Facing America’s Long-Term Budget Challenges Brian Riedl Grover M. Hermann Fellow for Federal Budgetary Affairs The Heritage Foundation June 19, 2006

Spending Growth is Accelerating

Spending is Rising Across Government Defense and Homeland Security account for just 30% of all new spending since Other Increases:  Education: 137%  International Affairs: 111%  Health Research/Regulation: 78%  Social Security & Medicare: 38%  Antipoverty Programs: 45%  Veterans’ Benefits: 56% Projected 2016 Budget Deficit: $700-$800 Billion

The Problem 77 million baby boomers will soon begin retiring. Ratio of workers supporting each retiree:  1945 – 42-to-1  1950 – 15-to-1  1960 – 5-to-1  2005 – 3-to-1  2030 – 2-to-1 By 2030, a married couple will have to support themselves, their children – and their very own retiree. In addition to demographics, Medicare also must deal with rising health care costs. Senior health care will also push up Medicaid costs.

Social Security, Medicare, and Medicaid Costs As a Percent of GDP

Option 1: Tax Increases Per Household & Translated Into 2005 GDP

Option 1: Implications Would have to raise taxes every year until they were 10% of GDP higher than today.  In today’s economy, a 10% of GDP tax increase would average $11,000 per household.  Marginal tax rates would likely more than double. Combined federal, state, and local taxes would reach European levels. Generally, these high tax rates have been shown to reduce economic growth, depress incomes, and increase unemployment.

Option 2: Other Program Cuts Yearly Budget Breakdown, Assuming No Tax Hikes or Budget Deficits

Option 2: Implications Would have to immediately begin terminating programs to make room for Social Security, Medicare, Medicaid, and interest on past debt. By 2026, defense would be the only other remaining program. By 2045, defense would have to be eliminated too. By that point, 100% of the budget would go towards Social Security, Medicare, Medicaid, and interest on past debt. Clearly, this is not realistic.

Option 3: Continue Current Policies And Cover Shortfalls With Budget Deficits

Option 3: Implications Hold all taxes and other spending constant as a percent of GDP, and then cover shortfalls with budget deficits. Borrowing 10% more of GDP per year ($1.2 trillion more in today’s economy) would raise the federal debt to levels never seen before. Such debt could increase interest rates, which would in turn trigger an exponential increase in federal debt and net interest costs. Depending on interest rates, net interest spending alone (adjusted into today’s GDP) could range from $44 trillion to $118 trillion. Such large expenses could create an economic crisis.

Option 4: Modernize Social Security, Medicare, and Medicaid Reform is the only way to avoid the scenarios listed above. Delays only push up the final reform costs. Social Security reform may involve transitioning to a system whereby individuals’ payroll taxes go into their own personal retirement fund. Medicare and Medicaid reforms allowing more consumer choice and competition may hold down costs. Limiting the Medicare drug entitlement to low-income seniors would save $8.1 trillion over the next 75 years – an amount twice as large as the entire Social Security shortfall.

Conclusion This issue is about more than economics. There is a moral question of whether one generation should hand a multi-trillion dollar retirement bill over to the next generation. In the absence of fundamental reform, those entering the workforce today will experience both higher lifetime tax rates and lower incomes than their parents as a result of these retirement costs.