The coming challenge of paying Social Security, Medicare, and Medicaid benefits to 77 million retiring baby boomers will be one of the greatest economic chal­lenges of the 21st century. What Federal Reserve Chair­man Ben Bernanke called the "calm before the storm" ended on January 1, 2008, when the first baby boomers became eligible for early Social Security benefits.[1] In three years, they will also become eligible for Medicare.

In the coming decades, the cost of these programs will leap from 8.4 percent of gross domestic product (GDP) to 18.6 percent of GDP-an increase of 10.2 percent of GDP. Without reform, this increased cost would require raising taxes by the current equiva­lent of $12,072 per household or eliminating every other government program. Funding all of the prom­ised benefits with income taxes would require rais­ing the 35 percent income tax bracket to at least 77 percent and raising the 25 percent tax bracket to at least 55 percent.

Although aware of this coming crisis, Members of Congress have largely ignored it because all of the possible reforms are considered politically risky. Yet delays only increase the pain of the ultimate reforms, which are becoming about $1 trillion more expensive annually. Furthermore, many believe that Americans ages 55 and over should be exempt from any reforms. One-third of all baby boomers have already crossed that threshold, and at 4 million per year, all of them will have crossed it by 2019.

Entitlement reform is more than just an economic issue. Americans need to decide whether they want a future in which older Americans have an automatic claim on one-fifth of the future income of their grandchildren-who will be raising their own chil­dren and paying off their home mortgages. Under the current system, retirees will spend one-third of their adult lives in taxpayer-funded retirement while national security, education, health research, and antipoverty programs fight for the few remain­ing tax dollars.

This paper provides an introduction to the com­ing crisis in Social Security, Medicare, and Medicaid and sets up a framework for the consideration of various reforms.

No Easy Solutions

The Congressional Budget Office (CBO) projects that federal spending on Social Security, Medicare, and Medicaid will leap from 8.4 percent of GDP today to 18.6 percent by 2050.[2] (See Chart 1.) For comparison, the entire federal budget is 20 percent of GDP (18 percent spent on programs and 2 per­cent on net interest). This massive cost increase will be fueled by the 77 million retiring baby boomers, combined with steep inflation in health care costs and automatic scheduled benefit hikes.

These costs far exceed what taxpay­ers will be able to afford. Increasing taxes by 10.2 percent of GDP today would come to $1.394 trillion, or $12,072 per household. (See Chart 2.) It could mean raising income tax rates by at least 120 percent-and probably more because tax increases slow economic growth and dampen new revenues-with additional raises thereafter.[3] Funding all of the prom­ised benefits would require raising the 35 percent income tax bracket to at least 77 percent and the 25 percent tax bracket to at least 55 percent.

Regrettably, five common myths undermine the cause for immediate action.

MYTH 1: There is no hurry.
Social Security, Medicare, and Medicaid already absorb 42 percent of the federal budget and are growing by 7 percent annually, making them the largest impediment to balancing the budget. Fur­thermore, many believe that anyone over age 55 should be exempt from entitlement reforms.

Yet every year, 4 million more baby boomers turn 55, effectively locking in their future benefits (and taxpayer costs) by this standard. By 2019, all 77 million baby boomers will have turned 55,[4] leaving future lawmakers with the unpalatable options of massive, economy-stagnating tax in­creases, unprecedented program terminations, or the paring back of benefits for those over 55. Tack­ling reforms immediately will reduce their ultimate costs, spread the burden across more people, and give baby boomers more time to adjust their retire­ment strategies.

MYTH 2: These budget projections are unreliable.
Projecting economic variables such as growth and inflation rates is difficult, but the impending retirement of 77 million baby boomers is not a vague theoretical projection. The Social Security costs for these future retirees are determined by a set benefit formula. Medicare faces the same demo­graphic realities, and its steep spending projections even assume a sharp slowdown in per capita growth. These same baby boomers will also push up Medicaid spending on long-term care.

MYTH 3: Economic growth will solve the problem.
Revenues associated with higher economic growth would help only marginally. As Federal Reserve Chairman Ben Bernanke has testified:

Economic growth leads to higher wages and profits and thus increases tax receipts, but higher wages also imply increased Social Security benefits, as those benefits are tied to wages. Higher incomes also tend to increase the demand for medical services so that, indirectly, higher incomes may also increase federal health expenditures.[5]

In short, the same factors that could increase tax revenues would also increase spending.

MYTH 4: Cutting waste and pork is enough.
Although Washington wastes billions of dollars, cuts in federal spending cannot absorb a cost increase of 10.2 percent of GDP. In fact, offsetting this spending hike would require eliminating every other federal program by 2049 except interest pay­ments on the federal debt. Non-defense programs would be eliminated by 2030, and defense spend­ing would be eliminated by 2049. (See Chart 3.)

MYTH 5: Letting the 2001 and 2003 tax cuts expire is enough.
The CBO projects that tax revenues willincrease from 18.8 percent of GDP to a record 22.8 percent by 2050, but letting the 2001 and 2003 tax cuts expire in 2011 would only nudge revenues up to 23.4 percent by 2050.[6] Thus, losing the tax cuts would close less than 1 percentage point of the 10.2 percent gap.

Even that projection unrealistically assumes that such a large tax increase on families, investors, and businesses would have no negative economic con­sequences and that Congress would not spend the new revenues elsewhere. Massive new spending, not low tax revenues, is the problem.

All five of these myths distract America and its lawmakers from confronting the difficult but nec­essary entitlement reforms. The con­tinued refusal to modernize Social Security, Medicare, and Medicaid leaves only three options:

1. Massive and economically debili­tating tax increases. (See Chart 2.)
2. Elimination of other federal pro­grams. (See Chart 3.)
3. Unprecedented budget deficits. (See Chart 4.)

How Entitlements Hijack the Budget Process

Biased budget rules are a major obstacle to fixing Social Security, Medicare, and Medicaid. Federal spending should be allocated based on national priorities, yet programs classified as entitlements are given a nearly untouchable status above dis­cretionary programs.

Entitlement programs-includ­ing Social Security, Medicare, Medic­aid, most antipoverty programs, farm subsidies, and refundable tax cred­its-are effectively on autopilot. Their budgets grow automatically each year without going through the regular budget process, being examined, or being forced to justify their growth. Smaller entitlement programs are ex­amined only once or twice per decade when they are reauthorized. Large enti­tlement programs are not required to be reauthorized or re-examined.

Each year, when Congress begins writing the annual budget, it accepts the 53 percent of the budget (and growing) spent on entitlements as a given, sets aside an additional 9 percent for net interest, and then spends the rest of the year deciding how to allo­cate the remaining scraps to defense, homeland security, education, health research, transportation, justice, for­eign aid, and the environment.

This practice conflicts with America's budget pri­orities. It effectively gives Medicare drug subsidies for well-off Americans priority over body armor for American troops serving in Iraq and Afghanistan. It guarantees farm subsidies to corporate agribusi­nesses, leaving homeland security, education, and health research to fight over whatever tax dollars are left over.

These trade-offs are not theoretical. As Social Secu­rity, Medicare, and Medicaid costs surge over the next few decades, the funds available for other programs- such as defense, education, poverty relief, and veter­ans aid-will continue to shrink toward zero.

Approaches for a Solution. Entitlements were originally placed on autopilot to provide predict­ability in eligibility standards and benefit formulas. While overhauling these standards and formulas each year would be unwise, Congress could con­vert major entitlements into 30-year budgeted pro­grams that must be reviewed and reauthorized every five years to keep spending within long-term allowable levels.

Additionally, Congress could create triggers that would automatically adjust the program if current and future spending trends exceed the allowable amount. (This is similar to a law that triggers reform proposals when outside sources are needed to fund at least 45 percent of Medicare spending.[7]) As long as the 30-year budget and five-year targets are written realistically, any annual adjustments would be small.

The Coming Costs

Over next few decades, the cost of providing promised Social Security, Medicare, and Medicaid benefits will exceed projected revenues by trillions of dollars.

Social Security. Social Security was created in 1935 to provide pensions to Americans age 65 and over.[8] Old Age and Survivors Insurance is funded by a 10.6 percent payroll tax, split equally between employer and employee, on the first $102,000 earned-a level that is adjusted annu­ally for inflation.[9]

Initial Social Security benefits are calculated based on the worker's average monthly income, called the Average Indexed Monthly Earnings (AIME), during the worker's 35 years of highest earnings. (Each year's earnings are indexed for sub­sequent average wage growth in the economy).[10] Monthly benefits equal a percentage of the AIME, ranging from 90 percent for very low earners down to 15 percent for the highest earners.[11] After the ini­tial benefit is determined, it is indexed annually for price inflation.

Currently, the average annual benefit is approxi­mately $15,000. Those who live long can receive benefits well in excess of what they paid into the system. Those who die young can pass only mini­mal benefits on to their survivors. For the most part, they can leave little to nothing of their contributions for their heirs.

The Problem. Social Security spending is pro­jected to increase from 4.3 percent of GDP today to 6.1 percent by 2050-an increase of 1.8 percent of GDP. Today, a spending increase of 1.8 percent would equal $246 billion, or $2,130 per household.Of this spending hike, 55 percent would result from demographic changes, and 45 percent would result from higher benefit levels.

The demographic side is simple. The 77 million retiring baby boomers born between 1946 and 1964 will overwhelm a Social Security system that currently pays benefits to only 42 million seniors.[12] Not only will more Americans retire, but they will live longer and collect benefits longer. In 1940, a 65-year-old senior could expect to live 13 more years. Today, that figure is 18 years and is pro­jected to increase to 22 years in coming decades. The combination of 77 million retiring baby boomers and longer life spans will double the num­ber of Social Security beneficiaries by 2030, while the number of taxpaying workers will increase by just 17 percent.[13]

This will endanger the program because today's benefits are paid by today's payroll taxes. Social Security's sustainability depends on having enough workers to support all of the retirees. In 1960, five workers supported each retiree. This ratio has fallen to 3:1 and will drop to 2:1 by 2030. A 2:1 ratio means that each married couple in 2030 will be supporting the Social Security and Medicare bene­fits of one retiree.

Higher benefit levels will drive the rest of the cost increase. As stated, initial Social Security benefits are calculated by adjusting lifetime incomes upward for the economy's average wage growth over a per­son's working life, which is historically higher than price inflation. This pushes people's AIMEs well above their inflation-adjusted lifetime earnings. Because of this more generous formula, the CBO estimates that the average retiree's inflation-adjusted benefits will nearly double by 2075.[14]

What About the Trust Fund? The Social Security Trust Fund is the most misunderstood aspect of this program. In 1983, with Social Security's finances in dire straits and baby boomers approaching retirement, lawmakers raised the pay­roll tax so that Social Security could build a $5 tril­lion "surplus." Beginning in 2017, when the payroll tax can no longer cover the rising annual program costs, this "trust fund" would be large enough to cover all program shortfalls until 2040. At least, that was the idea.

In practice, Congress has already spent this money. Each year, the Social Security program lends its surplus to Congress to spend on regular govern­ment programs in return for special-issue Treasury bonds, which are backed only by the federal gov­ernment's promise to repay them. In 2017, when Social Security begins to redeem these bonds, Con­gress-and the taxpayers-will start to repay the entire $5 trillion from scratch.

This means the trust fund does not save taxpay­ers a dime. Future taxpayers are still on the hook for the entire $5 trillion Social Security deficit between 2017 and 2040. The "assets" of the trust fund are only an IOU, a tally of how much the American peo­ple will have to repay the system. Congress taxed workers to build the trust fund, spent the money, and will have to tax them a second time to repay the trust fund.

Critics respond that the federal government has never defaulted on its debt, so the Social Security program will definitely be repaid the $5 trillion, allowing it to pay full benefits until 2040. While this may be true, the key question is how lawmakers will find the extra $5 trillion. These critics must be counting on big tax increases or spending cuts else­where in the budget beginning in 2017.

Thus, 2040 is not a very important date. The program currently runs an $85 billion annual sur­plus that Congress uses to fund other federal pro­grams, thereby reducing the budget deficit by that amount.[15] The surplus will begin decreasing by 2012, and Congress will be less able to use these funds to reduce the budget deficit artificially. By 2017, Social Security will begin running a deficit, and Congress will need to begin transferring outside taxes into the system to pay full benefits. After 2017, the amount of outside taxes needed to pay all promised benefits will grow every year.

Approaches for a Solution.The options for pre­serving Social Security's solvency are relatively straightforward. Rather than dumping large debt or tax increases on the next generation, several feasible options exist to restrain program costs. One option is to raise the retirement age (currently set to rise to 67 by 2030) by two months each year until it reaches 70, which would allow future seniors an average retirement of 17 years.

A second option would income-adjust benefits to target needy seniors more effectively. This could be accomplished through "progressive indexing," which would index initial benefit levels for middle-income and upper-income families to price inflation rather than wage growth, eliminating much of the increased Social Security costs driven by higher ben­efits. This would also target more benefit growth to lower-income retirees. If accompanied by an increase in the retirement age, progressive indexing could eliminate the entire Social Security shortfall.[16]

Finally, many economists believe that the con­sumer price index overstates inflation. Aligning Social Security's inflation adjustment with the actual (and lower) inflation rate would save money while still providing benefit growth.

In the long run, a more generationally equitable system would add a Social Security option in which individuals set aside money for their own retire­ment that they own themselves. The challenge is funding the transition period when one generation will need to fund current senior citizens' benefits while prefunding its own retirement.

Personal accounts by themselves do not reduce the taxpayer liabilities to current seniors. However, if Congress slightly pared back the growth rates of benefits for upcoming retirees and allowed workers to direct a portion of their payroll tax savings into personal retirement accounts, workers could har­ness enough long-term investment growth to do much better than they can under today's system. This is the most realistic way to fund two genera­tions of retirement on one generation's payroll tax. Millions of Americans with 401(k) plans and IRAs already understand how even safe investments can grow significantly over several decades.[17]

Medicare. Medicare was created in 1965 to pro­vide medical care to Americans age 65 and older. An average of just under $10,000 is spent annually on each of Medicare's 43 million enrollees.[18] Medicare has three main components:

• Medicare Part A covers hospital and skilled nursing care. It is funded by a 2.7 percent payroll tax (split equally between employer and employee) on all income. For most enrollees, Medicare operates as a fee-for-service system, meaning that once the enrollee satisfies a modest deductible, Washington reimburses participat­ing health care providers for services based on a set payment schedule.
• Medicare Part B covers physical and outpatient care. This optional program, in which most Medicare recipients participate, requires recipi­ents to pay a monthly premium set at approxi­mately 25 percent of total program costs, leaving the taxpayers to fund the remaining 75 percent.
• Medicare Part D is the new prescription drug benefit enacted in 2003. This optional program is funded mostly from general tax revenues, although enrollees pay a small deductible and monthly premium. Enrollees choose from com­peting private health plans, which are reim­bursed by Washington.

Only Medicare Part A is a social insurance pro­gram in which retirees "earn" their benefits with lifelong payroll taxes. Benefits for Medicare Parts B and D are not earned with payroll taxes. They are financed by general revenue (75 percent) and pre­miums (25 percent) paid by the senior enrollee.

The Problem. Medicare costs are projected to more than triple from 2.7 percent of GDP today to 9.4 percent by 2050. In current terms, a cost increase of 6.7 percent of GDP would equal $916 billion, or $7,930 per household annually.

Even this projection assumes that per capita Medicare costs will grow only about 1 percentage point faster than GDP, even though Medicare costs have grown an annual average of 2.4 percentage points faster than GDP since the 1970s.[19] If this trend continues, actual Medicare costs through 2050 could be double the current projection.

Medicare faces the same demographic challenges as Social Security, and the projected increase in seniors over age 85 will add additional strains.[20] It also faces steep inflation in health care costs that will increase its long-term debt well beyond Social Secu­rity's debt. Overall, health spending has been increasing 7 percent to 10 percent annually. Health spending averaged $7,026 per person in 2006, or 16 percent of GDP.[21] Furthermore, creation of the Medicare prescription drug entitlement added approximately $8 trillion to Medicare's 75-year unfunded obligations.[22]

What About the Trust Fund? Medicare Part A is funded by payroll taxes that are theoretically "saved" in a trust fund for future retirees. Parts B and D are not funded by payroll taxes. As with Social Security, Congress has already spent all past sur­pluses for Part A, leaving taxpayers to fund all future shortfalls from scratch. The program is projected to begin running a deficit in 2010 (2007 if interest income is excluded) and then remain in deficit indefinitely.[23] Because at least 75 percent of Parts B and D is funded by taxpayers, these programs also face enormous long-term deficits.

Approaches for a Solution.Medicare reform is very complex. While Social Security transfers income from one group to another and therefore can be fixed with formula changes, fixing Medicare is more difficult because it is a major part of the health care economy. Thus far, reforms have cen­tered on reducing payment rates to doctors and hospitals, but payment rates are already well below market prices. This amounts to rationing health care, which may reduce costs but will not advance better care or encourage more rational decisions.

Some reforms, which could be made quickly, would significantly rein in Medicare costs. One new approach would be to reduce the massive Part B and Part D subsidies for upper-income families. These programs are not social insurance: Enrollees did not earn their benefits with payroll taxes. Rather, they are large subsidies from taxpayers. Part B recently began modest income-relating. President Bush has proposed larger means-testing of Parts B and D.

Long-term fundamental reform will likely involve bringing more choice and competition into health care, such as moving Medicare from a defined-benefit system to a defined-contribution system. The Federal Employees Health Benefits Pro­gram (FEHBP) has held down costs by creating a voucher-type system for fed­eral employees to purchase coverage from competing health plans that offer differing coverage and costs.[24] By creating more choice and competi­tion, the FEHBP has held down cost increases and may serve as a model for Medicare reform.

Medicaid. Medicaid is a federal-state partner­ship, created in 1965, that provides medical care to 46 million low-income individuals. States run their own Medicaid programs, while Washington sets minimum eligibility and benefit standards and reimburses states for an average of 57 percent of all program costs. Approximately one-third of Medic­aid spending is on senior citizens, partly because Medicare does not cover most long-term care such as nursing homes. Overall, Medicaid finances 40 percent of all long-term care costs.[25]

The Problem. Federal Medicaid spending is pro­jected to jump from 1.4 percent of GDP to 3.1 per­cent by 2050. Today, a 1.7 percent of GDP spending hike would equal $232 billion, or $2,012 per household. Most of this spending growth will come from senior citizens, whose long-term care costs are not covered by Medicare.

Two other factors will also drive up Medicaid costs: inflation of health care costs and the funding structure, which encourages states to overspend on Medicaid. Because Washington reimburses states for 57 percent of all costs, every dollar that a state spends on Medicaid guarantees an additional $1.33 grant from Washington. Consequently, states have a stronger incentive to allocate their budgets to expand Medicaid benefits and eligibility levels rather than to provide tax relief or education, regardless of the state's actual needs.

Not surprisingly, approximately 60 percent of the average state's Medicaid budget is now spent on optional services and populations beyond the fed­eral minimum.[26] These optional services, such as weight-loss help and substance-abuse treatment, have played a large role in increasing the program's spending by an inflation-adjusted 227percent since 1990.[27]

Approaches for a Solution. Converting Medicaid into a block grant to states would eliminate state incentives to overspend on Medicaid. Additionally, giving states more flexibility to craft different Medic­aid packages for different individuals based on their unique personal circumstances could save money while improving service delivery.[28] State incentives to help individuals purchase long-term care insur­ance could also substantially reduce Medicaid's bur­den insofar as these expenses are concerned.

Conclusion

Unless lawmakers promptly reform Social Secu­rity, Medicare, and Medicaid, America faces a future of soaring taxes and government spending that will cause poor economic performance. Americans will pay onerous taxes, and future generations will have lower living standards than Americans enjoy today. The longer lawmakers wait to enact the necessary reforms, the more painful those reforms will be.

Brian M. Riedl is Grover M. Hermann Fellow in Federal Budgetary Affairs in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.