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United States of America: Selected Issues

Author(s):
International Monetary Fund
Published Date:
August 2002
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IX. Social Security, Medicare, and Long-term U.S. Fiscal Prospects1

1. The re-emergence of U.S. budget deficits has revived concern regarding the implications of demographic trends for the longer-term fiscal position. Substantial progress had been made in addressing fiscal imbalances during the 1990s, and by 2001 projections were for large surpluses and the elimination of public debt by 2009. However, the fiscal situation has eroded significantly since that time and while unified budget surpluses are expected to re-emerge by FY 2005, these are now projected to be smaller than the surpluses of the Social Security system. Moreover, the Trustees of the Social Security and Medicare trust funds continue to stress the actuarial deficits of these systems in the face of the impending retirement of the baby-boom generation and pressures on health care costs.

2. This chapter briefly reviews these issues. Section A describes the Social Security and Medicare systems, and their longer-term fiscal implications. Section B discusses the reforms to Social Security that have recently been put forward by a presidential commission, and reviews Medicare reform initiatives. Section C offers a few concluding remarks.

A. Social Security, Medicare, and the Long-Term Fiscal Situation

3. There are two principal federal programs in the United States that offer support for the elderly (Box 1). Social Security provides retirement income to the aged, and is funded from payroll taxes on the working-age population. The Medicare system provides the elderly with medical insurance. This latter program is only partly funded by payroll taxes and premium payments by retirees, with the balance of its resources coming from the general revenues of the federal government.

4. Demographic and other pressures on these systems are expected to increase significantly in coming decades. In particular, the retirement of the baby-boom generation, declines in the fertility rate, and increases in longevity are projected to cause the dependency rate–the ratio of retirees to the working-age population–to rise from around 2:10 presently to nearly 4:10 by the middle of the century, significantly reducing the tax base relative to the numbers of beneficiaries. Moreover, rapid increases in medical care costs are also expected to place additional pressures on the Medicare system.

Box 1.The Social Security and Medicare Systems

Old-Age and Survivors Insurance and Disability Insurance (OASDI)

  • Participation in the OASDI system is mandatory and near-universal. The programs are funded by a 12.4 percent payroll tax on labor income up to an inflation-adjusted ceiling—$80,400 in 2001. Although retirement benefits may be drawn as early as age 62, an unreduced pension is provided at the normal retirement age–presently 65 and scheduled to increase to 67 by 2022.

  • Benefits are based on the average of monthly earnings of a worker’s 35 highest-earning years prior to eligibility up to a maximum—$1,500 per month in 2001. In setting post-retirement benefits, pre-retirement earnings are indexed to average wage growth, and post-retirement benefits are indexed to CPI inflation. Significant disability and survivor benefits also apply.

  • Both contributions and benefits are subject to tax. The employee’s portion of the payroll tax—6.2 percentage points—is included in earned income for tax purposes. Benefits are included in taxable income according to a graduated formula–they are 100 percent excluded below a certain income threshold, with the exclusion rate falling to a minimum 15 percent at higher incomes. Taxes paid on up to 50 percent of benefits are returned to the OASDI system.

  • The cash surpluses of the OASDI system are held in trust funds, and are invested in nonmarketable, interest-bearing government securities.

Medicare

  • The Medicare program provides health insurance coverage for the elderly and disabled.

  • Part A provides hospital insurance (HI)and is funded by a 2.9 percent payroll tax—which in this case applies to income without a ceiling.

  • Part B provides supplemental medical insurance (SMI) that covers the cost of physician and other services, and is funded in part by premiums paid by retirees. These cover only around 25 percent of SMI costs, with the balance coming from general government revenues.

  • The cash surpluses of the HI system are also held in a trust fund, and are invested in nonmarketable, interest-bearing government securities.

5. Despite their present cash surpluses, these systems are estimated to be in significant deficit on an actuarial basis. For example, the combined OASDI and Medicare surplus was estimated at nearly 1 percent of GDP in FY 2002 (excluding interest receipts), and the balances in their trust funds totaled roughly 14 percent of GDP. However, the programs are expected to begin running deficits within the next two decades, and over a 75-year projection period their combined unfunded liability is estimated at roughly 80 percent of GDP:2

  • The OASDI system is projected to fall into deficit (excluding interest receipts) by 2020, with deficits rising to over 2 percent of GDP by the end of the 75-year projection horizon. The assets held by the OASDI trust funds are expected to be exhausted in 2041, and the system has an unfunded liability estimated at around 35 percent of GDP, equivalent to an increase in the payroll tax of 1.87 percentage points.

  • The situation of the Medicare HI system is worse, since its current surplus is more modest, the assets in its trust fund total only around 2 percent of GDP, and health care costs are rising rapidly. The system is projected to run deficits by 2020, which grow to over 3½ percent of GDP by the end of the 75-year projection period. As a result, its unfunded liability is estimated at around 50 percent of GDP, equivalent to a 2.02 percentage point increase in the contribution rate.

  • The position of the Medicare SMI system is even more worrisome. The SMI system is run purely on a pay-as-you-go basis—i.e., there are no trust fund assets that have been accrued—and premium payments cover only a part of its outlays. The Administration’s FY 2003 budget estimated that the unfunded liability of the SMI system would be roughly an additional 80 percent of GDP, equivalent to 3.37 percentages points of the payroll tax.

6. (Figure 1)illustrates the longer-term pressures on the system. For example, in the baseline scenario, both the OASDI and HI systems begin to run significant primary deficits in the next 20 years, with a substantial buildup of liabilities resulting thereafter. An immediate 1.87 percentage point increase in payroll taxes to meet the actuarial deficit would improve the situation but—despite a significant increase in tax rates—the systems would still be left with substantial cash flow deficits in the longer run. By contrast, more modest cuts in benefit growth—e.g., reducing the growth of OASDI benefits by ½ percentage point beginning in 2010, and slowing the pace of HI benefits by 1½ percentage point in the same year—would achieve actuarial balance and keep the cash flow deficits relatively modest over the 75-year projection period.

Figure 1.United States: Social Security and Medicare Projections

(In percent of GDP)

Source: Staff estimates based on long-range projections in the 2002 Trustees’ reports. Benefit adjustments involve assuming that OASDI and HI benefits grow 0.5 percent and 1.6 percent slower than the baseline in 2010. Balance is equal to the difference between non-interest receipts and expenditure.

7. These projections are subject to considerable uncertainty. For example, compared to the baseline estimate of the combined actuarial OASDI and HI deficit of 3.89 percent of taxable payrolls over a 75-year period, the Trustees’ report illustrates that plausible low-cost and high-cost scenarios would yield estimates ranging from an actuarial surplus of 0.64 percent to a deficit of 11.47 percent of payrolls. In all cases examined, the real interest rate is assumed to remain significantly higher than the real growth rate of the economy, which significantly exacerbates the systems’ debt dynamics.

8. The longer-run fiscal implications of these trends are significant. In the absence of reforms, outlays on Social Security and Medicare programs are projected to rise rapidly from around 7 percent of GDP presently to nearly 10 percent by 2023, increasing further thereafter to reach nearly 16 percent of GDP by the end of the 75-year horizon (Figure 2). Simple budget simulations illustrate that these trends would cause the unified balance to erode beginning in the next decade.3 As a result, federal debt held by the public would decline to around 5 percent of GDP just after 2020, but would then begin to increase rapidly as spending pressures intensified.

Figure 2.United States: Budget Projections

(In percent of GDP)

Source: Staff estimates.

9. Although serious, the financial situation of the U.S. social security system is less dire than in many other industrial countries. In a recent OECD study, the United States was considered among the “slower-aging economies,” compared to other industrial countries, owing to its relatively high immigration and fertility rates, and relatively modest life expectancy. As a result, the projected increase in its age-related spending—including outlays for pensions and health care—was estimated to be at or somewhat less than average (table below). In view of the U.S. system’s relatively large trust fund assets and substantial contribution rate, its unfunded liability is also typically viewed as smaller than in other industrial countries. For example, Kohl and O’Brien (1998) estimate the unfunded liability of the Japanese, Italian, and Swedish systems as a share of GDP as 70 percent, 60 percent, and 132 percent, respectively.

Cross-Country Comparisons of Pension Systems(In percent of GDP)
United StatesAdvanced Country AverageCanadaItalyGermanyJapanUnited Kingdom
Age-related spending
2000 level11.216.917.914.211.813.715.6
Increase to 20505.55.98.7-0.35.03.00.2
Unfunded liability
(1994)23101607024
Sources: Age-related spending: OECD (2001a); and unfunded liability: Kohl and O’Brien (1998).

B. Social Security Reform: The President’s Social Security Reform Commission

10. The President established a commission in early 2001 to examine options for reforming Social Security, taking into account several principles. In particular, reforms were supposed to (i) maintain benefits for retirees and near-retirees, (ii) avoid any increase in social security taxes; (iii) maintain the survivor and disability benefits; (iv) offer personal retirement accounts as a supplement to social security; and (v) avoid investing social security trust funds in the stock market.

11. The commission reported its findings in December 2001 and described three alternative plans whose key elements included:

  • Personal retirement accounts (PRAs): Participants would be permitted to divert a portion–up to 4 percentage points–of their OASDI contributions to personal retirement accounts. OASDI benefits would be reduced by the amount of direct contributions to PRAs plus an implicit real return of up to 3½ percent.

  • Indexation: The commission suggested moving to a system in which the pensionable earnings of future retirees would be indexed to prices rather than wages, which (as illustrated above) would tend to lower the growth of benefits substantially. In addition, the formula for calculating benefits could be adjusted to increase its progressivity.

  • Minimum benefit: In some of the reform options considered, a worker with 30 years of employment would be provided a minimum benefit of up to 120 percent of the poverty line.

12. Although the report argued that PRAs would have important advantages—including increasing the rate of return on employee contributions and possibly increasing national saving—the report also clearly illustrated that PRAs would exacerbate the system’s insolvency. For example, introducing a PRA that would divert 2 percentage points from the OASDI payroll tax, would significantly reduce the cash flow available to meet current obligations. As a result, “transition payments” from general revenues to the trust funds would be needed over an extended period until benefit outlays were reduced to their new steady-state level. The net present value of these payments over the 75-year period would be equivalent to 10 percent of GDP.

13. The report also illustrated that reducing the generosity of the indexation of OASDI benefits would significantly improve the financial situation of the system, but that significant additional funding would still be required to close the system’s actuarial deficit. For example, in the third reform option considered, which assumed amending the benefit formula and a relatively modest PRA—i.e., a diversion of only 1 percentage point of payroll taxes—would still require significant transition payments as well as a permanent increase in system financing equivalent to 0.62 percent of the payroll tax.

C. Medicare Reform

14. With growing awareness of the longer-term fiscal pressures associated with Medicare, the Balanced Budget Act of 1997 legislated a number of reforms to the system.4 In particular, payments to physicians and hospitals were reduced, and in order to contain costs and promote competition in health care delivery, a wider variety of private plans were permitted to contract with Medicare, including health maintenance organizations, provider-sponsored organizations, and preferred provider organizations

15. Although a number of subsequent reform proposals have been released, none have resulted in any significant changes to the Medicare system, and cost pressures have intensified. Recent Medicare proposals have focused on modernizing the benefit package which is widely regarded as overly limited in that only basic medical services are covered. In particular, prescription drugs are not a covered expense, and a variety of proposals have suggested how such a benefit could be introduced. While improving Medicare coverage, a prescription drug benefit would entail considerable costs, exacerbating the underlying financial pressures of the system, particularly given the rising costs of prescription drugs. For example, Congressional Budget Office (2002b) estimates suggest that in 2005, a prescription drug benefit—which pays for 100 percent of expenses over a $3,000 deductible—would cost about $50 billion. Such an estimate understates the true cost since it ignores subsidies to cover the federal share of premiums, cost-sharing for low-income enrollees, and the costs of creating and administering the benefit.

16. As outlined in Congressional Budget Office (2001b), options for comprehensive longer-term reform to restore solvency to the Medicare system might include an increase in premium revenues; a change in eligibility conditions to reduce the number of beneficiaries; cost reductions per beneficiary; or an increase in payroll taxes.5 However, more fundamental structural reform of the system has also been under discussion. For example, under a “premium support approach” Medicare recipients would be able to choose among a variety of competing private sector health plans with the government paying a portion of the premium. Private plans would be required to submit the level of premium at which they would provide the basic Medicare benefits package. Beneficiaries would enroll in at least one plan for a modest premium but could pay additional premiums for a more expensive plan. Although proponents of this approach have argued that such a plan would improve choice and reduce Medicare costs, others have doubted the scope for cost-saving.

D. Concluding Remarks

17. The foregoing discussion has illustrated that demographic and other trends imply that the Social Security and Medicare systems are likely to place significant longer-term pressures on the U.S. fiscal system. Little progress has been made toward addressing the problems of the Medicare system, despite the very large deficits of the SMI and HI systems. Instead, the Administration’s budget and the Congress appear to be focusing their attention on expanding benefits in the area of prescription drugs rather than addressing the fundamental reforms that would assure the programs’ longer-term solvency.

18. In contrast, specific proposals for reform of Social Security have been put forward by the President’s commission. The commission’s report usefully illustrated that relatively small changes in benefit formulas could substantially improve the financial position of the system and that directing contributions to private retirement accounts would result in significant transition costs. Nonetheless, whether this recent set of proposals will trigger the broader reforms that are needed remains to be seen. Significant issues still need to be resolved:

  • Guarantees: The commission’s reform proposals explicitly do not include a guaranteed minimum return on PRA investments. Since PRAs would be seen as a replacement of at least part of the existing OASDI entitlement, there may be pressure to attach at least some insurance to these accounts, which would increase their fiscal cost.

  • Tax issues: The tax treatment of OASDI is somewhat anomalous, since both contributions and benefits are taxable, but benefits are combined with other income by a formula that increases the progressivity of the system. It is unclear how PRAs would be treated, but to the extent that participants are able to voluntarily increase their contributions, there is a stronger argument for adopting similar tax treatment as for other retirement savings instruments (IRAs, 401(k)s, etc.).

  • Administrative issues: The commission appears to favor PRAs held in the form of investment vehicles that would be somewhat constrained in order to minimize moral hazards related to excessive risk-taking by participants in their investment decisions, and would allow lump-sum distributions versus annuitization at retirement only to the extent that retirees could demonstrate sufficient wealth. As a number of authors have noted, a system of annuities could be expensive to administer and would pose challenges for regulatory and tax policies.6

  • Benefits: The report offers relatively limited options regarding cuts in OASDI benefits and more stringent alternatives could be considered. For example, pre-retirement earnings and post-retirement benefits could be indexed to the CPI less an ad hoc adjustment for the bias it contains, or by the national accounts deflator for consumer expenditures. Consideration could also be given to increasing the pace at which the normal retirement age is increased or lengthening the computation period for calculating benefits

  • Supplemental Security Income: The Commission’s report acknowledges that reforms to the OASDI system should take into account the SSI system, and increases in the minimum OASDI benefits would likely need to be attached by a parallel increase in the SSI benefit.

List of References

Prepared by Paula De Masi and Christopher Towe.

These estimates are staff calculations based on the actuarial estimates contained in the 2002 trustees’ reports for the OASDI and Medicare systems.

The simulations are based on the assumption that the balance for the non-Medicare, non-OASDI, and noninterest federal budget remains constant as a share of GDP after 2012; that net interest payments on federal debt increase in line with the stock of debt; and that OASDI and Medicare spending as a share of GDP rise in line with the projections contained in the 2002 Trustee’s reports.

The Balanced Budget Act also established a National Bipartisan Commission on the Future of Medicare which was charged with making recommendations by March 1999 to “strengthen and improve” the Medicare system in time for the retirement of the baby-boom generation. The 17-member commission failed to reach consensus on a single plan, and therefore was unable to make any formal recommendations.

The Administration has proposed a Medicare modernization program, and called for additional funding rising to $19 billion by FY 2012, but no details appear available.

CBO (2001a) notes, for example, that there would be a strong incentive for providers to discriminate among retirees according to risk class. Diamond and Orszag (2002) also note that the administrative costs of PRAs would likely be significantly largely in the initial years than assumed by the President’s commission, and these could be prohibitive when the size of accounts is small.

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