US Social Security and Medicare Primer

US Social Security and Medicare Primer

Paul Alois, March 2007

In recent years the question of Social Security’s future has come to the foreground of American political discourse. In his 2007 State of the Union address, President George W. Bush said of Social Security and Medicare, “They are commitments of conscience, it is our duty to keep them permanently sound, and we are failing in that duty.” Countless other politicians and economic leaders have warned of the coming crisis presented by out of control benefit spending programs, but the debate has often served to further confuse the issues.

Retirement benefit programs are the third rail of American politics; consequently obfuscation and distortion of the facts has become the norm. This paper will clarify the significant issues surrounding Social Security and Medicare, and discuss the projected future of these programs.

1. Demographic Shifts

Two demographic shifts that have occurred in the last 50 years are fundamentally driving today’s problems with retirement benefit programs: falling birth rates and an aging population. Birth rates have been declining in America since the country was founded, but the anomalous post-WWII baby boom hid this trend from social planners. During the 1960s birth rates plummeted to below their prewar numbers, and it is the fruition of this shift that is endangering Social Security today. Social Security was created under the assumption that there would always be a high ratio of workers to retirees. In 1960 there were over 5 workers per retiree, today there are 3, and by 2025 there will be only 2. Furthermore, the US population is aging, leading to a much higher percent of GDP being spent on health care. While these demographic shifts are not problems in and of themselves, coupled with the structure of the US benefit programs they represent a serious threat.

1. A Brief History of the US Retirement Benefit Programs

President Roosevelt signed the Social Security Act in August of 1935. The Great Depression and the Dust Bowl left many Americans in a state of extreme poverty, and they demanded government intervention. The original intent of the Social Security Act was to provide income insurance for the elderly, children and unemployed adults; its structure mirrored other “pay-as-you-go”+ schemes in the Western world. The Social Security Act provided valuable help to many in need, and stemmed the rise of radical Socialism that was occurring in other parts of the Western world.

The post-WWII economic boom saw a vast expansion in the size and scope of social insurance systems. The widespread feeling that future generations would be fabulously wealthy justified the nation’s desire for expanded retirement benefits. Mainstream Americans also became increasingly aware of the large number of citizens still living in extreme poverty, and called on the Federal government to take action. President Lyndon B. Johnson supported many new programs, the largest of which was Medicare, a program designed to cover the healthcare needs of retirees. The Federal government went on to dramatically increase Social Security benefits and create Medicaid, which provided healthcare for the poor. These programs were so expensive that between 1966 and 1976 benefit spending nearly doubled as a share of total federal outlays, from 27% to 49%.[1]

By the mid-1970s America’s optimism had turned sour. The Arab oil embargo, coupled with a stagnant economy and inflation ushered in a period of caution and conservatism. When Ronald Reagan became President in 1981, he planned to cut taxes and decrease benefit spending. However, he was unable to adequately maneuver Congress into following his plan, resulting in a massive tax cut far beyond his initial designs and absolutely no decrease in benefit spending. By the end of Reagan’s Presidency the tax cuts had been completely reversed, benefit spending remained unchanged, and the federal debt had tripled.[2] His successor President George H.W. Bush created a bipartisan plan to raise taxes and cut spending that would have successfully balanced the federal budget. However, Democrats criticized him for cutting programs while Republicans attacked him for raising taxes, and his plan failed.

During the Clinton years the problems posed by unrestrained spending became increasingly apparent. However, President Clinton understood that cutting benefit spending was political suicide so he took no action, and George W. Bush inherited the problem in 2001. In 2002 President Bush created a prescription drug coverage plan for seniors, sharply increasing the cost of programs for retirees. He also initiated enormous tax cuts, hamstringing the Federal government’s ability to manage the rising cost of benefit programs. He then made an attempt in 2005 to reform Social Security, but was unable to motivate the nation.

Presently the US social insurance system is in dire need of reform. In the coming decades these programs will continue to put enormous pressure on the Federal budget, and their costs have to potential to increase to levels beyond what the economy can bear.

2. The Present Situation

While there are dozens of retirement benefit spending programs in the US, Social Security and Medicare are the two largest ones, and the ones most affected by the aging US population. These two programs have different functions and are financed in different ways.

2.1 Social Security

In 2006, Social Security (SS) reached 49 million people with outlays totaling $539 billion. 90% of Americans over 65 receive some money from SS, and over half of them depend on SS for most of their income.[3] The importance of SS in the lives of American seniors cannot be overestimated: without it many of them would live below the poverty line. Additionally, more than half of the workers in America today have no retirement plans outside of SS. The Social Security Administration (SSA) actually controls two distinct entities: Old-Age, Survivors Insurance (OASI) and Disability Insurance (DI)

2.1.1. Old-Age, Survivors Insurance[4]

OASI covers retired workers and their surviving spouse. In 2005 its expenses were $442 billion. OASI received income from two sources: payroll taxes* and interest on its trust fund.o In 2005 OASI received $507 billion from payroll taxes, $84 billion in trust fund interest, and an additional $14 billion in other income. After paying its expenses, OASI had an income of $163 billion. At the beginning of 2005, its trust fund was worth $1,501 billion; by the end it was worth $1,664 billion.

OASI is currently the most stable of the government’s retirement benefit programs, but it is important to note that the trust fund can only support OASI for three years without payroll taxes. Therefore, although OASI has a considerable trust fund, it is essentially a “pay as you go” system. According to the SSA, OASI will have to spend money from its trust fund in 2028, and by 2042 the trust fund will be exhausted. Once the trust fund is exhausted the SSA will either have to cut benefits or increase payroll taxes.

2.1.2 Disability Insurance

DI covers people who are unable to continue employment because of a physical disability. In 2005 its expenses were $88 billion. It received $86 billion in payroll taxes and $10 billion in interest from its trust fund, which is worth $185 billion. SSA projections show that DI will begin spending money from its trust fund in 2013, and by 2025 the trust fund will be exhausted.

2.2 Medicare

Medicare was enacted in 1965 to provide medical insurance for retirees. In 2006 Medicare spent $382 billion+ on its 43 million beneficiaries (roughly $9000 per person).[5]

Medicare is already the nation’s largest purchaser of health care services, and is projected to increase spending far more rapidly than SS due to the rising cost of health care. Medicare is actually composed of two completely separate pieces, Hospital Insurance (HI) and Supplementary Medical Insurance (SMI).

2.2.1 Hospital Insurance

The HI portion of Medicare mainly covers inpatient hospital visits, but it also covers other types of care in medical facilities. HI is funded much like the SS programs in that expenses are covered primarily by payroll taxes, although a small trust fund also generates interest. In 2005, HI had $186 billion in expenses with income from payroll taxes at $181 billion and trust fund interest at $15 billion.

HI is the least stable retiree benefit program. It will begin spending its trust fund before 2010, with a projected depletion in 2018.[6]

2.2.2 Supplementary Medical Insurance

SMI covers most aspects of health care not included in the HI program like outpatient hospital visits, prescription drugs, lab tests, therapy, etc. SMI is funded in a completely different manner from HI and the SS programs. SMI receives its income from patient premiums* and from the US Treasury Department. Essentially, the Federal government must meet SMI’s projected budget every fiscal year using money from general income taxes. In 2006 SMI had expenses of $199 billion that were offset by $43 billion in premiums.[7]

SMI can be considered a stable system in that it has a guaranteed source of funding for the indefinite future (i.e. US taxpayers). However, its costs are rising faster than any of the above mentioned programs, and it will place a serious burden on American taxpayers in the coming years.

3. Future Projections

In 2006 the Federal Budget was approximately $2,570 billion.[8] Of that sum, roughly $870 billion+ was spent on Social Security and Medicare alone, representing 34% of Federal spending. However, the Federal government only received $2,180 billion in 2006. It borrowed the remainder by selling US Treasury bonds, mainly to overseas investors. If Social Security and Medicare spending are calculated as a percentage of actual income, they account for 40% of Federal spending. Either way, these two programs are major expenses that are increasing every year.

According to the White House Office of Management and Budget, the Federal budget should increase by around 3% a year.[9] Assuming this is the case, by 2015 the Federal budget will be roughly $3,500 billion. According to the SSA, by 2015 Social Security and Medicare are projected to cost a combined $1,780 billion, which will make up over 50% of the Federal budget.[10]
3.1 Future Projections to 2015 by Individual Program[11]

OASI will increase by 70% between 2006 and 2015, when its expenses will be $803 billion. DI will increase by 62.5% in the same time period, and will cost $159 billion in 2015. OASI will be able to fund itself through payroll taxes, but DI will have to begin spending its trust fund in 2013.

While Social Security will continue to be more expensive than Medicare until 2028, Medicare’s costs will increase far more rapidly. The expenses incurred by HI will increase 80% between 2006 and 2015 to $363 billion. It will begin using its trust fund in 2010, and in 2018 its trust fund will be depleted.

The costs of SMI will skyrocket by 300% in the same time period to $455 billion. This estimate is less accurate than the others because some of this will be offset by premiums, while an interesting “doughnut hole”* in President Bush’s prescription drug plan will likely be filled in, raising the costs significantly.

3.2 Long Term Projections

Social Security and Medicare are both required to generate 75 year projections. While trying to forecast that far into the future is highly imprecise, it does reveal some seriously problematic underlying trends. If Social Security and Medicare continue on their current course, there is a $21 trillion dollar difference between expenses and revenue over a 75 year period.[12] This amounts to roughly 50% of the entire value of the US economy, and comes out to $70,000 for every American alive today.

According to the Long Term Budget Outlook published by the US General Accounting Office (GAO), in 2000 Social Security and Medicare spending equaled roughly 7% of the nation’s GDP. By 2080, these two programs alone will equal 20% of GDP, a highly untenable number.[13]

The same report points out that the US government has roughly $50 trillion in unfunded liabilities on an infinite time horizon, meaning that it has promised to spend $50 trillion more than it has planned to make. Out of this $50 trillion liability, $6.4 trillion comes from Social Security and $32.4 trillion comes from Medicare.+ The report goes on to say that if spending continues as planned until 2040, balancing the budget will require the Federal government to either cut all spending by 40% or double taxes. To quote GAO comptroller David Walker, “If these numbers are making your head spin, don’t worry; just remember they are all big, and they are all bad.”[14]

This graph consolidates the data presented in the previous pages.

Figures in Billions

5. Conclusion

Maintaining the solvency of Social Security and Medicare is one of the greatest economic, social, and political problems facing the US. Essentially, the federal government has three options for giving these programs financial stability: decreasing benefits, raising taxes, or cutting other programs.

A dramatic reduction in benefits is very unlikely in the short term. Social Security is single-handedly responsible for keeping most of America’s senior citizens above the poverty line. Furthermore, more than half of working Americans who have been paying taxes their whole lives have no retirement plan outside of Social Security. It would be morally irresponsible and politically impossible to cut their benefits. With respect to Medicare, health care costs for seniors are beyond the reach of even wealthy Americans. Without government assistance many retirees would be unable to get any health care at all.

Raising taxes offers a more feasible option, although it too presents very real political and economic difficulties. From a political standpoint, raising taxes is never popular. With many Americans already paying more in payroll taxes than income taxes,[15] the will to increase taxes simply does not presently exist. However, when faced with a choice of higher taxes or starving seniors, the country will most likely choose higher taxes. From an economic standpoint raising taxes would likely damage the economy. With enormously high household debt most Americans cannot afford to have less take-home pay. Higher taxes would also lower consumption, creating more unemployment. However, the money taken in taxes would be reinvested into the economy primarily in the health care sector, which would offset losses in other areas.

Cutting non-benefit programs is also a likely solution. Senior citizens have the highest voter turnout of any age demographic, and are more likely to vote as a block. If politicians are forced to choose between cutting programs for seniors or programs for other age groups, they will likely protect the group that keeps them in office.

There is no quick fix to this dilemma. The most likely solution will be some combination of all three options listed above, the extent and severity of each depending on future political and economic conditions. The future of retirement benefit programs affects every American in a very personal way, one can only hope that both politicians and average citizens will have the will to look at the issues in a clearheaded fashion and do what needs to be done.

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