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April 1992

The Next New Deal

A call for a comprehensive reform of our trillion-dollar system of federal entitlements, which favors the rich over the poor, the old over the young, and consumption over savings, and in other ways makes no economic or social sense

by Neil Howe and Phillip Longman

With the coming of the Next New Deal, Americans will look back and marvel at what became of our old welfare state--that tangle of inequity and dysfunction once known as federal entitlements. Why did the public tolerate a system that wound up distributing most of its benefits to the well-off? And how did the economy survive its costs?

History books will no doubt concentrate on a few choice examples of the conditions that finally forced a wholesale reform. Readers may learn, for instance, that by 1991 the federal government's largest housing subsidy program was providing an average of $3,000 a year to each of the six million wealthiest households in America, while offering nothing to the 36 million Americans in poverty.

To qualify for this particular benefit, called the home-mortgage deduction, you had to borrow using your first or second home as collateral. And the more you borrowed, even if it was to finance a chalet in Aspen--or just a ski trip to Aspen--the more subsidy you would receive from other taxpayers. By 1991 the cost of the home-mortgage deduction had risen to $37 billion, of which 81 percent went directly to households with incomes over $50,000. Meanwhile, economists bemoaned the anemic U.S. personal savings rate, which in the late 1980s fell to its lowest level since the 1930s.

The U.S. health-care system a quarter century after the announcement of the Great Society will also provide future historians with rich examples of the conditions that led to the next New Deal. How to explain that the U.S. economy staggered under the highest per capita health-care costs on earth, and still 23 million Americans under the age of thirty-five were uninsured for any medical care at all?

Stranger yet was what happened to these uninsured Americans, and to everyone else, if they happened to live to be sixty-five. After that birthday a citizen, regardless of income, became entitled to take part in a program called Medicare, which would pay for everything from CAT scans to pacemakers, from chiropractic to orthopedic recliners. In 1991 Medicare spent nearly $19 billion subsidizing the health care of households earning $50,000 or more. That year government experts projected that the mounting cost of Medicare would cause the program to collapse within fifteen years, and that if current trends continued, total health-care spending would rise to an economy-shattering 44 percent of the gross national product by 2030. No one listened.

Gold-plated pensions for federal employees will also no doubt be held up by future historians as emblematic of the decadence of late-twentieth-century political culture. By what accident of history were military and civil service retirees with incomes over $100,000 collecting $9.2 billion from the U.S. Treasury in 1991? For half this sum the official poverty rate for all American elderly could have been reduced to zero. At the very least, Congress could have done something about the $1.4 trillion in unfunded federal pension liabilities on the books. But the House of Representatives was busy with other business at the time--such as voting itself a controversial pay hike that would later be remembered for its explosive impact on pension costs. Retiring in 1991, a typical congressman looked forward to $1,098,735 in lifetime benefits; by 1993 the figure had risen to $1,523,263.

Finally, there was the program originally designed to offer all Americans what President Franklin Roosevelt's brain trusters called "a floor of protection" against destitution in old age. But over the course of more than half a century Social Security had evolved into something radically different. By 1991 the system was distributing more than 555 billion a year, or more than a fifth of its benefits, to households with incomes above $50,000 a year. For that much money the government could have provided every American with cradle-to-grave insurance against poverty--including the one American child in twenty who lived in a household reporting a cash income during 1991 of less than $5,000.

For many years the worsening inefficiency and inequity of the U.S. social-welfare system seemed to make little impression on American political opinion. Political leaders as diverse as Newt Gingrich, George Bush, Bill Clinton, and Daniel Patrick Moynihan expressed alarm at the moral hazard of providing welfare benefits to poor unwed mothers. But few political leaders worried about the moral hazard--and incomparably larger cost--of subsidizing home-equity loans for rising young stockbrokers, granting free medical care, PX cards, and half pay for life to ex-colonels at age forty-two, passing out farm payments to affluent agribusiness owners, or writing checks to globetrotting senior citizens which got forwarded to Bermuda. It was convenient to assume that free lunches corrupted only the underclass.

As the 1990-1992 recession lingered, forcing local governments to cut teachers' pay, ignore the raving homeless, and fence off sagging bridges, state governors turned to Washington, where politicians shrugged their shoulders and pointed to a budget bursting with entitlement programs running on auto pilot. Meanwhile, ordinary Americans wondered what was happening to their nation's public sector. It could afford neither to build for the future nor to care for the needy--despite unprecedented borrowing, a near-record level of taxation, and sinking defense outlays that by the fall of 1992 had reached their lowest share of GNP since Harry Truman ran for President. With the vaunted post-Cold War Peace dividend" evaporating, the United States found itself unable to invest adequately in either its infrastructure or its children. Eventually people began to talk of another Great Depression, before the coming of the next New Deal.

A Welfare State for the Affluent

Rudolf Goldscheid, the socialist economist, once observed, "The budget is the skeleton of the state stripped of all misleading ideologies." By now federal entitlement spending has become so pervasive in American life--not just among the poor but most notably among the middle class and the affluent--that one cannot make sense of our politics or the condition of our economy without considering how this spending rearranges the nation's resources and defines our choices as a society.

Ever since the early 1980s, when the United States lost control of its fiscal policy, the term Entitlements--referring to all federal benefit payments to individuals--has been part of the American political lexicon. Today the twelve-digit numbers that first worried budget experts back in the late 1970s look positively quaint--although events have proved that the growth of entitlements is indeed the leading cause of the nation's long-term structural deficits. This year the cost of federal benefits is larger than was the entire federal budget when Ronald Reagan arrived in Washington with a mandate to slash the welfare state.

All told, entitlements have become a trillion-dollar river. The main current includes more than $700 billion in direct outlays, received by at least one member of roughly half the nation's households. These expenditures account for more than 45 percent of all federal spending, and are more than twice as large as the amount consumed by defense. Another flow of nearly $200 billion is distributed in the form of tax subsidies to individuals, such as the home-mortgage deduction and the exclusion for employer-paid health care. These explicit breaks in the tax code are the moral and fiscal equivalent of the government's simply mailing a check. To pay for them, other people's taxes have to be raised, other benefits have to be cut, or the deficit has to be increased.

The accumulating burden is not about to ease. Our economy shows no sign of "outgrowing" the cost of entitlements, as many partisans of Reaganomics, along with many liberals, once hoped. Though the relative cost typically rises and falls with the business cycle, it has always emerged from each new recession larger than it emerged from the last. In fiscal year 1992 federal benefit outlays alone u ill exceed 12 percent of GNP, the second highest level ever. Including tax benefits, the total cost of federal entitlements amounts to well over 15 percent of GNP, and Congress now projects that it will climb steadily through the late 1990s. For the first time, the economy should not expect any post-recession relief.

Who benefits from this spending? Until recently no one really knew. Budget experts, to be sure, have always pointed to a few eyebrow-raising numbers. Consider the fact that of all federal benefit outlays, only a quarter flows through programs that require any evidence of financial need--and that even this "means-tested" quarter includes such middle-class staples as student loans and VA hospital care. Consider also that only one of every eight federal benefit dollars actually reaches Americans in poverty. But reliable income figures for all recipient households have simply not been available. Cash-income surveys conducted by the Census Bureau are plagued by high rates of underreporting (especially by the wealthy). Tax-return data from the Internal Revenue Service are more accurate, but do not cover the entire population (especially the poor).

Several years ago, however, growing curiosity on Capitol Hill persuaded the nonpartisan Congressional Budget Office to try to unravel the mystery. By merging the Census and IRS data sources, CBO economists ultimately arrived at reliable and comprehensive estimates of benefits by household income. The estimates were circulated behind closed doors during the 1990 budget summit and have since been updated-- though they have never yet been published. The benefit income statistics we cite throughout this article are based on these CBO estimates, which cover about 80 percent of all federal benefit outlays.

These numbers destroy any ideological myths Americans may cling to about who gets what from government. They offer an accurate glimpse of that "skeleton of the state"--which has too long been locked in the political closet.

The CBO research demonstrates, in fact, that the most affluent Americans actually collect slightly more from the welfare state than do the poorest Americans. It shows that last year U.S. households with incomes over $100,000 received, on average, $5,690 worth of federal cash and in-kind benefits, while the corresponding figure for U.S. households with incomes under $10,000 was $5,560. Quite simply, if the federal government wanted to flatten the nation's income distribution, it would do better to mail all its checks to random addresses. The problem is not that poverty programs don't target the poor. More than 85 percent of the benefits from AFDC, SSI, and food stamps do indeed go to households with incomes under $20,000. But their impact is neutralized by all the other programs, which tilt the other way and are, of course, much greater in size.

The trend over time is also unsettling. Liberals sometimes attribute the growing disparity of income in America to Reagan-era cuts in targeted poverty programs. Among the very poorest households that is indeed one cause. From 1980 to 1991, in consent dollars, the average federal benefit received by households with incomes under $10,000 declined by seven percent. Yet liberals typically overlook the gentrification of America's untargeted nonpoverty programs, which has been pushing even more powerfully to widen the gap between rich and poor. During those same eleven years, among households with incomes over $200,000 the real value of average benefits received (mostly Social Security, Medicare, and federal pensions) fully doubled.

But thus far we have been considering only direct outlays. When we include the value of entitlements conveyed through the tax code, the bias in favor of the well-off becomes even more pronounced.

Tax Expenditures and Other Subsidies

Such tax subsidies date back to 1918, when patriotic fervor for U.S. troops in Europe was running high. Political leaders in Washington felt they should do something dramatic to reward the doughboys. Facing a tight budget, Congress hesitated to raise veterans' benefits directly. But then someone on Capitol Hill took a look at the five-year-old federal income-tax system and came up with a nifty idea: Why not "raise" veterans' benefits simply by exempting such benefits from the tax?

Over the years many more "tax expenditures" have followed, nearly all of them--like the first--created entirely off budget, without estimating eventual cost and far from the scrutiny that normally accompanies direct appropriations. Several, including the exemptions for Social Security benefits and for employer-paid health care, were created not by Congress but by offhand IRS rulings in the 1930s and 1940s. At the time, no one paid them much notice, because tax rates were low, Social Security benefits were modest, and company health plans were rare. But in fiscal year 1992 these two rulings alone are costing the federal government nearly $90 billion, which is more than the Pentagon's total budget for weapons procurement.

Though tax expenditures as a political art were invented during the First World War, the term itself dates back only to the mid-1960s, when it was coined by Stanley S. Surrey, a Harvard Law don who served as assistant secretary of the Treasury for Ox policy in the Kennedy and Johnson Administrations. In the course of his battles with Congress over tax policy, Surrey was struck by the fact that Congress w as increasingly using selective tax reductions for specific groups of people, rather than direct appropriations, as a means of distributing public resources.

Surrey's favorite example was the deduction for medical expenses. He explained that this tax provision had precisely the same impact, both on the budget and on the public, as a multibillion-dollar benefit program that heavily favored the very rich (because they pay taxes at the highest rates) and that entirely excluded the very poor (because they don't pay Axes at all). There was indeed only one big difference: the same Congress that created the tax provision would never dare to create the benefit program.

Although the tax-expenditure concept has been widely accepted by economists over the past thirty years, it strikes many Americans the wrong way. A common complaint is that the concept somehow assumes that government "owns" all your income before doing you the favor of letting you keep part of it. This is not the case. The concept simply assumes that each person owes the government according to a general rate schedule superimposed on every person's ability to pay. Whatever violates such equal treatment is deemed the equivalent of a benefit outlay--the same, that is, as a check in the mail.

From the dogmatic insistence that there is no such thing as a tax expenditure, any number of absurdities must follow: for instance, that a public policy exempting all circus clowns from paying income taxes would not be a public benefit to circus clowns--who would simply be keeping more of "their own" money. Who cares if keeping more of "their" money means taking more of someone else's? Or if it means bankrupting everyone's kids? The ultimate thrust of this line of reasoning is to deny that a society can consent to and act upon any equitable principle of public sacrifice. Accordingly, all taxation is inherently unjust, and though cheating on your taxes may be legally wrong, it cannot be morally wrong.

It is no surprise that many well-off Americans, uneasy about their nation's loss of fiscal discipline, find consolation in this pugnacious illogic. What is surprising is to hear conservatives leading the chorus. Back in the early 1970s, strange to say, many of these same intellectuals pushed Nixon's ill-fated "negative income Ox," the very premise of which is that less tax is the precise equivalent of more income. But during the 1980s they have become the preachers of a selective civic virtue--austerity for targeted benefits to the poor and indulgence toward shotgun tax favors to the affluent.

Today, even though the government publishes estimates of the cost of different tax expenditures, this form of spending still attracts comparatively little attention. But by now the numbers involved, and their social and economic effects, are too large to ignore. Honest people can and do differ over what constitutes a genuine tax expenditure, as opposed to "equitable" treatment--say, for investment income or charitable donations. According to some, ability to pay should be measured by what a person earns; according to others, by what a person consumes. But even if we confine our list of tax expenditures to those that contradict any principle of ability to pay--that is, to those that nearly all economists can agree on--the total fiscal cost comes to at least $170 billion. Those tax expenditures arbitrarily reward millions of lucky people for such endeavors as financing a built-in sauna, hiring an au pair, or getting the boss to pay for the therapist.

This spending is regressive in the strictest sense of the word. Even when poorer households qualify for these benefits (and often they do not), what they receive is smaller, relative to their income, than what goes to the affluent. According to the congressional Joint Committee on Taxation, for example, last year the average value of the mortgage-interest deduction for taxpayers with incomes over $100,000 was $3,469. In contrast, the same deduction was worth an average of only $516 for taxpayers in the $20,000 to $30,000 bracket who qualified to take the benefit--and of course many, including renters and those who opted for the standard deduction, did not.

When we add together all the tax expenditures and all the direct outlays for which we have 1991 income data-- and this is about 80 percent of each type of entitlement--an unambiguous picture emerges. On average, households with incomes under $10,000 collected a total of $5,690 in benefits. On average, households with incomes over $100,000 collected $9,280. In terms of total fiscal cost, moreover, the aggregate amounts received by the non-needy in 1991 were staggering. One half (at least $400 billion) of all entitlements went to households with incomes over $30,000. One quarter (at least $200 billion) went to households with incomes over $50,000. These are the facts--regardless of what our political folktales might say.

How did our entitlement system wind up delivering most of its benefits to people who are clearly not in need? Obviously, the overall spending pattern does not conform to any master plan. Congress never passed a "Comprehensive Welfare for the Well-Off Act." Rather, the system we see today is the inadvertent legacy of thousands of why-not-please-everybody votes on Capitol Hill--together with economic and demographic trends that no one anticipated.

Nor does any conspiracy lie behind the way Americans have chosen over the past decade to finance the growth of entitlements. They have done so through deficit spending--the result of a persistent ideological deadlock between cutting spending and raising taxes. Each side, unfortunately, has reason to regret the outcome. On the one hand, those who prevented significant reform in the welfare state have worsened any prevailing trend toward inequity by income and class. On the other hand, those who urged that it is better to finance the welfare state through debt than through taxes have burdened Americans with a new layer of inequity by age and generation.

These are the conditions leading to the coming of the next New Deal--a new deal that is needed to restore both fairness and efficiency to our trillion-dollar entitlement budget. The U.S. social-welfare system has by now come to resemble a ramshackle mansion on a hill, with squeaky back stairways and barren hallways leading to musty, sealed-off chambers.

Open this door and behold the federal railroad retirement system--a Christmas gift from Congress to the railroad industry in 1935, still chugging after all these years, at an annual cost of $7.8 billion. That crowing in the pantry is the sound of $50,000, on average, in direct federal payments being snatched up by each of the 30,000 biggest-grossing farmers in America. Not one of them looks like Pa Joad. And down this hall you'll find the bonanza-baby nursery, filled with Americans born from 1910 through 1916, whose Social Security benefit levels are higher than those of anyone born before or after. Can anyone remember why? What about that thumping noise? Maybe it's the so-called one percent "kicker" from the 1970s, which still inflates civil-service pensions.

This is a structure, leaky and drafty and wildly expensive to heat, that was tolerably suited to its previous owners but now requires radical remodeling. What would FDR, architect of the original New Deal, have said if he had learned that by 1991 a fifth of American children would be living in poverty--still ill housed and ill nourished--while a fifth of the dollars spent by major federal benefit programs went to households earning $50,000 or more?

Fortunately, the system can be made to work again. But before the next New Deal can happen, Americans will have to start viewing entitlements as a whole, and debating comprehensive reforms.

Welfare for the Well Off

Even if our current entitlement system were sustainable well into the twenty-first century--and it is not--most Americans would still have good reason to demand a new deal. Consider how little we as a nation are getting back for the money we are spending: no national health insurance plan, no maternity benefits or family allowances such as are available in Germany and France, no guarantee against falling into poverty or even becoming homeless-- in old age or at any other time of life.

In 1990, for example, the federal government handed out an average of $11,400 worth of benefits to every American aged sixty-five or over--more than ten times what it gave to each child--yet 3.7 million senior citizens still languished below the poverty line. Many of the latter receive a "means-tested" benefit-- Supplemental Security Income. But for an elderly person living alone in 1990 the federal SSI program offered a maximum cash benefit of 74 percent of the poverty level, or $4,632 annually. That same year, while 18 million Americans earning less than $15,000 at full-time, year-round jobs "contributed" their FICA dollars, a CEO and spouse could retire and expect to receive more than $24,000 annually in tax-sheltered Social Security and Medicare benefits, in addition to their corporate pension and "medigap" plan, and sundry forms of private investment income.

Why doesn't the welfare state do a better job of actually insuring against poverty? The bottom-line reason is that we divert too many resources to the affluent.

The most stunning illustrations of welfare for the well-off come in the form of entitlements conveyed through the tax code. Consider, for example, the exclusion from taxation of most Social Security income along with the insurance value of Medicare benefits, which together cost the Treasury about $34 billion last year. The households that receive the largest favor are those with the most income. In fact both these tax expenditures may be regarded as especially insidious forms of back-door spending, since they simply add to the already top-heavy distribution of Social Security and Medicare benefits. For the 37 percent of senior citizens who regularly vacation abroad, these tax subsidies are enough to pay for a few extra days of shopping in tropical ports of call. But they do little for another 40 percent of senior citizens who owe no tax on their Form 1040 because they aren't as well off. This is why every other major industrial nation regards all or nearly all of its social-insurance benefits as taxable income.

The same point applies to the child-care credit which cost the government more than $3 billion last year. Households with incomes below $10,000 received virtually no benefit from this tax subsidy. Those with incomes above $z0,000, however, received $1.2 billion to help pay for nannies and other child-care expenses.

For the really big bucks, take a look at the exclusion for employer-paid health care. Under this provision, those Americans fortunate enough to receives health-care insurance from their employers are allowed to exclude the value of their insurance from both income and payroll taxation. Last year this single tax expenditure cost the U.S. Treasury $60 billion in forgone revenue.

Who benefited? Obviously, no one among the 35 million people not covered by any form of health insurance or among the 32 million people who pay for their plans out of their own pockets. These 67 million Americans are twice as likely to live in poverty as are all other Americans. But that is only part of the inequity. Among households that were covered by employer-paid health-care plans, the average benefit for those in the highest income brackets was many times larger than the average for those in the lowest income brackets. Moreover, most economists agree that such large subsidies encourage their beneficiaries to overconsume health-care services, and thus put even more inflationary pressure on a system already in crisis. Who will argue with an employer who offers a Gold Plan" package that provides generous coverage for every medical contingency, from orthodontia to nose jobs to psychoanalysis, as long as it's tax-free?

It is much the same story with most other entitlements conveyed through the tax code. Not only are they inequitable in their distribution of benefits but also they contribute to gross distortions in how the U.S. economy allocates resources. In addition to overconsuming health care, for example, affluent Americans tend to overconsume powder rooms and swimming pools and vacation homes at the expense of more-productive investments-- thanks to the mortgage deduction and other tax subsidies for owner-occupied real estate. One result of all these tax favors: the hospitals and homes of Grosse Point and other affluent suburbs of Detroit are far more luxurious than any to be found in, say, the suburbs of Yokohama or Stuttgart. But only in Detroit do the suburbs surround a burned-out, deindustrializing core. Not coincidentally, every major industrial society except the United States pays for little (or none) of its health care with tax-sheltered insurance, and tightly restricts (or prohibits) any deductions for interest on home mortgages.

To the rule that says most tax subsidies go to the wealthy, there is one exception: the Earned Income Tax Credit. First enacted in 1975, the EITC is the closest America has ever come to a negative income tax. But its effect on the overall picture is negligible. Even after including the EITC with all the other tax expenditures mentioned above, the bottom line is still that the rich receive by far the largest benefits.

Households with incomes below $10,000, for example, receive an average of $131 a year from all these tax-subsidy programs combined. Middle-class households do better: those with incomes in the $30,000 to $50,000 range receive tax benefits averaging $1,483. But it is the truly affluent who receive the greatest subsidy: the average benefit for households with incomes over $100,000 is $3,595 a year, or nearly thirty times what goes to households most in need.

The Weight of Reality Upon Ideology

Why have Americas put up for so long with such flagrant malfunctioning of their social-welfare system? Part of the explanation must lie in today's political culture, which by the standards of FDR's crusading generation has remained exceptionally cautious in its thinking about the major institutions of the welfare state, and preoccupied with mere process issues. Meanwhile, as the decades have passed, the earth has been slowly shifting beneath the major monuments of the first New Deal. The old assumptions will not hold.

When Social Security first started paying out benefits, for example, the elderly were by far the most destitute age group in American society. As recently as 1969,25 percent of American elderly were officially designated "poor"--as were only 14 percent of children under age eighteen. Today the relative positions of the very old and the very young are just about reversed: in 1990, 12 percent of the elderly and 21 percent of children were poor. Other indicators, such as noncash income, financial assets, and homeownership rates, also show that the typical elderly household is now considerably better off than the typical young family. At the same time, as we have seen, millions of the elderly continue to live in poverty. And yet Social Security continues to distribute none of its benefits on the basis of need.

We live in a world radically different from that of FDR's generation. How touching it is for the historian to read that New Deal planners once projected that Social Security's survivors' and unemployment benefits would steadily reduce means-tested family assistance. The assumption, of course, was that widows were the only single mothers struggling to raise children. That 13 million children would be living with single nonwidowed mothers in 1990 was simply unthinkable. And how maddening it is for today's married woman to learn that she won't receive Social Security benefits based on her earnings unless she makes at least half her husband's salary throughout her working life. It should come as no surprise that a social welfare system designed to serve the America of Benny Goodman and Norman Rockwell now stands in need of serious structural repair.

We also live in a world radically different from that of the Johnson and Nixon presidencies, when the steepest increases in entitlement spending took place. In that era renowned economists wrote books about the "challenge of abundance" and testified before Congress about how Americans would soon enjoy a twenty-two-hour workweek. In 1972, on the eve of Social Security's largest single benefit hike, the system's actuaries projected that henceforth real U.S. wages would forever rise at the rate of 56 percent every two decades--an assumption that made almost anything affordable. Looking back, that sort of economic euphoria seems as dated as 2001:A Space Odyssey. What has in fact happened over the twenty years since 1972 is that real wages, as defined by the actuaries, have grown by hardly more than four percent. Polls indicate that most Americans are no longer confident that today's children will do as well economically as their parents--and indeed they will not, unless the country frees up the resources it needs to undertake wide-scale investments m improving productivity. Sixty years after the New Deal there is virtually no connection between the pattern of entitlement spending and any coherent public purpose. So why is reform so often regarded as impossible?

Part of the reason is ideological. Throughout the Reagan years the allure of supply-side economics persuaded many conservatives that reforming entitlements was no longer necessary; with tax cuts and deregulation, the nation could simply "outgrow" them. The party that once fought losing battles against the New Deal could thereby dish the Whigs and painlessly rid itself of its plutocratic reputation. Liberals, meanwhile, have been slow to grasp how an ideal that was once taken as the nation's highest expression of community has evolved into a system that serves the interests of economic royalists at the expense of the common man.

Today reality is gradually wearing away these ideological misconceptions. Still, the reform of any single entitlement program is blocked by highly organized special-interest groups, from the graypower and pension lobbies to the agribusiness, construction, and health-care industries. Even affluent beneficiaries who may be uncomfortable accepting government money don't like feeling singled out for sacrifice. The Palm Beach retiree, for example, won't go along with higher taxes on his Social Security benefits just so that the yuppie down the street can get another tax break.

What is needed is a comprehensive approach to entitlement reform--one that cuts not only direct spending but also tax expenditures for the well-off. In this way entitlement reform could avoid becoming a contest between generations. By putting every form of government spending on the table, America could also end that long-running, sterile debate between those who want to cut

spending and those who want to cut taxes. Genuine reform could at last be what it should be: a more equitable and productive redirection of the nation's limited resources.

The Peace Dividend Is Not Enough

But couldn't we get by, many readers will ask with just staying the course? Won't the end of the Cold War free up enough resources so that we won't need to take on entitlement reform?

The short answer is no. A world at peace won't be enough to right the nation's fiscal imbalance.

As we mentioned earlier, benefit outlays accounted for 45 percent of all federal spending in calendar year 1991. Yet this conventional measure of the cost of entitlements, large as it is, underestimates their practical importance. First, it includes only the benefits themselves, not the cost of administering them. Add on a minimal five percent overhead, and the total rises to 48 percent of the budget. Second, a fair measure would compare entitlements only with other types of spending that are adjustable, not with spending that is entirely beyond anyone's control. So let's subtract net interest payments on the national debt ($199.4 billion) and last year's payments on the S&L bailout ($101.8 billion). Both are obligations that must be met in order to avoid a devastating financial panic. Now the total rises to 60 percent of the budget. Finally, let's figure in the $170 billion in benefit-like tax expenditures. This pushes the total up to just over 65 percent of the budget.

The bottom line might be summarized this way: Entitlements, defined as the full cost of both direct and taxcode benefits, amount to two thirds of the federal spending over which government has some control.

A large part of the remaining third is defense spending. The cuts now scheduled will help, but alone they are clearly insufficient. Consider that even eliminating the entire blaring Corps would not defray the annual cost of military pensions. In fact, even if the Department of Defense were abolished and all the armed forces disbanded, the U.S. Treasury would still not be able to pay this year's bills without borrowing. As for the small corner of the budget still dedicated to "discretionary" civilian projects--everything from running parks, regulating polluters, and sheltering runaway children to building highways, testing superconductors, and arresting drug traffickers--as a share of GNP that corner has been smaller since the late 1980s than at any other time since the late 1950s. It is unlikely that Americans could achieve major savings in this catchall budget area without curtailing some of the vital core services they expect from government. Most policy discussions instead favor more of this type of spending, which no doubt would already be larger today were it not perpetually crowded out by the metastasizing of universal benefits.

Another question, still sometimes heard in post-Reagan America, is "Why reform entitlements or even worry about the deficit when we can always just raise taxes?" But the answer is clear enough: The revenue option won't work because it won't happen. One can find many polls showing that most Americans favor the concept of a means test for benefits. But one cannot find any poll showing that more than a small minority of Americans favor a large, general-purpose tax hike.

This anti-tax sentiment is linked to widespread cynicism about government, especially the federal government, which should make many liberals think twice before dismissing entitlement reform. Quite simply, those who want more taxes and bigger budgets must first demonstrate that government can apply commonsense priorities to the money it is already spending. Anyone waiting for public attitudes to change spontaneously should take a closer look at America's rising generation of voters under thirty--not just at their Republican sympathies, which incline them against taxes anyway, but at their intense distrust of unkeepable promises, breakable chain letters, and crocodile tears. What the typical new voter most distrusts, in short, is just the sort of rhetoric that still enshrouds our welfare state.

Unfavorable Demographics

Each decade since the first New Deal, from the 1930s through the 1980s, entitlement spending has grown faster than the economy. Under our current system it is certain to do so in future decades as well, especially once the oldest members of the enormous postwar Baby Boom generation begin reaching retirement age, just sixteen years from now. Today more than 60 percent of all federal benefit spending flows to the 12 percent of Americans who are age sixty-five or older. As long as the welfare state allocates most benefits on the basis of seniority alone, the cost will grow geometrically as the size of the elderly population increases. In combination with the aging of the population, improvements in medical technology will likely cause per capita health care costs to continue growing several times as fast as per-worker GNP.

Demographic data easily numb the mind, but one can gain an intuitive sense of what all this means for government spending by considering just how favorable demographic trends have been for the United States in recent years. During the 1980s the 76 million members of the Baby Boom generation moved into their prime productive years--old enough to have mastered job skills but too young to retire. The result was an automatic surge in federal revenue--especially since the women of this generation have been far more likely than their mothers to work for wages, and therefore to contribute taxes.

Meanwhile, demographics have also been favorable to the spending side of the budget. The growth rate of the retirement-age population has actually been slowing down since the mid-1980s, owing to the declining birth rates of the late 1920s. Yet the United States is still running enormous budget deficits. What will happen when these favorable demographic trends turn into unfavorable trends, beginning around 2010?

Since 1960, federal benefit outlays alone have grown from roughly five percent to 12 percent of GNP. No one knows, of course, what the future may bring. But if one adopts the economic, demographic, and medical assumptions used by the Social Security Administration and the Health Care Financing Administration. the total cost will rise much further over the next fifty years, perhaps to 71 percent of GNP (best case) or to 30 percent of GNP (most plausible case). And this assumes not a single new program or eligibility provision. Outlays of this magnitude would threaten to crowd out not only all forms of public and private investment but also any hope that government might respond to new social needs. Ultimately, even huge tax hikes would merely cover the growing cost of programs whose original intentions had long been forgotten.

Well before we reach such nightmare fiscal scenarios, moreover, the income inequity of the U.S. welfare state will become painfully obvious. Look ahead to the year 2000, when today's unusually affluent Americans in their fifties begin to retire. This is a cohort of lifelong upward mobility whose average household wealth in retirement (according to the economists Frank Levy and Richard Michel) is likely to exceed that of all living Americans born either before or after them. Then consider the position of today's young adults-- handicapped by unstable family backgrounds, an inferior education, and stagnating entry-level wages. By the year 2000, while raising families amid growing talk of yet another hike in the payroll tax, they will cast searching eyes at the abundance of their elders. In her recent book Social Insecurity the former Social Security commissioner Dorcas Hardy does not hesitate to link the issues of age, income, and race. "As we move into the next century," she asks, "will the minorities of this country--immigrants and otherwise-- come to see the Social Security system as a mechanism by which the government robs their children of a better future, in order to support a group of elderly white people in a retirement that is both too luxurious and too long?"

Take it from someone who once ran the system: the entitlement crisis is not about to go away if we just ignore it.

A Comprehensive Reform

Overhauling the O.S. welfare state so that it serves our national goals will entail enormous changes, most likely including a wholesale restructuring of the U.S. health care system. But in the meantime we Americans can make federal entitlements much more equitable and free up the resources we need to cut our fiscal deficits and boost our national savings, by acting on a simple if far-reaching principle. The principle is that one's benefits should be proportional to one's need--whether the subsidy comes in the form of health insurance or a farm subsidy or a mortgage-interest deduction or a Social Security check.

How might such a principle be applied to the existing welfare state and how much money would it save? Any reform package should satisfy the three most common objections to a cost-control effort. First, it should not reduce the income of any household that is anywhere near the poverty line. More precisely the half of all U.S. households that report incomes over $30,000 should be asked to bear nearly all the extra burden.

Second, any reform package should adjust benefits according to a graduated scale, so that middle- and upper-income households do not become net losers just because they happen to rise a few dollars above a certain threshold. Nor should earning a high income become a disqualification for receiving any subsidy. To preserve the universal character of our major entitlement programs, members of every household, regardless of income, should still stand to gain some benefits, albeit in proportion to their needs.

Third, any comprehensive reform must take into account the quasi-contractual nature of at least some entitlement programs. This last proviso is the toughest to accommodate, but not as tough as is sometimes thought.

Strongly rooted in American political folklore, for example, is the idea that Social Security recipients are only "getting their money back," that Social Security is an "inviolable contract," and so forth. But such claims have no financial or even legal basis, however much certain politicians and interest groups may claim otherwise. True enough, the original Social Security Act of 1935 included a "money back" guarantee (with some interest) on all employee contributions, and called for benefit levels to be calculated on the basis of the lifetime covered wages earned by each individual. But the guarantee was eliminated by Congress in 1939, and the link between benefit levels and years of participation, after being weakened in 1939, was entirely discarded in 1950.

Ever since, the U.S. Supreme Court has repeatedly ruled that no covered worker retains any right, contractual or otherwise, over taxes paid into the system. In fact, the Social Security Administration keeps no direct records of how much each person contributes. It just keeps records of each person's wage history, to which a politically determined benefit formula is applied when that person retires. Today's retirees, as it happens, receive benefits north two to ten times what they would have earned had they invested all their lifetime Social Security taxes (both their own and their employer's) in Treasury bonds. Meanwhile, largely because of the very steep increases in Social Security taxes in recent years. most economists agree that under current law Social Security will not offer large categories of younger participants anything approaching a fair market return on what they paid into the system.

So there is no reason that Social Security benefits for the well-off cannot be reduced if a majority of Americans decide that their collective resources should be used for different purposes. The same is true for civil-service and military pensions, although here the case is much stronger that an implied contract exists between well-off pensioners and the government.

Before the 1970s federal employees worked for lower wages than their counterparts in the private sector. One reason they did so was the expectation of receiving government pensions far more generous than any offered by private-sector employers. Even today, no private pension offers benefits at such an early age, at such a high percentage of pay, with such lenient provisions for disability, or with such generous indexing. Moreover, because these government pension programs were never funded on an actuarially sound basis, current taxpayers are now unjustly stuck with a huge tab for yesterday's unwise policy.

Still, these benefits are part of the compensation that was promised at the time--a distinction that makes a moral if not a legal difference and ought to limit benefit reductions even to the most affluent federal pensioner.

Applying our simple principle would not require a big new bureaucracy. All means-testing could be achieved exclusively through tax returns, much as we now handle the limited taxation of Social Security for households with adjusted gross incomes over $25,000. Each filer would be required to enter all benefits received, which could be checked against federal records. Above certain limits the total would trigger a "benefit-withholding" liability, which the filer would send back to the IRS along with any outstanding income-tax liability. As a practical matter, federal benefits could be withheld just as wages are withheld, based on a tax filer's previous experience.

How would benefit-withholding rates be set? Here are a few illustrative options, with estimates of how much money they would have saved in calendar year 1991 alone. For all cash and in-kind entitlement programs except federal employee pension plans: Withhold 7.5 percent of any benefits that cause total household income to exceed $30,000, and withhold an additional five percent at the margin for each additional $10,000 in household income. The maximum reduction of benefits would be 85 percent, applicable to households with incomes of $190,000 or more. Total savings: $33.5 billion.

For civil-service and military pensions: Same as above, but with a much lower maximum withholding rate, in deference to the quasi-contractual nature of these benefits. The maximum reduction of benefits would be 25 percent, for households earning $70,000 a year or more. Total savings: $7.6 billion.

For all major entitlement benefits conveyed through the tax code except benefit exclusions: Limit the amount of such tax expenditures received by upper income households to the average expenditure per household within the $30,000 to $50,000 bracket. In 1991, for example, this would have limited the total allowable mortgage interest deduction to roughly $2,500. Total savings: $34.7 billion.

For benefit tax exclusions: Get rid of all income thresholds and make Social Security just as taxable as any other cash income--except for 15 percent of pro reform benefits. This untouched residual will offer, to even the wealthiest of today's retirees, at least a five percent tax-free return on all contributions they have personally paid into the system. Also, for households with incomes from $30,000 to $50,000, phase out half of the tax exclusion on the insurance value of Medicare (net of Medicare Part B premiums). Total savings: $16.9 billion.

Altogether, these provisions, if they had been in place in 1991, would have freed up $93 billion in the federal budget. To be sure, no one would advocate instituting all of them in one year, especially in a bad recession year. But imagine that they were phased in over four years--starting, say, in 1993. Assuming that income brackets were adjusted for inflation, and using official budget and revenue projections, total annual savings would rise to $149 billion by 1996. That would be enough to ensure that the next recovery is a genuine investment-led expansion, not another borrow-and-consume bacchanalia.

The budget savings could be considerably higher. The figures noted here reflect only about 80 percent of all federal entitlements and tax expenditures, those for which income distributions are known. The extra 20 percent included, total budget savings in 1996 could rise to more than $186 billion. Furthermore, trimming subsidies to the affluent reduces their incentive to take advantage of available benefits. Thus, to the extent that it would prompt middle- and upper-income Americans to forgo benefits altogether--for example, by retiring later, or by opting for less tax-sheltered health insurance and housing--the measure would clearly save taxpayers more than the amount a static calculation would indicate.

Because all the savings would be collected through the tax code, a single piece of legislation, falling under the jurisdiction of the tax committee in each house, would be sufficient to implement the reform. Imagine doing the same job by amending every benefits statute: the process would snake through dozens of committees, grind on for years if not decades, and ultimately be undone by interest groups.

This approach also has the virtue of treating all Americans fairly, according to their individual circumstances, unlike most other reform proposals--for example, limiting all cost-of-living adjustments (COLAs). Even a COLA freeze that discriminated against large monthly benefits would lead to obvious inequities. For a widow receiving no income other than one large Social Security check, a COLA may be essential to keep food on the table. For a triple-dipping federal pensioner receiving the minimum Social Security benefit, that same COLA may be just enough to cover the annual rise in greens fees at the club. An income-based approach takes account of the difference. Unlike most government agencies, moreover, the Internal Revenue Service is well trained in tracking dollars no matter how far they Gavel. Even the farm subsidy that filters down through five partnerships before appearing as personal income will have to show up, earmarked, on someone's Form 1040.

Politically, this approach balances the sacrifices asked of elderly and working-age Americans, without raising tax rates and without burdening the poor or even most of the middle class. Moreover, the plan would reduce specific programs in rough proportion to their overall size in the budget. Roughly half the savings would come from Social Security and Medicare and the related taxation of benefits. An additional 40 percent would come from other programs and tax expenditures, especially employer paid health care and mortgage interest. Another eight to nine percent would come from federal pensions.

Would such a reform in and of itself constitute another New Deal? Hardly. The measures it would comprise are, however, the essential preconditions for the next New Deal. Without them the United States will simply see more and more of its options as a nation crowded out by the compounding costs of our subsidies to the well-off.

As always, every area of federal spending should be scrutinized. Missionless bombers must be cut. Porkbarrel waterways must be eliminated. Welfare programs targeting the poor must undergo further changes, to require the able-bodied to work and to reduce the cycle of dependency. But none of these areas is where the big money is, and it is not by reforming them that the United States will free up the resources it needs to build a more just and productive society in the next century.

Whatever one's vision of that new society--whether it includes a national health service or means-tested health vouchers, a negative income tax or a 15 percent flat tax, green cars running on hydrogen or mag-lev trains humming from city to city--to get something new, one must give up something old. A society that cannot find the resources to pay for sixty-cent tuberculosis vaccinations for ten-year-olds must ask itself why it is offering subsidized health care and housing to millionaires. Call it a rendezvous with destiny.

Copyright © 1992 by Neil Howe and Phillip Longman. All rights reserved.
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