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OCR for page 174
9
The Outlook for Fiscal Policy
INTRODUCTION
Population aging will generate significant changes for the macroecon-
omy. As discussed in Chapter 2, barring significant changes in productivity
growth, responding to population aging will require some combination of
slower consumption growth and greater labor force participation, relative
to an economy in which the age structure of the population is unchanged.
Because the public sector finances a large share of the consumption of the
elderly, population aging presents a particularly difficult challenge for gov-
ernment. Increases in life expectancy increase the number of beneficiaries of
government programs, while declines in fertility lower the relative number
of taxpayers upon whom these programs depend for financial support.
Thus, as in the economy in general, population aging requires changes to
government programs that ultimately involve some combination of lower
consumption (which can be achieved through lower benefits or higher
taxes) and higher labor force participation in order to remain financially
viable. Furthermore, as explained in Chapter 3, the aging of the population
is not a temporary phenomenon associated with the retirement of the baby
boom generation. Rather, current projections suggest that the share of the
population that is elderly is likely to remain elevated and even to increase
over the foreseeable future. Thus, population aging is a phenomenon that
needs to be addressed with changes to government programs.
The changing demographics affect both federal and state budgets. At
the federal level, population aging raises expenditures on Social Security,
Medicare, and Medicaid, while the projected slowdown in the growth rate
174
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THE OUTLOOK FOR FISCAL POLICY 175
of the labor force lowers payroll tax revenues and lowers gross domestic
product (GDP) growth, making it more difficult to service existing debt.
States finance part of Medicaid as well, so they, too, face financial pressure
from demographic change. In addition, many states have promised pension
and health benefits to their retirees, and these commitments will also put
pressure on budgets as the population ages.
From an academic perspective, it would be interesting to distinguish
the effects of demographic change from other factors affecting the fiscal
outlook. However, in order to do so, it would be necessary to construct
a counterfactual baseline (alternative scenario) of what the history and
future of spending and tax revenues would have been in a world with no
demographic change. Such a counterfactual is very difficult to create, be-
cause it is difficult to know how policies might have been different under
alternative demographic patterns. To cite just a couple of examples: One
would have to know how Medicare policies concerning payments to hos-
pitals and physicians might have evolved differently in the absence of the
looming fiscal challenges associated with an aging population or whether
Medicaid benefits might have been more limited had states had to finance
the education of the much larger cohort of children who would have been
born had fertility not declined.
To the extent that the policies currently in place already reflect the
actual or anticipated effects of demographic change, an examination of
the current fiscal outlook may understate the impact of such change. For
example, the 1983 Social Security Commission raised payroll taxes and
increased the Social Security full retirement age. These measures reduced
the imbalances in Social Security by, in essence, lowering consumption by
workers through higher payroll taxes and a reduction in expected benefits.
Thus, the current imbalances in the Social Security system provide a mea-
sure of how much further policy needs to adjust, but not of the entire effect
of demographic change on consumption and/or labor force participation.1
On the other hand, for many parts of the budget, the projected imbal-
ances between revenues and expenditures are only partially explained by
demographic change. In particular, excess cost growth in health care and
past tax and spending policies that contributed to today's outsized deficits
1Some observers believe that the buildup of surpluses in the Social Security trust fund was
used to offset deficits in the on-budget accounts--that is, that taxes would have been higher
or spending lower had those surpluses not been amassed. In that case, it is still true that the
combined effects of the earlier tax increases and benefit cuts provide a good metric, when com-
bined with the adjustments that still need to made, of the effects of aging on Social Security.
However, if on-budget deficits are higher than they would have been in the absence of the tax
increase, it means that, as a society, we have yet to make any of the adjustments required in
the face of aging--some of the adjustments need to be made to shore up the Social Security
trust fund, and other adjustments need to be made to pay off the extra debt that was amassed.
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176 AGING AND THE MACROECONOMY
both contribute importantly to the difficult fiscal adjustments that will be
necessary in years ahead.
Accordingly, it is difficult to isolate the effects of ongoing demographic
change on the fiscal outlook. Furthermore, from a practical perspective, the
ease with which our nation can adapt to the challenges of aging is greatly
affected by the other factors shaping fiscal policy choices. For example,
aging becomes a much more difficult problem in the face of rapidly ris-
ing health spending, and raising taxes to finance Social Security benefits
becomes more difficult and has greater efficiency costs if taxes are already
being raised to finance federal government debt or to pay for the pension
and health benefits of state and local workers. Thus, in this chapter, the
committee provides an overview of the financial imbalances projected for
Social Security and Medicare, but it also focuses more broadly on the over-
all fiscal conditions of federal and state and local governments rather than
solely on the challenges presented by aging.
FEDERAL GOVERNMENT
Social Security and Medicare are the two largest federal programs that
support the elderly. In addition, Medicaid, a joint federal-state program that
provides health care to those of modest means, is an important source of
financing for the long-term care needs of the elderly. These three programs
currently account for over 40 percent of all federal spending and almost 10
percent of our nation's gross domestic product. In addition, the federal gov-
ernment's publicly held debt now stands at roughly $10 trillion, or about
62 percent of GDP, and current projections suggest that, under reasonable
(though still quite uncertain) policy assumptions, it will rise to 80 percent
of GDP over the coming decade (Auerbach and Gale, 2012). The projected
slowdown in the rate of labor force growth, by lowering the growth rate of
the tax base, also makes that debt more difficult to service.
Social Security
The Social Security program assesses payroll taxes on workers and uses
those revenues to provide cash benefits to retired workers and their depen-
dents.2 Thus, Social Security revenues depend on the size and productivity
of the labor force, whereas Social Security outlays depend on the size of
the elderly population. Both increases in life expectancy (which increase the
size of the elderly population) and reductions in fertility (which eventually
2While payroll taxes provide most of Social Security's revenues, small amounts are also
collected from the personal income taxes paid on Social Security benefits by upper-income
taxpayers and from interest earned on trust fund reserves.
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THE OUTLOOK FOR FISCAL POLICY 177
reduce the size of the labor force) contribute to imbalances in the Social
Security program.
Figure 9-1 presents 2011 estimates from the Social Security Adminis-
tration on the future of the program. Under the intermediate estimates, the
retirement of the baby boom generation raises costs by about 25 percent,
from almost 5 percent of GDP in 2010 to about 6 percent of GDP by 2030,
while program revenues rise a little, on net, over this period.3
The traditional method used by the Social Security actuaries to por-
tray the uncertainty in their analyses is to provide three alternative sets of
assumptions: (1) the intermediate, baseline assumption; (2) a low-cost as-
sumption, which assumes that life expectancy and unemployment are lower
and fertility and productivity are higher than in the baseline case; and (3) a
high-cost assumption, which makes the opposite assumptions. The actual
outcome for future costs is very unlikely to be as extreme as either of the
last two outcomes. According to the Social Security Trustees, these high-
and low-cost projections correspond very closely to a 95 percent probabil-
ity interval, meaning that there is only a 5 percent chance that the actual
experience will be more extreme than represented by these two projections.
Yet, even under these assumptions, the range of uncertainty is not that large
over the next 20 years. For example, under the low-cost scenario, by 2030,
Social Security expenditures will have increased only a little, to about 5.5
percent of GDP, while under the high-cost scenario, expenditures are closer
to 7 percent of GDP. Revenues are fairly stable over this time period for
both these scenarios.
Medicare
The Medicare program provides health insurance to Americans aged
65 and over, as well as to certain disabled Americans younger than 65. The
Medicare program shares some features with Social Security. In particular,
it finances a large share of elderly consumption, its benefits accrue pre-
dominantly to the elderly, and much of the financing comes from taxes on
current workers.4 However, the effect of aging on Medicare expenditures
and revenues is more complicated than its effect on Social Security. Because
Medicare provides health services rather than cash, the expenditures depend
3This chapter utilizes projections of spending from the Social Security and Medicare Trustees
and from the Congressional Budget Office. These projections are based on different demo-
graphic assumptions than those presented in Chapter 3.
4According to the Congressional Budget Office (2011), in 2010 about 35 percent of Medi-
care spending was financed by the payroll tax, about 12 percent by beneficiaries' premiums,
almost 40 percent through general revenues, and the remainder through various other sources,
including income taxes on high-earning Social Security beneficiaries.
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178 AGING AND THE MACROECONOMY
7.5
7.0
Percent of GDP
6.5
6.0
5.5
5.0
4.5
4.0
2011 2017 2023 2029 2035 2041 2047
Costs-Intermediate Costs-Low Income-High
Costs-High Income-Intermediate Income-Low
FIGURE 9-1 Projected costs and revenues for the Social Security Old-Age, Survi-
9-1.eps
vors, and Disability Insurance (OASDI) program, 2011-2050. SOURCE: Board of
Trustees, Federal Old-Age and Survivors Insurance and Federal Disability Insurance
Trust Funds (2011).
not only on how many people are eligible for the program, but also on their
health needs and the costs of treatments.
One important question is the relationship between increased life ex-
pectancy and Medicare spending. Holding all else constant, an increase
in longevity raises Medicare spending because it increases the size of the
elderly population, and that increase is concentrated among the oldest old
(those aged 85 and over), who generally have the greatest need for health
services.5 However, to the extent increased life expectancy is associated
with better health at a given age, then Medicare expenditures need not rise
as much. Indeed, several researchers have found that time until death is a
better predictor of health expenditures than is age, and that taking this into
account can lead to a substantial reduction in projected health expendi-
tures (Shang and Goldman, 2007; Seshamani and Gray, 2004; Stearns and
Norton, 2004; Lee and Miller, 2002; Cutler and Sheiner, 2001). However,
much of this research uses data from the period when disability levels were
still declining, and it remains an open question how the recent stabiliza-
tion in old-age disability, discussed in Chapter 4, will affect future health
expenditures.
A far more important source of uncertainty concerns the expected rate
5Increased life expectancy raises the share of the population that is 85 years and older, but
the large flow of baby boomers entering into retirement raises the share of the young elderly.
The average age of Medicare beneficiaries is projected to decline into the 2030s; after that,
the average age of the elderly population increases gradually over time with increased life
expectancy.
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THE OUTLOOK FOR FISCAL POLICY 179
of growth of health spending holding health status constant. For more than
four decades, health spending growth has exceeded GDP growth. As shown
in Table 9-1, excess cost growth--defined as the difference between age-
adjusted per capita health spending growth and per capita GDP growth--
averaged 2 percent from 1975 to 2007 and 1.5 percent from 1990 to 2007.
As a result, the share of health spending in GDP increased from 8 percent
in 1975 to 16 percent in 2007.6
Most analysts believe that this rapid rise in spending in large part re-
flects the increasing value that our society has been placing on health care as
we become richer, which has fueled the demand for new medical technolo-
gies and services (Smith, Newhouse, and Freeland, 2009). But health spend-
ing cannot continue to rise in excess of GDP forever, and it is likely that the
growth in demand for health services will slow over time as expenditures
on health increasingly crowd out spending on other goods and services.7
However, there is little basis to predict by what means and at what rate that
slowdown will occur. Many researchers believe that there is a considerable
amount of inefficiency in our health system, and so part of the slowdown
in spending could come from efficiency improvements. In addition, greater
financial pressures on providers will likely lead to a slowdown in the rate of
adoption of new technologies. The Congressional Budget Office (CBO) and
the Centers for Medicare and Medicaid Services (CMS) both assume that
excess cost growth in health spending will decline over time, although their
assumptions about the rate of decline differ, particularly for Medicare.8
In the past, Medicare beneficiaries have received the same type of care
from the same providers as those having other forms of insurance, and
Medicare and other health spending have increased at similar rates (Ta-
ble 9-1). However, the health reform measures enacted in 2010 (the Patient
Protection and Affordable Care Act, as amended by the Health Care and
Education Reconciliation Act of 2010, collectively known as the Afford-
able Care Act, or ACA) included provisions to lower the annual updates to
provider payment rates and to cap annual Medicare growth. According to
the 2011 Trustees' projections, with these payment changes, average excess
cost growth for Medicare spending under the ACA will be close to zero over
6The share increased to 18 percent in 2009, but this sharp increase reflects the effects of
the severe economic downturn, which lowered GDP more than it lowered health spending.
7When health spending is a small share of the budget, it can increase rapidly without hav-
ing a large effect on other spending. As health spending becomes a larger and larger share of
the budget, rapid rates of growth increasingly require large adjustments in the growth rate
of other spending.
8In particular, the CBO assumes that, under a current law framework, the Medicare program
will have less flexibility than states and private insurers to take measures to slow the rate of
health spending, and thus that Medicare excess cost growth will not slow as much as that of
private health spending.
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180 AGING AND THE MACROECONOMY
TABLE 9-1 Excess Cost Growth (%) in Health Spending During Four
Time Periods
National Health
Spending Medicare Medicaid All Other
1975 to 2007 2.0 2.4 2.0 1.9
1980 to 2007 2.0 2.2 1.7 2.0
1985 to 2007 1.7 1.4 1.3 1.9
1990 to 2007 1.5 1.6 1.1 1.5
SOURCE: Congressional Budget Office (2011).
the long-run projection period; that is, most of the increase in Medicare
spending in the Trustees baseline projection is the result of demographic
change rather than health care cost growth.9
There is a great deal of uncertainty about whether these lower payment
updates will allow Medicare beneficiaries to continue to be provided health
care at a level roughly comparable to that received by the nonelderly and,
if not, whether such a system would continue to be viewed as desirable (see
Boards of Trustees, Federal Hospital Insurance and Federal Supplementary
Medical Insurance Trust Funds, 2011, also referred to as the Medicare
Trustees Report). For these reasons, both the CBO and CMS present alter-
native Medicare projections in which Medicare payments to providers are
higher than those allowed under current law. The CBO assumes that the
ACA cuts turn off in either 2020 (CBO baseline) or 2030 (CBO alterna-
tive), whereas the Medicare Trustees projections assume that the ACA cuts
either last indefinitely (Trustees Current Law) or are phased out beginning
in 2020 (Trustees Alternative). In addition, it is widely believed that Medi-
care's payment system for physicians, the Sustainable Growth Rate (SGR)
system, will eventually be amended, as the administration and Congress
have repeatedly stepped in to postpone the cuts to physician payments
required under this system.10 Both the CBO and the Trustees alternatives
assume physician payments will be higher than those allowed by the SGR.
The impact of these varying assumptions, along with an estimate of
how Medicare spending would rise under the assumption of no decline in
excess cost growth, are depicted in Figure 9-2. Under the 2011 Trustees
current-law projection, Medicare expenditure rises from 3.7 percent of
9The Trustees boosted their assumption about excess cost growth in their most recent report
(Board of Trustees, Federal Old-Age and Survivors Insurance and Federal Disability Insurance
Trust Funds, 2012), but aging is still the predominant factor contributing to the rise in the
share of GDP allocated to Medicare over the long run.
10The SGR has annual caps on Medicare spending on physician and other services; when
these caps are exceeded, the prices paid per service are lowered.
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THE OUTLOOK FOR FISCAL POLICY 181
Medicare Spending as a Percent of GDP
11
10
9
8
7
6
5
4
3
2011 2017 2023 2029 2035 2041 2047
CBO Alternative
No slowdown in excess cost growth
2011 Trustees Current Law Projection
2011 Trustees Alternative
CBO Baseline
FIGURE 9-2 Alternative projections of Medicare spending, 2011-2050. SOURCE:
Boards of Trustees, Federal Hospital Insurance and Federal Supplementary Medical
Insurance Trust Funds (2011).
9-2.eps
GDP in 2011 to 6 percent by 2050. Under the CBO alternative (which is
similar to the Trustees alternative), Medicare spending in 2050 reaches 7.5
percent of GDP. The anticipated slowdown in health spending is important
to these projections; under the assumption of no slowdown in excess cost
growth, Medicare spending reaches over 10 percent of GDP by 2050.
Medicaid and Other Health Programs
Medicaid, a program that is financed in part by the federal govern-
ment and in part by the states, is not an old-age program, yet it plays an
important part in financing the long-term care needs of the elderly. In 2004,
for example, Medicaid financed about one-third of long-term care services
for the elderly (O'Brien, 2005), and in 2007 these services represented 14
percent of Medicaid expenditures (Centers for Medicare and Medicaid
Services, 2011a). Table 9-2 shows the distribution of Medicaid spending by
age in 2004. Per capita Medicaid spending is highest for those 75-84 and
over 85, a reflection of the increased utilization and high cost of nursing
home care.
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182 AGING AND THE MACROECONOMY
TABLE 9-2 Medicaid Spending by Age, 2004
Per Capita Medicaid Spending, Share of Medicaid Spending by
Age Group 2004 ($) Age Group (%)
0-18 819 24
19-44 662 27
45-54 737 11
55-64 1,026 11
65-74 1,112 8
75-84 2,058 10
85+ 5,424 10
SOURCE: Centers for Medicare and Medicaid Services (2011b).
As noted in Chapter 3, increases in life expectancy are projected to
significantly increase the share of people aged 85 and older. Thus, popula-
tion aging may increase the demands on Medicaid. For example, assum-
ing that relative Medicaid spending by age remains constant at the 2004
levels, projected changes in the age distribution of the population would
raise Medicaid spending by about 10 percent by 2035 and 15 percent by
2050. Medicaid expenditure growth is also affected by excess cost growth
in health spending (Table 9-1) as well by the recently enacted health re-
form, which expanded eligibility for the program. Taking into account the
expected slowdown in health spending growth, the aging of the population,
and the effects of the recently enacted health reform, the CBO projects
(Figure 9-3) that federal spending for Medicaid and other non-Medicare
health programs (the much smaller Children's Health Insurance program
5.0
4.5
4.0
Percent of GDP
3.5
3.0
2.5
2.0
1.5
1.0
2011 2017 2023 2029 2035 2041 2047
FIGURE 9-3 Projected federal spending on Medicaid and other health programs,
2011-2050. SOURCE: Congressional Budget Office (2011, Underlying Tables, Table
B-1, Extended Baseline). 9-3.eps
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THE OUTLOOK FOR FISCAL POLICY 183
and the future outlays for health insurance subsidies under health reform)
will rise from about 2 percent of GDP in 2011 to 3.7 percent in 2035 and
4.5 percent in 2050.11
STATE AND LOCAL GOVERNMENT
For the state and local sector, there are likely to be two significant
sources of fiscal pressure going forward. First, since states finance roughly
40 percent of Medicaid spending, on average, rapid increases in Medicaid
expenditures are also likely to put pressure on state budgets as well. Second,
although states are subject to balanced budget requirements in their operat-
ing funds and so typically don't have substantial amounts of debt outstand-
ing, they do have implicit debt in the form of unfunded liabilities for the
pension and retiree health benefits of state workers (Munnell et al., 2011).
There has been much less attention paid to long-term budget projec-
tions for the state and local sector than to the federal government sector.
One exception is the Government Accountability Office (GAO), which re-
ports its projections for state and local expenditures and revenues through
2060 (Government Accountability Office, 2012). The GAO examines both
the impact of health care cost growth and the liabilities for state and local
pension and retiree health benefits, assuming that these benefits are fully
paid as scheduled. According to these projections, without policy changes,
state and local government operating budgets are likely to be under increas-
ing stress over time. By 2025, for example, the GAO's base case shows
an imbalance between revenues and expenditures of about 1.5 percent
of GDP, rising to close to 4 percent of GDP by 2060. Much of this rise is
attributable to rapidly increasing excess cost growth (the GAO assumes
slightly faster growth of excess health cost growth for Medicaid and retiree
health insurance than does the CBO). While not strictly comparable to the
CBO projections, the GAO projections show that, even with the assumed
slowdown in health spending, expenditure and revenue adjustments will
need to be made in the state and local sector as well. While not all of these
adjustments are directly attributable to demographic change, they are an
important component of the overall fiscal outlook for the U.S. economy.
11Medicaid is by far the largest component of these. For example, in 2021, under the CBO
projections, Medicaid accounts for 83 percent of the federal government spending on health
programs other than Medicare. The CBO assumes that excess cost growth in these health pro-
grams will decline linearly over time, from 1.7 percentage points per year in 2022 to 0 in 2086.
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184 AGING AND THE MACROECONOMY
PUTTING THE PIECES TOGETHER: THE
LONG-TERM BUDGET OUTLOOK
The sustainability of federal fiscal policy is affected not only by the
expected growth in entitlement programs but also by the current level of
national debt and by the expected trajectories for tax revenues and discre-
tionary spending. Auerbach and Gale (2012) present a detailed analysis of
alternative trajectories of total federal spending, revenues, and debt under
a variety of assumptions about fiscal policy.
Figure 9-4 presents two such scenarios for noninterest expenditure
and revenues. The more optimistic scenario uses the Medicare Trustees
projections for Medicare spending and assumes that taxes will rise to about
21 percent of GDP over the long term, 3 percentage points above the 18
percent average recorded from 1970 to 2007. In addition, it assumes that
savings from the Budget Control Act of 2011 will materialize. The more
pessimistic scenario uses the CBO "alternative" projection for Medicare
spending, which is considerably higher than that of the Medicare Trustees,
assumes that Congress will maintain tax revenues at roughly its recent his-
torical average of 18 percent of GDP, and assumes that parts of the Budget
Control Act will be repealed.12 This scenario can be interpreted as one in
which taxes and entitlement programs operate largely as they have in the
past, whereas the optimistic scenario already incorporates some adjust-
ments to demographic change, including a reining in of health care cost
growth and an increase in average tax rates.
Under the optimistic scenario, noninterest expenditures fall from 22
percent to roughly 20 percent of GDP by 2018 as the economy recov-
ers and then rise slowly thereafter, to about 22 percent by 2030 and 23
percent by 2050. Under the more pessimistic scenario, noninterest outlays
rise faster, reaching almost 26 percent by 2050. With tax revenues of 21
percent and 18 percent of GDP, respectively, the primary deficit (that is, the
deficit excluding interest payments on the national debt) reaches 2 percent
of GDP by 2050 under the optimistic scenario and almost 8 percent in the
pessimistic scenario.
Figure 9-5 shows the deficit projections implied by these two sets of ex-
penditure and revenue projections, including projected interest payments. In
both scenarios, the deficit declines sharply over the next few years relative
to GDP as the economy recovers, and then begins to climb. In the optimistic
scenario, the deficit falls to close to 1 percent of GDP over the next decade
and then increases only gradually over time, reaching 4 percent of GDP by
2030 and almost 8 percent of GDP by 2050. Even under this positive sce-
12In particular, the pessimistic scenario assumes that the $1.2 trillion in budget savings that
would be triggered by automatic sequestration under the Budget Control Act of 2011 will
be repealed.
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THE OUTLOOK FOR FISCAL POLICY 185
25
Pessimistic Scenario, Expenditures
23
Percent of GDP
Optimistic Scenario, Expenditures
21
Optimistic Scenario, Revenues
19
Pessimistic Scenario, Revenues
17
15
2012 2016 2020 2024 2028 2032 2036 2040 2044 2048
FIGURE 9-4 Alternative federal projections of revenue and noninterest outlays,
2012-2050. SOURCE: Auerbach and 9-4.eps
Gale (2012).
25
20
Percent of GDP
15
10
5
0
2012 2016 2020 2024 2028 2032 2036 2040 2044 2048
Total Deficit, Optimistic Scenario Total Deficit, Pessimistic Scenario
FIGURE 9-5 Alternative federal deficit projections, 2012-2050. SOURCE: Com-
mittee calculations based on Auerbach and Gale (2012).
9-5.eps
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186 AGING AND THE MACROECONOMY
350
300
250
Percent of GDP
200
150
100
50
0
1960 1970 1980 1990 2000 2010 2020 2030 2040 2050
Optimistic Scenario Pessimistic Scenario
FIGURE 9-6 Alternative federal debt:GDP ratios, 2012-2050. SOURCE: Commit-
tee calculations based on Auerbach and Gale (2012).
9-6.eps
nario, future adjustments will still be necessary. In the pessimistic scenario,
the deficit hovers around 5 percent of GDP for much for the next decade
but climbs sharply thereafter, reaching over 10 percent of GDP by 2030
and over 20 percent of GDP by 2050. The sharp acceleration in the future
deficits under the pessimistic scenario reflects the combination of continued
rapid growth in health expenditures as well as rapidly rising interest pay-
ments from continued large deficits.
Figure 9-6 shows the implied debt:GDP ratios under these two sets of
projections. Under the most optimistic set of assumptions, the debt:GDP
ratio falls over the next 15 years and then begins to climb sharply, reaching
100 percent of GDP by 2046. Under the more pessimistic set of projections,
the debt:GDP ratio climbs much more rapidly, reaching 100 percent of GDP
by 2027 and 200 percent of GDP by 2043.
The debt:GDP ratio cannot continue to rise indefinitely; at some point,
investors would become uncertain of full repayment (or worry about repay-
ment in greatly inflated dollars) and start demanding a risk premium13 on
U.S. Treasury securities. At that point, rising interest payments on the debt
would trigger even larger deficits, potentially resulting in an unsustainable
deficit spiral. Although there is uncertainty as to exactly what level of debt
13The
extra expected return over the risk-free rate demanded by investors to compensate for
the volatility of returns or the possibility of default of risky assets.
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THE OUTLOOK FOR FISCAL POLICY 187
TABLE 9-3 Adjustment Needed to Maintain the 2011 Debt/GDP Ratio
Through 2050
Required Adjustment (% of GDP)
Adjustment Takes Place in Optimistic Scenario Pessimistic Scenario
2012 1.1 4.8
2022 1.7 6.1
2032 2.4 7.7
SOURCE: Committee calculations based on Auerbach and Gale (2012).
will elicit such a reaction, it is clear that fiscal policy adjustments will need
to be made eventually. In particular, even through 2050, it is unlikely that
the pessimistic scenario could actually unfold, as it is unlikely that investors
would be willing to continue to finance the projected deficits.
One response to population aging would be to attempt to smooth
the required adjustments over time in order to minimize the size of the
adjustment in any given year. Because population aging is projected to be
permanent, however, spreading the adjustments equally over time would
require the government to build up a large stock of assets and to use the
earnings on those assets to help finance part of future government spending.
Alternatively, the government could smooth through the adjustments over
a more finite period. For example, Table 9-3 presents calculations based
on Auerbach and Gale (2012) showing the size of the adjustments required
in order for the debt:GDP ratio in 2050 to be the same as it was in 2011.
For example, under the more optimistic scenario, which already includes
higher revenues and lower health spending growth than the historical aver-
ages, an immediate and permanent change to tax revenues or expenditures
equal to just over 1 percent of GDP would leave the debt:GDP ratio in
2050 the same as it is today; under this scenario, the debt:GDP ratio would
decline to 44 percent over roughly the next two decades years, and then it
would start to climb again, reaching 68 percent in 2050. Alternatively, if
the adjustment were delayed until 2022, a 1.7 percent of GDP adjustment
would be required, and if it were delayed until 2032, a 2.4 percent of GDP
reduction in expenditures or increase in taxes would be required. Under the
pessimistic scenario, which assumes significantly lower tax revenues and
higher health expenditures, the required adjustments are significantly larger.
MACROECONOMIC IMPLICATIONS OF
RESPONSES TO DEMOGRAPHIC CHANGE
The aforementioned budget projections indicate that a large change in
the combined trajectory of federal tax revenues and expenditures will be
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188 AGING AND THE MACROECONOMY
required over the coming decades. These changes will have important mac-
roeconomic consequences, but there is no natural baseline against which to
measure these macroeconomic effects because the status quo trajectory is
not a feasible one--it would lead to an exploding and unsustainable level
of national debt. Thus, we can only compare the effects of different feasible
paths, especially their relative effects on capital accumulation and labor
supply, both in the aggregate and across generations. To estimate these ef-
fects, several attributes of budget adjustments will be relevant, including
those described in the next seven subsections.
How Quickly the Changes Are Implemented
Under both the optimistic and pessimistic scenarios, annual deficits are
projected to grow over time as a share of GDP, even when debt service costs
are excluded. Thus, as mentioned above, if the adjustment process targets
the rate of debt accumulation, the magnitude of deficit cuts will grow over
time as a share of GDP.
A different policy that would lessen the magnitude of the required
deficit cuts over time would be to make larger immediate adjustments to
taxes and spending policies that could temporarily lower the debt:GDP
ratio. This would have the effect of smoothing the adjustments across more
cohorts. However, it is unclear how much of this type of "prefunding" is
feasible. According to Auerbach (2002 and 2003), there is a predictable
reaction function of government spending to the deficit: As the deficit falls
as a share of GDP, government spending increases and tax revenues fall as
a share of GDP. Thus, policies that would significantly lower deficits ahead
of the baby boom retirement, while possibly economically attractive, might
prove politically unsustainable.
On the other hand, waiting too long to announce and implement policy
changes is a risky strategy. As noted above, it is impossible to predict the
level of debt at which investors might lose confidence in the ability or will-
ingness of the United States to fully repay its debts. This loss of confidence
could occur quite suddenly, and it might lead to a period of financial crisis
or a situation in which policy adjustments would have to be quite large and
immediate, which could have deleterious effects on short-term macroeco-
nomic performance (National Research Council and National Academy of
Public Administration, 2010).
When Changes Are Announced or Anticipated
Changes that are implemented in the future may nonetheless be an-
nounced or anticipated many years before. If announcements of future
policies are credible or if expectations reflect an accurate assessment of the
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THE OUTLOOK FOR FISCAL POLICY 189
policies that eventually will be undertaken, then these policies can affect be-
havior long before their implementation. An example is the phased increase
in the Social Security full retirement age, which was enacted in 1983 but
implemented over a long period beginning several years after enactment.
To the extent individuals are forward looking, this change in policy would
have boosted private saving in the years prior to its implementation, as
people increased their saving in anticipation of lower future Social Security
benefits.
Changes That Explicitly or Implicitly Increase Marginal Tax Rates
Some policy changes quite explicitly increase marginal tax rates.14 Most
tax increases would do so, unless accompanied by changes in tax structure.
But many marginal tax rates are implicit, as in the case of the means-testing
of social insurance benefits. This point has been made quite frequently in
the context of antipoverty programs, where the simultaneous loss of differ-
ent benefits for those who enter work can in combination lead to very high
marginal tax rates and create a poverty "trap" that strongly discourages
exits from poverty and dependence. But the point also applies to universal
old-age entitlement programs. For example, the share of Social Security
benefits subject to the income tax depends on retirees' other income, which
imposes an implicit marginal tax rate (in addition to the explicit one) on
that other income. Similarly Medicare Part B premiums are now income-
based, which also imposes a tax on such income.
Note that implicit marginal tax rates on income may be imposed
through the tax system (as in the case of Social Security benefit taxation)
or through the expenditure system (as in the case of Medicare premiums,
which are classified in the budget as offsetting receipts that reduce expendi-
tures). This fact highlights an important point: Macroeconomic effects will
depend on the distribution and structure of budget changes but not directly
on whether these changes are recorded on the tax side or the expenditure
side. Though this distinction sometimes appears paramount in political dis-
cussions, it is of little relevance for economic analysis except to the extent
that the underlying behavioral effects of tax or expenditure changes may
systematically differ.
The Intergenerational Distribution of Policy Changes
The intergenerational distribution of policy changes will relate to the
first point above, because changes that are delayed are likely to affect
14The marginal tax rate is the rate that would have to be paid on any additional taxable
income earned, which may be higher than the rate paid without additional earnings.
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190 AGING AND THE MACROECONOMY
younger generations. But two policies of the same magnitude implemented
at the same time may have different distributional effects among genera-
tions. For example, an immediate, permanent cut in Social Security benefits
will affect older generations more than an immediate, permanent increase
in Social Security taxes with the same budget result. Similarly, a consump-
tion tax would affect older generations more than an increase in the income
tax. The generational distribution of deficit reductions will matter for ag-
gregate economic activity because generations have different propensities
to consume goods and leisure out of income changes, and they are af-
fected differently by changes in marginal tax rates. For example, we would
expect larger reductions in consumption (say, through reductions in tax
exemptions) from income reductions imposed on 70-year-olds than from
equal-size reductions imposed on 40-year-olds, because the latter group is
in a better position to offset income losses by increasing labor force par-
ticipation. Likewise, we would expect larger changes in labor supply from
increased marginal income tax rates on 40-year-olds than from increased
marginal income tax rates on 70-year-olds, who are mostly retired and out
of the labor force.
The distributional effects of a program of budget adjustments over
time can be summarized using generational accounts, which cumulate the
effects on different generations at different dates. Such accounts, however,
focus on incidence and hence must be complemented by analysis of how
changes in incentives, via marginal tax rates, are distributed across genera-
tions and, as discussed next, within generations. Also, because generational
accounts are forward-looking calculations, their usefulness for macroeco-
nomic analysis hinges on the extent to which the affected individuals (1)
actually are forward looking and (2) are not liquidity-constrained15 in a
manner that makes future taxes and benefits irrelevant, as they would be
for households with little or no saving who spend essentially all of their
disposable income each year.
The Intragenerational Distribution of Policy Changes
Two policies with the same timing, intergenerational distribution, and
marginal tax rate changes can affect members of a given cohort differently.
For example, one might vary the progressivity of a given cut in Social Se-
curity benefits. As with differences across generations, differences in the
impact of deficit cuts within a generation can be expected to have different
effects on labor supply and saving. For example, lower-income individu-
als are more likely to be liquidity-constrained and hence to suffer a big-
15That is, without sufficient cash to make purchases, and/or unable to borrow to consume
or invest.
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THE OUTLOOK FOR FISCAL POLICY 191
ger decline in consumption in response to a given reduction in after-tax
income. Also, those who are liquidity-constrained or myopic are less likely
to respond to anticipated future policy changes; such individuals may not
change their labor force or saving behavior, which become irrelevant when
current decisions are constrained.
The Timing of Tax Increases and Benefit Cuts over a Lifetime
One of the important rationales for the existence of programs like So-
cial Security and Medicare is that many people are not farsighted enough
to adequately save for retirement, and these programs are a form of forced
saving, at least from the individual's standpoint. Thus, while people with
perfect foresight will adjust their consumption optimally in response to an
announced cut in benefits, many others may not. This means that, even for
an individual, a tax increase and benefit cut that lower lifetime resources
by the same amount can have different effects, with changes occurring in
the distant future possibly having a smaller impact today.
The Role That Policy Changes Play in Insuring or Exacerbating Risk
Under reasonable assumptions, uncertainty about future resources af-
fects current behavior. Individuals may engage in precautionary saving if
the future is uncertain, and they may also work more or delay retirement.
These effects are in addition to those resulting from expected changes in
resources. Uncertainty is always present in the economy, and indeed one
stated purpose of social insurance is to reduce such uncertainty by cush-
ioning the shocks of economic forces on particular individuals or, through
intergenerational risk-sharing, entire cohorts. But uncertainty about future
policy changes might exacerbate existing uncertainty. For example, budget
deficits rise when the economy is weak because of a loss in revenues, so if
policy aims to achieve a fixed budget reduction, budget cuts must be larger
when the economy is weak and individual resources are low.
In summary, to analyze the macroeconomic effects of a given policy
trajectory, one would like to estimate the inter- and intragenerational distri-
bution of changes in resources and marginal tax rates under the policy, the
dates at which future policy changes are anticipated, and the distribution of
possible policy paths and how these paths relate to the economy's possible
trajectories. Sophisticated general equilibrium models with overlapping
generations, forward-looking agents, and within-generation heterogeneity
do exist, but it would be a considerable challenge to construct a detailed
model that incorporates realistic tax and expenditure elements and is ca-
pable of taking all of the factors discussed into account simultaneously.
Thus, the most reasonable approach is to use different models designed to
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192 AGING AND THE MACROECONOMY
capture different elements of the overall picture, simplifying where possible
to keep the most important elements of particular policy changes in focus.
To see how these different channels of transmission from policy to the
economy may operate, it is helpful to focus on the three broad categories of
policy adjustments that have been considered to address the fiscal imbalances.
Steps to Rein in Excess Health Care Cost Growth
One of the key differences between the most optimistic and most
pessimistic scenarios in Figure 9-4 is the assumption about the trajectory
of federal spending on health programs after 2020. Under the optimistic
scenario, per-beneficiary health spending grows roughly in line with GDP,
whereas under the pessimistic scenario, rapid health spending is responsible
for a large and growing portion of the fiscal imbalances over time.
Accordingly, measures like the ACA that attempt to lower the overall
health spending of the elderly are likely to be an important component
of long-term fiscal policy. Yet the macroeconomic consequences of such
measures are among the most difficult to determine. If, as some believe,
changes in Medicare policy can induce innovations in health care delivery
that lead to reduced spending without a reduction in the quality of care (for
example, by eliminating duplication of services, eliminating unnecessary
care, or reducing costly errors), then these policy changes would help ad-
dress the fiscal problem without any required reduction in living standards.
On the other hand, lowering the rate of growth of health spending may
be accompanied by reduced access to care and a slower rate of growth of
innovation, which would lower the living standards of the elderly relative
to a baseline in which spending continued to rise faster than GDP. Finally,
cuts in Medicare spending could lead to lower income for health service
providers, which would be equivalent to a tax on providers. Over time,
such a tax could reduce the attractiveness of practicing medicine, which
could lead to lower quality and reduced access as well.
Benefit Cuts
There is a wide variety of policies that could lower the growth rate of
entitlement spending beyond changing the growth rate of health care costs.
Such options include changing the age of eligibility for benefits, changing
the generosity of benefits, and limiting benefit growth by increased reliance
on means-testing. These different approaches would likely have different
distributional consequences; in addition, they might also have differential
effects on labor supply.
For example, a policy to index retirement ages (particularly the full
retirement age) for Social Security benefits to life expectancy would lower
benefits disproportionately for those with a shorter life expectancy. Given
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THE OUTLOOK FOR FISCAL POLICY 193
the dramatic widening of the gap in life expectancies across the income
distribution seen in recent decades (Congressional Budget Office, 2008),
this distributional effect might be deemed undesirable. On the other hand,
if changing the retirement age--particularly the age of early retirement--
could induce workers to stay in the labor force longer, this could offset
the effect of the reduction in benefits on income and would also provide a
greater boost to economic activity than a benefit cut for all retirees. But,
those with shorter life expectancies may also have less capacity for work
(Cutler, Meara, and Richards-Shubik, 2011). Other possible policies might
also face some trade-offs between efficiency and equity. For example, a
policy to further means-test benefits might have favorable distributional
consequences but would also impose greater implicit taxes on saving.
Tax Increases
Many observers believe that increased tax revenues will be necessary
to meet the fiscal challenge posed by population aging. From a macroeco-
nomic standpoint, the particular details of the tax changes are quite impor-
tant. For example, simply raising tax rates on the existing tax base could
have significant disincentive effects on labor force participation as well as
on saving, making the required adjustments to the fiscal challenge of ag-
ing that much more difficult. On the other hand, many economists believe
that reforming the tax code by broadening the base could lead to higher
revenues while lowering marginal tax rates. This type of policy could help
address the fiscal imbalance while also boosting economic activity.
CONCLUSIONS
A sizable share of the consumption of the elderly is financed by the
government, in the form of Social Security, Medicare, and Medicaid. The
projected changes in the population's age distribution will create imbalances
in these programs and, even under the most optimistic projections, lead to
progressively larger budget deficits. The challenges of population aging are
made more difficult by rapidly growing health costs and by the underlying
structural budget deficits that federal and state and local governments face
even in the absence of demographic change. Although government debt
can grow faster than the economy for a time, policy changes that increase
revenues and/or lower expenditures are inevitable in the next few decades.
Analyzing the macroeconomic effects of the potential policy changes re-
quires a consideration of their likely impact on private behavior, which will
depend on their timing, their distribution, and their effects on the marginal
incentives to work and to invest. To the extent that spending can be reduced
and revenues increased in ways that increase economic efficiency, the macro
economic consequences of the necessary policy changes would be muted.
