Last year's legislation adding a prescription drug benefit to Medicare is the biggest unfunded entitlement expansion in nearly 40 years. Unfortunately for taxpaying Americans, the projected 10-year cost-estimated at $400 billion last year but now already well above $500 billion-is just a drop in the bucket compared to the new entitlement's long-term unfunded liabilities. According to the just-released Trustees' Report, the new drug entitlement will add $8.1 trillion to Medicare's unfunded liabilities through 2078.

Unless this mistake is fixed, burgeoning entitlement spending will create enormous pressure for higher taxes. President Bush's recently enacted tax cut and tax reform package will likely be the first casualty. Because of arcane budget rules, the bulk of the 2001 and 2003 tax cuts expire at the end of 2008 and the end of 2010. Extending these tax cuts or making them permanent will be enormously difficult in an environment of skyrocketing spending for government-provided health care.

Regardless of what happens to the 2001 and 2003 tax cuts, the prescription drug entitlement will likely be the death knell of further tax relief and fundamental tax reform. A prescription drug benefit means more federal spending and bigger deficits-especially as the baby boomers start to retire in the next decade. Once these demographic and fiscal variables become part of the budget forecast, lawmakers seeking to cut taxes and create a simple and fair tax code, such as the flat tax, in all probability will face insurmountable political obstacles.

The entitlement explosion

This new entitlement takes America even faster down the road that has caused so much economic damage in Europe's welfare states. Indeed, the unfunded Medicare expansion is essentially a huge future tax increase since the population of Medicare recipients will nearly double once the baby-boom generation retires. Ironically, just when some European countries are waking up to the problem and restraining unfunded entitlements, America has created an enormous new entitlement.

This new program adds fuel to the fire. Entitlement spending is the fastest growing part of the federal budget. In just the past 40 years, entitlements have nearly doubled as a share of federal outlays, climbing from 32 percent of total outlays in 1962 to 60 percent of the federal budget in 2002. But the problem will soon get much worse. The elderly will be a much bigger share of the population once the baby-boom generation retires. And since the elderly consume most entitlement spending, the fiscal outlook will worsen-particularly if the drug program isn't repealed. According to the Congressional Budget Office, mandatory spending for Social Security and Medicare will nearly double as a share of the gross domestic product (GDP) over the next 40 years.

Financing those benefits will be a huge challenge. Although Social Security and Medicare spending are projected to explode, payroll tax revenues to finance these programs will remain relatively constant as a share of GDP. The net result will be huge long-term deficits, and Medicare is the main problem. According to the trustees' reports on Social Security and Medicare, the combined deficit of the two programs will swell to more than 8 percent of national economic output in 2075, with Medicare accounting for about three-fourths of the red ink. According to government data, the Social Security cash-flow deficit through 2078 is $25.85 trillion in today's dollars. But this is spare change compared to the Medicare cash-flow deficit, which is a staggering $111.4 trillion over the same period.

While the long-term outlook is catastrophic, even the short-term prognosis is grim. The baby-boom generation will begin to retire in about 10 years, and the fiscal consequences will be profound. The combined deficit from Social Security and Medicare will rapidly expand, climbing to 1 percent of GDP in 2015, 2 percent of GDP in 2020, and 3 percent of GDP in 2025. To put that figure in perspective, 3 percent of GDP today would be almost $344 billion, or more than $3,000 per household.

Unpleasant options

The tax implications of these big deficits should concern all responsible lawmakers as well as taxpayers. Raising revenue by just 1 percent of GDP next year would require an annual tax increase of more than $100 billion. Over the next 10 years, the tax increase needed to finance such a deficit would be more than $1.5 trillion. Such a tax increase would be a body blow to the economy, threatening European-style stagnation and higher unemployment.

The fiscal outlook gets worse with every passing year. According to Medicare Trustee Thomas R. Saving, a professor of economics at Texas A&M University and senior fellow at the National Center for Policy Analysis, the Medicare program is now projected to consume 24 percent of all federal income taxes by 2019 and 51 percent of all federal income taxes by 2042.[1] This will leave lawmakers with three options:

1. Raise taxes to make up the shortfall. Payroll taxes would have to be increased by more than 100 percent to make up the overall financing shortfall in Medicare. Lawmakers could choose higher income tax rates, of course, but the net result will still be more money in Washington and less money for the productive sector of the economy. The additional per-household tax burden would be $2,227 in 2010, climbing quickly to more than $12,000 in 2030.
2. Accept enormous additional deficits. If politicians do not want to raise taxes or premiums, they can borrow money from the private sector to pay benefits. This will mean deficits approaching 8 percent of national economic output on a permanent basis. Deficits are not necessarily a bad thing, particularly if they are incurred to facilitate a policy with long-term benefits to the nation (such as winning World War II, lowering tax rates, or creating personal Social Security accounts). A prescription drug entitlement, however, does not fall in this category.
3. Scale back benefits and/or ration care. The last choice is to reduce or renege on promised benefits-the least likely choice by future politicians.

Big future tax increases

In a political environment of rising costs and demands for more benefits, the most likely scenario is action by Congress to repeal existing legislation that would reduce tax revenue while concomitantly dampening enthusiasm for future tax reduction and reform. The remaining Bush tax cuts would be the first target.

The bulk of the 2001 tax cuts expire at the end of 2010, and most of the 2003 tax cuts expire at the end of 2008. Good economic policy suggests that these provisions should be made permanent to maximize the economic benefit of lower tax rates. At the very least, however, they should be extended to protect the economy from a significant tax increase in either 2009 or 2011. If the temporary tax cuts are allowed to expire, the economy will be hit with a $990 billion tax increase between today and 2014. This tax increase would have serious economic consequences, particularly since much of it would be in the form of higher penalties on work, saving, and investment.

Yet, is it reasonable to assume that lawmakers will make the Bush tax cuts permanent when future budget projections will be adversely affected by the upcoming retirement of the baby boomers? Even extending the tax cuts will be much more difficult in that environment, and making the Bush tax cuts permanent might be impossible. For example:

• The 15 percent tax rate on dividends and capital gains will expire at the end of 2008, and static revenue estimates will show an annual "cost" of more than $20 billion to continue these rate reductions.
• Extending the 2001 tax cuts would be even more problematical. According to the Treasury Department, making the income tax rate reductions permanent would "cost" nearly $400 billion between 2011 and 2014.
• Permanent repeal of the death tax would be particularly vulnerable. This unfair levy finally ends in 2010, but will reappear in 2011 under current law. Since permanent repeal would "cost" about $40 billion per year, that goal will be extremely difficult to achieve.

Goodbye to future tax reform

Further tax relief and fundamental tax reform would also be jeopardized if entitlements continue to consume an ever-larger share of national economic output. All of the following tax cuts are necessary steps on the road to fundamental tax reform-and all will be much harder to achieve if prescription drugs become an entitlement:

• Corporate tax rate reduction: The United States has the highest corporate tax rate of any developed nation. This punitive levy undermines the competitiveness of U.S.-based companies. Based on static scoring, reducing the tax rate by just 1 percentage point will "cost" more than $50 billion over 10 years, but can lawmakers "afford" to drop the rate when budget choices are dominated by rising entitlement expenditures?
• Alternative minimum tax (AMT) repeal: The alternative minimum tax is a "Catch-22" system that forces an ever-larger number of taxpayers to calculate their tax burden a second time using the AMT. If this results in a higher tax liability, the taxpayer must pay more tax. Is it reasonable to think that this unfair tax-with its $600 billion price tag-will be repealed when prescription drug spending is consuming a huge share of income tax revenue?
• Universal IRAs: People should not be taxed twice on income that is saved and invested, which is why individual retirement accounts should be universal. Back-ended IRAs (Roth IRAs) are particularly attractive to politicians since they increase tax revenue in the short run, but will lawmakers be willing to adopt a system eliminating the second layer of tax on saving and investment when it might mean lower revenues in the long run?
• Expensing of business investment: Companies should be allowed to fully deduct investment expenses when calculating taxable income (expensing), but the current system only allows them to deduct a portion of expenses in the year they are incurred (depreciation). This depreciation system creates a bias against capital formation and reduces worker productivity. Extending expensing for small businesses through 2013 will "cost" $23.7 billion. Providing this neutral treatment for all businesses would require an even bigger tax cut, but will Congress do anything when Medicare expenses are climbing much faster than inflation?
• Territorial taxation: The United States has the world's worst treatment of foreign-source income. The greedy hand of the Internal Revenue Service reaches out to tax labor income, capital income, and corporate income earned in other nations-even though this income already is subject to foreign tax. This "worldwide" tax reach hinders U.S. competitiveness and is largely responsible for many companies' deciding to re-charter in jurisdictions with better tax law, such as Bermuda and the Cayman Islands. Territorial taxation-the common-sense notion of taxing only income earned inside national borders-would solve this problem, but is this solution feasible when prescription drug costs take an ever-larger share of national income?

Conclusion

The fiscal policy consequences of entitlement expansion are staggering. The new drug entitlement endangers the 2001 and 2003 Bush tax cuts. In the future, as lawmakers examine the need to extend those tax cuts and make them permanent, they will be haunted by budget projections showing an enormous expansion in Medicare spending. This will create a political environment that hinders the enactment of supply-side tax policy.

In the long run, entitlement expansion also threatens fundamental tax reform. Many of the reforms needed to bring the tax code closer to a simple and fair flat tax involve a reduction in tax revenue. This will be a daunting challenge. A bigger Medicare system-particularly one insulated from market-based reforms-will make it more difficult to replace the Internal Revenue Code with a pro-growth flat tax.

Daniel J. Mitchell is McKenna Senior Fellow in Political Economy at The Heritage Foundation.