The limited market for long-term care insurance

Filed Under (Health Care) by Jeffrey Brown on Nov 8, 2011

Rather than post an original blog this week, I am going to settle for providing a link to a blog that someone else wrote, but which is based on my research on long-term care insurance … you can read it by clicking here.


The Lexus and the Human

Filed Under (Health Care) by Jeffrey Brown on Nov 1, 2011

Yesterday, I had the honor of hosting University of Illinois Jeff Margolis as a guest speaker in my Employee Benefits course here in the Illinois College of Business.  Jeff Margolis may not be a household name, but he ought to be.  Jeff just recently retired from the TriZetto Group, the company he founded in 1997 to provide the knowledge and the tools to help power “Integrated Healthcare Management.”  His company’s software touches the lives of over half the U.S. population.  He is also author of the book “The Healthcare Cure: How Sharing Information Can Make the System Work Better,” which is due out later this month (which is an extended and updated version of an earlier book, The Information Cure, from which I am drawing my post for today.)  Jeff understands the U.S. health care system inside and out.

Jeff’s talk to my classes yesterday had several really important take-aways.  Of these, perhaps the most important is the need to carefully define the problem that one is trying to solve.  I often point out to my class that there are many ways to define the problem with health care in the U.S., and each has a different set of solutions.  For example, if one simply wants to reduce health care spending, there are lots of easy ways to do that – restricting access, limiting innovation, reducing insurance coverage – but we probably would not like many of the outcomes!  Similarly, if one simply wants to increase insurance coverage, we can do that too.  But then don’t be surprised when health care spending rises as a result.

Jeff Margolis focused on a more clearly-defined problem – one with which economist like me tend to agree is right way to think about health care policy.  In my words, he was fundamentally focused on how do we get the right care to the right people at the right time?  At its essence, this is a question of resource allocation, and the only way we are going to get it right is if all the relevant actors (doctors, hospitals, patients, payers, etc.) have access to the information they need.  Information about patients.  Evidence-based information about which treatments work for which types of patients.  Information about costs.  And so on …

To give but one illustration, in Chapter 3 of Jeff’s “Information Cure” book, he has a great chapter (the title of which I have borrowed for this post), called “The Lexus and the Human.”  He starts with the provocative question – “which would you rather be: a Lexus or a human being?”  He then goes on to point out that when a Lexus is “ill” (i.e., something is wrong, and it needs to be diagnosed and fixed), there is a very rich, thorough, and transferable set of maintenance records that are easily communicated to the right mechanic in the right garage at the right time.  In contrast, when a human being shows up at a Doctor’s office, the information is often incomplete, fragmented, and out of date.

As Jeff states, “in stark contrast to Lexus’ systematic way of maintaining and repairing its cars, the U.S. healthcare system lacks the coordination to care for humans as reliably and comprehensively … the Lexus enjoys a much higher degree of precision regarding its care.  For starters, our system does not reliably enable providers and consumers to access medical records wherever and whenever we need them.”  He talks about the inefficiencies this creates in the form of duplicate tests.  But he also notes the much more serious consequences, such as being improperly treated because an emergency room doctor was unaware of your drug allergy.

He also points out that the information exists.  But the overall system needs re-engineered to optimize the use of this information.  He points out that health plan providers – such as Cigna, Aetna, United Health Care, and others – may be in the best position to help us get there because of the role they play in the health care supply chain.  Unfortunately, our politicians are so busy villain-izing these health care companies that we may be overlooking an enormous opportunity for increasing the efficiency and efficacy of our health care system.

It is worthwhile food for thought.  There is much, much more to say on this topic – and hopefully I will return to it in future posts.  But for now, thanks to Jeff Margolis for lecturing at his alma mater, and for helping to educate the next generation about ways to productively identify and solve problems.

The Economic Cost of Political Uncertainty

Filed Under (U.S. Fiscal Policy) by Jeffrey Brown on Oct 24, 2011

If given only one word to describe the current state of the economy AND the current state of the political and policy climate in the U.S., it would be “uncertain.”  Some of the uncertainty is due to factors beyond our control, such as whether the E.U.’s efforts to come to the aid of Greece will be effective in limiting systemic damage to financial markets.  But much of the uncertain is, essentially, our own fault.  And by “our,” I mean all of us who participate in the U.S. political system as voters.

Policy uncertainty is common whenever there is a Presidential election coming up that could go either way.  But the current state of uncertainty seems much higher than normal.  The debt ceiling debate over the summer was a case-in-point.  In the course of a few short weeks, we saw policymakers move back and forth between “grand bargains” that would have substantially reduced the size of government, to a real possibility of default on government debt, to a “resolution” that essentially punted on the hard fiscal issues.  Now, we wait with bated breath for a Congressional super-committee to issue its report, with conflicting reports of whether they will reach substantive agreement.

Earlier this month, I organized and ran the 26th annual NBER Tax Policy and the Economy conference at the National Press Club in Washington DC.  One of the papers presented at this conference, by Francisco Gomes, Larry Kotlikoff and Luis Viceira, was on “the excess burden of government indecision.”  They point out that “delaying the resolution of fiscal imbalances comes at two costs.  First, it leaves a larger bill for a smaller number of people to pay.  Second … it perpetuates uncertainty, leading economic agents to make saving, investment, labor supply and other decisions that are suboptimal form an ex-post perspective.”

The first of these effects is well-known.  The second is an important contribution of their paper.  Put simply, the authors show (using a carefully parameterized life-cycle model) that policy uncertainty comes at a real cost.  This cost is in the form of an “excess burden” that is very similar to the “excess burden” that we usually associate with taxes that distort behavior.

They calculate that government indecision in the case of delaying changes to Social Security can reduce overall consumer well-being by more than half a percent of lifetime resources.  This may not sound like much, but half a percent of total lifetime resources is quite substantial.  Their model is highly stylized, and thus one may not wish to take the quantitative estimate as being precise.  But their conceptual point is clear.  Our inability to grapple with our fiscal problems – and the uncertainty this creates – creates very real additional costs over and above the direct effect of the fiscal problems themselves.

No Mourning for Death of the CLASS Act

Filed Under (Health Care, U.S. Fiscal Policy) by Jeffrey Brown on Oct 16, 2011

Late Friday afternoon, the Obama Administration announced that it was killing the CLASS Act, a controversial provision of Obamacare (the Patient Protection and Affordability Act) that was going to create a new, government-run long-term care insurance program.  The fact that they released this news late on a Friday should not come as a surprise, as this is a time honored trick for trying to bury bad political news (although as noted by Stefano DellaVigna and Joshua Pollet, this strategy does not have long-lasting benefits, at least for publicly traded companies!)  Undoubtedly, both sides of the political divide will try to spin this issue for political benefit, as it is the first part of Obamacare that has been ended.

Politics aside, however, the death of this program is a rare victory for good economics.  And we should give credit to the Obama Administration for killing it before it grew into yet another unworkable and fiscally irresponsible government program.

Early in the life of this blog (November 2009), in a post entitled “A Solution in Search of Problem,” I wrote about why the proposed CLASS Act (which went on to become law several months after my post) was fatally flawed.  In that post, I made the point that “the government has developed a solution to a supply problem that does not exist, but has failed to address the demand problems that do exist.”

In a recently issued NBER working paper, MIT economist Amy Finkelstein and I wrote in much more detail about the flaws of the program.  Here are a few of the points we make:

“Medicaid will likely impose a large implicit tax on CLASS benefits, just as it does on private insurance policies … Overall, the Congressional Budget Office (2009) has estimated that only 4 percent of the adult population would enroll in the CLASS Act program by 2019.”

“The pricing and financing of the program are controversial. Monthly premiums are to be set by the Secretary of Health and Human Services with a goal of maintaining program solvency over 75 years.  In practice, this means that premiums will likely be below “actuarially fair” levels. To understand why, imagine that individuals start paying premiums immediately, but the average payout will not occur for, say, 25 years in the future. To oversimplify, a 75-year “solvency” calculation counts 75-years’ worth of premium payments, but only 50 years’ worth of benefit payments. Thus a program could be technically solvent even though it is being run on a negative NPV basis. The financial problem is magnified by the fact that individuals below the poverty line and full-time students would be able to participate at only $5 per month (in 2009 dollars). A number of experts have also voiced concerns about adverse selection into this voluntary program, and have suggested that the program will face a troubled fiscal future.”

This program was a clear example of a program designed by people with good intentions, but who had such a frail grasp on basic economic concepts that they designed a program destined to fail. We should all just be glad that it was killed before it developed its own constituency and grew to become “too big to fail.”

Is Social Security a Ponzi Scheme?

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Sep 25, 2011

A hot topic in the recent Republican presidential candidate debates has been whether it is fair to characterize Social Security as “Ponzi scheme,” as Governor Rick Perry has done.  For this assertion, he has come under criticism from, among others, former Massachusetts Governor Mitt Romney.  Political rhetoric aside, this raises an interesting question.  Is Social Security a Ponzi scheme?

 Many individuals may be hoping for a simple “yes” or “no” answer to this question.  But like so many policy questions, the answer is a somewhat less satisfying “sort of.” 

 To explain, we need to start with a definition of a Ponzi scheme.  According to the U.S. Securities and Exchange Commission, a Ponzi scheme is:

 “an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses, instead of engaging in any legitimate investment activity.”

 The name of this scheme comes from the exploits of Charles Ponzi, who back in the 1920s promised his “investors” an enormous rate of return (according to the SEC, 50% in just 90 days, relative to the 5% people could get in a bank account) by investing in postage stamp speculation.  The modern-day equivalent is Bernie Madoff, who more recently defrauded individuals, non-profits and institutional investors out of enormous sums of money (on the order of $50 billion according to Forbes) in order to support his lavish lifestyle. 

 So let’s compare Social Security to the likes of Ponzi and Madoff. 

 How does Social Security look like a Ponzi scheme?

 The characteristic of Social Security that most closely parallels the misdeeds of Ponzi and Madoff (and gives rise to the claim that Social Security is one giant Ponzi scheme) is that Social Security pays one generation using the contributions of the next.  Just as Ponzi and Madoff used the money from new investors to pay off prior investors, rather than actually investing the funds in real assets, so too does Social Security take contributions from current workers and use it to pay off current retirees.  Like the Ponzi schemes, Social Security is not investing the money in productive real assets.  We economists refer to this design as a “pay-as-you-go” system (as opposed to a funded system where the money would be invested to pay off future benefits).  But it sounds an awful lot like the part of the SEC definition above that states “payment of purported returns to existing investors from funds contributed by new investors.” 

 How does Social Security NOT look like a Ponzi scheme? 

 The first difference between Social Security and the likes of Ponzi and Madoff is that the Social Security system is legally enforceable.  Ponzi schemes do not “blow up” until the purveyor of the fraud runs out of new money at a time when some of the old money wants out.  With Social Security, the government has the ability to force contributions by levying taxes on current and future generations or by borrowing money (which is just another way of levying taxes on future generations).  Nobel prize winning economist Paul Samuelson showed the world many decades ago that pay-as-you-go systems can go on forever, offering a rate of return equal to the rate of population growth plus productivity growth, so long as demographics are stable.  The problem facing Social Security is that people are living longer, working less, and having fewer children.  So as the ratio of workers-to-retirees falls, it becomes more and more expensive for today’s workers to pay for today’s retirees.  So the system may be fiscally unsustainable (i.e., we may not like the tax rates required to keep the program going), but the government does have the ability to keep it going if it is willing to impose such high taxes.

 A second difference is that Social Security does not purport to offer “high returns” as did Madoff or Ponzi.  It is true that it offered higher than market returns to the early generations, who received back far more than they contributed, but nobody today serious argues that the rate of return on Social Security is greater than that which can be achieved in the market.

 A third difference is that nobody in the government is skimming money off the top or personally profiting from the money.  I suppose one could argue that the U.S. Congress and every President since Ronald Reagan have all conspired to “skim the money” by using Social Security surpluses to mask the magnitude of the deficits we were running in the rest of government.  And in that way, these politicians may have “profited” in a political sense, as it allowed them to provide higher services to the public while not paying the full price.  This is a fair point.  But it is also the case that the very same people who are “investors” in the program (e.g., taxpayers) are largely the same individuals who benefit from whatever largesse the government doles out. 


 I understand the temptation to call Social Security a Ponzi scheme, particularly when a politician is looking for an easy way to explain a fairly complex program (I certainly don’t consider it a “crime,” as does the Huffington Post).  But it is certainly not the most accurate description of the program.  Most of all, the problem with calling it a Ponzi scheme is that name-calling does not really help us understand how to solve the problem.  In a real Ponzi scheme, we bring in the Feds, we shut down the fraudster, and we let the courts sort out who loses.  With Social Security, we need our leaders in both parties to provide meaningful ideas on how they will bring Social Security’s finances back onto a sustainable path.  If calling the program a Ponzi scheme somehow helps us to get a solution, then so be it.  But I suspect it will do little more than stir the political juices on both sides of the aisle, allowing both Democrats and Republicans to demagogue the issue, rather than suggesting meaningful solutions.


The Economic Costs of September 11, 2001

Filed Under (Other Topics, U.S. Fiscal Policy) by Jeffrey Brown on Sep 11, 2011

Today, September 11, 2011, we remember the terrible human tragedy that occurred 10 years ago.  What started out as just another beautiful Tuesday morning was devastatingly interrupted by the sights and sounds of four commercial aircraft being intentionally flown by terrorists into the World Trade Center, the Pentagon, and a field in Shanksville, Pennsylvania.  In the hours and days following, we learned of countless acts of courage and selflessness, such as the stories of first responders who were on their way up when the Twin Towers came down.  Or the brave passengers on United 93 who fought back and most likely prevented their plane from crashing into the White House or the Capitol.

A lot was lost that day.  Thousands of innocent lives.  Our nation’s sense of security.  Clearly, relative to those human costs, the economic costs seem almost inconsequential.  Indeed, as someone who feels personally indebted to the heroes of United 93 for quite possibly saving my life (if their flight had hit the White House, I would have been among the victims that day), I will be among those who spend this day remembering their heroism.

Nonetheless, a decade out, it is indeed appropriate that we consider the broader implications of these terrorist attacks.  There are few aspects of our lives, culture and economy that have been left unchanged.  As an economist, I feel most qualified to speak to the economic issues, so this post is about the economic impact of 9/11.

This is a far more difficult exercise than it may seem.  Any numbers I cite here should be taken with a grain of salt, but I felt it useful to at least give a sense of the order of magnitude of the economic implications.

Let’s begin with the easiest part – the direct financial costs of that day.  This includes the loss of buildings and properties, such as the World Trade Center and surrounding buildings and the cost of the four aircraft.  According to an estimate in the Insurance Journal, the direct insured costs from 9/11 were approximately $40 billion in today’s dollars.  But this number includes things like business interruption insurance, which is a real cost to the insurers, but may double count some of my other numbers below.   So if we limit the numbers to property (WTC, other property, worker’s compensation claims, and the like), we are looking at something on the order of $20-25 billion.  A big number, but small in comparison to the indirect costs.

Second, the loss of life.  Economists are often accused of being insensitive, or worse, by trying to place a dollar value on human life.  Without getting into the debate here, suffice it to say that we feel that we can at least measure the value of a  “statistical” life.  Individuals, families, businesses and governments implicitly do this all the time (such as when a worker accepts higher pay in return for taking more risk to his or her life.)  There is a large literature on the “Value of a Statistical Life,” and it is clear that the measure varies by context and by how one models the analysis (if you are interested, you can read more about the difficulties in this nice article by economist Orley Ashenfelter.)  Just for the sake of conversation, let’s use a $5 million per life.  Then we are talking about a $15 billion “economic cost” associated with the lives lost.  Note this is much higher than the $1.2 billion of losses as measured by the value of life insurance payouts.


Third, and much more difficult to measure, there are the ongoing costs of slower economic growth as a result of these events.  In the short-run, the 9/11 attacks exacerbated the weakness of an already weak economy (recall that we were already in a recession).   But figuring out how much of the economic slowdown in the period was due to the attacks is notoriously difficult.  A paper put out about a year after the attacks by the Congressional Research Service discusses the many reasons it is so hard to measure, include the fact that we were already in recession, and that there were policy responses to the attacks (both in terms of monetary and fiscal policy) that helped mitigate the short-term impacts (but in some cases at longer term costs).  Even so, it is worth noting that, given the size of U.S. GDP at the time, even a 0.5% reduction in economic growth over the subsequent year would have resulted in output losses on the order of $50 billion, a number larger than the prior to estimates of the direct effects combined.  If the effects persisted more than one year, or if the effect was larger, then the estimates would go up even more.

Fourth, there are the ongoing costs of our investment in additional security measures.  Think about the extra time spent each traveler spends in airport security lines taking off their belts, shoes, removing liquids and gels, getting full body scans, etc.  Now multiply that by the millions of travelers.  And then think about the value of that time.  I have not seen reliable estimates of this, so I won’t attempt to quantify it, but it is a big number.

Finally, perhaps the largest cost of all – our wars in Afghanistan and Iraq.  Without getting into the debate over whether the war in Iraq was really justified based on a terrorist attack by a non-Iraqi terrorist group, I think it is plausible that if the 9/11 attacks had never occurred, the Iraq war would not have occurred either.  In 2007, the Congressional Budget Office made news with an estimate that the cost of these wars could total $2.4 trillion (projected through about 2016 or so).  And, yes, that is trillion, with a t.  That is just the direct costs of these wars – if one includes indirect costs, such as the value of the military lives lost, the numbers would be much higher.

Some of these costs – indeed the most tragic ones, such as the loss of human life, the permanent destruction of the Twin Towers, and so forth – are costs with no corresponding benefit.  Other costs – such as those associated with ridding the world of a horrible dictator (Hussein) and the head (bin Laden) of the world’s leading terrorist organization – also bring enormous direct and indirect benefits.

But no matter how you look at it, the true economic cost of 9/11 was orders of magnitude greater than the direct costs incurred on that day.


What Happens When the Disability Insurance Trust Fund Runs Out of Money?

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Aug 29, 2011

Last week, the non-partisan Congressional Budget Office (CBO) put out an update of the financial status of the Social Security system’s finances (using, by the way, new “infographics” to illustrate the issues).  To policy wonks like myself who follow Social Security’s more closely than we do the Major League Baseball standings, the report simply confirms what we already know – namely, that the Social Security system is on a financially unsustainable course and that it is doomed to insolvency unless Congress gets its act together and makes some difficult decisions.

What really hit the news cycles in the past week, however, was the fact that the expected date of insolvency of the Disability trust fund is now just five years and a few months away – the year 2017.  This is a couple of decades earlier than we usually talk about exhausting the Social Security trust funds, and thus, I suspect, this news has caused some confusion.  So this blog attempts to explain how the trust funds work, and what the exhaustion of the trust fund means for recipients of disability payments.

First, it is worth knowing that the Social Security program is really more than one program.  Formally, there is the OASI program (Old-Age and Surivivors’ Insurance – think of this as the program for retirees and their widowed spouses), and the DI program (Disability Insurance – this is the one that pays benefits to workers who have a disability that severely limits their ability to work).

Second, while we often talk about the “Social Security trust fund,” there are, in fact, two separate funds – one for OASI, and one for DI.  While these are legally separate funds, they are often talked about as a “combined trust fund,” and most of the debate about the long-term problems facing Social Security use data on the combined trust fund.  This masks, however, the fact that the current financing status of the OASI and DI programs are not exact duplicates.  Specifically, the DI trust fund is expected to be exhausted much sooner than the OASI trust fund – 2017 according to the CBO’s most recent estimate.

Third, while we economists can forever debate the economic meaning of the trust funds (I will spare you this debate for now), there is little question about the legal meaning of the trust funds.  Specifically, it is widely understood that so long as the DI trust fund has a positive balance, the Social Security Administration can continue to send out benefit checks to DI recipients, even if the tax revenue flowing into Social Security from the DI portion of the payroll tax (known as the FICA tax) is insufficient to cover benefit payments.  This is because the DI trust fund can redeem the U.S. government bonds that it is holding.  And as long as the U.S. Treasury does not default on its obligations, this means that the Social Security Administration has the legal authority to issue checks.

So, what happens if and when the DI Trust Fund runs dry in 2017?  Well, if Congress failed to act in any way (an outcome I consider implausible, and will say more about below), the Social Security would find itself in a position in which it did not have sufficient dedicated revenue to cover benefits.  The most likely scenario is that they would begin delaying the issuance of checks to beneficiaries.   Eventually, the backlog of checks would grow so long that it would amount to a benefit cut – beneficiaries may only get 11 checks per year instead of 12, for example.  This would be a terrible outcome, because no matter what your views on the role or size of government, it is hard to explain how reneging on payments to some of our most financially vulnerable citizens is the best way to close a budget shortfall.

You may wonder why the Social Security Administration could not just “borrow” some of the OASI money to pay the DI beneficiaries.  And the short answer is that the agency does not appear to have the authority to do this.  Rather, it would require an act of Congress to re-allocate the proportion of the payroll tax revenue that goes to each program.  As they did in the 1980s, for example, Congress could simply state that a larger fraction of the existing FICA tax go to DI instead of OASI.  This patches the short-term problem facing DI, and allows checks to go out.  Of course, it is also “robbing Peter to pay Paul” because it simply makes the OASI trust fund go dry that much sooner.

What we really need is thoughtful reform of both the OASI and DI programs.  Both are important programs to the well-being of individuals who are retired or disabled, but both programs are also not financially sustainable.  We need to adjust benefits, taxes or eligibility in order to bring the system back into long-term balance.

So the good news is that those who rely on the Social Security Disability Insurance program most likely have little to fear about the 2017 insolvency date, because Congress will most likely paper over that problem by reallocating the FICA tax.  But the bad news is that their ability to do so will most likely lead to further delays in making the serious reforms that these programs so badly need.

An Amusing Analysis of the Pension Discount Rate Controversty from a Nobel Laureate in Economics

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Aug 22, 2011

Readers of this blog know that I have written several posts over the past 2 years about the mis-use of “expected returns” as a discount rate for public pension liabilities.  It turns out, this issue even has risen to the attention of Bill Sharpe, Stanford Professor and winner of the Nobel Prize in Economics for his contributions to financial economics.   Don’t worry – this is not a difficult technical piece.  It is a cartoon – and I highly recommend it.  You can watch it by clicking here.   It shows the absurdity of acting like future liabilities are smaller just because the assets are invested in a diversified portfolio.  Enjoy!

Thoughts on the Current Economic Environment

Filed Under (Finance, U.S. Fiscal Policy) by Jeffrey Brown on Aug 16, 2011

Larry DeBrock and I were interviewed by News Bureau Business & Law Editor Phil Ciciora, on the chances of another recession, and what the government needs to do to avert another economic crisis.  Below are our responses.

Jeff Brown: The recent volatility in financial markets is one of several indications that we are operating in an environment marked by high levels of economic uncertainty. While I continue to believe that the most likely scenario going forward is that we will continue to experience a very slow recovery marked by a prolonged period of high unemployment, I also believe there is something on the order of a one-in-four chance that we will fall into a second recession.

It appears that markets are responding to three primary concerns. First, we have had a mixed set of economic indicators released in recent weeks suggesting that the recovery in the U.S. is still quite fragile. Second, the sovereign debt problems in Europe – Greece, Spain and Portugal, among others – are weighing heavily on the minds of many investors, as Europe is a major trading partner. Third, there is tremendous political and policy uncertainty about the willingness and ability of the U.S. to get its fiscal house in order.

The down-to-the-wire debt ceiling debate has clearly signaled to the world that our economic policy-making process is dysfunctional, thus casting some doubt on whether we have the political backbone to address the serious fiscal problems that lie before us. Also, the fact that Congress kicked the can down the road by leaving the hard choices in the hands of a Congressional “super-committee” creates tremendous policy uncertainty, leaving individuals and companies unsure what tax rates they will face in the future.

The current economic environment is extremely difficult to navigate. Many believe we need short-term stimulus, such as reducing payroll taxes or increasing government spending, in order to boost economic activity. From a longer-term perspective, the problem is that these are the wrong policies for reducing deficits. And many of the proposals for stimulus really do very little good over the long run because of their explicitly temporary nature.

The most important thing to understand is that the private sector, and not the government, is the real engine of job growth over the long run. So the best thing the government can do is to create a policy environment that is pro-growth.

How do we do this? First, quickly come up with a credible plan for reducing our long-term deficits, one that is more heavily focused on spending cuts than on revenue increases. Second, reform our tax system so that we promote, rather than penalize, business investment, entrepreneurial activity and work. In short, shift taxes away from work and investment (things we want more of) and onto consumption. Third, once we have placed the country on a sustainable fiscal path with reduced spending and pro-growth tax reform, make the tax regime as permanent as possible so that individuals and companies can make long-term decisions with some confidence that the rules won’t change in the middle of the game.

Larry DeBrock:  I am not sure of the true impact of the S&P downgrade. If you look at U.S. Treasuries, the yields have fallen steadily in the days since the announcement by S&P, which indicates that investors are still very much interested in purchasing U.S.-issued debt. Still, the downgrade did have a big impact on both consumer and investor psychology. The inability of Congress to show leadership in the recent debt limit spectacle combined with the formal announcement of a downgrade of the U.S. credit rating has certainly caused some unnerving volatility in the stock market.

Are we headed for another recession? Quite possibly. Americans are impatient and wish for a rapid return to full employment and strong growth in our country’s gross domestic product. But history indicates that the recovery from a deep recession such as we have just experienced is always a slow process. And, this “recovery” is different in that our government is responding in a manner we have not seen before. In other recessions, the government acted “counter-cyclically” in that it would increase its spending in the face of an economic slowdown. In the current climate, our 50 statehouses as well as our lawmakers in Washington are acting to decrease spending. This “pro-cyclical” response has undoubtedly contributed to the slow pace of job recovery and could contribute to factors that end in a double-dip recession.

The response of the Federal Reserve to announce a stable two-year plan to hold interest rates low is a movement in the right direction. However, interest rates have been low for quite some time. The flight away from risk, as indicated by the increase in prices of U.S. Treasuries despite the S&P pronouncement, is very real. The Fed may have to consider another round of quantitative easing, this time aimed at removing riskier assets from the market.

The most troubling economic news is really the debt crisis in Europe. Economists have long argued that having a single currency across multiple sovereign nations with independent fiscal policies was a recipe for disaster. As each week seems to highlight another example of this incompatibility, the Eurozone economies will continue to struggle. And if Europe experiences an economic slowdown, our economy will certainly share some of that pain.

The Worst Tax of All is Not Even a Tax: The Case of the Social Security Earnings Test

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Aug 8, 2011

Most people dislike paying taxes because every dollar sent to the government is one less dollar they have to spend themselves.  Because taxes make people “poorer” (ignoring, for a moment, the fact that many of those tax dollars are returned to citizens in the form of Social Security income, health benefits, or other government services), they have less money to spend on goods and services.  This is what economists call the “income effect” of taxes.  While this is the part that most normal people dislike, it is not what economists typically care about. 

You see, economists recognize that if you need to raise revenue, then it has to come out of somebody’s pocket.  And whoever’s pocket you choose to take it from will cause that person to have less money to spend.  That is just arithmetic. 

We can also have very spirited debates about whose pocket we should take those taxes from.  This is the “distributional” question.  Or to put it in laymen’s terms, this is the issue of “fairness” or “equity.”  While economists have a lot to contribute to these discussions in terms of analytical rigor, at the end of the day, one’s views on this are determined by non-economic factors, such as ideology, religion, one’s sense of justice, and so on.  Economists may get passionate on these issues, but there is really no reason that a randomly drawn economist’s view of the “fair” level of income redistribution should be given any more weight than a randomly-drawn non-economist’s view.

But there is a third factor – one that is at the heart of economics.  It is the issue of the “efficiency” of a tax system.  And by efficiency, we don’t mean something as narrowly conceived of how much it costs the IRS to collect your taxes (although that is a part of it, albeit a tiny one).  Rather, what we really care about are the incentive effects of taxation.  To use economics terms, we care about “substitution effects” of taxes (as opposed to the income effects above).  And we care about the “deadweight losses” that arise when taxes distort incentives. 

Put simply, for a given amount of revenue raised, some taxes destroy more economic activity and/or population well-being than do others.  This is because of the natural human behavioral response to switch away from taxed goods or activities and towards untaxed (or lower taxed) goods or activities.  So, when we tax labor earnings, people work less.  When we tax capital, people invest less.  When we tax wage income more heavily than health insurance, people get paid a higher share of their compensation in the form of health insurance.  When we tax dividends more highly than interest, firms issue more debt and less equity.  When we levy tariffs on foreign-made goods, people buy more American-made and fewer foreign-made goods.

In all of these cases, the taxes distort decisions, leading to a reallocation of economic activity.  And it is this reallocation that is inefficient, because in addition to raising revenue, the reallocation of activity destroys value.  So, for every dollar raised by levying a tax, we might destroy two dollars of economic value.  The amount of value destroyed over and above the revenue raised is what we refer to as a “deadweight loss.”  And this is what economists really dislike.  (As an aside, there are some unusual cases where imposing a tax is actually good for social well-being, such as when we tax something that the private market fails to account for on its own, such as pollution.  This is the basis for my earlier blog in which I called for an Osama bin Laden tax on carbon to reduce our dependence on foreign oil.)

So, if you wanted to design the PERFECT example of the WORST possible tax, what would it look like?  It would be a tax that created a lot of deadweight loss, but raised no revenue.  That is, you would impose a tax that changed the way people behave, making them worse off, while raising no revenue.

Why would anyone ever want to do this?  Well, my hope is that no one ever would want to do it.  But that does not stop politicians from actually doing it. 

My example?  The Social Security Earnings Test.

If you want an explanation of how the Earnings Test works, you can read all about it by clicking here.  But the quick version is this: If you claim Social Security benefits at age 62 but continue to work and earn money over a threshold, then Social Security reduces your monthly benefit by 50 cents for each additional dollar you earn.  This is on top of any income and payroll taxes you may have to pay.

The Earnings Test is actually not a tax in reality.  It raises no revenue whatsoever.  Why?  Because the money that Social Security reduces your benefit by is actually returned to you in the form of higher future Social Security payments!  And the calculation is roughly “actuarially fair” – meaning that for the average person, you get back the same amount with interest that you put in. 

In other words, the government raises NO revenue from this tax.  That is ingredient #1 for the worst possible tax.

Ingredient #2 is that the earnings test distorts behavior, causing people to work less than they otherwise would.  At least that is my working hypothesis.  The issue is this – if people understood that the earnings test is not really a tax, then it should have very little impact on the work versus retirement decision.  But most people do not understand this.  Rather, they view it as a 50% tax on earnings.

As evidence of this, the AARP conducted a survey of Social Security knowledge.  When they asked people what would happen to a hypothetical 63-year old who continues to earn $40,000 per year while collecting benefits, four out of 5 people ages 55 -66 correctly answered that this would reduce his current benefit.  Then, equally importantly, 3 out of 5 respondents believed that this person would never get the money back. 

So there you have it.  The “tax that is not a tax.”  You get all the negatives (i.e., distortion of labor supply decisions) and none of the revenue.

This idea was implemented so poorly that one might just think it was thought up by the U.S. Congress.  And you’d be right.