The Long-Term Budget Outlook and Social Security Reform: - - PowerPoint PPT Presentation

The Long-Term Budget Outlook and Social Security Reform: Implications for Financial Markets

The Q Group, October 18, 2005 Carlsbad California Kent Smetters The Wharton School & NBER

I ntroduction

Traditional budget measures substantially

underestimate existing liabilities

In the past, “brick and mortar” public goods

could be allocated on an annual basis

But they have been replaced during past 50

years with long-term liabilities (e.g., Medicare; Social Security, etc.)

Two Main Problems with the Traditional Budget

1.

Substantially underestimates unfunded liabilities by ignoring long- term liabilities

2.

Is biased against reforms that would reduce these unfunded liabilities

• 1. Underestimates Liabilities
• Budget does not track many unfunded obligations
• They’re “off balance sheet”
• Examples
• Social Security and Medicare
• Medicaid
• Federal Employee / Military pensions
• Instead, the budget focuses on a particular

unfunded obligation: public debt

Debt Held by Public Misses almost $60 Trillion in Liabilities

Public debt is only one component of

government’s true Fiscal Imbalance (FI)

FI = debt held by public + PV of all future

• utlays – PV of all future revenue = $63 trillion

In contrast, debt held by public is only $4.4

trillion (gross debt is about $8 trillion)

• 2. Reforms are hard

Example 1: An actuarially-fair “carve out”

Part of payroll tax invested in personal accounts Future SS benefits reduced in equal present

value Debt held by the public will increase Other unfunded obligations decrease equally Zero impact on total Fiscal I mbalance But focusing on public debt federal liabilities appear to be larger since the other unfunded

• bligations are not being tracked.

So even a perfectly neutral reform appears bad

Example 2: “Carve out” with a “haircut”

Part of payroll tax invested in personal accounts Future SS benefits reduced by slightly more than

the present value of diverted payroll taxes

Similar to Commission’s Model 1 People might still want a personal account

Debt held by the public will still increase Other unfunded obligations decrease by more Total Fiscal I mbalance is actually reduced Focusing on public debt liabilities seem larger Biases reform debate against reforms that would actually reduce the Fiscal I mbalance

New budgetary framework

Two main integrated components:

“Fiscal Imbalance” (FI) = Debt held by public +

PV of all future outlays – PV of all future revenue

Similar to open-group liability concept

“Generational Imbalance” (GI) = portion of FI on

account of current and past generations

Similar to the closed-group liability concept

Simple and easy to understand

Both FI and GI are Useful

Fiscal Imbalance measure needed to

address the sustainability of policy.

The FI must equal 0 for sustainability

Generational Imbalance needed to choose

among the set of all sustainable policies

Examples:

New pay-go financed prescription drug benefit Many options for reforming Social Security

Key Economic and Demographic Assumptions

Real annual discount rate, r = 3.6% Real annual per-capita productivity, g = 1.7% Excess real growth of health care over

productivity until 2080, h = 1.0%

2080 – 2100: excess growth reduced linearly to 0 After 2100: excess growth fixed at 0

Sensitivity analysis conducted below

Health Care Assumption, h

The wedge, h= 1.0%, is same as Trustees Very conservative by historic standards

1980 – 2001: actual wedge was 2.3% Double-digit growth this year; expected to last

Total spending on Social Security and

Medicare increases from 7.6% of GDP in 2002 to 13.1% of GDP by 2080

2004 2005 2010

• 1. Fiscal Imbalance in Social Security

8,006 8,352 10,158 On Account of Past and Living Generations 9,549 9,899 11,676 On Account of Future Generations

• 1,543
• 1,547
• 1,518
• 2. Fiscal Imbalance in Medicare (Parts A, B and D)

60,886* 63,381 75,599 On Account of Past and Living Generations 24,094 25,431 32,289 On Account of Future Generations 36,791 37,951 43,310

• 3. Fiscal Imbalance in Rest-of-Federal-Gov’t
• 5,608
• 5,805
• 6,339

Total Federal Fiscal Imbalance (FI) 63,284 65,928 79,417

Table 2: Fiscal and Generational I mbalances (Selected Years) (Present Values in Billions of Constant 2004 Dollars; Fiscal Years)

$2.6 trillion $16.1 trillion * Part D (new Rx benefit ) alone = 24,186

2004 2005 2010

• 1. Fiscal Imbalance in Social Security

2.3 2.3 2.5 On Account of Past and Living Generations 2.71 2.74 2.87 On Account of Future Generations

• 0.44
• 0.43
• 0.37
• 2. Fiscal Imbalance in Medicare (Parts A, B and D)

17.3 17.6 18.6 On Account of Past and Living Generations 6.83 7.05 7.94 On Account of Future Generations 10.44 10.52 10.65

• 3. Fiscal Imbalance in Rest-of-Federal-Gov’t
• 1.6
• 1.6
• 1.6

Total Federal Fiscal Imbalance (FI) 18.0 18.3 19.5

Table 2: Fiscal and Generational I mbalances (Selected Years) (% of Present Value of Uncapped Payrolls; Fiscal Years)

Options for Paying for $63 Trillion

Confiscate all physical capital assets in the U.S.

(actually does not go far enough!)

Increase federal income taxes by 68%

immediately and forever, assuming no reduction in labor supply or savings

Increase the combined employer-employee

payroll tax from 15.3% to over 32% and remove the payroll tax ceiling (but don’t credit benefits)

Slash Social Security and Medicare by over half

Sensitivity Analysis: Parameter Assumptions

Policy Baseline High Low Discount Rate, r 3.6% 3.9% 3.3% Productivity Growth Per Capita, g 1.7% 2.2% 1.2% Health Care Outlay Growth Per Capita, h 1.0% 1.5% 0.5%

Sensitivity Analysis: FI as Share of PV of Payroll

Policy Baseline High Low Discount Rate, r 18.0 16.2 20.2 Productivity Growth Per Capita, g 18.0 19.0 16.4 Health Care Outlay Growth Per Capita, h 18.0 21.5 14.9

But are these obligations “real”?

Yes: the only difference between these

• bligations and regular debt is the policy
• ptions available for dealing with them.

Options for reducing explicit debt:

Monetize it (except TIPS) Increase taxes Declare bankruptcy

Options for reducing implicit debt:

Hard to monetize (since inflation protected) Control outlays, increase taxes

Is there a hidden silver lining?

International prospects also gloomy

Outlook of many European countries also bad. That’s bad for the U.S. fixed income markets! Some hope in Latin America (e.g., Chile)

Will capital deepen as baby boomers

approach retirement?

What about “dynamic scoring?”

Some Glimmer of Hope: Groundwork Being Set for Reform

1.

New accounting methodology recently Adopted by Gov’t Trustees

• For Social Security, starting with 2003 Report
• For Medicare, starting with 2004 Report
• They estimate a Medicare + SS FI of $82

trillion!

2.

Senator Lieberman has introduced a bill requiring it for government as a whole

Easy Fix / Hard Fix

Social Security: The “Easy Fix”

Smaller problem Nature of problem is also easier since it is

cash payment (e.g., “just” price index)

Medicare: The “Hard Fix”

7 times large (new Rx plan imbalance alone is

larger than Social Security’s imbalance)

Nature of problem is also harder since in-kind

payment and driven by tech change

Pension Fund Implications

Asset Side

Long-dated fixed income instruments risky? Invest in more stocks?

Liability side (won’t talk much about)

Private payments could increase to extent

that private pensions are integrated with Social Security (not common)

Why Haven’t Fixed Income Markets Reacted with higher interest rates?

View I: Capital markets don’t understand. View II: Capital markets believe that most

• f the obligations will be reduced by

reducing benefits (hard to believe)

View III: Term Structure

Include More Stocks?

Aside: accounting issues Risk: Liability matching problems Risk: Demographic issues

Source: Poterba (2004), “Population Aging and Financial Markets”

President’s Social Security Plan

An actuarially-fair carve out

Few minor exceptions: pre-retirement

mortality and bequeath-ability of accounts

Won’t have any impact on markets (fixed

income or not) provided if households are not borrowing constrained

Intuition

But, about 50 percent of U.S. households don’t

hold any equities either directly or indirectly in employer-sponsored DC plans

Exact reason is important for policy goal

Rational (correlation between human capital and

physical capital returns) or irrational (“fixed costs” associated with learning)

If rational, then President’s plan neutral If irrational, then likely small increase in equity

values and small reduced bond prices