Zero Hour

The United States is facing its greatest economic challenge in decades. Our response will set the course for the future of the American economy. Will we continue to create jobs and raise living standards, or will we enter an extended period of stagnation and decline? Will we leave our children and grandchildren better, or worse, off than us? Will the United States continue to be the economic envy of the world, or become just one more empire in decline?

I'm not talking about the current economic recession and sluggish recovery. The real long-term threat is the historic surge of government spending and debt.

Over the past decade, federal spending has expanded 61 percent, even after inflation. Most of that increase has come in just the past three years. Only during the height of World War II was the government larger than it is today. Thankfully, World War II ended, and spending went back down. But the current spending spree is set to accelerate until it leads to economic calamity.

The main culprit? The Social Security, Medicare and Medicaid costs of 77 million retiring baby boomers. Simply put, Washington has made expensive commitments that the economy and taxpayers will not be able to fulfill. Social Security and Medicare costs have already begun growing rapidly. Those two programs alone constitute unfunded obligations totaling $43 trillion over the next 75 years. That's more than 60 times larger than the Troubled Asset Relief Program (TARP) bailout of Wall Street. And every year, this fiscal hole deepens. The response of the United States to these incomprehensible costs will, in many ways, shape its economic future.

How We Got Here. Over the past half-century, Washington has typically spent 20 percent of the nation's total income, or gross domestic product (GDP). During that same period, tax revenues have averaged 18 percent of GDP, regardless of tax rates. Note that spending 20 percent, and taxing 18 percent, of GDP translated to yearly budget deficits of 2 percent of GDP. But as long as the economy continued growing, paying the interest on these modest deficits was relatively manageable.

Between 1998 and 2001, Washington actually ran budget surpluses. A temporary stock-market bubble pushed revenues up to 20 percent of GDP, while the end of the Cold War saved defense dollars and reduced spending to 18 percent of GDP. Unfortunately, by 2002, the stock-market bubble had burst, and the 9/11 attacks forced defense spending back up. Ultimately, Washington reverted to taxing at 18 percent of GDP and spending at 20 percent. These percentages led to a $161 billion budget deficit in 2007.

Then the Great Recession hit, creating enormous deficits. With less income to tax, revenues plunged to 15 percent of GDP. Meanwhile, more people signed up for unemployment and welfare benefits, and Congress enacted a $1 trillion "stimulus" and expensive financial bailouts. Federal spending soared to 25 percent of GDP, a post-World War II record.

Today's deficits are truly historic. In 2011, Washington will log its third consecutive budget deficit of 10 percent of GDP - nearly double the previous post-World War II record. Before 2009, the largest budget deficit ever had been $458 billion. The past three years have averaged deficits of $1.4 trillion.

One might assume that an economic recovery will bring the federal budget back to those average levels. That assumption is only half right. Economic recovery is expected to return tax revenues to 18 percent of GDP, even if all 2001 and 2003 tax cuts are extended. However, spending is projected to continue rising past 26 percent of GDP by the end of the decade - and even that assumes peace, prosperity and low interest rates.

Rising spending - not falling revenues - is the moving variable driving these long-term deficits.

The numbers are staggering. Between 1789 and 2008, Washington accumulated a national debt of $5.8 trillion. Between 2009 and 2021, it is set to borrow an additional $17 trillion. In just 13 years, Washington will have quadrupled the national debt. A decade from now, yearly deficits are expected to approach $2 trillion.

It gets worse. The Congressional Budget Office (CBO) estimates that federal spending as a percentage of GDP will soar to 32 percent by 2030, 45 percent by 2050, and 75 percent by 2080. The total national debt is on pace to exceed the size of the entire economy by 2020, and rise to triple the size of the economy over the next few decades.

Obviously, the economy would collapse long before spending and debt reached those levels. Many economists now believe that within a decade, rising debt will, at best, cut our economic growth rate in half. More likely, it will precipitate an economic crisis. Many economic models, including those of the CBO, show complete collapse by the 2030s.

We can't wait that long before acting. Once a large debt builds, the net interest costs create even more debt. Allowing the national debt to quadruple between 2008 and 2021 would cause a permanent surge in interest rates that would slow economic growth. It would also mean that half of all income taxes would be needed just to pay the interest on the national debt. Preventing this means fundamentally reforming spending not in 2025, 2020, or even 2015. Reforms must come now.

A Heavy Burden. Let's set aside the temporary spending binge caused by the recession. In the long run, nearly all spending increases will come from four sources: Social Security, Medicare and Medicaid (the three largest entitlement programs), and net interest on the debt. Much of this is driven by simple demographics: a wave of 77 million baby boomers beginning to collect entitlement benefits. In each of these programs, current taxpayers finance current recipients. This system can be sustained as long as there are enough workers paying taxes to support the benefits of each retiree. In 1960, five workers supported one retiree. Today, that ratio has fallen to 3-to-1. By 2030, it will be just 2-to-1.

To understand the meaning of a 2-to-1 worker-to-retiree ratio, imagine two kids, in kindergarten today, who marry and start a family in 2030. They will try to figure out how to repay their student loans, buy a home, and afford children on their entry-level incomes. But they will also have to pay all the Social Security and Medicare benefits of their very own retiree. The burden will be enormous.

Beyond the demographic challenges, Medicare spending will be pushed up even further by rising health-care costs. Thus, over the next 75 years, Social Security faces a $7 trillion deficit, and Medicare a $36 trillion deficit. The baby boomers' long-term health-care expenses will also drive Medicaid costs upward. And putting those new costs on the national credit card will bring an enormous net-interest bill for the national debt. That is, unless they are reformed first.

This case for reform requires addressing two common myths about Social Security and Medicare.

The first myth is that baby boomers will be getting back only the amount they paid into these programs. In reality, a recent Urban Institute study shows that a 56-year-old married couple now earning an average income will pay $820,000 into Social Security and Medicare over their lifetimes, yet receive $1,040,000 in total benefits. Their highest return will be in Medicare, where this couple will receive $3 in benefits for every $1 they paid into the system.

The other myth is that the Social Security trust fund has the means to pay all benefits until 2037. It is true that Social Security ran a $3 trillion surplus between 1983 and 2009, before entering permanent deficits last year. However, Congress has already spent that surplus money on other programs. As infuriating as this may be, the fact remains that the money is gone, replaced with paper IOUs in a filing cabinet at the Bureau of Public Debt in Parkersburg, W.Va. Sure, Congress could pay full benefits until 2037 by redeeming those $3 trillion in IOUs, but that requires raising taxes, or cutting other spending by the entire $3 trillion. So while the trust fund does exist, it doesn't reduce the burden on future taxpayers by even one penny.

No Easy Alternatives. The reforms needed to bring spending and deficits under control will not be easy. Over the next decade, Washington is scheduled to tax $35 trillion, and spend $48 trillion (truly astounding amounts). Of that spending, $21 trillion will go toward Social Security, Medicare and Medicaid, and $7 trillion toward interest on the debt. Totally eliminating widely unpopular programs such as foreign aid ($0.5 trillion over the next decade), corporate welfare ($1 trillion) and even President Barack Obama's health-care program ($1 trillion) comes nowhere close to offsetting these major entitlement costs. Certainly, some of the cuts would be worth it (every dollar helps), but they do not avert the need for entitlement reform. Even ending all funding for the troops in Iraq and Afghanistan ($0.5 trillion) would not avert the need for fundamental entitlement reform, especially since Social Security, Medicare, Medicaid and interest costs are set to double again in the 2020s.

On the tax side, the story is the same. Repealing the 2001 and 2003 tax cuts for those earning more than $250,000 annually would raise just $0.7 trillion over the next decade. Repealing them for everyone - which would mean steep tax hikes for low-income families - would raise only $3 trillion. And even that assumes that the tax hikes would not harm the economy (thereby reducing the amount of income to tax). It also assumes that Washington would actually apply all new tax revenues to deficit reduction, when so far nearly every tax increase signed by President Obama has gone toward new spending instead.

The CBO found that fully financing all projected government spending would require putting middle-income households in a 63-percent tax bracket, and upper-income households and small businesses in an 88-percent bracket. That is a recipe for economic disaster. And besides, how is drowning our children and grandchildren in exorbitant taxes any more compassionate than drowning them in debt? The only viable solution is to address the source of the debt: runaway entitlement spending.

In short, there is no easy alternative. The choice is between reforming Social Security, Medicare and Medicaid, and economic catastrophe.

The Path Forward. Today's budget debates are not just about numbers. They are about our future, and whether the next generation of Americans will have any hope of matching the living standards of their parents.

Social Security and Medicare do represent a social contract. But no social contract should involve bankrupting a generation not yet old enough to vote. When Mom and Dad buy a home they cannot afford, the solution is not to tell their children to get second and third jobs. The solution is for Mom and Dad to scale back their spending and move to a less expensive neighborhood.

Social Security and Medicare have been among the most successful and popular government programs ever. But the bills are piling up faster than we can borrow. If these programs are to survive, they must modernize.

Reform does not mean cutting off low-income seniors. If done right - and soon - reform can protect all seniors from poverty, without bankrupting their children and grandchildren.

First, Washington should put Social Security, Medicare and Medicaid on a long-term budget with yearly spending caps. Then, Social Security can be saved by gradually raising the eligibility age to reflect longer life spans, and by trimming benefits for upper-income seniors while strengthening them for lower-income seniors.

Medicare can be saved by reducing government subsidies to the wealthiest seniors and, instead, asking them to assume more of their own insurance costs. These programs would work more like real home or disability insurance, where benefits are provided when needed rather than delivered in an unlimited stream regardless of need.

In the long run, Medicare can be saved by transforming it into a premium support program, which seniors can use to choose their own qualified health plan with a government subsidy. That system - much like what members of Congress currently enjoy - would put patients in charge, and allow choice, competition and transparency to reduce costs. Rep. Paul Ryan, R-Wis., has proposed phasing in this system for Medicare.

Time is critical to success. These reforms must be implemented within the next few years. Otherwise, the rising national debt will cause permanent economic damage. And the longer we wait, the less time baby boomers will have to adjust to the new policies.

We can choose a future of escalating spending, debt and taxes, followed by economic calamity. Or we can responsibly bring government programs in line with economic reality. The future of the American economy - and the future of our children and grandchildren - depends on which path we choose.

Brian Riedl is a former Grover M. Hermann Fellow in Federal Budgetary Affairs at The Heritage Foundation.