases. For example, nondefenseoutlays rose 12.2 percent in FY02 and 8.8 per-cent in FY03.

Continued growth in discretionary spend-ing will only cause the coming entitlementcrunch to be even worse for taxpayers.Elsewhere, I have proposed reducing federaldiscretionary spending from the current 8 per-cent of GDP to no more than 5 percent and setout a detailed list of cuts totaling about $300billion.90 Many federal programs need to beeither terminated or privatized.

To help structure program cuts, Congressshould establish a federal “sunset” commis-sion.91 Sunsetting is a process of automaticallyterminating government agencies and pro-grams after a period of time unless they arespecifically reauthorized. A sunset commissionwould review federal programs on a rotatingbasis and recommend major overhauls, privati-zation, or elimination. Such a commissioncould recommend programs that should beended because they duplicate state and privatefunctions, such as education. Remarkably,while the entitlement crisis has loomed overthe federal budget, Congress has expanded

17

If Americanswant to limit thegovernment to itcurrent size relative to theeconomy, entitlementsmust be reformeand large cutsmade to discretionaryspending.

spending in many areas outside its constitu-tional authority. For example, federal educa-tion outlays skyrocketed from $36 billion inFY2000 to $60 billion in FY03.92 Federal mis-sion creep should be reversed, with the federalgovernment exiting from areas that are state,local, and private responsibilities.

Many federal programs should be priva-tized. Not only would that generate long-termsavings, it would generate up-front cash to paydown the federal debt. Some federal activitiesthat could be privatized include the U.S. PostalService, the Tennessee Valley Authority, thepower marketing administrations, and the airtraffic control system. Air traffic control hasbeen privatized in Canada with great success.The Bush administration has moved to openabout one-quarter of federal positions to com-petitive sourcing. That process should beexpanded to include the option of outright pri-vatization of federal activities that are alreadyclassified as “commercial in nature.”93

The Bush administration has embracedreforms in federal budget management. It hasbegun detailed reviews of programs, flaggingthose that are “ineffective.” Congress shouldsupport the effort by spending more time onexecutive branch oversight and terminatingineffective and unneeded programs. The pres-ident should require that department secre-taries come up with detailed lists of cuts anddownsizing proposals to be included in eachfederal budget update. Even needed agencieshave a great deal of waste that should be cut.For example, the GAO finds that the $400 bil-lion Defense Department has “serious finan-cial management problems that are pervasive,complex, longstanding, and deeply rooted invirtually all business operations throughoutthe department.”94 There is simply no roomfor such waste with the coming entitlementcrunch.

House Budget Committee chairman JimNussle’s (R-Iowa) current campaign to rootout waste and fraud in federal programs suchas Medicare, Medicaid, and agricultural subsi-dies shows that savings are not hard to find.95

Medicare is one of the biggest money wastersin the federal government. For example, it has

been on GAO’s “high-risk” waste list for morethan a decade and makes erroneous or fraud-ulent payments of at least $13 billion or moreevery year.96 It is not surprising that theSoviet-style structures of such programs cre-ate huge amounts of waste and abuse. Healthcare for the elderly must be moved away fromtop-down planning toward individual spend-ing decisions, and every department in gov-ernment needs to be scoured for cuts and ter-minations. The next generation does notdeserve to be handed a massive entitlementproblem on top of a bloated and ill-function-ing federal government.

Conclusion

Social Security is ripe for real reform.Reform is a political challenge, but the politi-cal rewards are great considering that privateaccounts would give 155 million potentialvoters an option to gain more financial free-dom. Franklin Roosevelt gained great fame inthe 20th century as the champion of SocialSecurity. President Bush would gain no lessfame by delivering on the promise of a sav-ings-based Social Security system for the 21stcentury.

Entitlement reforms have been paralyzedin Congress partly because the problems areso huge. But both Social Security andMedicare reforms can be incremental. Thedirection of Social Security reform is clear—prefunding of benefits in personal savingsaccounts. Congress could begin with modestaccounts and expand them as the publicgains more experience with them. ForMedicare, the reform direction is also clear—personal savings accounts, cost cutting, high-deductible plans, and provider competition.

It is also clear that adding an unfundedprescription drug benefit to Medicare movesdirectly against reform because it puts theprogram’s spending on an even more unsus-tainable path. Unfortunately, tomorrow’syoung taxpayers are not here to defend them-selves against the huge burdens that are beingfoisted on them by Congress.

18

The next generation does

not deserve to behanded a massive

entitlement problem on topof a bloated and

ill-functioningfederal

government.

Notes1. Quoted in U.S. Department of Health andHuman Services, Health Care Financing Admin-istration, “Medicare 2000: 35 Years of ImprovingAmericans’ Health and Security,” July 2000, p. 6,www.cms.gov/statistics/35chartbk.pdf.

2. The 2003 Annual Report of the Board of Trustees of theFederal Old-Age and Survivors Insurance and the FederalDisability Insurance Trust Funds (Washington:Government Printing Office, March 17, 2003), p. 82.Cited hereafter as 2003 Social Security Trustees Report.

3. Jagadeesh Gokhale and Laurence Kotlikoff, “IsWar between Generations Inevitable?” NationalCenter for Policy Analysis, Report no. 246,November 2001, p. 2.

4. Ibid., p. 3.

5. Budget of the United States Government, Fiscal Year2004 (Washington: Government Printing Office,February 2003), p. 32.

6. Jagadeesh Gokhale and Kent Smetters, Fiscal andGenerational Imbalances (Washington: AmericanEnterprise Institute, 2003), p. 3.

7. Congressional Budget Office (CBO), “FederalSpending on the Elderly and Children,” July 28,2000, p. 3, ftp://ftp.cbo.gov/23xx/doc2300/fsec.pdf.The CBO calculated the share of each program’sbenefits that is received by those aged 65 and older.

8. Mid-Session Review, Budget of the United StatesGovernment, Fiscal Year 2004 (Washington: Gov-ernment Printing Office, July 2003).

9. 2003 Social Security Trustees Report, p. 51.

10. Budget of the United States Government, Fiscal Year2004, Historical Tables (Washington: GovernmentPrinting Office, 2003).

11. CBO, “The Budget and Economic Outlook:An Update,” August 2003, p. 9, www.cbo.gov.

12. Douglas Holtz-Eakin, Congressional BudgetOffice, “The Economic Costs of Long-Term FederalObligations,” Testimony before the HouseCommittee on the Budget, July 24, 2003. The CBOprojections show the 2040 cost of Social Security at6.2 percent, Medicare at 6.0 percent, and Medicaidat 3.4 percent. These figures are rounded. CBO’ssum of the precise, unrounded costs is 15.5 percent.

13. Holtz-Eakin. For a discussion of the realism ofCBO’s projections, see Laurence Kotlikoff, “TheComing Generational Storm,” June 2001, p. 11,www.bu.edu/econ/Working%20Papers.

14. Martin Feldstein, “Prefunding Medicare,”National Bureau of Economic Research (NBER),Working Paper no. 6917, January 1999. See alsoLiqun Liu and Andrew Rettenmaier, “The EconomicCost of the Social Security Payroll Tax,” NationalCenter for Policy Analysis, Policy Report no. 252,June 2002.

15. Feldstein, p. 5.

16. Ibid., p. 4.

17. CBO, “Federal Spending on the Elderly andChildren,” p. 3.

18. Ibid.

19. 2003 Social Security Trustees Report, p. 82.

20. Ibid., p. 85.

21. Gokhale and Kotlikoff, p. 8. See also Kotlikoff,p. 15.

22. Social Security Advisory Board, “SocialSecurity: Why Action Should Be Taken Soon,”July 2001, pp. 6, 7, www.ssab.gov/actionshouldbetaken.pdf.

23. 2003 Social Security Trustees Report, p. 52.

24. Jagadeesh Gokhale, Laurence Kotlikoff, and JohnSabelhaus, “Understanding the Postwar Decline inU.S. Saving: A Cohort Analysis,” NBER WorkingPaper no. 5571, May 1996. See results in Table 5.

25. Victor Fuchs, “The Financial Problems of theElderly: A Holistic Approach,” NBER WorkingPaper no. 8236, April 2001, p.10.

26. Gokhale, Kotlikoff, and Sabelhaus, p. 45.

27. For example, see the Budget of the United StatesGovernment, Fiscal Year 1999, Analytical Perspectives(Washington: Government Printing Office, 1998).

28. Gokhale and Kotlikoff, p. 12. These figures arein present values for the year 2000.

29. Ibid., p. 16.

30. Note that these tax rates are not simply total taxesdivided by total income. Generational accountingtaxes have transfers netted out of taxes paid, and thedenominator is labor income. For further back-ground, see CBO, “Who Pays and When? An Assess-ment of Generational Accounting,” November 1995.

31. Gokhale and Smetters, p. 3.

32. Jagadeesh Gokhale and Joseph Antos, “The Cost

19

of Adding a Prescription Drug Benefit to Medicare,”Testimony to the Subcommittee on Wellness andHuman Rights of the House Committee onGovernment Reform, July 17, 2003, p. 3.

33. Gokhale and Kotlikoff, p. 16.

34. U.S. Bureau of Labor Statistics, CurrentPopulation Survey data, “Employment Status of Men16 Years and Over by Age, 1949–2003,” www.bls.gov/data.

35. Federal Interagency Forum on Aging-RelatedStatistics, “Older Americans 2000: Key Indicators ofWell-Being,” pp. 28, 78, 79, www.agingstats.gov.

36. John Goodman, Robert Goldberg, and GregScandlen, “Medicare Reform and PrescriptionDrugs: Ten Principles,” National Center for PolicyAnalysis, Policy Report no. 256, October 2002, p. 5.

37. Federal Interagency Forum on Aging-RelatedStatistics, p. 77.

38. U.S. Bureau of the Census, Historical PovertyTables, “Table 3: Poverty Status of People, by Age,Race, and Hispanic Origin: 1959–2001,” www.census.gov/hhes/poverty/histpov/hstpov3.html.

39. U.S. Bureau of the Census, Current PopulationSurvey, “Table 1: People and Families in Poverty bySelected Characteristics, 2000 and 2001,” www.census.gov/hhes/poverty/poverty01/table1.pdf.

40. Federal Interagency Forum on Aging-RelatedStatistics, pp. 13, 65. Note that the reportedpoverty rate for the elderly sharply declinesbetween 1970 and 1974.

41. Ana Aizcorbe, Arthur Kennickell, and KevinMoore, “Recent Changes in U.S. Family Finances:Evidence from the 1998 and 2001 Survey ofConsumer Finances,” Federal Reserve Bulletin, January2003, p. 7.

42. Fuchs, “The Financial Problems of the Elderly,”p. 4.

43. Martin Feldstein and Jeffrey Liebman, “SocialSecurity,” NBER Working Paper no. 8451, Septem-ber 2001, p. 52.

44. Mark McClellan and Jonathan Skinner, “TheIncidence of Medicare,” NBER Working Paper no.6013, April 1997, abstract. The authors note thatthe analysis is only a “first pass” at estimatingMedicare’s complex distributional effects. A morerecent study found that Medicare was insteadprogressive in impact. See Jay Bhattacharya andDarius Lakawalla, “Does Medicare Benefit thePoor? New Answers to an Old Question,” NBERWorking Paper no. 9280, October 2002.

45. Laurence Kotlikoff, Kent Smetters, and JanWalliser, “Finding a Way Out of America’sDemographic Dilemma,” NBER Working Paper no.8258, April 2001, p. 8.

46. Ibid., p. 40.

47. “Social Security: Congress Writes 45,000,000Life Insurance Policies,” Life, August 7, 1939.

48. 2003 Social Security Trustees Report, p. 2.

49. Social Security Administration, Report of the1994–1996 Advisory Council on Social Security, vol. 1,Findings and Recommendations, January 1997, www.ssa.gov/history/reports/adcouncil. The report pro-vided a number of alternative options but advancefunding was a common general principle.

50. President’s Commission to Strengthen SocialSecurity, “Strengthening Social Security andCreating Personal Wealth for All Americans,”December 21, 2001, www.csss.gov.

51. For a summary of proposals in the 106thCongress, see Chris Edwards, “Personal AccountOptions for Social Security Reform,” JointEconomic Committee, January 2000.

52. Richard Nadler, “The Rise of Worker Capitalism,”Cato Institute Policy Analysis no. 359, November 1,1999, p. 3.

53. Investment Company Institute and SecurityIndustry Association, “Equity Ownership inAmerica,” Fall 1999, www.ici.org/pdf/rpt_equi-ty_owners.pdf.

54. See Cato’s Social Security website, www.socialsecurity.org, for an extensive list of books, briefingpapers, and other information on the subject.

55. Feldstein and Liebman, p. 48. See alsoFeldstein, p. 5.

56. If individuals perceive current payroll taxes aspartly retirement contributions (not taxes), thenthe reduction in deadweight losses would not beas large as otherwise.

57. For a discussion, see Victor Fuchs, “MedicareReform: The Larger Picture,” NBER WorkingPaper no. 7504, January 2000.

58. 2003 Social Security Trustees Report, p. 168. Thisis the “cost rate” of OASDI and HI under theintermediate projection.

59. Projection of Medicare Part B from 2003Annual Report of the Boards of Trustees of the FederalHospital Insurance and Federal Supplemental MedicalInsurance Trust Funds (Washington: Government

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Printing Office, March 17, 2003), p. 23. See alsoThomas Saving, Social Security Board ofTrustees, Testimony before the Senate SpecialCommittee on Aging, July 29, 2003, p. 4.

60. For a discussion of Medicare financing, seeJulie Lee, Mark McClellan, and Jonathan Skinner,“The Distributional Effects of Medicare,” NBERWorking Paper no. 6910, January 1999, p. 5.

61. Dan Crippen, Congressional Budget Office,“Projections of Medicare and Prescription DrugSpending,” Testimony before the Senate Committeeon Finance, March 7, 2002, Table 1.

62. David Cutler and Louise Sheiner, “GenerationalAspects of Medicare,” Federal Reserve Board,Finance and Economics Discussion Series 2000-09,2000, pp. 1, 2, 7.

63. Ibid., p. 1.

64. Feldstein, p. 8.

65. Ibid., p. 10.

66. MSAs were enacted under the HealthInsurance Portability and Accountability Act(HIPAA) of 1996. For a discussion of MSAs, seeVictoria Craig Bunce, “Medical Savings Accounts:Progress and Problems under HIPAA,” CatoInstitute Policy Analysis no. 411, August 8, 2001.See also Greg Scandlen, “MSAs Can Be a Windfallfor All,” National Center for Policy Analysis,Policy Backgrounder no. 157, November 2, 2001.

67. Robert Moffit, “Improving and PreservingMedicare for Tomorrow’s Seniors,” in Priorities for thePresident, ed. Stuart Butler and Kim Holmes (Wash-ington: Heritage Foundation, January 2001), p. 2.

68. Ibid., p. 8. See also Tom Miller, “New EffortsUnderway to Inject Competition into Medicare,”Health Care News (Heartland Institute), August2000.

69. Amy Goldstein, “Bush Urges Medicare-HMOEnrollment,” Washington Post, July 29, 2002, p. A17.

70. For a cost savings estimate, see Dan Crippen,director of the Congressional Budget Office,“Projections of Medicare and Prescription DrugSpending,” Testimony before the Senate Committeeon Finance, March 7, 2002, p. 7.

71. For a discussion, see Goodman, Goldberg, andScandlen.

72. Federal Interagency Forum on Aging-RelatedStatistics, pp. 42, 89.

73. Fuchs, “The Financial Problems of the Elderly,”

p. 11.

74. CBO, “Budget Options,” March 2000, p. 232.

75. Lee, McClellan, and Skinner, p. 5.

76. CBO, “Budget Options,” March 2003, p. 154.

77. Kaiser Family Foundation, “Medicare andPrescription Drug Spending Chartpack,” June2003, www.kff.org.

78. Feldstein and Liebman, p. 40.

79. Ibid., p. 58.

80. U.S. Department of the Treasury, “President’sBudget Proposes Bold Tax-Free Savings andRetirement Security Opportunities for AllAmericans,” press release, January 31, 2003.

81. Fuchs, “The Financial Problems of the Elderly,”pp. 16, 17.

82. Fuchs, “Medicare Reform,” p. 13.

83. Fuchs, “The Financial Problems of the Elderly,”p. 17.

84. Feldstein and Liebman, pp. 44, 48.

85. Jonathan Gruber and David Wise, “SocialSecurity Programs and Retirement around theWorld: Micro Estimation,” NBER Working Paperno. 9407, December 2002.

86. Alan Gustman and Thomas Steinmeier, “TheSocial Security Early Retirement Age in aStructural Model of Retirement and Wealth,”NBER Working Paper no. 9183, September 2002,pp. 1, 33. See also Courtney Coile and JonathanGruber, “Social Security and Retirement,” NBERWorking Paper no. 7830, August 2000, p. 1.

87. Feldstein and Leibman, p. 48.

88. Gruber and Wise.

89. CBO, “The Budget and Economic Outlook.”

90. Chris Edwards, “The Federal Budget,” in CatoHandbook for Congress (Washington: Cato Institute,2003), p. 223, www.cato.org/pubs/handbook/hb108/hb108-23.pdf.

91. Chris Edwards, “Sunsetting to Reform andAbolish Federal Agencies,” Cato Institute Tax &Budget Bulletin no. 6, May 2002, www.cato.org/pubs/tbb/tbb-0205-6.pdf.

92. Mid-Session Review, Table 17.

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93. Edwards, “The Federal Budget,” p. 223.

94. U.S. Department of the Treasury, “FinancialReport of the U.S. Government 2001,” March 29,2002, p. 26, www.fms.treas.gov/ft.. See the GeneralAccounting Office memo within the Treasury report.

95. For Rep. Nussle’s initiatives, see www.house.gov/budget/wastefind.htm.

96. U.S. Congress, House Budget Committee,“Examples of Government Waste,” August 2003,www.house.gov/budget/wastefind.htm.

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