Key Points
- Rapid growth in entitlement spending is threatening to push the federal government past the point of insolvency—a fiscal challenge largely ignored by the nation’s policymakers.
- To avoid an economic crisis, Social Security, health care programs, and the safety net for lower-income households all need reforms that reduce the long-term federal budget deficit while ensuring limited resources are mainly directed to households with limited means.
- Entitlement reforms must improve the programs’ effectiveness and efficiency by promoting work, personal responsibility, and an effective market-based health care system. These reforms should be based primarily on programmatic and social goals, not merely reducing costs.
Executive Summary
The United States faces a large and growing fiscal challenge that is being ignored by most of the nation’s policymakers. The Congressional Budget Office (CBO) projects that debt held by the public will reach 100 percent of gross domestic product (GDP) in 2039.[1]
The primary cause of the problem is the steady, decades-long rise in entitlement spending. Over the past 75 years, the United States has built a vast and sprawling network of social welfare protections and programs—the entitlement state. These programs’ cumulative costs now threaten to push the federal government past the point of insolvency.
However, it is insufficient to base a push for reform on a fiscal rationale alone. Reforms must be—and must be understood by the public as—good ideas that improve the programs’ effectiveness and efficiency, separate and apart from budgetary effects.
Although entitlement programs vary greatly in their roles and design, the important themes for reform should be:
- Promotion of Work. Much of the federal safety net is designed to help households that have inadequate resources from earned income. But it is counterproductive when government programs discourage work and thus create unnecessary dependence on public support.
- Personal Responsibility. Most working-age households with middle-class incomes (or higher) could save and provide for their own retirement without subsidization from other taxpayers. Entitlement reform should proceed on the assumption that limited public resources should provide a solid safety net against poverty in old age, but that those who can afford to save for retirement should be expected to do so.
- Innovation and High Quality in Health Care. Slowing cost escalation in health care without undermining the quality of care requires higher productivity and more efficiency in how care is provided to patients. That can be achieved only with a functioning marketplace.
The federal government’s entitlement spending is concentrated in Social Security, health care programs, and the safety net for lower-income households. Reforms are necessary in all three areas.
Social Security. The current Social Security program provides benefits to nearly all retired Americans, including those with higher incomes, based on their preretirement earnings. Social Security, however, does a poor job of preventing poverty in old age.
Social Security should move toward providing a universal flat benefit, set initially at the federal poverty line, to all US residents age 65 and older. In effect, Social Security would shift toward becoming a guarantee against poverty in old age rather than a scheme for partially replacing preretirement earnings for middle- and high-earning households. There would be a long transition from the current formula to the new benefit to ensure no one lost accrued benefits. This new benefit would eliminate old-age poverty and would be sustainable over the long run with a lower payroll tax rate.
The flat benefit would provide lower Social Security benefits to middle and higher earners. They could offset this income with additional private savings, facilitated with reforms promoting automatic 401(k) enrollment and simplified 401(k) plans for small employers. In addition, a reform plan should eliminate the 12.4 percent Social Security payroll tax at age 62, thus removing a major disincentive to continue working at older ages. This change could be coupled with increasing the early retirement age (now 62) to age 65 during the transition to the flat benefit.
Health Care. With the passage of the Affordable Care Act (ACA) in 2010, the federal government assumed even more control over the allocation of resources in the nation’s system of health insurance and health care. Over time, this will result in lower-quality health care. What is needed instead are market-based reforms that empower consumers to pursue high-value and low-cost care.
The starting point for building such a marketplace is to move away from open-ended federal subsidization of insurance toward a defined-contribution approach. The ACA would be replaced with a program with much less regulation. Employer coverage would remain as it is today, with no mandates or requirements. The “Cadillac” tax of the ACA would be replaced with a more rational upper limit on the federal tax preference for employer plans.
Households without access to employer coverage would get a tax credit (refundable for those with low incomes). The credit could be used to enroll in any state-approved plan. People who stay continuously insured would be protected against high premiums or restricted coverage based on a previous episode of expensive care.
The Medicare program would be converted into a premium support program, with a fixed level of support that beneficiaries would use to offset the cost of a plan of their choosing. Medicaid would be separated into two components (for the able-bodied and children and for the disabled and elderly) and converted into fixed, per capita federal payments to the states for the two enrolled populations. States would have substantial flexibility to manage the program according to their preferences.
The rules for enrolling and contributing to health savings accounts (HSAs) would be liberalized to encourage widespread participation and thus also bolster the consumer role in the marketplace.
Safety-Net Programs. The federal government spends about $400 billion annually to fight poverty (not counting health care programs), with unsatisfactory results.[2] The existing array of support programs improves lower-income households’ material well-being and enables them to meet their daily needs, but it does not help families lift themselves out of poverty and up the income ladder with better-paying jobs. A major impediment is the lack of coordination among the many federal and state initiatives that have been created over the years.
Reforms to safety-net programs should emphasize work as the key to improved economic prospects, greater state control over resources to allow for innovation and coordination, and the elimination of wasteful spending.
Two major reform concepts—block grants and wage subsidies—should be tested in several states. States could opt to receive a large portion of existing federal funding for safety-net programs in the form of a block grant, based on historical spending patterns. They could then design better-coordinated programs that move as many beneficiaries as possible into employment. Some states would also be allowed to use the block grant to provide direct wage subsidies to lower-income households, effectively giving them a raise that the beneficiaries would see directly in their paychecks. The federal government would help facilitate the testing of this reform.
Since this would be a significant departure from the status quo, demonstrations of this approach would need to be carefully evaluated and show evidence of helping low-income Americans before it is adopted on a wide scale. In the meantime, existing safety-net programs have many problems in need for improvement. Targeted reforms are needed to eliminate unnecessary spending, close loopholes around work requirements, support low-income workers, and target resources on those most in need of assistance.
Federal Budgetary Effects of Reforms. The CBO projects that both federal spending and revenue will rise over the coming 25-year period, but spending growth will outpace the rise in revenues. Today, all noninterest federal spending equals about 19.2 percent of GDP. The CBO expects federal spending, excluding net interest payments, to rise to 21.2 percent of GDP by 2040. This projection assumes a major downsizing of the nation’s defense capabilities and deep cuts in domestic appropriations. Neither is likely to occur.
At the same time, current projections show spending on major entitlements—Social Security, Medicare, Medicaid, and the subsidies for health insurance provided in the Affordable Care Act—increasing from 10.3 percent of GDP today to 14.2 percent of GDP in 2040—a large bump in a relatively short time. Revenue is expected to rise from 18.4 percent of GDP today to 19.5 percent of GDP in 2040.
Entitlement reform is essential to avoid a fiscal crisis, poorly conceived counterproductive cuts in defense spending, and tax increases. The target for savings should be ambitious but achievable.
The flat-benefit proposal (and associated reforms) has been analyzed using a model developed by the Policy Simulation Group and was found to generate a 75-year actuarial surplus. This implies that the flat-benefit plan would more than eliminate Social Security’s long-term deficits, based on the projections from the Social Security Trustees. In 2050, the reform plan would improve Social Security’s financial position by about 1.3 percent of GDP.
The Center for Health and Economy evaluated the health entitlement reforms and found they would reduce the federal budget deficit by $230 billion in 2025. Although the center generally does not produce longer-term estimates, for purposes of this proposal, the cost estimate showed potential annual savings growing to around $400 billion annually by 2035. Savings of this magnitude would equal about 1 percent of GDP.
The reforms recommended for safety-net programs have not been evaluated for their federal budgetary effects. However, the reforms, which are aimed at improving independence, encouraging work, and eliminating waste, certainly will reduce overall program costs.
The savings estimated from the combined effects of these reforms almost certainly understate federal savings, particularly in the health programs. It is difficult to fully anticipate the savings from intense market competition, but the health system has significant waste that could be reduced with better incentives and more cost-conscious consumers.
Notes
- Congressional Budget Office, The 2015 Long-Term Budget Outlook, June 2015, https://www.cbo.gov/sites/default/files/114th-congress-2015-2016/reports/50250-LongTermBudgetOutlook-4.pdf.
- United States Government Accountability Office, “Federal Low-Income Programs: Multiple Programs Target Diverse Populations and Needs,” Report to Congressional Requesters, July 2015, http://www.gao.gov/assets/680/671779.pdf.