The Government's Long-Term Fiscal Shortfall: How Much Is Attributable to Social Security?

^Pr^ep^ar^{ed f}^o^r^M^e^m^b^ers^an^d^Com^mⁱ^t^t^ees^of^C^ong^r^e^ss

One reason that Social Security reform is on the congressional agenda is the large projected long-
term fiscal shortfall facing Social Security, estimated at an average of 0.9% of gross domestic
product (GDP) between now and 2080. But relatively little attention has been given to the
potential long-term shortfall faced by the rest of the government, which is estimated to be more
than 6.5 times larger than Social Security’s shortfall. The government’s overall fiscal gap under
an extension of current policy, estimated at an average of 7.2% of GDP between now and 2080, is
the result of the large projected increase in future spending that is not matched by any projected
increase in tax revenue. Most of the increase in spending occurs in Medicare and Medicaid;
Social Security is the third largest contributor to the fiscal gap. If viewed from the revenue side,
the 2001 and 2003 tax cuts increased the fiscal gap by an average of 2.2% of GDP between now
and 2080. The fiscal gap measure may be useful to policymakers because it highlights the
unsustainability of current policy in the long term and the potential cost of inaction, and it
provides a measure that can be used to estimate the implications of current policy for the
macroeconomy and generational equity. This report relies on data from a 2004 study that is
unlikely to be updated.

Measuring the Fiscal Gap on the Spending Side.......................................................................3
Measuring the Fiscal Gap on the Revenue Side........................................................................4
Why Is the Fiscal Gap Important?...................................................................................................5
The Sustainability of Current Policy.........................................................................................5
Macroeconomic Effects.............................................................................................................5
Reforming Now vs. Later..........................................................................................................6
Generational Equity..................................................................................................................6
Figure 1. Fiscal Gap by Source, 2004-2080....................................................................................2
Table 1. Fiscal Gap by Spending Program, 2004-2080...................................................................4
Author Contact Information............................................................................................................6

ne rationale given for Social Security reform is the large long-term fiscal shortfall that
Social Security is projected to face. In particular, observers point to the 75-year shortfall
faced by the Social Security trust fund, which amounts to a present value (defined below) O

of $4.7 trillion according to official estimates.
While this amount is unquestionably large, the government’s ability to close that shortfall under
current policy depends on the fiscal position of non-Social Security spending and revenues. If the
rest of the budget were in surplus, then revenues could be transferred from the rest of the budget
to finance promised Social Security benefits without raising taxes or cutting spending on Social
Security. However, if the rest of the government were in deficit, then there would be no general
revenues to transfer to Social Security to finance the benefits promised to retirees, without policy
changes that improved the government’s overall fiscal position.
Thus, to determine whether the government will have the means to compensate for Social
Security’s fiscal shortfall and honor promised benefits, look at the government’s overall fiscal
position. There is no official estimate of the government’s overall fiscal shortfall, or “fiscal gap”;
there have been two recent unofficial estimates, however, that reached similar conclusions.
According to the more detailed estimate, the government’s overall fiscal gap to 2080 equals an
annual average of 7.2% of GDP or a sum of $36.3 trillion in present value terms, as seen in ¹
Figure 1, under an extension of current policy. In this estimate, Social Security accounts for $4.7
trillion of the fiscal gap to 2080, and the rest of the government accounts for $31.6 trillion of the
gap. In other words, the projected fiscal gap facing the rest of the government is more than 6.5
times larger than the one facing Social Security.

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Figure 1. Fiscal Gap by Source, 2004-2080
Rest of
6. 3 31. 6 Go vernm ent
Social Security
0.94.7
% of GDPtrillions of $ (PV)
^Source:^Aue^rbac^{h, Gale, and Or}^{szag, 200}^4.
^Note:^{PV = present value, GDP}^{= gross domestic product. See te}^{xt for details.}
The fiscal gap measures in present discounted value terms the cumulative excess of future
spending over future revenues plus the current national debt. To keep the national debt from
rising as a share of GDP until 2080, taxes would need to be immediately raised or spending
immediately cut by 7.2% of GDP—far greater than the changes required to balance the FY2006
budget because the budget deficit is forecast to grow significantly from present levels under an ²
extension of current policy.
The fiscal gap, like budget deficits in general, can be eliminated only through higher taxes or
lower spending. There is no objective way to assign the source of the fiscal gap to excessive
spending or inadequate taxation. By definition, the fiscal gap is caused by spending exceeding
taxation. Whether this means that spending should be lower or taxes higher is a value judgment.
But, in the discussion below, the reader should keep in mind that future deficits are not growing
because spending rises under current policy. Rather, future deficits grow because revenues are not
projected to rise along with spending.
Fiscal gap calculations are made in present value terms because a $1 deficit today cannot be
meaningfully compared to a $1 deficit in 50 years. Present discounted value calculations adjust
for the fact that a dollar borrowed today would grow because of compound interest. If a dollar
were borrowed today at, say, a 3% real rate of interest, it would grow to $4.38 in 50 years. In this
example, the fiscal gap could be reduced by $1 by instituting a one-time tax increase or spending
cut equal to $1 today or by instituting a one-time tax or spending cut equal to $4.38 (in real terms)

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50 years from now. Thus, the tax increases or benefit cuts needed to eliminate the fiscal gap are
smaller if taken now rather than in the future. A failure to adjust future sums into present value
terms overstates the contributions of future financial flows relative to present flows. (If future
deficits were not discounted, as 5-year and 10-year budget totals are usually presented, then the ³
fiscal gap would be much larger than $36.3 trillion.)
For example, Social Security’s annual deficits in 75 years are large, equal to about 2% of GDP.
But Social Security is currently in surplus, and will remain so until 2018. Therefore, Social
Security reduces the fiscal gap in the short run, and its overall contribution to the fiscal gap is
relatively small (0.9% of GDP) once its distant deficits are discounted to the present. By contrast,
budget deficits today outside of Social Security will compound under current policy and become
very large in the distant future. The budget deficit outside of Social Security in 2004 was 4.9% of
GDP, more than twice as large as Social Security’s deficit at its 75-year peak. The policy changes
that moved the budget from surplus to deficit in the past four years have increased the fiscal gap
by more than Social Security’s total contribution to the fiscal gap.
Because Social Security is intended to be entirely self-financed, it is the only program that can be
assigned a portion of the government’s fiscal gap in a straightforward manner. Although the same
sort of straightforward comparison of spending and revenue could be made for Medicare Part A,
it could not be made for Medicare Parts B, C, or D since they were designed to rely heavily on
general revenues. Most other spending programs receive general revenue. Because most other
programs do not receive specific revenue streams, there is no way to compare projections of any
other program’s spending to its revenue.
Therefore, if the sources of the fiscal gap were to be broken down by spending programs, a
somewhat arbitrary assumption about how much general revenue to dedicate to each program
must be made. In one scenario, Auerbach et al. assume that each program continues to receive its
current fraction of general revenue for the next 75 years. In other words, they assume that each
program’s share of the revenue “pie” in the future is determined by its share of the pie today. This
assumption means that spending programs that grow relative to other programs in the future, such
as Medicare and Medicaid, will be assigned higher portions of the fiscal gap than if some other
assumption were made. (Estimates of the fiscal gap under other assumptions can be found in their
article.) Medicare and Medicaid spending are projected to increase from 3.8% of GDP in 2004 to
16.7% of GDP in 2080. This increase is driven by the aging of the population and the assumption
that health care spending will continue to grow as a share of GDP. Table 1 shows that the rapid
projected growth in future Medicare and Medicaid spending—which are not matched by any
corresponding increase in revenues under current policy—are responsible for most of the fiscal
gap by this measure. Similar results were found in another recent estimate of the fiscal gap ⁴
published by AEI Press.

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Table 1. Fiscal Gap by Spending Program, 2004-2080
^{% of GDP}^{Present Value}
^{(trillions of $)}
^{Social Security}^0.9%^$4.7
^{Medicare 4.1}^20.5
^{Medicaid 1.7}^8.4
^{Other Entitlement}^S^pending^-0.1^-0.6
^{Defense and}^{Homeland Security}^{Discretionary Spending}^0.3^1.7
^{Non-Defense, Non-Homeland Se}^{curity Discretionary Spe}^nding^0.3^1.5
^Total^{7.2% $36.3}
^Source:^Aue^rbac^{h, Gale, and Or}^{szag, 200}^4.
^Note:^{See the text for a discussi}^{on of how the e}^{stimates were}^calculated.
Discretionary spending makes a small contribution to the fiscal gap, about two-thirds as much as
Social Security’s contribution. However, discretionary spending is assumed to fall to relatively
low levels by historical standards in this projection. If, instead, it remained at its current share of
GDP, both the fiscal gap and discretionary spending’s contribution to the fiscal gap would be
greater. Other entitlement spending (e.g., unemployment insurance) reduces the gap because it is
projected to be lower than its current share of revenue in the future.
As discussed above, the fiscal gap is not the result of spending or revenue policy decisions in
isolation, but rather represents the shortfall under current policy of past and projected future
revenue relative to past and projected future spending. Table 1 illustrates the contribution of
various spending programs to the fiscal gap given current revenue policy. The opposite should
also be able to be seen: the contribution of different revenue decisions given current spending
policy.
The major policy change affecting revenue in the past few years has been the 2001 tax cuts (P.L.
107-16), which were expanded and accelerated in 2003 (P.L. 108-27). Assuming that the tax cuts
are not allowed to sunset, Auerbach et al. have estimated that the 2001 and 2003 tax cuts have
increased the 75-year fiscal gap by an average of 2.2% of GDP or a total of $10.9 trillion in ⁵
present value terms. This equals nearly one-third of the total fiscal gap, and is larger than the
contribution of any single spending category except Medicare to the fiscal gap. The authors
estimate that total spending would need to be immediately reduced by 9% to cancel out the
effects of the tax cuts on the fiscal gap.

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Thus far, this report has presented data on the size of the fiscal gap and its causes. But why is it ⁶
important to Congress? This section discusses four reasons.
Estimates of the fiscal gap suggest that budget deficits would need to be reduced by 7.2% of GDP
annually between now and 2080 to keep the national debt stable as a share of GDP. Deficits at the
end of the projection will be even larger than the 75-year average. Financing deficits this large on
an ongoing basis would be unprecedented and lead to a continually rising national debt. If current
policy were not altered, at some point, creditors would likely conclude that they could not
reasonably expect the government to honor its debt and refuse to continue financing the deficit.
This would disrupt government operations, and lead to serious economic and financial
disruptions. The fiscal gap highlights this danger, while current year deficits, or even 10-year
deficit projections, do not.
Even if long-term budget deficits prove to be smaller than expected because of projection errors
or policy changes, large budget deficits would still have a negative effect on economic growth.
Private capital investment spending must be financed out of national saving or foreign borrowing.
National saving consists of household saving, business saving, and government saving; when the
government runs a budget deficit, it has a negative saving rate. In the case of no foreign
borrowing, the budget deficit is said to “crowd out” private investment because it is financed out
of private saving that is diverted from financing private investment. Since interest rates are
determined by the supply of national saving and investment demand, budget deficits raise interest
rates, all else being equal. Private investment is a source of economic growth; if budget deficits
crowd out private investment, then the future size of the economy will be smaller and future ⁷
living standards will be lower than they otherwise would have been.
To the extent that shortfalls in national saving can be financed through foreign borrowing, interest
rates will not rise and private investment will not be crowded out. But foreign borrowing comes
to the United States in the form of a trade deficit: Americans can borrow abroad only if they
import more than they export. While foreign borrowing is one factor that appears to have
prevented the budget deficit from pushing up interest rates at present, it is highly unlikely that the
United States could borrow enough abroad to prevent long-term crowding out of private
investment under current policy.

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The fiscal gap highlights the advantage of reforming current policy now, rather than waiting until
budget deficits become unsustainably large. Because of the power of compound interest, spending
cuts or tax increases that reduce the budget deficit today would reduce the fiscal gap more than if
the same spending cuts or tax increases were implemented in the future. That is because
reductions in the budget deficit would reduce interest payments on the national debt, which
compound to further reduce future deficits from what they otherwise would be. By contrast, if no
action is taken, the current trajectory of deficits will lead to a larger national debt, and higher
interest payments which will compound to increase future deficits further. For example, Auerbach
et al. estimate that if no action is taken between now and 2014, the fiscal gap will increase by
another 1.1 percentage points of GDP.
The fiscal gap measure also highlights the generational equity issues inherent in current policy.
While an unsustainably large fiscal gap may have little effect on economic outcomes today, it
portends significant reductions in economic output in the long-term future. Budget deficits allow
current generations to consume more than they otherwise would by borrowing against national
saving to finance spending. This implies that consumption is in effect being transferred from
future generations (since they will consume out of a smaller economy) to current generations
under current policy. To compound the generational transfer, the “pay-as-you-go” nature of
elderly entitlement spending means that if entitlement spending as a share of GDP increases as
current policy dictates, it would be financed through higher taxes on future workers. As a result of
these two factors, current policy makes current generations better off and future generations
worse off than if there were no fiscal gap.
Equity questions can be identified but not resolved by economic analysis—only the political
process can determine whether it is “fair” to transfer consumption from future generations to
current generations.
^{Marc L}^a^bon^t^e
^Specialis^{t i}ⁿ^Macroecon^o^mⁱ^c^P^o^licy
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