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
Introduction
„
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
1.
2.
Substantially underestimates
unfunded liabilities by ignoring longterm liabilities
Is biased against reforms that would
reduce these unfunded liabilities
1. Underestimates Liabilities
„
Budget does not track many unfunded obligations
„
„
„
They’re “off balance sheet”
Examples
„
Social Security and Medicare
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Medicaid
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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
Æ Debt held by the public will increase
Æ Other unfunded obligations decrease equally
ÆZero impact on total Fiscal Imbalance
ÎBut focusing on public debt Æ federal liabilities
appear to be larger since the other unfunded
obligations are not being tracked.
ÎSo 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
Æ Debt held by the public will still increase
Æ Other unfunded obligations decrease by more
ÆTotal Fiscal Imbalance is actually reduced
ÎFocusing on public debt Æ liabilities seem larger
ÎBiases reform debate against reforms that would
actually reduce the Fiscal Imbalance
New budgetary framework
„
Two main integrated components:
„
“Fiscal Imbalance” (FI) = Debt held by public +
PV of all future outlays – PV of all future revenue
„
„
“Generational Imbalance” (GI) = portion of FI on
account of current and past generations
„
„
Similar to open-group liability concept
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%
„
„
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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
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Very conservative by historic standards
„
„
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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 Imbalances (Selected Years)
(Present Values in Billions of Constant 2004 Dollars; Fiscal Years)
2004
2005
2010
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*
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
1. Fiscal Imbalance in Social Security
2. Fiscal Imbalance in Medicare (Parts A, B and D)
* Part D (new Rx benefit ) alone = 24,186
$2.6 trillion
$16.1 trillion
Table 2: Fiscal and Generational Imbalances (Selected Years)
(% of Present Value of Uncapped Payrolls; Fiscal Years)
2004
2005
2010
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
1. Fiscal Imbalance in Social Security
Options for Paying for $63 Trillion
„
„
„
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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
Discount Rate, r
Productivity Growth
Per Capita, g
Health Care Outlay
Growth Per Capita, h
Policy
Baseline High
3.6%
3.9%
Low
3.3%
1.7%
2.2%
1.2%
1.0%
1.5%
0.5%
Sensitivity Analysis:
FI as Share of PV of Payroll
Discount Rate, r
Productivity Growth
Per Capita, g
Health Care Outlay
Growth Per Capita, h
Policy
Baseline High
18.0
16.2
Low
20.2
18.0
19.0
16.4
18.0
21.5
14.9
But are these obligations “real”?
„
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Yes: the only difference between these
obligations and regular debt is the policy
options available for dealing with them.
Options for reducing explicit debt:
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„
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Monetize it (except TIPS)
Increase taxes
Declare bankruptcy
Options for reducing implicit debt:
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Hard to monetize (since inflation protected)
Control outlays, increase taxes
Is there a hidden silver lining?
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International prospects also gloomy
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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
1.
New accounting methodology recently
Adopted by Gov’t Trustees
ƒ For Social Security, starting with 2003 Report
ƒ For Medicare, starting with 2004 Report
ƒ They estimate a Medicare + SS FI of $82
trillion!
2.
Senator Lieberman has introduced a bill
requiring it for government as a whole
Easy Fix / Hard Fix
„
Social Security: The “Easy Fix”
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„
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Smaller problem
Nature of problem is also easier since it is
cash payment (e.g., “just” price index)
Medicare: The “Hard Fix”
„
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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
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Asset Side
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„
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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?
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„
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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?
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Aside: accounting issues
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Risk: Liability matching problems
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Risk: Demographic issues
Source: Poterba (2004), “Population Aging and Financial Markets”
President’s Social Security Plan
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An actuarially-fair carve out
„
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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
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Intuition
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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
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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