The U.S. government’s future obligations outweigh its projected revenues so heavily that it would need a permanent income tax increase of 66% or the immediate elimination of all federal discretionary spending to put it on track for balancing its finances.


Such is the startling conclusion of a report by Wharton insurance and risk management professor Kent Smetters and Cleveland Federal Reserve Bank economist Jagadeesh Gokhale. The two argue that the government’s accounting system is backward looking and so has failed to properly account for future outlays such as Social Security and Medicare.


Their report, “Fiscal and Generational Imbalances: New Budget Measures for New Priorities,” estimates that the “fiscal imbalance” – existing debt plus future projected deficits – is an enormous $45.47 trillion, expressed in 2003 dollars. That dwarfs the $3.8 trillion debt that the government officially reports. If steps are not taken immediately to correct the imbalance, it will rise to $53.96 trillion by 2008, the report says.


“Because the current structure of Social Security and Medicare involves long-term payment obligations, backward looking or short-term measures such as debt and deficits need to be complemented by long-term forward-looking ones that explicitly measure future payment obligations relative to the resources available to meet them under current laws,” the authors say, adding that adopting backward-looking measures “understates significantly the financial shortfall that the federal government faces under today’s fiscal policies.”  


Of this year’s total imbalance, $37.59 trillion, or almost 80%, comes from projected outlays on Medicare, reflecting the rising cost of caring for an ageing population, while Social Security accounts for $7.2 trillion – about a fifth of the Medicare number. Other government spending shows a relatively insignificant imbalance of $676 billion. The Bush administration’s tax cuts, now totaling $350 billion, are even less important in the overall calculation, Smetters said, although he declined to put a number on the tax cuts’ fiscal impact.


The fiscal gap could be even bigger because the Medicare estimate is based on “very conservative health-care growth assumptions,” Smetters noted in a May 28 Financial Times interview.


At the heart of the case is the concept of “present value,” which converts future receipts and outlays into current dollars by adjusting for inflation and discounting the value of future dollars by the amount the government pays for long-term borrowing. It uses the recent average of 30-year Treasury bond yields. Any attempt to correct the fiscal imbalance that did not use present-value numbers would miss more than 90% of future obligations, Smetters said.


Smetters and Gokhale have calculated the present value of the fiscal imbalance into perpetuity by discounting future dollars by the long-term rate each year. Dollars in the more distant future, therefore, are discounted more heavily than dollars paid or received in just a year or two. The authors then aggregate across the values of each year’s fiscal imbalance to arrive at their total fiscal imbalance. Attempting to measure the government’s level of imbalance by looking at only the government’s current official measure of public debt, but without measuring future obligations and revenue, would miss more than 90% of the true fiscal imbalance, Smetters said.


The present-value operation implies that the government should come up with the $45.47 trillion if it wishes to correct the fiscal imbalance immediately. Since that is clearly just a theoretical possibility, it will have to make future cuts or revenue increases of more than this amount so that the money, when discounted, equals the fiscal imbalance in today’s dollars.


To emphasize the burden on future obligations, the new accounting method also breaks down the fiscal imbalance by generations of those who receive Social Security, Medicare and other federal government services. The figures for Social Security show that living and past generations are projected to receive $8.9 trillion more in benefits than they have paid and will pay in taxes. Future generations, by contrast, are expected to pay $1.7 trillion more in taxes than they will receive in benefits, and so help to close the gap somewhat.


Medicare’s Rising Costs

When it comes to Medicare, the imbalance on account of future generations, at almost $22 trillion, outweighs that for past and current generations, which shows a gap of $15.7 trillion. The higher number for future generations reflects the rising cost of medical expenses per capita. Eliminating the imbalance on Medicare would require tax increases or service reductions to the tune of $37.59 trillion.


The report acknowledges that the government uses 75-year estimates of Social Security and Medicare shortfalls but says even these result in a significant understatement of the fiscal shortfall and therefore lead to policies that continue to focus on backward-looking measures. The five- and 10-year budget tables by the Office of Management and Budget and the non-partisan Congressional Budget Office are not stated in present-value form, the report notes.


Smetters and Gokhale also look at the 75-year horizon, a period approximately equal to a human lifespan, and conclude that the fiscal imbalance has a 2003 value of $17.1 trillion over that period.


Their 75-year projection is more persuasive than the perpetual accounting, according to Richard Kogan, senior fellow at the Center for Budget and Policy Priorities, a liberal-leaning Washington think-tank, because of the long-term assumptions about Medicare spending.


Kogan questions the heavy reliance on Medicare outlays on the grounds that future advances in medical technology are unknowable and could significantly affect the estimates of Medicare spending. “We really have no idea what Medicare and Medicaid costs are going to look like in 30 to 40 years, let alone 75 or further out. Things could be much worse or they could be much better.”


A $17 trillion fiscal gap would represent 3.3% of gross domestic product for the next 75 years, according to figures from the Social Security Administration. And if the government sought to eliminate the imbalance, it could do so with an across-the-board tax increase of 20%, a significant but not implausible number, Kogan argued.


As for the huge in-perpetuity numbers that have drawn so much attention, they may not be too surprising simply because of the mathematics involved, Kogan said. “Present-value infinity calculations often produce eye-popping numbers.”


Political Interference?

Smetters presented his case last March to the House Judiciary Committee in a hearing on a balanced-budget amendment to the Constitution. To illustrate the magnitude of the problem, he said the imbalance could be corrected by an increase of 16.3 percentage points – more than doubling – in the employee’s payroll tax on uncapped earnings used to pay for Medicare and Social Security. Such a measure would start in 2004 and be permanent. Waiting until 2008 to enact such a measure would mean an increase of 17.4 percentage points to achieve the same result, he said.


Alternatively, the government could consider shutting down half of its activities outside of Medicare and Social Security. Such a dramatic gesture would involve cutting departments such as homeland security, agriculture, commerce, education, and roads but even this would fail to completely fix the problem, leaving a fiscal imbalance of $3.2 trillion. “Shutting down half of the rest of the government forever is not enough to put the U.S. fiscal policy on a sustainable course,” Smetters told the committee.


Such measures were not put forward as policy advice because they would probably do severe economic damage, Smetters said in his testimony, but were presented as illustrations of the magnitude of the problem.  


The report was initially written as an internal discussion paper for former Treasury Secretary Paul O’Neill, when Smetters was deputy assistant secretary for economic policy at Treasury and Gokhale was a consultant there.


In an interview with Knowledge at Wharton, Smetters denied a report in the Financial Times on May 29 that the Bush administration chose to keep the report out of its 2004 Budget because it was trying to promote its tax-cut plan which critics say will expand the federal deficit.


“It was simply internal thinking,” Smetters said. “It was to try to help O’Neill think about it from an economic perspective. The whole conspiracy theory really had no legs.” He said the Administration had an incentive to incorporate his report into the Budget because it showed that the impact of the tax cuts on future obligations was insignificant compared with Social Security and Medicare, but it chose not to do so. There are “people in the Administration who are very excited about fixing the accounting,” he added, but declined to be more specific.


Democratic presidential contender Senator Joseph Lieberman, however, claims the Treasury “suppressed” the report at a time when the administration’s tax cuts are expected to reduce government revenues by as much as $1 trillion over 10 years.


In a letter to Treasury Secretary John Snow on June 4, Lieberman accused the administration of “stripping out” the report’s findings from the 2004 Budget at the last minute, “suggesting that this administration is trying to hide the true nature of our financial obligations from the American people in order to advance its agenda of cutting taxes indiscriminately.” He called for an explanation. As of June 12, Lieberman’s office had received no response from Treasury, said Lieberman counsel Chuck Ludlam.


Spokespeople from Treasury and the Office of Management and Budget did not return phone calls and emails seeking comment. White House spokesman Ari Fleischer was quoted by the Financial Times on May 30 as saying the administration agreed with the report’s conclusions and was concerned about the “crushing burden” of long-term deficits on taxpayers.


Hard Choices

Robert Inman, professor of finance and economics at Wharton, echoed Lieberman’s claims, saying the apparent exclusion of the Smetters report from the Budget was inspired by the tax-cutting agenda. “The Financial Times got it right,” Inman said. “It’s political. They have this whopping big tax cut and they know darn well that it’s going to lead to future tax hikes.”


The Smetters-Gokhale report shows that tax cuts are not affordable given the increasing burden of Social Security and Medicare spending in light of the ageing population, Inman said. “My instincts are that there are some very hard choices that have to be made in the federal sector.” He applauded the report, calling it “absolutely essential information for effective budgeting.”


The failure of government to properly address long-term obligations reflects a refusal by the electorate to look beyond the short term, and a naivete about taxation and federal spending, noted Olivia Mitchell, professor of insurance and risk management at Wharton. “Many people think there’s a bank account where their contributions have been piling up and which they can draw on when the time comes. They don’t realize that the money is collected from those who are working and then goes straight to the retirees.”


Mitchell, who in 2001 served on the President’s Commission to Strengthen Social Security, a bipartisan panel to examine the government’s future pension obligations, called the Smetters-Gokhale report a “great service” that will allow policymakers to look beyond the 75-year horizon that has been the traditional limit of budget planning.


In his testimony to the House Judiciary Committee, Smetters drew a parallel between the government’s accounting methods and those of some corporations whose practices have recently undermined confidence in financial reporting.


“We have seen in the past year how dubious private-sector accounting hides large cash-flow shortfalls for a period of time, only to be revealed later at a great loss to pensioners and other shareholders,” he said. “The federal government now needs to lead by example by getting its own books into shape as well.”