"Innovation" Isn't Enough to Fix Entitlements

Last month, I attended the Conservative Political Action Conference, where I spent a lot of time talking about entitlement reform. Entitlement costs, especially those related to health care, are exploding: over the next 25 years, federal spending on Medicare and Medicaid is expected to nearly double from about 5.3% of GDP to 10%, and will continue rising thereafter.

I kept repeating one message. Any discussion of restraining federal taxation and maintaining the current size of government -- let alone shrinking it -- must start with entitlement reform that controls costs. And that means making hard choices, like raising retirement ages and cutting benefits.

During the conference, I had a radio host ask me a revealing question, which I think demonstrates why many activists have failed to grasp the centrality of the entitlement issue. He noted that private businesses respond to rising costs by innovating, or figuring out how to produce an equally good product by using fewer resources. Can't we apply that approach to Social Security and Medicare?

The answer, unfortunately, is "no" for Social Security and "only partly" for Medicare. Because of the nature of entitlement programs, innovation and efficiency improvements can only play a limited role in controlling their costs.

Let's start with Social Security, where innovation is essentially useless. It's hard to imagine a simpler government program than Social Security, which involves taking money from some people and sending it to other people. No amount of innovation will allow the government to send out a $1,000 check at a cost below $1,000.

And the Social Security Administration has little non-benefit fat to cut -- over 98% of Social Security's costs go to benefits, meaning opportunities for savings in overhead are severely limited. The only ways to save real money on Social Security are to send out smaller checks or fewer checks.

One innovative proposal for Social Security -- private accounts -- isn't a money saver either. Every payroll tax dollar moved to a private account is one that the government can't use to finance current operations -- and therefore a dollar that the government must now borrow in public markets. The rise in government-issued debt would soak up exactly the amount of capital unleashed in accounts, and the economic effect would be a wash.

Of course, the government could cut other spending to avoid issuing more debt. Rep. Paul Ryan's Roadmap plan, which I profiled two weeks ago, couples private Social Security accounts with benefit cuts and increases in the retirement age. But it's the non-innovative components of Ryan's plan that provide real savings: the CBO found that his plan would cut the deficit more if he scrapped privatization and kept his other Social Security reforms.

Innovation has a greater role to play in medical entitlement reform. Unlike Social Security, Medicare and Medicaid involve the government funding services for beneficiaries -- and those services could be made more efficient. For example, tort reform would likely lead to a modest reduction in health care costs. Tax and insurance reforms to reduce incentives for health care overconsumption would also reduce the cost of care, and therefore Medicare costs.

The trouble is that these reforms can only fix some of the phenomena driving higher Medicare costs. Three of the biggest cost increase drivers -- expensive new medical advances, flat medical productivity, and an aging population -- would be unaffected.

There is constant innovation in health care technology. But the usual nature of these advances is to make available better care at greater cost -- not to offer the same or better care at lower cost. Improvements in technology provide great social benefits and increase life expectancies, but they also increase costs.

We can also expect continued cost growth because medical innovation does not substantially increase health care workers' output. While mechanization has drastically reduced the number of autoworkers needed to make a car, it still takes approximately the same number of medical professionals to treat a patient as it did decades ago.

Flat productivity does not just mean flat labor costs. In fact, labor costs must rise to keep pace with other fields that have seen productivity gains -- otherwise knowledge workers would flee the medical sector. Therefore, medical costs rise relative to the cost of other goods and services.

This is a phenomenon of Baumol's Cost Disease, where sectors that lag in productivity growth see cost increases above the inflation rate. Other classic Baumol sectors include education (technology does not help teachers handle more students, so tuition skyrockets) and live performances (it takes the same number of actors to stage Hamlet today as it did 400 years ago).

Government policy can't do much to change this phenomenon. That's a key reason why other advanced countries -- which historically have been much more successful than America in holding down health care consumption and costs -- are seeing similar percentage growth in health care costs.

Most importantly, demographics drive rising entitlement costs -- while Medicare's eligibility age has been unchanged at 65 since 1967, life expectancy at age 65 grew from 14.5 years in 1967 to 18.5 years in 2006. The Social Security Administration believes this figure could reach 20.5 years by 2035, meaning the average Medicare beneficiary would live to age 85.

Essentially, in 1967, the average Medicare beneficiary could expect to spend 18% of his or her life receiving Medicare benefits. By 2006, that figure was 22%, and in 2035 (assuming no change in the retirement age) it will be 24%. There is only one way to restrain growth in this figure, unless you count sending the elderly out to die on ice floes as an option.

So, if innovation isn't the answer to exploding entitlement costs, what is? The answer is simple, but not easy: entitlements must be made sustainable through benefit cuts, tax increases, or a combination.

Benefit cuts can take the form of retirement age increases, means testing, and reduced rates of growth in benefit value. On the Medicare side, cuts' effects can be somewhat blunted through policy changes that reduce the cost of care. Paul Ryan's Roadmap plan combines all these approaches, but it may cut the value of Medicare benefits below a level that is acceptable to the public -- and it still takes 40 years to cut the federal budget deficit below 2% of GDP.

On the tax side, potential revenue sources include increases in payroll or income tax, elimination of tax deductions, and introduction of VAT. Any increase in marginal tax rates will have negative economic effects, but some of these choices would be more damaging than others. Tax increases specifically targeted at high-income people could raise some additional revenue (at significant economic cost) but would not be sufficient to close the gap.

Doing nothing is an option now, but not forever. Staying on our current fiscal course will take the ratio of public debt to GDP over 100% by the mid-2020s, putting us in a club with fiscal powerhouses like Greece and Italy. Eventually, we will need to reckon with the entitlement monster, and "innovation" alone will not save us.