The budget deficit and inter-generational fairness

A blog of Bridge Environment, updated most Thursdays

Not the only way old people are screwing young ones

Last month, I posted a couple of blog entries about the US economy. One highlighted that fiscal stimulus, while most likely a good idea, requires a balanced perspective based on risk management. Another contrasted the typical effectiveness of economists with the ineffectiveness of ecologists at influencing policy, despite similar information gaps and system complexities. Whereas I feel economists do generally succeed and perform well in informing many policy decisions, fiscal stimulus is not the only exception. There has also been a general failure to inform what economists would describe as distributional consequences or, more simply put, fairness.

The current projections of US debt serve as an excellent example where economic analysis on equity is available but generally has not entered into public debate. Much of the facts in the following paragraph come from an information-intensive but ideologically-conservative source, JustFacts. I prefer to avoid ideology, but do appreciate well-researched arguments on either side of an issue.

Our official government debt presently stands at $16.7 trillion. However, this figure does not account for outstanding obligations. If the government were a publicly-traded company, it would be required to include:

• $7.5 trillion in federal employee retirement benefits, accounts payable, and environmental liabilities.
• $21.6 trillion in Social Security obligations, above and beyond expected revenues.
• $27 trillion in Medicare obligations, above and beyond expected revenues.

Using these values and taking into account assets that the government holds (cash, loan holdings, inventories, etc.), the government has a shortfall of $67.7 trillion dollars.

This figure is still not the full story. The government is projected to run ongoing budget deficits, which will add to the debt. On the other hand, the government has created public infrastructure which is worth a substantial amount of money. Neither of these issues is accounted for in the $67.7 trillion dollar figure.

This debt figure is eye-catching and worthy of consideration in its own right, but becomes even more fascinating when we consider its distributional consequences. Let’s consider the winners and losers of three different sources of deficit: excess past spending, Social Security, and Medicare.

Past spending (including commitments to programs like the federal retirement system) makes up about a third of the total deficit figure. Heavy debt is, for the most part, a recent phenomenon. Earlier governments generally ran modest deficits and contributed greatly to the country’s infrastructure and potential for economic growth. Here are a few examples. The Civilian Conservation Corps engineering projects in the 1930s created water supplies and economic opportunities in many parts of the country. The G.I. Bill provided college education to millions of World War II veterans, and a sophisticated work force for the country. The interstate highway system, which began in the 1950s, allowed for efficient movement of people and goods across the country. This sort of project is important to keep in mind when weighing debt because of the long-term value it creates, much like the fact that a family investment in a new business is very different from buying big screen TV.

Our current debt came primarily during the 1980s, 1990s, and past 10 years, when tax cuts were not balanced by spending reductions. This debt did not provide major infrastructure improvements. Instead it funded ongoing discretionary government spending along with weapons development (e.g., the Cold War) and military campaigns (e.g., Iraq, Afghanistan, Iraq again). The benefits from earlier generations’ investments as part of relatively balanced budgets continue to pay off to society at large. The deficit spending of the 1980s, 1990s, and present supported our current economy but may not add much future value. Who are the winners from this debt? The wealthy surely benefited, not only from tax breaks but also from the fact that they have garnered the bulk of recent economic growth. The poor may have broken even: they have seen job opportunities and some key services (e.g., public universities) shrink. On the other hand, they too have received tax breaks/credits, and the lost job opportunities may be more related to cheap unskilled overseas labor alternatives than to U.S. fiscal policy. Future generations definitely lose out since we most likely will pass on this debt without the same level of infrastructure investment of previous generations.

Social Security and Medicare make up the rest of the deficit. These two programs are paid for through payroll taxes and provide benefits once people reach retirement age. Social Security began in 1935, during the Great Depression. The idea of a government health insurance program was debated for decades before Medicare was enacted in 1965, and the end product was scaled back to cover only retirees. Neither program functions as a savings account. Money for current outlays comes from taxes levied on current employees. However, the tax rates for these programs are roughly designed so that an individual’s contributions while working will pay for their expected expenses in retirement. However, the rate calculations are not dynamic, meaning they do not change terribly often. The rates for both programs have been the same since the late 1980s/early 1990s. More importantly, the rates reflect survival rates of retirees at the time. In reality, there have been dramatic increases in life expectancy for Americans since Social Security was enacted. A sizable portion of this increase comes from reduced infant mortality, which does not affect these programs since people who die before they begin to work do not contribute to nor benefit from them. However, life expectancy at age 20 has also steadily improved and continues to do so. In 1940, slightly more than half of 20 year olds lived to reach 65, and those who did typically lived an extra 12 years. Today, about 80 percent of 20 year olds reach 65 and typically live an extra 18 years. As a result, people spend more years in retirement but contribute over the same number of years worked. For Social Security, and to a lesser extent Medicare, we run a bit of a Ponzi scheme. The first entrants had no history of paying taxes to fund these entitlements and so got them at the expense of workers at the time. Because we continue to underestimate longevity while calculating the tax rates, retirees still get more than they paid for at the expense of current workers.

As with any Ponzi scheme, these programs will work well until they finally don’t. Baby Boomers just might be the breaking point. They are no different from retirees that came before them in having underfunded their own public retirement and health insurance. What makes them different is their sheer numbers. Birth rates fell through the early 1900s as a result of industrialization, then spiked following World War II. Whereas the relatively large numbers of babies in the early 20th century were offset by high mortality rates, working-age Baby Boomers are surviving longer than any generation before them. The result is that, whereas large numbers of Boomers contributed funds their retired elders, the ratios are shifting and fewer workers will be supporting more retirees. Given the Ponzi scheme nature of Social Security and Medicare, we will see an extreme burden on the post-Baby Boomers, partly because tax rates were insufficient to bankroll enough savings to support the Baby Boomers in retirement, and partly because the burden of making up the gap will fall on relatively few working adults. Who wins from the resulting deficits? First generation recipients of Social Security and Medicare were the biggest winners since they had not paid into the systems. Generations following them received lesser benefits but still got some. As with any Ponzi scheme, it is the final investors who take the loss. Here we have a choice. We can scale back the scope of these programs by, for example, raising the retirement age or reducing benefits. Doing so would spread the pain out over multiple generations. Or, we can go on our current trajectory, which will leave a much smaller group of Americans to bear the brunt of the costs. 

This issue is not just one of equity. As the debt figures quoted earlier indicate, addressing Social Security and Medicare will get us a long way towards tackling the federal deficit. Doing so would reduce the chances of broader economic stagnation and give the government more flexibility to use tools like stimulus funds to smooth out bumps in our economic performance.

Best,

Josh

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