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Wall Street to Your Street
Understanding the Budget Debate Part 4: Federal Spending
June 26, 2017 | Russ Swansen, Chief Investment Officer
Editor's Note: This is the fourth in a five-part series of articles on the federal budget. In the first one, we examined deficits and the mounting federal debt, in the second we looked at government revenues and individual taxes, and in the third we focused on business taxes, particularly corporate taxes. This article focuses on federal spending policies.
The federal government collects trillions of dollars in taxes each year, and, in recent years, it has been spending even more. That budget imbalance has added up to a national debt of about $19 trillion dollars.
In the first three articles we explained where the revenue comes from – taxes on individuals, corporations and other entities – and this article will lay out where all of that revenue goes.
Exhibit 1 illustrates the broad categories of federal spending, and separates what is called discretionary spending from mandatory spending. It is important to understand that the budgeting process is different for discretionary and mandatory spending.
Mandatory spending – comprised almost entirely of Social Security, Medicare, Medicaid and interest on the debt – makes up the majority of federal spending. This spending is on autopilot. It keeps going unless the programs are changed via legislation.
For legislation to pass, the House, the Senate and the president must all agree. As a result, it is difficult to cut mandatory spending.
Discretionary spending represents a minority of federal spending – about 31% in 2016. Discretionary spending covers a number of government departments, such as defense and education, as well as a number of agencies, such as the Environmental Protection Agency.
Discretionary spending must be approved through the budget process each year. This makes it easier to control than mandatory spending.
What is driving spending growth?
Exhibit 2 details the projected growth in federal spending as a share of our nation's gross domestic product (GDP).
Note especially the rapid growth in interest costs. As the federal debt increases, this becomes a viciously accelerated expense. This is why we must control the size of the debt.
The cost of medical entitlements is projected to grow faster than the economy. Several things are compounding to drive these costs: more people becoming eligible for Medicare as the baby boomers reach retirement age, people living longer, an increasing range of treatments and increases in the costs of those treatments.
Pulitzer Prize winning journalist and author David Wessel gives a good example of this in his book on the federal budget, Red Ink, when he discusses joint replacements – a wonderfully successful medical innovation that is being used more frequently by a growing number of people. For those who are interested in more detail and history on budget issues, I highly recommend his book, Red Ink.
There is wide agreement across both political parties that the growth in medical entitlement costs must be reined in. While Congress and the president are currently struggling with the challenges of containing health care costs, the problem has been a long-standing one for the nation.
Former President Obama said in 2011 that, "if you look at the numbers, then Medicare in particular will run out of money and we will not be able to sustain that program no matter how much taxes go up."
Evidence suggests that these costs can be reduced. Exhibit 3 is based upon data from the Organization for Economic Cooperation and Development (OECD).
It compares per capita spending on health care among developed countries. It suggests that substantial savings should be possible in medical entitlements. The political differences are in how to reduce the costs.
U.S. health care spending grew 5.8% in 2015, reaching $3.2 trillion, or $9,990 per person. As a share of the nation's gross domestic product, health spending accounted for 17.8%, according to the Centers for Medicare and Medicaid Services.
To curtail that spending growth, the U.S. may need to look at the cost models of the world's other developed countries.
Haven't we all paid for our benefits?
A while ago I was asked the question, "Haven't we all paid for our Social Security and Medicare benefits? So why is there a problem?" The short answer is that we have not paid enough.
Many people believe that Social Security and Medicare work like life annuities or long-term care policies. After all, they share similar characteristics. I wish it were so.
Insurance companies are required to ensure that their policies are actuarially sound. Unfortunately, the government programs have no such requirement.
From the beginning, neither Social Security nor Medicare collected enough in taxes to cover the costs of benefits. In fact, the very first Social Security trustee's report in 1941 projected that Social Security would go broke; it was just a question of when. It has been tweaked periodically since then to keep it going.
When Medicare was started, the gap was even greater. Medicare taxes were never expected to cover the whole cost. The plan was that general tax revenue would cover a significant share.
To make matters worse, Medicare costs grew much faster than expected, putting ever mounting pressure on the federal budget, and it is projected to do so for as far as the eye can see.
Many people, perhaps most, believe that they have paid for their benefits. Many in the government encourage this thinking, or at least do nothing to dispel it.
Eugene Steuerle, economist at the Urban Institute, prepared an interesting analysis comparing the value of Social Security and Medicare benefits to the accumulated value of taxes paid for various household types and retirement years.
It showed that no group paid enough to cover its combined benefits of Social Security and Medicare.
A closer look at the detail shows that the gap for Social Security is less severe than for Medicare, and that some people actually pay more than the value of their Social Security benefits.
The story is very different for Medicare. No group paid even half of the value of its benefits. Exhibit 4 provides a summary of Steuerle's findings on Medicare for those retiring in 2020.
The country needs to solve the debt problem or go broke, and this requires consideration of entitlement spending. Social Security may be difficult to solve, but Medicare is the much larger and more difficult problem.
- Federal expenditures fall into two categories: mandatory spending, which is on autopilot, and discretionary spending, which is approved annually.
- Discretionary spending makes up about 31% of federal spending, but it is where nearly all of the recent spending reductions have focused.
- Mandatory spending, mainly entitlements and interest on the debt, make up the majority of federal spending.
- Interest costs are viciously accelerating as a result of the growing debt.
- Entitlement costs are difficult to cut because of the requirement that the House, Senate and president agree on legislation.
- Many people believe they have paid for their Social Security and Medicare benefits through taxes, but those taxes have not been enough to cover the costs, especially for Medicare.
- Both parties agree that entitlement costs must be reined in, but they differ strongly on how to do it.
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All information and representations herein are as of May 31, 2017, unless otherwise noted.
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