Understanding the Budget Deficits

Today’s Atlantic column is a follow-up to last week’s on the size-of-government fallacy. In the column, I break down the projected 2021 deficit into three components: Social Security, Medicare, and Everything Else. (It’s important to use 2021, or some year out there, because most of the current spike in deficits will go away as the economy recovers.) I wanted to explain here how I came up with the numbers and talk a bit more about this approach.

The Social Security budget is simple: it’s 2021 outlays (mainly benefit payments) minus 2021 receipts (payroll tax); interest on the trust fund doesn’t come into play since that’s an intra-governmental transfer. Payroll taxes of 4.5 percent of GDP are from the January Budget and Economic Outlook (BEO), Table 4-5; outlays of 5.3 percent of GDP are from the June Long-Term Budget Outlook (LTBO), Table 1-2 (it’s the same in both scenarios).You get a deficit of 0.8 percent of GDP.

Medicare is more complicated, since Medicare was never designed to be fully self-funding. Medicare Part A (hospital insurance) is supposed to be self-funding like Social Security, but Part B (supplemental medical) was always funded partly by beneficiary premiums and partly by funds from general revenues. Part D (prescription drugs) is also funded like Part B.

Gross Medicare spending in 2021 is easy: that’s 4.3 percent of GDP, from the LTBO, Table 1-2, alternative fiscal scenario (the more realistic one). Medicare gets another 1.1 percent of GDP in offsetting receipts. That’s from the 2011 Medicare trust funds report, Tables V.E4 and V.E5.* I took all Medicare receipts and subtracted out the payroll tax and the contributions from general revenues; most of what’s left is beneficiary premiums. So if you think of Medicare like a health insurance plan, it collects 1.1 percent of GDP in premiums and pays 4.3 percent in benefits, for net spending of 3.2 percent. The Part A payroll tax brings in 1.4 percent of GDP (BEO, Table 4-5), leaving a deficit of 1.8 percent of GDP. Under current law, that deficit is filled by general revenues.

If you subtract Social Security and Medicare from the total 2021 budget, you get Everything Else, which has receipts of 12.5 percent of GDP and primary outlays (not counting interest on the debt) of 13.0 percent, for a primary deficit of only 0.5 percent. And that assumes that all of the Bush/Obama tax cuts are made permanent (except for the two percentage-point cut in the payroll tax).

So as far as 2021 is concerned, the solution seems pretty simple. Let the tax cuts expire at the end of 2021. Assuming that we do patch the AMT, killing the tax cuts is worth $444 billion in 2021, or 1.9 percent of GDP. That would cover almost two-thirds of the total deficit.

But while many Democrats support using more general revenues to fill the Medicare deficit, I’m not sure that’s the best solution. I lean toward the position that Medicare should be self-funding, because it’s basically an insurance product you’re buying from the federal government: you pay with payroll taxes and premiums, and you get health insurance coverage in return (or at least that’s the way it should be). One reason people don’t like taxes is that they can’t see what they’re getting in return. With Social Security, people can see exactly what they’re getting for their payroll taxes, and as a result they strongly prefer raising payroll taxes to cutting benefits (Times poll, question 43). They also feel the same way about Medicare (question 39), perhaps because people think that Medicare is fully funded by payroll taxes.

If Medicare were fully self-funding, I think this would help clarify the relationship between taxes and benefits, and people would be more willing to pay the taxes necessary to get their benefits. As I said in the Atlantic column, how much you’re willing to pay for Social Security comes down to how much insurance you need, and that’s a question you answer differently from the abstract question of how much government you need. If the same were true of Medicare, it would be obvious that as health care costs rise in general, the amount we pay for Medicare should rise at the same rate. As it is, it’s hard to explain why general tax revenues have to go up constantly because of health care inflation. On the other hand, it’s possible that making government finances more transparent will just make people want to pay taxes even less, so I could be wrong.

The other issue is that payroll taxes are regressive, which is the big reason why most Democrats want to raise income taxes on the rich and use the revenue to bolster Social Security and Medicare. This is true, but it’s also important to remember that Social Security and Medicare are net progressive programs (especially Medicare, where everyone gets the same benefits). If you raise payroll taxes, you could use the additional revenue to make the income tax system more progressive at the low-to-middle end (larger EITC, larger standard exemptions).

* Actually, the detailed projections only go out to 2020. So I took 2020 values and divided them by 2020 GDP.

This post originally appeared at The Baseline Scenario and is reproduced here with permission.