The Long-Term Budget Outlook and Social Security Reform: Implications for Financial Markets The Q Group, October 18, 2005 Carlsbad California Kent Smetters The Wharton School & NBER
I ntroduction � Traditional budget measures substantially underestimate existing liabilities � In the past, “brick and mortar” public goods could be allocated on an annual basis � But they have been replaced during past 50 years with long-term liabilities (e.g., Medicare; Social Security, etc.)
Two Main Problems with the Traditional Budget Substantially underestimates 1. unfunded liabilities by ignoring long- term liabilities Is biased against reforms that would 2. reduce these unfunded liabilities
1. Underestimates Liabilities Budget does not track many unfunded obligations � They’re “off balance sheet” � Examples � Social Security and Medicare � Medicaid � Federal Employee / Military pensions � Instead, the budget focuses on a particular � unfunded obligation: public debt
Debt Held by Public Misses almost $60 Trillion in Liabilities � Public debt is only one component of government’s true Fiscal Imbalance (FI) � FI = debt held by public + PV of all future outlays – PV of all future revenue = $63 trillion � In contrast, debt held by public is only $4.4 trillion (gross debt is about $8 trillion)
2. Reforms are hard Example 1: An actuarially-fair “carve out” � Part of payroll tax invested in personal accounts � Future SS benefits reduced in equal present value � Debt held by the public will increase � Other unfunded obligations decrease equally � Zero impact on total Fiscal I mbalance � But focusing on public debt � federal liabilities appear to be larger since the other unfunded obligations are not being tracked. � So even a perfectly neutral reform appears bad
Example 2: “Carve out” with a “haircut” � Part of payroll tax invested in personal accounts � Future SS benefits reduced by slightly more than the present value of diverted payroll taxes � Similar to Commission’s Model 1 � People might still want a personal account � Debt held by the public will still increase � Other unfunded obligations decrease by more � Total Fiscal I mbalance is actually reduced � Focusing on public debt � liabilities seem larger � Biases reform debate against reforms that would actually reduce the Fiscal I mbalance
New budgetary framework � Two main integrated components: � “Fiscal Imbalance” (FI) = Debt held by public + PV of all future outlays – PV of all future revenue � Similar to open-group liability concept � “Generational Imbalance” (GI) = portion of FI on account of current and past generations � Similar to the closed-group liability concept � Simple and easy to understand
Both FI and GI are Useful � Fiscal Imbalance measure needed to address the sustainability of policy. � The FI must equal 0 for sustainability � Generational Imbalance needed to choose among the set of all sustainable policies � Examples: � New pay-go financed prescription drug benefit � Many options for reforming Social Security
Key Economic and Demographic Assumptions � Real annual discount rate, r = 3.6% � Real annual per-capita productivity, g = 1.7% � Excess real growth of health care over productivity until 2080, h = 1.0% � 2080 – 2100: excess growth reduced linearly to 0 � After 2100: excess growth fixed at 0 � Sensitivity analysis conducted below
Health Care Assumption, h � The wedge, h = 1.0%, is same as Trustees � Very conservative by historic standards � 1980 – 2001: actual wedge was 2.3% � Double-digit growth this year; expected to last � Total spending on Social Security and Medicare increases from 7.6% of GDP in 2002 to 13.1% of GDP by 2080
Table 2: Fiscal and Generational I mbalances (Selected Years) (Present Values in Billions of Constant 2004 Dollars; Fiscal Years) 2004 2005 2010 1. Fiscal Imbalance in Social Security 8,006 8,352 10,158 On Account of Past and Living Generations 9,549 9,899 11,676 On Account of Future Generations -1,543 -1,547 -1,518 60,886 * 2. Fiscal Imbalance in Medicare (Parts A, B and D) 63,381 75,599 On Account of Past and Living Generations 24,094 25,431 32,289 On Account of Future Generations 36,791 37,951 43,310 3. Fiscal Imbalance in Rest-of-Federal-Gov’t -5,608 -5,805 -6,339 Total Federal Fiscal Imbalance (FI) 63,284 65,928 79,417 * Part D (new Rx benefit ) alone = 24,186 $16.1 trillion $2.6 trillion
Table 2: Fiscal and Generational I mbalances (Selected Years) (% of Present Value of Uncapped Payrolls; Fiscal Years) 2004 2005 2010 1. Fiscal Imbalance in Social Security 2.3 2.3 2.5 On Account of Past and Living Generations 2.71 2.74 2.87 On Account of Future Generations -0.44 -0.43 -0.37 2. Fiscal Imbalance in Medicare (Parts A, B and D) 17.3 17.6 18.6 On Account of Past and Living Generations 6.83 7.05 7.94 On Account of Future Generations 10.44 10.52 10.65 3. Fiscal Imbalance in Rest-of-Federal-Gov’t -1.6 -1.6 -1.6 Total Federal Fiscal Imbalance (FI) 18.0 18.3 19.5
Options for Paying for $63 Trillion � Confiscate all physical capital assets in the U.S. (actually does not go far enough!) � Increase federal income taxes by 68% immediately and forever , assuming no reduction in labor supply or savings � Increase the combined employer-employee payroll tax from 15.3% to over 32% and remove the payroll tax ceiling (but don’t credit benefits) � Slash Social Security and Medicare by over half
Sensitivity Analysis: Parameter Assumptions Policy Baseline High Low Discount Rate, r 3.6% 3.9% 3.3% Productivity Growth Per Capita, g 1.7% 2.2% 1.2% Health Care Outlay Growth Per Capita, h 1.0% 1.5% 0.5%
Sensitivity Analysis: FI as Share of PV of Payroll Policy Baseline High Low Discount Rate, r 18.0 16.2 20.2 Productivity Growth Per Capita, g 18.0 19.0 16.4 Health Care Outlay Growth Per Capita, h 18.0 21.5 14.9
But are these obligations “real”? � Yes: the only difference between these obligations and regular debt is the policy options available for dealing with them. � Options for reducing explicit debt: � Monetize it (except TIPS) � Increase taxes � Declare bankruptcy � Options for reducing implicit debt: � Hard to monetize (since inflation protected) � Control outlays, increase taxes
Is there a hidden silver lining? � International prospects also gloomy � Outlook of many European countries also bad. � That’s bad for the U.S. fixed income markets! � Some hope in Latin America (e.g., Chile) � Will capital deepen as baby boomers approach retirement? � What about “dynamic scoring?”
Some Glimmer of Hope: Groundwork Being Set for Reform New accounting methodology recently 1. Adopted by Gov’t Trustees � For Social Security, starting with 2003 Report � For Medicare, starting with 2004 Report � They estimate a Medicare + SS FI of $82 trillion! Senator Lieberman has introduced a bill 2. requiring it for government as a whole
Easy Fix / Hard Fix � Social Security: The “Easy Fix” � Smaller problem � Nature of problem is also easier since it is cash payment (e.g., “just” price index) � Medicare: The “Hard Fix” � 7 times large (new Rx plan imbalance alone is larger than Social Security’s imbalance) � Nature of problem is also harder since in-kind payment and driven by tech change
Pension Fund Implications � Asset Side � Long-dated fixed income instruments risky? � Invest in more stocks? � Liability side (won’t talk much about) � Private payments could increase to extent that private pensions are integrated with Social Security (not common)
Why Haven’t Fixed Income Markets Reacted with higher interest rates? � View I: Capital markets don’t understand. � View II: Capital markets believe that most of the obligations will be reduced by reducing benefits (hard to believe) � View III: Term Structure
Include More Stocks? � Aside: accounting issues � Risk: Liability matching problems � Risk: Demographic issues
Source: Poterba (2004), “Population Aging and Financial Markets”
President’s Social Security Plan � An actuarially-fair carve out � Few minor exceptions: pre-retirement mortality and bequeath-ability of accounts � Won’t have any impact on markets (fixed income or not) provided if households are not borrowing constrained � Intuition
� But, about 50 percent of U.S. households don’t hold any equities either directly or indirectly in employer-sponsored DC plans � Exact reason is important for policy goal � Rational (correlation between human capital and physical capital returns) or irrational (“fixed costs” associated with learning) � If rational, then President’s plan neutral � If irrational, then likely small increase in equity values and small reduced bond prices
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