Recent budget projections from the Congressional Budget Office (CBO) indicate that the two major entitlement programs – Social Security and Medicare – will account for almost 40 percent of all federal spending this year. Additionally, federal revenues will cover only 86 percent of federal outlays, leaving us with a $534 billion deficit for the year. Annual deficit spending adds to the cumulative federal debt and must be financed by borrowing. This year alone, almost 7 percent of all federal spending will be for interest payments on the existing federal debt.
Looking ahead 10 years, CBO projects that federal spending will grow by $2.5 trillion (to $6.385 trillion). Rising spending for Social Security and Medicare will account for nearly half of this growth. Interest payments on the accumulating federal debt will account for almost another quarter of the projected growth in federal spending over the next decade. These projections of net interest costs assume that the atypically low interest rates observed in the past several years will return to more normal levels by 2026. Growth in interest payments will be lower than projected if rates remain lower than anticipated but could be significantly higher if rates rebound more quickly. Regardless of what happens to interest rates, however, repeated annual deficits will add to our total debt and require higher aggregate interest payments. High debt and federal borrowing are a drag on economic productivity and limit the ability of policymakers to use monetary policy to respond to fiscal crises, raising the probability of a sudden spike in interest rates if investors lose faith in the ability of the government to repay borrowed funds.
CBO also projects that net interest outlays and entitlement program spending will grow much more quickly than nominal GDP in the coming decade, therefore, rising as a percent of our national economy. The anticipated rise in the share of GDP needed to cover interest payments is particularly pronounced, increasing at a rate of nearly 8 percent each year. The annualized growth rate for Medicaid, CHIP and ACA subsidies is expected to slow relative to the rapid increases associated with the early implementation years of the ACA. Provider payment reductions and other program changes are moderating the pace of growth in Medicare spending somewhat. Social Security spending is expected to continue past growth patterns, as dictated by demographic trends. In contrast, driven by the spending caps enacted in the Budget Control Act of 2011, spending for virtually everything else the federal government does is projected to decline at a rate of nearly 2 percent per year relative to GDP.
Over the very long term, CBO projects a continued steep rise in Medicare and net interest spending as a percent of GDP. Medicare spending increases are driven by rising health spending per beneficiary and by population aging that increases the size (and eventually the average age) of the covered population. Population aging also affects projected spending for Social Security, but once the last cohort of Baby Boomers reaches its normal retirement age in 2032, the size of the covered population will begin to stabilize, easing upward pressure on overall program spending.
With few exceptions over the past 35 years, the annual revenues raised by the federal government have not only fallen short of covering primary (non-interest) spending – resulting in a primary deficit – but have also failed to cover the interest costs of servicing the accumulated federal debt. The cumulative impact of these shortfalls has brought us to a level of federal debt held by the public of approximately 75 percent of GDP (right hand axis) in recent years. The long-term outlook through 2090 is for average annual primary deficits of 0.3 percent of GDP. In combination with unfunded interest spending, these operating deficits will rapidly drive debt levels ever higher – in turn rapidly increasing interest costs and adding further to the debt.
Medicare is financed primarily by a mix of payroll taxes levied on current workers and employers, premiums paid by current beneficiaries, and general revenues from taxpayers. While the amount paid in payroll taxes and (to a lesser extent) premiums depends on a person’s income, benefits received from Medicare do not – rather, these are determined by a person’s actual health care utilization once in the program. Simulations for a variety of lifetime earnings profiles illustrate how the amount of payroll taxes paid increases with earnings. A worker entering Medicare in 2015 with a history of low annual earnings ($22,500 in 2015 dollars), for example, would have paid about $32,000 over his/her career, while someone who each year earned the maximum taxable threshold for Social Security (currently $118,500) would have paid about $160,000 to Medicare while working. Even with a lifetime history of high earnings, the typical beneficiary can expect to draw more in benefits than s/he personally contributed via payroll taxes and premiums. A male with average life expectancy and average health care utilization is projected to receive $195,000 in benefits once entering the program; a higher life expectancy leads to higher expected lifetime benefits for females. Married couples are entitled to full benefits for both spouses, even if one spouse never paid payroll taxes, leading to much larger gaps between benefits and contributions for one-earner couples. A couple with one low-wage earner and average health care use would, for instance, expect to receive nearly $400,000 more from Medicare than personally contributed. Even when the one working spouse had a lifetime of very high earnings and payroll tax contributions, the difference in benefits and contributions for the couple is projected to exceed a quarter of a million dollars. When both spouses contributed payroll taxes throughout full working careers, the benefit-to-contribution imbalance is less striking, but nonetheless substantial, even at very high contribution levels by both spouses.
The payroll taxes paid by a given worker to finance Medicare Part A (for hospital and post-acute care) are not earmarked to cover the future benefits for that worker. Rather, Part A is a pay-as-we-go system in which contributions from current workers and employers are used to cover program expenses for current beneficiaries. A small amount of program revenue is also generated from taxes on Social Security benefits for high-income tax payers, and a small number of beneficiaries without a sufficient work history (on their own or via a spouse) pay a Part A premium. In years when the revenues paid into the program exceed the Part A benefits paid out, the operating surplus is credited to the Part A Trust Fund. These excess funds are effectively lent to the federal government for other uses in exchange for treasury notes that will be repaid to Medicare with interest at a later date. Conversely, in years when Part A revenues fall short of expenditures, the resulting operating deficit must be covered by this interest income and by redemption of trust fund assets. Dipping into the trust fund requires transfers from federal general revenue, even when the fund still registers a positive balance on government ledgers. The Medicare Trustees currently project a brief period of very small Part A surpluses, but then annual spending will quickly begin to outstrip annual income, depleting all trust fund assets by 2030. At that point, scheduled Part A benefits would have to be cut to a level that can be fully supported by the annual program income or new sources of funding must be identified. The CBO paints a gloomier picture, projecting depletion of the Part A Trust Fund by 2026.
Parts B and D of Medicare, covering physician and outpatient services and outpatient prescription drugs, are financed through the Supplemental Medical Insurance (SMI) Trust Fund. Beneficiaries electing to enroll in Parts B or D pay premiums that are set to cover about 25 percent of program costs, with higher-income beneficiaries paying somewhat higher premiums. Part B receives a small amount of additional revenue from fees paid by drug manufacturers and importers, and Part D receives transfers from states to cover a portion of drug costs for beneficiaries who are also eligible for Medicaid. By statute, program outlays in excess of these sources of revenue are financed by automatic transfers from general revenue. Thus, by definition, the SMI Trust Fund is always fully financed, but it is requiring larger and larger general revenue transfers as program spending mounts.
Putting these pieces together shows the extent to which Medicare affects the federal budget through large and increasing draws from general revenue. The impact will be even larger if general revenue financing is used to maintain scheduled benefits after 2030 when the Part A Trust Fund is depleted.
As with Medicare Part A, the Social Security program relies heavily on payroll taxes paid by current workers and employers. Higher income workers pay higher aggregate taxes over their careers (blue bars) and can expect higher benefits, but not commensurately so relative to taxes paid. The ratio of benefits received to taxes paid is highest for lower income beneficiaries; at higher income levels single beneficiaries can actually expect less in lifetime benefits than they have paid into the system. At all income levels, the availability of spousal benefits means that married couples with only one working spouse can expect significantly higher joint benefits (yellow bars) compared to single counterparts who have paid the same level of taxes. When both spouses work, their joint tax contributions to the program increase by more than their joint benefits. For example, a married couple with one average wage earner can expect to pay $272,000 in taxes and receive $495,000 in benefits, but if the other spouse also works at an average wage, their tax bill would double (to $543,000) while benefits increase by only $121,000 (24 percent).
The two components of the Social Security program – Old Age and Survivors Insurance (OASI) and Disability Insurance (DI) – have separate trust funds, each financed by payroll taxes and income taxes on some Social Security benefits. The combined operation of these two funds is shown here. Each year between 1984 and 2010 the OASDI Trust Fund realized operating surpluses and was accumulating assets. Then, as the leading edge of the Baby Boomers began to retire, payroll tax revenues fell and benefit spending rose. This situation is expected to persist into the long run, with the annual shortfalls rising rapidly as the beneficiary population both grows in number and lives longer. These gaps are not trivial: the annual funding shortfall is estimated to be around $70 billion this year and projected to rise to $8.1 trillion in 2090. For a while, the annual operating deficits will be financed using interest income and redemption of trust fund assets, both of which require transfers from general revenue. The Social Security Trustees anticipate that all OASDI Trust Fund assets will have been redeemed by 2034. If new sources of revenue are not identified at that point, benefits to current beneficiaries will have to be cut by 21 percent immediately. Again, the CBO analysis of the trust fund finances is even more dire, predicting fund depletion five years earlier – by 2029.
As long as the trust funds are solvent, annual operating deficits for Medicare Part A and for Social Security will be covered by interest earnings and redemption of fund assets. Both income streams require transfers from general revenue. Additionally, by current program design, approximately 75 percent of Medicare Part B and D expenses are financed from general revenue. All told, the current draw against general revenue for these major entitlement programs is almost 2 percent of GDP, and by the time the Part A Trust Fund is depleted in 2030, these transfers will account for 3.6 percent of GDP. Absent other new dedicated sources of program income, payment of all scheduled benefits after the trust funds are exhausted will require still more draws against general revenue, further straining the federal budget. As these programs consume more general revenue, some combination of lower spending on other budget items, new tax revenue, or additional borrowing and debt will be needed.
Unchecked, the spending trends and burgeoning interest expenses described above imply that debt-to-GDP levels that are already much higher than at any time in our recent history will skyrocket. Budget experts consider fiscal policy to be sustainable if the level of publicly-held debt remains steady or declines as a percent of GDP, and they ask what policy changes are needed to reach the target debt level at the end of a 75-year period. Achieving this long-term fiscal sustainability will require reductions in non-interest spending and/or increases in revenue that are large enough to eliminate any primary deficit and cover interest payments. The sooner we begin making these difficult choices, the less drastic the changes will have to be. An immediate start would require increasing our annual primary surplus by 1.2 percent of GDP for each of the next 75 years. Delaying just 10 years means that we would need to raise our primary surplus by 1.5 percent of GDP over 65 years, while a 20-year delay raises the bar even higher. More and more debt would be accumulating during these delays, imposing more burdensome fiscal changes on future generations in order to climb out of the deeper hole. These simulations are based on a number of assumptions about factors that will affect future spending, not least of which is expectations about health care inflation. Even relatively small increases in the assumed rate of health spending growth will have dramatic implications for the magnitude of spending cuts and revenue enhancements that will be required to achieve the 75-year sustainability goal. Do you think you can make the changes in spending and revenues needed to achieve long-run fiscal sustainability? Try your hand using the new Brookings Institution simulation game, The Fiscal Ship. Be prepared for some very difficult decisions.
