Thinking Waaaaaaaaaay Outside the Box on Public Pensions

Posted by on May 16, 2012

Filed Under (Other Topics, Retirement Policy)

I’ve written over the past couple of weeks about public pensions in Illinois.  Short version: they’re a possibly-unfixable mess.  Since the state constitution forbids reducing promised benefits for current employees (or increasing contributions) and the state has failed to plan for their pension promises in a timely manner, the state is stuck between the proverbial rock and a hard place.

With this in mind, over the past few days I’ve been trying to think of unconventional ways in which the state can save money.  This is a bit tricky, since in the case of public employees the state pays their salary when they’re working AND their pension when they retire.  It’s the overall cost that matters.  So, for example, when the University of Illinois had an early retirement program last year, the University stopped paying them and SURS, the state university retirement system, started paying them.  But since both are ultimately using state dollars (but less-so in the case of the University, whose state appropriation as a fraction of overall cost has fallen drastically in recent years), this is really just a reshuffling of which pocket the money comes from.  The state is still on the hook.

Thinking outside the box leads to some crazy ideas.  And here’s one of them.  I make no promises about whether it will work in practice.  But it does point to some of the strange features of state finance.

Here’s the idea: to help the state’s pension system’s finances, the state should pay its workers more as they near retirement.  That’s right.  More.

As I started to play around with the idea, I had a dim recollection of reading something related.  It turns out that a couple of weeks ago, Andrew Biggs wrote in the Wall Street Journal about how cutting the Social Security payroll tax for workers nearing retirement could actually help the system’s finances.  The idea is simple: if older workers get to keep more of their wages, they’ll work longer.  And, if they’re working, they’re not collecting Social Security.  Lowering the payroll tax pushes back retirement, and this helps the system’s finances.  The idea is also related to my post from two weeks ago, where I discussed research showing that retiree health benefits induce early retirements.  If the state can’t pay retirees less and can’t ask them to contribute more, the only thing it can do to reduce pension costs is induce them to retire later, and it needs to do so in a way that costs less than the potential savings from delayed retirement.

So, how does it work?  Consider a worker near retirement age who has been working for the state his whole career, or at least long enough to reach the earnings cap on the state’s retirement system.  This worker, let’s call him Charlie, will earn 80% of his final salary after retirement.  And, assuming this worker was actually fulfilling a necessary function (e.g., teaching students finance), that worker will have to be replaced after retirement by a new worker.  Let’s call him David.  New workers tend to earn less than senior workers, so David will earn less than Charlie did.  Maybe David earns 80% of Charlie’s final salary.  But, essentially, after Charlie retires the state will be paying both Charlie and David – two people – to do work that could be supplied by one person.  While the state paid 100% of Charlie’s salary for that work before retirement, it pays 160% of Charlie’s salary after retirement!

So, the state has the potential to save a lot of money overall – 60% of Charlie’s salary per year – if it can induce Charlie to delay retirement.  Due to the non-impairment clause, a lot of the ordinary ways of doing this such as increasing the full retirement age are off the table.  One thing the state can do is increase Charlie’s salary.  This could be done through an actual wage increase or, as Biggs suggests, by reducing the 8% of wages that Charlie must pay into the retirement system as he nears retirement.

It is easy to see how it might be worth it to the state to spend more money on Charlie’s wages in order to delay his retirement.  But, let’s make up some simple numbers.  I’m going to ignore things like the fact that pension payments increase 3% per year and other details of the retirement system. They don’t change the basic insight, and the uncertainty involved with the other numbers that I’M JUST GOING TO MAKE UP is a much bigger deal than details like this.  I’m illustrating – not proposing policy.

So, suppose that increasing Charlie’s wage by 10% per year leads him to delay retirement by 3 years.  Suppose Charlie makes $50,000 per year and has maxed out his service so he’ll earn 80% of that ($40,000) after he retires.  Assume that David will earn $40,000 after he’s hired.

There are two things that should be taken into account.  If Charlie’s wage goes up, the basis for his pension will go up as well.  Roughly speaking, pensions are based on average earnings over the last four years of work.  Over these years, Charlie earns 50,000 for one year (the year before he gets the raise) and 55,000 for three years (after he gets the raise).  His final pension is 80% of the average, or 0.8 * 53,750 =  $43,000 per year.  Again, there are subtleties to the formula, but too many details obscure the main idea.  And, if Charlie works additional years, he will pay an additional 8% of salary into the pension system.  This would seem to be money that the state gets back.  But, as far as I can tell, these “excess contributions” are refunded to the employee at retirement.  So, in the case of a worker who has maxed out his pension, there would be no additional benefit to the state.  (For a worker who has not maxed out their pension, the state would receive additional contributions from the worker who delays retirement, but it would also have to pay an additional 2.2 percent of final earnings for each additional year of work, so it is unclear that this would benefit the state.)

Total 10 year cost if Charlie retires now:

Charlie’s pension payments: 10*40,000 = 400,000
David’s wages: 10*40,000 = 400,000
Total Cost:   $800,000

 

Total 10 year cost if Charlie retires in 3 years:

Charlie’s wages (years 1 – 3): 3*55,000= 165,000
Charlie’s pension (yrs 4 – 10): 7*43,000= 301,000
David’s wages (yrs 4 – 10): 7*40,000= 280,000
Total Cost:   $746,000

 

So, the total savings over 10 years from my COMPLETELY MADE UP numbers is $54,000, or 6.75% of the cost under the current system.  And, this savings occurs in the first three years from not having to pay David.  Although I’ve ignored the time-value of money to keep things simple, the fact that the savings come up front would favor giving Charlie the raise if there were a positive interest rate.

Whether a scheme like this could actually save money would depend on a lot of things.  Among them are how much more near-retirees need to be paid to delay retirement, how long the delay retirement for, the relative cost of replacement workers, the length of time over which retirees draw pensions, and the time-value of money. Again, for the purposes of illustration, I COMPLETELY MADE UP THE NUMBERS ABOVE.  Economists invest a lot of time and energy in estimating quantities like these, though, and they’d need to do so before anything like this could go forward.

One crucial factor would be how well the state can target workers who are really on the margin of whether or not to retire.  While a wage increase across the board would be extremely unlikely to save the state money, one that is targeted at workers who are thinking about retiring and induces them to delay retirement just might.  One thing’s for sure: it wouldn’t run afoul of the non-impairment clause!

Incredible Pension Promises

Posted by on May 8, 2012

Filed Under (Other Topics, Retirement Policy, U.S. Fiscal Policy)

in•cred•i•ble (adjective): too extraordinary and improbable to be believed.

I wrote last week about the Illinois public pension mess and how ceasing to offer fully-paid retiree health benefits might help to address the problem by causing workers to delay retirement.  The reason why such a convoluted route to reducing pension costs is needed is because of the non-impairment clause of the Illinois state constitution, which prevents the state from reducing benefits for current employees.  In short, the non-impairment clause says that membership in a state pension system is a contractual relationship between the worker and the state.  And since contracts cannot be unilaterally renegotiated by one of the parties, the state is in a situation where it would seem to have no way out of its obligation to pay promised benefits to its current and future retirees.

In his proposal to reform the state pension system, Governor Quinn has tried to avoid the non-impairment clause by offering workers a choice.

On the one hand, current workers can keep their current pension plan but lose the right to have future pay increases be included in their final pension benefits and lose the subsidy that the state currently pays for retiree health benefits.  (Now, the first part of this plan clearly violates the non-impairment clause because the formula used to compute final benefits is specified in the Illinois Pension Code and clearly includes future pay raises.  But, that’s not today’s topic.)

On the other hand, employees can accept a significantly less-generous pension plan but maintain the employer subsidy toward retiree health benefits.  (Now, the less-generous pension plan pushes full retirement to age 67, when employees would be eligible for Medicare anyway, so it is unclear how valuable this promise would be to retirees.  But, that’s not today’s topic either.  There is also the real question of whether this would be considered “coercion” by the state.  In the past the Supreme Court of the United States has ruled that an employee cannot be coerced into giving up his pension benefits.  But, that’s also not today’s topic.)

This would be the time to ask ourselves why the non-impairment clause was included in the Illinois Constitution in the first place.  An analysis by Eric Madiar, Chief Legal Counsel to Illinois Senate President John Cullerton, confirms what you might suspect.  Public workers in the state of Illinois were concerned about whether the state would pay the pension benefits that it had promised them.  State and local workers generally receive lower cash wages than their private-sector counterparts, but higher benefits, including more generous pensions.  Thus, when an employee accepts a job working for state or local government, promised future pension benefits play a major role in making that job attractive enough for them to accept.  In light of this it is not surprising that they would be concerned about whether the state could be trusted to pay those future benefits.  This led state and local workers to propose that pension benefits be guaranteed in the Illinois constitution, and this proposal ultimately became the non-impairment clause.

Economists think a lot about commitment.  That is, we wonder about things like how it is that an agent can commit to take an action in the future that is not it its own short-term interest.  Or, we wonder how it is that an agent can be given incentives to take actions today that do not benefit it until the distant future.  Both of these issues arise in the context of pension funding.  In order to induce an worker to take a government job that pays less today, that worker must believe that the state will actually fulfill its promise to pay higher pension benefits in the future.  Similarly, in order for current legislators to cut current spending and use the money to fund future pension payments, there must be consequences.  The non-impairment clause addresses both of these issues.  The highest law of the state guarantees that the state will make the future payments.  This guarantee is so strong that a state that fails to properly plan for these payments will face fiscal collapse – as we do now.  Even in the face of fiscal collapse, the non-impairment clause suggests that pension payments must take precedent over many other payments.  With these promises in place, workers should be confident that the state will fulfill its future obligations.  Ideally, knowing that failure to plan for the future will jeopardize the entire state, legislators will make appropriate funding decisions to avert disaster.

Consequently, the non-impairment clause plays a vital role in the state’s finances.  Over the years it has been used to induce workers to accept a lower wage today in exchange for the seemingly-credible promise to provide higher benefits in the future.  In other words, the non-impairment clause has allowed the state to push the cost of paying current workers onto future taxpayers.  Kicking the can down the road in this manner has been a major tool in the state’s fiscal toolbox.

Let’s think about the role of commitment in regards to Governor Quinn’s proposed choice.  The plan says that those who want to keep their current pension will lose retiree health benefits.  The governor can take away retiree health benefits because they are not guaranteed by the non-impairment clause.  An employee who accepts the governor’s proposal would get a less-generous plan but keep the state’s promise of retiree health benefits.

In order for an employee to voluntarily accept this plan (if they believe that current pensions cannot be impaired), it must be because the employee values retiree health benefits.  But, even an employee who values retiree health benefits would have to believe that, when they retire in the future, the state would actually provide the promised benefits, and would continue to do so even if times were tough.  In fact, when times are tough that’s when people need their pensions the most.  So workers might be particularly concerned about whether a state under fiscal pressure would continue to fulfill their promises.  Sound familiar?

This is where things become a bit tricky for the state.  Times are tough right now, and the state has responded by threatening to take away retiree health benefits.  This has occurred both in the governor’s proposal and in the state legislature, where pending legislation would eliminate the state’s subsidy for retiree health premiums, which amounts to about $7400 per retiree per year.  So, the state is, on the one hand threatening to take away retiree health benefits and on the other hand asking workers to believe that their promise that those who accept the governor’s proposal will continue to receive these benefits in the future.  And, all of this is taking place in a situation that was brought about by the state’s failure to adequately plan to meet its constitutional obligation to pay pension benefits.

This brings us to the big question: Why should workers expect the state to honor its commitment to provide a non-guaranteed benefit when it isn’t even honoring the benefits that it is constitutionally obligated to provide? While the governor’s plan should be commended for attempting to address the pension crisis through asking workers to voluntarily accept a change in benefits, in the end I would be surprised if workers are willing to give up their constitutionally guaranteed pension benefits for an incredible promise to provide health benefits.

Practically speaking, any proposal that asks for voluntary acceptance by workers is going to have to exchange currently promised benefits for some promise of future benefits, and any such promise of future benefits is going to face this same credibility problem.  The state, by finding a way around its constitutional promise of future benefits, may find that it loses the ability to induce people to work today for lower wages and promises of higher payments via pensions in the future.  If workers respond to this by insisting on higher wages today, the state may find itself facing a choice between higher wage costs or lower-quality workers.  Even if the state can find a way around the non-impairment clause, it will not be without its costs.

 

ADDENDUM (5/30/12):  Retirees who began working for the State of Illinois before April 1986 (at least in the case of SURS) may not be eligible for Medicare Part A.  In this case, removing health insurance benefits would leave workers exposed to significant financial and health risk even after the age of 65.  Obviously, removing employer-sponsored health benefits is much more complicated and controversial in this case.

What is “Sustainability”?

Posted by on May 4, 2012

Filed Under (Environmental Policy, Finance, Retirement Policy, U.S. Fiscal Policy)

My own research area is environmental and natural resource economics, which others often call “sustainability”.  That’s actually embarrassing, because I don’t know what it means.  For a renewable resource like timber, it seems pretty easy:  you just plant trees, let them grow, cut them down, and then plant trees again.  For a nonrenewable resource like oil, it’s impossible: once a barrel of oil is consumed, it’s gone forever.  The only way to make oil “sustainable” is not to use it, which does not make any sense, because oil has no value at all if it can’t be used.

So, sustainability is either obvious or impossible.  The concept seems to be of no use whatever.  So I turn to people smarter than me, to get some answers.  By “smarter than me”, in this case, I mean (1.) Nobel-Prize winning economist Robert Solow, and (2.) whoever writes for Wikipedia.

Way back in 1991, Robert Solow wrote “Sustainability: An Economist’s Perspective”, in which he says:  “It is very hard to be against sustainability. In fact, the less you know about it, the better it sounds.”   He says he has seen various definitions, but they all turn out to be vague.  So his essay is an attempt to make it more precise.  “Pretty clearly the notion of sustainability is about … a moral obligation that we are supposed to have for future generations.”   But you can’t be morally obligated to do something that is not feasible!  He notes UNESCO’s definition:  “… every generation should leave water, air, and soil resources as pure and unpolluted as when it came on earth.”   But taken literally, that injunction “would mean to make no use of mineral resources; it would mean to do no permanent construction, … build no roads, build no dams, build no piers.”  That is neither feasible nor desirable!

Instead, he suggests that sustainability might be both feasible and desirable if it is defined as “an obligation to conduct ourselves so that we leave to the future the option or the capacity to be as well off as we are.”   In the final analysis, what that means is that we don’t necessarily have to leave all the oil in the ground, if we leave something else of equal or greater value, some other investment that can be used by future generations to produce and consume as we do, and which they can leave to other generations after them.  It is a holistic concept, both simple and operational.  We only need to add the value of all assets, subtract all liabilities, and make sure that the net wealth we bequeath is not less than we inherited. 

We can use oil, but we should not simultaneously be running huge government budget deficits that reduce the net wealth left to our children and their children.  The measure of “net wealth” should include the value of ecosystems, fresh water supplies, biodiversity, and oil, as well as productive farmland, infrastructure, machinery, and other productive assets.   All those values are extremely difficult to measure, but at least the concept is clear.

Has that message been adopted since 1991?  It certainly does not seem to be part of the thinking of the U.S. Congress and the rest of our political system.   What are they using for guidance?

Wikipedia says  “Sustainability is the capacity to endure. For humans, sustainability is the long-term maintenance of responsibility, which has environmental, economic, and social dimensions, and encompasses the concept of stewardship, the responsible management of resource use.”  Okay, well, that’s still pretty vague, by Solow’s standards.  Let’s see if they make it more specific: “In ecology, sustainability describes how biological systems remain diverse and productive over time, a necessary precondition for the well-being of humans and other organisms. Long-lived and healthy wetlands and forests are examples of sustainable biological systems.”

I’m sorry, that kind of specificity does not make it more operational.   They haven’t read Solow.  In fact, the whole entry seems to read like it is intended to maximize the number of times it can link to other Wikipedia entries!

“Moving towards sustainability is also a social challenge that entails, among other factors, international and national law, urban planning and transport, local and individual lifestyles and ethical consumerism. Ways of living more sustainably can take many forms from controlling living conditions (e.g., ecovillages, eco-municipalities and sustainable cities), to reappraising work practices (e.g., using permaculture, green building, sustainable agriculture), or developing new technologies that reduce the consumption of resources.”

Actually, the only phrase in the whole entry that really struck me was “more sustainably.”  Now, I REALLY do not know that THAT means.  Our current trajectory is either sustainable, or it’s not!  If future generations can live forever, how can they live longer than that?  And if not, well, …

Retiree Health Insurance, Early Retirement and the Illinois Pension Mess

Posted by on May 2, 2012

Filed Under (Health Care, Retirement Policy, U.S. Fiscal Policy)

Ever since Governor Quinn proposed his plan to reform government employee pensions in Illinois, I’ve been thinking about how to blog about it.  The problem is, my primary opinion is a legal one – that the proposal clearly violates the non-impairment clause of the Illinois state constitution because it threatens current employees with excluding future pay raises from pensionable earnings in contradiction of the “contractual relationship” laid out in the Illinois Pension Code – and I’m not a lawyer.  Better to stick with what I am supposed to know.

So, let’s turn to economics.  While the non-impairment clause prevents the state from reducing pensions, it does not affect other benefits.  In particular, the state would seem free to reduce or remove subsidies for retirement health benefits without running afoul of the non-impairment clause.  New research from by Steven Nyce, Sylvester Schieber, John B. Shoven, Sita Slavov, and David A. Wise suggests that doing so might be a way to lower pension costs.  In short, they show that removing the employer subsidy for health benefits for early retirees would cause people to work longer.  And, when people work longer they contribute more toward the pension fund and draw pensions for less time, improving the overall finances of the pension system.

In the new article, entitled “Does Retiree Health Insurance Encourage Early Retirement,” the authors investigate the relationship between employer subsidies for health insurance to retirees.  The paper begins by noting that many Americans delay retirement until they reach age 65 because employment gives them access to health insurance at far better prices than they could receive in the private market (if such insurance is even available).  When an employer offers subsidized health insurance to those who retire before age 65, it makes it possible for people to retire earlier than they otherwise would.  Using newly-available data, the paper finds that retiree health coverage significantly increases retirements among people in their early 60s.  In fact, when employers subsidize 50 percent or more of the cost of retiree health insurance (as the state of Illinois does), retirements increase by “1-3 percentage points at ages 56-61, by 5.9 percentage points (33.7 percent) at age 62, and by 6.9 percentage points (43.7 percent) at age 63. Overall, an employer contribution of 50 percent or more reduces the total number of person-years worked between ages 56 and 64 by 9.6 percent relative to no coverage.”

What does this mean for the state of Illinois?  Take, for example, SURS, the State Universities Retirement System.  In this system, a worker’s total retirement benefit is limited to 80% of final salary.  This means that, after about 36 years of working for the state, the worker’s pension no longer increases with additional years of service.  Further, state law provides that the state will pay 5% of retiree health premiums for each year of service.  (Importantly, the applicable law is not the Pension Code!)  So, a person who started working for the state at age 25 would, by age 62, be eligible for the maximum pension and free health benefits.

Given this deal, it is no wonder that people choose to retire before age 65.  This costs the pension system, since early retirees do not contribute and they draw their pension for longer.  Removing retiree health benefits would have a significant financial impact on early retirees.  Back in 2006, the most recent data I could find in a quick search, the average health insurance premium for an adult age 60 – 64 on the non-group health insurance market was around $360/month.   A family policy would cost about twice that.  Such policies are usually less generous than employer-provided insurance and feature higher deductibles and coinsurance rates.  So, a near-elderly state employee contemplating retirement might face expected monthly costs of $500 – $700 or more if they had to pick up their own health insurance, and even more if they had a dependent spouse or children.

So, suppose the state were to eliminate retiree health benefits.  Faced with such costs, many people would choose to work until age 65 (or at least until age 63.5 when the COBRA law would allow them to continue to purchase health insurance under the state plan until they become eligible for Medicare at age 65).  And, when people retire later, they draw pensions for less time.

Now, I am not necessarily advocating this, and certainly not across the board.  There are strong arguments why for some government employees – in particular police and firefighters –the physical demands of the job make early retirement reasonable.  For other government employees, such as professors, there is no strong reason why the state should be subsidizing early retirement through providing free health benefits after I stop working.

My broader point is that whatever the state does, and it must do something, it must be done in a way that does not violate the constitution.  While the state cannot touch pension benefits, it is free to reduce health insurance.  And, since retiree health insurance makes retirement more attractive, reducing or removing retiree health benefits would seem to be a constitutional and, based on recent research, effective way to delay retirement, which would improve the ailing pension systems’ finances.

ADDENDUM (5/30/12):  Retirees who began working for the State of Illinois before April 1986 (at least in the case of SURS) may not be eligible for Medicare Part A.  In this case, removing health insurance benefits would leave workers exposed to significant financial and health risk even after the age of 65.  Obviously, removing employer-sponsored health benefits is much more complicated and controversial in this case.

Ag-Gag Bills: Bad for Animals, Bad for Business

Posted by on Apr 27, 2012

Filed Under (Other Topics)

“Sunlight is the best antiseptic.” –Louis Brandeis, U.S. Supreme Court Justice

Over the past few years, animal-rights groups have increasingly used undercover investigations to expose horrific conditions in factory farms and slaughter houses across the United States.  One such investigation in 2008 by The Humane Society of the United States (HSUS) prompted the largest recall of beef in U.S. history and resulted in new Federal legislation banning the slaughter of downed cattle (source).

In what can accurately be described as backlash, bills have been introduced across the nation in state legislatures to discourage whistle-blowing and undercover investigations on factory farms and in slaughter houses (source).  These “ag-gag” bills criminalize undercover investigations and will have a chilling effect on future investigations into animal abuse (source).  Earlier this Spring, Iowa became the first state to pass ag-gag legislation, but a similar bill in Illinois failed (source).

In addition to protecting bad actors that abuse animals, ag-gag legislation is also bad for the honest farmers that adhere to humane animal husbandry practices.  As State Senator Quirmbach from Iowa accurately observed, “Passing this bill will put a big red question mark stamped on every pork chop, every chicken wing, every steak, every egg produced in [Iowa] because it will raise the question of ‘what have you got to hide?’”  A good question!

The recent fervor over pink-slime in beef shows that the American public demands to know more about where their food comes from and how it is made.  Hiding questionable farming practices behind ag-gag bills is the wrong way to go.  Selling food inherently requires trust between producers and consumers.  When consumers lose trust – as in the pink-slime case – the effects can be disastrous for business.  In the end, the truth always comes to the light of day.

Making Sense of the 2012 Social Security Trustees’ Report

Posted by on Apr 24, 2012

Filed Under (Retirement Policy, U.S. Fiscal Policy)

Yesterday, the Trustees of the Social Security and Medicare Trust Funds issued their annual report on the financial status of these entitlement programs.  These annual reports have been published for decades, and are generally recognized as the most credible, unbiased, and objective assessment of the long-run financial situation facing these programs.  I am going to focus on the Social Security program in this post.

Interest groups and policy analysts from across the political spectrum immediately issued press releases trying to spin the findings of the report.  Here are the first two that crossed my virtual desk yesterday:

The National Academy of Social Insurance (of which I was a member for many years before finally resigning over frustration at their defense of the status quo) issued a release spinning the report in the most positive light possible:  The 2012 Trustees Report shows that Social Security is 100 percent solvent until 2033, but faces a moderate long-term shortfall. In 2011, Social Security had a surplus – revenue plus interest income in excess of outgo – of $69 billion. Reserves are projected to grow to $3.1 trillion by the end of 2020 … While the trustees’ projections indicate that major changes are not needed, modest changes should be made in a timely manner and can bring Social Security into long-term balance.

In sharp contrast, the Committee for a Responsible Federal Budget issued a release stating:  “Today, the Social Security and Medicare Trustees released their 2012 report on the financial status of Social Security and Medicare, showing that reforms will be needed soon to make these programs sustainable … Social Security as a whole is on an unsustainable path … Social Security’s financial status has deteriorated significantly since last year’s report … Currently, Social Security is adding significantly to unified budget deficits. Not counting the payroll tax holiday this year and last year, the program is projected to run a $53 billion deficit in 2012 and $937 billion from 2013 through 2022.”

Both NASI and CRFB are highly respected organizations, yet the pictures they paint could not be more different.  So, who is right?  Is it possible to reconcile these two views?

Like last week’s post, in which I tried to cut through the rhetoric over the cost of the Affordable Care Act, this post tries to cut through the rhetoric over Social Security’s finances by using a fictitious debate.  And just like last week, the answer to “who is right?” is “It depends …”

Let’s focus on what appears to be a factual disagreement.  NASI says “In 2011, Social Security had a surplus.”  CRFB says “Social security is adding significantly to unified budget deficits.”

How can the program be running both a surplus and adding to the deficit?

The answer is that it depends on whether you think about interest on the Social Security trust funds as being income or not.  One’s views about the Trust Funds also help shed light on whether we should view Social Security as being in financial distress now (the CRFB view), or whether we still have two decades before we have any real problems (the NASI view).

How does the Trust Fund work?  (For this post, I am going to ignore the distinction between the retirement and disability trust funds – implicitly, I am assuming that Congress will simply re-allocate the payroll tax revenue across the two programs, as they have done in the past when needed).

Let’s go back a few years to the pre-financial crisis, say, 2007.  Suppose you earned $50,000 that year.  You and your employer each paid 6.2% of payroll into the system, for a total of 12.4%.  This was approximately $6,200 that the U.S. Treasury collected, and this money was designated for the Social Security Trust Fund.

Social Security took most of that $6,200 (just to keep that math easy, let’s say they took $5,200 of it), and paid it out to current retirees and other beneficiaries (such as disabled workers, widows, etc).  The remaining $1,000 was not needed in that year, so it was handed back to the U.S. Treasury.  In return, the U.S. Treasury issued a $1,000 special-issue U.S. Treasury bond to the Social Security trust funds.  Like other U.S. Treasuries, this one was backed by the full faith and credit of the U.S. government.

Now, back in 2007, like in most years in recent history, the U.S. government was running budget deficits.  Thus, the Treasury department basically took your $1,000 and used it to finance the government spending that we were doing in excess of the income tax revenue we were bringing in.  They did not actually invest the money in financial securities – rather, they spent it.  Of course, they still owe the $1,000 to the Social Security trust fund.

This has been going on for about three decades.  As a result, the Social Security trust fund now owns several trillion dollars’ worth of government bonds.  And the U.S. Treasury pays the trust funds interest on these bonds.

Today, to a first approximation, the entire $6,200 that a $50,000 per year worker and her employer pay into the system is all going to pay benefits.  So there are no more new deposits to the trust fund.  But the balance of the account is quite large, and is spinning off interest.

So here is the key question.  Should the interest that Treasury is paying to the Social Security trust funds be counted as income?  Here is how a discussion might go between NASI and CRFB representatives.  (Any misrepresentations of views are mine alone).

NASI: “Of course the interest should count as income.  The interest grows the trust funds, and the trust funds represent a legal claim by the trust funds that will be backed by the full faith and credit of the U.S. government.”

CRFB: “Yes, but while these bonds – and their interest – represent an asset to Social Security, they are a liability to the U.S. Treasury.  And because the Treasury spent that money rather than saving it, it is crazy to think that we should count this as income.  The interest payments are just an accounting fiction, not a real flow of money into the government as a whole.”

NASI:  “Ah, but the trust funds do represent real savings.  If the Treasury had not issued this debt to Social Security, they would have had to increase public borrowing.  So the Trust Fund balance represents money that the U.S. did not have to borrow – and that is a form of saving.”

CRFB: “But for decades, Congress used the Social Security surpluses to hide the deficits in the rest of the government.  As a result, Congress spent more money over the past few decades than they would have if they had not been able to hide the true cost of their profligacy behind a unified budget framework.”

NASI: “There is no way to know for sure that the Social Security surpluses led to increased spending by Congress.”

CRFB: “Ah, but there is – at least two academic studies (here and here) have shown that this is exactly what happened.”

NASI: “Academic studies aside, there is no question that we should count this interest.  And if we do count it, it is clear that Social Security is running a surplus.  It is also clear that the program can pay 100% of promised benefits at least until 2033.”

CRFB:  “But that is a narrow perspective.  We care about the government budget as a whole – not just the narrow question of the Trust Funds.  From that perspective, what we know is that the amount of money we are collecting in payroll taxes today is no longer enough to cover the payments to beneficiaries.  The days of cash flow surpluses are gone.  And because interest on the trust fund is just one arm of government (Treasury) making a paper transfer to another arm of government (the Trust Funds), this does not represent real income to the government as a whole.  As such, the program is in dire straits, and needs to be fixed now.”

That fictitious debate roughly captures the economic disagreement underlying these two very different assessments of the latest Trustees’ Report.

I happen to support the CRFB view that the problem is serious, that we need to address it sooner rather than later, and that there is no pain-free solution.  But at the end of the day, it is impossible to fully refute the NASI view because we cannot go back in time and re-run an alternate history to know how spending would have responded in the absence of past Social Security surpluses.

Regardless of which view one holds, it is becoming increasingly difficult to deny the existence of a financing problem.  Even if you take the NASI view that we do not have a problem until the trust funds run dry in 2033, it is worth noting that this date is quite a bit earlier than what has been previously estimated.  Furthermore, 21 years is not a very long time when we are talking about a retirement program.  After all, nearly half of today’s 65-year olds will still be alive in 2033 and relying on Social Security benefits.  Today’s 46-year olds will reach their normal retirement age in 2033.  And today’s college students will be nearly half-way to their own retirement age.  We need to make changes now – so that we have time to phase-in the changes gradually and to allow individuals to adjust.

So, regardless of one’s views about the trust funds, it seems obvious to me that the real story behind the release of the Trustees’ Report is that the problem is real, it may be larger than we previously thought, and that it is not going to go away on its own.

Negative Leakage

Posted by on Apr 20, 2012

Filed Under (Environmental Policy, U.S. Fiscal Policy)

What is that, a gastrointestinal disorder?   No, it’s the title of one of my recent research papers  (joint with Dan Karney and Kathy Baylis) about unilateral efforts to reduce emissions of greenhouse gases (GHG).   When worldwide agreement is not possible, then the question is whether GHG abatement policy might be implemented by only one country, or bloc of countries (or region or sector).   The fear of any one country or bloc is that they would only raise their own cost of production, make themselves less competitive, and lose business to firms in other countries that may increase production and emissions.  When only one country limits their emissions, any positive effect on emissions elsewhere is called “leakage”.

Yes, that’s a word in economics, see http://en.wikipedia.org/wiki/Leakage .

In efforts to “abate” or to reduce GHG emissions, the fear of lost business has pretty much deterred any attempt at unilateral climate policy.  That positive leakage might be called a “terms of trade effect” (TTE), because unilateral policy raises the price of exports and reduces the price of imports.   But our recent research paper points out a major effect that could offset part of that positive leakage.  The “negative leakage” term in the equation might be called an “abatement resource effect” (ARE).   That is, one additional thing happening is that the domestic firms face higher costs of their emissions, and so they want to substitute away from GHG emissions and instead use other resources for abatement – such as windmills, solar cells, energy efficient machinery, hybrids, electric cars, and even “carbon capture and sequestration” (CCS).  Thus they have at least SOME incentive to draw resources AWAY from other sectors or other countries.  If that effect is large, the result might shrink those other sectors’ operations overall, and thus possibly SHRINK emissions elsewhere.

I don’t mean to oversell this idea, because it probably does not completely offset the usual  positive “terms of trade effect”.  But in some circumstances it COULD be large, and it COULD result in net negative leakage.  The best example is probably to think about a tax or permit price for carbon emissions only in the electricity generating sector, within one country.  For simplicity, suppose there’s no trade with any other countries, so the only choice for consumers in this country is how much to spend on “electricity” and how much to spend on “all other goods”.   Demand for electricity is usually thought to be inelastic, which means consumers buy almost the same amount even as the price rises.  If firms need to produce almost as much electricity, while substantially reducing their GHG emissions, they must invest a lot of labor AND capital into windmills, solar panels, and CCS.  With any given total number of workers and investment dollars in the economy, then fewer resources are used to produce “all other goods”.

The ability of consumers to substitute between the two goods (electricity vs “all other”) is called the “elasticity of substitution in utility.”  The ability of firms to substitute between GHG emissions and those OTHER inputs is called the “elasticity of substitution in production”.  If the former is bigger than the latter, then net leakage is positive.  If the latter is bigger than the former, then net leakage can be negative.

Okay, too technical.  But the point is that other researchers have missed this “abatement resource effect” and overstated the likely positive effect on leakage.  And that omission has led to overstated fears about the bad effects of unilateral carbon policy.  What we show is that those fears are overstated, in some cases, where leakage may not be that bad.  With some concentration on those favorable cases, one country might be able to undertake some good for the world without fear that they just lose business to other sectors.

Making Sense of the War of Words over the Cost of Obamacare

Posted by on Apr 18, 2012

Filed Under (Health Care, Retirement Policy, U.S. Fiscal Policy)

A war of words (and numbers) has broken out in the policy wonk world over the effect of Obamacare on the deficit.  It is important, entertaining, and confusing.  This blog attempts to bring a bit of clarity to the debate.    

 It began last week with an article, written by Charles Blahous and issued by the Mercatus Center, that argued that Obamacare increased the deficit.  The piece was discussed in the Washington Post (and on my blog) on the day it was issued.

It took almost no time at all for Paul Krugman to denounce the study.  He first began, in typically unfortunate fashion, by attacking the credibility of the author through a suggestion that Blahous was just another Koch-funded crazy who should not be believed.  He then went on to make a slightly more substantive argument about the fact that Blahous’ result rested upon a view (that Krugman called “bogus”) about what Obamacare spending should be compared with.

Blahous publicly responded, defending his position.  A few days later, former CBO Director and former OMB Director Peter Orszag joined the broadside attack against Blahous.  Peter also joined in the credibility attack and went on to also attack Blahous’ choice of baseline. 

So who is right?   The point of this post is to try to provide a bit of clarity on the issue. 

Before proceeding, I should disclose my own personal biases.  First, I consider both Chuck Blahous and Peter Orszag to be personal friends – and I believe both would agree with that assessment.  I have known and worked with both of them for over a decade.  I have an incredibly high level of respect and admiration for both Chuck and Peter as public servants, as intellectuals, and as individuals.  This is not the first time they have publicly tangled (they did so frequently over Social Security reform).  Ideologically, I almost always find myself on the same side of issues as Chuck.  But Peter is an outstanding economist, and when his views are also echoed by other highly respected economists like David Cutler of Harvard (one of the most highly respected health economists in the world, who engaged in a debate with Chuck on my Facebook page), I often find myself temporarily in a state of cognitive dissonance.  When this happens, I try to figure out the core reason for the disagreement.  Is it different values (e.g., perhaps one cares more about redistribution and the other more about economic efficiency)?  Is it different assumptions (e.g., fundamentally different views about how the politics will play out or on how future health costs will evolve?)  In such cases, two very smart people can disagree on policy, without either being “wrong.”

But this debate seems different.  This is – or at least should not be – an ideological debate.  The question here is deceptively simple.  It is a debate over a “fact.”  Either Obamacare increases the deficit, or it does not. 

So who is right?

The correct answer is “it depends.”

To understand the long-term effect of any public policy change, one must first ask the question “compared to what?”  And this is where Blahous and Krugman/Orszag differ.

The following is a FICTITIOUS conversation between Blahous and his critics.  I am trying to be clear on their views.  The material in “quotes” is taken from their writing.  The rest is my own attempt to explain their views, and I alone am responsible for any misattributions.  The Orszag quotes can be found hereThe Krugman quotes are here.  Blahous’ views can be found in his original paper, his follow-up post on Forbes, and a new post at E21.  The use of the term “Obamacare” is mine.    

Me:  “If I look at the new spending programs under Obamacare, and compare that to any spending reductions or tax increases under Obamacare, does the program increase or decrease the deficit?”

Blahous:  Over the next ten years, the increases in spending from Obamacare – Medicaid/CHIP, new exchange subsidies, making full Medicare benefit payments for an additional eight years, etc. – exceed the ways that it reduces spending or raises taxes by $346 billion through 2021.  (This is based on a CBO projection of $352 billion adjusted slightly by Chuck.)

Krugman:  This is just “another bogus attack on health reform.”

Orszag:  Indeed.  The cost savings exceed the new costs by $123 billion through 2021.   

Blahous:  But you are both ignoring the cost of extending the solvency of Medicare!  One of the effects of Obamacare is to extend our full financing commitment to Medicare through 2024.  This costs money.  Add up all the things the legislation does, and it is $346 billion more than the legislation’s cost-savings.

Orszag:  This is a “trick.”  The Blahous analysis “begins with the observation that Medicare Part A, which covers hospital inpatient care, is prohibited from making benefit payments in excess of incoming revenue once its trust fund is exhausted. He therefore argues that the health reform act is best compared to a world in which any benefit costs above incoming revenue are simply cut off after the trust-fund exhaustion date. Then, he argues that since the health-care reform act extends the life of the trust fund, it allows more Medicare benefits to be paid in the future. Presto, the law increases the deficit by raising Medicare benefits.” 

Blahous:  Look guys, this is really simple.  Without the ACA, Medicare would have been insolvent in 2016.  Under the new legislation, we are making a binding commitment to make full benefit payments through 2024.  These are real payments to real people.  How can you ignore the extra commitments through 2024?  After all, you claim the Medicare solvency extension as one of the achievements of the ACA.

Krugman:  “OK, this is crazy. Nobody, and I mean nobody, tries to assess legislation against a baseline that assumes that Medicare will just cut off millions of seniors when the current trust fund is exhausted.”

Blahous:  But under a literal interpretation of current law – which is how most budget scoring is done in Washington – a law that extends Medicare for additional years would be scored as a cost.  Do you acknowledge that under a literal change in law, this legislation puts us $346 billion deeper in the hole? 

Krugman:  The literal law does not matter.  Everyone knows that Congress is not going to allow Medicare benefits to be slashed in 2016.  To suggest these costs are a cost of Obamacare is misleading.  “In general, you almost always want to assess legislation against ‘current policy’, not ‘current law’; there are lots of things that legally are supposed to happen, but that everyone knows won’t, because new legislation will be passed to maintain popular tax cuts, sustain popular programs, and so on.

Blahous: But we have to abide by these budget rules in other contexts.  For example, let’s look at the Alternative Minimum Tax. The Congressional Budget Office counts the revenue from the AMT in its baseline budget projections, even though it knows full well that Congress is likely to continue to provide AMT relief before that revenue is collected.  Similarly with the “doc fix” in Medicare!

Orszag:  Yes, but by your logic, if we just assume that Medicare benefits are cut when the trust fund runs dry, or that Social Security benefits are cut when its trust fund runs dry a few decades later, then we do not have a long term budget problem!  Indeed, Chuck, you are “far too modest. The government is not legally allowed to issue any debt above the statutory limit, so (you) should have assumed the deficit would disappear when we reach that limit at or around the beginning of next year.”

Blahous:  Look, when you make Medicare benefit payments, real money leaves the US Treasury.   We can’t send the same check to Medicare and to Medicaid.  If you want to take credit for all the benefits of the ACA – one of which was to extend Medicare – then you have to account for the Medicare commitments as well as the Medicaid ones.  Even if you don’t think we would have allowed benefits to be suddenly cut, historically Congress has always enacted other savings to avert Medicare insolvency.  And, now that Medicare solvency is extended through 2024, the pressure on Congress to enact further savings is reduced.  So it’s not only as a matter of literal law but as a matter of practical budgetary behavior that the ACA worsens the outlook.  No matter how exactly you think things would have played out under prior law, this legislation still worsens deficits by $346 billion relative to prior law.

Krugman:  Don’t believe any of this.  The Mercatus Center is funded by the Koch brothers.  The Koch brothers, by golly!!

Blahous:  Look guys, I am trying to make a real point here, not engage in character assassination.  If carried to its logical conclusion, this is not only a departure from interpreting actual law, it is also fiscally dangerous.  You guys are basically saying that there are no prior law restraints on Medicare spending.  So every time we extend the program’s solvency, it does not cost anything!  

Me:  Okay, guys, thanks for clearing that up.  I understand it all so much better now. 

—–

So there you have it.  A knock-down, drag-out battle over budget baselines.  The debate is not over the cost of things like the coverage mandate.  It is a debate over the proper way to account for an extension of Medicare’s solvency. 

To summarize:

Relative to a world where Medicare expenditures are brought into balance with revenues within the next few years (which does appear to be required under the literal reading of current law), ACA increases Medicare expenditure and the deficit.  This is the Blahous view.   

Relative to a world in which we project current practice forward, ACA reduces Medicare expenditure and the deficit.  This is the Krugman and Orszag view. 

I think most reasonable people can understand both points.  And I don’t think this really calls for name-calling and credibility-questioning.  But in Washington, that is what passes for debate.

Most ordinary people probably think that what we should be doing is making some cuts, but not cut so deeply as to eliminate the entire Medicare shortfall.  If so, the effect on the deficit is better than if we did nothing, but worse than if we solved the problem. 

So most people probably think the “truth” (whatever that means in this context) lies somewhere in the middle.

How the Supreme Court can Reduce the Deficit: The Fiscal Impact of Ending Obamacare

Posted by on Apr 10, 2012

Filed Under (Health Care, U.S. Fiscal Policy)

West face of the United States Supreme Court b...
(Photo credit: Wikipedia)

Last week’s U.S. news was dominated by the oral arguments before the Supreme Court of the United States (SCOTUS) on the constitutionality of the Patient Protection and Affordable Care Act (PPACA), also known more succinctly as the Affordable Care Act (ACA), or, simply, “Obamacare.”  Most of the news coverage revolved around legal issues, such as how to define a “limiting principle” that would distinguish health insurance from other goods and services.  A few of those analyses, including one by my colleague Nolan Miller at the University of Illinois, provided useful economic insights on these legal questions.

But what I have not seen much of – until now – is a careful analysis of the impact of repeal on the federal budget.  Yes, there is plenty of rhetoric around this topic, with Democrats arguing that PPACA saved money and Republicans arguing that it created a huge new entitlement.  But there has been very little careful analysis.

That changed today, when the Mercatus Center at George Mason University released a meaty new report written by Charles (“Chuck”) Blahous.  His analysis shows quite clearly that the Supreme Court now finds itself in the position of having an enormous impact on the long-run fiscal situation in the U.S.

As background, Chuck Blahous is one of two public trustees of the Social Security and Medicare trust funds, having been appointed to this post by President Barack Obama and confirmed by the U.S. Senate.  Previously, Chuck served all eight years of the G. W. Bush administration at the National Economic Council.  After spending over two decades in both the legislative and executive branches of the U.S. government, Chuck knows the ins and outs of federal budgets.  He is also widely respected on both sides of the aisle as a serious policy analyst.

In a nutshell, here is what Chuck’s careful analysis finds:

  1. PPACA is expected to increase net federal spending by more than $1.15 trillion over the next decade.
  2. PPACA is likely to add more than $340 billion, and perhaps as much as $530 billion, to federal deficits over the next decade.
  3. Despite these realities, government scorekeeping rules lead to deep confusion over the fiscal impact, and have the effect of making PPACA appear less expensive than it really is.

How can this be?  In part, the law “relies upon substantial savings already required under previous law to maintain the solvency of the Medicare Hospital Insurance (HI) Trust Fund.  These do not represent new net savings … but substitutions for spending reductions that would have occurred by law in the absence” of this act.  There are other issues at play as well.

All of this is “public,” in the sense that it has been disclosed in scoring documents by the Congressional Budget Office (CBO). But the CBO is constrained to report the effect of government tax and spending programs according to various scoring rules – even when those rules deviate substantially from the likely political or economic reality.  Skilled politicians have learned to use these scoring rules to their advantage.

As Chuck points out in his paper:

“A full understanding of the ACA’s budget effects requires appreciation of the distinction between two important points:

  1. CBO found that the ACAD would reduce federal deficits when a specific scoring convention was applied;
  2. The same analysis shows implicitly that the ACA would substantially increase federal deficits relative to previous law.

The paper is over 50 pages in length (including the helpful Q&A in the appendix), but is well worth a read if you want to know the details behind the calculations.

But if you don’t have time to read it, here is the bottom-line: “Taken as a whole, the enactment of the ACA has substantially worsened a dire federal fiscal outlook.  The ACA both increases a federal commitment to health care spending that was already unsustainable under prior law and would exacerbate projected federal deficits relative to prior law.  This is an unambiguous conclusion …”

Were the Supreme Court to strike down all or part of this Act, we should view it as an opportunity to revisit health care reform in a way that reduces, not increases, public spending.

Privatize, Privatize, Privatize!

Posted by on Apr 6, 2012

Filed Under (Environmental Policy, Finance, Other Topics, U.S. Fiscal Policy)

Many advocates of small government have many ideas for how to move activities out of the public sector and into the private sector.  Social Security can be privatized, using fully-funded private retirement investment accounts.  Education can be privatized, with vouchers that can be used by parents to choose the best private school or charter school.  All could save money for the federal budget, by taking advantage of the more efficient operations of the private sector.

In this blog, I’ll describe my new idea for privatization.  Why not privatize the military!  Many rich Republicans want more military spending, and I can imagine that they might well be willing to pay for it.   Why not let them?  Now, they are probably not willing to simply donate money to the federal government, with no recognition, nor any private return on their investment.  But, we could provide the same kind of naming rights as many private operations: FedEx Field is the home of the Washington Redskins, because FedEx paid for the naming rights and they get PR advantages of doing so.  The name of the business school at the University of Texas is the “McCombs School of business”, because Red McCombs paid for the naming rights, and he gets PR advantages of doing so.  The J. Paul Getty Museum is the name of a major art museum in Los Angeles, presumably because somebody in the Getty family or foundation paid for the naming rights and gets PR advantages of doing so.

So, the idea is to write the name of any major donor on any piece of military equipment for which that donor covers at least half the cost.  Pay for half a tank, and it will be the “Your Name Here” Army Battle Tank, with the name engraved on the equipment.  You can even visit it, at certain times of year under certain conditions, and have your picture taken with it.  If you are willing to pay a little more, half the cost of a cruise missile, you can have your name on that instead.

Now I’m not suggesting that the donor ought to be allowed to decide when to push the button.  Nor even make any decisions at all.  The payment is just to help out the U.S. Federal Budget deficit, with recognition for doing so.  I’d bet that a good number of millionaires would really be willing to pay, for that kind of prestige.  It might even be greater recognition if the missile were actually used!  The well-heeled U.S. businessman might even get more U.S. business activity, after the newspaper announces that the “Your Name Here” cruise missile was launched at Tehran, killing 137 innocent civilians, but successfully deterring the Iranian government from pursuing a nuclear weapon that might kill even more.