The Road to Freedom

by Arthur C. Brooks

  Third, there are no quick fixes. The national debt is a vast and long-term problem. The scope of a consolidation plan must reflect this reality. Any proposal that does not deal with the long run—at least twenty-five years—is not serious.

  AMERICA IS NOT the first country to face a debt problem. Many other nations have faced such problems. Some have returned to solid footing and prosperity. Others have failed, leading either to default or years of malaise. We can learn a lot from the paths other countries have taken.

  A group of American Enterprise Institute (AEI) economists recently looked closely at twenty-one developed countries’ attempts to reduce debt and deficits (economists call this “fiscal consolidation”) from 1970 to 2007.36 Like America today, all these countries had spent too much money for too long. In response, some countries cut spending radically, while others tried to get more tax money from their citizens. Still others tried a combination of spending cuts and tax increases.

  Some of the countries succeeded and escaped their crises. Others defaulted on their debts or limped along in long-term economic recession. Of the nations that succeeded, 85 percent of their deficit reduction, on average, came from spending cuts. Of those that failed, spending cuts were only 47 percent. In a nutshell, cutters succeeded, and taxers failed.

  Again, all this may seem like common sense. Countries that meet spending problems head on with spending cuts inspire confidence among investors. Those that meet their overspending with tax increases are treated in much the same way as financially irresponsible individuals—no one wants to lend to them or go into business with them. But that common sense is often sadly lacking among politicians who have the ability to collect tax money by force.

  What sort of spending did the successful countries cut? You guessed it: entitlements. Reducing entitlements is the single most effective step a country can take toward reducing its national debt. The reason is simple: Entitlement programs become more expensive over time. Every dollar of savings from reducing entitlement spending today is accompanied by many more dollars of savings in the future. The lesson for America is that changes to Medicare or Social Security right now will pay big dividends into the future.37

  But all the benefits of entitlement reform are not far off in the future—some come right now. Economists at the International Monetary Fund have shown that cutting entitlements can have an immediate, positive impact on the current economy.38 The reason is that when global investors see a country deal with its long-term spending problems, it bolsters confidence and attracts capital, growth, and jobs. If America deals with entitlements now, foreigners will be more likely to invest their money and establish their businesses in the U.S. That is precisely what the nation needs to emerge from the economic slump.

  The bottom line when it comes to debt and deficits is this: If the U.S. can get entitlements under control, it can achieve budget balance. For years, irresponsible politicians from both parties have made promises to the American people about their pensions and their health care—promises that simply cannot be fulfilled. If the U.S. does not deal with entitlement reform, particularly of Social Security and Medicare, debt will continue to explode, and future generations will pay the price.

  Figure 7.2. Entitlement spending is the real cause of the U.S. government debt explosion. (Source: Author’s calculations. Congressional Budget Office Long-Term Budget Outlook, June 2011, Alternative Fiscal Scenario.)

  While entitlements are the main problem leading to debt and deficits, discretionary spending—the spending that the government approves every year—can and should be cut as well. Many good proposals have shown how this can be done. President Obama’s Fiscal Commission in 2010—which to date he has ignored—recommended cutting $84 billion from discretionary spending in 2012, $153 billion in 2013, and a total of almost $2 trillion between 2012 and 2020.39

  A number of discretionary programs should be slashed right away. Prime among them are agricultural subsidies, which cost the nation nearly $20 billion each year,40 drive up food prices, and hurt farmers in poor countries around the world. Similarly, the U.S. subsidizes both fossil fuel and “clean energy,” distorting markets and putting almost $20 billion in tax money into corporate pockets each year.41 Examples like this are, sadly, easy to find.

  America can also save money by reducing the federal workforce. The government could cut 10 percent of federal workers—200,000 jobs–relatively painlessly by not replacing those who retire or quit. This would save taxpayers $13.2 billion by 2015.42 In addition to cutting jobs, a three-year compensation freeze (in wages or benefits) could be imposed on federal workers and Defense Department civilians, which would save $20.4 billion by 2015.43

  Cutting spending on entitlements, discretionary spending, and the federal workforce would go a long way toward reducing the national debt. But shouldn’t we also raise taxes to close the gap?

  No. In fact, the government should match spending cuts with tax decreases, especially on businesses. Taxing companies at very high rates leads some to pay more, but others to lower their production or go overseas. As a result, they pay less in taxes. As I will show, the U.S. could lower corporate taxes and raise more money for the Treasury than it does currently.

  ISSUE 4: FIXING ENTITLEMENTS

  As any child knows, it is wrong to make promises you cannot keep—and even worse to make promises you have no intention of keeping. That is the essential moral problem with our creaking system of entitlements.

  The promises politicians have made to their constituents have created massive unfunded liabilities in pensions and health care. These programs have made millions of Americans dependent on the government, which has promised them more in benefits than they ever paid into the system.

  Without immediate reform, the insolvent system will require that future generations pay in much more than they take out, which is manifestly unfair. If people are unable or unwilling to pay for future benefits and the system goes bankrupt, those most harmed will be the poor, who will lose their safety net. A system that allows people a free ride at the expense of the least powerful members of society—the young and the poor—is blatantly unethical.

  Here are the facts about the entitlement system that show the urgent need for reform:

  •To date, most Americans have withdrawn more from the Social Security and Medicare systems than they ever paid into them.44 In the coming decades, most people will have to pay in more than they take out, costing tens of trillions of dollars.

  •Social Security and Medicare are going broke because benefit payments are exceeding the taxes to pay for them. The fund to pay for Medicare hospital care has been running a deficit since 2008.45 Without reform, Social Security will be insolvent in 2036.46

  •The U.S. currently spends 9.9 percent of GDP on entitlements ($1.49 trillion). Without reform, by 2030, that number will rise to 14.3 percent ($3.43 billion).47

  •Despite the appalling costs, the system fails many of the neediest citizens. The U.S. currently spends over $725 billion per year on Social Security benefits, yet leaves almost 10 percent of seniors in poverty.48

  Figure 7.3. Americans retiring today are going to take out more than they have paid in to Medicare and Social Security. (Source: Urban Institute. Steuerle, C. Eugene, and Rennane, Stephanie. “Social Security and Medicare Taxes and Benefits Over a Lifetime,” Urban Institute, June 2011.)

  Before I discuss the specific policies needed to enact reform, there are three fundamental principles underlying a fair and stable entitlements system.

  First, entitlements should be a minimum basic safety net for the poor, not a source of retirement benefits for everybody. The government should move away from a system that is effectively for the middle class.

  Second, entitlement policy should not create incentives for people to stop working and saving their money. The system should encourage people to work longer, retire later, and save more, so they can take care of themselves without resorting to the safety net.

  Third, the s
ystem must create incentives for people to use public resources in a responsible way. Entitlements should not reward governments or individuals for overspending on programs and services, as they currently do.

  •••

  BASED ON THESE PRINCIPLES, we can reform entitlements, and in the process, solve much of our problem with debt.

  Let’s start with Social Security. The system is going broke, and many politicians would have us believe that the only way to fix this is by raising taxes. The easiest way to do so, they say, is by lifting the cap on taxable earnings. Right now, people pay payroll taxes on their first $106,800 of earnings for Social Security. If people paid payroll taxes on all their income, it would create a flood of new money and a huge tax increase on upper-income Americans.49

  This is nothing more than a sneaky way to make our tax system more progressive, and it is completely unnecessary. There is no reason to do this. The system can be fixed without more taxes, in three steps.

  First, the retirement age is absurdly low. Unless you are in a heavy physical industry or have a health issue, why should you retire at 65? You’ll still be in your prime. The U.S. should gradually raise the retirement age to age seventy by 2065, indexed to longevity (meaning that the retirement age will continue to increase as people live longer, which no doubt they will).

  Believe it or not, the retirement age for receiving benefits has only increased by one year (from 65 to 66) since the system was founded in 1935. In 1935, the average man living at age 65 would survive an additional 12.7 years, and the average woman, an additional 14.7 years.50 Now those numbers are 18.7 and 20.8 years, respectively. In addition, more people retire early today than they did when Social Security started. It is not hard to see why the system is unsustainable.51 People live longer and better lives today and can work productively for more years. Social Security should reflect this fact.

  Second, index benefits to price inflation because that is what matters when it comes to maintaining seniors’ standard of living. The government currently raises benefits on the basis of wage inflation, which is higher than price inflation. This doesn’t make sense, because Social Security is intended as a way to support the elderly, not as a salary reflecting the increasing productivity of current workers. By making this small change, the U.S. would save $7.6 trillion over seventy-five years.52

  Third, gradually adopt means testing and reduce benefits for earners whose incomes are so high that Social Security is not a major part of their retirement income. This recognizes that the safety net is not intended to provide benefits to people who are not in poverty and moves America away from a system in which middle- and upper-class people become dependent on the government for retirement income they could and should generate on their own. A few nondraconian changes (lowering spousal benefits slightly and reducing the percentages of wages that Social Security replaces for high earners, for example) would save about $3.2 trillion over seventy-five years.53

  Together, these reforms would keep the current Social Security system solvent in perpetuity without raising the cap on contributions or raising the payroll tax rate.

  If making major changes, however, why not build a whole new system? Imagine a system that is cheaper than the current one, is not in danger of insolvency, better protects seniors, and is not a kind of welfare for the middle class.54 What would that look like?

  To begin with, as with the reforms I have already described, the U.S. would need to raise retirement ages to reflect the happy reality that people are living longer, healthier lives. People should be given a positive incentive to work longer through the elimination of the Social Security payroll taxes for individuals aged sixty-two and over and of the “Social Security Retirement Earnings Test,” which lowers Social Security benefits to workers if they earn money.

  In addition, we should give people ownership over their retirement savings, instead of putting them into the government “trust funds” that are systematically raided by politicians. All workers age 55 and younger should be enrolled in an actual retirement savings account funded by 5 percent of a worker’s earnings (2.5 percent from the individual and a matching 2.5 percent from the employer). This would be like a universal IRA account and would supplement workers’ own voluntary retirement savings. It would be owned and controlled by the individual.

  Next, all seniors should be guaranteed a standard of living above poverty. It is shocking to think that, with all the U.S. currently spends, it still hasn’t managed to care adequately for all senior citizens.55 A basic income supplement could provide enough income to bring all low-income seniors to above the level of poverty (provided they use it wisely), paid for with a tax on wages well below 6 percent. This would be an actual safety net and would cost about 60 percent of what the U.S. currently pays for Social Security.56

  These simple reforms would achieve the four things America needs from the Social Security system: solvency, keeping the elderly out of poverty, ensuring that people save something for their retirement, and giving citizens—not politicians—control over retirement savings. And by keeping costs manageable, the reforms will ensure that Social Security is around for future generations.

  SOCIAL SECURITY is only one of the bloated entitlement programs that threaten America’s future. Medicare (providing health care for seniors) and Medicaid (providing health care for the poor) are arguably much bigger problems. Medicare in particular has been expanding faster than any other area of government, growing by 180 percent in real dollars from 1990 to 2010.57

  Medicare and Medicaid are out of control not just because of high inflation in health costs but because the government has made open-ended commitments to citizens, regardless of cost. Imagine trying to operate a supermarket where “members” pay a low monthly fee and are then invited to take anything they “need” off the shelf. That’s more or less the Medicare and Medicaid model.

  Let’s start with Medicaid, which is intended to give the poor medical coverage. The states administer Medicaid, with a subsidy from Washington. The federal government currently matches state dollars spent on the program, at a rate of between one-to-one and three-to-one (depending on the state). So if Arizona, which receives a 2.06:1 match, spends $1,000 treating a poor person, it gets $2,060 from the federal government. There is no limit on federal support—the more Arizona spends, the more the federal government spends. Arizona (and every other state) has the incentive to expand Medicaid programs wastefully, because the federal government is picking up the tab. Every dollar Arizona spends means $3.06 in total health care expenditures.58

  Not surprisingly, states are offering Medicaid services to more and more people—and not just poor people. Take the case of New York. While that state’s poverty rate is 14.2 percent, 27 percent of New Yorkers in 2009 got their health care through Medicaid, costing federal taxpayers $29.3 billion.59 Simply put, the federal government makes it too economical for New York—a traditionally liberal state prone to extravagant government spending on social services—to offer Medicaid to too many people who are not poor.

  There is a relatively straightforward solution to this problem: Provide the federal subsidy as block grants to the states—that is, send the states checks for the year’s total federal allotment—and let them use it as they see fit. If New York wants to be profligate and overspend, it can do it with its own money, not with unlimited federal tax dollars coming from places like Kentucky and Texas. States would have the incentive to economize and innovate within a fixed budget, just as private companies (and all individuals) do.

  While excessive expenditure on Medicaid poses a major budget problem for America, Medicare is even worse. The program guarantees unlimited payment for the health-care costs for the rapidly growing population of seniors. The CBO projects that Medicare spending will grow from $521 billion in 2011 to $725 billion in real (inflation-adjusted) dollars in 2020, a growth rate 3.3 percentage points higher than inflation.60 If no changes are made to the current law, Medicare spending will be gobbling up 5.9 perce
nt of American GDP by 2035.61

  Runaway Medicare spending occurs because the system treats seniors the same way the Medicaid system treats states; it takes away any incentive for people to live within a budget. Predictably, nobody does. Without reform, Medicare will almost singlehandedly bankrupt the country.

  To fix the system, two things are needed: Keep people in the workforce (and on private insurance, if possible), and move away from guaranteeing unlimited health benefits without regard to cost.

  First, the U.S. should gradually raise the age for receiving Medicare benefits to sixty-seven. This is a minor change that no reasonable person can deny makes sense, looking at the improved health of seniors in the past decades. Government disability benefits will still be available to those who need them. Also, the Medicare payroll taxes for individuals aged sixty-two and older should be eliminated so there are better incentives for older Americans to work.

  Second, the U.S. must move away from “defined benefits” (where the government guarantees unlimited services) to “defined contributions” (where the government guarantees a certain level of insurance coverage). Your employer most likely provides health benefits to you. That means they guarantee they will make insurance payments on your behalf (which are defined contributions), not pay all your medical bills (which would be defined benefits). The government needs to use this kind of model as well. There is no other way to contain costs.

  Each senior citizen should be guaranteed a fixed payment adjusted for age, income, and health status. This payment would go into an individual account, from which seniors would pay for health insurance provided by private companies that guaranteed certain minimum coverage levels. Seniors who wanted generous “Cadillac” health care plans could have them, provided they were willing to pay the difference out of their own pockets. Those who chose more cost-efficient plans would get to keep the savings. This would cap the government’s exposure and encourage seniors to make cost-effective insurance decisions according to their desires and needs. The Federal Employees Health Benefits Program works this way, so it would not be a radical departure from government procedures.62