Hassett on the Fiscal Gap

Economist Kevin Hassett recently testified in front of the Senate Budget Committee. Here are his observations on the federal government's looming fiscal problems:

As the members of this committee so often emphasize in their public statements, the near term picture, as vexing as it is, is not nearly as important as the long run outlook. Figure 7 portrays the sharp increase in government spending that is projected to occur in coming years. If policy is unchanged, then the U.S. will see its share of government to GDP approach that of Sweden and other European countries, and will face ever more difficult borrowing conditions, or striking tax increases, or both. Given the literature on government size and economic growth, one would expect soaring government share to push us onto an economic path similar to that currently experienced in much of Europe.

The lion’s share of the problem is attributable to the aging of our society. This puts pressure on Social Security and especially Medicare.

It seems that one obstacle to the kind of bipartisan cooperation necessary for entitlement reform is disagreement concerning the source of the rebalancing, with some arguing that tax increases are preferable to benefit cuts, and some taking the opposite view.

As an economist, it seems that this debate is often muddled by misconceptions.

Suppose, to start, that we live in a world of absolute certainty and rational individuals. In this world, everyone knows what their income will be until the day they die. In this world, if an individual pays $10 in Social Security tax today, but gets back $10 in present value when he retires, then his net benefit is zero. A rational individual in this case would not think of the $10 as a tax, or as anything at all. It’s the net benefit that matters. If he pays in $14 and gets out $16, then the system increases his lifetime income by $2. The same is true if he pays in $2 and gets out $4.

If you want to raise money from this fellow, then you could do it by increasing his tax to $11 and leaving his $10 benefit unchanged, or, reducing his benefit to $9 and leaving his tax unchanged. Either way, you take a dollar from him.

Restoring balance in this example requires that the net benefit be reduced. Money is money. Since the net benefit is the true tax, a benefit reduction is as much of a tax hike to a rational individual as an explicit tax hike.

While the example focused on Social Security, the same analysis could also apply to Medicare. In this case, we ask individuals to pay money into the system with the promise that they will receive health benefits in the future with a certain value. If the individual values a dollar of health benefits as being worth a dollar (which he would not if we give him too many health benefits) then a tax increase and a benefit cut will not be much different economically.

If we add uncertainty, needy individuals, and redistributional objectives, then the labels matter more of course. However, the situation is ambiguous enough that it is safe to say that lines in the sand over labels make little sense economically, and that the opposing sides in this debate are far closer on the true economic content than they may realize. That is reassuring, because the long-run outlook is so bleak that business as usual is not an option.

Kevin is right that the distinction between spending cuts and tax increases is sometimes overstated. A better distinction, perhaps, is whether or not the fiscal gap is closed in a way that distorts incentives to work, save, and invest. As I have pointed out before, some ways of cutting spending, such as means-testing, have disincentive effects similar to those from higher marginal tax rates.

Policy analysts more concerned about incentives will favor less distortionary steps to close the fiscal gap (such as raising the age of eligibility for Social Security and Medicare). Those more concerned about the income distribution will favor more distortionary steps (such as raising marginal tax rates and means-testing). As is often the case, the efficiency-equality tradeoff will be the background for the debate.