Choosing the Nation’s Fiscal Future

Committee on the Fiscal Future of the United States

Division of Behavioral and Social Sciences and Education

NATIONAL RESEARCH COUNCIL and NATIONAL ACADEMY OF PUBLIC ADMINISTRATION

THE NATIONAL ACADEMIES PRESS

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Choosing the Nation’s Fiscal Future Committee on the Fiscal Future of the United States Division of Behavioral and Social Sciences and Education NATIONAL RESEARCH COUNCIL and NATIONAL ACADEMY OF PUBLIC ADMINISTRATION

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THE NATIONAL ACADEMIES PRESS 500 Fifth Street, N.W. Washington, DC 20001 NOTICE: The project that is the subject of this report was approved by the Govern- ing Board of the National Research Council, whose members are drawn from the councils of the National Academy of Sciences, the National Academy of Engineer- ing, and the Institute of Medicine. The members of the committee responsible for the report were chosen for their special competences and with regard for appropri- ate balance. This study was supported by Grant No. 07-90771-000-HCD to the National Acad- emy of Sciences and Grant No. 07-90771-001-HCD to the National Academy of Public Administration from the John D. and Catherine T. MacArthur Foundation. Any opinions, findings, conclusions, or recommendations expressed in this pub- lication are those of the author(s) and do not necessarily reflect the views of the organizations or agencies that provided support for the project. International Standard Book Number-13: 978-0-309-14723-1 International Standard Book Number-10: 0-309-14723-9 Library of Congress Control Number: 2009943505 Additional copies of this report are available from the National Academies Press, 500 Fifth Street, N.W., Lockbox 285, Washington, DC 20055; (800) 624-6242 or (202) 334-3313 (in the Washington metropolitan area); Internet, http://www.nap. edu. Copyright 2010 by the National Academy of Sciences and the National Academy of Public Administration. All rights reserved. Printed in the United States of America Suggested citation: National Research Council and National Academy of Public Ad- ministration. (2010). Choosing the Nation’s Fiscal Future. Committee on the Fiscal Future of the United States. Washington, DC: The National Academies Press.

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The National Academy of Sciences is a private, nonprofit, self-perpetuating society of distinguished scholars engaged in scientific and engineering research, dedicated to the furtherance of science and technology and to their use for the general welfare. Upon the authority of the charter granted to it by the Congress in 1863, the Acad- emy has a mandate that requires it to advise the federal government on scientific and technical matters. Dr. Ralph J. Cicerone is president of the National Academy of Sciences. The National Academy of Engineering was established in 1964, under the charter of the National Academy of Sciences, as a parallel organization of outstanding en- gineers. It is autonomous in its administration and in the selection of its members, sharing with the National Academy of Sciences the responsibility for advising the federal government. The National Academy of Engineering also sponsors engineer- ing programs aimed at meeting national needs, encourages education and research, and recognizes the superior achievements of engineers. Dr. Charles M. Vest is presi- dent of the National Academy of Engineering. The Institute of Medicine was established in 1970 by the National Academy of Sciences to secure the services of eminent members of appropriate professions in the examination of policy matters pertaining to the health of the public. The Insti- tute acts under the responsibility given to the National Academy of Sciences by its congressional charter to be an adviser to the federal government and, upon its own initiative, to identify issues of medical care, research, and education. Dr. Harvey V. Fineberg is president of the Institute of Medicine. The National Research Council was organized by the National Academy of Sci- ences in 1916 to associate the broad community of science and technology with the Academy’s purposes of furthering knowledge and advising the federal government. Functioning in accordance with general policies determined by the Academy, the Council has become the principal operating agency of both the National Academy of Sciences and the National Academy of Engineering in providing services to the government, the public, and the scientific and engineering communities. The Coun- cil is administered jointly by both Academies and the Institute of Medicine. Dr. Ralph J. Cicerone and Dr. Charles M. Vest are chair and vice chair, respectively, of the National Research Council. www.national-academies.org

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THE NATIONAL ACADEMY OF PUBLIC ADMINISTRATION The National Academy of Public Administration (National Academy) is a non-profit, independent organization of top policy and management lead- ers who tackle the most critical, timely, and challenging problems facing American government. With a network of more than 650 distinguished Fel- lows who lead the institution and guide its work, the National Academy is trusted across government to provide objective analysis and find practical, innovative solutions to management problems by bringing the best think- ing and experience to bear on government problems. National Academy Fellows are elected by peers based on their impressive contributions to and experience in the field of public leadership and management. The Fel- lowship includes former cabinet officers, members of Congress, governors, mayors, and state legislators, as well as distinguished scholars, business executives, and public administrators. Individually, they are experts and trusted thought leaders; collectively, they are a national treasure. Established over 40 years ago and chartered by Congress, the National Academy continues today to make a positive impact in America by helping federal state and local governments respond effectively to current circum- stances and changing conditions. The National Academy is led by Kenneth S. Apfel and Timothy B. Clark, who serve as chair and vice chair, and Jennifer L. Dorn, who is president and chief executive officer. www.napawash.org

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COMMITTEE ON THE FISCAL FUTURE OF THE UNITED STATES John L. Palmer, Cochair, Maxwell School, Syracuse University Rudolph G. Penner, Cochair, Executive Office Research, Urban Institute, Washington, DC Joseph Antos, Healthcare and Retirement Policy, American Enterprise Institute, Washington, DC Kenneth S. Apfel, School of Public Policy, University of Maryland Richard C. Atkinson, President Emeritus, University of California, San Diego Alan J. Auerbach, Department of Economics, University of California, Berkeley Rebecca M. Blank,* Economic Studies, Brookings Institution, Washington, DC Andrea L. Campbell, Department of Economics, Massachusetts Institute of Technology Chris Edwards, Tax Policy Studies, Cato Institute, Washington, DC Dana P. Goldman, Leonard D. Schaeffer Center for Health Policy and Economics, University of Southern California Robert F. Hale,* American Society of Military Comptrollers, Alexandria, VA Ellen Hughes-Cromwick, World Headquarters, Ford Motor Company, Dearborn, MI Joseph J. Minarik, Committee for Economic Development, Washington, DC Olivia S. Mitchell, Wharton School, University of Pennsylvania Sean O’Keefe, Chief Executive Officer, EADS North America, Arlington, VA Gilbert S. Omenn, University of Michigan Medical School, University of Michigan June E. O’Neill, Zicklin School of Business, Baruch College, City University of New York Paul L. Posner, Department of Public and International Affairs, George Mason University Robert D. Reischauer, President, Urban Institute, Washington, DC Margaret C. Simms, Low Income Working Families, Urban Institute, Washington, DC William E. Spriggs,* Department of Economics, Howard University Thomas C. Sutton, Pacific Life Insurance Company (Retired), Newport Beach, CA Susan Tanaka, Citizen Education and Engagement, Peter G. Peterson Foundation, New York, New York Ruth A. Wooden, President, Public Agenda, New York, New York * Resigned in early 2009 to accept an appointment in the Obama Administration. 

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F. Stevens Redburn, Study Director Jane L. Ross, Senior Staff Officer Mark David Menchik, Senior Program Officer Kathy A. Ruffing, Senior Program Officer (March-November 2008) Malay Majmundar, Senior Program Associate Danielle Johnson Bland, Senior Program Assistant i

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Foreword This report represents the outcome of a joint and shared effort between our two organizations: the National Academy of Public Administration (NAPA) and the National Academy of Sciences (NAS). In their respective spheres, these two institutions play important roles by bringing to bear ex- pert advice on some of the most significant challenges facing our nation. At the request of and with the support of the John D. and Catherine T. MacArthur Foundation and using procedures of the National Research Council, NAS and NAPA jointly undertook a 2-year study of the long- term fiscal challenge facing the United States. The work was performed by a stellar committee representing a diversity of disciplines and practices, a wealth of experience with the federal budget and various public policies, and a wide range of political and policy views. The committee has worked in harmony and forged a strong consensus under the leadership of its co- chairs, John Palmer and Rudy Penner. We thank them for their leadership and the entire committee for their extraordinary efforts. No one reading this report can avoid being struck by the magnitude of the long-term budget challenge facing the federal government. Other studies have called attention to this challenge in similar terms. Uniquely, however, this study provides a framework that leaders and others can use to systematically consider a range of choices to put the federal budget on a sustainable course. This report neither presumes nor recommends a particular path to a stable fiscal future. In a democracy, it is not the role of experts from outside the government to decide important policy questions, especially questions of this magnitude. That is the task of political leaders. And voters have the ii

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iii FOREWORD responsibility to engage in the issues, elect officials who understand the challenges, and then hold them accountable for acting responsibly. As a group of experts, the committee is providing the basis for making policy decisions and their professional judgment about the key issues for our fiscal future. It acknowledges the differences in values and perspec- tives that must be reconciled in order to reach agreement. It illustrates the range, as well as the difficulty, of the policy choices that have to be faced. It also offers a set of analytical tools for weighing those choices, including practical tests that can be applied to budget proposals to determine their fiscal prudence. Much is at stake. If we as a nation do not grapple promptly and wisely with the changes needed to put the federal budget on a sustainable course, all of us will find that the public goals we most value are at risk. This re- port will have served its purpose if its insights and analytical framework are widely used to support serious discussion of this most urgent question. We hope that it will receive the widest possible attention. Ralph J. Cicerone Jennifer L. Dorn President President and Chief Executie Officer National Academy of Sciences National Academy of Public Administration Chair National Research Council

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Acknowledgments This study is the product of the generous support, hard work, and dedication of many organizations and individuals. The officers and staff of the John D. and Catherine T. MacArthur Foundation originated the idea for the study and provided its funding. They maintained strong support and interest throughout the course of the work. Jennifer Dorn, president and chief executive officer of the National Academy of Public Administration; Lois Fu, senior adviser to the president of the National Academy of Public Administration; Michael Feuer, execu- tive director of the Division of Behavioral and Social Sciences and Educa- tion (DBASSE) at the National Research Council (NRC); and Jane Ross, director of DBASSE’s Center for Economic, Governance, and International Studies provided leadership in the development of the study and continued support through the study process. We owe special thanks to our fellow committee members, who gave long hours to this project, providing not only in-depth analyses, but also drafts—and repeated redrafts—of text for the report. The members hold a broad range of views on topics related to this study, and they used those differences to explore a very wide range of policy ideas and to draft a report that would be useful to individuals and groups with diverse beliefs and priorities. A great deal of the success of this project is due to its excellent staff, who performed innumerable analyses and produced many drafts of the report. We are especially indebted to our study director, Steve Redburn, who managed the overall work of the panel, led a complex set of analytic activities, and helped us to meet our deadlines. The fast pace of the work ix

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x ACKNOWLEDGMENTS and the outstanding quality of the final product are due to an important extent also to the work of Mark Menchik, Malay Majmundar, Kathy Ruffing, and Danielle Bland. Eugenia Grohman, associate executive director of DBASSE, shared her extensive experience at critical points in the study process, especially in editing the manuscript. Staff members of the Social Security Administration’s Office of the Chief Actuary provided cost estimates on various proposals contained in the report’s illustrative scenarios and reviewed text for completeness and accuracy. The Urban Institute-Brookings Institution Tax Policy Center con- tributed to the detailed analysis in the report by producing simulations of tax changes that were part of several illustrative scenarios. Barry Anderson and his colleagues in the Budgeting and Public Expenditures Division of the Public Governance and Territorial Development Directorate of the Organi- sation for Economic Co-operation and Development produced a study of the international experience with long-term budgeting. This report has been reviewed in draft form by individuals chosen for their diverse perspectives and technical expertise, in accordance with pro- cedures approved by the Report Review Committee of the NRC. The pur- pose of this independent review is to provide candid and critical comments that will assist the institution in making the published report as sound as possible and to ensure that the report meets institutional standards for objectivity, evidence, and responsiveness to the study charge. The review comments and draft manuscript remain confidential to protect the integrity of the deliberative process. We thank the following individuals for their participation in the review of this report: Henry J. Aaron, Economic Studies Program, Brookings Insti- tution, Washington, DC; Robert Greenstein, Center on Budget and Policy Priorities, Washington, DC; Edwin L. Harper, Public Affairs/Government Relations, Assurant, Inc., Washington, DC; Ron Haskins, Brookings Insti- tution, Washington, DC; Peter S. Heller, Paul H. Nitze School of Advanced International Studies, Johns Hopkins University; James R. Horney, Center on Budget and Policy Priorities, Washington, DC; Philip G. Joyce, George Washington University; Lawrence S. Lewin, Executive Consultant, Chevy Chase, MD; Alicia H. Munnell, Carroll School of Management, Boston College; William Nordhaus, Department of Economics, Yale University; Marilyn Rubin, Department of Public Management, John Jay College of Criminal Justice; John B. Shoven, Department of Economics, Stanford University; and Theda Skocpol, Department of Government, Harvard University. Although the reviewers listed above have provided many constructive comments and suggestions, they were not asked to endorse the conclusions or recommendations nor did they see the final draft of the report before its release. The review of this report was overseen by Charles F. Manski, De-

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xi ACKNOWLEDGMENTS partment of Economics, Northwestern University, and M. Granger Morgan, Department of Engineering and Public Policy, Carnegie Mellon University. Responsibility for the final content of this report, however, rests entirely with the authoring committee and the institutions. John L. Palmer and Rudolph G. Penner, Cochairs Committee on the Fiscal Future of the United States

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Contents Summary 1 1 The Long-Term Challenge 9 The Budget Outlook, 11 The Fiscal Challenge: Historical Perspective, 16 Changing Patterns of Spending and Revenues, 18 How the Nation Got Here, 24 Consequences of Inaction, 27 The Opportunity to Act, 32 Notes, 33 2 Framing the Choices 35 Connecting Budgets and Values, 35 Values and Budget Decisions, 37 Fairness, 37 Economic Growth, 38 Efficiency, 39 Security and Risk, 40 Size of Government, 40 Values and Practical Choices, 45 Notes, 46 3 Fiscal Prudence 49 Limiting the Growth of Federal Debt, 50 Tests for Fiscal Prudence, 58 xiii

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xi CONTENTS Primary Tests for Fiscal Prudence, 58 Secondary Tests for Fiscal Prudence, 60 Applying the Framework, 62 Notes, 63 4 Choices for a Sustainable Budget 65 Spending Options, 66 Options for Medicare and Medicaid, 66 Options for Social Security, 67 Options for Defense and Other Domestic Spending, 67 Revenue Options, 68 Budget Scenarios, 69 Low Path, 70 Intermediate Paths, 71 High Path, 71 Conclusion, 72 Note, 73 5 Options for Medicare and Medicaid 75 The Current Context, 75 Four Trajectories, 78 Health Spending, 80 Reasons for Increasing Spending, 81 Health Spending and the Federal Budget, 82 Reform Issues, 84 Competing Reform Objectives, 84 Uncertainty About What Works, 85 Broad Reform Approaches, 86 A Single-Payer Health Insurance System, 86 A “Robust Public Option,” 87 A “Non-Robust Public Option,” 88 Price Controls, 89 Individual, Cost-Conscious Choice of Insurance Plans, 89 Eliminating Group Health Insurance, 90 Summary of Broad Reform Approaches, 91 Specific Reform Options, 91 Imposing Caps on Federal Health Spending, 92 System Reforms with Direct Implications for Slowing Federal Health Spending Growth, 94 System Reforms with Indirect Implications for Slowing Federal Health Spending Growth, 98 Caveats Regarding Savings from Reform, 101 Conclusion, 101 Notes, 102

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x CONTENTS 6 Options for Social Security 105 Program Overview, 106 Financial Projections, 110 Options to Restore Solvency, 110 Overview, 110 Option 1: Benefit Changes Only, 116 Option 2: Two-Thirds Benefit Growth Reductions, One-Third Payroll Tax Increases, 118 Option 3: One-Third Benefit Growth Reductions, Two-Thirds Payroll Tax Increases, 121 Option 4: Payroll Tax Increases Only, 123 Conclusion, 123 Notes, 125 7 Options for Defense and Other Domestic Spending 129 Spending Categories and Trends, 130 Debates About Spending, 130 Spending Trends, 132 Four Options, 133 Option 1: Cut Spending by 20 Percent, 135 Option 2: Cut Spending by 8 Percent, 137 Option 3: Increase Spending by 5 Percent, 138 Option 4: Increase Spending by 16 Percent, 139 Conclusion, 140 Notes, 141 8 Revenue Options 143 The Current Tax Structure, 144 Revenue Levels and Sources, 144 Complexity of the Tax Code, 145 Issues in Tax Reform, 146 Simplification, 147 Economic Efficiency and Growth, 148 International Context, 150 Fairness, 152 Illustrative Tax Options, 154 Current Tax Structure, 156 Simplified Tax Structure, 158 Effects of the Options on Distribution of the Tax Burden, 162 Conclusions, 167 Notes, 168

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xi CONTENTS 9 Multiple Paths to Sustainability 173 Low Spending and Revenues Path, 174 High Spending and Revenues Path, 176 Two Intermediate Spending and Revenues Paths, 178 Summary of the Paths, 181 Consequences of Delayed Action, 182 The Political Challenge, 185 Notes, 185 10 Fiscal Stewardship: A Budget Process for the Long Term 187 The Political Challenge, 188 Leadership, 189 The Role of Process, 191 Budget Reform for Responsible Stewardship, 191 Information on Long-Term Implications of Current Decisions, 192 Integration of Long-Term Budget Projections, 194 Information on Fiscal Exposures, 194 Accrual Accounting, 196 Fiscal Goals and Targets, 197 Accountability, 199 Presidential Accountability, 200 Reinforcing Accountability for Meeting Goals and Targets, 201 Consideration of the Long-Term Costs of New Policies, 205 Conclusion, 206 Notes, 207 11 What Should Be Done Now? 209 Why Is This So Hard?, 209 Why Is Delay Risky?, 211 How Can This Report Help?, 212 What Can Everyone Do?, 213 What Should Leaders Do?, 214 Notes, 215 References 217

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xii CONTENTS Appendixes Appendixes A through G are not printed in this book; they can be found online at http://www.nap.edu/catalog.php?record_id=12808. A Fiscal Sustainability 233 B Baseline Assumptions and Estimates 237 C Social Security Options 247 D Defense and Domestic Spending: Program Options 261 E Revenue Options and Their Implications 275 F Constructing Multiple Paths to Sustainability 299 G International Experience with Long-Term Budgeting 321 H Biographical Sketches of Committee Members and Staff 329

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Figures, Tables, and Boxes FIGURES S-1 The long-run budget outlook, 2 S-2 Debt savings from stabilizing the debt-to-GDP ratio in 12 years, 3 S-3 Projected federal spending under the committee’s four scenarios, 5 1-1 The long-term budget outlook, 13 1-2 The long-term outlook for the debt, 14 1-3 Factors in projected Social Security, Medicare, and Medicaid spending, 2009-2079, as a percentage of GDP, 18 1-4 Federal outlays in fiscal 2008, 19 1-5 Federal spending as a percentage of GDP, 1962-2008, 21 1-6 Federal revenues and borrowing in fiscal 2008, 22 2-1 Federal government spending by function, 1962-2007, 37 2-2 General government total tax and nontax receipts as a percentage of nominal GDP in 2008, 41 3-1 Debt savings from stabilizing debt-to-GDP ratio in 12 years, 60 5-1 Federal health spending under four sustainable budget trajectories and in the baseline, 78 5-2 Average excess cost growth in Medicare and Medicaid, 80 xix

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xx FIGURES, TABLES, AND BOXES 6-1 Annual Social Security benefits and earnings replacement rates, for workers who retire at age 65, scheduled for 2010, 108 6-2 Social Security benefits as a percentage of total income, for families and individuals aged 65+, by quintile of total income, 2006, 109 6-3 Social Security scheduled spending and tax revenues as a percentage of GDP, 111 6-4 Cumulative Social Security revenue less spending under current- law tax rates and scheduled benefits, 111 6-5 Monthly Social Security benefits for workers who retire at age 65 under current law and under option 1 (in 2009 dollars), 117 6-6 Social Security benefits as a percentage of past earnings for new retirees at age 65 under current law and under Option 1, 117 6-7 Monthly Social Security benefits for workers who retire at age 65 under current law and under Option 2 (in 2009 dollars), 120 6-8 Social Security benefits as a percentage of past earnings for new retirees at age 65 under current law and under Option 2, 120 6-9 Annual Social Security payroll tax projected for 2010 and for 2050 under current law and under Option 2 (in 2009 dollars), 120 6-10 Monthly Social Security benefits for workers who retire at age 65 under current law and under Option 3 (in 2009 dollars), 122 6-11 Social Security benefits as a percentage of past earnings for new retirees at age 65 under current law and under Option 3, 122 6-12 Annual Social Security payroll tax projected for 2010 and for 2050 under current law and under Option 3 (in 2009 dollars), 122 6-13 Annual Social Security payroll tax projected for 2010 and for 2050 under current law and under Option 4 (in 2009 dollars), 124 7-1 Defense and other domestic spending as a percentage of GDP, 1962-2008, 132 7-2 Defense and other domestic spending as a share of GDP in 2019 under four options, 134 8-1 Federal government revenues as a share of GDP, 144 8-2 Tax revenues as a share of GDP, 151 8-3 Top corporate tax rates in the United States and 30 OECD countries, 152 8-4 Current tax structure: top personal income tax rates for the committee’s four scenarios, 157 8-5 Personal income tax rates for the first and second brackets under a simplified tax structure for the committee’s four scenarios, 161 8-6 Distribution of the percentage share of combined federal taxes by relative income in 2050 for the committee’s four scenarios, 163

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xxi FIGURES, TABLES, AND BOXES 9-1 Projected federal spending under the committee’s four scenarios, 174 9-2 Projected federal debt under the committee’s four scenarios, 175 9-3 Projected federal deficits under the committee’s four scenarios, 175 9-4 Federal spending and revenues under the committee’s low scenario, 176 9-5 Deviation from the study baseline for revenues and noninterest outlays under the committee’s low scenario, 176 9-6 Federal spending and revenues under the committee’s high scenario, 177 9-7 Deviation from the study baseline for revenues and noninterest outlays under the committee’s high scenario, 177 9-8 Federal spending and revenues under the committee’s intermediate-1 scenario, 179 9-9 Deviation from the study baseline for revenues and noninterest outlays under the committee’s intermediate-1 scenario, 179 9-10 Federal spending and revenues under the committee’s intermediate-2 scenario, 180 9-11 Deviation from the study baseline for revenues and noninterest outlays under the committee’s intermediate-2 scenario, 180 TABLES 6-1 Four Illustrative Social Security Options: Overview, 114 8-1 Federal Tax Structure and Revenue Levels Under the Committee’s Four Paths, 155 8-2 Percentage Change in After-Tax Income Under the Committee’s Four Scenarios in Comparison with Current Law for Selected Income Groups, in percent, 164 BOXES 1-1 Committee Charge, 11 1-2 The Deficit and the Debt, 12 1-3 Constructing a Budget Baseline, 14 1-4 Uncertainties, 15 1-5 Tax Expenditures, 23 2-1 Health: An Example of Values and Choices, 42 2-2 Government Size and Economic Growth, 44 3-1 The Arithmetic of the Debt, 52

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xxii FIGURES, TABLES, AND BOXES 5-1 2009 Health Care Reform Proposal: Affordable Health Care for America Act, 76 5-2 Medicare and Medicaid, 83 6-1 Sustaining the Social Security Trust Fund, 112 8-1 Distortions in the Current Tax Code, 149 10-1 The 1990 Budget Agreement, 190 10-2 Australia’s Experience with Long-Term Budgeting, 195 10-3 New Zealand’s Budget Principles, 198 10-4 Automatic Balancing Mechanisms in Canada, Germany, and Sweden, 204