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Reviewing the Ryan Budget (Part 1)

e21 | 08/14/2012
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The addition of Representative Paul Ryan to the Presidential campaign has generated a large volume of media coverage concerning the budget he proposed as Chairman of the House Budget Committee. Chairman Ryan has proposed transforming Medicare and Medicaid and placing fiscal policy on a path to eliminate the outstanding stock of federal debt. Proposals as ambitious as Chairman Ryan’s naturally generate discussion. At a time of the year when elected officials generally try and obscure the enormity of current fiscal challenges, a budget as comprehensive as Chairman Ryan’s can be jarring and easily mischaracterized. Given this context, it is important to evaluate the proposals with the following three points in mind:

(1) The so-called radicalism of the Path to Prosperity merely reflects the radical imbalance of the U.S. budget situation. Critics who characterize Chairman Ryan’s budget reforms as “radical” leave the mistaken impression that small changes are all that’s necessary to close the current fiscal gap. In truth, the Ryan proposal represents the absolute least policymakers would have to do to close the long-run budget gap without raising taxes above the post-war average. Anyone who describes the Ryan budget as “radical” is either deluding themselves about the size of current entitlement commitments or thinks a sustained tax burden 50% larger than any previously recorded in U.S. history is a more natural state of affairs.

The fiscal crisis has two dimensions: (1) the current fiscal gap, which reflects current spending in excess of tax revenue; and (2) an age-related spending gap that reflects the size of unfunded liabilities net of available revenues. The current U.S. deficit is 8% of GDP. This $1.2 trillion gap between spending and revenues partially reflects the rise in baby boomer retirement since 2008, but is mainly the result of deliberate policy choices to run large deficits in the hopes of stimulating the economy. Due largely to the euro crisis and rising interest rates, the current fiscal gap is much larger in the U.S. than it is in Europe (with the exception of the U.K., which has retained its own currency). As shown in Table 1, to keep the public debt at a sustainable level, the U.S. fiscal policy would have to be tightened by 10.85% of GDP between 2011 and 2020. This would mean policies would have to be changed to generate an additional $2.4 trillion of annual spending cuts or tax increases by 2020.

Yet, amazingly, this does not include the added age-related spending gap caused by demographic changes. When these shifts are included, the total adjustment necessary by 2030 is 17.62% of GDP, or nearly $4 trillion of annual tax increases or spending cuts in 2020 dollars. Despite a somewhat better demographic profile, the U.S. age-related spending gap is actually much larger than those of Europe. The U.S. retiree benefits are more generous than Europe’s (i.e. the average retiree receives $35,000 per year in pension and health care benefits), while pre-retirement social spending is much lower in the U.S. than in Europe’s so-called cradle-to-grave welfare system. Thus, aging has a greater marginal impact on the U.S. fiscal situation. For countries like Italy and Sweden that undertook pension reforms, the age-related adjustment is actually negative, as the system moves more towards balance through time. As the IMF explains:

Italy long ago embarked on widespread reforms of its entitlement programs, which has increased the nation’s ability to pay for them, but the United States has yet to change mandatory spending in ways that are conducive to fiscal solvency.

In a sense, then, the United States and Italy find themselves not just in different stages of the aging process but also in different phases of the solution to the problems aging brings. In the United States, aging issues (including rapid growth in health care costs) are expected to have their heaviest impact on future deficits. Italy, on the other hand, is already in the thick of things. Age-related spending in Italy is expected to stabilize in the short and medium term, about the time the United States should see its costs exploding.

Is it radical for Chairman Ryan to propose reducing future U.S. indebtedness to Italian levels? Is it wrong for him to want to start the process now, given that the acceleration in costs occurs between now and 2025?

(2) Health Care costs depend on demand and utilization. A key component of Chairman Ryan’s budget is the transformation of Medicare into a premium support program. Medicare faces two challenges: (1) the number of beneficiaries is expected to increase by nearly 20 million over the next ten years (37% growth); and (2) the net cost (after deducting premiums) per beneficiary is expected to rise by $3,400 per year (34% growth). The Ryan budget would cap the growth rate in the net cost per beneficiary by moving away from the inefficiency of the current fee-for-service program and replacing it with inflation-adjusted premium support model.

Critics contend that if health care costs grow faster than inflation, this program will simply push more of the costs of health care onto seniors. But evidence suggests that health care costs have been growing faster than inflation precisely because of fee-for-service Medicare. The introduction of Medicare can explain half of the increase in per capita health spending since 1965. The introduction of Medicare not only increased spending because of greater utilization (people with insurance consuming more health care), it also increased health spending by providing a new source of demand for medical services that encouraged hospitals and other health providers to incur the fixed costs associated with entering the market for new treatments. Expanded budgets also provided support for medical technology innovation, as firms were able to attract discretionary risk capital to invest in research to produce new medical technologies to sell to hospitals and health care practices.

The existence of Medicare creates a large, price inelastic purchaser for whatever new therapy can be developed. When someone else is footing the bill, a new technology is never too expensive to be justified given its cost. Over its first 25 years, Medicare grew at an annual rate that was nearly three times as fast as projected – largely because budget analysts could not predict all of the technological advances Medicare was partially responsible for bringing about. And, as economics Katherine Baicker and Amitabh Chandra explain, when Medicare “covers Provenge for prostate cancer (at a cost of over $90,000 for a few weeks of survival) or the latest cyclotron-based proton-beam therapy (an unproven treatment with a 120 million price tag requiring a football field sized accelerator), private insurers are likely to follow the coverage decision to avoid litigation where their patients claim that insurers are withholding valuable care.”

(3) The Government is not an exogenous source of purchasing power. The government’s ability to spend comes from its power to tax. There can be cross-sectional and intergenerational differences in the tax burden, but taxes must be imposed to cover outlays if a full-blown public financial crisis is to be avoided. The cost of retiree health care, for example, is therefore always borne by households; the policy question is which households will bear the cost and how the shifting of the cost burden impacts incentives. Talk of “pushing” the costs of education or health care onto households misses this point.

The costs of entitlement spending – including the interest payments on the $4 trillion of debt incurred in the past four years – cannot be financed through higher tax rates on “the rich.” The $80 billion of incremental revenue from increasing the top two tax brackets to their 2000 levels is about 5% of the fiscal adjustment required between now and 2020 to stabilize the debt ratio at 60% of GDP. The sad truth is that the longer Congress waits to address the debt problems, the more likely it is that retirees will see their benefits cut capriciously. Either future workers will have to endure tax burdens far in excess of those placed on previous generations, or their unwillingness to pay confiscatory tax rates will generate a public financial crisis that forces sudden retiree benefit cuts on an unprepared population. The call to “strengthen” Medicare by reducing or controlling its promises may seem oxymoronic to progressives, but those who recognize that Medicare’s promises are bounded by the government’s future tax revenue realize that a stronger program is also one that its beneficiaries can count on to be there.

Coming soon from e21: Part 2 -- Further details of the Ryan plan.


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