Special Report

Entitlement Reform, Not Tax Increases

Washington conservatives are settling for Social Security and Medicare reforms modeled on the first President Bush's memorable 1990 budget deal.

By 5.28.08

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On March 31, the Brookings Heritage Fiscal Seminar, a joint project of the Heritage Foundation and the Brookings Institution, issued a paper at an event at the National Press Club. The paper sported 16 co-authors, with the most prominent conservative being Heritage Foundation Vice-President for Domestic Policy Stuart Butler. Other prominent co-authors included former CBO Directors Alice Rivlin, Robert Reischauer, and Rudolph Penner, Isabel Sawhill of the Brookings Institution, Progressive Policy Institute President Will Marshall, and Eugene Steuerle of the Urban Institute. The event was co-sponsored by Heritage and Brookings, with Stuart Butler as co-organizer.

The paper was entitled "Taking Back Our Fiscal Future." Its 16 co-authors "have been meeting informally for over a year, under the auspices of the Brookings Institution and the Heritage Foundation."

The paper begins by defining the problem to be addressed as "Unsustainable deficits in the federal budget" that "threaten the health and vigor of the American economy." It also states upfront, "The first step toward establishing budget responsibility is to reform the budget decision process so that the major drivers of escalating deficits -- Social Security, Medicare, and Medicaid -- are no longer on autopilot." (Emphasis added.)

But from a conservative and free market perspective, future deficits are not the real fiscal problem facing the country. From this perspective, a budget with Federal spending at 15% of GDP, and a deficit of 3% of GDP, is far preferable to a balanced budget with Federal spending at 35% of GDP. To conservatives, the real problem is runaway big government and massive federal spending growth.

Current official U.S. government projections show that without fundamental reforms, federal spending will soar over the next three decades from 20% of GDP today, where it has been relatively stable for over 50 years now, to close to 40% of GDP. The major drivers of this spending explosion are precisely the major entitlement programs -- Social Security, Medicare, and Medicaid.

If anything even close to that happens, limited government conservatives will have been completely routed. Add in state and local spending, and total government spending in America will be over 50% of GDP. America's highly successful heritage of free market capitalism will then have been replaced by Swedish socialism (which even the Swedes don't believe in anymore).

Whether the problem is defined as massive future Federal deficits, or massive, future runaway Federal spending, makes a fundamental difference. If the problem is future deficits, then the solution is finding a politically feasible combination of tax increases and benefit cuts, which is the actual goal of the authors of the Heritage-Brookings paper. But if the problem is runaway federal spending, then tax increases are not part of the solution. Tax increases would just support more federal spending, and so are part of the problem. The solution is to promote fundamental reforms that would restructure these programs from the bottom up to create new, modernized programs that would actually serve the public far better than the current, outdated, 19th-century structures, while costing the government only a fraction of the cost of the current programs.

An Automatic Tax Increase Trigger
The co-authors of "Taking Back Our Fiscal Future" agree that the first step in countering the looming deficit explosion that concerns them is budget process reform. They recommend that "Congress and the president enact explicit long term budgets for Medicare, Medicaid and Social Security...." These entitlement budgets would be reviewed every five years. But the key budget reform recommendation is as follows:

The rules for the five-year review must include a trigger or action forcing device that requires explicit decisions when projected spending exceeds budgeted amounts. The trigger might involve automatic benefit cuts or revenue increases (including premium increases) that could only be overridden by an explicit vote or enactment of alternative policies that would achieve budget outcomes similar to the automatic adjustments. Alternatively, the trigger process could require that a commission make recommendations for closing the gap to the president and Congress on which an up or down vote must be held.

The paper then goes on to discuss various tax increase options. These include raising the payroll tax rate, or increasing the earnings subject to the payroll tax. Another option mentioned is "replacing or supplementing the payroll tax with a broad-based energy levy or other earmarked tax that would raise revenues." Still another option mentioned is to increase the taxation of Social Security benefits.

The paper also discusses benefit cut options that may also be included in any overall solution. Among these are delaying the retirement age, changing the basic benefit formula to reduce future promised Social Security benefits, means testing, and, under Medicare and Medicaid, reducing even more the fees paid to doctors and hospitals, increasing deductibles and co-payments, and raising premiums paid by retirees.

None of these benefit cut options would reduce future Federal spending by nearly as much as the fundamental, structural entitlement reforms discussed below. Moreover, these benefit cut options are all deeply unpopular, as are the tax increases, making the political feasibility of this entire reform approach doubtful. Most importantly, the great political unpopularity of the benefit cut options means none of them will ever be adopted without compromising with Big Government liberals for a tax increase, a huge tax increase. Enacting any of these benefit cuts would require bringing almost everyone in Washington along for political cover in a Grand Compromise including stiff tax increases as well as the benefit cuts.

Indeed, at the event at the National Press Club where the paper was released, Rudolph Penner explained more clearly the thinking of the 16 co-authors. He said that he hoped that the proposed budget process reforms "would lead to the kind of outcome preferred by this committee [the 16 co-authors] -- the 1990 budget deal." That was the deal where President George H.W. Bush broke his "Read my lips, no new taxes" pledge, which led to his defeat in 1992. That budget deal included a massive tax increase in return for spending reductions, which were soon erased in later budget years. The budget deficit, in fact, increased after that deal.

Even though another huge tax increase was enacted in 1993, the long string of budget deficits were actually not eliminated until Republican Congressional majorities were elected in 1994. President Clinton's budget proposal in January 1995 projected annual budget deficits continuing at about $200 billion for the next 10 years. The Gingrich led Congress cut taxes on savings and capital investment, producing an economic boom. Then they held down the growth of Federal spending, which along with robust revenues produced by the growing economy, turned the $200 billion annual deficits into $200 billion annual surpluses.

Another co-author of the paper, Ron Haskins of the Brookings Institution, published a commentary in the Washington Times on April 7, along with former Congressman Bill Frenzel, that further explained the thinking of the 16 co-authors. Haskins and Frenzel explained the proposal of the gang of 16 as follows:

Specifically, they proposed that: (1) Congress and the President enact 30 year budgets for Social Security, Medicare, and Medicaid; (2) Congress review the budgets every five years; and (3) automatic program cuts or revenue increases be triggered if projected spending exceeds the budget.

The two co-authors described the expected effect of this proposal as follows:
The second effect of the trigger proposal will then kick in. Congress and the President will realize they cannot achieve a 30-year sustainable budget for Social Security, Medicare and Medicaid by simply reducing benefits. Rather, the solution will require a combination of benefit cuts and revenue increases.

Obviously, if this reform approach ever does amount to anything, it will lead to an enormous, historic, tax increase, ramping up our Federal government several notches to new realms of glory. In particular, when the alternative is benefit cuts for retirees, sick people, and sick old people, the issue is framed very poorly for avoiding tax increases.
Those responsible for leading us to this obvious result must be held accountable if and when it occurs. No one deputized Stuart Butler, or the Heritage Foundation, to negotiate a tax increase on behalf of the conservative movement.

Entitlement Reform Without Tax Increases
To achieve successful, positive, entitlement reform, again we must think outside the box of our current entitlement programs, and promote reforms that thoroughly restructure and modernize these programs, rather than packages of tax increases and benefit cuts. The key is to bring in much greater roles for highly productive modern capital and labor markets to serve the goals of these programs. Reformers have to recognize that voters are going to insist upon sturdy safety nets remaining in place. But with positive, pro-growth, structural reforms and the broad benefits of capital and labor markets, we could maintain such safety nets and actually serve the beneficiaries and the social goals of these programs far better, with far less in government spending.

Those reforms would consequently not only be politically feasible, but potentially quite popular. This is where conservatives and free market advocates should be focusing their energies.

One key concept for such positive, structural, entitlement reform is personal accounts for Social Security, where workers would be free to choose to substitute savings and investment accounts for at least part of the current system. These accounts are especially powerful in reducing government spending because they don't just trim the growth of such spending. They would shift huge chunks of it from the public to the private sector, dramatically reducing Federal spending over the long run.

The accounts can start at any size, and then can be expanded over time until workers can choose to substitute the accounts for all of their Social Security retirement benefits. The accounts could be expanded further, eventually substituting private life insurance for Social Security survivors' benefits, and private disability insurance for Social Security disability benefits. Eventually, the accounts could be expanded to cover the payroll taxes for Medicare, with the saved funds financing annual annuity benefits that would be used to purchase private health insurance in retirement. Such fully expanded accounts would reduce Federal spending by about 9% of GDP, as the personal accounts replace this spending with market-financed benefits. Such spending reductions would involve an unprecedented, historic achievement.

In the process, the payroll tax would ultimately be phased out completely, and replaced with an engine of personal family wealth in the personal accounts. Workers would get much better benefits through these accounts because market investment returns are so much higher than what the non-invested, purely redistributive, Social Security system can even promise, let alone what it can pay. Workers across the board would accumulate several hundred thousand dollars in real terms by retirement, directly owned by each worker, which can be left to the family at death. This would do far more to reduce inequality than anything else, yet do so in a way that reinforces rather than undermines the economy. Indeed, done right, such reform would produce an historic breakthrough in the personal prosperity of working people.

The bill introduced in the last Congress by Rep. Paul Ryan (R-WI) and Senator John Sununu (R-NH) serves as a comprehensive model of how to structure such accounts, with substantial input from the Social Security Administration itself and from experienced Wall Street fund administrators on how to make the concept workable. That bill also maintained the current social safety net in full, by including a federal guarantee that if any retiree's account cannot pay at least what Social Security would under current law, the federal government would pay the difference.

Block Grant Welfare to the States
A second key concept for positive, structural entitlement reform is block grants back to the states for the remaining Federal welfare programs. Legislation enacted in 1996 block granted the old Aid to Families with Dependent Children (AFDC) program back to the states. The share of Federal spending on this program was returned to each state in a block grant to be used in a new program designed by the state based on mandatory work for the able bodied. The key is that the block grant is finite, not matching, so it does not vary with the amount the state spends. If the state spends more, it must pay for the extra costs itself. If the state spends less, it can keep the savings.

The reform was shockingly successful, with the old AFDC rolls reduced by close to 60% nationwide, close to 80% in states that pushed work most aggressively. Requiring able-bodied recipients to work for their benefits eliminates the old welfare work disincentives. But probably even more important are the reversed incentives for state administrators. Previously, the Feds matched increased state spending, so each new welfare dependent signed up brought more federal funds to the state. But with the state now paying all added costs, the focus has changed to getting recipients out to work.

These same reforms should now be extended to the other Federal welfare programs, particularly budget busting Medicaid. Even if the reform allowed each state to keep all of its savings from greater flexibility, positive incentives, and reduced rolls, and Federal spending on the block grants was just not increased, the reform would save the Federal government a trillion dollars over the first 10 years.

Such block grant reforms should be expanded to Food Stamps, Federal housing assistance programs, and other, smaller Federal welfare programs as well. The new state programs created with these block grant funds can be focused on getting beneficiaries into real, private sector jobs, market health insurance, and ultimately even home ownership. The result would be a much better overall safety net system for the poor, providing a new, historic opportunity to end poverty.

Instead of supporting reform commissions composed of Washington insiders with no ideas, or budget process reforms with automatic tax increase triggers, conservative reformers should be working directly for the above fundamental entitlement reforms, which would dramatically reduce Big Government, while still appealing broadly to the general public.

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About the Author
Peter Ferrara is Director of Entitlement and Budget Policy at the Heartland Institute, General Counsel of the American Civil Rights Union, Senior Fellow at the National Center for Policy Analysis, and Senior Policy Advisor on Entitlements and Budget Policy at the National Tax Limitation Foundation. He served in the White House Office of Policy Development under President Reagan, and as Associate Deputy Attorney General of the United States under President George H.W. Bush.