Loss of Control: Look the Other Way

Don’t measure it so that you can ignore it

Just saying “show me the money” doesn't work

A previous posting pointed out that the federal government does not have a balance sheet. It operates on a cash basis. The point was made in connection with the discussion of the Medicare and Social Security trust funds. Those trust funds illustrate one problem created by the federal government accounting. As ridiculous as it seems, the only asset that the federal government treats the same way other institutions treat assets is its own debt. Treating one's own debt as an asset makes no more sense for the federal government than it would for you or me. Further, the only obligation it treats as a liability is the national debt. So it's treating its debt as a liability in some instances, but if it holds that debt, it treats it as an asset.

The problem with the approach is that owing oneself money is hardly an asset. Plus, debt is not the only form of a liability. So, the first step is to identify what is not being taken into account. In some respects, liabilities are easier to identify. Easier because a major liability is recognized as the national debt, but even there a more realistic approach would be to delete that portion of the national debt the federal government owes to itself.

The national debt, however, is not the only liability of the federal government. Liabilities are contractual obligations to future payments. In the case of the federal government, contractual obligation is a nebulous term. Federal obligations originate from the promises of politicians when they are written in the law. But even then, laws can be changed. So the true extent of federal liabilities depends upon one's belief that the federal government will honor previous commitments.

A common approach and one that is highly useful is to assume that current laws will not be changed and project the obligations based on that assumption. The advantage of the approach is that it recognizes unfunded mandates as liabilities. Some of those mandates have been discussed in previous postings. Even recognizing them as liabilities only goes halfway to establishing an accurate accounting for the liability side of the federal government.

One doesn't need to make a direct promise of payment in order to create a liability. Liabilities can also be created by guaranteeing or cosigning on a liability of someone else. In the federal government case, such liabilities almost always take the form of a guarantee. Essentially, the federal government is subsidizing the borrower by lending them its good credit rating. The subsidy has value. But the implied liability has a cost that the federal government does not recognize. That sets up a terribly perverse incentive. The federal government treats loan guarantees as if they had no cost.

There are multiple ways one could go about estimating the liability implied by the loan guarantee. One appropriate approach would be to estimate the probability of default on the loans that the federal government has guaranteed. In the private sector regulated financial institutions would be required to create a loss reserve to cover that cost. That reserve would then become an asset that would balance the liability.

Absent a balance sheet no similar procedure exists for the federal government. However, the federal government could estimate the loan losses and treat that as if it were the cash outlay in the year the loans are made. It's unlikely such a procedure would be acceptable since it would necessitate recognizing that the federal government is making bad loans.

Perhaps a more appropriate approach given the federal government's practice of doing cash accounting would be to impose the same charge off rules that are applied to private sector loans. Then as the loans become delinquent the federal government would have to make it a cash charge against its budget. That would be an improvement on the current practice of just allowing the delinquent loan to exist and ignoring the fact that the federal government (i.e., taxpayers) are going to have to pay it off.

What is being ignored is not trivial. Multiple previous postings have noted the magnitude of the loans the federal government is guaranteeing. Most recently there were postings on student loans where the risks are already in the hundreds of billions of dollars range. However, there have also been postings on the government's inclination to assume the role as the leading subprime mortgage lender. The recent financial crisis makes it impossible to overlook that risk, and it automatically puts the magnitude of the risk in perspective.

The ability to create liabilities without having to account for them until they come due encourages financial mismanagement. It provides an incentive for the government to incur liabilities beyond what would be considered prudent if they were accounted for properly. But the total reliance on cash accounting also creates perverse incentives when it comes to assets.

Cash accounting means that any expenditure whether for immediate consumption or for a long-lasting asset is accounted for in the same way. Consequently, if the benefit of investment accrues over 20 years, the current period return on that investment is only about 1/20 of its lifetime value. By contrast, any expenditure for current period consumption results in 100% of the value of the expenditure in the current period. Is it any wonder then that they get expanded food stamps, relaxed qualifications for disability payments, and subsidies to buy health insurance while infrastructure is allowed to degenerate. If that seems partisan, I could've used the Medicare prescription drug plan or a tax cut as examples. The point is not partisan; the point is there is a structural problem with the incentives created by cash flow accounting.

At the state level where they have balanced budget requirements, they also use cash flow accounting. Their solution to the problem of capital investments is often to borrow specifically for the construction of a particular capital investment. School bonds are a familiar example. The effect is to create more congruence between the cash outlay requirements and the flow of benefits from the capital investment. At the federal level, no similar procedure is common. Another way to address the issue is to have separate operating and capital budgets. That creates its own problems, but at least it makes explicit investment decisions.

The deficiencies of cash flow accounting when assets are involved doesn't just pertain to investment decisions. It also creates perverse incentives with regard to managing existing assets. One would have to be incredibly naïve not to realize that the federal government has tremendous assets. They include Federal lands, offshore drilling rights, microwave spectrum, buildings, and in some cases, mineral rights just to name a few.

At any given point those assets can be viewed either in terms of their current cash value or the stream of benefits they can provide to Americans over centuries. Just as there is an incentive to focus on the immediate cash flow when investing, cash flow accounting also encourages the view of assets as a means of managing current cash flow. Thus, if the budget is out of balance, an asset can be sold to rectify the cash flow situation. Since there's no balance sheet, it has no other consequence in terms of the financial position of the federal government.

The comprehensive balance sheet for the federal government is an unreasonable request. After all, the greatest asset of the government is the ability to tax. Determining that would involve speculating on the attitude of future populations toward taxes. Nevertheless, the net effect of cash flow accounting is to encourage the natural propensity of politicians to have a short-term focus coinciding with their reelection cycles.

Cash flow management is an important aspect of financial management, but it isn't a blueprint for a complete view of appropriate financial management. At a minimum, the federal government should try to estimate those aspects of the balance sheet that can be subjected to reasonable accounting rules. 

However, far more important than trying to apply private sector accounting rules to the federal government is getting elected officials to think in terms of a balance sheet rather than election cycles. Elected officials are only part of the problem; executive employees, the bureaucrats, need to think in terms of the balance sheet rather than processes and throughput. After all, various federal agencies have tried applying private sector accounting practices with almost no improvement in performance.

Loss of Control: The Proliferation of Constraints

The Outlook for Budgetary Constraints Part 2

Miscellaneous mandated expenditures are quite stylish

Medicaid

With Medicaid, the focus is on a program where the payout is mandated by a formula, but, unlike Social Security and Medicare, there is no dedicated funding source. Medicaid is jointly funded by the federal government and the states. The federal government pays the states for a specified percentage of program expenditures. The financing structure guarantees federal matching dollars for qualifying expenditures with no limit on the level of the federal payment. 

The federal government does not match a one-to-one basis, but even so, the partial match provides an incentive to the states to provide Medicaid services. The percentage the federal government pays is called the Federal Medical Assistance Percentage (FMAP). It varies by state based on criteria such as per capita income. The regular average state FMAP is 57%, but it ranges from 50% up to 75%. The FMAP limits the portion of the expenditures the federal government matches, but not the total magnitude of the expenditures.

The only limits on the federal expenditures are the definition of who is eligible for Medicaid and each state’s ability to match. The disabled, the aged, adults, and children can be Medicaid eligible. Medicaid eligibility is grounded on a needs-based measure, but that measure varies by eligible groups.

Increases in Medicaid expenditures come from aging, growth in healthcare costs and expanded eligibility under the Affordable Care Act. The demographics will drive increasing expenditures associated with the elderly. Healthcare costs are their own story, but expanded access to healthcare that is covered by insurance will increase costs. It's basic supply and demand; as more people are able to afford healthcare because of public subsidies, they will increase the demand for health services. Without a commensurate increase in supply, that will increase costs. So, both the increase in the age of the population and the greater access to subsidized healthcare will tend to drive up the federal government's cost of Medicaid.

As mentioned, federal expenditures are not capped; states receive more matching funds the more they grow Medicaid expenditures. Is it any wonder then that Medicaid is the third largest domestic program in the federal budget? We are basically paying the states to grow the program.

A perfect example of the impact of the Medicaid incentives for states is illustrated by the Affordable Care Act (ACA). The implementation of ACA coverage expansions in 2014 led to higher enrollment and higher spending growth for Medicaid: add a new eligible population and not surprisingly, state governments will find them and bring them into the program. This, of course, increases the amount of money they receive from the federal government as a match. The incentive to find ways to spend 

Medicaid money is particularly strong when the federal government identifies a new eligible group and attaches a high priority to getting them onto Medicaid. For example, Medicaid provides a higher matching rate for some services or populations, the most notable being the ACA Medicaid expansion’s enhanced match rate.

To illustrate the impact, consider that the federal government’s Medicaid expenditures had been relatively stable for the five years ending in 2013. They had fluctuated between $243 and $266 billion with no apparent trend. With the expanded coverage under the ACA, the Federal government’s expenditures grew by about 35% between 2013 and 2015. Total Medicaid spending (state and federal) grew 9.7% to about $545 billion in 2015 with the federal share coming to about $344 billion.

While the ACA impact sounds like history, the important issue is the outlook. The newly eligible group was just used to illustrate the incentive because the states already have every incentive to monitor every potentially eligible group for the possibility of increasing the federal government match. Further, states have some flexibility to target specific groups for inclusion in Medicaid.

With respect to ACA, despite the enhanced incentives provided by the ACA, there are still a significant number of states to be brought into the program, and thus, it will expand coverage and the federal government's expenditure on Medicaid. Plus, even in states that fully implemented ACA, there is a belief, reflected in federally-subsidized outreach programs, that there are still many more eligible participants who haven't been brought into the program. It is quite likely that those nonparticipants are disproportionately represented by individuals who will need Medicaid assistance in order to participate.

In summary, the demographics, healthcare costs, and the likely increase in enrollment all imply higher future Medicaid expenditures. The only potentially offsetting aspect of Medicaid is that it is needs-based. Thus, rapid economic growth that includes increases in income of low income individuals would reduce expenditures. The economic assumptions used to forecast Medicaid expenditures are important. But, it would require an economic forecast of growth far above the estimates of most forecasters for the growth to offset the other forces that will increase Medicaid expenses. It's reasonable to assume that Medicaid, like Medicare and Social Security, will continue to grow as a constraint on budgetary flexibility.

Veterans’ benefits

Veterans’ benefits are the next most important program where expenditures are determined by a formula rather than the budget process. They are in many respects a weird duck; which is another way to say that they have a very unusual way of determining eligibility. There are aspects to the benefits that are an earned right, yet, at the same time, there are aspects to them that resemble other needs-based programs.

Fortunately, from the perspective of the outlook for expenditures, and thus the degree to which the budget process has been made irrelevant, important issues can be ignored. But, the issues remain, for example: whether they should be needs-based at all, whether criteria should resemble those used in other programs even with different thresholds, what form the benefit should take, and whether the benefits are adequate to reflect the benefit to society from the service represented by veteran status. 

But, from the perspective of the outlook, judgment regarding those issues and speculation about how they will be resolved is unnecessary. The important thing about veterans’ benefits from an outlook perspective is that they are based upon three criteria: status as a veteran, need for the service, and criteria for whether the government will pay for a particular service (i.e., a needs-based threshold).

Veterans’ benefits can take a variety of forms. The most broadly-used services are related to healthcare. But, there are also benefits related to pensions, loan guarantees, life insurance, education, housing, and a variety of other services. But, it is largely the health benefits that drive the outlook for expenditures for veterans’ benefits. Further, some of the same factors that will affect expenditures for health care also affect other categories of benefits, especially pensions.

Health services loom large in the outlook for a variety of reasons. Almost every factor that affects the outlook will tend to drive up health care expenditures. Starting with veteran status, the composition of the veteran population is important. Veteran status is a function of the historical size of the military over time. Not surprisingly, the largest cohort of veterans served during the Vietnam Era.

Veterans, on average, are older than non-Veterans, and the difference is dramatic, with major implications. For example, in 2015, half of the male veterans were 65 or older. By contrast, the median age of non-Veteran men was 41. The 65 to 74-year-old cohort is the largest cohort of veterans, but right behind it is the 55 to 64-year-old cohort. Consequently, for quite a while the veteran population will be older. Further, the absolute size of the veteran population will not decrease for many years. So, the first factor to consider, status as a veteran, points to higher healthcare costs over the outlook.

However, age is not the only factor that affects the use of healthcare benefits by veterans. Partially it's a matter of what services veterans are most inclined to use, and partially it's a matter of the degree of need. Veterans have lower uninsured rates than non-veterans. In other words, they're more inclined to choose to be insured. However, one should never lose sight of the fact that many veterans take advantage of the availability of the veteran benefit for health because of injuries they sustained while serving.

In order to maintain coverage, veterans are far more likely to have a combination of public and private health insurance coverage than the population in general.  That’s partially due to Medicare and the use of VA health care by veterans over 65, and it's partially due to the VA’s expertise in treating medical conditions that are associated with military service. So, the second factor, need, reinforces the likelihood that expenditures for healthcare costs as a veterans’ benefit will increase.

The final factor to consider is the needs-based criteria. Here there is some good news. Veterans are less likely to live below poverty, and have higher personal incomes than non-veterans.  But, remember veterans’ benefits aren’t welfare; they are benefits earned through service. There may be needs-based criteria, but the criteria reflect the fact that veterans earned the benefits. The very design of the program and the range of services available are intended to protect veterans from extreme need. From the perspective of the outlook for expenditures on programs, it is highly unlikely that the criteria for accessing services will inhibit the growth of expenditures. If anything, it seems reasonable to assume that the criteria will be made more generous.

Up until this point, the discussion of veterans' benefits has not made any reference to defense expenditures or the size of the military. That was done intentionally in order to show that expenditures will grow regardless of current decisions about the size of the military. But, the size of the military and whether it is involved in active conflicts also affects veterans’ benefits. With respect to the issue of active conflicts, veterans’ benefits are a minor consideration. There are far more important considerations. However, it should be noted that among the costs of conflicts is increased health benefits for those injured in combat.

The size of the military is clearly an issue under the control of currently-elected officials. Without judging the wisdom of their decisions, it is still possible to see the likely impact on the outlook for expenses. Between 2011 and 2016, the portion of the federal budget allocated to defense fell from 19.6% to 15.2%. In some years it actually fell in constant dollars. Currently-elected officials plan to expand defense expenditures which will increase the number of veterans. Even if the next administration reverses any growth in the military, those who served will be veterans for the rest of their lives.

In summary, the composition of the population of veterans guarantees that expenditures on veterans programs will increase. Further, it points to healthcare costs as a primary driver of that increase in expenditures. The factors driving this entitlement are the same factors driving the increase in Medicare expenses, but in the case of veterans, it's far more acute because they are generally older than the non-veteran population. Realistically, the likely growth in veterans’ healthcare benefits looks like the growth in Medicare expenditures on steroids.

Civilian federal retirement

I don't think civilian federal retirement costs really need much comment. Anyone who thinks the civilian federal workforce will shrink or that their retirement benefits will be cut should know I have a bridge in Brooklyn I'd like to sell. As discussed in this posting, there are just too many mandated programs where growth is inevitable without major changes in the laws. Those programs will require more employees to manage the expansion, and those employees will qualify for civilian federal retirement benefits.

Refundable tax credits

When we talk about refundable tax credits, we are not talking about deductions. With a refundable tax credit, individuals calculate their taxes and also calculate whether they qualify for the refundable tax credit. The refundable tax credit is a payment from the government to the individual.

A refundable tax credit is an amount the IRS will pay the individual if he or she qualifies. The payment can be used to pay taxes; that is, it can be credited against their taxes, thus the name. But, if the individual does not have enough taxes to use the credit, the IRS sends the person the money. With refundable tax credits, we are talking about money actually spent rather than taxes that are being foregone.

For example, the Earned-Income Credit is the largest refundable tax credit. It is paid to millions of households. The amount paid can be up to $6,269. If the credit completely pays the individual’s tax bill, any remaining credit is paid to the individual as a cash refund. The Earned-Income Credit isn't the only program that works that way.

Other programs include, the American Opportunities Credit for college. It is a tax credit of up to $2,500 of the cost of tuition, fees and course materials paid during the taxable year. 40% of the credit (up to $1,000) is refundable. This means people can get it even if they owe no tax.

The Child Tax Credit is nonrefundable; if the credit exceeds the tax liability, no tax is due and any remaining unused credit may be lost. However, the individual who couldn't use all their Child Tax Credit may be able to get the money anyway by claiming a refundable Additional Child Tax Credit for the unused balance. It is the same result but with an additional tax form.

So, there are refundable tax credits related to a variety of different conditions, but experience under all these programs would seem to indicate that they will grow. Further, the IRS's assessment is that although millions of households already claim these special breaks, many more are eligible for the credits but fail to take them. While the IRS was primarily referring to the Earned-Income Credit, they’re clearly indicating that all the programs have room to grow.

Further, their comments include the rather telling statement when referring to the Earned-Income Credit that “the rules were recently liberalized, so more households are eligible.” The comment is particularly telling because it points out the tendency to liberalize the rules in order to allow more people to qualify. Thus, not only are there already potential claimants who can be expected to cause expenditures to grow, but the eligible population is being expanded.

In summary, it would be incredibly naïve to believe that refundable tax credits that already exist won't become more expensive. Further, it is likely that new credits will be invented, and the eligibility for the existing credits will be expanded.

Other programmatic expenditures and mandates

There are other programmatic expenditures and mandates, often needs-based. However, none of them individually accounts for as much is 2% of government expenditures. Their growth, stability, or decline has very little impact upon the degree to which elected officials can control government expenditures. Their impact is swamped by the impact of the factors discussed in this and the other postings in this series.

Conclusion

Currently-mandated federal expenditures are going to grow over the foreseeable future. Consequently, regardless of the intent of elected officials during budgetary considerations, the cost of the federal government is going to increase. In some cases, that growth of the federal government feeds back into the growth of the mandated expenditures, for example into increased federal civilian retirement benefits. Unless programs are changed, either taxes will have to go up or the debt will have to be increased. Further, without programmatic changes, the budgetary process as conducted by elected officials will become less and less relevant. Budget decisions won't matter to priorities for government programs or to tax levels. They would be driven by the mandates imposed by previously-elected officials.

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.

Loss of Control: The Current Situation

The growing budgetary impotency of elected officials

The previous posting, discussed the CBO's estimates for the deficit over the next 10 years. It pointed out that past politicians have accumulated debt and interest obligations that severely constrain currently-elected officials, and it noted how the debt and interest payments are going to grow. This posting expands upon that theme by looking at the constraints in their entirety.  It focuses on the current constraints. The next few postings will look at how those constraints will behave in the future.

A review of how the federal government spends money shows that previous legislation and executive actions have placed severe and growing constraints on elected officials and, indirectly, voters. Obviously those constraints are from laws that could be changed, but an appreciation of their extent highlights the challenge faced by current and future elected officials.

Many of those constraints take the form of removing control of expenditures from the annual budgetary process. The loss of budgetary control also raises questions about proper functioning of a democracy. Governments are formed in order to constrain behavior. In the US Constitution, considerable emphasis was placed on forming a government where the actions of the government are constrained by other branches of government (e.g., the federal system, the delegation of powers between the three branches of government, the two houses of Congress, the Bill of Rights).

Government constraining future governments is not unusual. Problems arise when there is an imbalance between what is required in order to create the constraint and what is required in order to adjust or eliminate that constraint. When there are such imbalances, a natural response is to avoid adjusting or eliminating the constraint. Workarounds are always possible.

For example, as mentioned in the posting on debt, when the constraints are on the budget, a potential response is to just increase the debt. Making debt an easier solution ultimately turns the budget process into a fiction. Unfunded mandates, accumulated debt, mandatory expenditures written into laws become the game politicians play rather than a realistic planning process. Consequently, examining the constraints placed on the budgetary process is important. It shows just how far we've drifted from being able to rationally approach resource allocation decisions on an annual basis.

Current Budgetary Constraints

Right now it appears that about 70% of the government expenses are mandated by programmatic entitlements written into existing laws. Consequently, our elected officials are budgeting only 30% of federal revenue. The current constraints can be seen by reviewing how the government spends money and then examining which expenditures are controlled by currently-elected officials through the budget process. That's the starting point.

Social Security currently accounts for just over a quarter of federal expenditures. Medicare absorbs another 15-16%. So, those two programs alone take about 40-42% of federal expenditures out of the budgetary process. Interest on the national debt accounts is about 6.25% of the federal government's expenses. When you add in tax credits at 2.2%, it comes close to half of all expenditures that are clearly and totally obligated without any budgetary process.

Medicaid represents about a 10th of the federal expenditures (9.55%) and Veterans’ benefits are about 4.6%. Those two are also largely determined outside of the budgetary process as are civilian federal employees’ retirement benefits at the 2.6%. 

In summary, seven programs where expenditures are mandated account for approximately 65% of federal expenditures. There are also mandated expenses in some of the remaining programs for example, food stamps. So, is it any wonder that many independent analysts have concluded that 70% of all government expenditures are not under budgetary control?

This review tells us where we are but not where we're going. So, to understand the severity of the problem, one has to look at the outlook for different categories of expenditures and especially those that are not controlled by the annual budget process. In many respects, the outlook for these programs is more important than their current impact. It will be the topic of the next few postings.

Loss of Control: Federal Government Debt’s and It’s Budget Impact

Prisoners of our history

Introduction

This first posting on the loss of control is based on a previous posting about the federal government's debt. The series of postings that will follow this posting will cover much more than just any single factor. This series of postings is intended to show the scope of our loss of control of federal expenditures. Consequently, the debt should be included. Further, the debt is a good place to start in a highly partisan environment since it is probably the factor in the loss of control that can be presented with the lowest probability that someone will mistake the analysis for partisan advocacy. Most people can view debt as a fact rather than an opinion.

Overview

CBO reported that the federal budget deficit rose $63 billion in the first half of fiscal 2017 (October to March) to $522 billion from a year earlier. Those aren’t estimates; they are actual numbers. But, they were used to introduce CBO estimates of deficits over the next 10 years. Since the forecast has implications, it's worth looking at how much value to place on CBO estimates. Only then does it make sense to look at the substance of their forecasts.

What looking at the CBO estimates makes clear is the difficulty in interpreting any forecast. It is highly unlikely that their forecast, or any forecast, will be realized exactly as predicted. Therefore, much of the discussion that follows will focus on the forces that influence the outlook rather than any specific forecast for the outlook. When specific estimates are quoted, they are provided to show the order of magnitude of the forces involved.

You gotta love the CBO.

While the Obama administration was about doubling the national debt over eight years, the CBO wasn't just low-profile on the issue; in many cases, they actually obfuscated it. For example, they grossly underestimated the deficit impact of the stimulus plan. If you think it was a partisan ploy, you might note that this was done by overestimating its stimulative impact. As I argued in a bunch of postings in September 2010, every neo-Keynesian was overestimating the stimulative impact because of flaws in their models. CBO was just particularly bad.

If you need another example of CBO's wacko analysis, the Affordable Care Act (ACA) was estimated to reduce federal deficits by $124 billion by 2019 (March 2010 estimate by the CBO before the law was enacted). They not only got the magnitude wrong, they got the direction of the impact wrong. Their estimates were so indefensible that CBO has stopped estimating the effect on the deficit from the ACA.

It isn't just economic impacts CBO screws up. In February 2013, CBO predicted that ACA enrollment in the individual market would be 13 million in 2015, 24 million in 2016 and 26 million in 2017. The actual enrollments were 11 million, 12 million and initially about 10 million for 2017. The initial 2017 enrollment was so low the Obama administration extended the enrollment period and launched an outreach effort which still only got it up to about 12 million, not the 26 million CBO forecast would get coverage thought the ACA’s exchange. As recently as March 2016, CBO was projecting an enrollment of 15 million for this year. They were equally flaky on their forecasts for Medicaid.

Similarly, CBO was also badly wrong about the 2003 Medicare prescription drug benefit. The drug benefit cost about 40% less over its first decade than CBO projected. You may recall that this was the unfunded entitlement that was going to destroy the world.

The less you think it is a partisan issue, Ryan Lizza in “The Mandate Memo: How Obama Changed His Mind,” (NewYorker.com, March 26, 2012) reports that Obama became so frustrated with the CBO that at one point during the healthcare debate he banned aides from using the term “CBO” in his presence. Instead, he called the CBO “banana.”

Don't misunderstand my comment about nonpartisan. I'm not naïve enough to believe that public employees don't respond to the conflict of interest of being a public employee when evaluating the impact of public sector activities. I'm just pointing out that CBO isn't a serious analytical organization. One doesn't need partisan politics to be incompetent. CBO could be incompetent and partisan, not just incompetent, but that's a different issue.

The debt is real and the problem is real

There is one aspect of CBO’s analysis of the deficit outlook that is free of the conflict of interest noted above. To some extent, their projection of the deficit is based upon their assessment of another government organization’s impact, rather than the impact on the public sector of the private sector. Part of their projection for growth in the deficit is an assessment of how much the Federal Reserve (FRB) is going to contribute to the deficit.

The CBO deficit forecasts are predicated on their own economic growth forecasts as well as stability in policies. Policies will change, and the CBO is no better at economic forecasting than anyone else. So, the forecasts themselves are of less value than their analysis of what's driving the debt and deficit. In some instances, the impact of CBO forecasts and assumptions are easily isolated. The impact of the debt on future deficits is one such variable. The impact of the debt is a product of the size of the debt and the interest-rate the government pays.

A logical question is how sensitive are the forecasts to the CBO's assumptions regarding interest rates. CBO estimates that if interest rates are one percentage point higher than in its current projections, the result will be $160 billion additional spending in each year over the next decade. Given that level of sensitivity and the uncertainties associated with any interest-rate forecast, current data on the debt and deficit are important to understanding the forecasts.

The Federal Government’s net interest payments increased $7 billion in March from a year earlier. To put that in perspective, the president’s 2018 preliminary budget proposed cuts of $2.7 billion in discretionary spending. So, the interest costs increase in one month was almost 3 times what the president was able to propose cutting in his first year of operations. Further, it's worth noting that the increase is about 30% for the month. Payments increased by $28 billion for the six months of fiscal 2017 to $152 billion. That is about a 22% increase, and it is among the biggest increase in a single spending items in the CBO estimates.

The increases reflect the larger debt.  As mentioned, the debt has about doubled over the last eight years, but the more ominous fact is that the growth in the debt accelerated in the last year of the Obama administration: Federal spending exceeded revenue by $176.2 billion per month in the closing days of the previous administration. The budget gap was about $68.2 billion higher than a year ago. For the first six months of the fiscal year the deficit was about 15% higher than the same period a year earlier. Over the last 12 months of the administration, the deficit stood at $651.5 billion, compared to $460.6 billion the year before. Those are Treasury Department figures not CBO estimates.

The size and accelerating growth of the debt obviously has implications, but those implications depend upon one's forecast of interest rates that will be applied to that debt.  For the last eight years the FRB’s near-zero policy kept Federal government interest rates at historic lows. That reduced net interest payments even as the overall debt increased. However, at the same time, the federal fiscal outlook deteriorated due to ever-higher future interest obligations. In the CBO forecast the Federal Reserve’s decision to raise interest rates after years of near-zero rates compounds the impact of the debt.

Raising interest rates is not the only way the FRB is influencing the deficit forecast. The FRB’s bond-buying programs earned money. The FRB turned that money over to Treasury each year, reducing the size of the federal budget deficit by tens of billions of dollars. FRB officials are indicating that this year they may stop buying new bonds as those on its balance sheet come due. That will reduce the number of bonds they have earning interest, and, as a consequence, there will be smaller FRB contributions to the federal budget. Also, as interest rates rise, the FRB will have to pay more on bank reserves deposited at the Central Bank. The FRB pays banks 1% on reserve balances. As the amount the FRB has to pay banks increases, it will reduce the amount they can turn over to the government. The amounts aren’t negligible; they pay about $20 billion a year on reserves.

Thus, in addition to the higher interest rates that the federal government will have to pay, there will be a reduction in the more than $90 billion the FRB has turned over to Treasury in recent years. According to CBO, all of this is set to explode on President Trump’s watch. One might ask why CBO ignored this time bomb for so long.  After all this is not the first time they've done 10 year forecasts, and even they aren’t naïve enough to have assumed that interest rates would never rise. But the more important point is that the chickens have come home to roost, here-and-now, according to CBO.

The FRB is not the only instance where the government pays interest which it then recovers. According to the Flow of Funds data from the Federal Reserve, about 28% of the federal debt is held on other federal accounts. That includes about 16% of the total federal debt held by the Social Security Trust Fund.

Consequently, between the FRB which holds 13 to 14% of the debt and the other agencies that hold about 28%, a significant portion of the federal debt, about 42%, is held in accounts were some or all of the interest is recovered by the government.  Even that 42% estimate understates the total public-sector ownership of federal government debt. Another 3 – 4% is held by state and local governments and about 1% is held by the pensions of state and local governments.

The fact that close to half the federal government debt is held by the public sector determines the implication of the rise in the deficit and debt. Basically, the higher interest payments remove control of how taxes are spent from the currently-elected federal officials. Some of it is shifted to the state and local governments that hold the debt. But, the main effect is that it shifts those revenues to mandated expenditures resulting from the actions of previous elected officials.

The interest on debt run up by previous administrations and previous commitments to programs where expenditures are determined by a formula, independent of revenue, consume a larger portion of tax revenue. Social Security and Medicare are the largest such programs, but now they must compete with Affordable Care Act-mandated expenditures. The fact that the interest cost of the debt rose by three times as much in one month as the administration was able to cut in its plan for a year of operations illustrates the loss of control implied. Basically, elections become irrelevant as currently-elected officials have less and less control over government priorities. Increasingly, the only option open to an elected official who wants to control government priorities is to ignore the deficit, run up the debt, and let the next administration worry about it. That is a terrible set of incentives.