Economist sees peril in nation's long-term financial future

By David J. Craig

Five years ago, expanding Medicare benefits was the furthest thing from the minds of U.S. government officials. It was well known that the long-term solvency of the system was shaky; the only debate was whether or not draconian measures were required to fix it.

But now that the economy is booming, the stock market soaring, and the federal government projecting annual surpluses in the trillions of dollars over the next decade, attitudes seem to have changed. No presidential candidates have proposed serious Medicare or Social Security reforms, and last month the U.S. Senate set aside $20 billion in next year's budget for Bill Clinton's plan to add prescription drug benefits to Medicare.

According to Laurence Kotlikoff, a CAS professor of economics, the situation could hardly be worse.

"In the case of the prescription drug plan, we're talking about laying a major program on top of a system that is already fiscally unsustainable," says Kotlikoff, who recently lambasted the proposal in a study published by Third Millennium, a Generation X advocacy group. "Social Security and Medicare are in much worse shape than most people are aware, and our children are going to face a major financial disaster if we don't take care of it. Politicians, meanwhile, are pointing to the surplus and claiming that there's no problem. That's just not true."

Laurence Kotlikoff Photo by Kalman Zabarsky

Kotlikoff has been studying the long-term effects of fiscal policy for most of his 25-year career. By analyzing a host of demographic and financial variables, he determines how big a tax bill our descendants will inherit if current fiscal policy is maintained, and how large a tax hike is needed now to keep future generations from paying higher tax rates. He calls his unique approach "generational accounting" (taken from the title of his 1992 book). Several times during the Bush administration, Kotlikoff wrote a section of the U.S. budget, projecting the long-term effects of the year's spending.

Currently, he says, the future looks troubling. Because the Social Security system has only 60 percent of the funds it needs to provide benefits to all Americans, by 2030, when 80 million baby boomers are collecting old-age benefits, the system could collapse. As a result, future generations will pay a 55 percent higher federal income tax rate than Americans now pay. In order to avoid this scenario, Kotlikoff says, the federal income tax rate of all workers needs to increase by about 20 percent immediately and permanently.

"When the baby boomers are screaming for benefits and there are relatively few workers behind them paying into the system, we're going to have real crisis," he says. "Eventually, the government would have to renege on some benefits, start printing a lot of money, and we'd have inflation, huge tax rates, and a recession -- basically, all the problems faced by a country that gets its fiscal house out of whack, like Brazil or Russia."

Kotlikoff is blunt about his feelings toward the issue of prescription drug coverage for the elderly, in light of that larger picture. "If the elderly want to have insurance they should have to pay for it," he says. "They want to put it on the backs of their grandchildren and their children, and that's not fair given what else they've put on their backs."

Symptom of a larger problem
Generational accounting, of course, has its detractors. Dean Baker, an economist at the Center for Economic and Policy Research, a Washington think tank, for instance, says that there is too much uncertainty about future interest rates and demographic trends to accurately predict tax rates in the far future. (He has nonetheless taken a swing: he predicts that taxes should increase no more than 3 percent between 2010 and 2040, and that the wealth of the average American will have increased so greatly by that time that the increase will hardly be felt.)

"The other part of the story is that health-care costs have been rising more rapidly than inflation in the United States," says Baker. "So fixing the health-care system should be our first priority, and it's kind of silly to be worried about future tax rates."

But according to Kotlikoff, even the fact that Clinton's prescription drug plan is considered a viable option demonstrates the misconceptions that exist -- among the public and among many economists -- about the nation's long-term fiscal situation. A major cause of the confusion, he says, is annual reports published by the Congressional Budget Office and the Office of Management and Budget, the main sources of public information about the nation's finances.

He charges that the reports regularly underestimate the expected life spans of American citizens, fail to forecast debt accumulation far enough into the future, and assume that the federal government will dramatically shrink relative to the economy in the next several decades to the tune of 40 percent. "These future surpluses we hear about are based on a baseline projection that involves the federal government disappearing to a large extent," Kotlikoff says. "I don't think anyone in Washington really believes that's going to happen."

It's not due to incompetence that the forecasts are so out of whack with reality, he says. "Delivering bad news isn't something that politicians want to do. So the government forecasters are under a lot of pressure in Washington to deliver rosy scenarios, and they systematically do that."

In order to ensure the solvency of the nation's old-age welfare programs, Kotlikoff says, the government should stabilize Medicare spending and invest a portion of each American's Social Security taxes in a global index fund that would accumulate the same interest for all investors. A moderately increased payroll tax rate could then be implemented to pay off the obligations of the old system, he says. But he's keeping his fingers crossed.

"Because of these short-term surpluses, this administration as well as the next one will probably drift along without admitting the problem and the country won't really start addressing it for another decade or so," Kotlikoff says. "It's a tough battle to get people to be concerned about more than themselves, and politicians really don't care as much about the next generation as they care about the next election. The politicians have a fiduciary responsibility to protect our children, and they're ducking it."