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FRBSF ECONOMIC LETTER
Number 2003-27, September 19, 2003
The Fiscal Problem of the 21st Century
Last year, the Congressional Budget Office (CBO)
released a remarkable report entitled A 125-Year
Picture of the Federal Government’s Share of the Economy,
1950 to 2075. This report projects the future of
government spending as a share of GDP assuming
current policies remain in place, and the projections
put forward are stunning: while the share has averaged about 19% since 1950, it is projected to rise
drastically in coming decades, more than doubling
to 39.7% by 2075.With no change in tax policies,
this rise in spending implies exploding budget deficits, reaching 20% of GDP by 2075.
The inescapable implication of this report is that
our current policies are unsustainable, and something will have to change.This Economic Letter explains the nature of this fiscal problem and provides
some perspective on how it might be resolved.
The fiscal problem
Figures 1 and 2 summarize the forecasts in the
CBO’s report. For the period 1950 to 2000, the
figures plot actual numbers for the U.S. economy.
For the period 2010 to 2075, the figures plot CBO
projections under the assumption that current policies continue. In general, the projections are based
on reasonable assumptions for the future path of
wages, the number of recipients of various entitlement programs, and spending per recipient.
Figure 1 graphs several statistics related to this fiscal
problem.The first is total federal spending, excluding interest on the debt, as a fraction of GDP.The
CBO projection quoted at the start of this Letter
referred to a spending share that rose to nearly 40%.
What Figure 1 implies is that about 10 percentage
points of this total consists of interest on the debt,
under the assumption that tax revenues as a share
of GDP do not rise with spending.The rise in noninterest spending is more modest, but still quite
significant: by 2075, revenues would need to rise
by about 9 percentage points of GDP to cover noninterest spending.
Figure 1 also shows the main change accounting
for the rise in government spending: federal spending on three entitlement programs—Social Security,
Figure 1
Total spending, entitlement spending, and revenues,
1950 to 2075
% of GDP
30
Federal spending
(excluding interest)
25
Federal revenues
20
15
10
Social Security,
Medicare, and
Medicaid
combined
5
0
1950 1970 1990 2010 2030 2050 2070 2090
Source: CBO (2002a) Tables 2 and 3.
Note: Actual data until 2000, CBO forecasts afterward.
Medicare, and Medicaid.This entitlement spending has risen from 0.3% of GDP in 1950 to 7.6%
in 2000.Total federal spending has averaged about
19% of GDP over this period, so spending on health
and retirement has gone from a negligible fraction
to more than a third of the total.
What are the reasons for this increase? One is the
increased generosity of these entitlement programs,
and another is the larger fraction of the U.S. population that will be eligible for these benefits because of the general aging of the U.S. population.
For example, in 1940 there were 8.6 people of
working age for every person aged 65 and above;
by 2000, this number had fallen by nearly half to
4.7 (CBO 2002b).
What is even more remarkable about federal spending on health and retirement, however, is the continuation of the trend in the CBO’s projections.
As shown in Figure 1, under the assumption that
current policies continue, the fraction of GDP devoted to entitlement spending on these programs
will rise from 7.6% in 2000 to 13.9% in 2030 and
FRBSF Economic Letter
to 21.1% by 2075. This increase is driven by the
continued aging of the U.S. population: the ratio
of working-age population to the population aged
65 and over is expected to fall from 4.7 in 2000
to 2.8 in 2030 and to 2.4 in 2075.
To put the rise of this entitlement spending in perspective, Figure 1 also plots federal revenues as a
percentage of GDP. Like total federal spending, federal revenues have averaged about 18% or 19% of
GDP since 1950. Assuming current policies continue, the CBO projections assume that revenues
stabilize at 19% of GDP in the future.When entitlement spending was low, this left ample room for
additional spending on defense, unemployment
insurance, environmental protection, and federally
funded research, among other things. However,
according to the CBO projection, health and retirement spending by itself will exceed 19% of GDP
by 2070 if current policies continue.
Figure 2 breaks down the projections for the entitlement programs into health care costs and Social
Security.The CBO projects Social Security expenditures to rise from 4.2% of GDP in 2000 to 6.2%
in 2030, and then to level off. In contrast, spending on Medicare and Medicaid rises from 3.4% of
GDP in 2000 to 7.7% of GDP in 2030 and then
to 14.9% of GDP by 2075.A primary cause of this
increase in the projections is an underlying assumption that health care costs per recipient will grow
at a rate that is 1 percentage point faster than the
rate of per capita GDP growth.While this rate may
appear to be high, it is, in fact, slower than the rate
of growth in health costs in recent decades.
An alternative perspective
Another way to look at the problem is presented
in Hall (2003), who analyzes from the standpoint
of the typical household in the United States. He
imagines a statistical household consisting of one
man and one woman, earning the typical amount
of income over a typical lifetime and facing the
typical health, retirement, and education expenses.
Hall then computes the fraction of this household’s
pre-retirement resources that must be devoted to
each of these spending categories. An important
component of Hall’s analysis is that he looks through
the veil of who actually does the spending: all expenditures on behalf of a given household, whether paid
for by the government or by an insurance company or by the household itself, are incorporated
into the calculation.
According to Hall’s analysis, a household that entered
adulthood in 1960—that is, people now in their
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Number 2003-27, September 19, 2003
Figure 2
Components of federal expenditures, 1950 to 2075
% of GDP
15
Medicare and
Medicaid
10
5
All other
spending
(excluding
interest)
Social Security
0
1950 1970 1990 2010 2030 2050 2070 2090
Source: CBO (2002a) Table 2.
Note: Actual data until 2000, CBO forecasts afterward.
mid-60s—will have devoted about 30% of their
pre-retirement resources to health, retirement, and
education, with 16% going to health, 8% to education, and 6% to retirement.The 30% devoted to
health is a substantial fraction, but it pales in comparison to the expenditures that are projected for
future generations.
For example, consider a household entering adulthood in 2001.This household, according to Hall’s
projections, can expect to spend a total of 52%
of its pre-retirement resources—35% on health, 14%
on education, and 3% on retirement. (The reason
the fraction of pre-retirement resources going to
retirement is smaller than for the earlier generation
is that high medical and education expenditures
limit consumption, so that the modest labor income
received by a typical retired couple is enough to
finance most of its consumption.)
The projections for the generation born in 2003
and reaching adulthood in 2025 are even more
dire. This household could expect to spend 56%
of pre-retirement resources on health and 18% on
education, so that nearly 75% of pre-retirement
resources are devoted to these two categories.
Hall interprets these results as suggesting that existing institutions, designed to finance health, education, and retirement expenditures equal to about
30% of a household’s pre-retirement resources, are
likely to come under severe strain when asked to
transfer more than twice this amount for future
generations. One of the key institutions doing these
transfers, of course, is the federal government.
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Implications
The fiscal problem of the 21st century, then, is this:
Under current policies, the fraction of resources
society devotes to health care appears likely to rise
substantially over the next 50 years. Reasonable
projections suggest that spending on Medicare and
Medicaid as a percentage of GDP may well rise
from 3.4% in 2000 to nearly 15% by 2075.
It is far from clear how our existing institutions can
deal with this projected increase.Tax revenue as a
share of GDP has averaged around 18% since 1950,
and a rise to 25% or more by 2050 is one option.
Alternatively, the current policies governing the
Medicare, Medicaid, and, to a lesser extent, Social
Security programs may be forced to change.
At the moment, existing economic research does
not offer clear guidance as to which of these alternatives is more desirable, or whether some other
alternative is better. In recent decades, society has
reaped enormous gains from its health spending.
In the United States in 1950, life expectancy at
birth was 68.2 years, and by 1990 it was up to 75.4
years. Standard economic analysis suggests that the
economic value of these gains in life expectancy
far exceed the cost in terms of health expenditures
(for example, see Jones 2001). If similar returns to
future spending could be expected, perhaps the
projected rise in federal health spending is desirable,
and a substantial change in taxes as a share of GDP
will be needed. Alternatively, of course, perhaps
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Number 2003-27, September 19, 2003
Medicare and Medicaid will need to be reformed
to bring projected spending back in line with a
lower tax share. A goal of future research is to help
clarify the difficult decisions that society will face
in coming decades.
Charles I. Jones
Associate Professor, UC Berkeley,
and Visiting Scholar, FRBSF
References
[URLs accessed September 2003.]
Hall, Robert E. 2003.“The Unbearable Forward Burden:
Health, Education, and Retirement.” Mimeo. Stanford
University (February 18).
Jones, Charles I. 2001.“The Economic Return to Health
Expenditures.” FRBSF Economic Letter 2001-36
(December 14). http://www.frbsf.org/publications/
economics/letter/2001/el2001-36.html
U.S. Congress. Congressional Budget Office. 2002a.
A 125-Year Picture of the Federal Government’s Share
of the Economy, 1950 to 2075. Long-Range Fiscal
Policy Brief No. 1 (June 14, revised July 3). http://
www.cbo.gov/showdoc.cfm?index=3521
U.S. Congress. Congressional Budget Office. 2002b. The
Looming Budgetary Impact of Society’s Aging. Long-Range
Fiscal Policy Brief No. 2 (July 3). http://www.cbo.gov/
showdoc.cfm?index=3581
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03-19
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03-22
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03-24
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TITLE
Economic Prospects for the U.S. and California: A Monetary...
Technological Change
Shifting Household Assets in a Bear Market
Time-Inconsistent Monetary Policies: Recent Research
Foreign Exchange Reserves in East Asia:Why the High Demand?
Finance and Macroeconomics
What Monetary Regime for Post-War Iraq?
Minding the Speed Limit
What Makes the Yield Curve Move?
Underfunding of Private Pension Plans
Growth in the Post-Bubble Economy
Financial Development, Productivity, and Economic Growth
Pension Accounting and Reported Earnings
Is Official Foreign Exchange Intervention Effective?
Bank Lending to Businesses in a Jobless Recovery
Disclosure as a Supervisory Tool: Pillar 3 of Basel II
Understanding State Budget Troubles
Improving the Way We Measure Consumer Prices
The Present and Future of Pension Insurance
Are We Running out of New Ideas? A Look at Patents and R&D
AUTHOR
Parry
Trehan
Marquis
Dennis
Aizenman/Marion
Dennis/Rudebusch
Spiegel
Walsh
Wu
Kwan
Lansing
Valderrama
Kwan
Hutchison
Marquis
Lopez
Daly
Wu
Kwan
Wilson
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