12 Nov 2010

The Truth About Entitlements

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Arnold Kling examines the feasibility of maintaining current US level of entitlement spending for seniors and arrives at highly pessimistic conclusions.

Most Americans would be happier if the outlook for the budget could be taken care of without having to make major changes to entitlement programs. Certainly, politicians would have it easier if this were the case.

Unfortunately, arithmetic and prudence imply a need to tackle entitlements. What this paper has shown is that various alternative solutions to the budget problem are largely myths. Social Security is not protected by its trust fund. The trust fund contains no real assets. It is simply an accounting device that indicates the promises that have been made to current workers to provide benefits to them in retirement. There is no way to avoid having Social Security absorb a large share of
the budget during the years when the Baby Boomers are collecting benefits.

Raising taxes on high earners (those in the top 1 percent of the income distribution) is not a reliable way to deal with the budget deficit. Increasing the effective tax rate requires much more than just raising marginal rates because individuals have the opportunity to shift income into forms that are taxed at lower rates. Structural reforms to the tax system could reduce the ability of high earners to shelter income, but only with adverse effects on capital accumulation, entrepreneurship, and risktaking. In any case, even doubling the effective tax rate on high earners would not make the budget problem disappear.

Health care spending is rising as a share of GDP. This is true all over the world, reflecting the high income elasticity of the demand for health care. As people get wealthier, they are willing to spend more to remain healthier. Certainly, greater efficiency in health care management and delivery is both desirable and possible. However, the potential for pure efficiency gains is limited, and it will not solve the problem of ever-increasing Medicare spending. The only way to address Medicare specifically and health care spending more generally is to change the way that Americans make choices about the utilization of medical services. This will require either a stronger move toward government rationing or a shift toward more consumer sharing of the costs and responsibility for decisions about which procedures to undertake and which procedures to forgo.

Broad-based tax increases, bringing rates in line with those seen in Europe, will only solve the budget problem if there is minimal response of labor supply. However, there is notable evidence that higher taxes produce significant long-run reductions in hours spent engaging in market work, with households substituting home production for taxable labor. Higher tax rates could result in a large loss in consumer well-being with little or no increase in government revenues.

Finally, it is true that we faced a higher ratio of debt to GDP at the end of the Second World War. However, our current position does not resemble that of 1945, when we could look forward to sharp declines in government spending and large primary surpluses. Instead, the outlook over the next two decades is for increased spending and ever-widening primary deficits. Certainly, if productivity growth greatly exceeds the 1.6 percent per year embedded in current projections, the prospects for the budget would be brighter. However, it is most prudent to align our promised entitlement benefits to realistic projections, not to optimistic hopes.

Today, the American people must face up to significant structural changes in entitlement programs that reduce promised benefits. We have exhausted the alternatives.

One Feedback on "The Truth About Entitlements"


Sadly, this could all have been avoided if Social Security had been set up as a defined contribution plan. The biggest problem most of those retiring now after working 40 years would have is what to do with all the money.
But, no. Long dead politicians thought it would be oh so clever to bribe our parents and grandparents with “gifts” taken from the younger working and paid to those who had contributed little from their own earnings to Social Security. See, each generation could perform the same magic act with the next and the cost of those “gifts” could be deferred forever. Except in the real world they couldn’t.


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