Touching the Third Rail: Social Security and Medicare Reform in the Next Administration

It is safe to say that the American economy is in trouble. With stock markets fluctuating five to ten percentage points per day and unemployment on the rise, many people, corporations, and even states are looking to the federal government to solve their financial problems. Unfortunately, the government is in trouble as well. This year will mark a record federal deficit that is on track to get even worse over the next few years. Many are pointing at the current administration and saying that these problems are its fault due to its execution and persistence of the Iraq war. While it is true that the Bush administration has spent more money than would be ideal in a “conservative” presidency, many of these problems can be dated back to the 1930s and 1960s with the blossoming of entitlement programs.

The federal government currently spends over a trillion dollars per year on Social Security and Medicare. Because these issues affect seniors, a highly efficient voting bloc, these topics are often labeled as “third rail” because they destroy politicians who try to alter the status quo. Nevertheless, these expenditures are just short of half of the federal budget of $2.7 trillion. These programs have grown in size as the retired and elderly population has grown. This increase has led to a level of spending that the government cannot sustain for much longer. The Social Security and Medicare Board of Trustees—consisting of the Secretaries of Treasury, Labor, Health and Human Services, and the Commissioner of Social Security—projects that as the “baby boom” generation retires in the next few years, the costs for these programs are expected to double in the next ten years. In other words, without an increase in overall GDP, entitlement programs to seniors would encompass close to 100% of the entire federal budget. While economic growth is likely to defer some of that threat, this scenario is still obviously unacceptable.

The next administration will be forced to address whether to cut benefits, raise taxes to increase revenue, or do both. These are not politically popular options, which is one of the reasons why the problem persists. A leader will have to rise above the partisan politics that prevent problems from being solved. The need for such a leader is reminiscent of the situation in the United Kingdom during Margaret Thatcher’s first term as Prime Minister during the early 1980s. Faced with a decrepit economy, inflation, and rising unemployment, Thatcher raised taxes and cut entitlement programs against political will. Rather than raise taxes solely on the wealthiest incomes, her tax increase was reflected in a Value Added (Sales) Tax that affected everyone’s consumption. Due in part to her sound fiscal policy, the British economy soared above the rest of Europe in the late 1980s. She was able to have these longer-term strategies in part because the Labour Party was struggling in the early 1980s and her Conservative Party had a strong majority in the House of Commons. Likewise, an Obama administration, combined with an increasingly Democrat-dominated Congress could have the power to pass legislation that could address these mounting entitlement problems. It would be up to them to show the courage to do so.

Unfortunately, Senator Obama’s current tax plan is less fearless than that of Prime Minister Thatcher. He is promising a “net tax break” for 95% of Americans. He says he will only raise income taxes for those making over $250,000 per year—the wealthiest 2% of families. Additionally, he will raise capital gains tax rates for the top 2% of earners to 20% from 15%. Also, he would introduce Social Security taxes of a few percentage points on marginal dollars over $250,000. Currently, workers stop paying social security tax once their income reaches $102,000. Additionally, he plans to issue various tax credits for the lower and middle classes that will further put the country in debt. Senator McCain, meanwhile, has vowed not to increase taxation at all, and wishes to make the Bush tax-cuts permanent.

Since the outstanding bills and debts in this country are larger than ever, and are going to be even larger in the next few years, it is likely that tax increases will be inevitable. Still, these increases cannot be taken lightly. The ultimate goal of taxes would be to increase revenue. Policymakers, however, must recognize the Laffer curve in their decision-making. The Laffer curve states that there is an optimal level of revenue in taxation. To illustrate the point, while taxing zero percent, the government would receive zero dollars in revenue. But also, while taxing 100%, the government also receives zero dollars in revenue because there would not be any incentive to work and thus produce taxable economic output.

The Obama plan, which heavily taxes the wealthiest 2% in various ways, might be too aggressive on the rich. The Internal Revenue Service reports that wealthiest one percent of Americans already pays roughly 40% of the tax dollars. Raising income taxes from 35% to 40%, along with increasing Social Security and capital gains taxes would mark the largest overall tax increase since the Clinton hikes in 1993. While not the most politically or even short-term humane economic strategy, the Thatcher-like plan of taxing everyone could produce more revenue as the middle and lower income segments of the population would be less likely to substitute work for leisure in the event of a tax increase.

Such a policy would require a courageous leader who would not be worried about polls. John McCain has shown such “maverick” traits, but is unlikely to have the necessary political power with the Congress if he is elected and chooses such a strategy. Barack Obama, meanwhile, has not shown that he is willing to bring about the “Change We Need”—a balanced budget.

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