Payroll Taxes Cover About a Third of Medicare Costs

I get the impression that many Americans believe Medicare is financed like Social Security. They know that a portion of payroll taxes goes to Social Security and a portion goes to Medicare. So they conclude workers are paying for Medicare benefits the same way they are paying for Social Security benefits.

That isn’t remotely true, as new data from the Congressional Budget Office demonstrate.

In 2010, payroll taxes covered a little more than a third of Medicare’s costs. Beneficiary premiums (and some other earmarked receipts) covered about a seventh. General revenues (which include borrowing) covered the remainder, slightly more than half of total Medicare costs.

If you prefer to focus on just the government’s share of Medicare (i.e., after premiums and similar payments by or on behalf of beneficiaries), then payroll taxes covered about 40% of the program, and other revenues and borrowing covered about 60%.

In contrast, payroll taxes and other earmarked taxes covered more than 93% of Social Security’s costs in 2010, and that was after many years of surpluses.

The difference between the two programs exists because payroll taxes finance almost all of Social Security, but only one part of Medicare, the Part A program for hospital insurance. Parts B and D (doctors and prescription drugs) don’t get payroll revenues; instead, they are covered by premiums and general revenues. But that distinction often gets lost in public discussion of Medicare financing.

As recently at 2000, general revenues covered only a quarter of Medicare’s costs. That share has increased because of the creation of the prescription drug benefit in 2003 and because population aging and rising health care costs have pushed Medicare spending up faster than worker wages. Over the next decade, CBO projects that premiums will cover a somewhat larger share of overall costs, while the general revenue share will slightly decline.

Note: For simplicity, I have focused on the annual flow of taxes and benefits. The same insight applies if you want to think of Social Security and Medicare as programs in which workers pay payroll taxes to earn future benefits. That’s approximately true for workers as a whole in Social Security (but with notable differences across individuals and age cohorts and uncertainty about what the future will bring). But it’s not true at all for Medicare.

The Rhetoric of Economic Policy: Inequality vs. Dispersion

Rhetoric matters in economic policy debates. Would allowing people to purchase health insurance from the federal government be a public option, a government plan, or a public plan? Would investment accounts in Social Security be private accounts, personal accounts, or individual accounts? (See my post on the rule of three.) Are tax breaks really tax cuts or spending in disguise? Is the tax levied on the assets of the recently departed an estate tax or a death tax?

In an excellent piece in the New York Times, Eduardo Porter describes another important example, how we characterize differences in income:

Alan Krueger, Mr. Obama’s top economic adviser, offers a telling illustration of the changing views on income inequality. In the 1990s he preferred to call it “dispersion,” which stripped it of a negative connotation.

 In 2003, in an essay called “Inequality, Too Much of a Good Thing” Mr. Krueger proposed that “societies must strike a balance between the beneficial incentive effects of inequality and the harmful welfare-decreasing effects of inequality.” Last January he took another step: “the rise in income dispersion — along so many dimensions — has gotten to be so high, that I now think that inequality is a more appropriate term.”

More Budget Foxes, Fewer Hedgehogs

My latest column at the Christian Science Monitor:

America’s fiscal challenges are often portrayed as a conflict between hawks and doves. The real battle, however, is between foxes and hedgehogs.

Unfortunately, fiscal hedgehogs still have the upper paw.

“The fox knows many things, but the hedgehog knows one big thing,” wrote the ancient Greek poet Archilochus. Both foxes and hedgehogs play important roles in the policy ecosystem in normal times. In times of great change, however, society needs more foxes and fewer hedgehogs. More citizens and leaders who can adapt to new conditions, and fewer who want to preserve the status quo.

That’s where we find ourselves today. Despite all the anguish over a debt limit deal, America’s fiscal outlook remains daunting. Little progress has been made on our largest budget challenges. Despite bipartisan efforts, prospects for a grand fiscal bargain remain dim.

One reason is that fiscal hedgehogs still have the upper paw on key issues.

Consider entitlements. Everyone knows that entitlement spending is our No. 1 long-term budget challenge. Because of an aging population and rising health-care costs, spending on Social Security and federal health programs will explode. The Congressional Budget Office estimates that over the next 25 years spending on these programs will rise from roughly 10 percent of the economy to almost 17 percent. Accommodating that growth would require substantial cuts in other government programs, much higher tax revenues, or unsustainable deficits and debt.

The challenge is to find ways to keep the core benefits of these programs while reining in costs. This is where entitlement hedgehogs and foxes part company.

The hedgehogs know one big thing: These programs provide major benefits. Social Security, for example, has dramatically reduced poverty among seniors and provides essential income to millions of retirees.

Inspired by that one big thing, hedgehogs oppose any benefit reductions, such as increasing the eligibility age or trimming benefits to reflect increased longevity.

Entitlement foxes have a more nuanced view. They recognize, like the hedgehogs, the value of the guaranteed retirement income that Social Security provides. But they also know that the number of retirees receiving benefits is growing faster than the number of workers paying payroll taxes. They know that Americans are living longer but retiring earlier. They know, in short, that the future will be different from the past and that the program needs to evolve to remain sustainable. Foxes are thus open to ideas like raising the eligibility age or changing the benefit formula.

A similar dichotomy exists with taxes. Revenue hedgehogs know one big thing: Taxes place a burden on taxpayers and the economy. Thus, they oppose all tax increases, even efforts to reduce the many tax breaks that complicate our tax code.

Revenue foxes see things differently. They recognize the burden that taxes place on taxpayers and the economy. But they also know that tax increases are not all created equal. Higher tax rates, for example, are usually worse for the economy than cutting back on tax breaks. Indeed, cutting tax breaks sometimes frees taxpayers to make decisions based on real economic considerations rather than taxes, thus strengthening the economy. That’s why revenue foxes support eliminating many tax breaks.

Fiscal hedgehogs will never embrace such changes. To make progress, we need more fiscal foxes.

Chain, Chain, Chain, Chain CPI

Over at the Moment of Truth project (a continuation of the president’s fiscal commission), Adam Rosenberg and Marc Goldwein make a compelling case that the government should use a different inflation measure when calculating cost of living increases and indexing the tax code:

Maintaining purchasing power in spending programs and indexing various parts of the tax code is an important policy goal. However, policymakers should ensure that the most accurate measure of inflation is being used.

To correct the problem of over-indexation, many have proposed switching to the chained CPI [consumer price index] to provide a more accurate measure of inflation for indexed provisions in the federal budget. This switch was recommended by the National Commission on Fiscal Responsibility and Reform (“Fiscal Commission”) and the Bipartisan Policy Center ‘s Debt Reduction Task Force (“Domenici-Rivlin”). It has been incorporated into a large number of other plans, including from the Heritage Foundation on the right and the Center for American Progress on the left. An overwhelming majority of economists from both parties agree that the chained CPI is far more accurate measure of inflation than the CPI measurements currently in use.

In addition to improving technical accuracy, switching to chained CPI would have the secondary benefit of reducing the deficit – by about $300 billion over the next decade alone.

For the reasons they mention, I endorse this change and predict it will be part of any “grand bargain” on America’s budget.

With apologies to Aretha Franklin (and any of you with sensitive music sensibiities), let me suggest a theme song for the effort:

Chain, Chain, Chain, Chain CPI

Chain, chain, chain, chain, chain, chain

Chain, chain, chain, chain CPI

For these long years, we have indexed all wrong

We pay too much, that leads to fiscal pain

And now money’s getting tight

But we have no need to cry

We know what to do, oh a better measure we can try

Chain, chain, chain, chain CPI

P.S. To my readers who believe that the regular CPI understates inflation, rather than overstating it: Yes, Aretha’s song is “Chain of Fools”. And yes, that makes it easy for you to make up lyrics that mock the chain CPI rather than endorse it. Have fun.

Another Deficit Panel at the Milken Conference

A few hours after attending the “Attention Deficit” panel at the Milken Global Conference, I spoke on a panel about another deficit you may have heard about: “The Federal Deficit: What Options Are Really on the Table?”
My fellow panelists were:

Charles Blahous, Research Fellow, Hoover Institution

Peter Passell, Senior Fellow, Milken Institute; Editor, The Milken Institute Review (pinch-hitting for budget guru Alice Rivlin, whose flight from Washington didn’t cooperate)

Andy Stern, Senior Fellow, Georgetown Public Policy Institute; former President, SEIU

Moderator, Jim McCaughan, CEO, Principal Global Investors

Here’s a link to video of our panel; a bit more than an hour.

Bowles-Simpson, Health Insurance, Social Security, and Payroll Taxes

The other day I discussed the Tax Policy Center’s distributional analysis of the Bowles-Simpson tax proposal. As you may recall, a key feature of the proposal we considered (“Option 1”) is that it eliminates almost all existing tax breaks and reduces tax rates on most types of income (but raises them on capital gains and dividends).

We subsequently learned that we misinterpreted one aspect of the Bowles-Simpson proposal. As a result, we posted an updated distributional analysis yesterday. Let me turn the mike over to Howard Gleckman at TaxVox:

One of the most dramatic elements of the tax reform plan offered by the chairs of President Obama’s deficit commission, Erskine Bowles and Alan Simpson, was their proposal to eliminate tax breaks for employer-sponsored health insurance, contributions to retirement plans, and other employee benefits. When the Tax Policy Center did its first analysis of that proposal on November 16, our modelers assumed (perfectly reasonably) that if these benefits were now subject to income tax, workers would have to pay Social Security and Medicare payroll taxes on them as well.

Because these tax subsidies are so generous, a payroll tax on their value would generate a lot of money—more than $100 billion a year. And that extra levy would have a noticeable impact on the how taxes would be distributed among various earners under the plan. But after we published our analysis, the Bowles-Simpson staff told us they did not intend to hit workers with payroll tax on this income as well.

So TPC has run a new distributional analysis for the Bowles-Simpson plan without those extra payroll taxes. It turns out that everyone still pays more tax on average, but less, of course, than if they were hit with bigger payroll taxes. The lowest 20 percent of earners (who will make an average of about $12,000 in 2015 and who pay far more in payroll tax than in income tax) would pay about $200 more than they do today, instead of an average of $400 if they took a payroll tax hit as well. Their typical after-tax income would be cut by 2 percent, instead of 3.4 percent if they had to pay that extra payroll tax.

Middle-income earners (who’ll make about $60,000) will pay about $1,000 more instead of $1,900. Their after-tax income would be cut by about 2.2 percent instead of 4 percent. People at the top 0.1 percent of the economic food chain would also save about $1,000. But when you’re making an average of $9 million, and paying a half a million in new taxes, an additional thousand bucks is easily lost in the sofa cushions.

You can also see the importance of the payroll tax effect in the debt reduction proposal released on Wednesday by a Bipartisan Policy Center task force on which I served. In that proposal, the rollback affects both payroll taxes and income taxes. The extra Social Security revenues from phasing out the tax exemption for employer-sponsored health insurance account for about one-third of the plan’s overall improvement in Social Security solvency.

Bottom line: When you are cutting tax breaks, it’s a big deal whether you do that for payroll taxes as well as income taxes.

Another Year Without a Social Security COLA

It looks like 2011 will be another year without a cost-of-living adjustment (COLA) for Social Security recipients. Why? Because consumer prices haven’t yet returned to the peak they reached in the third quarter of 2008, when the 2009 COLA was set.

Beneficiaries received a healthy 5.8% boost in their payments in 2009, which made sense after the sharp run-up in energy prices in 2008. But then energy prices collapsed. The inflation rate used to calculate the COLA was negative from 2008 to 2009. The cold logic of cost-of-living adjustments would thus have implied a reduction in Social Security benefits in 2010. For understandable reasons, however, Social Security doesn’t allow negative COLAs. So benefits remained flat, and 2010 went into the record books as the year without a COLA.

The same thing will happen in 2011. Consumer prices have increased since the third quarter of 2009, but as of the August CPI report, they still fell far short of the peak reached back in 2008. Barring a miraculous surge in inflation in September, that means that 2011 will be the second year without a COLA.

The Social Security Administration will make its official no-COLA announcement on October 15, just a few weeks before the mid-term elections. If last year is any guide, that announcement will set off a flurry of debate about whether Social Security recipients should receive a special benefit adjustment above that implied by the COLA formula (or, in this case, the unCOLA formula) and whether such special payments might be desirable as a form of economic stimulus.

If you are interested in all the facts surrounding the COLA calculation, the incomparable Calculated Risk has a wonderfully detailed analysis.

Fiscal Policy in Interesting Times

Back on August 5, I gave a speech at the Retirement Research Consortium’s annual conference “Retirement, Planning, and Social Security in Interesting Times.” I’ve been saving up the link to the C-Span video to share during my vacation.

Here it is. (I hope the link still works; if not, I will fix it once I get back on the grid.)

Keeping with the spirit of the event, I spoke about “Fiscal Policy in Interesting Times.” And with that title, I simply had to mention the famous curse, “May you live in interesting times.”

As the helpful folks at Wikipedia point out, chances are good that this curse originated in England or the United States not, as often alleged, China. Regardless of its origin, it’s still an excellent curse, which I remember my mom invoking often in my childhood (rhetorically, I should note, not at me). For an audience of policy researchers, however, it’s a curse with a silver lining. We may not want interesting things to happen (financial crises, trillion-dollar deficits, 9.5% unemployment, etc.), but they do increase the odds that policymakers, journalists, and the public will pay attention to what we are saying (whether they should is a separate question …).

What makes today particularly interesting is that we face lots of uncertainty and major challenges. That a potent mix. We know less about what’s going on than usual, but we are playing for bigger stakes. Case in point: Fed Chairman Ben Bernanke’s recent statement about the outlook being “unusually uncertain” while the economy still struggles to heal from the financial crisis. Is it a rebound or a relapse? I fear it may be the latter, but we just don’t know.

The meat of the speech considers the economic and fiscal uncertainties and challenges we face. For example, I lament the ridiculous uncertainty in our tax system. Not only do we not know what will happen in 2011, after the scheduled expiration of the 2001 and 2003 tax cuts, we don’t even know what the tax code is in 2010. Will there be an AMT patch? A retroactive change to the temporarily extinct estate tax? What about the (in)famous tax extenders?

I wrap up by sharing one other thing I learned from Wikipedia. The “interesting times” curse is apparently the mildest of a trio of curses.

If you are feeling really mad, the appropriate curse is “May you come to the attention of people in authority.” Which again is rather a mixed curse for policy researchers who want policymkaers to pay attention.

And if you are really, really mad, then you should bring out the worst of the curses: “May you find what you are looking for.”

P.S. At the moment, I am looking for puffins, humpback whales, glaciers, and grizzly bears.

The Social Security Windfall

As you have probably heard, Social Security recipients won’t be getting a cost-of-living adjustment (COLA) in 2010. Well, at least under current law.

The reason is simple: The annual COLA is based on a measure of consumer inflation from the third quarter of one year to the next. Last year, that measure was boosted by the run-up in energy prices, and Social Security recipients received a 5.8% increase in their monthly payments. That price shock has receded and, as a result, inflation from the third quarter of 2008 to the third quarter of 2009 was actually negative. According to today’s release of September consumer price data, the CPI-W (the inflation measure used to set the COLA) fell by 2.1% since the third quarter of last year.

If Social Security payments were exactly indexed to inflation, that would imply a negative COLA—a reduction in monthly benefits—of 2.1%. But the law doesn’t allow benefits to fall. So monthly benefits in 2010 will be the same as in 2009.

Some observers are portraying this as a hardship for seniors and are suggesting that they should get a special COLA this year. If you put on your green eyeshade for a moment, however, you will realize that the reverse is true. The fact that Social Security benefits will be flat means that seniors are receiving a windfall. Under the logic of cost of living adjustments, those benefits should have fallen by 2.1%. Instead they will be flat. Seniors will thus receive a 2.1% increase in their real Social Security benefits.

That’s why thoughtful budget analysts from across the political spectrum believe that a special COLA is not warranted. See, for example, this piece by Andrew Biggs at the American Enterprise Institute and this piece by Kathy Ruffing at the Center on Budget and Policy Priorities. (In case you aren’t familiar with them, Andrew and Kathy are two of the most knowledgeable people about Social Security on the planet.)

Kathy’s piece includes a nice discussion of alternative measures of cost-of-living (addressing the question of whether the cost of living for seniors may be rising faster than the CPI-W suggests). She also concludes, rightly in my view, that if policymakers fell compelled to act, it should in the form of lump-sum payments rather than any messing around with the COLA structure. President Obama endorsed that idea yesterday.

In a separate piece, Andrew notes that one group of seniors are getting a bum deal from the absence of a COLA: new retirees. They never received the benefit of the too-large 2009 COLA, but will have to bear the burden of no COLAs during the year or two that it will take for inflation to catch up to its 2008 peak.

Finally, another Andrew who’s an expert on Social Security–Andrew Samwick at Capital Gains and Games–suggests that any lump sum payments to Social Security beneficiaries in 2010 be paid for by reducing their COLAs the next time they are positive. The payments would thus provide some stimulus in 2010, but wouldn’t add to the long-term federal debt.

Latest Data on Transfers and Income

In a series of posts (most recent here), I’ve documented that Americans are getting an increasing portion of their income from the government.

BEA released new data on incomes a couple weeks ago, including revisions back to 1995. These data reinforce the story I’ve described in my previous posts:

  • Transfers accounted for 17.3% of personal income in June. That’s the second highest in history, topped only by the 18.2% recorded in May, when transfers were boosted by one-time payments from this year’s stimulus act:

Transfers June 2009

  • The increasing importance of transfers reflects both short-run developments and long-run trends. In the past year, the importance of transfers has grown because of (a) weakness in other forms of income, (b) the natural expansion of transfers due to economic weakness (e.g., increases in unemployment insurance payments), and (c) policies to expand benefits (e.g., as an attempt at stimulus). Over the longer run, however, the growth of transfers has been driven by the expansion of entitlement programs.

Continue reading “Latest Data on Transfers and Income”