How to Reform Entitlement Spending: A Memo to President-elect Obama
We've got 78 million baby boomers who are going to be
retiring over the next couple of decades. That means more retirees,
fewer workers to support those retirees. It is common sense that we
are going to have to do something about it. That is not a
Republican talking point. And if we don't deal with it now, it will
get harder to deal with later.... [W]e are still going to have an
actuarial gap that has to be dealt with. It is not going to vanish
and if we have a moral responsibility to the next generation to
make sure that Social Security is there, the most successful
program to lift seniors out of poverty that we've ever devised,
then we need to start acting now and having a serious conversation
--Barack Obama, Democratic presidential debate, October 30,
Well, Tom, we're going to have to take on entitlements, and
I think we've got to do it quickly. We're going to have a lot of
work to do, so I can't guarantee that we're going to do it in the
next two years, but I'd like to do it in my first term as
--Barack Obama, Townhall Presidential Candidates Debate, October
President-elect Obama, you based much of your presidential
campaign on the promise of a better future for all Americans. A
better future must be one in which Americans have the financial
freedom to provide for themselves and their families. Yet this
future is currently endangered by a Social Security, Medicare, and
Medicaid system that is set to drown future generations in taxes
and debt. Reforming these programs will be one of the greatest
economic challenges of the 21st century.
In the coming decades, the cost of these three programs will
leap from 8.4 percent to 18.6 percent of gross domestic product
(GDP)--an increase of 10.2 percent. Without reform, this increased
cost would require either raising
taxes by the current equivalent of $12,072 per
or eliminating every other government program. Funding all of the
promised benefits with income taxes would require raising
the 35 percent income tax bracket to at least 77 percent and
raising the 25 percent tax bracket to at least
You know that the current system is unsustainable. With the cost
of reform growing $1 trillion more expensive annually, there is no
time for delay. Furthermore, many believe that Americans ages 55
and over should be exempt from any reforms. One-third of all baby
boomers have already crossed that threshold, and at 4 million per
year, all of them will have crossed it by 2019.
Entitlement reform is more than just an economic issue.
Americans need to decide whether they want a future in which older
Americans have an automatic claim on one-fifth of the future income
of their grandchildren, who will be raising their own children
and paying off their home mortgages. Under the current system,
retirees will spend one-third of their adult lives in
taxpayer-funded retirement while national security, education,
health research, and antipoverty programs fight for the few
remaining tax dollars and low taxes are threatened.
Modernizing Social Security, Medicare, and Medicaid can provide a
healthy retirement for those in need while also protecting future
The following guidelines can help you fulfill your pledge of
- Disclose the government's long-term
obligations. Though Social Security and Medicare currently
comprise about one-third of the entire federal budget, Congress is
not required to pass an annual budget for either program. Rather,
both operate on autopilot under formulas contained in their
governing laws. Moreover, the tendency of politicians to make
promises to expand or enact new benefits is greatly enhanced by the
lack of any measure of long-term costs of these programs in the
budget. Two changes should be madein the budget process to ensure
better stewardship for the nation's long-term solvency.
- You should ensure that the long-term costs of entitlement
programs are built into the budget process and considered along
with other priorities during the annual budget process so that
spending onMedicare would be considered in the same context as
defense, education, or tax policy.
- Any changesin entitlement programs should also be measured over
the long term.
Bringing long-term costs into the legislative debate will mean
that, unlike today, Congress must consider whether children and
grandchildren can really afford to pay for new benefits for their
parents and grandparents.
- Put Social Security, Medicare, and Medicaid on
long-term budgets. Discretionary programs are forced to
justify themselves annually though the budget process. By contrast,
entitlement programs--including Social Security, Medicare,
Medicaid, most antipoverty programs, farm subsidies, and
refundable tax credits--
are effectively on autopilot. Their budgets grow
automatically each year without going through the regular
budget process, being examined, or being forced to justify--or even
constrain--their growth. Smaller entitlement programs are
examined only once or twice per decade when they are
reauthorized. Large entitlement programs are not required
to be reauthorized or re-examined and are thus not subject to
budgetary trade-offs. This is not a formula for sound
You should call on Congress to create a framework for a budget
that would be evaluated periodically to ensure that entitlement
programs are sustainable over the long term. This could be done by
creating a long-term budget window--for example, 30 years. All
spending on entitlements would have to be reviewed and reauthorized
every five years. This is similar to how other countries manage
their long-term commitments. Congress should include "triggers"
that would make automatic adjustments should spending grow above
budgeted levels. One way to keep spending within budgeted levels
would be to raise premiums, deductibles, and out-of-pocket expenses
for Medicare Part B and Part D automatically for middle- and
- Create a commission to submit recommendations to
Congress for a vote. A promising bipartisan approach to
entitlement reform already exists. The SAFE Commission Act,
authored in the House by Representatives Frank Wolf (R-VA) and Jim
Cooper (D-TN), would create a bipartisan commission intended to
address the "unsustainable imbalance" between federal commitments
and revenues while increasing national savings and making the
budget process give greater emphasis to long-term fiscal issues.
While the commission could consider a range of approaches, the bill
places emphasis on two:
- Reforms that would limit the growth of entitlements while
strengthening the safety net and
- Tax reforms that would make the tax system more economically
efficient and improve economic growth.
The commission would hold public hearings around the country to
discuss the long-term fiscal problem, and its recommendations would
receive "fast-track" consideration by Congress.
Senate Budget Committee Chairman Kent Conrad (D-ND) and ranking
Republican Senator Judd Gregg (R-NH) have also introduced
commission legislation. Such an approach can break the political
logjam by requiring that Congress craft entitlement reform
proposals and vote on them as well.
- Create incentives for savings. Social Security
and Medicare were intended originally to supplement the savings
that Americans build up over their lifetimes. However, too many
retirees have not saved adequately and are wholly dependent on
Social Security and Medicare to fund their entire retirement.
You have spoken positively of "automatic IRAs" for American
employees not covered by employer-sponsored retirement plans. Such
employees could direct payroll deposits to a low-cost, diversified
individual retirement account that would continue automatically--an
opportunity now limited mostly to 401(k)-eligible workers. To
maximize participation, employers would be encouraged to use
automatic enrollment, whereby employees automatically participate
at a statutorily specified rate of contribution unless they opt
Auto-IRAs are a terrific way to increase savings and thus empower
Americans to build their own retirement savings. Lowering tax rates
on savings would also help Americans to build wealth.
- Do not increase taxes. During the presidential
campaign, you floated the idea of reforming Social Security by
assessing a payroll tax of 2 to 4 percentage points on those who
earn over $250,000 annually. President Bill Clinton rejected this
idea in the 1990s, and you should as well. In addition to closing
only a small percentage of the long-term Social Security shortfall,
this policy would reduce economic growth by reducing incentives to
work, save, and invest.
America cannot tax its way out of this entitlement challenge. The
problem is caused by surging spending levels, not declining
revenues--in fact, taxes as a percentage of the economy are already
projected to rise to record levels over the next few decades.
Furthermore, it is not clear why drowning future generations in
higher taxes is any better than the status-quo approach of drowning
them in debt. Any new tax revenues would go into the general pot of
revenues, which Congress would likely allocate to business-as-usual
government spending rather than shoring up entitlement programs.
Better to focus on the real problem of skyrocketing entitlement
- Reform Social Security. Social Security
projected to increase from its current 4.3 percent of GDP to
6.1 percent by 2050--an increase of 1.8 percent. Today, a spending
increase of 1.8 percent of GDP would equal $246 billion, or $2,130
per household. Of this spending hike, 55 percent would result from
demographic changes, and 45 percent would result from higher
Your options for preserving Social Security's solvency are
relatively straightforward. Rather than dumping large debt or tax
increases on the next generation, several feasible options exist to
restrain program costs. One option is to raise the retirement age
(currently set to rise to 67 by 2030) by two months each year until
it reaches 70, which would allow future seniors an average
retirement of 17 years.
A second option would income-adjust benefits to target needy
seniors more effectively. You can accomplish this through
"progressive indexing," which would index initial benefit levels
for middle-income and upper-income families partially to price
inflation rather than wage growth, eliminating much of the
increased Social Security costs driven by higher benefits.
This would also allow for more benefit growth among lower-income
Finally, many economists believe that the most used consumer
price index overstates inflation. Aligning Social Security's
inflation adjustment with a more accurate price index would save
money while still providing inflation protection.
In the long run, a more generationally equitable system would add
a personal savings element to Social Security. While personal
accounts by themselves do not reduce the taxpayer liabilities to
current seniors, the long-term investment growth of a balanced
portfolio would enable workers to do much better than they can
under today's system. In addition, workers would be able to own
their accounts, which could be passed on to their families in the
event of their untimely death.
Millions of Americans with 401(k) plans and IRAs already
understand how long-term investments can grow over several decades.
Even with the recent market carnage, once investments return to
their historical earnings level, workers will be able to recoup
their losses in less than two years and again build their
investments. Further, new savings instruments greatly reduce the
risk that older savers will lose money close to their
- Reform Medicare. Medicare costs are projected
to more than triple from today's 2.7 percent of GDP to 9.4 percent
by 2050. In current terms, a cost increase of 6.7 percent of GDP
would equal $916 billion, or $7,930 per household annually
Medicare reform is very complex. While Social Security transfers
income from one group to another and therefore can be fixed with
formula changes, fixing Medicare is more difficult because it is a
major part of the health care economy. Thus far, reforms have
centered on reducing payment rates to doctors and hospitals,
but payment rates are already well below market prices. This
amounts to rationing health care, which may reduce costs but will
not advance better care or encourage more rational decisions.
Some reforms, which could be made quickly, would significantly
rein in Medicare costs. One new approach would be to reduce the
massive Part B and Part D subsidies for upper-income families.
These programs are not social insurance: Enrollees did not earn
their benefits with payroll taxes. Rather, they are large subsidies
from taxpayers. Part B recently began modest income-relating.
President George W. Bush has proposed larger means-testing of Parts
B and D.
Your long-term reforms should bring more choice and competition to
health care, such as moving Medicare from a defined-benefit system
to a defined-contribution system. The Federal Employees Health
Benefits Program (FEHBP) has held down costs by creating a
voucher-type system for federal employees to purchase coverage
from competing health plans that offer differing coverage and
costs. By creating more choice and
competition, the FEHBP has held down cost increases and may
serve as a model for Medicare reform.
- Reform Medicaid. Federal Medicaid spending is
projected to jump from 1.4 percent of GDP to 3.1 percent
by 2050. Today, a 1.7 percent of GDP spending hike would equal $232
billion, or $2,012 per household. Most of this spending growth will
come from senior citizens, whose long-term care costs are not
covered by Medicare.
Two other factors will also drive up Medicaid costs: inflation of
health care costs and the funding structure, which encourages
states to overspend on Medicaid. Because Washington reimburses
states for 57 percent of all costs, every dollar that a state
spends on Medicaid guarantees an additional $1.33 grant from
Washington. Consequently, states have a stronger incentive to
allocate their budgets to expand Medicaid benefits and eligibility
levels rather than to provide tax relief or education, regardless
of the state's actual needs.
Converting Medicaid into a block grant to states would eliminate
state incentives to overspend on Medicaid. Additionally, giving
states more flexibility to craft different Medicaid packages
for different individuals based on their unique personal
circumstances could save money while improving service delivery.
State incentives to help individuals purchase long-term care
insurance could also substantially reduce Medicaid's
burden insofar as these expenses are concerned.
You have asserted a "moral responsibility" to reform
entitlements. Unless Social Security, Medicare, and Medicaid
are reformed, America faces a future of soaring taxes and
government spending that will cause poor economic performance.
Americans will pay onerous taxes, and future generations will have
lower living standards than Americans enjoy today.
Delay only makes the necessary reforms more painful. It is
vitally important to take up this challenge and make entitlement
reform a top priority.
Brian M. Riedl is
Grover M. Hermann Fellow in Federal Budgetary Affairs in, and Alison Acosta
Fraser is Director of, the Thomas A. Roe Institute for
Economic Policy Studies at The Heritage Foundation.
Show references in this report
 This section is largely excerpted from Moffit and Fraser, "Congress Must Pull the Trigger to Contain Medicare Spending."
 For additional information on Social Security, Medicare, and Medicaid reform, see Riedl, "A Guide to Fixing Social Security, Medicare, and Medicaid."
 Even this projection assumes that per capita Medicare costs will grow only about 1 percentage point faster than GDP, even though Medicare costs have grown an annual average of 2.4 percentage points faster than GDP since the 1970s. If this trend continues, actual Medicare costs through 2050 could be double the current projection.