October 15, 2004

Pay (Through the Nose) As You Go

by Jagadeesh Gokhale and Kent Smetters

Jagadeesh Gokhale is a senior fellow at the Cato Institute. Kent Smetters is an associate professor at The Wharton School of the University of Pennsylvania.

Mercifully, the words "lock box" weren't uttered once. Nonetheless, the last presidential debate produced the starkest contrast yet in the candidates' approaches toward entitlement reform. President Bush wants to introduce personal Social Security accounts for young workers and future generations. This will sequester their payroll taxes from being diverted by the government to fund other programs. Sen. Kerry, however, rejects that approach, rejects benefit cuts, and provides no concrete reform plan except a vague promise of making changes along the way as needed. To us, that suggests future tax hikes.

During the debate, Sen. Kerry also said that he would adopt a "pay-as-you-go" approach to ensuring financial solvency to Social Security. President Bush's response, though apt, needs amplification.

We think it's high time the public was clearly informed about when pay-as-you-go is effective and when it is dangerous. It's effective in imposing fiscal discipline when we are concerned with surging discretionary spending. Such spending is annually appropriated by Congress and used to finance public goods such as defense, roads and highways, judicial services, and homeland security -- items that potentially benefit future generations. Under pay-as-you-go rules discretionary spending can be increased only if Congress is willing to finance it 100% out of other spending cuts and tax increases. The political undesirability of both financing methods serves to check both higher deficits and growth in the size of the government.

On the other hand, the pay-as-you-go approach has proved ineffective in imposing fiscal discipline in our entitlement programs. Pay-as-you-go in this context usually implies benefit increases -- for which retirees obviously don't pay -- and tax increases for workers and future generations. The taxpayers' higher future benefits never make up for their earlier payroll tax hikes in present value -- and future benefits remain subject to changes. Consequently, today's retirees (who vote in larger numbers) receive windfalls, but workers and future generations lose out.

Pay-as-you-go, therefore, is precisely the approach that has created a financial mess in Social Security and Medicare. Our future benefit commitments now far exceed our ability to pay. The financial imbalance is now estimated by Social Security's independent actuary to equal $10.4 trillion. For Medicare, the overall shortfall is even larger -- $62 trillion. Using the official numbers, we estimate that rejecting an attempt to control the growth rate of costs implies an immediate and permanent tax hike of 17.4 percentage points. That would more than double the current payroll tax rate of 15.3%. Inaction over another four years will increase the required hike to 19.7 percentage points. A recent study by the latest Nobel laureate for economics, Ed Prescott, points out that higher tax rates will slow economic growth.

As the aphorism goes: When you're in a hole, stop digging. A promise of inaction or, at best, of continuing to use the pay-as-you-go approach, is not a solution to our entitlement programs' financial travails. It is an invitation to continue digging deeper.

Reprinted from the Wall Street Journal © 2004 Dow Jones & Company, Inc. All rights reserved.