Investor’s Business Daily ran a story recently, Tax To The Max, on a Congressional Budget Office study of the U.S. finances.What it says is that spending on Social Security, Medicare, Medicaid, and other entitlement programs is unsustainably high. The study projects tax increases of 150%, with the lowest income-tax bracket going from 10% to 25% and top rates going from 35% to 88%.
The IBD correctly notes: “Allowed to grind on without real reform, Social Security, Medicare and Medicaid will do what no invading army or cabal of terrorists has done or will ever do: bring this mighty republic to its knees. Increasing federal taxes by 150% will strangle economic growth.”
I think the IBD is too optimistic. Even pushing tax rates to 100% confiscation wouldn’t finance the entitlements black hole at the rate we can expect the client population’s needs to grow — especially not after 2050, when the demographics of the U.S. will tilt in a distinctly less favorable direction. A mere 150% increase in current rates certainly won’t do it. One way or another, the Federal entitlements system seems headed for a terminal crash. The only question is when it will happen.
Raising taxes can delay this, but not prevent it. And might, actually, trigger it sooner; the historical evidence suggests that current tax rates may already be at above the minimum level where, by suppressing and unhealthily redirecting economic activity, they actually reduce total revenue. (One reason to believe this is that the much-derided “Bush tax cuts” actually increased revenues despite the effects of the dot.com bust.) But even if this isn’t true yet, diminishing returns will set in at some point as rates go up.
The only alternative to raising taxes (or deliberately inflating the currency, which in this context has similar effects) is to buy debt and pay entitlements out of that, pushing the unsustainability problem into the future.
The fundamental problem is that income-transfer programs (and the interest service on the debt purchased to keep them running) are spending wealth in higher volumes than the economy can actually generate, and demand for that spending is rising faster than the economy is growing. Thus, raising tax rates is no longer a way out, if it ever was.
At some point, the U.S. government is going to lose both the ability to increase revenues and the ability to sell bonds. At that point the entitlements system will crash. Transfer checks will either stop issuing or become meaningless because the government has, like some banana republic, hyperinflated the currency in order to get out from under its debt obligations.
Unlike the oncoming European demographic crash, the entitlements crash will be survivable in that there will still be people around to make things and trade things with. But it’s going to be ugly. probably rioting-in-the-streets ugly. People dependent on income transfers will starve or die of preventable diseases in large numbers, unless they can find work or private charity. Since many of those people will be old, work will be unlikely unless they are exceptionally capable at something. Families will have to re-assume the burden of caring for their elderly; retirees without children will be in especially severe jeopardy.
Violent revolutions have been fought over less wrenching economic changes than this one promises to be.
The next questions to ask are (a) when will it happen?, and (b) how can the pain be minimized?
There are good reasons to believe the crash could happen as early as 2012, with the trigger being the mass retirement of the Baby-Boom demographic bulge. That is, it will happen that soon if we are lucky.
If we are unlucky, the Federal government will concoct some sort of accounting flimflam (like Al Gore’s infamous lockbox full of IOUs from one part of the government to another) that will push back the day of reckoning out past 2020 — making the numbers and demographic profile of the stranded dependents worse every year it’s delayed. I think this is the most likely scenario, though I’d love to be wrong.
In the rest of this essay I am going to make, against my best judgment, the optimistic choice of a near-term crash; bear in mind that if I’m actually correct in my pessimism the devastation will be worse…
The pain-minimizing strategy, from an economic and human-misery point of view, would be to voluntarily crash those programs now. Learning the adaptations required to live without them would be easier in today’s strong economy than it’s going to be in the world after an uncontrolled crash. This is impossible, however, as it would create immediate grief for the political and bureaucratic class that runs them and for various powerful interest groups allied to it. At present, this coalition is certainly powerful enough to block abolition.
My friend Ken Burnside argues for the near-term crash as follows: “The dinosaur killer on the economy is the 53 trillion dollars of accumulated debt on Social Security/Medicaid, which starts coming due around 2013, when revenues for the program are less than its obligations, and all those ‘IOUs’ that Congress has been writing against the trust fund start coming due.”
My best guess is that 2013 will fall in President Palin’s first term, after McCain steps down and she clobbers the living crap out of an aging and bitter Hillary Clinton. There’s still a possibility, though, that the economy-killer could strike early in an Obama second term. If it goes down that way, I think the chances of Federal flim-flam and hyperinflation go up considerably. Whatever his personal good intentions might be, Obama is heavily tied to interest groups for whom admitting that federal income transfers have to effectively end would be ideological and electoral suicide. Palin isn’t, and thus might — might — be able to administer the harsh medicine required to pull us through with minimum dislocation.
One of my commenters posted, in the thread attached to The Obama campaign smells of defeat, “I think the worst case scenario will be averted when the decision is made to cut benefits. One of the unspoken secrets is that the 30-and-under generation is fairly confident this is going to happen anyhow, which will help it happen.”
His second sentence is quite true. Unfortunately it has been true for at least fifteen years; that is, sensible 30-and-unders had as I recall already written off their old-age entitlements by the early 1990s (when I was in my mid-30s), but this produced no slowdown in the growth of those entitlements at all.
In any case, the crisis could be averted only if the sum of entitlement payouts and debt service were to be cut to a level the tax base could sustain indefinitely. But the government has been buying debt to fund entitlements rather than covering them with year-over-year revenues since the 1960s, which suggests that entitlements would have to be cut to pre-Great-Society levels before they would be sustainable again. No Medicare. No Medicaid. No AFDC. Social Security might survive, but only as the income-banking program it was originally intended to be.
In other words, the political and economic pain from a managed reduction to sustainability would be as broad and nearly as severe as voluntarily crashing the programs entirely. Therefore, it won’t happen until the economy-killer hits, for the same reasons abolition is politically impossible today.
Ken Burnside also writes: “If you want to know what the sound of a bullet whipping by your ear is for an economy, the recent broaching of the subject of certain [U.S. Treasury] bond issues being dropped from AAA to AA was one. To paraphrase Alec Guinness, ‘I sensed the clenching of a hundred thousand sphincters on K-street, all in unison.’”
He’s right. The day U.S. sovereign debt doesn’t have a platinum-plated rating, world investors will bail out of U.S. bonds and related dollar assets so fast your head will spin. Since their purchases are, in effect, financing our entitlements system (and the rest of Federal deficit spending), the entitlements crash would follow shortly thereafter.
The general point is that the entitlements system is so heavily dependent on debt finance that it is already vulnerable to external shocks, even before 2013. The next bullet might not miss. Sooner or later, one is certain to hit.