Wednesday, July 12, 2017

Loss of Control: The Main Event

The Outlook for Budgetary Constraints Part 1

Social Security and Medicare

Godzilla visits Tokyo

This is the third posting focusing on how previous political decisions have made the budget process at the federal level irrelevant. It shifts the focus from current constraints addressed in the previous posting (“Loss of Control: The Current Situation”) to the outlook for those constraints. This posting focuses exclusively on Social Security and Medicare. They deserve a separate posting since they already account for about 42% of all federal expenditures.

As mentioned before, when discussing the outlook it is more productive to focus on the forces at work rather than specific forecasts. That will be the general thrust of the discussion. However, various forecasts will be quoted. The purpose of quoting individual forecasts is to illustrate the order of magnitude of the issues involved. The particular quotes chosen do no more than that. Other estimates are also available, but generally only confirm the order of magnitude. The specific numbers are irrelevant.

Lest these posting be misinterpreted, it should be stated up front and emphasized that the objective of these postings is to show the impact of the programs. Whether that impact is good, bad, or indifferent is a totally different issue. There are many voters who would argue that constraining the actions of politicians is a desirable outcome. In fact, that philosophy reflects the thinking of the founding fathers of this country.

So, comparing the outlook for Social Security and Medicare expenditures to Godzilla visiting Tokyo may seem harsh. But, remember that over time Godzilla evolved from the monster that destroyed Tokyo into a friend of mankind in subsequent movies where he defended the earth from other demons. That said, the image of Godzilla visiting Tokyo is not an exaggeration of what Social Security and Medicare could do to the federal budget.

The debt service burden discussed in a previous posting is only one example of automatic expenditures that will grow and exacerbate the current constraints. The interaction of higher interest rates and increased debt ensure that debt service will grow. But, finance is not the only influence on the growth of the budgetary constraints faced by elected officials. Social Security and Medicare illustrate the issue. As the population ages the expenditures for those programs will grow automatically. Thus, the outlook for those programs is extremely important.

Social Security expenditures currently account for about a quarter of federal government expenditures. Over the last five years, that has increased from about 20% of federal expenditures to 25%. Much of that has to do with the increase in disability claims under Social Security. The increase occurred despite the Americans with Disabilities Act, the shift toward less risky occupations in the economy, and improvements in the treatment of injuries and ailments that previously were disabling. Given all the factors that should be reducing disability, one can debate whether the increase in disability claims represents a true need, but it's impossible to argue about whether the population is getting older.

As we are all aware, the baby boomer generation is reaching retirement, and the importance of the growth in old-age and survivor benefits is increasing. It might be possible to control the runway disability claims, but old-age and survivor benefits are driven by demographics that are beyond the control of the government. Further, until the baby boomer generation stops collecting Social Security, demographics will be the principal driver of Social Security expenditures.

Thus, that one program, about a quarter of the federal government expenditures, is going to grow both in absolute terms and in terms of its importance as a portion of federal expenditures. It isn't totally beyond the control of currently-elected officials, since they could modify Social Security. However, the pressure on expenditures is unavoidable.

Medicare expenditures present a similar problem in that it is almost totally demographically driven. CBO projects total Medicare outlays to increase from $632 billion in 2015 to $1.1 trillion in 2024. CBO’s estimates ignore the spending effects of changes to Medicare’s physician payment system. When it is included total Medicare spending looks likely to increase to at least $1.2 trillion in 2024. A doubling of expenditures over the next decade is easily conceivable.

The rise in the number of people claiming disability has a more perverse effect on Medicare than on Social Security. Once declared disabled, the person is entitled to full Medicare benefits. By contrast, under Social Security, benefits are generally less than the full retirement benefit because of the shorter work life. Further, disability claims, when made by the young, involve expenses over a much longer period of time. Finally, disability claims tend to be higher since many 65-year-olds begin collecting Medicare while they are still quite healthy, whereas a disability claimant is making the claim because of the sickness or injury which caused the disability. So, there is some potential for managing Medicare expenses related to the handling of disability claims.

As with Social Security, disability tends to be a sideshow compared to demographics. Some things can be done at the margin. Steps could be taken to lower drug costs. Unfortunately, to effectively lower those costs would require addressing the FDA approval process, consumer-focused advertising of drugs, class-action lawsuits against drug companies, and our current patent system. It also would make sense to remove the tax placed on medical devices by the Affordable Care Act. Those taxes are passed on to consumers and thus, the federal government when they're covered by Medicare. Judging from the popularity of demonizing the drug manufacturers instead of taking on the heavy lifting required to seriously address the issue, improvements will be small. 

It is also possible that steps can be taken to address other medical costs, but again that would require addressing issues such as the supply of doctors and hospital rooms which haven’t traditionally been a fruitful area for progress. Yet, another possibility would be to address medical malpractice or the proliferation of class-action lawsuits against drug producers, but that would require taking on the legal profession that benefits from the abuse of both. Consequently, looking at the demographics pretty much explains what to expect.

The demographics look even worse for Medicare than they do for Social Security. While Social Security is mainly a function of the number of retirees, Medicare is also a function of the age of the retirees. The 65-year-old may only require a few physicals and treatment for minor issues, but over time the likelihood that the treatments will be required for permanent risks such as high blood pressure or high cholesterol increases. But, even more important is the fact that over time the likelihood of critical, complex and expensive treatments increases. A significant portion of medical expenses are incurred very late in life. The first baby boomer reaching 65 was important, but for Medicare, the first baby boomer reaching 75 or 85 will be more important.

Social Security and Medicare contributions also need to be considered in order to assess the fiscal impact of the programs. Expenditures are driven by demographics and most people know when they're getting older. So, the fact that Social Security and Medicare expenditures are crowding out other government priorities isn't too surprising. Also, there is a tendency for commentators to focus on unavoidable demographic implications. Demographics are much easier to forecast than the economy and more easily understood by their readers.

However, it's easy to overlook the fact that the recipients of those programs are no longer paying into those programs. The fiscal impact of the expenditures is aggravated by slower growth in the workforce, and thus revenue for the programs. The fiscal impact depends upon assumptions about the growth in wages. Wages are a function of wage rates and the number of workers. Wage rates have not been growing at the same pace as they did over the historical period during which Social Security has existed. There is considerable debate among economists as to whether productivity gains can be restored to a level that would allow wage growth similar to that experienced historically. In short, if productivity doesn't improve, Social Security and Medicare become greater fiscal drags because growth in contributions will slow.

Further, the growth in the labor force is inhibited by lower labor force participation rates and smaller cohorts in the working-age population. Over the near-term, the smaller cohorts that will be working are a direct product of the size and age distribution of those who are currently too young to work. It's hard to see how anyone could argue against the demographically obvious trend.

Immigration can help if the immigrants are working age. Further, increases in the labor force participation rate and any steps that bring the disabled back into the labor force would also help. But, as is so often the case when looking at Social Security and Medicare, the impact is small compared to the demographic trends at work.

The trust funds don't really help. It doesn't matter whether payments are from Social Security and Medicare tax receipts, interest on the trust funds, or selling off the assets of the trust funds. Regardless of which accounting convention is used, the benefits are paid out of the revenue the federal government is currently receiving. So, the constraint on the flexibility of federal spending is the same. Social Security and Medicare expenditures are expenditures regardless of the accounting convention.

That said, the trust fund accounting does have some interesting implications, but they are indirect and are a bit counter-intuitive. Because the expenditures are more than the taxes for these programs, the difference is made up from general revenues. In some cases, it's called interest on the trust fund. In other cases, it's best to view the expenditures as being financed by selling the trust fund assets back to the federal government. Very shortly, all of the programs will have to be financed by a reduction in the trust fund balance. That's already the case for some of the components of the Social Security and Medicare programs.

Once all the trust funds are being reduced in order to finance the expenditures, the impact is the opposite of what common sense would suggest. Usually, when more is spent than the income coming in, it creates debt. But, since the government owns itself the debt, in the case of Medicare and Social Security the effect is the opposite. The debt decreases because the federal government owes itself less. The only effect of the trust fund accounting is that the money reduces the interest due on the debt. But, remember, that it is interest that the government is paying to itself. From the cash flow position, and thus from the perspective of its impact on budget constraints, the trust fund accounting is irrelevant.

Here's the irony of the situation: the trust funds under current law can only be used to fund benefits for the particular program to which they're attached. That's why in the past when elected officials wanted to use the money in the trust funds, they created the fictional accounting of borrowing the money. It's also why in 2015 when it appeared that the Disability Insurance (DI) Trust Fund was in danger of being depleted, Congress passed a law shifting money from the Old-Age and Survivors Insurance (OASI) Trust Fund to the DI Trust Fund. That ensured that DI remained off the budget.

Once a trust fund is exhausted, the program will have to be partially budgeted; partially, because the programs will still have their dedicated revenue streams, Social Security or Medicare contributions. So, the dates when the trust funds are exhausted and the percentage of their estimated expenditures covered by the estimates of their revenue are important. They're important because they indicate when and to what degree these programs will come back on budget unless something is modified.      
Social Security's trust fund will be irrelevant in about 17-18 years under current economic assumptions. That's one takeaway from the Social Security and Medicare trustees' Annual Report. Based on the trustees’ actuarial and economic assumptions, it means that at that point the program will only have enough revenue coming in to pay 79% of promised benefits.

The Social Security Trust Funds are the Old-Age and Survivors Insurance (OASI) and the Disability Insurance (DI) Trust Funds. The 17-18 year estimate is for the exhaustion of both funds when combined. But, if considered separately, the estimate is that the old-age fund will last about a year longer and after that it would be able to pay just 77% of benefits. The disability fund will be tapped out in 6 years, after which it could only pay out 89% of promised benefits.

The Medicare program has two separate trust funds, the Hospital Insurance Trust Fund (HI) and the Supplementary Medical Insurance Trust Fund (SMI). HI covers Medicare Part A. It helps pay for hospital, home health services following hospital stays, skilled nursing facility, and hospice care for the aged and disabled. Supplementary Medical Insurance (SMI) is a trust fund for Part B (doctors' bills and other outpatient expenses) and Part D (prescription drug coverage).

The Medicare Trustees project that the Medicare Hospital Insurance (HI) Trust Fund will be depleted in about 11 years. Supplementary Medical Insurance (SMI) will remain adequately financed into the indefinite future because current law provides financing from general revenues and beneficiary premiums each year to meet the next year's expected costs. However, it will grow steadily from 2.1 percent of GDP in 2015 to approximately 3.5 percent of GDP in 2037 according to recent estimates by the trustees of the program. SMI illustrates how constraints can be created based upon promised benefits rather than the fiction of the trust fund with a dedicated revenue structure.

Frequently commentators focus on promised benefits and shortcomings in how they are supposed to be funded and refer to them as unfunded mandates. It's a perfectly legitimate way to approach the issue, and the analysis of the trust funds makes apparent when the unfunded mandates come due. The problem with referring to it as an unfunded mandate without reference to timing is that it creates the impression that it is a current balance sheet issue. However, one should keep in mind that the federal government doesn't have a balance sheet. It operates on a cash basis.

It's a problem, but one with a specific date when it affects the cash flow accounting of the federal government. It is quite likely, based upon the commitments that have already been made, that the cash flow position of the federal government will be in worse shape at the time when the unfunded mandates becomes most relevant. The balance sheet accounting shouldn't be the major focus. Rather the important thing is that when the trust funds are exhausted, the mandated program expenditures will have to come back on the budget to the degree that the contributions to those programs fall short.

In summary, the outlook is for rapid expenditure growth to accelerate while the revenue growth rate decreases. Both will increase the portion of federal revenue that has to be allocated to Medicare and Social Security. The programs have already begun paying out more than they take in, and that trend is going to accelerate.

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