July 20, 2004 | WebMemo on Federal Budget
The Entitlement Problem
July 9, 2004
Stuart Butler, Ph.D., Vice President of The Heritage Foundation
Bruce Bartlett, Senior Fellow at the National Center for Policy Analysis
Chris Edwards, Director of Tax Policy Studies at the Cato Institute
Moderator: John Berthoud, President of the National Taxpayers Union
Stuart Butler, Ph.D.
Vice President for Domestic and Economic Policy Studies, The Heritage Foundation
(View PowerPoint presentation here)
If the current tax legislation is made permanent, we will not see a reduction in the percentage of GDP going to taxes; it will stay about the same that it has been historically, at 17 percent of GDP. If the tax cuts are ended, then we will see a steady rise in taxation as a percentage of GDP to historically high levels.
We begin to see quite staggeringly high levels of expenditures committed by the federal government under these entitlement programs. By 2050 we're seeing total expenditures exceeding 30 percent of GDP and steadily rising.
By 2020 the deficit will be around 7 percent of GDP; by 2030 the deficit will be around 10 percent of GDP, or one trillion dollars.
If you are in favor of balancing the budget, but you don't want to tackle these major entitlements, then what tax rates would you actually have to have in place to balance the budget? You will see very quickly that taxes will have to exceed historical levels and then go up beyond 25 percentage points within the next generation or two. In other words, a 30 percent increase in taxes would have to be enacted if you do not wish to deal with the entitlement issue.
If a member of Congress says, 'I do not want to tackle these entitlement problems and I want to balance the budget,' they are telling you that they want to have very sharp tax increases. There is no alternative.
What are the true economic effects of entitlement programs? The first cost of entitlement programs is that we are withdrawing a huge amount of labor from the workforce, which is going to reduce economic growth and make it harder to pay those benefits. The second cost is that the profitability of making new drugs will drop and we will have to get by on the discoveries that have already been made. The last economic cost is taxes. The history of entitlement programs is that when they run into trouble they never cut benefits-they always raise taxes.
We really have a serious problem here that is going to require taxation an order of magnitude larger than anything that has ever been contemplated. I don't see how we can get that kind of money out of the existing tax system except at an excessively high economic cost.
Eventually, the added subsidies are going to drive up the prices of drugs to the point where they are no more affordable than they are today. The subsidy will simply be eaten up by higher prices. And when this happens, people are going to scream bloody murder, and it is absolutely inevitable that Congress is going to respond by putting on price controls.
We've backed ourselves into a situation where we are going to seriously have to consider a value-added tax. Every major country has one of these except the United States. And the reason they have the value-added tax is because they wouldn't cut entitlements. All you have to do is look to Canada and England to see what we are going to look like in about 20 or 30 years. The problem with this is that the tax is easily increased because it is hidden in the cost of goods. The value-added tax has increased very substantially in every country where it has been imposed.
Director of Tax Policy Studies, Cato Institute
The elderly entitlement crisis is worse than you think. The cost of Social Security and Medicare Part A (the part that comes out of the payroll tax) is expected to rise from 14 percent of taxable wages today to 24 percent by 2040. If you add in Medicare Part B and the new drug bill, it pushes that up to about 30 percent. Thirty percent is horrible, but the problem is even worse than that. Those sorts of projections that you see in the CBO are purely static estimates of future tax rates. They assume that the government will be able to double the payroll tax on workers with no negative effects. But as economists point out, as tax rates rise, the tax base shrinks, work effort declines, and tax avoidance increases.
If payroll taxes have to increase by 9 percentage points on a static basis to pay for all these entitlement costs, the actual payroll tax rate will have to increase 14 percent just for the government to get that extra money. All the estimates you see in the paper about what future tax rates would have to be are understatements because of the dynamic effect of tax hikes.
If we don't reform Social Security, there will be a vicious cycle: tax rates will keep on rising to fund elderly entitlements, young families will be left with less money to save for their own retirement, they will work less, and people will reach retirement with even less savings than today, making them even more dependent on the government. That is an economic death spiral.
The elderly spending crisis is so huge that we need entitlement reforms and cuts to the budget. Let's return the $400 billion the federal government currently spends on state and local activities-education, health, and highways. Those are state responsibilities.
We cannot afford a big, inefficient government in an increasingly global economy. On the tax side, the United States is trailing most European countries on corporate tax reforms. But even on the spending side, we are trailing a lot of countries as well. On Social Security, Chile, Britain, Australia, and a dozen other countries have partially or fully privatized their Social Security plans. Even China is moving in that direction. But it is not just Social Security but a bunch of other areas as well: airports around Europe are being privatized and post offices are being open to competition.
Audience:What would you do first to address the entitlement problem?
Mr. Bartlett: I would increase the retirement age.
Dr. Butler: I would make sure we don't put into place the Medicare prescription drug benefit scheduled for 2006. Those are absolutely unfunded. We have no idea what the costs are. At the very least, we shouldn't be adding to the problem, which in this case, is what the last Congress did.