February 13, 2019

The End of Policymaking and the Rise of Mandatory Spending

A Fiscal Dilemma

Washington policymakers assume that the policy future is much like the policy past: replete with opportunities for tweaking some policies and fundamentally altering others. Speaking at a university event in 2015, US Senator Bernie Sanders proclaimed that “if the federal government were to invest $18 billion a year, with a dollar-for-dollar match from state governments, we would slash college tuition in the United States by more than half.” New members of Congress never come to Washington without bold dreams of policy change dancing in their heads. That expectation, however, is increasingly challenged by the growing realization that more and more of the annual federal budget is being devoted to mandatory programs, as the share of the budget subject to annual appropriations continues to shrink. While mandatory programs can be changed (and sometimes fundamentally altered, as in the case of healthcare and the Affordable Care Act), the usual practice is to leave the programs alone and fund the growing number of beneficiaries.

Roughly 7 in every 10 federal taxpayer dollars are allocated according to demographic changes in the groups that receive those dollars, not by decisions made by policymakers. Whether this trend signals the end of policymaking as we know it is a serious question. In this brief we assess the underlying factors in the growth of mandatory spending, which we regard as a democratic and fiscal dilemma. Only by having a more comprehensive understanding of the issues at hand can we begin to restore both discretion and sustainability to the budgetary process.

In order to better understand the issues underlying this growing lack of budgetary discretion, we analyze programs such as Medicare and Social Security. Medicare is a mandatory spending program that has been subject to marginal adjustments over time but never fundamentally altered. Because of statutory requirements, there is no annual legislation dealing with Medicare, and it is not part of the annual spending debate. In other words, the policy discussion about healthcare for seniors practically ended with the adoption of Medicare in 1965. Since then, the “policy debate” has been about who should qualify as a beneficiary and how to fund the program. A large and growing share of the federal budget replicates this Medicare system of autopilot financing, with 86 percent of total federal revenues going toward mandatory outlays.

Social Security is largely a pay-as-you-go system, meaning that current workers pay Social Security taxes into the program, and this money flows back out as monthly income to current beneficiaries. When Social Security was signed into law, there were several workers for every beneficiary, so in the early stages of the program, many paid in and few received benefits. In 1955 there were almost nine workers for every beneficiary. Today this ratio is less than three workers for every beneficiary, and it is expected to drop to two workers per beneficiary by 2030. Pay-as-you-go schemes can work only as long as enough people are paying into the system. Yet with the leading edge of the enormous baby boomer generation now reaching retirement, these programs are becoming deep seas of red ink. The resultant economic implications of a large and growing national debt are widely recognized. According to one study by the European Central Bank, those implications include reduced business and investment confidence, declining access to capital, deteriorating growth conditions, and fewer economic opportunities.

The political and budgetary ramifications of entitlement-fueled debt, however, are not as widely acknowledged. As mandatory spending continues to outgrow federal revenues, policymaking becomes increasingly futile in the budgetary process. If the current trends in spending continue, all federal revenues will be consumed by autopilot programs in just 12 years, leaving elected representatives with no decision rights over Americans’ tax dollars.

This policy brief will focus on the underlying causes of declining discretion in policymaking: specifically, the unsustainable growth of mandatory spending programs rooted in a rapidly aging population. We will discuss how this phenomenon will lead effectively to the end of policymaking in a little over a decade if no action is taken to avert this problem. While drastically raising taxes is not a feasible solution to this problem of unsustainable spending, numerous workable solutions are available to lawmakers. We recommend six modest reforms to Social Security, healthcare programs, and the budgetary process. While we recognize that these modest reforms are not a cure-all solution to America’s fiscal dilemma, these changes would demonstrate the willingness and ability of policymakers to address our deteriorating fiscal outlook.

Changing Demographics and Unsustainable Social Programs

Owing to the rapidly aging population of the United States, we can single out three fundamental drivers of the unprecedented growth in mandatory spending. The three major entitlements— Medicare, Medicaid, and Social Security—account for 50 percent of federal spending and equal 10.4 percent of GDP. These three programs will surge from 10.4 percent of GDP to 15.5 percent by 2048, with interest on the nation’s debt exceeding 6 percent of GDP.

In fiscal 2017, the federal government spent almost $4 trillion. Of that, 41 percent, or $1.64 trillion—or 8 percent of US GDP—went to Social Security and Medicare. Social Security is primarily funded by payroll taxes, while Medicare is funded by a combination of payroll taxes and general revenues. These two programs are projected to consume $23 trillion in the coming decade, and that figure doesn’t include the federal government’s growing interest payments. The main beneficiaries from Social Security and Medicare—meaning the main beneficiaries of most of the US budget—are seniors (those age 65 and older). Over 73 percent of Social Security benefits are paid based on age (that’s the money going to retirees, as opposed to disabled workers, dependents, and survivors). The same is true for Medicare, with around 84 percent of benefits being paid based on age as of 2016. It’s also worth noting that about 28 percent of Medicaid’s $400 billion in spending—federally provided healthcare payments for low-income Americans—goes to seniors. What’s more, in 2016 spending on Medicare and Medicaid was greater than all combined private spending on healthcare, at 51.6 percent of total national health expenditures, versus 48.4 percent for private healthcare spending. This represents a shift in expenditure from a decade earlier in 2006, when the ratio was 49.2 percent versus 50.8 percent.

We find that the resources being spent on these programs tend not to reach the intended demographic groups. According to combined data from 15 federal agencies in 2016, older Americans are in remarkably good financial shape compared with previous generations, as they’ve seen their net wealth go up by over 80 percent since the 1980s. Older Americans are also doing well relative to younger Americans. According to the Pew Research Center, in 2009 the typical household headed by someone 65 or older had $170,494 in net wealth, compared with just $3,662 for the typical household headed by someone younger than 35. As a result, today’s seniors are heavily represented in the top quintile of the income distribution. As demographic trends continue, the country is about to witness an even larger redistribution from relatively young and poor Americans to relatively old and wealthy ones. Age-based redistribution was not what programs such as Social Security and Medicare were originally intended to achieve.

What’s more, the growing debt burden and consequent rising interest payments have important distributional and intergenerational consequences. Older, high-income individuals are the predominant holders of government debt, so this demographic group benefits from growing interest payments. As policymakers continue to borrow more money, they are forcing future taxpayers to pay the costs of current consumption—this financing system marks a significant redistribution from the bottom to the top. Studies have demonstrated that a growing public debt burden lowers future generations’ well-being. It is unavoidable that the issuance of public debt impairs the welfare of future generations even in a Keynesian framework.

The other portion of mandatory spending that has seen unprecedented growth in recent decades is the expansion of means-tested welfare programs. Means-tested programs determine eligibility based upon whether individuals or families possess the means to go without that help. For example, certain means-tested benefits may be available only to low-income families. There are 79 means-tested social welfare programs in total (excluding Social Security and Medicare), with the federal government funding around 80 percent of the costs of these programs. The remainder of welfare program costs is funded by the state governments, which lack any incentives to constrain welfare growth. Totaling more than $1 trillion, welfare spending has expanded drastically in recent decades. In fact, of the 79 social welfare programs, 24 federal programs are currently spending at unsustainable rates. This determination is made by comparing estimated annual growth in program spending with annual estimated GDP growth for the coming decade; program growth that exceeds growth in the economy is considered unsustainable under this definition.

A rapidly aging population causing expansions in the number of Social Security and Medicare beneficiaries, combined with a broadening eligibility criteria for means-tested social welfare programs, has led to the unsustainable growth of mandatory spending as a proportion of the federal budget. For example, the Affordable Care Act (ACA) led to substantial gains in Medicaid enrollment. The expansion to adults with income at or below 138 percent of the poverty line, the simplification of enrollment, and increased outreach efforts led to estimated gains of 16.5 million new beneficiaries in 2014 and 2015 alone. What’s less well understood is that many entitlement programs have become increasingly more expensive per beneficiary, worsening this policymaking dilemma.

Increasing Futility of Policymaking

According to 2018 projections by the Congressional Budget Office (CBO), by 2031 all revenues collected by the federal government will be precommitted before Congress even begins to debate the budget. This precommitted budget will cover just four areas of mandatory spending—Medicare, Medicaid, Social Security, and net interest. Eighteen years ago congress had discretion over more than 40 percent of government revenues, today that figure is around 14 percent, and by 2031 Congress will officially have no say on how Americans’ tax dollars are spent—policymaking as we know it will become futile.

The primary drivers behind the decline in policymaking are rapid increases in mandatory spending, often at rates faster than economic growth. Urban Institute fellow and economist on budget and tax policy Eugene Steurle describes the increasingly futile function of policymaking as the “decline in fiscal democracy.” Unchecked growth in mandatory programs continues to occupy an ever-larger share of the federal budget; meanwhile policymakers are reluctant to backpedal on previously made promises in fear of electoral suicide. Policymakers’ fears are validated by public opinion, as voters from both sides of the political spectrum are opposed to cuts in large government programs: only 3 percent of Democrats and 10 percent of Republicans support cuts to Social Security, according to a 2017 Pew Research Center poll. Meanwhile, public opinion polls consistently show that Americans care a great deal about federal spending and the budget deficit. A Gallup poll from early 2018 found that 77 percent of Americans care about these issues a great deal or a fair amount, compared to 7 percent who don’t care at all.

Figure 1

With a large and growing proportion of the federal budget not being subject to annual appropriations, a lack of budgetary discretion will continue to produce negative results, both for the economy and for the aims and aspirations of policymakers. Automatic mandatory spending increases are fueling our national debt, which has now surpassed $22 trillion, or $180,000 per taxpayer. An ever-larger debt ensures that a smaller share of the budget is available to spend on noninterest programs, as interest payments are projected to cost more than all federal income security programs combined in 2019, and more than Medicaid by 2021.

Policymakers will thus find themselves increasingly incapable of fulfilling their promises. Whether the promises of politicians revolve around tax cuts or program expansions, these promises will have to be scaled back and revoked as larger shares of the federal budget are automatically committed to mandatory programs. The former tactics of electioneering—the promising to voters of all kinds of new programs, benefits, and tax cuts—will no longer be a viable option at election time. If, as the CBO predicts, by 2031 all government revenues are precommitted to mandatory spending programs, policymakers will only have the ability to squabble over deficit spending, which by that time could amount to almost 6 percent of GDP.

With the failure to make policy changes comes the inability to effectively respond to the next recession or financial crisis. Much like many European countries during the Great Recession, our ability to engage in fiscal policy as a response to financial crises is lessened owing to the crowding out of discretionary spending by autopilot mandatory spending. The ceaseless growth of mandatory spending will inevitably lead to the end of policymaking in a little more than a decade, leaving politicians less prepared for fiscal crises and leaving taxpayers with no say on how their money is spent.

Raising Taxes Does Little to Solve this Dilemma

It has been suggested that one approach to this dilemma could be to simply raise taxes so that we can continue to spend more on entitlements. However, in order to fund the unsustainable growth of federal spending, taxes would have to be increased tremendously for all tax brackets.

A 2011 Heritage Foundation report found that financing promised entitlement spending solely through raising taxes would require doubling the marginal tax rates for all income brackets by 2041, reaching a 47 percent federal income tax rate for many middle-income Americans and 66 percent for high-income Americans, on top of payroll taxes and state and local income taxes. Corporate taxes—already among the highest in the industrial world—would also need to increase more than threefold from current levels.

If the United States were to increase taxes (both individual and corporate) to these levels, then Americans would have less incentive to work and invest. Empirical studies have shown that tax increases have a negative impact on GDP growth. If the definition of unsustainable program spending is calculated as spending that outpaces economic growth, then higher taxes will only worsen the problem by lowering rates of economic growth. It is also important to consider that during periods of slow or negative growth, spending on federal social welfare programs increases substantially, especially on programs such as the Supplemental Nutrition Assistance Program, unemployment compensation, and housing assistance.

Brian Riedl at the Manhattan Institute has noted that popular solutions to this fiscal dilemma, such as increasing taxes on the rich or cutting defense spending, will simply not work: “Doubling the 35 percent and 37 percent tax rates to 70 percent and 74 percent would close just one-fifth of the long-term Social Security and Medicare shortfall. . . . Cutting defense to European levels would close just one-seventh of it. Nor can economic growth or inflation fix the gap.”

Figure 2

Historically, federal government revenues have hovered around 17 percent of GDP, fluctuating slightly with economic growth. As figure 2 illustrates, changes in the rates of taxation since 1965 have had little influence on the level of revenues collected by government. Federal spending has also tended to remain fairly constant since 1965, at around 20 percent of GDP, also with minor fluctuations depending on the level of economic growth. Looking forward, however, these historical patterns are set to change drastically; federal revenues are expected to grow moderately from around 17 percent to a little more than 19 percent of GDP over the next 30 years. Meanwhile, federal spending is projected to explode from around 20 percent of GDP today to almost 30 percent over the same 30-year period.

Expenditure-Based Solutions vs. Taxation-Based Solutions

Since the onset of the Great Recession, there has been a small but growing body of literature studying episodes of austerity, specifically the effects of spending-based and tax-based consolidations. Alberto Alesina and Silvia Ardagna find that fiscal adjustments based on spending cuts are more likely to reduce deficit-to-GDP and debt-to-GDP ratios than adjustments based on tax increases. In addition, Christina and David Romer find that tax-based austerity has very large negative effects on economic output: “An exogenous tax increase of one percent of GDP lowers real GDP by almost three percent.” These findings support the existing body of literature on the negative economic effects of tax increases.

More recently, Alberto Alesina, Carlo Favero, and Francesco Giavazzi estimate the macroeconomic effects of expenditure-based and tax-based fiscal adjustments in an attempt to ascertain which form of consolidation is least costly to economic activity and most effective at reducing the deficit. The study finds that expenditure-based adjustments result in zero costs if the economy is not in recession, and a small downturn in output if the economy is in recession. Tax-based adjustments, on the other hand, result in large recessions that may last several years.

Fortunately, numerous workable solutions are available to lawmakers. Efforts to ensure sustainable levels of future spending and the restoration of fiscal democracy include the following:

  1. Adding a system of personal savings accounts to Social Security. Research from the Mercatus Center at George Mason University has analyzed the options for establishing mandatory add-on savings accounts, called Supplemental Transition Accounts for Retirement (START), to provide workers and their spouses the necessary income to delay claiming Social Security benefits, thereby reducing Social Security’s 75-year actuarial deficit by about 12 percent.

  2. Gradually raising the early and full retirement ages, constraining benefits to nonworking spouses of high earners, and basing future cost-of-living increases on the chained CPI. Mercatus research demonstrates that these Social Security reforms should not only address the program’s fiscal solvency issues, but also reduce the disincentives to working later in life.

  3. Increasing the share of medical expenses paid out of pocket, liberalizing medical savings accounts, and making that liberalization permanent to reduce healthcare costs by increasing competition between providers and making consumers more responsive to tradeoffs. Such cost sharing reduces use of healthcare services without significantly affecting the quality of care and without adverse effects on health.

  4. Freeing the healthcare supply from the many constraints imposed by federal and state governments and the special interests they serve. This requires that healthcare policymakers discard their “fortress” mentality and adopt a “frontier” attitude that tolerates calculated risks and welcomes competition from diverse practitioners and disciplines. Bringing revolutionary innovation to this industry would drastically reduce costs for healthcare, which federal and state governments spent more than $1.7 trillion on in 2016 alone.

  5. Implementing real institutional reform to change the debt trajectory, including meaningful budget rules that have broad scope, few and high-hurdle escape clauses, and minimal accounting discretion. Reform should also include ending abuse of the emergency spending rule and all other gimmicks, instituting a transparent budget process.

  6. Creating a well-designed constitutional amendment that would place permanent, truly enforceable limits on Congress’s ability to tax and spend. A constitutional amendment would counteract the temptation to circumvent rules, and it would also provide a foundation on which a new budget process could be built.

The dilemma of declining fiscal democracy and the increasing futility of policymaking is not a problem rooted in government revenue shortfalls. Driven by the ceaseless growth in entitlement programs, this is a spending problem. Rather than increasing the tax burden, with negative repercussions for economic growth and dynamism, the real solution to this dilemma is found in reforming Social Security to reduce future outlays while also implementing more effective rules to immediately reduce discretionary spending.

The aforementioned recommendations for restoring sustainable levels of spending are not a cure-all solution to our fiscal dilemma, but these modest and viable steps would demonstrate the willingness and ability of policymakers to address America’s deteriorating fiscal outlook.