By Andrew G. Biggs Thursday, September 16, 2010
Filed under: Economic Policy, Government & Politics, Public Square
In an op-ed in the Wall Street Journal, AEI President Arthur Brooks and Representative Paul Ryan (R-Wisconsin) discuss why America continues to have big government even though Americans consistently tell pollsters that they’d prefer smaller government. The Left answers that Americans suffer from some form of cognitive dissonance, in which they retain nominal loyalty to an outmoded view (from the Left’s perspective) of the government’s role , while in practice embracing the benefits of expansive government.
Brooks and Ryan answer that, despite Americans’ broader preferences, elected officials present the public with marginal choices in which bigger government always wins. Feed hungry children? Check. Keep grandma out of poverty? Check. Once you check enough of these boxes, you end up with big government even if you say you’d prefer something smaller. Brooks and Ryan argue that citizens need to be presented with larger, macro-oriented choices rather than incremental ones, since only with big choices do voters focus on the larger decisions that need to be made. I agree with this strategy.
But I think there’s an alternate explanation that may better account for the growth of government and also show why that growth is so hard to stop. While aid for vulnerable groups obviously drives a lot of government spending, we could lift every American, young or old, above the poverty line with government transfers of around 1 percent of gross domestic product (GDP). Yet the federal government today spends more than 25 percent of GDP. Big government isn’t generated by caring for the truly poor; after all, despite spending 25 times more than needed to fill the poverty gap, we nevertheless leave millions in poverty. Rather, rising pension and health spending on middle- and upper-class Americans—principally through the Social Security, Medicare, and Medicaid programs—is the true fiscal burden and the largest imposition on personal choice and freedom. Without these three programs, the current size of government would be much smaller and the dangers of future fiscal catastrophe due to rising spending and debt would be all but eliminated. The question is: How did we get here?
One answer is that rising spending is facilitated by how we finance entitlement programs; under a “pay-as-you-go” approach, legislators promise benefits before funding them producing an inexorable upward creep in total costs. This contrasts with private-sector pensions, which are generally pre-funded. Rather than amassing assets to fund obligations as they are generated, entitlement programs generate benefit obligations today, which are paid for out of tax revenues tomorrow. For instance, by working today I become entitled to Medicare benefits in retirement, but those benefits will be financed by taxes future workers will pay.
Why does this matter? The universal pattern for entitlement programs is to start small, then grow. Initial benefits or eligibility may be modest, keeping today’s costs low. But over time benefits and eligibility rise, raising costs alongside them. When benefits are financed on a pay-as-you-go basis, current taxpayers can be promised a generous benefit in future years in exchange for only modest payments today. Once today’s taxpayers reach retirement they feel fully entitled to their benefits, even if the taxes they paid were nowhere near enough to fund the benefits they will receive. (I calculated that a new retirees’ lifetime Medicare benefits will be about $100,000 more than the taxes he paid while working.) We have heard even Republican politicians say that current retirees paid Medicare taxes during their working years and therefore deserve every penny of their benefits in retirement. The fact that the taxes paid aren’t nearly enough to finance the benefits promised falls by the wayside.
All our entitlement programs promise overgenerous benefits relative to current taxes, and in theory can be resolved either by raising taxes or reducing benefits. But because beneficiaries have been told they paid for and earned their benefits, they present a pseudo-moral case for raising taxes rather than reducing benefits. (A true moral case would exist if beneficiaries actually had paid taxes sufficient to fund their benefits.) Pay-as-you-go financing biases policy toward promising rising benefits over time and biases politics toward raising taxes to whatever level necessary to pay them.
One would think that, if pay-as-you-go financed programs bias policy and politics toward unsustainably large benefit obligations and tax levels, the solution would be to switch entitlements toward pre-funding. In a pre-funded program, citizens receive only the benefits that they as a cohort are willing to pay for. There is no way for today&rsqu
But here the effects of pay-as-you-go financing are most insidious. As I noted in a recent National Review column on why Social Security reform has proved so difficult, shifting from a pay-as-you-go program to a funded system entails significant “transition costs,” which are borne by the very citizens who would decide to make the change. Since today’s Social Security, Medicare, and Medicaid benefits are paid from today’s taxes, if we decide to pre-fund these programs then the current generation must pay twice: first for current beneficiaries, and second for their own benefits. Put simply, to shift from an unfunded program to a funded program, someone must contribute extra funds. When the defining characteristic of domestic policy has been for voters to shift their own cost burdens to future generations, it is highly optimistic to expect current voters to accept a double burden. The expected result is to kick the can down the road, such that deficits grow and future taxpayers become even worse off. My own take: it was the transition costs associated with Social Security personal accounts, more than the risk of investing Social Security taxes in stocks, that doomed President Bush’s 2005 reform drive to failure.
In a pre-funded program, we can change the size and the form of the system at any time without incurring large costs. For instance, a fully funded, defined-benefit pension system could shift to a defined contribution program of personal accounts without cost. Likewise, if a fully funded plan decided to increase its size and generosity, the plan must immediately begin amassing extra assets to fund those extra benefits. These disciplines are largely absent in programs financed on a pay-as-you-go basis and, in my view, account in large part for the current level and projected growth of government.
Brooks and Ryan are right to argue for big choices, since it is only by confronting these choices that we can arrest creeping statism. But having looked at how we got here, those who value individual and economic freedom have a difficult task at hand in resolving this issue.
Andrew G. Biggs is a resident scholar at the American Enterprise Institute.
Image by Rob Green/Bergman Group.
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