The $45 Trillion Problem

Carefree spending, huge tax cuts, and—above all—unalterable demographic facts have put us all in a box. And there's no easy way out

Even if you think government budget numbers are generally not very interesting (and they do tend to blur together into an eye-glazing morass), here's a number to quicken the pulse: $45.5 trillion. That's the size of the long-term gap between the federal government's projected outlays (future spending plus current debt) and its projected revenues. Most government budget projections look only a brief distance into the future—a year, perhaps, or ten at the most. But Jagadeesh Gokhale and Kent Smetters, economists working at the Federal Reserve Bank of Cleveland and the University of Pennsylvania, respectively, have looked further into the future and determined that, in effect, if the U.S. government were a company its owner would have to pay a rational investor $45.5 trillion to take it off his hands. To put this figure in perspective: the entire U.S. economy generated only about $10.4 trillion last year, and total household wealth is currently only about $39 trillion.

This year the national debt is likely to hit $7.5 trillion, or about $25,600 for every American. But each American's share of the government's long-term unfunded liabilities—meaning tomorrow's debt as well as today's—comes to about $156,000. Though no single generation will have to cover the whole $45.5 trillion (and the generations that are already in or very near retirement may not need to cover any of it), ultimately some Americans will have to pay, through dramatically higher taxes or dramatically reduced government services or both.

Of course, warnings about government deficits have taken on something of a Chicken Little quality over the past twenty years. Since the end of World War II the annual budget has been in balance or surplus only eight times out of fifty-eight—and the sky has yet to fall. This is because even perpetual deficits are sustainable as long as the economy expands faster than the national debt. Moreover, budget forecasts frequently change with unexpected increases in tax revenue, changes in the business cycle, policy alterations, and other factors, which can suddenly turn presumed future shortfalls into surpluses and vice versa. Today the Congressional Budget Office's baseline ten-year projections show a deficit on the order of $1.4 trillion—but projections made just three years ago showed a ten-year budget surplus of $5.6 trillion.

The long-term imbalance between the amount of taxes that Americans are accustomed to paying and the level of government services that Americans are accustomed to receiving will not, however, be changed by any alterations in short-term projections. Under any reasonable set of assumptions about economic growth, the natural growth rate of health-care costs, and other important factors, the gap between what we expect to pay and what we expect to receive is enormous. The magnitude of this looming gap has been masked for the past several decades by a demographic blip—the Baby Boom, which for nearly forty years has provided a large base of workers who contribute payroll and income taxes while consuming relatively few government services. In 2012, however, when the first Boomers hit retirement age, the situation will begin to reverse: a large proportion of the population will begin drawing more heavily on government services, while the relative number of taxpaying workers will start to shrink. Today there are nineteen elderly for every 100 working-age Americans; by 2050 there will be thirty-five for every 100. This means trouble: in 2015 Medicare taxes will fall short of Medicare expenditures for the first time; in 2018 Social Security payments will outstrip payroll-tax revenues. In short, if we don't make policy changes soon, the government's financial situation will begin imploding within the next ten years.

The implications are profound: by 2050 the very nature of the federal government may be radically different. At the extremes the country has two basic options. One is to retain Social Security and Medicare as broad middle-class entitlements, maintain Medicaid, hold defense spending near present levels (about 3.5 percent of GDP), and keep the rest of the government at its current size. In this scenario federal spending would grow from 19.5 percent of GDP today to 39.7 percent in 2075, resulting in a government proportionally larger than Germany's or France's. To fully cover a U.S. government of this size, lawmakers would need some way to permanently increase tax revenue by 70 percent a year—beginning today.

The second option is to hold taxes near current levels—they have ranged from 17 to 20 percent of GDP every year since 1960—while ending entitlements as we know them. If we decided that we wanted to keep taxes relatively constant, we would need to cut Medicare, Medicaid, and Social Security benefits in half immediately; if we waited longer to act, the cuts in those programs would have to be even deeper. The social impact of such cuts could be mitigated by, for example, subjecting Social Security and Medicare benefits to a means test, so that benefits would be reduced more (or entirely) for affluent citizens; compared with across-the-board benefit reductions, this would hold down increases in poverty and poor health among the elderly. But any cuts of this magnitude would still be likely to increase poverty, make three-generation households more common (as some seniors were forced to move in with their children), and perhaps even reduce the average American life-span, since many poor and elderly people would no longer be able to afford medical care.

To put into perspective just how large a share of government expenditures entitlement programs are expected to consume over the coming decades, consider a third option: Couldn't we manage to keep tax levels constant and retain Medicare and Social Security if we were willing to eliminate, permanently and completely, all other government spending on everything including the military? Nope; wouldn't work. The gap between tax revenues and entitlement expenditures is so large that not even reducing the federal government to a shell would close the long-term deficit.

Needless to say, none of these three options would appeal to many Americans. A more desirable path would fall somewhere between the extremes—raising taxes some and decreasing services and entitlements some.

What we should be doing to prepare for the future is talking forthrightly about which painful tradeoffs we are willing to make: Do we care more about keeping taxes low or about preserving entitlements? Meanwhile, we should be trying to restrain expenditures so as not to make the problem worse.

What we are in fact doing, however, is almost exactly the opposite. No one is asking the hard questions about what kind of society we would like to be. And any semblance of fiscal discipline seems to have been completely abandoned, by both Congress and the White House. Defense spending has risen by 22 percent since Bush took office. This increase was understandable—perhaps necessary—given the war on terror. But nondefense discretionary spending has also risen during the past three years, by 14 percent—more than it increased during either the eight years of the Reagan Administration or the eight years of the Clinton Administration. Recent tax cuts, meanwhile, have added hundreds of billions of dollars to the ten-year deficit. And Congress just passed a major increase in Medicare spending (projected to be $400 billion over the next decade alone) through the addition of a drug benefit. A recent joint statement by the Committee for Economic Development (composed of prominent business and education leaders), the Concord Coalition (a bipartisan group focused on fiscal issues), and the Center on Budget and Policy Priorities (a left-leaning think tank) described the current budgetary situation as the "most fiscally irresponsible" in U.S. history.

What has produced this predicament? In part it is the result of an ideological struggle between the political parties, in which each side responds to the other by making the situation worse. Influential Republicans, both in and out of the Bush Administration, are convinced that running budget deficits will eventually compel a dramatic decrease in federal spending, ultimately starving many government programs of money entirely. (In the infamous formulation of the Republican strategist Grover Norquist, the goal is to shrink the federal government until it is small enough to "drown it in the bathtub.") Democrats, for their part, call for large and varied spending increases, knowing that the Republicans (who are causing the deficits to balloon with tax cuts and defense spending) are currently ill positioned to criticize them for lack of fiscal restraint.

The most cynical interpretation of what's going on here is that both Republicans and Democrats recognize the fiscal disaster looming on the horizon—but rather than attempting to prevent the coming of this disaster, each side is scrambling to maximize its preferred policy outcome (the Republicans by lowering taxes, the Democrats by strengthening entitlements for seniors and other government programs), so that when the crisis arrives, and painful adjustments become necessary, each party will feel that it is starting from a stronger bargaining position.

Fundamentally, though, the reason we are doing nothing to address these problems is that legislators are generally reluctant to focus on the long-term consequences of their policy decisions. For one thing, we lack the tools to gauge such consequences properly. The most common measures of the government's fiscal health, one- and ten-year budget projections, don't capture the real state of federal finances; not only are they myopic and disproportionately influenced by short-term fluctuations in the business cycle, but they explicitly exclude entitlement costs.

Thus, as an important first step the federal government should officially adopt a more comprehensive accounting measure, along the lines of the one produced by the economists Gokhale and Smetters. Had such a measure been in use throughout the 1990s, it would most likely have revealed a slowly deteriorating long-term fiscal picture at a time when we were giddy about rising short-term government surpluses. A more realistic long-term picture might have given at least some politicians reason to pause before indulging in the recent frenzy of tax cuts and spending increases. A helpful second step would be to reinstate rules that make deficit spending more difficult and help to rein in an increasingly anarchic budget process. (Such rules were allowed to expire in 2002.)

Getting out of the fiscal box we are now in will be painful; as a society we will have to make hard choices. But prompt action and intelligent policy changes can minimize the pain. The longer we wait, the larger and blunter the adjustments we will force onto future generations. If we continue with the status quo, and simply allow debt to accumulate for years, the result will be not only higher tax rates and diminished government services for our children and grandchildren, but also (because of the upward pressure on interest rates exerted by so much outstanding debt) a damaged economy.

The appropriate size and scope of government is a legitimate matter for debate. But we should be actively debating—not backing ourselves into a corner so that our choices about size and scope are tightly circumscribed. And whatever we decide the government's role in society should be, we will have to pay for it. This is not merely an economic matter but a moral one. Future generations will pay for our profligacy; by the fiscal choices we've made (or failed to make), we are lowering the living standards of our grandchildren and depriving them of the ability to shape a government that fits their priorities.