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October 1993

Facing Up

The cause of our huge budget deficits is not government waste or welfare programs for the poor--it's the out-of-control spending on welfare programs (called "entitlements") for the middle and upper classes. President Clinton's plan barely makes a dent in this spending.

by Peter G. Peterson

Early on in his presidential campaign Bill Clinton talked about the need for Americans to pull together and "sacrifice." Later, in a State of the Union address remarkable for its candor, he spoke to a raptly attentive nation about how our ballooning federal deficits cloud our economic future. That was a subject George Bush had found worthy of mention only once in his 5,000-word State of the Union address the year before. The budget plan that Bill Clinton then delivered to Congress not only used real numbers instead of rosy scenarios; it shattered some paralyzing dogmas. The nonsense that we could put our fiscal house in order without new taxes was laid to rest. Especially commendable was the President's opening the door to energy taxes, which not only raise revenues but also represent a means to curb a particularly toxic kind of consumption. Even Social Security, our ultimate sacred cow, was put on the budget-cutting table--if only at the table's edge. After years of empty "Morning in America" and "Don't Worry, Be Happy" rhetoric, all of this was welcome--even intoxicating--to us deficit hawks.

But in the end the actual sacrifice called for under the Clinton plan is so mild and selective that it can hardly be said to address our long-term economic challenges. The President's new taxes on the "rich" turned out to spare almost entirely a much enlarged but fiscally misnamed middle class, excluding all but the top one percent of U.S. tax filers. Despite all the talk of draconian sacrifice, the Clinton plan's proposed energy tax amounted to little more than a flea bite. As for entitlements, the thing that mattered most, the President barely managed to crimp their growth. From 1993 to 2004 federal benefit spending under the original Clinton plan, which, in its handling of entitlements and its overall budget savings, differs only in detail from what Congress approved, would have soared by some $730 billion--as compared with $790 billion under the Congressional Budget Office's business-as-usual baseline scenario.

Without much broader sacrifice--and a presidential vision that truly explains its purpose and inspires us to consume less today for a better tomorrow--we will never cure America's economic ills.

The Clinton plan doesn't come close to balancing the budget, even in the near term. According to the numbers developed by the White House itself, if the President's entire original budget package had been passed and implemented, by 1997 the federal deficit would have declined by only $140 billion from what it otherwise would have been. That would put it at $206 billion, or 2.7 percent of gross domestic product--just a smidgen under where it was (3.0 percent of GDP) in 1989 before the recession began. If 2.7 percent of GDP doesn't seem like a lot, consider that in 1992 a deficit that size would have soaked up about half of U.S. net private savings. And consider also that about three quarters of the spending cuts that the President has proposed for 1994 to 1998--modest as they are--are only to take place after the 1996 election, which, of course, raises the risk that they will not materialize at all.

After 1997 the federal deficit will once again begin to rise rapidly. Under the impact of continued growth in entitlement spending, by 2004 it will have climbed to about $465 billion, or 4.6 percent of GDP. As the Baby Boom generation begins to reach retirement age in the years that follow, a General Accounting Office study indicates, the deficit could then soar to an unthinkable 21 percent of GNP in the year 2020, when today's toddlers are starting to raise their own families.

Economists disagree on many things, but almost none would disagree that it is essential not to let our public debt grow faster than the economy. Yet under the Clinton plan public debt is on track to grow far faster than the economy. Today public debt is already at a higher level--55 percent of GDP--than it has been at any other time since the mid-1950s, when we were still paying off the costs of the Second World War. Because the Clinton budget plan leaves on the table a full two thirds of deficits previously projected for 1993-2004, public debt will grow to about 65 percent of GDP by the end of that period. And along with the debt, needless to say, federal interest costs will soar.

Considering how ravenously a large deficit consumes national savings--and Clinton has spoken eloquently about this--and how important the availability of savings is to making the future-oriented investments that Clinton says he wants (and that America surely needs), how can we possibly justify short-term tweaking of the deficit in lieu of radical surgery to balance the budget?

I have asked the Clinton people this question. One answer they offer is that the volcanic eruption of red ink projected for after 1997 will never occur, owing to steps they will take to control that most intractable force driving our deficits--exploding health-care costs.

The President is certainly right to go after health care. This is where much of deficit reduction must occur. But as to whether Bill Clinton will find his hoped-for health-care savings, I am more than a bit skeptical. As Charles Schultze, a former chairman of the Council of Economic Advisers, put it, "God couldn't design a program" that will achieve net savings in health care in the near term. The President, after all, is proposing that we spend more on health care--according to some, as much as $100 billion to $150 billion annually in new public and private benefits, much of it picked up by the federal government. In the longer term achieving real savings elsewhere in health care will require real sacrifices--including, ultimately, selective rationing of high-cost, low-benefit medical technologies and services. But the Administration isn't preparing the American people for such sacrifices. Until it does, it won't be able to come up with enough health-care savings to offset the cost of the benefit expansions we are now talking about, much less contribute to overall deficit reduction.

Bill Clinton warned of an economic Armageddon if we fail to change course--but then all he was able to give us to cure our economy's ills was a few teaspoons of syrupy medicine.

What happened? The President, according to senior aides, kept asking, "What is politically feasible? I do not want this to be another budget that is D.O.A." In the end his political advisers told him he couldn't ask for sacrifice where he had to--from the great American middle class. Let me now speak the unpopular truths that I am sure the President knows but believes are too politically dangerous to act upon. Let me turn to the problem of the great American middle class--and the absolutely essential role it must play in shared national sacrifice if we are to reclaim our future.


The Brutal Truth

If you listen carefully to most economists and policy experts today, a consensus emerges about the magnitude of America's economic challenges and what sorts of reforms will be necessary to overcome them.

In particular, most would agree with the following: (1) To get American living standards rising again, we must increase productivity growth. (2) To boost productivity we must invest more--much, much more--not just in machines but in research and development, in infrastructure, and in people. Making the new investments we need if we are again to know the kind of rising living standards we remember from the 1950s and 1960s will require a lot of money. Many, myself included, think that at least $400 billion a year in new investments is needed in order to boost our rate of investment back toward our long-term historical average and put us in the ballpark of what other major industrial countries are now managing to invest. (3) This in turn means that we must save much, much more--at least $400 billion a year more (4) The surest and fastest way to increase our savings is to reduce and eventually eliminate the federal deficit, which is really just a form of negative public savings. (5) To reduce the deficit and keep it down we must make major cuts in consumption spending, and in particular in entitlements. But this, alas, requires us to confront a brutal question: If we are to save more by consuming less, whose consumption growth do we propose to cut?

It's at this point that agreement on what needs to be done, while not exactly breaking down, comes face to face with a truth that remains politically inexpressible. That truth is that the problem is all of us. Most Americans--emphatically including the middle class--will have to give something up, at least temporarily, to get back our American Dream.

We all remember the slogan that came out of the Clinton campaign: "It's the economy, stupid." Well, when it comes to the budget, the watchword ought to be "It's entitlements, stupid." From Social Security and Medicare to the vast tax favors for home-mortgage interest and employer-paid health insurance (policy wonks call these benefitlike subsidies in our tax code "tax expenditures"), consumption-oriented spending dominates the budget today. And the explosive growth of these entitlements will continue to rob our future. The budget arithmetic is inescapable: we just can't get the spending cuts we need from anywhere but entitlements. As big as it is, even defense spending isn't big enough. We could shut down the Pentagon tomorrow and still not balance the budget. Nor can we count on saving much on our huge interest bill unless we first reduce other types of spending. Interest on the national debt is something that we must pay to avoid a devastating financial panic--and it keeps growing as our national debt grows, just as it would fall if we began to attack the deficit. The rest of what government does represents just pennies out of the overall budget dollar.


The Cost of Entitlements

Let's define some key terms and look at some key facts about entitlements. Entitlements are any public-sector payments, received by a person or a household, that do not represent contractual compensation for goods or services. This definition obviously excludes large portions of the federal budget, from defense procurement to interest on the national debt to purchases designed for America's collective benefit (such as highway construction). But it includes nearly everything else--most notably such dominating fixtures of the American political landscape as Social Security, Medicare, Medicaid, food stamps, unemployment compensation, veterans' benefits, and farm aid, to say nothing of our lavish federal pension systems.

The most striking single fact about entitlements is their vast cost. Over the course of fiscal year 1993 the U.S. Treasury will have mailed out benefit checks (directly to individuals or to state agencies and insurance companies that administer benefits) totaling some $800 billion, or about one eighth of our nation's GDP. That amounts to more than half (53.5 percent) of the entire federal budget--or about $6 million every minute of every working day, flowing to one out of two American households. These figures, moreover, include only direct outlays from the federal budget. The numbers would be even larger if we included tax expenditures. If we count them and add the cost of administering entitlement programs--as many economists argue we should in order to get the full picture--federal entitlements now amount to more than $1 trillion annually and flow to well over three quarters of all U.S. households.


Ten Myths About Entitlements

Myths about entitlements are everywhere. They are used--and abused--in the political dialogue in ways that seem to make reasoned debate and reasonable reforms impossible. Let's look at ten of the most common myths.

1. Most federal social spending goes to the poor.

It is important to remember what entitlements have done to reduce poverty. Before the New Deal millions of Americans had no means of support in the event of unemployment, disability, unexpected retirement, or the death of a parent or spouse. Vast numbers of children grew up in destitute families. At great cost to society and the economy, millions of workers could fall into poverty and never recover. In 1937 President Franklin D. Roosevelt could say, "I see one third of a nation ill-housed, ill-clad, ill-nourished." Today entitlements prevent some 20 million Americans (half of them elderly) from falling into poverty.

This is clearly all to the good. However, keeping people out of poverty is not the purpose toward which most entitlement spending is directed. In reality, only about one out of eight federal dollars of social spending serves to lift poor families above the poverty line. Only about one out of four federal benefit dollars even flows through a program that uses financial need as a criterion for eligibility. Counting both direct benefits and the value of entitlements conveyed through the tax code, the aggregate amounts received by people above the national median income are simply staggering. In 1991 nearly half of all entitlements went to households with incomes over $30,000. One quarter went to households with incomes over $50,000.

2. Entitlement spending helps to equalize incomes by giving more to the poor than to the rich.

Few axioms of American political life find such uncritical acceptance as the belief that social-welfare programs effect a dramatic redistribution of wealth in favor of low-income households. It apparently makes little difference that most experts, liberal and conservative alike, have never subscribed to this axiom--and that recent data repudiate it altogether.

Back in the sixties the Nobel laureate economist Milton Friedman used to shock audiences by asserting that Social Security was actually a regressive program--since the program's mildly progressive benefit formula compensated neither for its regressive payroll tax nor for the fact that the poor pay taxes over more years (since they tend to start working at a younger age) and receive benefits over fewer years (since they tend also to die at a younger age). Most economists found Friedman's analysis at least plausible; no one has yet disproved it. More recently the celebrated political scientist Mancur Olson looked over the panoply of American entitlement programs and concluded:

"Most of the redistribution of government is not from upper-income and middle-income people to low-income people. Most of the redistribution of income in fact is from middle-income people to other middle-income people, or from the whole of society to particular groups of rich people, or from one group to another where the groups are distinguished not by one being poor and the other being rich, but only by the fact that some groups are organized and some are not."

Income data from the Congressional Budget Office tend to bear out Olson's critique. Total federal benefits to the affluent are at least as substantial as those to the needy. Among Social Security beneficiaries, for instance, households with incomes of $100,000 or more receive, on average, checks that are twice as large as those of households with incomes of less than $10,000. Even when we add in the cash and in-kind benefits disbursed by all of the other federal sources for which we have income data--including "means-tested" welfare and food stamps--we find that households in the top bracket ($100,000 and up) received an average of about $5,700 in 1991, slightly more than the average of $5,600 received by households in the bottom bracket (under $10,000).

But direct federal payments are not the only way in which the federal government distributes benefits. We also have to take tax expenditures into account. These loopholes, designed to favor certain households and bearing no relationship to ability to pay, are the fiscal and economic equivalent of a government check. Most tax expenditures are unquestionably regressive: many poor households cannot qualify for them--and even when they do, what they receive is smaller, relative to their income, than what the affluent get. This year, for example, the Congress's Joint Committee on Taxation estimates that the average value of the home-mortgage interest deduction for taxpayers with incomes over $100,000 is $3,453 and that the same deduction is worth an average of only $478 for taxpayers in the $20,000 to $30,000 bracket. Even these figures include only those who qualified for the benefit. They exclude many low-income families, including renters and those who opted for the standard deduction, who do not qualify.

When we add together all the direct-benefit outlays and all the tax expenditures, an unambiguous picture emerges. On average, a household with an income under $10,000 collected roughly $5,700 in 1991. On average, a household with an income over $100,000 collected $9,300. This distribution of benefits by income became more--not less--skewed during the 1980s. Clearly, it has nothing to do with economic equality. Let's phrase the issue a bit more bluntly. If the federal government's purpose were to straighten out the national income distribution, it would do a better job if it dispensed with all the programmatic rules and simply scattered all the money by airplane over every population center, to be gathered at random by passers-by.

3. Social Security and Medicare are an earned right: beneficiaries are only getting back what they paid in.

Here the case is open and shut. Most currently retired Americans receive Social Security benefits that are two to five times greater than the actuarial value of prior contributions, by both employer and employee. The payback for the Medicare Hospital Insurance program is five to twenty times greater. A typical middle-income couple who retired in 1981 have already received back, with interest, not only the total actuarial value of their previous Social Security and Medicare taxes but also the total value of their lifetime federal income taxes.

And these calculations of actuarial value are conservative. They assume that employer contributions "belong" to the beneficiary and that the public must guarantee a "market" interest rate on all contributions, no matter what the condition of the economy or the wages of those who are taxed to make good on this claim. In fact, the Social Security Administration keeps no direct record of how much each person contributes. It just keeps records of each person's wage history, to which a politically determined formula is applied when that person retires.

The politically potent and disingenuous language adopted by the Social Security Administration has contributed to the earned-right myth. The system is described as an "insurance" program, although it is nothing of the sort. References are made to contributors' "accounts," when no such accounts exist.

My father, helped along by years of such misleading nomenclature, went to his grave thinking that he was simply getting back his money, by which he meant what he had put into his "account" over the years. Since by this logic the benefits belonged to him, any proposal to take any of them away was both unjust and immoral. In truth, it was as though the government had a moral obligation to provide a windfall forever. He could only wonder why his otherwise well-educated son thought differently. I could never persuade him. It would have depressed him to find out that in fact there was no Social Security savings account in Washington with George Peterson's name on it.

Nor would I have wanted to depress him further with other unpleasant facts about entitlements. My father was immensely supportive of my wife's work in behalf of poor children at the Children's Television Workshop. He would have been distressed to learn that in 1986, the last year of his life, the nation was told that it could not afford to fund fully the much-admired Head Start program. Yet merely the increases in Social Security's cost-of-living adjustments that year would have fully funded Head Start. Had he known the facts, I am confident he would have been happy to give up his sliver of the huge entitlement pie for such a worthy cause.

4. The elderly, as a group, are poorer than young Americans.

In reality, the 1990 official poverty rate among the over-sixty-five population was 12 percent, as compared with 21 percent among children. When we include the value of all noncash benefits as income, the poverty rate for the elderly is six percent, as against 15 percent for children. On this latter basis poor children outnumber the poor elderly in America by more than five to one. In no other major industrial nation is the poverty rate for children (using identical definitions) anywhere near what it is in the United States.

Children are the truly needy in our society, but they certainly don't get most of the public money. In 1990 of all direct federal benefits 63 percent went to the 13 percent of all Americans over age sixty-five, while nine percent went to the 26 percent of all Americans under age eighteen. On a per capita basis, and including all federal outlays that might be called "child benefits," from education to immunization, the ratio of average benefits received was eleven to one $13,8930 to each elderly person and $1,271 to each child. Even adding in everything spent by state and local governments (on schools, for instance), the ratio still favors the elderly by at least three to one.

Some argue that entitlements for the elderly merely substitute for transfers of wealth that the young would otherwise make to their parents. That might be true if these programs weren't so lavish. Before Social Security and Medicare, young families did sacrifice for older parents--if and when Mom and Pop were in need. Yet because today's retirees are, as a whole, wealthier than the young, adults aged twenty-five to thirty-four now report receiving from their parents twenty times more support than they give to them; even for adults thirty-five to forty-four, the ratio is five to one. Social Security and Medicare, far from embodying traditional family values, have turned them on their head.

5. Social Security is building up a huge surplus that will be available to pay for benefits promised to Baby Boomers.

It is true that Social Security receipts from payroll withholding taxes currently paid into the retirement part of the Social Security system (not the health-care or Medicare part) are higher than Social Security expenditures, and will probably remain so until the Baby Boomers start retiring in large numbers. But this surplus is temporary. What is more, the funds are not being saved or invested. Instead they are being used to help offset each year's overall federal budget deficit. Thus these surpluses are transformed into debts held by the Social Security trust funds. Future taxpayers will become liable for the principal and interest.

Let's peer into the future to see what the real financial status of our old-age benefit programs is. In assessing their solvency actuaries tally up what are known as unfunded liabilities--the amounts (in this year's discounted dollars) by which future benefits promised to today's adults exceed all their future payroll taxes plus the assets currently held in all the government's relevant "trust funds." The federal government's unfunded liabilities

for just four programs--Social Security, Medicare, and federal civil-service and military retirement--come to about $14 trillion. That's a sum several times larger than the national debt, and one equivalent to roughly $140,000 for every household. This is a system in surplus?

6. Today's younger Americans will eventually receive the same health and pension benefits they are providing today's retirees.

Recently the Senate Finance Committee held a hearing on likely paybacks to various generations. No expert disagreed on the trend (an unusual fact in itself): the earliest beneficiaries got by far the best deal, and the deal has been getting worse for each successive generation. By some calculations some upper-income single males retiring this year may get less out of Social Security than they put in.

Moreover, financing even the reduced returns that are promised to tomorrow's retirees is unlikely to be economically or politically sustainable as America ages. The Social Security Administration projects that, depending on demographic and economic trends, the cost of Social Security and Medicare will by 2040 rise to between 38 percent and 53 percent of payroll--unless we cut benefits. I believe the only real question is when, not whether, we will change course. We can make modest, fair-share sacrifices now. Or we can make wrenching changes later, amid economic crisis and, as Paul Tsongas would say, intergenerational war. The choice is not just economic but also moral. I can imagine few ethical principles more important than fairness toward our children.

7. Retirement benefits are an "inviolable contract" between the generations.

No, Virginia, there is no sacred contract, at least not according to the U.S. Supreme Court, which has repeatedly ruled that no covered worker retains any rights, contractual or otherwise, over taxes paid into the Social Security system. Perhaps I may be permitted a layman's less lofty legal opinion. As I recall (from a college course in commercial law), one fundamental requirement of a valid contract is a "meeting of the minds" of the parties to the contract: between those who pay and those who receive. But no such meeting of the minds exists. I am not aware that anyone has consulted my grandson, Peter Cary, now aged three, about the staggering tax rates that our current entitlement "contracts" will require him to pay when he enters the work force.

Simply repeating "inviolable contract," "mandatory," "nondiscretionary," "uncontrollable" payments, or some other disingenuous mantra does not change certain truths. What Congress mindlessly gives can be taken away. A fundamental reality is that the current system is not sustainable. If Social Security (or Medicare) is a contract, it is an unenforceable one.

8. Tax breaks for health insurance primarily benefit people who otherwise could not afford proper health care.

Maybe this one isn't really a myth, but the regressivity of our subsidies to privately paid health care is too shocking not to mention. In 1994 exempting employer-paid health insurance from taxes will cost the U.S. Treasury about $75 billion. Needless to say, of the 35 million or so Americans without health insurance, who receive zero benefits from this huge tax break, most are poor or low-income citizens. Among households that do have insurance, those with the highest incomes and the most generous insurance plans receive several times as much from this federal tax subsidy as those with low incomes and a cost-conscious HMO.

9. The federal government's major housing entitlement, the home-mortgage interest deduction, promotes homeownership and stimulates the economy.

In 1994 the cost of the home-mortgage interest deduction in lost revenues to the federal Treasury will be $46 billion, 80 percent of which will go directly to households with incomes over $50,000. The main economic effect of the home-mortgage deduction is to inflate the price (and size) of homes, while diverting investment away from more productive sectors of the economy.

Our global competitors, who hear us publicly rail about our investment-starved economy and the stagnation of our productivity, politely ask what conceivable connection this tax subsidy for the relatively well off has with enhancing productivity. Officials in Canada regularly chide me about the fact that Canada has the same rate of homeownership as the United States without the benefit of this tax subsidy.

Why, then, do we have it? The answer, of course, does not lie in any real economic imperative. The subsidy exists because we all think we deserve it. What's more, it props up one of our most powerful special interests: the real-estate lobby.

10. The only reason that Ronald Reagan could not keep his promise to shrink the size of government was the huge rise in defense spending.

Judging by the cheers of his supporters and the jeers of his critics, we might suppose that President Ronald Reagan cut everything but defense. And judging by the similar partisan bickering over the policies of his successor, George Bush, we might suppose that the "welfare state" was the victim of further slashing and hacking for another four years after Reagan stepped down.

But the reality is very different: the cost of all direct federal benefits today ($807 billion in fiscal year 1993) is considerably greater than the entire federal Budget that existed when Reagan first took office ($696 billion in fiscal year 1981). In fact, adjusted for inflation, federal benefits soared by 54 percent from 1981 to 1993--while all other domestic spending showed zero real growth, and defense, the one area where everyone supposed the Reagan and Bush Administrations had gone hog-wild, showed real growth of only 15 percent.

Contrary to popular impressions, the advent of the Reagan-Bush era did not signal a decisive shift in entitlement policy. With the exception of the 1983 Social Security amendments (designed by a bipartisan commission), both Presidents left non-means-tested outlays and tax expenditures--that is, most entitlements--on autopilot. Thus the Reagan-Bush years only reaffirmed that these vast middle- and upper-class entitlements were politically "uncontrollable"--a weasel word behind which Congress and the President can hide their unwillingness to act, since together they can control any spending they want.


The Middle Class: The Third Rail of American Politics

The middle class is at the heart of our budget problem--and must be at the heart of the solution. Taken together, the major benefit programs for which we have income data on recipients--spending roughly 80 percent of total federal benefit dollars, and including everything from Social Security and Medicare to AFDC and food stamps--deliver 99 percent of their benefits ($529 billion in 1991) to the 99 percent of American households with incomes under $200,000. This is the upper boundary of what President Clinton has for political convenience defined as the "middle class." (The income-tax increases proposed by the Clinton Administration begin at $140,000 of taxable income, the number most people have heard quoted. But that's really equivalent to about $200,000 of adjusted gross income from all sources.)

Yet 43 percent of such benefit dollars ($227 billion in 1991) go to households that cannot possibly be considered poor: those with incomes between $30,000 and $200,000. And note that the absolute dollar figure surely understates the total since it reflects only 80 percent of all benefit dollars. What about the remaining 20 percent? We cannot be sure. Some of it flows through programs such as Medicaid, which mostly benefit lower-income households; some, too, flows through programs such as student loans, farm aid, and veterans' health care, which disproportionately benefit upper-income households. All told, it would be safe to assume that total federal benefit outlays reaching the $30,000-to-$200,000 income bracket amounted to at least $265 billion in 1991.

And what about our ocean of so-called tax expenditures--the subtle subsidies that help the wealthy borrow huge sums for home mortgages and take unlimited health-care deductions? More than two thirds go to tax filers with incomes between $30,000 and $200,000. Just seven percent go to the Americans whom the President calls "rich."

The top-earning one percent of Americans, it's true, receive 13 percent of all income in the United States. Going after the rich to help balance the budget is fine--as far as it goes. Unlike some of my Wall Street colleagues, I see absolutely nothing wrong with imposing higher tax burdens on the wealthiest in our society. But it does not require any arcane knowledge of fiscal arithmetic to see that even with the substantial tax increases proposed by the Clinton plan, trying to balance the budget is quite literally impossible on such a narrow stretch of income territory. In fact, to meet this goal by the year 2000 by taxing the "rich," we would need to tax away all the taxable income of everyone with more than $175,000 of adjusted gross income. Or, if we would prefer a less draconian approach, we could merely double the income taxes of "affluent" tax filers--but we would need to include everyone down to about $50,000 of income. Even this kinder and gentler approach would amount to something more like expropriation--hardly consistent with either free markets or democracy.

As for direct entitlement benefits, here too not much help is available from the rich. The maximum entitlement savings obtainable from the one percent of households enjoying incomes of more than $200,000 are unfortunately limited to the benefits that go to them--about $5 billion if we took away all their benefits (something that even Bill Clinton, with his laser beam on the rich, has never dreamed of suggesting).

But if we are willing to ask for even modest sacrifices from all Americans with incomes above about $30,000, the picture changes entirely. Suddenly we're talking about a whopping 73 percent of national household income. We're also talking about a stunning 74 percent of all tax expenditures and 43 percent of major federal entitlement benefits, which, taken together--and including our estimate for all benefits--amounted to $372 billion in 1991. That's a sum we simply cannot afford to ignore if we are at all serious about putting our fiscal house in order.

Twelve years ago, when Ronald Reagan ascended to the White Louse, I hoped that his politically candid talk about cutting the budget deficit would lead to politically courageous action. But instead we found a convenient scapegoat. The "poor," we learned, were bankrupting America. Just eliminate the "waste, fraud, and abuse" in our welfare system--all those mink-wearing welfare queens driving Cadillacs and buying vodka at taxpayers' expense--and a balanced budget would be in reach. The premise, of course, was wrong from the beginning. Despite cuts in programs for the poorest Americans during the Reagan years, the deficit kept exploding.

When Bill Clinton ascended to the White House, I was once again hopeful that the President would seize the moment and make the tough choices needed to cut the deficit and boost savings and investment. But we seem to be caught up in another form of scapegoating. This time it's not the poor who are to blame; it's the rich who are not paying their way.

To be sure, President Clinton will get further with his scapegoat than President Reagan did with his. But both ways of dodging tough choices veer away from the heart of the problem. We are all implicated in our budget deficits, our entitlement ethos, and the overall consumption bias in our economy. And all of us most particularly the broad middle class that is the backbone of America, must now be part of the solution.

Let's pause for a moment to ask ourselves, what in reality is the "middle class"? Ask any American if he or she is "middle class," and the answer will almost always be yes. The truly poor will admit to being "lower middle class," and the rich will go along with "upper middle class," but few will forthrightly call themselves "poor" or "rich." This is a characteristically American self-perception, and it reflects our desire to live in a basically egalitarian society. But in recent years it has allowed nonpoor Americans to believe that they deserve universal federal entitlements--much of them windfalls--such as Social Security and Medicare, which are often disingenuously called "insurance," and which people mistakenly think of as the payback on their contributions to "their accounts."

Next, ask any group of Americans to specify the annual income that defines "middle class" and you'll hear responses ranging from, say, $20,000 all the way up to $200,000--if we include the Clinton Administration's definition. But there are more precise and realistic definitions. If nontaxable entitlement benefits and other tax-exempt income are included with adjusted gross income reported to the IRS, the median family in the United States had a total adjusted gross income of $31,700 in 1993. If "middle class" is then narrowly defined as comprising half of all American families equally distributed around that $31,700 family, the statistical middle-class income turns out to range from $14,040 to $55,880.

This exposition regularly startles those who are new to it. A family with $60,000 of income invariably thinks of itself as "just getting by," but it actually stands in the top quarter of families. A two-earner family with an income of $120,000 may think of itself as just middle class. In fact that two-earner family stands in the top five percent of American families. By the time we reach those with incomes in excess of $200,000--the only households targeted for significant sacrifices by the Clinton Administration's proposals--we are left with a mere statistical sliver of the population: roughly one percent.

Middle-class Americans today, it seems, suffer from what might be called a "reverse Lake Wobegon" syndrome. As Garrison Keillor fans know, Lake Wobegon is a wonderful fictional place where all the children are above average. When it comes to incomes, however, most middle-class Americans, trying hard to make ends meet, assume they must be below average.

Middle-class Americans today feel hard pressed and beleaguered--and they are. Nobody could possibly argue that even a well-above-the-median $50,000 a year in household income will put one on easy street. It's hard to make it on a typical middle-class income today--when paychecks barely keep up with the cost of homes, of college educations and even of necessities.

Working hard and trying to follow the rules, middle-class Americans have adopted a kind of siege mentality in the face of evaporating expectations about fixture income growth. The middle class is already making a de facto and unplanned sacrifice in terms of the loss of upward mobility. But an organized, planned, and temporary additional sacrifice can reverse that trend. Only if we all give up something to reinvest in our future will we be able to rekindle the rise in U.S. living standards. If we all just hunker down to protect what we feel we're entitled to, we will condemn ourselves to a future that grows bleaker each year. Evaporating and diminished expectations are not what America is about. The willingness of middle-class citizens to sacrifice a little today for a better tomorrow is, however, exactly what America used to be about and ought to be about once again.

In spite of the recent stagnation of its living standards, the American middle class is still the world's richest middle class, consuming far more than any of its counterparts in Europe or Japan--and paying far lower taxes than most. Indeed, Americans may think themselves overtaxed, but we pay some 10 to 20 percent less of our national income in taxes than do the citizens of most other industrialized countries. The actual economic room for sacrifice exists; what we are missing is the public understanding and the political will to recognize such sacrifices as being in our long-term best interests.

We can't, of course, call on the middle class alone to sacrifice. The rich must pay their fuller and fairer share. Many of the same people who argue that the middle class is too beleaguered to contribute to solving our economic problems stand by silently as the $30,000-a-year middle-class worker pays ever-increasing payroll taxes (which in many cases come to more than his or her income taxes) to subsidize the entitlement benefits of retirees who are getting ten times their contributions in Medicare payments (tax-free) and who may be earning $100,000 or more a year in retirement. This is unconscionable.


Relearning Our Endowment Ethic

These things are certain: we can't do it without the without the middle class. And we can't do it without going at entitlements head on.

Bill Clinton's decision to skirt entitlements and to spare the middle class from all but token sacrifice may have seemed a politically expedient course for the short term, just as it has to the past several Administrations. (According to the economist Benjamin Friedman, 74 percent of the burden of what deficit reduction the Clinton plan does achieve through higher taxes or benefit cuts will be borne by the small share of U.S. families earning more than $100,000. But it has meant that his only feasible program is one that has no hope of balancing the budget--or even coming close.

Bad economics may end up being bad politics as well. It is a matter of debate whether the American public is actually ready for real change and tough choices. And avoiding excessively rapid spending cuts or large tax increases in the midst of a creeping recovery was an understandable concern--though for all too many years it has never been the right moment in the business cycle or the political-election cycle for decisive action on the long-term economic predicament that by now also harms our short-term economic prospects. Any responsible budget plan must be phased in gradually if we want to avoid too bumpy a ride. But I believe that a clear goal of budget balance--and a commitment to meeting it by the end of the decade--would ultimately go over better with both the markets and the public than the course Clinton has chosen. Indeed, if one adopts Richard Nixon's dictum that the economy that matters most is the one that prevails three months before the next election, the President's current approach is a dangerous one.

By not asking the public to swallow the bitter pills at the outset, Clinton risks being forced to ask the public--and especially the middle class--to swallow them later, closer to the 1996 election. At that point, having denied the middle class its promised tax cut--and having created the impression that Americans are already making the needed sacrifices when they're not--Clinton may find the public wondering at the need for further sacrifice. Moreover, the lift given to the bond market in 1993 by the early promise of deficit reduction may by 1996 have reversed itself. With health care and other entitlements still spiraling out of sight, and with private credit demands likely rising as we and the rest of the world fully emerge from recession, the United States could once again see soaring interest rates right around election time. As 1996 approaches, Bill Clinton not only inevitably faces a second major budget-cutting exercise but also runs the distinct risk of being tagged the Biggest Borrowing President in history--and he won't even have the excuse of having presided over a divided government. It's easy to imagine a 1996 Republican campaign advertisement along these lines: "Bill Clinton raised your taxes, still borrowed a million dollars a day, built a bunch of bridges to nowhere--and this time you know who to blame."

My view is that everybody except the poor and near-poor must be part of the solution to America's economic problems. But as we move through the various strata of the middle middle class and upper-middle middle class, and on into the upper middle class, the sacrifices called for in the form of higher taxes or curtailed entitlement benefits should get much larger. By the time we reach the genuine upper class, we should have increased the tax bite significantly and cut deeply into tax subsidies and windfall entitlement benefits.

To help restore fiscal and moral responsibility to our entitlement system, the budget plan I propose in my book Facing Up: How to Rescue the Economy From Crushing Debt and Restore the American Dream therefore includes an "affluence test," or a graduated entitlement-benefit reduction. This affluence test (along the lines of the comprehensive means-testing idea discussed by Neil Howe and Phillip Longman in "The Next New Deal," in this magazine in April of 1992) would apply to all federal benefits, both cash and in-kind. No sacrifice would be required of households with incomes below the U.S. median (generously assumed to be $35,000 by 1995, when the test's phase-in would begin). For families with above-median incomes a portion of total entitlement benefits would be withheld on a steeply progressive basis. Under the test, households would lose 7.5 percent of all benefits that cause their incomes to exceed $35,000, plus five percent at the margin for each additional $10,000 in income. For most types of entitlement benefits, the maximum benefit-reduction rate would be 85 percent, applicable to household incomes greater than $185,000.

If this proposal doesn't silence those who rail that entitlement reform is inevitably regressive and must ravage the poor, it should at least give them pause. For families who are earning between $30,000 and $40,000, are receiving benefits, and are subject to the test, the sacrifice called for would average just $260 a year--or one percent of their benefits. Moreover, most who would have to sacrifice are retired and have lower expenses than working-age adults with similar incomes. For families earning between $50,000 and $75,000, the sacrifice would rise to an average of $2,310, or 12 percent of benefits; for families with incomes over $200,000, it would average $15,345, or 72 percent of benefits.

All told, the budget savings made possible by the affluence test are enormous: at least $93 billion in 2004, on the basis of a conservative calculation that takes into account only the 80 percent of entitlement benefits for which we currently have detailed data on recipient income. Affluence testing alone, however, does not add up to complete entitlement reform. Among other measures, we will also need to cap our open-ended tax subsidies for retirement, housing, and health care, accelerate the scheduled rise in Social Security retirement ages, and trim the largesse of our federal pension systems.

All of these reforms involve structural spending cuts that will save significant money in the 1990s and much more beyond. In a business-as-usual budget scenario, entitlement costs could be closing in on a quarter of GDP by 2040. Under my plan we would already be saving about 1.9 percent of GDP in entitlement spending by 2004; by 2040 we would be saving 5.3 percent of GDP or some $690 billion in today's dollars--more than twice what we now spend on the Pentagon. That's what I mean by structural spending cuts.

We must invent a new entitlement system that will not just pay us affordable benefits when we need them but will also encourage us to save more for the future, care better for our own children and parents, and take more responsibility for our own health. As America itself grows old, perhaps the most vital changes in our entitlement system will be those that encourage a positive new vision of aging. Entitlements for the elderly must promote an active, economically self-sufficient lifestyle for elders who are able. We will no longer be able to afford a system that equates the last third or more of one's adult life with a publicly subsidized vacation.

Getting our entitlements system back on a sound footing is the key to both a balanced budget and a renewed rise in U.S. living standards in the next century. But of course, putting our fiscal house in order will require much, much more. There is still room for trimming in the small discretionary domestic corner of the federal budget. I also believe that in this post-Cold War world we can spend substantially less on defense, and I endorse the President's proposed cuts. To balance the budget by the year 2000, and at the same time spend more on worthy public goals, from more-generous targeted assistance to the poor to productivity-enhancing investments in human capital, research and development, and infrastructure, we will also need to raise new revenues above and beyond the tax increases President Clinton has already proposed. Along with a broad-based progressive consumption tax, I recommend higher "sin" taxes and a fifty-cent-a-gallon federal gasoline tax phased in over five years, in order to target a particularly profligate type of consumption. But in the end, unless we are willing to touch the third rail of American politics and rein in the growth in middle- and upper-class entitlements, our goal will elude us.

The worst aspect of our entitlement addiction is how it subtly fixes our attention on how much we are going to get--and how it obscures any thought of what we have received from others and what we wish to pass on in our turn. In this sense our entitlement ethos pervades not just our public benefit programs but our entire approach to deficit-financed consumption. It is time for America to begin unlearning its entitlement ethic and begin relearning its endowment ethic. At some point we must decide how much we are willing to give up today in order to save for and invest in a tomorrow of rising living standards for ourselves and, of course, our children. The alternative--a future without an American Dream--is no alternative at all.


Peter G. Peterson is the chairman of the Blackstone Group, a private investment bank. He is also a member of the board of the Federal Reserve Bank of New York and co-founder of the Concord Coalition, a bipartisan economic policy group. Earlier in his career Peterson served as the U.S. Secretary of Commerce and as chairman and CEO of Lehman Brothers and Bell & Howell.

Copyright © 1993 by Peter G. Peterson. All rights reserved.
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