Attention has focused recently on the explosion of federal borrowing to meet the demands of economic "stimulus," market stabilization, and the financial sector crisis. However, even if the United States had been fortunate enough to avoid these crises, the federal government would still face an unsustainable fiscal course.

The most current long-term projections of growth in Social Security, Medicaid, and Medicare (often referred to as entitlements) paint a bleak fiscal picture, which emphasizes the need for reform. Left unchecked, entitlement spending is projected to exceed 20 percent of gross domestic product (GDP) by 2060. Viewed in isolation and from the distance of 50 years, this may not seem altogether daunting--distressing perhaps, but hardly alarming. However, the federal budget would also need to expand to include discretionary spending and the other mandatory outlays. Even more important, mandatory outlays would include spending a crushing 22 percent of GDP to service the debt accumulated from five decades of debt-financed federal spending. The projections beyond 2060 reflect the snowball effect of compounding debt and dwarf the nearer-term estimates. Regardless of the time horizon, addressing U.S. fiscal straits will require increasingly drastic measures.

The projections demonstrate the futility of attempting to finance entitlements with debt. On its present course, this debt and the accompanying interest will swamp the U.S. economy, harm U.S. standing in world capital markets, damage capital formation and productivity growth in the United States, and reduce future standards of living.

The problem needs to be addressed soon, but some proposed solutions will not work. Raising taxes to match the growth in the spending would dramatically harm economic growth and competitiveness. Similarly, it is unrealistic to expect sustained GDP growth sufficient to afford this spending. Instead, addressing the long-term fiscal challenges confronting the United States will require fundamentally reforming entitlement spending.

This paper suggests some possible approaches that Congress should consider when it reforms entitlements to rein in spending and makes broader reforms to the health care and health insurance markets.

Reforming Social Security. Social Security should be reformed by reducing the growth of future benefits to higher-earning workers to balance the cash flow so that revenue from Social Security payroll taxes equals Social Security retirement benefits. Achieving a cash-flow balance would immunize Social Security from the larger vagaries of the federal budget.

Reforming Medicare and Medicaid. In Medicare and Medicaid reform, an important first step is to think separately about the markets for health care and health insurance.

The Health Care Market. In reforming the health care market, the first step is to employ the bully pulpit as loudly and frequently as possible to encourage people to take care of themselves and prevent chronic diseases when possible, but this would not be enough by itself. Next, the reforms should focus on promoting competition throughout the health care system among providers and among alternative treatments. Medicare payment policy needs to be reoriented away from paying for all treatments used on a patient and toward paying for cost-effective, coordinated care that yields high-quality outcomes.

These "supply-side" approaches to changing the use of medical services could be complemented by needed legal reforms to eliminate frivolous lawsuits and excessive damage awards and to provide a safe harbor for doctors that follow clinical guidelines and adhere to patient safety protocols.

The Health Insurance Market. The first pillar of reforming the health insurance market is to change the tax treatment of health insurance to level the playing field between employer-provided insurance and other types of insurance.

The second pillar is to improve the variety and affordability of these alternatives. As with markets for providers, health insurance markets should be national in scope and support vigorous competition. Highly competitive, deep national insurance markets will avoid the potential for large insurers to "capture" state regulators, limit monopoly power, provide out-of-state alternatives for consumers saddled with unreasonably costly insurance mandates, and reduce the potential for wasteful overhead and excessive compensation that survives in the absence of competition.

The third pillar of better insurance markets is to "risk-adjust" the tax credit so that higher-cost individuals receive greater resources, thereby transforming the nature of insurance company competition.

Conclusion. The U.S. faces a fundamental budgetary challenge that will have severe economic implications over the long term. However, the scale of these challenges and the severity of an attendant economic collapse demand a near-term approach to bring the U.S. fiscal situation back into balance.

Entitlement spending seriously threatens U.S. fiscal solvency. Left unchecked, it will contribute to a crippling national debt burden, which will stifle economic growth and force later and unluckier generations to bear the cost of these imbalances through severe federal cuts or draconian tax increases.

The U.S. still has a window, however indeterminate, during which it could implement sensible reforms to return Social Security to solvency without incurring massive future deficits and to rein in the health care costs that are driving the increasing Medicare and Medicaid spending. Properly implemented, reforms along the lines suggested in this paper would return federal spending to a sustainable path and ensure a foundation for prosperity throughout the coming decades.

Douglas Holtz-Eakin is President of DHE Consulting, LLC, and a Visiting Fellow at The Heritage Foundation. Gordon Gray is a Senior Adviser at DHE Consulting, LLC.