Fiscal Child Abuse American Style
President Kennedy said, “Our problems are man-made. Therefore, they may be solved by man.” Looking at America’s current horrendous fiscal situation, one might well add, “Man’s solutions have become his problems.” Indeed, many of our problems today can be described as cases of catastrophic success, where we have identified a major problem and fixed it. But, in doing so, produced a different and, potentially, much worse problem than originally existed.
Our most disastrous success has been turning retirement into a well-paid, long-term occupation. We have done this by trying to do right by our elders – by expending ever-larger sums each year in Social Security, Medicare, and Medicaid benefits to keep them healthy and financially secure. These sums are now huge, amounting to more than $30,000 per oldster per year. That is three fourths of annual U.S. per capita income. In the process, we have done terrible wrong by our children, grandchildren, and great grandchildren. We have saddled them with massive government bills to pay for this largess. These bills stretch from here to eternity. The bills are far beyond their capacity, just as they are far beyond our own capacity—and will—to pay.
The United States Is Bankrupt
When individuals can not pay their bills, they are bankrupt. When companies can not pay their bills, they are bankrupt. And when countries– even those that print their own money and can still get foreigners to accept it—can not pay their bills, they are bankrupt. Thanks to six decades of running an ever-larger Ponzi scheme, one can safely declare: The United States is bankrupt.
And the United States is not bankrupt 10, 30, or 50 years from now. It is bankrupt right now. Indeed, the U.S. is, arguably, in worse fiscal shape than any developed country in the world.
You will not learn this by looking at our nation’s official debt.1 Our 73 percent debt-to-GDP ratio is lower than that of any of the BIGPIS countries (Belgium, Italy, Greece, Portugal, Ireland, and Spain). Actually, it’s less than half of Greece’ ratio, which is supposedly in the hottest water.2 Unfortunately, our $11 trillion official debt is but a small fraction of our nation’s true $222 trillion net indebtedness, known as the fiscal gap!
Yes, you read that number right. Our fiscal gap – the value in the present (the present value) of all our future spending obligations (including servicing the official debt) net of all our future tax receipts is simply enormous. It is 15 times our nation’s GDP. It is 20 times the official debt that now has everyone’s attention.
“The U.S. is arguably in worse fiscal shape than any developed country in the world. Our $11 trillion official debt is but a small fraction of our nation’s true $222 trillion net indebtedness, known as the fiscal gap!”
Doing Madoff Proud
Since the fiscal gap equals $222 trillion and the official debt equals $11 trillion, it is clear that our unofficial I.O.U.s – our unofficial spending commitments — overwhelm our official ones. Worse, they are growing rapidly. Yet these unofficial liabilities have been carefully kept off the government’s books via a system of duplicitous accounting that goes far beyond Enron’s and Madoff’s wildest dreams. That is why most people know little or nothing about the true size of our problem.
The trick used is remarkably simple, namely use the words “taxes” and “future transfer payments” instead of “borrowing” and “future repayment of principal plus interest.” For example, this year almost 6 percent of GDP will be collected from workers and labeled “payroll taxes.” But these payroll taxes come with future benefit commitments. Now, supposed we label these receipts, not “payroll taxes,” but “government borrowing,” and label a portion of Social Security and Medicare the benefits today’s workers will receive when they are, say, 75, as “return of principal plus interest” on this “borrowing.” With this equally valid choice of words, our official accounts record smaller taxes – 6 percent of GDP smaller — received now. And, voila, this year’s federal deficit is not $1.3 trillion, but $2.2 trillion!
“The economic reality is that America’s “unofficial” I.O.U.s represent senior claims on Uncle Sam. Our seniors exercise tremendous political clout in ensuring they get what’s “owed” them. This includes demanding that their benefits be fully adjusted for inflation.”
No economist worth their salt will be able to tell you whether this year’s deficit is really $1.3 trillion or $2.2 trillion or, for that matter, -$10.9 trillion or any other number you would like it to be; since language is flexible, we can choose labels to produce any reported size deficit or surplus we want. For example, we could claim that the 6 percent of GDP that has been collected as “payroll taxes” is really 25 percent of GDP collected as “payroll taxes” with 19 percent of GDP being lent back to the self-same taxpayers. The reason that no economist can tell you what “the” deficit is is that economic theory does not pin down the deficit. On the contrary, economic theory tells us that the deficit is a linguistic construct with no inherent economic content. Stated differently, the equations of economic models with rational agents (but not necessarily well functioning markets) do not uniquely determine “the” deficit, just as the equations of physics do not uniquely determine “the” current time or “the” current length of any object. Like physics, economics suffers from a relativity problem, which is referred to as economics labeling problem.
One might claim that our unofficial I.O.U.s aren’t legal and, therefore, are not as real as our official ones. Economics is about economics, not legalities. And the economic reality is that America’s “unofficial” I.O.U.s represent senior claims on Uncle Sam because the claimants are, to a large extent, seniors. And our seniors exercise tremendous political clout in ensuring they get what’s “owed” them. This includes demanding that their benefits be fully adjusted for inflation.
Compared to cutting, say, the Social Security benefits of today’s retirees, Uncle Sam can de facto on its official debt by paying interest and principal with freshly printed money, i.e., by generating inflation. Indeed, the Federal Reserve’s recent massive increase in money creation suggests this is precisely what Uncle Sam intends to do although their announced intention has been to save the economy. Yes, the Chinese and other foreigners who hold half of all U.S. Treasury bills and bonds as well as the American citizens holding the rest will get paid each and every dollar owed. But they will be, most likely, paid back in watered-down dollars and be none to happy.
Living Beyond Our Children’s Means
For those used to looking at long-term fiscal projections, our looming fiscal debacle is not news. What is news is that it can no longer be ignored, that it has gotten dramatically worse, and that it could easily touch off a financial collapse that would make 2008 look tame.
Bankruptcy is always in the eye of the creditor. So far, U.S. creditors seem to be blind to what is coming. One reason, as indicated earlier, is that they focus on our country’s official debt relative to its GDP, thinking this actually says something about a country’s fiscal condition. One consequence is distraction: the financial wolves are circling small countries with high debt-to-GDP ratios, forcing those countries to borrow at high interest rates. Uncle Sam remains a preferred customer and pays at far lower rates.
America’s creditors should think again. Virtually all of Uncle Sam’s I.O.U.s are off the books. They are unofficial, informal, implicit, hidden away in odd places like an alcoholic’s bottles. But call them what you will, paying 78 million baby boomers their Social Security, Medicaid, and Medicare benefits are very real obligations.
To get a feeling for how large these bills are going to be, recall that we are now paying $30,000, on average, per oldster per year in Social Security, Medicare, and Medicaid benefits. In twenty years, when the baby boomers are fully retired and today’s newborns are just entering the labor market, the average benefit will equal at least $40,000, measured in today’s dollars. The total cost of these three programs will equal roughly 15.5 percent of GDP in 2032.3 To put 15.5 percent of GDP in perspective, the CBO projects total revenues in 2030 will equal 18.5 percent of GDP. Hence, the CBO is telling us that expenditures on less than a quarter of the population will absorb 84 percent of the government’s tax take!
Doing Ponzi Proud
The $30,000 combined Social Security, Medicare, and Medicaid payment being handed, on average, to each of today’s elderly equals almost two thirds of per capita GDP. When the boomers are fully retired, the figure could exceed 100 percent of per capita GDP! Whoever said America isn’t a welfare state? It is a welfare state, but the welfare is for the elderly, not the poor and certainly not the young and unborn.
Allow us to ask a rude question: Is this fair? After all, many of today’s elderly are very poor. According to the Social Security Administration, for instance, 22 percent of married couples and 43 percent of single retirees depend on Social Security for at least 90 percent of their income.4 They also spent their entire working lives contributing FICA taxes to Social Security and Medicare and paying regular income taxes to support Medicaid. These payments could just as well have been saved and invested in the market and might have produced more income than the three programs provide in cash and in-kind healthcare benefits.
The first part of this last sentence— that they could have saved and invested— is true. The second part— that the savings might have produced more in benefits— is not. To date, successive generations of elderly have received more, or far more, from these programs than their accumulated past tax contributions.
This should come as no surprise. One postwar Administration after another, from President Eisenhower to President Obama, has expanded these programs’ benefits without asking retirees to pay for what they received. So who gets the bill? You guessed it, the next generation, the best people to tax because they have no representation.
The most recent example is the introduction of Medicare Part D – the prescription drug benefit initiated by President George Walker Bush. This new benefit, which started paying out in 2006, provides the elderly, on average, with over $1,500 per year.5 Not a single older person, including senior billionaires like Warren Buffett, has been asked to pay a penny more in taxes to help defray the program’s $16 trillion present value unfunded liability.6 This fact did not bypass David Walker, former Comptroller General of the General Accountability Office (GAO). Walker described the enactment of Medicare Part D as “probably the most fiscally irresponsible piece of legislation since the 1960s.”
Unfortunately, Medicare Part D was only part of President Bush’s no child left without a legacy of debt policy. At the same time he also massively expanded his intergenerational transfer by cutting taxes, including capital gains and dividend tax rates. These are taxes paid primarily by the elderly. The elderly are the ones who hold most of the country’s wealth. A regular examination of the distribution of wealth based on the Survey of Consumer Finance, for instance, shows that households in their 60s have about 5 times the net worth of households in their 30s.7 While household wealth tends to decline after the 60s, households 80 and over routinely have more wealth than households in their 20s, 30s, or 40s.
In 2003, the fiscal gap was $60 trillion. By 2007, it was $175 trillion. To repeat, today it is $222 trillion. Hence, President Bush has quite a track record when it comes to encumbering America’s progeny and destroying the American dream, but his successor, President Obama, has done nothing to stop the gap’s relentless growth.
“The $30,000 combined Social Security, Medicare, and Medicaid payment being handed, on average, to each of today’s elderly equals almost 2/3 of per capita GDP. When the baby boomers are fully retired, the figure could exceed 100% of per capita GDP!”
In the last year alone, the fiscal gap grew by $11 trillion, which is roughly as large as all the debt in the hands of the public. Most of this growth reflects the fact that we are one year closer to having to pay the baby boomers their massive benefits, so the present value of the obligation is larger. Stated differently, the fiscal gap is our country’s credit card bill, and like every credit card bill, if you do not pay the interest, it grows. We are not paying the interest.
What Goes Around, Comes Around
As long as they are alive, all the living presidents and their underlings should have real trouble looking their grandchildren in the eye. In giving the elderly so much more in benefits and taking so much less from them, our presidents have left their own descendants—and everyone else’s—to pay for their largess. Like the proverbial traveling salesman who leaves the farmers’ daughter, many of the current elderly will not be around when taxes are ultimately raised to pay these bills. It appears that those in power, regardless of party, have taken an old Irish saying to heart: “Only a fool would die solvent.”
When Ben Franklin said the only guarantees in life are death and taxes, he got it only half right. In postwar America, death lets each generation pass the generational buck. Each generation leaves much of its fair share of taxes for future generations to pay.
In taking from the young and giving to the old, year after year, decade after decade, in ever-larger sums, Uncle Sam has, in fact, run a massive Ponzi scheme. And he has sold his chain letter to the young with reassuring words that Charles Ponzi or Bernie Madoff might use —
“Not to worry. Every dollar you hand over now will be repaid many times over when you hit retirement and collect the terrific benefits I’ve promised you.”
Of course, our fiscal system does not sell explicit chain letters to current working generations that they can sell when old to their own children, or, if need be, force them to buy. But the effect is the same. The most pernicious aspect of this generational Ponzi scheme is that it leaves every generation in a position of deniability.
Who says I’m getting back more than I put in? I worked my whole life and paid taxes year in and year out and, let me tell you, they were a lot of taxes and now you are claiming these benefits for which I sweated bricks aren’t mine, fair and square. Prove it!
Proving anything to anyone is not easy. But convincing someone that her lifetime benefits have, or will, far exceed her lifetime taxes requires an understanding of actuarial analysis on behalf of both the convincer and the convincee. Last we checked, almost all those over 45, i.e., those on the receiving end of Uncle Sam’s great Ponzi scheme, have not had actuarial training. They are not planning to get it, either.
Paying off the fiscal gap with taxes requires an immediate and permanent 64 percent hike in all federal taxes!
We’re talking federal personal income taxes, federal payroll (FICA) taxes (both employer and employee), federal corporate income taxes, federal excise taxes, and federal estate and gift taxes. Revenues from all of these taxes would have to be 1.64 times higher than what is now forecast in every future year starting this year to generate $202 trillion in present value.
Can’t handle a new payment that high? We were afraid of that. The alternative is find the money for the Solvent America by spending less on other things, just as some young men give up food, clothing, and rent to make payments on a new Corvette. This is called balancing the government’s intertemporal budget via spending cuts. But just as the tax hikes are gigantic, the requisite spending cuts are also enormous.
Paying off the fiscal gap via spending cuts requires an immediate and permanent 40 percent reduction in all federal non-interest expenditures!
Social Security, Medicaid, Medicaid, food stamps, and health exchange subsidies, gas for Air Force 1, the President’s lunch, Eisenhower Class nuclear submarines, Supreme Court Justices’ salaries, and the CIA’s budget – you name it. They would all have to be cut by two fifths.
“What if we do not immediately raise taxes by 64 percent or cut spending by 40 percent? What if we wait 20 years to change policy? Then these two figures become 77 percent
and 46 percent, respectively.”
The Zero-Sum Generational Game
What if we do not immediately raise taxes by 64 percent or cut spending by 40 percent? What if we wait 20 years to change policy? Then these two figures become 77 percent and 46 percent, respectively. And if we wait 40 years, until all the baby boomers have safely taken their leave, the requisite permanent tax hikes and spending cuts are 93 percent and 53 percent. In Maine, they call this a “Can’t get there from here” problem. Thus, the longer we wait to address the problem, the larger the bill we force our children and grandchildren to pay. Either they will pay higher taxes or they will have lower benefits. Whatever they choose, they are getting the short end of the stick. This is the awful zero-sum nature of our generational dilemma and the moral challenge of our day.
Maybe we have missed something, but we have yet to hear any politician advocate raising all taxes by almost two thirds for, well, forever. Nor have we heard any politicians advocate a 40 percent immediate and permanent cut in federal outlays.
On the contrary, Republicans want to cut taxes and Democrats want to increase spending. Both groups are engaged in what President George Herbert Bush called voodoo economics. Republican supply siders are sure that every federal tax would produce more revenue – if only it were cut. We think setting all tax rates to zero and forcing Republicans to announce each day’s tax collections would change their tune, but maybe not.
Democrat demand siders are equally subject to magical thinking. They believe that raising federal spending—even if it entails paying people to dig ditches and fill them back up—will stimulate the economy so much it will pay for itself via extra taxes. We think providing all Americans a year’s free vacation and forcing Democrats to provide daily revenue reports would alter their thinking, but who knows.
In the dream world of our political parties, their favorite action always “pays for itself.” Republicans buy votes by reducing taxes and claiming they pay for themselves. Democrats buy votes by spending money and calling it an “investment.” Setting just one set of these loonies loose on the economy would be damaging enough, but in recent years we have opened the asylum. We have watched them combine forces to both raise spending and cut tax rates. The bill goes to the kids. Conveniently, they are never in the room.
Unfortunately, we can not pay our bills by collecting less money to pay them. We can not pay our bills by making them bigger, either. Members of Congress and the Administration might check with fourth graders on this.
“There are simple, radical solutions to our fiscal problems that treat all generations and households within each generation fairly. We call them The Purple Plans because they are designed to appeal to both red Republicans and blue Democrats.”
The last decade’s experience is no outlier. There is no convincing evidence from any period in U.S. economic history that cutting tax rates per se (as opposed to changing the tax structure) will grow the economy by enough to generate more revenue, let alone 64 percent more revenue than is now forecast. Nor is there any convincing historical evidence that increasing spending will more than pay for itself.
On the contrary, standard economic growth models, even those in which households respond strongly to work and saving incentives, show that income tax cuts and spending hikes of the type we’ve been enacting will reduce rather than increase revenues and simultaneously wreak havoc on national saving, investment, economic growth, and real wages. We will document this, shortly.8
“There is no convincing evidence from any period in U.S. economic history that cutting tax rates per se will grow the economy by enough to generate more revenue”
Oh, And By the Way
Uncle Sam is not the only government in our country that is utterly broke. It is just the biggest. The state and local governments are also in very bad shape. According to the Government Accountability Office, state and local governments face a massive long-term fiscal gap. Closing their fiscal gap would require an immediate and permanent 12.3 percent cut in expenditures or a roughly equivalent immediate and permanent hike in state and local taxes.9 As a present value, the state and local fiscal gap appears to total some $38 trillion, bringing the U.S. total federal plus state and local fiscal gap to $260 trillion!
The Way Forward
As we discuss in our recent book, The Clash of Generations, there are simple, radical solutions to our fiscal problems that treat all generations and households within each generation fairly. We call them The Purple Plans because they are designed to appeal to both red Republicans and blue Democrats, or at least those members of the two parties who still cherish the American dream.
The plans are described in brief at www.thepurpleplans.org, and those who wish to can endorse whichever of the plans they like. The plans would make big changes to how we deliver healthcare and Social Security. They would also dramatically alter tax, banking, and energy policy. But make no mistake. Uncle Sam is on the operating table in dire need of open-heart surgery. Such surgery is called “radical,” but applying band-aids to Uncle Sam, given his condition, represents a death sentence and a radical mistake.
The article draws heavily on the book: The Clash of Generations: Saving Ourselves, Our Kids, and Our Economy , by Laurence J. Kotlikoff and Scott Burns, Published by the MIT Press. © 2012. Massachusetts Institute of Technology. All rights reserved.
About the authors
Laurence J. Kotlikoff is a William Fairfield Warren Professor at Boston University, a Professor of Economics at Boston University, a Fellow of the American Academy of Arts and Sciences, a Fellow of the Econometric Society, a Research Associate of the National Bureau of Economic Research, and President of Economic Security Planning, Inc., a company specializing in financial planning software. An active columnist, Professor Kotlikoff’s columns and blogs appear in the Financial Times, Bloomberg, Forbes, Vox, the Economist, Yahoo.com, and the Huffington Post.
Scott Burns is a newspaper columnist and author who has covered personal finance and investments for over 30 years. Today, he ranks as one of the five most widely read personal finance writers in the country, according to The Dallas Morning News. He is best known for creating the “Couch Potato Portfolio” investment strategy, which advocates the use of index funds over managed funds or stock-picking.In 2006, he co-founded the Web startup AssetBuilder, where he serves as chief investment strategist.
1. This references debt held by the public.
2. Financial Times, November 19, 2010, p.3.
3. These figures are calculated based on the CBO’s Alternative Fiscal Scenario projection and the U.S. Census’ population projection. The $30,000 and $50,000 figures do not include Social Security, Medicare, or Medicaid benefits paid to those under 65. They also exclude Medicaid payments made to those over 65 by state governments. The source for the CBO assumptions is http://www.cbo.gov/ ftpdocs/115xx/doc11579/06-30-LTBO.pdf. The CBO projections are posted at http://www.cbo.gov/ftpdocs/115xx/doc11579/LTBO- 2010data.xls.
6. http://www.cbsnews.com/stories/2007/03/01/60minutes/ main2528226_page2.shtml?tag=contentMain;contentBody
7. http://assetbuilder.com/blogs/scott_burns/archive/2006/08/13/ Yes_2C00_-the-Rich-Have-_2800_Still_2900_-More-Money.aspx
8. See Auerbach, Alan J. and Laurence J. Kotlikoff, Dynamic Fiscal Policy, Cambridge, England: Cambridge University Press, 1987. http://www.kotlikoff.net/content/dynamic-fiscal-policy
9. http://www.gao.gov/new.items/d10358.pdf, p.8.