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Backgrounder #1897 on Federal Budget

November 30, 2005

Entitlement-Driven Long-Term Budget Substantially Worse Than Previously Projected

By

Federal budget projections consistently warn that America faces a future of unaffordable entitlement spending, deep federal debt, and economic stagnation unless lawmakers modernize runaway entitlement programs. This paper shows that the long-term budget picture may even be substantially worse than previously projected.

Specifically, a realistic budget projection shows that combined nominal Medicare, Social Security, and Medicaid spending will double over the next decade. Adding in the costs of the war on terrorism, Hurricane Katrina, and other congressional spending priorities pushes total 2015 federal spending well past $4 trillion and the budget deficit to $873 billion-a level that could lead to harmful tax increases.

The 2006-2050 budget picture is even more dismal. Because of the cost of fully funding Social Security, Medicare, and Medicaid, leading long-term budget projections have calculated that federal spending will increase from the current 20 percent of gross domestic product (GDP) to a peacetime high of nearly 33 percent of GDP by 2050.[1]

Yet even that may be a severe underestimate. These projections assume slower entitlement growth than estimated by the Social Security and Medicare trustees as well as substantial reductions in defense and other spending. Most critically, they assume that the resulting unprecedented increase in the national debt will not affect interest rates. More realistic assumptions show that Social Security, Medicare, and Medicaid costs will leap from 8.4 percent of GDP to 18.9 percent by 2050. Unless lawmakers reform these programs, they will have to fund their costs by:

  1. Raising taxes every year until federal taxes are 57 percent ($11,000 per household, adjusted into today's economy)[2] above the current levels;
  2. Eventually eliminating every other federal program, including spending on defense, education, anti-poverty programs, and veterans benefits, by 2045; or
  3. Running massive budget deficits (the status quo option). This is the most expensive option because it would cause the federal debt to increase from the current level of 40 percent of GDP to 500 percent of GDP. Beginning in 2025, just a small interest rate response would push federal spending to 44 percent of GDP by 2040 and 73 percent by 2050-levels twice as high as previous projections.

The data presented in this paper are not predictions of what will occur. They merely represent three painful possible outcomes if lawmakers choose to continue on the current course with Social Security, Medicare, and Medicaid. The data show that unreformed entitlements not only could cause significant economic pain, but also could eventually place the entire American economic and financial system in crisis. Modernizing entitlements and averting this calamity is the most important economic challenge of this era.

2006-2015 Projections

The Congressional Budget Office's most recent 10-year baseline budget projections, released in August 2005, show a rapidly improving budget picture, with discretionary spending increases slowing down, tax revenues swelling, and the budget coming close to balance by 2015.[3] However, these projections are based on a set of unrealistic assumptions that Congress requires the Congressional Budget Office to include, based on existing law. The CBO is required to assume, for example, that:

  1. No additional supplemental funding will be appropriated for the war on terrorism;
  2. Congress will limit discretionary spending increases, which have averaged 9 percent annually since 2000, to the inflation rate (approximately 3 percent) over the next decade; and
  3. Congress will allow the 2001, 2003, and other tax cuts to expire and not update the income thresholds for the Alternative Minimum Tax (AMT). This would translate into a steep tax increase for nearly every taxpayer.

Because lawmakers require such unrealistic assumptions, the CBO's budget projections also include a table of alternative assumptions that allow readers to insert more realistic policies into the baseline.

Table 1 corrects for these flaws by (1) incorporating additional supplemental funding for the war on terrorism; (2) assuming that discretionary appropriations will expand as fast as the GDP after 2006; and (3) assuming that the tax cuts will be made permanent and the AMT will be fixed.[4] Table 1 also incorporates a rough estimate of hurricane relief and reconstruction spending in the Gulf Coast.

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Consequently, Table 1 shows a budget picture that is vastly different from the CBO baseline. Combined nominal Medicare, Social Security, and Medicaid spending doubles by 2015. Adding in the costs of the war on terrorism, Hurricane Katrina, and other congressional spending priorities pushes total 2015 spending well past $4 trillion and the budget deficit to $873 billion. Although these budget deficits would still not be large enough to raise interest rates or reduce economic growth significantly, they would increase the likelihood of major tax rate increases that would impose severe burdens on taxpayers and the overall economy. Because all spending must eventually be paid for with taxes, the only way to guarantee long-term tax relief is to control long-term spending.

These budget projections show how difficult it will be to exercise such spending control. Federal spending has already surged 33 percent since 2001 to a peacetime record of nearly $22,000 per household.[5] According to the CBO projections, retirement of the baby boomers combined with the unaffordable Medicare prescription drug benefit will increase Medicare spending by 9 percent annually. Medicaid spending will rise by nearly 8 percent annually, and Social Security will cost 6 percent more each year. Not even a strong economic boom could provide the tax revenue necessary to keep pace with such large, structural, persistent spending hikes.

Even these estimates could prove overly optimistic. Table 2, which breaks down the mandatory spending baseline, assumes that several entitlements will remain nearly frozen through 2015. History suggests that Members of Congress will continue to expand these programs by 4 percent to 6 percent annually and create additional entitlement programs on top of them. The Office of Management and Budget (OMB) estimates that these CBO numbers strongly underestimate the cost of the Medicare drug benefit.[6] Recession, additional terrorist attacks, and an extended American presence in Iraq would each harm the economy, reduce tax revenues, and/or precipitate additional spending increases.

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In other words, even though projections always include a large margin for error, all signs point to rapid spending increases and a deteriorating federal budget picture.

2006-2050: Long-Term Projections

Like the 10-year projections, the long-term budget picture may be vastly worse than previously thought. The most commonly cited long-term budget projections were released by the CBO in December 2003.[7] Its most middle-of-the-road scenario projected that Social Security, Medicare, and Medicaid costs would drive total federal spending from the current 20 percent of GDP to 33 percent by 2050-by far the highest peacetime spending level in American history.

While these projections are alarming by themselves, the CBO may have substantially underestimated the coming spending increases. This paper's 2006-2050 static budget projections begin with the 10-year numbers stated in the previous section.[8] After 2015, they differ from the CBO's December 2003 projections in four ways:

  1. Retaining the CBO's tax and Medicaid formulas but updating them for budget changes over the past 18 months.[9]
  2. Replacing the CBO's Social Security and Medi-care projections with the projections of the Social Security and Medicare trustees.
  3. Holding defense and all other program spending (excluding Social Security, Medicare and, Medicaid) constant as a percent of GDP after 2015 (the CBO assumed that defense spending would be halved and other spending reduced by 12 percent).
  4. Dropping the CBO's assumption that interest rates will remain generally frozen through 2050. While modest levels of debt, such as those experienced today, do not significantly raise interest rates, the huge projected debt levels almost surely would do so because of an uncertain economic future. As explained in detail below, this paper conservatively assumes that after 2025 (when public debt begins to exceed 100 percent of GDP) each 1 percentage point increase in America's debt-to-GDP ratio would increase the average interest rate paid on the federal debt by one basis point (1/100 of 1 percent).

Under these assumptions, federal spending is projected to reach 44 percent of GDP by 2040 and 73 percent of GDP by 2050-more than double the CBO projections. (See Chart 1.) Net interest costs account for nearly all of the difference. (See Table 3.) Even a minuscule interest rate response to this large debt pushes total spending exponentially higher.

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The spending projections detailed in Appendix 1 reveal that Social Security, Medicare and Medicaid, and net interest payments dominate projected federal spending trends through 2050.

Social Security. Social Security costs are projected to rise gradually from 4.2 percent of GDP to 6.3 percent in 2034 and then level off.[10] In today's economy, these GDP numbers would translate into a permanent increase from the current $519 billion spending level to approximately $770 billion- an increase of $2,200 per household annually.

Demographics are driving this cost increase. Social Security benefits for current retirees are funded by current taxpayers. This is sustainable only if there are enough workers paying taxes to support all current retirees collecting benefits. As the 77 million baby boomers retire (and as life spans continue to lengthen), the same-size workforce will need to support many more retirees. When Social Security was created in 1935, 42 workers supported each retiree. In 2005, the ratio is 3:1, and by 2030, it will be 2:1. At that point, a married couple will be supporting themselves, their children, and their very own retiree.

Some erroneously suggest that future taxpayers will be spared these costs because the Social Security "trust fund" will pay all promised benefits until 2041. It is true that years of payroll tax revenues exceeding program costs will have created a cumulative $5.7 trillion Social Security surplus (on paper) by the time the system starts running in the red in 2017. However, the surplus has already been spent. More specifically, each year's Social Security surplus has been lent to the U.S. Treasury for Congress to spend along with all other tax revenue. In 2017, when Social Security starts calling for its money back, the Treasury will be able to repay the debt only by collecting that amount in new taxes. In other words, the taxpayers, not some vague government entity, will have to repay the $5.7 trillion to the trust fund to keep the system running until 2041.[11]

In that sense, the Social Security trust fund does not save taxpayers a dime. It is merely an accounting device: a running tally of the amount of the Social Security surplus that Congress has spent and that future taxpayers will have to repay to fund all benefits until 2041. Each year's Social Security benefits will continue to be funded by current taxpayers. There is no mountain of money waiting to be tapped.

Medicare and Medicaid. Medicare's financial crisis is immensely more serious than Social Security's. Both programs face the same demographic crunch, but while Social Security simply transfers a predetermined amount of income from workers to retirees, Medicare must cope with the rapidly rising cost of delivering high-quality, technologically advanced health care to an aging population. If health care costs continue to rise by 8 percent annually, Medicare will have to increase spending steeply just to provide the same level of care to the same number of seniors. The addition of health care cost inflation to these demographic challenges will make Medicare's financial hole many times greater than that of Social Security.

The Medicare trustees project that Medicare spending will increase from 2.7 percent to 9.3 percent of GDP by 2050-triple the size of Social Security's increase. (See Chart 2.) Converting these GDP percents into their equivalents in today's economy, Medicare's annual budget would increase from $332 billion to $1,135 billion-an annual cost increase of $7,000 per household.

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Even this estimate may be low. The Medicare trustees estimate that per capita Medicare spending will grow approximately 1 percentage point faster than GDP. This represents a slowdown from the 3.0 percent excess growth rate since 1970 and the 1.7 percent excess growth of Medicare spending since 1990. (The CBO assumed even slower growth than the trustees assumed.)[12] If per capita Medicare spending continues to grow at historical rates, even the trustees' expensive projections will prove overly optimistic.

It is noteworthy that the new Medicare drug benefit will account for one-quarter of all projected Medicare spending after 2020.[13]

Seniors needing nursing home and long-term care treatment (which are not covered by Medicare) often end up on Medicaid. Such care is very expensive (thousands of dollars per month per patient) and is projected to drive up Medicaid spending from 1.5 percent of GDP to 3.5 percent by 2050. In today's economy, these GDP percents translate into an increase from $184 billion to $426 billion (an increase of about $2,200 per household), not counting the 43 percent of Medicaid costs that states must pay. This 2.0 percent of GDP increase matches Social Security's projected cost increase. In 2006, Medicare and Medicaid combined will cost the federal government more than Social Security for the first time ever. By 2050, they will cost taxpayers twice as much as Social Security.

Net Interest. The Social Security, Medicare, and Medicaid spending increases are projected to drive federal program (i.e., non-interest) spending from 18 percent of GDP to nearly 28 percent by 2050. Historically, tax revenues have remained relatively close to 18 percent of GDP. If lawmakers do not reform runaway entitlements, keeping up with this runaway spending will require raising taxes annually, with total taxes eventually reaching 57 percent of GDP, or nearly $11,000 per household (in today's economy).[14] Such tax increases, in addition to being politically unlikely, would severely damage long-term economic growth, not to mention making it nearly impossible for most families to make ends meet.

Without higher taxes or less spending, this runaway spending would likely create budget deficits of an unprecedented size. Over time, such debt would induce exponential increases in net interest costs. (See text box, "Debt, Interest Rates, and Vicious Circles.") Current debt levels of 40 percent of GDP are too small to increase interest rates significantly; as projected debt levels surpass 100 percent, 200 percent, and then 300 percent of GDP, however, it becomes increasingly likely that a global capital shortage or inflation would raise interest rates, especially since Western Europe is not likely to be in a position to supply much capital or buy American debt because of its own entitlement crises.

This paper assumes that after 2025 (when the public debt surpasses 100 percent of GDP), each 1 percentage point increase in America's debt-to-GDP ratio would increase the total interest rate paid on government bonds by one basis point (1/100 of 1 percentage point). This interest rate response to huge federal debt is actually smaller than the response projected by several leading economists.

Yet even this conservative assumption means that net interest will overwhelm the federal budget, rising gradually at first, from 1.5 percent of GDP in 2005 to 3.7 percent in 2020 and 7.7 percent in 2030. By then, however, the vicious circle of debt and interest rate increases is projected to push net interest costs to 17.5 percent of GDP by 2040 and 45.6 percent by 2050. To put that amount in context, in today's economy net interest spending of 45.6 percent of GDP would translate into over $5.5 trillion, or $50,000 per household annually.

Realistically, interest costs would never reach that level. The static scenario is sustainable only until about 2040, after which the escalating national debt and federal budget would likely trigger an economic crisis. Under status quo policies, projecting the federal budget or U.S. economy after 2040 may be like trying to project the specific devastation from a natural disaster.

Chart 3 puts these interest costs in perspective. Even without any interest rate response, total 2005-2050 net interest spending would total $43.9 trillion. A marginal interest rate response of one basis point would raise that cost to $64.1 trillion. A marginal interest rate response of two basis points would translate into a $118.3 trillion net interest cost in today's economy.

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Limited Options for Lawmakers

It is easy to brush off these projections by asserting that lawmakers would obviously fix the system before such an economic crisis could occur. Yet this is exactly the point: These programs will not repair themselves. Fundamental entitlement reforms are the only way to avert this economic and budgetary crisis. In effect, lawmakers who deny that Social Security and Medicare are in crisis and reject all options to modernize these programs are voting to keep the United States on this unsustainable path. Every year lawmakers delay these reforms pushes the ultimate cost up even further. Indeed, reform is the only acceptable solution.

Option 1: Reforming Social Security and Medicare. Successful Medicare reform would create an entirely new system based on the principles of personal choice, market competition, and light regulation. The key change would be in the financing of the system.

Instead of a defined benefit entitlement, which Medicare is today, the new Medicare program would be a defined contribution system. Based on an equitable formula that reflects market realities, the government would contribute a defined amount to Medicare beneficiaries' coverage, just as the Federal Employees Health Benefits Program (FEHBP) does for federal workers and retirees. Seniors in such a system could bring their pre-retirement health care plan with them into retirement or choose new coverage options, including new fee-for-service, managed care, or consumer-driven plans such as health savings accounts.

The government contribution would be capped at a dollar amount, just as the contribution in the FEHBP is capped, and seniors wanting more expensive plans could choose to pay extra amounts above the government contribution. Seniors choosing plans below the government contribution could keep 100 percent of the savings from choosing less expensive health plans. There would be no detailed benefit mandates or price controls. Unlike the current system, seniors would not be restricted by statute from spending their own money on medical services or physicians of their own choice.

This Medicare reform model is broadly similar to what a majority of the National Bipartisan Commission on the Future of Medicare recommended in 1999.[15] Thanks to competition, consumer choice, and minimal red tape, the FEHBP has proven to be a highly popular and successful government program. It relies on the free-market principles of consumer choice and competition and has a record of superior performance in controlling health care costs.[16]

Social Security reform must involve some reduction in the growth rate of benefits for younger workers, possibly through a combination of progressive indexing of benefits and a higher retirement age. However, these benefit changes would not leave future seniors with lower benefits than current seniors. Allowing workers to invest a portion of their payroll taxes in personal Social Security retirement accounts, with their names on them, that involve conservative stock index funds and bond funds could more than compensate for any changes in their Social Security benefits. Under such a reform, workers could create their own nest eggs, which they would own and could even pass down to loved ones.

It is true that the transition to private accounts could cost more than the current system in the short run. However, by paying slightly more now, taxpayers would avoid a $3.7 trillion tab over the next 75 years (in much the same way that, when refinancing a mortgage, paying points up front will significantly reduce the long-term interest costs).[17]

Option 2: Unprecedented Tax Increases. Chart 4 shows how much Congress would have to increase taxes to finance the projected spending and still balance the budget. Following an immediate tax increase of $3,323 per household to balance the budget, keeping pace with spending would require total tax increases of $4,516 by 2020, $7,472 in 2030, $9,436 in 2040, and $10,918 in 2050 (all adjusted into today's economy). This tax revenue could be collected by raising the top marginal income tax rate from 35 percent to 80 percent and the typical family's marginal tax rate from 25 percent to 57 percent. (If the tax increases harmed economic growth, even larger tax increases would be required to raise the necessary revenue).[18] Overall, this represents a federal tax burden of 28 percent of GDP, not counting the average state and local tax burden of 10.5 percent of GDP.

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This tax increase is actually lower than otherwise needed because annual balanced budgets would prevent the accumulation of mountainous budget deficits, which would drive up net interest costs. Still, tax increases of nearly $11,000 per household would overwhelm family budgets and stagnate the economy. Critics of the 2001 and 2003 tax cuts should note that repealing those cuts would not come close to making up this shortfall.

Option 3: Eliminating All Other Spending. Chart 5 provides a spending cut scenario to fund Social Security, Medicare, and Medicaid while retaining a balanced budget. Eliminating spending on homeland security, justice, veterans benefits, highways, unemployment benefits, the environment, social services, community development, energy, international aid, science research, and farm subsidies would immediately balance the budget. From there, making room for the "big three entitlements" would require eliminating education spending by 2018, health research by 2020, federal employee retirement benefits by 2021, other anti-poverty spending by 2026, and defense spending by 2045. By that point, Social Security, Medicare, and Medicaid would consume the entire federal budget except for relatively small interest payments on pre-2006 debt.

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While this scenario is unlikely, it illustrates what lawmakers would need to do to finance unreformed Social Security, Medicare, and Medicaid programs without tax increases or budget deficits.

Option 4: Spiraling Debt and Economic Crisis. If lawmakers do not reform entitlements and reject paying for them through unprecedented tax increases or program eliminations, the only other option is deficit spending on an unprecedented scale. The combination of revenues at 18 percent of GDP and government program (non-interest) spending at 28 percent of GDP would create budget deficits large enough to increase the national debt from the current 40 percent of GDP to 100 percent, 200 percent, and then 300 percent of GDP. This would set off a vicious circle of rapidly increasing debt translating into higher net interest spending (exacerbated by higher interest rates), which would increase debt even further-possibly to 500 percent of GDP. Such exponential increases in government borrowing would devastate financial markets and eventually could trigger a financial and economic crisis.

Weighing the Four Options. Raising taxes and using debt to pay for Social Security, Medicare, and Medicaid are not viable options because of their potential to harm the economy. Furthermore, government spending itself can harm the economy. Simply stated, higher government spending undermines economic growth by transferring additional resources from the productive sector of the economy to the government, which uses them less efficiently.

Government spending crowds out productive private-sector activity by taking away resources and reallocating them based on political considerations rather than economic decisions. In addition, government spending discourages work, savings, and other productive choices. For example, relying on government retirement programs discourages saving for retirement. Finally, government spending inhibits innovation because programs such as Medicare and Medicaid are more centralized and bureaucratic than the private sector, which is constantly seeking new opportunities and improvements to maximize the bottom line.[19]

Issues at Stake

Before choosing a course of action, American citizens and lawmakers must address two fundamental issues surrounding the entitlement debate: (1) budgetary priorities and fairness and (2) economic and budgetary unsustainability.

Budgetary Priorities and Fairness. When asked to describe the purpose of federal taxes and spending, respondents from across the political spectrum would typically include providing for the common defense, assisting poor families, and providing public goods. Yet the rapid growth of Social Security and Medicare threatens these and all other portions of the federal budget.

As Social Security and Medicare continue to expand, there will be no room in the federal budget for defense, homeland security, education, welfare, housing, social services, health research, veterans benefits, criminal justice, highway construction, or environmental protection. Each program will face massive spending cuts or complete elimination as America moves from a welfare state to what National Review editor Rich Lowry has called the "geriatric state."[20]

In other words, the federal budget will become one giant mechanism to transfer income from working families to senior citizens. One generation will be taxed into poverty to support another generation. As summed up by Ron Brownstein of the Los Angeles Times:

To call this behavior a breakdown of fiscal responsibility misses its true nature. This is a stunning abandonment of generational responsibility. Washington is behaving like a father who steals his kid's credit card and goes on a bender. Individually, America's parents make sacrifices every day to provide opportunities for their children; but collectively, the nation is now pursuing precisely the opposite course-indulging itself even at the price of reducing opportunity for its children.[21]

It is difficult to justify raising taxes by $11,000 per household for working families, who already face the expenses of raising children and making mortgage payments, to transfer money to senior citizens who are often wealthier, lack current child-raising costs, and often have entirely paid off their homes.[22] Senior citizens are certainly entitled to receive the amount that they paid into the Social Security and Medicare systems, and low-income seniors may require additional assistance.

However, the current system functions as an unsustainable pyramid scheme, through which many current seniors will receive benefits several times greater than the amount that they paid into the system and many current taxpayers will receive much less than they pay into the system. That is fundamentally unfair.

Economic and Budgetary Unsustainability. The current system is economically unsustainable. Spending for Social Security, Medicare, and Medicaid is projected to increase from 8.4 percent of GDP in 2005 to 18.9 percent of GDP in 2050. Lawmakers would have to raise taxes by an amount eventually nearing $11,000 per household (adjusted into today's economy) in order to pay for all projected spending. Over time, such tax increases would devastate the U.S. economy and substantially harm working families. Assuming that those tax increases do not occur, the net interest cost of current federal debt, combined with trillions of dollars of new debt, would push spending to unsustainable levels.

Those who consider these scenarios overly pessimistic should examine the Western European economies that are already sinking under the weight of their enormous social insurance systems. With birth rates that are not even sufficient to replace their current population, many "old Europe" nations have been forced to impose steep tax increases on their remaining workers to fund these bloated benefit systems.

Overall, government spending in the 15 nations comprising the pre-2004 European Union (EU-15) averages 48 percent of GDP, and tax revenues average 41 percent of GDP. (See Table 4.) These high tax rates and expenditures, combined with tight economic regulations, have hammered their economies. Compared to the United States, per capita income is 30 percent lower in the EU-15, economic growth rates are 34 percent lower, unemployment is substantially higher, and living standards match only America's poorest states.[23]

As their populations continue to age, the economies of countries such as Germany and France risk collapsing under the weight of their unrealistically generous retirement and welfare systems. These European crises provide a glimpse into America's future if government spending continues to increase steeply.

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Conclusion

The data presented in this paper are not predictions of what will occur. They merely represent three painful, possible outcomes if policymakers continue on their current course with Social Security, Medicare, and Medicaid. Unless lawmakers reform these programs, the nation will be forced to choose among devastating tax increases, the elimination of nearly every other federal program, and budget deficits large enough to jeopardize the entire U.S. economy. The longer lawmakers wait, the more expensive and painful these reforms will become.

Brian M. Riedl is Grover M. Hermann Fellow in Federal Budgetary Affairs in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

Appendix 1

Data

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Appendix 2

Methodology

2006-2015 Calculations

Revenue estimates begin with the August 2005 CBO baseline[24] and are adjusted using CBO data[25] that reflect extensions of the expiring provisions of the 2001, 2003, and other tax cuts (excluding outlay portions) and the cost of reforming the Alternative Minimum Tax.

Discretionary spending for both defense and non-defense purposes in 2006 is listed at the levels contained in Table 1.4 of the August 2005 CBO baseline and then held constant as a share of GDP through 2015. War supplemental spending estimates come from Table 1.3 of the CBO's January 2005 budget projections. Katrina-related spending is based on preliminary Heritage Foundation estimates.

Mandatory spending estimates come from the August 2005 CBO baseline, adjusted for the outlay portions of extending the tax cuts listed above and for the mandatory spending reductions contained in the fiscal year 2006 budget resolution. Savings for specific years are estimated using the five-year savings of $35 billion. Katrina-related spending is based on preliminary Heritage Foundations estimates.

Net interest spending estimates begin with the August 2005 CBO baseline and are adjusted by The Heritage Foundation after incorporating the net interest affect of each adjustment made to the baseline.

Mandatory program baselines were compiled using the data from the CBO Web site,[26] the CBO's August baseline, and the Office of Management and Budget's Current Services Baseline (projected past 2010 by The Heritage Foundation).

2016-2050 Calculations

GDP growth after 2015 is projected at 4.3 percent annually in nominal dollars, which is similar to the rate projected by the Social Security trustees in the "Economic Assumptions and Methods" chapter of the 2005 OASDI Trustees Report.[27]

Revenues are calculated in a manner similar to the CBO's low-tax scenario, used in the December 2003 Long-Term Budget Outlook, by setting tax revenues as a percentage of GDP (beyond the current 10-year window) at the average level of the previous 30 years. The 2003 report calculated that number at 18.4 percent of GDP after 2012, while the updated figure is 17.8 percent of GDP after 2015.

Social Security spending after 2015 is projected by using the intermediate scenario in the 2005 OASDI Trustees Report.[28]

Medicare spending after 2015 is projected using the intermediate scenario in the 2005 Medicare Trustees Report.[29]

Medicaid spending after 2015 is projected using the intermediate spending scenario in the CBO's December 2003 Long-Term Budget Outlook.[30] However, the CBO's current 2006-2015 baseline shows annual Medicaid spending levels at approximately 0.2 percent of GDP above the levels projected in December 2003. Accordingly, this paper adjusts annual Medicaid spending after 2015 up by 0.2 percent.

Defense and all other program spending is held constant as a percent of GDP after 2015. There is little legislative or historical evidence to suggest that this spending would see a strong diversion from current levels as a percent of GDP.

Net interest calculations are explained in the main text of this paper. Economic growth, inflation, and other economic impacts are less predictable than interest rates and therefore could not be incorporated into the paper. Those variables would likely worsen as a result of these fiscal pressures.

Other Calculations

Calculations after 2015 are first made as a percentage of GDP and then converted into nominal dollars, spending in terms of the 2005 economy, and costs per household.

Putting future spending in terms of the 2005 economy places future budget projections in context by showing how much those projections would cost Americans today. It can be done simply by taking long-term budget measures as a percentage of GDP (which automatically controls for GDP-influenced factors such as income, prices, and population) and then holding GDP constant at 2005 levels (effectively freezing those factors).

For example, Social Security is projected to cost $1.28 trillion, or 5.24 percent of GDP in 2020. In the 2005 economy (with an estimated GDP of 12.27 trillion), 5.24 percent of GDP would translate into $643 billion. Thus, Social Security's $1.28 trillion nominal budget in 2020 would place the same burden on taxpayers and the economy as would a program costing $643 billion in the 2005 economy. This represents the current equivalent of a $124 billion increase over the $519 billion spent in 2005.

Per-household calculations divide each program by the 112.5 million American households, as estimated by The Heritage Foundation using Census Bureau data. Because these percent-of-GDP measurements control for population over time, this 2005 household number can apply to future years when calculating the current equivalent tax or expenditure per household.

Tax increases needed to fund all spending and still balance the budget were calculated by setting tax revenues equal to spending beginning in 2006. Thus, publicly held debt and annual net interest payments remain roughly constant in nominal dollars and decline as a percentage of GDP. This keeps total spending each year much lower than would be the case if the debt and accompanying interest payments were increasing.

Federal program eliminations required to fund Social Security, Medicare, and Medicaid without tax increases or new debt were determined by setting federal spending equal to tax revenues beginning in 2006 (which limits net interest expenses) and then squeezing out the programs that would not fit each year as the big three entitlements expand. The order of eliminations was determined by working from the cheapest to the most expensive program categories.

Show references in this report

[1]Congressional Budget Office, The Long-Term Budget Outlook, December 2003, at www.cbo.gov/showdoc. cfm?index=4916&sequence=0 (November 3, 2005), and associated spreadsheet at www.cbo.gov/Spreadsheet/4916_Data.xls (November 3, 2005). The scenario reported here is the intermediate spending and low-tax scenario. World War II was the only time that federal spending exceeded this level.

[2]Throughout this paper, future budget data are adjusted into the 2005 economy. Generally, future spending and revenue pro­jections are calculated as a percent of future GDP. To provide a current perspective, this paper then translates those projected future percentiles into today's GDP level to come up with a "current equivalent." This is the best method for holding prices, income, and population constant over time. For a more detailed explanation, see Appendix 2.

[3]Congressional Budget office, The Budget and Economic Outlook: An Update, August 2005, p. 8, Table 1.4, at www.cbo.gov/ ftpdocs/66xx/doc6609/08-15-OutlookUpdate.pdf (November 3, 2005).

[4]For the methodology, see Appendix 2.

[5]The historical spending-per-household figures are adjusted for inflation. For a summary of recent federal budget trends, see Brian M. Riedl, "Federal Spending: By the Numbers," Heritage Foundation WebMemo No. 881, October 11, 2005, at www.heritage.org/Research/Budget/wm881.cfm.

[6]The Congressional Budget Office compared its Medicare drug benefit cost estimate with the Office of Management and Bud­get's estimate in Douglas Holtz-Eakin, director, Congressional Budget Office, letter to Representative Jim Nussle, February 2, 2004, at www.cbo.gov/ftpdocs/49xx/doc4995/OMBDrugLtr.pdf (November 3, 2005).

[7]Congressional Budget Office, The Long-Term Budget Outlook. The scenario reported here is the intermediate spending and low-tax scenario.

[8]For the methodology, see Appendix 2.

[9]Because some portions of the tax code are not easily adjusted for inflation, large inflation can slightly increase tax revenues as a percent of GDP. Thus, if debt monetization creates large inflation, the assumption of tax revenues at 17.8 percent of GDP will turn out to be a slight underestimate.

[10]These projections are very similar to projections by the CBO and the Social Security trustees.

[11]See Brian M. Riedl, "Why Social Security's Problems Begin in 2018," Heritage Foundation Commentary, February 17, 2005, at www.heritage.org/Press/Commentary/ed021705b.cfm.

[12]See Congressional Budget Office, The Long-Term Budget Outlook, and Technical Review Panel on the Medicare Trustees Reports, Review of Assumptions and Methods of the Medicare Trustees' Financial Projections, December 2000, pp. 27-42, at www.cms.hhs.gov/publications/technicalpanelreport/chapter3.asp (November 3, 2005).

[13]Centers for Medicare and Medicaid Services, 2005 Annual Report of the Boards of Trustees of the Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds, March 23, 2005, p. 28, at www.cms.hhs.gov/publications/trusteesreport/ tr2005.pdf (November 3, 2005). The trustees estimated that this expense pushes Medicare spending up by one-third, which translates into one-fourth (33/133) of the total Medicare cost.

[14]In 2005, taxes averaged $19,147 per household. Adding $10,918 in new taxes would be a 57 percent increase.

[15]The commission was led by former Senator John Breaux (D-LA) and Congressman Bill Thomas (R-CA). For more information, see National Bipartisan Commission on the Future of Medicare, Web site, at thomas.loc.gov/medicare (November 3, 2005).

[16]See Robert E. Moffit, Ph.D., "Lessons of Success: What Congress Can Learn from the Federal Employees Program," Heritage Foundation WebMemo No. 565, September 14, 2004, at www.heritage.org/Research/HealthCare/wm565.cfm.

[17]This transition cost could be financed by enacting a federal taxpayers' bill of rights limiting the growth of federal spending to inflation plus population growth. Such a common-sense spending limitation would save $4 trillion over the next decade-enough to finance Social Security reform, make all tax cuts permanent, and possibly even balance the budget. See Brian M. Riedl, "Restrain Runaway Spending with a Federal Taxpayers' Bill of Rights," Heritage Foundation Backgrounder No. 1793, August 27, 2004, at www.heritage.org/Research/Budget/bg1793.cfm.

[18]Tax revenues would have to increase by 9.8 percent of GDP. Under static scoring, this would mean that individual income taxes would rise from 7.6 percent of GDP to 17.4 percent of GDP, an increase of 129 percent. Thus, each marginal tax rate is multiplied by 2.29.

[19]See Daniel J. Mitchell, Ph.D., "The Impact of Government Spending on Economic Growth" Heritage Foundation Backgrounder No. 1831, March 15, 2005, at www.heritage.org/Research/Budget/bg1831.cfm.

[20]Rich Lowry, "Operation Please Granny," October 27, 2003, at www.townhall.com/columnists/richlowry/rl20031027.shtml (November 3, 2005).

[21]Ron Brownstein, "Snowballing Debt Awaits Tomorrow's Taxpayers," Los Angeles Times, December 1, 2003.

[22]For more information on the wealth of senior citizens, see Chris Edwards and Tad DeHaven, "War Between the Generations: Federal Spending on the Elderly Set to Explode," Cato Institute Policy Analysis No. 488, September 16, 2003, at www.cato.org/pubs/pas/pa488.pdf (November 3, 2005).

[23]Mitchell, "The Impact of Government Spending on Economic Growth."

[24]Congressional Budget Office, The Budget and Economic Outlook, p. 4, Table 1-2.

[25]Ibid., p. 16, Table 1-6.

[26]Congressional Budget Office, Supplemental Data on Mandatory Spending, at www.cbo.gov/factsheets/FactSheets2005.shtml (November 9, 2005).

[27]Social Security Administration, The 2005 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, March 23, 2005, pp. 90-91, at www.socialsecurity.gov/OACT/TR/TR05/tr05.pdf (Novem­ber 9, 2005).

[28]Ibid., pp. 169-173.

[29]Centers for Medicare and Medicaid Services, 2005 Annual Report of the Boards of Trustees, p. 29, Table III.A2.

[30]Congressional Budget Office, The Long-Term Budget Outlook.

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