Attention has focused recently on the explosion of federal
borrowing to meet the demands of economic "stimulus,"
market stabilization, and the financial sector crisis. However,
even if the United States had been fortunate enough to avoid these
crises, the federal government would still face an unsustainable
The most current long-term projections of growth in Social
Security, Medicaid, and Medicare (often referred to as
entitlements) paint a bleak fiscal picture, which emphasizes the
need for reform. Left unchecked, entitlement spending is projected
to exceed 20 percent of gross domestic product (GDP) by 2060.
Viewed in isolation and from the distance of 50 years, this may not
seem altogether daunting--distressing perhaps, but hardly alarming.
However, the federal budget would also need to expand to include
discretionary spending and the other mandatory outlays. Even more
important, mandatory outlays would include spending a crushing 22
percent of GDP to service the debt accumulated from five decades of
debt-financed federal spending. The projections beyond 2060 reflect
the snowball effect of compounding debt and dwarf the nearer-term
estimates. Regardless of the time horizon, addressing U.S. fiscal
straits will require increasingly drastic measures.
The projections demonstrate the futility of attempting to
finance entitlements with debt. On its present course, this debt
and the accompanying interest will swamp the U.S. economy, harm
U.S. standing in world capital markets, damage capital formation
and productivity growth in the United States, and reduce future
standards of living.
The problem needs to be addressed soon, but some proposed
solutions will not work. Raising taxes to match the growth in the
spending would dramatically harm economic growth and
competitiveness. Similarly, it is unrealistic to expect sustained
GDP growth sufficient to afford this spending. Instead, addressing
the long-term fiscal challenges confronting the United States will
require fundamentally reforming entitlement spending.
This paper suggests some possible approaches that Congress
should consider when it reforms entitlements to rein in spending
and makes broader reforms to the health care and health insurance
Reforming Social Security. Social Security should be
reformed by reducing the growth of future benefits to
higher-earning workers to balance the cash flow so that revenue
from Social Security payroll taxes equals Social Security
retirement benefits. Achieving a cash-flow balance would immunize
Social Security from the larger vagaries of the federal budget.
Reforming Medicare and Medicaid. In Medicare and Medicaid
reform, an important first step is to think separately about the
markets for health care and health insurance.
The Health Care Market. In reforming the health care
market, the first step is to employ the bully pulpit as loudly and
frequently as possible to encourage people to take care of
themselves and prevent chronic diseases when possible, but this
would not be enough by itself. Next, the reforms should focus on
promoting competition throughout the health care system among
providers and among alternative treatments. Medicare payment policy
needs to be reoriented away from paying for all treatments used on
a patient and toward paying for cost-effective, coordinated care
that yields high-quality outcomes.
These "supply-side" approaches to changing the use of medical
services could be complemented by needed legal reforms to eliminate
frivolous lawsuits and excessive damage awards and to provide a
safe harbor for doctors that follow clinical guidelines and adhere
to patient safety protocols.
The Health Insurance Market. The first pillar of
reforming the health insurance market is to change the tax
treatment of health insurance to level the playing field between
employer-provided insurance and other types of insurance.
The second pillar is to improve the variety and affordability of
these alternatives. As with markets for providers, health insurance
markets should be national in scope and support vigorous
competition. Highly competitive, deep national insurance markets
will avoid the potential for large insurers to "capture" state
regulators, limit monopoly power, provide out-of-state alternatives
for consumers saddled with unreasonably costly insurance mandates,
and reduce the potential for wasteful overhead and excessive
compensation that survives in the absence of competition.
The third pillar of better insurance markets is to "risk-adjust"
the tax credit so that higher-cost individuals receive greater
resources, thereby transforming the nature of insurance company
Conclusion. The U.S. faces a fundamental budgetary
challenge that will have severe economic implications over the long
term. However, the scale of these challenges and the severity of an
attendant economic collapse demand a near-term approach to bring
the U.S. fiscal situation back into balance.
Entitlement spending seriously threatens U.S. fiscal solvency.
Left unchecked, it will contribute to a crippling national debt
burden, which will stifle economic growth and force later and
unluckier generations to bear the cost of these imbalances through
severe federal cuts or draconian tax increases.
The U.S. still has a window, however indeterminate, during which
it could implement sensible reforms to return Social Security to
solvency without incurring massive future deficits and to rein in
the health care costs that are driving the increasing Medicare and
Medicaid spending. Properly implemented, reforms along the lines
suggested in this paper would return federal spending to a
sustainable path and ensure a foundation for prosperity throughout
the coming decades.
Douglas Holtz-Eakin is President of
DHE Consulting, LLC, and a Visiting Fellow at The Heritage
Foundation. Gordon Gray is a Senior Adviser at DHE Consulting,