Tightening the Terms of the Social Contract

Whatever one’s views of the New Deal, it is undeniable that it transformed the role of the federal government in American life, with the advent of Social Security at or near the top of the list of important changes. The program, which was central to President Franklin Roosevelt’s vision of an expanded social welfare system, was met with rapid public approval and led a generation later to Medicare, which now occupies a similarly lofty position in the public psyche.

These programs, which have grown into the largest line items in the federal budget, are seen as essential supports in old age, but they are not cost-free. They are now the principal sources of long-term fiscal concern, particularly in the case of Medicare, because the original concept of tying benefit payouts to the taxes paid by workers has been stretched. The current and projected borrowing needed to fill the gap is the most important reason the federal government is now skating on the edge of a fiscal crisis.

Charting a safer course has been elusive because the politics are challenging, to say the least. As Roosevelt predicted, voters believe they “paid for” these programs irrespective of the reality, and thus they contest the premise that reform is even necessary. There is no simple way around this public skepticism, but the odds might improve if policymakers sold the needed changes as a recommitment to the original principles upon which the programs were built.

Not “Relief”

Social Security’s popularity was planned. Roosevelt’s insight was that paying for old age benefits with “contributions” from workers, and tethering the benefit entitlement to those contributions, would erect an immense political wall around it.

He was right and knew he would be. After Social Security was launched, he was told the payroll tax—a levy on work—might become counterproductive during economic slowdowns but was unmoved. To him, cultivating the perception that workers pay for their benefits was more important. In his famous formulation, “with those taxes in there, no damn politician could ever scrap my social security.”

And so it has been. Americans have never viewed Social Security as one more social welfare program. To them, it is “their money.” Attempts to change the benefit formula are viewed with utmost suspicion.

Two other program characteristics reinforce the public impression. First, Social Security benefits are related, albeit loosely, to the amounts workers pay in taxes. The formula is weighted in favor of low earners, but, with many exceptions, the more workers “contribute,” the higher the monthly benefit they receive in retirement. This design may not be ideal as a policy matter, as it directs public resources toward middle and upper-middle-class households that might be more usefully sent to those with the lowest earnings. Nevertheless, there is no question of its political value in sustaining public support for the program.

Second, Social Security receipts and spending are tracked in two “trust funds” (for old age and survivors; and disability benefits) that were created to encourage elected leaders to enforce the program’s self-financing principle across generations (the disability fund was added to the account for old age protection in the 1950s; other legislative expansions also provided family support benefits to the payouts for eligible workers). The prominence of the trust fund accounting convention has further deepened the perception that the “workers’ money” has been set aside from the rest of the federal budget and is reserved for payouts to eligible beneficiaries.

The Medicare Addendum

Social Security’s rapid acceptance played an important part in opening the door to a federal role in health care too. It was a crooked path, however.

In the 1930s and 1940s, Democrats were focused on building a nationalized system of health insurance, much as like-minded parties were doing in Europe. Those ambitions were deflated, however, when a push by President Truman in 1945 failed to gain sufficient support in Congress, largely because the nation’s physicians organized an effective opposition campaign. That plan was then set aside for good shortly after Republicans took control of the House following the November 1946 midterm election.

When Democrats next saw the potential for a breakthrough—in the months following Lyndon Johnson’s 1964 landslide victory—they opted for a different approach. Instead of a nationalized system, the target was an incremental expansion modeled on Social Security because of the program’s immense public support. The new program would offer retirees coverage for hospitalization costs financed with an add-on to the payroll tax during their working years, with the claims paid from a new Medicare Hospital Insurance (HI) trust fund.

While the Medicare HI concept had been discussed within the party for several years, the program’s construction took a surprising and consequential turn at the 11th hour. The powerful chairman of the House Ways and Means Committee, Wilbur Mills, suggested that there should be a voluntary supplement to pay for physician services too (the GOP was then in favor of a voluntary system to counter the compulsory design favored by Democrats). Billed as Medicare Part B and financed from a separate account (the Supplementary Medical Insurance trust fund), this additional coverage would be financed from beneficiary premiums and subsidies from the Treasury, not payroll taxes.

The Johnson administration’s eager acceptance of the Mills amendment (which also included the creation of Medicaid) has had lasting effects on the federal budget. Prior to the 1960s, the federal government financed almost all of its expenditures through annually appropriated spending. The main exception was Social Security, but it had a trust fund that was supposed to ensure fiscal discipline by limiting expenditures to the taxes devoted to it.

SMI (Supplementary Medical Insurance) was something altogether different. It had the appearance of being a trust fund, but it received substantial, and uncapped, subsidies from the Treasury’s general fund, with the transfers set to ensure costs not paid for with premiums would be fully financed.

The general fund is the catch-all ledger in the Treasury into which all federal receipts and spending are first assigned before being divvied up among the government’s complex array of program-specific accounts. The Treasury office responsible for debt management borrows as needed to cover federal costs not payable from taxes when the bills are presented to the general fund, which means it has borrowed substantially over the years to cover SMI costs. In 1970, the general fund transfer to SMI was equal to just 0.2 percent of GDP. By 2000, it had grown to 0.7 percent annually, and it is now the equivalent of 1.6 percent of GDP each year. These transfers appear costless but in fact are a burden on taxpayers, as they must be financed from current revenue or debt that must be paid back in future years.

The rupture with past budget practice that the Great Society ushered in with Medicare and other programs has spread in the intervening years, with many programs now financed directly by the Treasury without the need for an annual appropriation from Congress. Among the largest programs that are financed in this fashion are Medicaid and the Supplemental Nutrition Assistance Program (formerly food stamps).

Relentless Growth

The popularity and design of both Social Security and Medicare allowed them to grow rapidly for many years without hitting a financial wall. It helped that an expanding labor force, fueled by the baby boom generation and expanding opportunities for women, pushed up revenue that accommodated a steady stream of benefit expansions. Higher taxes also papered over the costs to the government from changing the original 50-50 split between premiums and general fund financing for Medicare SMI to 25-75, which occurred gradually in the 1970s as rapid cost growth made it politically challenging for Congress to pass on half of the annual spending bump to the beneficiaries.

By 1990, the long period of benefit liberalizations that began with the New Deal had pushed the combined spending on Social Security and Medicare to 6.0 percent of GDP, which was 2.5 percentage points above the level of spending in 1970.

Since that time, there has been steady fiscal deterioration (with intermittent but temporary reprieves) owing to the aging of the population and healthcare cost escalation in excess of economic growth. The ratio of persons aged 65 and older to those aged 20 to 64, which was 0.209 in 1990, is now 0.307 and will rise to 0.384 in 2050, according to the government’s official projections. For Social Security, this shift will lead to the exhaustion of the combined reserves of the program’s two trust funds in 2034. For Medicare HI, insolvency is expected in 2031.

The effects of the widening gap between Social Security and Medicare receipts and spending are pushing the federal government toward a fiscal reckoning. The Congressional Budget Office (CBO), the non-partisan budgetary scorekeeper for the House and Senate, issues new 30-year projections of federal revenue, spending, and debt each year. In its most recent forecast, the agency expects cumulative federal debt to reach 183 percent of GDP in 2053 if the government were to cover Social Security and Medicare deficits with more borrowing. At the end of 2008, federal debt was only 40 percent of GDP.

It is perhaps a mix of good and bad news to note that fixing Social Security and Medicare would by itself substantially lessen the possibility of the country stumbling into a fiscal crisis. In CBO’s forecast of current policies, the government’s primary deficit, which is the gap between revenue and the government’s non-interest expenditures, would be 3.3 percent of GDP in 2040. Closing the non-interest deficits for Social Security (1.3 percent) and Medicare HI (0.3 percent) would eliminate half of it. Preventing the general fund contribution to Medicare SMI from rising from its level in 2023 (1.6 percent of GDP) would close another 33 percent. In all, more than 80 percent of the current financial hole in the federal budget—not counting the servicing of existing debt—would be filled by ensuring the government’s main programs for the elderly are sustainably financed over the long term.

There is now a growing danger that both Social Security and Medicare will be financed from more borrowing because, while the voters assume the old principles still apply, policymakers have been unwilling to enforce what they would require by way of adjustments.

Conflicting Visions

Identifying the benefits of a solution is far easier than getting a bill passed in Congress.

The challenge is accentuated by the accelerating proliferation of views on what principles should guide Social Security and Medicare reforms. Some elected officials would like to amend the current formulas to lower costs, while others advocate finding more revenue. Neither side has yet been able to build a broad coalition of support.

For his part, President Biden is emphasizing moving away from the original Social Security construct. As conceived by Roosevelt, workers paid for their benefits with contributions during their working lives. The program was made progressive through preferential benefits for lower-wage workers, not by taxing the rich. Medicare was promoted on similar terms.

The president argues that growing income inequality demands a new approach. While he has yet to offer a specific fix for Social Security, he has pledged to protect all workers with annual incomes below $400,000, which means he is ruling out a traditional increase in the payroll tax. The implication is that he will find a new source of revenue paid only by upper-income households.

This position represents a notable break from past practice, as raising the payroll tax was a main route to stabilizing program financing from the program’s launch through the 1970s.

For Medicare, the president proposes raising taxes on wage and non-wage income to cover the HI shortfall, but only for taxpayers with incomes exceeding $400,000. He would also redirect savings from drug price cuts from SMI to the HI trust fund. He has offered no proposals to limit the government’s general fund transfer to the SMI trust fund.

Toward Self-Correcting Programs

The political standoff seems insurmountable at the moment but the rapid depletion of reserves in the trust funds means that something will need to be done relatively soon. Elected officials should be searching for a way forward that has the potential to draw support from the two major parties and substantially reduce the government’s borrowing requirements over the long term.

Without ruling out other changes, one option would be to work with the public perception that taxes paid by workers fully cover the costs of their benefits, and that the Social Security and Medicare trust funds impose no financial burden on the broader federal budget. It is possible to translate those concepts more explicitly into the programs’ designs.

The first step would be to limit the tap on the general fund by SMI. In 2023, the transfer is set at 1.6 percent of GDP. As noted, drawing the line there would ease the pressure on the overall budget but at the expense of Medicare’s financial support. In other words, this step would mean that the reforms needed in Medicare must go beyond just shoring up the HI trust fund.

Second, the trust funds for both Social Security and Medicare must be elevated as budgetary devices. It is presumed that current law already prohibits spending by Social Security and Medicare when there are no funds in their trust funds to draw upon. With no reserves, the programs can only spend what comes in, which is expected to be far below what their formulas normally require. However, there is no provision in law that directs how a breach should be closed. The general expectation is that the agencies administering the programs would order across-the-board spending cuts.

A more formal process for preventing trust fund deficits would be salutary and might help encourage consideration of other options.

For Social Security, automatic adjustments could assign half of the required financial remedy to higher payroll taxes and the rest to benefit cuts. The adjustments could commence if the actuaries forecast a persistent gap emerging within five years. The formulas should allow for gradual transitions to prevent abrupt shifts on taxpayers and beneficiaries. Congress could also choose to weight the adjustments so that they fall more heavily on new entrants than current beneficiaries, and also protect the lowest-income retirees from any changes by pushing deeper cuts onto those with the highest lifetime earnings.

In Medicare, the possibilities for adjustments are too numerous to note comprehensively but mostly involve lowering payment rates for service providers, along with a payroll tax rate hike. Like Social Security, the burden of closing a projected gap could be split automatically 50-50 between current workers, via payroll tax increases, and current program spending. Medicare’s cost-sharing requirements might also be adjusted to reduce expenditures too.

None of this will be popular, of course. And, if offered as a fix, it would surely invite vigorous debate and the presentation of alternative schemes. That would be welcome. However, given the inability of the parties to advance their ideas without needing support from the other side, and the threat posed by continued drift, it is imperative to build into the programs a default mechanism that ensures financial stability without major changes to how the programs operate. If, when faced with the triggering of such adjustments, Congress chooses to pass a different solution, that would be a vindication of ruling out as an option permanent deficit spending.

What should not be allowed is procrastination to the point of a crisis. That was certainly not the original vision. The program’s architects wanted the American people to own Social Security by paying for it themselves, or at least to have the strong impression that this was the case. There is now a growing danger that both Social Security and Medicare will be financed from more borrowing because, while the voters assume the old principles still apply, policymakers have been unwilling to enforce what they would require.

There is nothing sacrosanct about the original conception of Social Security and Medicare, but national leaders have also never presented an alternative that could elicit sufficient support to supplant it. Congress should therefore work with what is already in law and build into the programs’ trust funds strict requirements limiting what is spent to what is collected from clearly defined sources of revenue. The changes, if phased in, would be reasonable in scale, and would ensure future generations of workers are treated as fairly by the nation’s implicit social contract as were those for whom it was first written.