A Plan to Cut Social Security and Medicare That Even Liberals Can Love

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The peril to entitlements has been overstated by the likes of Paul Ryan, but progressives can no longer ignore the need for smart reform. Here's how to do it.

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Something wonderful happened in the United States during the middle third of the 20th century. After decades of policies that smacked of Social Darwinism, our country created a strong, if incomplete, social-insurance safety net. The actions our government took expressed a solemn promise to vulnerable Americans. Social Security and Medicare assured the elderly and disabled basic cash income and health care roughly similar to that enjoyed by the rest of the population. They lifted the elderly and disabled from a status of privation to near equality with the nonelderly in both money income and access to health care. Various other federal programs provided food, housing, and educational support, or encouraged their provision by state and local governments. By official measures, poverty among the elderly fell below that of other age groups thanks to Social Security, and health coverage improved markedly for the nonelderly poor because of Medicaid.

Now, in the second decade of the 21st century, these advances are under attack and that solemn promise is in jeopardy. To be sure, these programs enjoy enormous popularity. At the same time, however, a solid minority has never accepted the idea that taxes should be used to pay for pensions and health insurance. As long as economic growth generated enough revenue to pay for these programs and the rest of government's commitments, opponents of social insurance and other elements of the safety net gained little political traction. Three deficit-reduction plans enacted during the presidencies of George H.W. Bush and Bill Clinton, along with sustained economic growth, produced budget surpluses in the late 1990s and early 2000s.

But then everything changed, and the national debt ballooned. The recessions of 2001 and 2007-2009 led to higher unemployment and lower revenues. Imprudent tax cuts slashed revenues still more. Wars in Iraq and Afghanistan following the tragedy of 9/11 led to huge increases in military spending. As a result, large and seemingly limitless deficits emerged, and budgetary angst has become epidemic.

In addition, official projections have warned that retiring baby boomers and rapidly rising health-care costs will cause Social Security and Medicare benefits to greatly outpace program revenues. Although these long-term forces have little to do with current budget deficits, they have combined to generate a sense of fiscal crisis. On top of this comes the "fiscal cliff," the concatenation of dubious fiscal decisions timed to take effect almost simultaneously. Although tax cuts enacted during President George W. Bush's first term were prevented, the payroll-tax holiday enacted in early 2011 expired on December 31, 2012. The government debt will soon breach the ceiling set in August 2011. Mindless spending cuts passed in 2011, based on formulas that pay no heed to the relative importance of programs and that have nothing to recommend them other than simplicity, are to begin on March 1, 2013.

Analysts agree that if the expenditure cuts take effect, economic activity will slow, and a weak recovery will morph into recession. Failure to raise the debt ceiling would wreak tsunami-like devastation on financial markets that would inundate the rest of the U.S. and world economy.

Against this backdrop, the American public is being told that the cause of looming financial catastrophe is an "entitlement crisis." Fiscal Jeremiahs warn that the only way to deal effectively with current deficits is to cut back Social Security, Medicare, and Medicaid years in the future. The full House of Representatives has twice passed budget plans, crafted by Budget Committee Chairman Paul Ryan, that would replace Medicare with a voucher that beneficiaries could use to buy either private insurance or a plan like traditional Medicare. The Ryan plan would also convert Medicaid into a block grant at spending levels well below what is projected under current law. The grants would not increase during recessions when Medicaid enrollments tend to spike. States, pinched by falling revenues and rising service demands, would have to cut benefits just when they are most needed.

But while reports of a crisis are overblown, and conservative proposals to solve it are draconian, progressives do need to think about how best to reform the entitlement programs. The simple fact is that Social Security, Medicare, and Medicaid form a very large and growing part of the federal budget -- currently 50 percent of noninterest spending. Furthermore, the phrase "entitlement crisis" has been repeated so often and so earnestly that denying its reality is more likely to damage one's own credibility than to dislodge what is actually profound confusion. Cuts in Social Security, Medicare, and Medicaid benefits are neither necessary nor desirable and should be resisted, even as reform of the whole health-care delivery system proceeds. But political and economic realities -- the need to secure majority support for measures to lower deficits once economic recovery is well advanced -- make some cuts highly likely. It behooves supporters of social insurance to have in reserve program cuts that would do the least harm and might advance other meritorious objectives. To begin this search, one should start with the underlying economic and demographic forces that are driving spending.

Demographics and Entitlements

Three demographic facts are key. Longevity is increasing. In contrast to the past, when life expectancy increased due mostly to declining mortality rates among infants and the young, almost all current and future longevity gains will occur among the old. Large groups of Americans are not sharing in these longevity gains.

Life expectancy has risen throughout most of the industrial era. But the character of that increase has changed profoundly, as documented by Stanford health economists Karen Eggleston and Victor Fuchs in theJournal of Economic Perspectives. For most of history, high infant and early-childhood mortality meant that most babies didn't live to grow old or even to child-bearing age. Only 40 percent of babies born in 1900 lived to age 65. Mortality before child-bearing age explains why high birth rates led to little or no population growth. In the early and mid-twentieth century, that changed. Major public health and medical advances -- notably, improved sanitation and diet, and antibiotics -- caused mortality from infectious diseases to plummet. Now, more than 80 percent of babies are expected to live to age 65.

As mortality rates for young adults approach zero, most longevity gains have to occur among the old. As Eggleston and Fuchs show, that is just what has been happening. The share of longevity gains among those over age 65 has risen from one-fifth at the start of the twentieth century to 80 percent now, and the share is rising.

For the past couple of decades, these gains have been unequally shared. Research by University of Illinois at Chicago public-health professor S. Jay Olshansky and his co-authors documents that most longevity gains have accrued to the well educated. Those with little education are actually dyingyounger than they were in the past. A pre-existing longevity gap is expanding with alarming speed. Between 1990 and 2008, life expectancy at age 25 among white men and women with less than a high-school education fell 3.3 years and 5.3 years, respectively. Part of the reason for this drop may well be that those with less-than-high-school education rank lower on the socioeconomic scale now than they did even two decades ago, but much of the shift is a mystery. Among white men and women with at least a college education, life expectancy at age 25 rose 4.7 years and 3.3 years, respectively, over that period. In 1990, life expectancy at age 25 for white men with at least a college education was five years more than it was for those with less than a high-school education; by 2008, the gap was 13.1 years. For white women, the gap shot up from 1.9 years to 10.5 years.

Even at age 65, the relative gaps remain jarringly large. In 2008, for example, white men with a college education or more had life expectancies five years, or 35 percent, longer than those without a high-school education.

As is well known, whites on average live longer than do blacks. That gap has narrowed somewhat over the last two decades. For reasons that are not well understood, Hispanics have longer life expectancies than either non-Hispanic whites or blacks.

Life Expectancy and Public Policy

While differences among groups are important, so too are averages. Half of men are out of the labor force by age 64, half of women by age 62. On average in 2008, life expectancy for 20 year olds was an additional 59 years, or to age 79. That would mean that the average American works 42 or 44 years and is retired for 15 or 17 years (though in reality, most people are not in the labor force all the time). Crunch all these statistics together and you find that, on average, people typically spend roughly one-third of their adult lives in retirement if one accounts for time spent out of the labor force for child-bearing, for education after age 20, and in unemployment. If consumption is spread evenly over the adult life cycle, roughly one-third of lifetime consumption will occur in retirement.

Stanford economist John Shoven points out that most people live as couples. That changes the arithmetic. Males usually marry women somewhat younger and who have somewhat longer life expectancies than themselves. Shoven points out that roughly 30 years will elapse, on average, before both members of a couple consisting of a 62-year-old man married to a 60-year-old woman will die. Typically, they will have worked no more than 40 years. Shoven bluntly asserts, "You can't finance 30-year retirements with 40-year careers without saving behavior that is distinctly un-American." Whether one uses my arithmetic or Shoven's starker version, it is surely fair to ask whether people will be willing to divert from current consumption enough to both support ever-lengthening retirements and pay for the rest of what they want government to do.

Perhaps they will. After all, workers retire earlier in many other developed countries and receive pensions more generous than those in the United States, even though their life expectancies equal or exceed our own. Still, the reaction of U.S. elected officials to current and projected budget deficits suggests that the United States will not readily accept European-level taxes. Europeans are, to be sure, cutting back pension commitments, but they are doing so from levels much higher than those in the United States and facing elderly populations that, relative to total populations, are considerably larger than any anticipated in the United States. The Republican Party wants no tax increases whatsoever. Even most Democrats support permanent extension of most Bush-era tax cuts.

For this reason, supporters of the current social-insurance system -- even as they fight against any cuts at all -- must think about changes in Social Security, Medicare, and other elements of the social safety net that reduce spending in the least damaging ways and that may accomplish other goals. Prominent among such goals should be measures to put in place financial incentives to "nudge" those who can do so without undue hardship to work until later ages than they now do.

Social Security

Two fundamental facts make the prospect of any cuts in Social Security particularly galling. One, Social Security benefits were cut significantly by 1983 legislation. (The law enacting those cuts is still only partly implemented; more cuts are to come.) Two, U.S. benefits look downright parsimonious when compared against those offered in other developed nations.

The 1983 Social Security Amendments, largely modeled on recommendations of a commission appointed by President Ronald Reagan and Congress and chaired by Alan Greenspan, cut benefits two ways. They skipped a cost-of-living increase for current pensioners and built that reduction into the benefit formula. They also put in place what is perhaps the most widely misunderstood and misnamed legislative provision in all U.S. history, the benefit cut that was misleadingly called an increase in Social Security's so-called "normal retirement" age -- from 65 to 66 starting with those born in 1938 and to 67 starting with people born in 1955.

Despite the name, that change had next to nothing to do with when people normally retire or claim benefits. What Congress actually did was to raise the age at which unreduced benefits -- the amount generated by the Social Security benefit formula -- are paid. Congress left unchanged the age when people can and, typically, do first claim benefits, age 62. Retirees who claim benefits before the "full-benefits" age receive less than the full benefit. The reduction is 6.67 percent multiplied by how many years before the full-benefits age that people take their pensions. For that reason, raising the age at which unreduced benefits are paid by two years simply cuts benefits for all retirees by just over 13 percent.

The Social Security checks people receive have fallen still more for another reason. Before it mails checks, the Treasury Department subtracts each pensioner's premiums on Part B of Medicare. Medicare premiums have outpaced pension growth and are expected to continue to do so. Furthermore, taxation of Social Security benefits will also increase as called for by the 1983 amendments. For all these reasons, the ratio of Social Security net take-home pay to earnings has fallen. For a worker with average earnings claiming benefits at age 65, Social Security take-home pay, which was 39 percent of average lifetime earnings in 2002, will fall to 35 percent by 2015 and to 31 percent by 2030.

Not only are Social Security benefits growing more slowly than earnings, they are lower than benefits in most other developed countries. For average earners, U.S. old-age benefits in relation to earnings are 9 percent lower than those of Germany, 30 percent lower than those of France, and 51 percent lower than Denmark's. Compared to pensions in the 16 economically developed members of the Organization of Economic Cooperation and Development (OECD), U.S. benefits for average earners are 34 percent lower and rank fourteenth. If one takes account not only of the amount paid at a point in time, but also longevity, the ages at which pensions are first available, and other features of pensions systems, U.S. pensions are 40 percent below the OECD average in absolute value, despite our higher average incomes. This mocks allegations that U.S. benefits are lavish or unsustainable.

The structure of Social Security could be improved, however. Poverty among the elderly rises with age. People deplete their assets, pensions often decline or end when a spouse dies, and the capacity to work wanes. The age-related increase in poverty rates suggests that one currently popular idea for scaling back Social Security benefits -- the introduction of a technically more accurate cost-of-living adjustment -- is perverse. The consumer price index used to adjust Social Security benefits somewhat overstates inflation. In the name of accuracy, various commissions have endorsed replacing the current index with one that more accurately measures inflation. The effect of this index shift would compound from year to year, cutting benefits each year relative to those now paid by ever larger amounts the longer one receives benefits. Use of the alternative index would cut benefits for an 85-year-old retiree by about 7 percent. The impact on the long-term disabled could be even larger because they may receive benefits for even longer than do the elderly. This genuflection to statistical precision would reduce benefits most for the long-term disabled and the very old.

A better reform would be to boost Social Security benefits for those who have been on the rolls for a long time. For example, a benefit increase of $25 per month for each year on the rolls after age 75 would amount to a benefit increase of about 2 percent per year of the average retirement benefit now being awarded. By age 85, a 2 percent annual increase would boost benefits 20 percent. The increase would be largest for the very old and would be proportionately larger for those with low benefits and smaller for those with high benefits.

These data do not change the need eventually to close the gap between promised Social Security benefits and currently projected revenues. But they should influence how we do it. Since pension benefits are low compared to those of other countries and are falling relative to earnings, exclusive reliance on increased revenues is where discussions of how to close the projected long-term deficit should begin. Those revenues could come from increases in the current payroll-tax rate, from raising the cap on earnings subject to tax, or from extending the tax to currently exempt compensation. The payroll tax is now 4.2 percent for workers (though the rate is expected to go up to 6.2 percent in 2013 at this writing) and 6.2 percent for their employers. Earnings above $110,100 in 2012 are exempt, as is compensation channeled into the increasingly popular medical savings accounts, dependent care accounts, and transportation reimbursement plans. Gradually raising the fraction of earnings subject to tax from the current 84 percent of earnings to the historical target of 90 percent of earnings, boosting the payroll-tax rate from 6.2 to 7 percent, and taxing currently exempt cash compensation would fully close Social Security's projected long-term financing gap.

For progressives, restoring long-term funding balance with added revenues should be the starting point for negotiations. Realistically, however, some combination of net benefit reductions and revenue increases may be inevitable. It would be worth accepting modest and well-targeted net benefit cuts to end fears that Social Security is inadequately funded. The lessons of the 1983 amendments are instructive. The 1983 compromise undercut more radical proposals for restructuring the system. To be sure, a similar compromise today would not mollify those who are ideologically opposed to the very idea of Social Security. But it would end their capacity to mobilize a credible attack on the system because it would reassure the majority of voters who value Social Security but have come to fear for its financial viability. If projected trust-fund deficits persist, proposals to replace the system with private accounts or to otherwise change it fundamentally will continue to get a hearing. Only one such attack needs to succeed to undo the crown jewel of U.S. social insurance. Removing that chance is why progressives should be open to compromise.

But the acknowledgment that net benefit cuts may be inescapable does not settle whose benefits should be cut and how they should be cut, nor does it exclude targeted benefit increases. Increases in longevity have raised pension costs most on behalf of those with comparatively high education and earnings. Fairness dictates that if benefits are to be cut, the reductions should fall on benefits for those groups. The way to cut spending is not to cut annual benefits for everyone but to cut them selectively for early retirees with comparatively high earnings, thereby encouraging them to work longer and claim benefits later than in the past. A trend to later retirement is already under way. Labor-force participation among people over age 55 has been rising over the last couple of decades. Even so, 50 percent of new benefits awarded to retirees in 2011 were claimed at age 62, and 94 percent were awarded on or before the full-benefits age of 66.

This pattern of claiming benefits early persists despite the fact that most people would gain financially from waiting as long as possible to claim benefits -- even up to age 70, when benefits hit their maximum. The reasons for waiting are instructive. When people were first allowed to claim benefits before age 65, their benefits were reduced so that, on average, the lifetime value of benefits would be the same regardless when they were claimed. Since then, however, life expectancies have increased, and interest rates have fallen. Both changes increase the cumulative reward for waiting -- the higher benefits continue longer because of increased longevity and deferred benefits are worth more because of the lower discount rate.

Reducing benefits only for comparatively high earners who claim them early -- say, those with earnings in the upper 30 percent of the Social Security earnings distribution, which means those with lifetime average earnings in 2011 above $57,066 -- would maintain benefits for lower earners who are least likely to have the financial means to support themselves if continued work becomes burdensome or impossible. Depending on the size of the reduction, this change could cut Social Security's long-term funding gap by up to one-half.

Medicare

The 2012 political campaign froze rational discussion of Medicare -- and, alas, many other topics as well. The Republican presidential and vice-presidential candidates and their platform called for repeal of the Affordable Care Act (ACA) and replacement of the current Medicare system with a voucher plan that was simultaneously more radical than they acknowledged and less of a break from the current system than they claimed.

Once upon a time, Medicare paid pretty much whatever price hospitals, doctors, and other providers charged for whatever services they rendered. But no longer. For nearly three-quarters of all enrollees, Medicare now pays a flat fee for treating particular conditions and aggressively regulates service prices. The remaining quarter or so of Medicare enrollees sign up for one of several competing private plans that accept a flat sum for delivering services at least as good as those offered under fee-for-service arrangements. Quite simply, Medicare enrollees now have a lot of choice, and the system as a whole is based on competition. The campaign claim that it is necessary to replace the current system with vouchers in order to give enrollees "choice" and to promote "competition" was and is utterly bogus.

So was the claim that these competing private plans save money. In fact, even if one adjusts for diverse health needs and subtracts the extra payments that private plans received under the Medicare Modernization Act of 2003, the data show that competing private plans on average cost about 3 percent more than traditional Medicare does.

The Republican agenda rested not only on a factually inaccurate assumption but also on a practical and political impossibility -- repeal of the ACA. Many elements of the law are already in effect, such as the extension of coverage under parents' insurance to young adult children and added coverage of preventive medical services under Medicare. Other provisions, such as the bar on using pre-existing conditions to deny coverage or charge high premiums, are so popular that those who called for "total" repeal of the ACA said simultaneously that they would retain them. But if insurance companies are barred from denying coverage based on pre-existing conditions, then much of the rest of the law that Republicans promised to repeal must also remain. If insurers must take all comers regardless of health status, then it is necessary to mandate people to buy insurance so that they don't wait until they are sick to buy it. To require insurance coverage, it is necessary to subsidize such coverage for those with modest incomes in order to make it affordable.

The "if we can't repeal it, we'll block implementation" strategy is also a dead end, as such efforts will create chaos in the roughly 15 states that are well along in implementing the law. Furthermore, the biggest administrative innovation of the ACA -- the exchanges that will regulate the sale of health insurance -- would be key to the effective operation of the voucher plan that Republicans proposed to replace Medicare. The challenge of setting up such exchanges for Medicare enrollees would dwarf the admittedly difficult task of setting them up for the prime-age population served by the ACA. To start with the more challenging Medicare population would make no sense.

Despite months wasted debating proposals that had little chance of adoption, changes to Medicare are likely, and some are desirable. Given the desire to cut deficits soon, Medicare is just too large to ignore. Current earmarked revenues and accumulated reserves will eventually be inadequate to pay for all promised hospital-insurance benefits. Furthermore, the program suffers from genuine shortcomings.

For starters, Medicare coverage has important gaps. It does not cover the costs of very extended illnesses. It exposes low-income beneficiaries to sizable deductibles and cost sharing. To avoid them, most Medicare beneficiaries -- other than the poor, who are protected from them by Medicaid -- either buy supplemental coverage against these risks or receive it from former employers. This multi-layered arrangement adds needless, costly, and vexing complexity. Furthermore, current arrangements actually subsidize private insurance because covering deductibles and cost sharing boosts use of services, much or all of which Medicare pays for and that private insurance premiums don't cover.

Fixes for both problems are straightforward. Protection against costs of very extended illnesses could be added to the standard Medicare benefit package and paid for with a small increase in premiums for upper-income enrollees, so that the burden on taxpayers is unchanged. Those Medicare enrollees who want to avoid facing deductibles and cost sharing could be offered a "super-Medicare" option that reduces or eliminates deductibles or cost sharing, priced to prevent any increase in the net cost of Medicare to taxpayers. Premiums could be set a bit below those of current Medigap coverage because of savings from eliminating one layer of administration.

Medicare's defenders take pride in its low administrative costs. The truth is that Medicare spends too little on administration. The program could lower overall spending somewhat if it spent a bit more in certain areas. Each dollar spent on policing fraud would yield several dollars in savings. More program managers could do a better job of making sure that when new procedures are approved as safe and effective, Medicare pays only for approved cases, not for others where safety and efficacy are unproven. Tighter administration is not the financial magic bullet, but if ever the old saying "a billion here, a billion there; pretty soon you're talking about real money" had bite, it would be here.

Third, some Medicare beneficiaries can afford higher premiums than they now pay. Individuals with incomes below $85,000 and couples with incomes below $170,000 currently pay no more than 25 percent of the cost of Medicare Parts B and D, which cover doctors, drugs, and medical devices. People with incomes above those thresholds pay premiums that cover 35 percent to 80 percent of the actuarial value of coverage. It is simply not credible to argue that couples with incomes of $100,000 to $170,000 cannot afford to pay more than one-fourth of the cost of Supplemental Medical Insurance.

The most controversial proposal is to raise the age of eligibility for Medicare. This proposal is premature: If implemented now, it would expose older people who lose Medicare coverage to an increased risk of being denied private coverage altogether or facing unaffordable premiums. When the ACA is fully in operation -- which means that the exchanges are up and running and nearly all states have agreed to the extension of Medicaid coverage -- raising the Medicare eligibility age to match the "full-benefits" age for Social Security, 67, makes sense. It would nudge some people into remaining economically active a bit longer than they now do. The ACA will guarantee people coverage through its health exchanges and it will provide subsidies to make private coverage affordable for those with low or moderate incomes. More generally, the argument that in the face of ever-lengthening life expectancies, public policies should be set as if everyone should be able to retire at the same ages as in the past is untenable. It's true that calls for longer working lives typically emanate from handsomely compensated incumbents of sedentary jobs, not from those who do physical labor or perform tedious and poorly paid tasks. But that means simply that the way to shift policy is to encourage those who can afford to do so into working longer, while preserving the option of earlier retirements and the assurance of basic financial security and health-insurance protection to those who need them.

The Fiscal Effects of Later Retirement

The fiscal effect of changes in Social Security and Medicare that nudge people into working longer goes well beyond the direct impact on these two programs. Tricia Neuman and Juliette Cubanski of the Kaiser Family Foundation have shown that raising the age of eligibility for Medicare cuts government health spending only slightly. Medicare spending drops some, while spending through other federal or state programs, such as Medicaid or subsidies through the ACA health insurance exchanges, goes up nearly as much. Total (as opposed to government) health-care spending probably goes up a little, as the average per-person cost of private plans -- which more people would buy if the eligibility age were raised -- is higher than that of Medicare.

The overall fiscal effect of policy changes that cause people to retire later is much greater, however. Longer working lives mean a larger labor force. A larger labor force means higher output at full employment. And higher output means increased tax collections from individuals and businesses, as well as some reduction in government spending. In a Brookings Institution study (carried out in collaboration with the Urban Institute and Moody's Econometrics and sponsored by the Sloan Foundation), Gary Burtless and I find that if labor force participation among workers over age 55 continues to increase at the same rate observed since 1995, rather than at the slower rate of increase projected by the Social Security Administration, cumulative government revenues would rise $2.7 trillion over the next three decades, mostly from income and payroll taxes, and spending would fall about $600 billion, mostly from Medicare and Social Security savings.

For several decades support for the legislative landmarks of the New Deal, the Fair Deal, and the Great Society seemed impregnable, both in the general public and among political elites. Public affection for Social Security and Medicare remains deep and broad. But budget deficits and specific projections for Social Security and Medicare have created a widespread, if misguided, sense that we just can't go on without retrenchment.

The first line of defense should be to defend the importance of these programs and others that comprise the social safety net, and to show that they can be sustained without unduly high tax burdens. But failure to plan for what to do if some ground must be given would be an abdication of responsibility.

For supporters of social insurance, not to make such plans would leave to those programs' critics and enemies the job of designing changes that may prove inescapable. That is not an outcome that progressives should allow. Nor should progressives deny the very real imperative resulting from a steady increase in longevity: People who can do so should be encouraged to work until later ages than has been common in the past.

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Henry J. Aaron is the Bruce and Virginia MacLaury senior fellow at the Brookings Institution.

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