Download The Developed World`s Demographic Demise

chapter 13
The Developed World’s
Demographic Demise
Laurence Kotlikoff
he greatest demographic change in human history
will occur within the next century as the United States
and the rest of the industrialized world move from being “forever young” to being “forever old.” In the United States, the
largest part of the change will happen in the next 25 years as
77 million baby boomers age and retire, nearly doubling the
percentage of the population over age 65 from 12 percent in
2000 to 21 percent in 2030. The economic and social effects
of an aging society are placing the federal support systems of
Social Security, Medicare, and Medicaid under extreme financial pressure as a result of both fewer working-age citizens paying taxes and rising health care costs for a long-lived population. More accurate and transparent accounting of the federal
debt is critical, as are massive reforms so that the debt is
shared across generations rather than handed down to our
children.
T
Material in this paper is excerpted from Ferguson, Niall, and Laurence J. Kotlikoff, “Benefits Without Bankruptcy—The New New Deal,” The New Republic
(August 15, 2005).
13.1
laurence kotlikoff
The Scope of the Problem
Two powerful forces, rising life expectancy and declining
birthrates, drive the aging of the planet. This aging is not a
temporary event. We won’t be getting older this year or this
decade, and then turn back and get younger. Indeed, we are
well into a demographic change that is inherently very longterm and nearly irreversible. In the United States, the dependency ratio—the ratio of those 65 and older to those 20 to
64—will rise between 2000 and 2030 from .21 to .35, a massive increase. Worldwide, children (those under 15) outnumber older people (65 and older) by three to one today; that ratio
will be one to one by 2050. Soon thereafter, after centuries
during which few people were old and nurturing children was
the primary social concern, children will become a minority
around the globe. The primary social concern will be caring for
the elderly.
Traditionally, the primary noninstitutional source of help
and support—physical and financial—for the elderly has been
their children. Yet as marriages shorten, birth rates decline,
and families’ geographical dispersion expands, the care and
support the elderly can expect from their children is shrinking.
Many are old and alone today, and more are likely to be so in
the future. In the United States, nonfamily supports for the elderly—Social Security, Medicare, and Medicaid—will become
more important to the quality of individuals’ lives at the same
time that these programs become crushingly expensive to the
younger generations.
13.2
the developed world’s demographic demise
Generational Accounting
The federal budget deficit as calculated today is economically
meaningless, nonsensical, and irresponsibly misleading. Indeed,
it represents a small fraction of the nation’s fiscal gap—simply
the difference between our government’s projected expenditures
and receipts in present value. Calculation of the fiscal gap is
based on generational accounting, a form of dynamic accounting
that shows the total magnitude of the federal government’s bills
(based on current policy) over time and the total of all taxes to be
collected over time, and compares the two streams. Generational
accounting clearly shows how much will be left for future generations to pay to close the fiscal gap. The United States’ fiscal gap
in 2005 was $65.9 trillion. This calculation by two economists—
Jagadeesh Gokhale and Kent Smetters—is an update of a fiscal
gap analysis they did while serving at the U.S. Treasury in 2002.
In contrast to this gigantic figure, the official federal debt in the
hands of the public—the figure that gets all the attention—is
closer to $5 trillion. The primary difference is that the government’s commitments to Social Security, Medicare, and Medicaid
are simply not on the books. With generational accounting,
everything is on the books and so the cost of any proposal,
whether a massive transportation bill or a small program, is clear
and the burden to either ourselves or our children is known.
A Grim Scenario
The U.S. government has never formally defaulted on its debt.
13.3
laurence kotlikoff
But it has implicitly done so many times by simply printing
more money to repay what it owes. The resulting inflation waters down the real value of the repayment and leaves creditors
with watered-down dollars. History is replete with examples of
what happens when countries can’t pay their bills. They raise
taxes to exorbitant levels, begin printing money, and either implicitly or explicitly default on their obligations. This triggers
inflation, high interest rates, low exchange rates, and, finally,
bankruptcies. The end result is complete financial meltdown.
Argentina is the latest country to suffer an economic collapse.
The United States could be next on the list.
Some financial gurus in New York, London, Zurich, Tokyo,
and elsewhere are beginning to realize that the United States
is not immune from going broke. Bond traders in particular
seem to be taking notice as long-term interest rates continue
to nudge up and the dollar heads down. The day of reckoning
will come when bond traders, individual investors, and foreign
central banks being to appreciate the true state of our country’s finances and start to dump their Treasury issues. This will
send interest rates and, most likely, inflation rates through the
roof. Prices will rise in reflection of the Federal Reserve’s attempt to lower rates by—guess what—printing money.
The real danger in this scenario is that our country will get
stuck in what economists call a bad steady state—one featuring
ongoing and economically suffocating liabilities, sky-high tax
rates, recurrent bouts of inflation, widespread tax avoidance,
capital flight, and a brain drain as the nation’s most talented
workers seek their fortunes on distant shores.
13.4
the developed world’s demographic demise
The implications of this scenario for higher education are
significant. As the government searches for additional sources
of revenue, the tax-exempt status of colleges and universities
and their many related enterprises could be lost. To help cut
costs, government-sponsored research, an important revenue
stream for higher education, could decline. Further, in a bad
economy families are less able to afford tuition, increasing
pressure on already-stretched financial aid budgets and decreasing enrollment. A bad economy also weakens giving to
colleges and universities, and endowment returns suffer. Finally, as opportunity in the United States declines, foreign students are less likely to be attracted to study here.
At Boston University, we’re working on an idea called Education for Life, which represents one small but concrete way in
which an institution can work to make a difference. Five years
ago we started a series called Conversations with Economists—early evening talks by faculty and distinguished guests
for students and members of the university community about
economics. One evening, 500 students showed up voluntarily
to hear Paul Samuelson. Our proposal is to expand this effort
across all our departments, every night of the week, and to
open the talks to the public. We plan to collaborate with our
local public radio station to publicize the conversations and to
make them available to anyone in the world on the Web. The
returns on building awareness and knowledge among the
broader population (we plan to target younger students as well
as working adults) on a topic such as the financial consequences of the massive demographic shift happening now on
13.5
laurence kotlikoff
our planet are well worth the effort and clearly help our university fulfill its mission.
Solutions
Niall Ferguson, professor of history at Harvard University, and
I propose a new New Deal—a combination of fundamental reforms to the federal fiscal system. We take a holistic approach,
embracing taxes, social security, and health care, and aim to be
both efficient and fair. The program, described in detail in an
article co-authored by Ferguson and myself in The New Republic (August 15, 2005), is based on fundamental principles we
think most Americans would subscribe to:
1. The federal fiscal system should be moderately
progressive. In other words, the net effect of all federal
programs taken together should be to reduce somewhat
the inequalities of income that are inherent in any
market-based economy, but not in such a way that
economic efficiency is compromised and growth lowered.
2. There should be a system of universal health care—
so that no American is denied necessary medical
treatment—but the system should also be affordable.
3. When they stop working, all Americans should be
guaranteed a basic income of at least 40 percent of their
pre-retirement earnings (the original goal of the Social
Security system).
13.6
the developed world’s demographic demise
4. The federal fiscal system should be based on the
principle of intergenerational equity; that is to say, net
lifetime taxes should take out of our children’s income
roughly the same proportion they take out of our
income.
These principles are important because our new New Deal
has several components—a federal sales tax, individual retirement accounts, and health care vouchers. The plan we envision is not only market-based and economically efficient, but it
is also moderately progressive and generationally equitable. It’s
simple and transparent, too—the very opposite of the status
quo. Taken together, our proposals would not only modernize
Social Security, provide universal health care coverage, and
overhaul the tax system. They would also eliminate most of the
fiscal gap described above, improve the well-being of the poor,
enhance incentives to work and to save, raise the nation’s rate
of saving and domestic investment, and stimulate economic
growth.
The three proposals covering taxes, Social Security, and
health care are interconnected and interdependent. In particular, tax reform provides the funding needed to finance Social
Security and health care reform. It also ensures that the rich
and middle class elderly pay their fair share in resolving our
fiscal gap. Finally, all Americans would receive health care coverage, and the government could limit its total voucher expenditure to what the nation can afford.
13.7
laurence kotlikoff
Tax Reform
Our plan is to replace the personal income tax, the corporate
income tax, the payroll (FICA) tax, and the estate and gift taxes
with a federal retail sales tax and a rebate. The tax would work
just like the sales taxes currently levied in many states, though
at a higher rate. The rebate would be paid monthly to households based on their demographic composition, and would be
equal to the sales taxes paid, on average, by households at the
federal poverty line with the same demographics.
Many may assume that a sales tax would be regressive. But
our version has three clearly progressive elements. First,
thanks to the rebate, poor households would pay no sales taxes
in net terms. Second, our reform would eliminate the highly
regressive FICA tax, which is levied on only the first $90,000
of earnings. Third, a federal retail sales tax would effectively
tax wealth as well as wages, because when the rich spend their
wealth and when workers spend their wages, both would pay
sales taxes.
The tax would be highly transparent and efficient, and
would save hundreds of billions of dollars in tax compliance
costs. And it would reduce the effective marginal taxes facing
most Americans when they work and save.
A federal retail sales tax would enhance generational equity
by asking rich and middle-class older Americans to pay taxes
when they spend their wealth. The poor elderly, living on Social Security, would end up better off. They would receive the
13.8
the developed world’s demographic demise
sales tax rebate even though the purchasing power of their Social Security benefits would remain unchanged (due to an automatic adjustment that would raise their Social Security benefits to account for the increase in the retail price level).
The sales tax would be levied on all final-consumption goods
and services. Its tax rate would be set at 33 percent—high
enough to cover the costs of the Social Security and health
care reforms proposed below, as well as meet the government’s
other spending needs. This rate sounds high compared with an
income tax, but a 33 percent sales tax is actually equivalent to
a 25 percent income tax: if you spend 75 cents on an item and
pay an additional 25 cents (33 percent of 75 cents) in taxes,
then that item cost you $1.00—the same net effect as if you
earned a dollar, paid 25 cents (25 percent of $1.00) in taxes,
and then had 75 cents left to spend.
Indeed, adding up the personal income, corporate income,
and FICA taxes that households pay, either directly or indirectly, shows that the vast majority of taxpayers today face
combined average and marginal direct tax rates above 25 percent. Will taxing consumption rather than income reduce
spending and put the economy in recession? No, it will shift
spending away from consumption goods and services to investment goods, which will help the economy grow through time.
As today’s China and yesterday’s Japan show, economies that
shift from consuming to saving and investment can experience
tremendous performance.
13.9
laurence kotlikoff
Social Security Reform
Our second proposed reform deals with Social Security. We
would shut down the retirement portion of the current Social
Security system at the margin by paying in the future only
those retirement benefits that were accrued by the time of the
reform. This means that current retirees would receive their
full benefits, but workers would receive benefits based only on
their covered wages prior to the date of reform. The retail sales
tax would pay off all accrued retirement benefits, which eventually would equal zero. The current Social Security survivor
and disability programs would remain unchanged, except that
their benefits would be paid by the sales tax.
We propose the establishment of a Personal Security System
(PSS)—a system of individual accounts, but with very different
properties than the scheme proposed by President Bush. All
workers would be required to pay 7.15 percent of their wages,
up to what is now the Social Security earnings ceiling (i.e.,
they would contribute what is now the employee FICA payment), into an individual PSS account. Married or legally partnered couples would share contributions so that each spouse
or partner would have the same size account. The government
would contribute to the accounts of the unemployed and disabled. In addition, the government would make matching contributions on a progressive basis to workers’ accounts, thereby
helping the poor to save.
All PSS accounts would be private property. But they would
be administered and invested by the Social Security Adminis13.10
the developed world’s demographic demise
tration in a market-weighted global index fund of stocks,
bonds, and real-estate securities. Consequently, everyone
would have the same portfolio and receive the same rate of return. The government would guarantee that at the time of the
worker’s retirement, the account balance would equal at least
what he or she had contributed, adjusted for inflation—that is,
the government would guarantee that workers could not lose
what they contributed. This would protect workers from the
inevitable downside risks of investing in capital markets.
For individuals between the ages of 57 and 67, PSS account
balances would be gradually sold off each day by the Social Security Administration and exchanged for inflation-protected
annuities that would begin paying out at age 62. By the time
workers reached age 67, their account balances would be fully
annuitized. Workers who died before reaching age 67 would
bequeath their account balances to their spouses, partners, or
children. The goal of the PSS plan is the same as Social Security’s original goal, that is, to guarantee all Americans a basic
and secure living standard in retirement.
Under our plan, unlike President Bush’s, neither Wall Street
nor the insurance industry would get its hands on workers’
money. There would be no loads, no commissions, no fees. Nor
would there be all the risks associated with individual investing. This is because PSS would continue to take advantage of
the overwhelming advantages enjoyed by all state systems of
social insurance: economies of scale and reduction of risk
through government guarantee.
13.11
laurence kotlikoff
Health Care Reform
Our third and final reform deals not just with our public
health care programs, Medicare and Medicaid, but with the
private insurance system as well. That system notoriously
leaves some 45 million Americans uninsured. We propose
abolishing the existing fee-for-service Medicare and Medicaid
programs and instead enrolling all Americans in a universal
health insurance system called the Medical Security System
(MSS). Every October, the MSS would provide each American
with an individualized voucher to be used to purchase health
insurance for the following calendar year. The size of the
voucher would depend on the recipient’s expected health expenditures over the calendar year. Thus, a 75-year-old with
colon cancer would receive a very large voucher worth, for example, $150,000, while a healthy 30-year-old might receive a
$3,500 voucher. Similar to the current Medicare and Medicaid
systems, the MSS would have access to participants’ medical
records and set the voucher level each year based on that information.
Some are sure to feel uneasy about this proposal, since it
seems to imply an invasion of privacy. Yet the government already knows about millions of Medicare and Medicaid participants’ health conditions, because it is paying their medical
bills. This information has never, to our knowledge, been inappropriately disclosed.
The vouchers would pay for basic inpatient and outpatient
medical care, prescription medications, and long-term care
13.12
the developed world’s demographic demise
over the course of each year. If a person cost the insurance
company more than the amount of his or her voucher, the insurance company would make up the difference. If a person
cost the insurance company less than the voucher, the company would pocket the difference. Insurers would be free to
market additional services at additional costs. MSS would, at
long last, promote healthy competition in the insurance market, which would go a long way toward restraining health care
costs.
The beauty of the plan is that all Americans would receive
health care coverage and that the government could limit its
total voucher expenditure to what the nation could afford. Unlike the current fee-for-service system, under which the government has no control over the bills it receives, MSS would
explicitly limit its liability.
Cost controls are crucial because current promised but underfunded Medicare and Medicaid benefits are approximately
six times larger than the unfunded liabilities of Social Security,
and rising life expectancies will only exacerbate the situation.
Data show that the United States has less control over its
health care costs than other countries, such as Japan and Germany. If the current rate of growth of Medicare and Medicaid
costs continues, by 2050 the United States will spend about
26 cents out of every dollar we produce on these two programs
(corresponding figures for Japan and Germany are 15 and 17
cents, respectively).
The MSS plan is also progressive. The poor, who are more
prone to illness than the rich, would receive higher vouchers,
13.13
laurence kotlikoff
on average, than the rich. And, because we would be eliminating the current income tax system, all the tax breaks going to
the rich in the form of nontaxed health insurance premium
payments would vanish. Added together, the elimination of this
roughly $150 billion tax break, the reduction in the costs of
hospital emergency rooms (where the poor too often go first
for care, and which are currently subsidized out of the federal
budget), and the abolition of the huge subsidies to insurers in
the recent Medicare drug bill would provide a large part of the
additional funding needed for MSS to cover the entire population.
Eliminating the Fiscal Gap
A 33 percent federal retail sales tax rate would generate federal
revenue equal to 21 percent of GDP—the same proportion the
Treasury collected in 2000. Currently, federal revenues equal
16 percent of GDP. So we are suggesting a tax hike equivalent
to 5 percent of GDP. But we believe such a hike is necessary
both for the country’s long-term fiscal stability and, in the form
outlined above, neutral—if not positive—in its macroeconomic
impact. The new New Deal also implies some major long-run
spending cuts. First, Social Security would be paying only its
accrued benefits over time, which is trillions of dollars less
than its projected benefits, when measured in present value.
Second, we would be putting a lid on the growth of health care
expenditures. Limiting excessive growth in these expenditures
13.14
the developed world’s demographic demise
will, over time, make up for the initial increase in federal
health care spending arising from MSS’s move to universal
coverage. Third, we would reduce federal discretionary spending by one-fifth, reversing the current administration’s spending splurge. Taken together, these very significant tax hikes and
spending cuts would, we believe, eliminate most if not all of
our nation’s fiscal gap.
Conclusion
The old New Deal is all but dead. It and the Great Society programs of the 1960s are being inexorably killed by demographic
changes that their architects could not have foreseen. Keeping
the old programs on life support is not an option; it merely prolongs their death. The new New Deal offers a viable way to
achieve social and generational equity through affordable programs of public pensions and health care that yoke dynamism
of the free market to the great cause of social justice.
For the sake of our children and the future of our country,
we must act now to institute dramatic changes in our fiscal
system before we exact a terrible toll on the next generation. As
an academic, I feel an intellectual obligation to offer public
policy solutions to the serious problems we face. My deepest
motivation, however, flows from the simple fact that I am a father. I love my children and worry about their future and that
of all the rest of America’s children.
13.15
laurence kotlikoff
Laurence Kotlikoff is a professor of economics at Boston University
and chair of the economics department there. His most recent book
is The Coming Generational Storm (2005), co-authored with Scott
Burns. Kotlikoff can be reached at [email protected].
13.16