This article originally appeared in Barrons.com on October 8, 2007.
FEDERAL SPENDING HAS HOVERED around 20% of gross domestic product for more than 50 years now, ever since it settled down after World War II. Despite all the battles over taxes and spending in that time, the federal share of our economy has remained fairly stable.
That will change quite dramatically without fundamental reform of our nation’s entitlement programs. The latest long-term projections of the Congressional Budget Office estimate that federal spending will soar, reaching close to 40% of GDP over the next 40 years, primarily owing to exploding costs for Social Security, Medicaid and Medicare. Add in costs for state and local government, and total government spending in America will be well over 50% of GDP.
If anything even close to this happens, the fundamental nature of our economy and our government will have changed. Our capitalist free-market system, the source of America’s historic prosperity, will constitute less than half of our economy. Something like Swedish-style socialism will dominate.
Too Big to Cut
Simply cutting entitlements will never avert this looming economic and fiscal catastrophe. The gap is just too big. And, in any case, the political system would never allow enough cuts to make much of a difference.
Some want to negotiate a grand deal, mixing huge tax increases in return for large benefit cuts. But such a deal would leave us spending 30% to 35% of GDP, still a disaster. The true problem isn’t the long-term deficits, but the long-term level of government spending.
Finding a way out of this trap starts with recognizing that our entitlement programs are based on old-fashioned ideas of tax-and-spend redistribution. Social Security, for example, doesn’t involve any saving and investment at all. Close to 90% of the money that comes in is paid out within 30 days in current benefits. Any surplus is lent to the federal government and immediately spent. Medicare has a small dedicated tax that doesn’t come close to covering expenses, and Medicaid is a spending program, pure and simple.
Such old-fashioned systems retard economic growth and carry perverse incentives on both the tax and spending sides. High taxes to finance these programs discourage savings, investment, entrepreneurship and work. Welfare discourages work, and government retirement benefits discourage private retirement savings, as workers don’t have to save for benefits that Uncle Sam will pay.
There is an opportunity to modernize and thoroughly restructure these entitlement programs through pro-growth reforms. The key: allowing efficient capital and labor markets to serve the goals of these programs.
Reformers must recognize that voters will insist that sturdy safety nets remain in place. But with positive, pro-growth, structural reforms and the broad benefits of capital and labor markets, we could maintain such safety nets while actually providing a far better deal for beneficiaries, and with far lower government spending.
An Example of Reform
We could start with something that has worked spectacularly well. Legislation enacted in 1996 turned the old Aid to Families with Dependent Children program back to the states. The money that the federal government contributes to this program was returned to each state in a block grant, to be used in a new program designed by the state based on mandatory work for the able-bodied. Block grants are finite. The federal government doesn’t match every dollar that the state spends. If the state spends more, it must foot the extra costs itself. If the state spends less, it can keep the savings.
The AFDC rolls were reduced by close to 60% nationwide, close to 80% in states that pushed work most aggressively. Requiring able-bodied recipients to work for their benefits was useful, but perhaps even more important were the reversed incentives for state administrators. Previously, the feds matched increased state spending, so that each new welfare dependent signed up brought more federal funds to the state. But with the state now paying all the added costs of adding “clients,” the focus changed to getting able-bodied recipients to work.
Such reforms should now be extended to the other federal welfare programs, particularly budget-busting Medicaid, the open-ended medical-care program for the poor. The federal government now spends about $275 billion a year on Medicaid, accounting for about 10% of its entire budget. States also pay a share of the total expense — as much as half in the wealthy states.
Even if the reforms allowed each state to keep all of the savings derived from greater flexibility, positive incentives and reduced rolls, the use of block grants would save the federal government a trillion dollars over the first 10 years.
If federal spending growth on the block grants were then barred from growing faster than the rate of expansion in the U.S. gross domestic product, Medicaid would no longer contribute to increasing federal spending as a percent of gross domestic product.
Ideally, such reforms should be expanded to food stamps, federal housing assistance programs and other, smaller federal welfare programs, as well. These programs account for roughly another $200 billion in spending each year, or about 7% of the federal budget. Adding these programs to the block-grant reform might enhance its appeal to the states, as it would give them greater flexibility, along with more funds.
The new state programs could be focused on getting beneficiaries into real, private-sector jobs, market-rate health insurance and home ownership. The result would be a much better overall safety net for the poor. We would be changing our welfare system into a prosperity system.
Keep Trying on Social Security
A second key reform would be the creation of personal accounts for Social Security. Workers would be free to substitute savings and investment accounts for some of their stake in the current system. Social Security spends close to $600 billion a year, constituting 21% of the federal budget.
Most importantly, personal accounts wouldn’t just trim the growth of such spending. They would redistribute huge chunks of it from the public to the private sector, dramatically trimming federal spending over the long run.
The accounts could start at any size, and then be expanded over time. Eventually, workers could choose to substitute the accounts for all of their Social Security retirement benefits. The accounts could be expanded further to substituting private insurance for survivors and disability benefits as well. Such accounts alone would reduce federal spending by close to 7% of gross domestic product without reducing retirement benefits, an unprecedented, historic achievement.
Workers would actually get much better benefits through these accounts because market investment returns are so much higher than what the noninvested, purely redistributive Social Security system can promise, let alone afford to deliver. Workers across the board could each accumulate several hundred thousand dollars by the time they retire.
These funds would be owned directly by each worker and would be available to pay for annuities or held as part of an estate. This would do a great deal to reduce inequality, yet in a way that would reinforce, rather than undermine, the economy. Done right, such reforms would produce a historic breakthrough in the personal wealth of working people.
A bill introduced in the last Congress by two Republicans, Rep. Paul Ryan of Wisconsin and Sen. John Sununu of New Hampshire, offers a comprehensive model of how to structure such accounts. It was devised with substantial input from the Social Security Administration and from experienced Wall Street fund administrators.
The bill would maintain the current social safety net in full, by including a federal guarantee that if any retiree’s account couldn’t pay at least what Social Security would under current law, the federal government would make up the difference.
This provision reflects the kind of risk reduction that would be necessary to succeed with such sweeping reform on an issue as politically explosive as Social Security.
The transition to the personal accounts would be financed primarily by spending restraints and reductions in other programs, and by the revenue from greater economic growth.
This plan can work politically. Many candidates have won elections while campaigning for private Social Security accounts, including President Bush. However, instead of fighting for what he campaigned on so successfully, the president got lost in the swamps of Washington, putting every bad, unpopular idea on the table as well. This buried the positive features of the personal accounts, confused people and blurred the appeal to the general public that’s necessary to have reform enacted. Few want to cut the basic benefit formula, increase taxes or raise the retirement age.
The Final Hurdle
Medicare, which now accounts for 13.4% of the federal budget, would be the most difficult entitlement program to reform, because it is so badly overextended in the long term. But personal accounts could be allowed for the 2.9% Medicare payroll tax, shifting some of the program’s spending to the private sector. Such accounts would also provide advantages for workers.
The general revenues financing the rest of the program would have to be limited to grow no faster each year than GDP growth, with the funds used to give vouchers for private health coverage to low- and moderate-income seniors to help them purchase private health coverage. The reform would have to be carefully designed to leave a health-care safety net in place for all seniors who need it.
If we also bar federal discretionary spending from expanding faster than the rate of growth of GDP, this reform program would eliminate projected federal deficits, sharply reducing long-run federal spending for interest.
The result would be a federal government spending less than 15% of gross domestic product each year, rather than more than 40%.
At the same time, the reforms would produce broad benefits and advantages for working people, while keeping comprehensive safety nets in place. This is a hopeful, positive vision for America, truly worth fighting for.
PETER J. FERRARA is director of entitlement and budget policy at the Institute for Policy Innovation and general counsel of the American Civil Rights Union.