Entitlement Apocalypse
From the March 22, 2010, issue of NR.


Our long-term budget challenge can be summarized in one word: entitlements. Without Social Security, Medicare, and Medicaid, the budget would be roughly in balance over the coming decades. But with these programs, and without reform, a fiscal crisis is inevitable. To balance the budget over the next 25 years would require an immediate and permanent 30 percent increase in all federal taxes. That is the future we face, and it is a future of our own making.

Entitlements traditionally have paid generous benefits — financed by affordable taxes — to rich and poor alike, because the ratio of workers to beneficiaries has been high. Those days are gone and will not return. Maintaining entitlements in their current form will require either crippling taxes or crippling debt. Alternatively, we can rethink the entitlement philosophy, focusing resources where they’re needed most, empowering individuals to make choices and giving them incentives to reduce waste, and buttressing personal retirement savings.

We spend 9.7 percent of GDP on entitlements today, and by 2030 we will spend around 14.4 percent. Two forces bear primary responsibility for pushing entitlement spending upward: population aging and health-care-cost growth.

Population aging is easily understood: The Baby Boom generation is retiring, seniors are living longer, and families are having fewer children. The ratio of workers to beneficiaries, which is now over three to one, will fall to around two to one by 2030. Aging alone will ultimately raise entitlement costs by nearly 50 percent.

As for health-care costs, they are rising for three reasons. First, as incomes rise, the value of health increases relative to that of other goods. (As you make more money, the marginal value of new goods falls, and you would rather live longer with the stuff you have than buy more stuff and die sooner.) Second, technology generates treatments we gladly would have purchased in the past but couldn’t, because they didn’t exist. Today they do, and we buy them. Third, the falling share of health care that is paid out-of-pocket — 47 percent in 1960, 12 percent today — encourages patients to purchase even marginally useful treatments. MIT economist Amy Finkelstein concluded that this factor alone accounts for 40 percent or more of health-care-cost growth.

Income effects and new technologies would increase health-care costs even in a totally free market. But the falling out-of-pocket share, which encourages waste and cannot be shown to contribute much to patient health, is due to government policy.

The political economy of reform is complicated by the fact that the budget automatically allocates funds rather than requiring new congressional appropriations each year. As a result, outlays can grow well out of proportion to our willingness and capacity to fund them. Entitlements are on autopilot, and the autopilot is steering us into the ground.

While traditionally called the “third rail of politics,” Social Security — which provides payments to disabled workers, retirees, and retirees’ survivors at an annual cost of $700 billion, making it the biggest federal program — might also be known as “the fixable entitlement.” It is the program whose problems — and their potential solutions — are best understood.

Social Security’s costs are driven primarily by the effects of population aging on the program’s pay-as-you-go financing, which redistributes taxes from workers as benefits to retirees. But Social Security’s inability to save money is important as well: While the program has a $2.5 trillion trust fund, several econometric studies have shown that policymakers don’t actually save its surpluses, but rather spend them or use them to finance tax cuts. As a result, future taxpayers will be no better off than they would have been had the trust fund never existed.