Economics Update (April-June 1996)

Social Security, Health-Care Reforms
Needed as Populations Age

s the baby boom generation approaches retirement, the graying of America will mean more demand on health-care services and Social Security payments. Rising budget deficits will magnify the problem of too few dollars for so many needs.

At a briefing to Federal Reserve Bank of Atlanta officials in January, Roberto Chang, a research officer at the Atlanta Fed, discussed the effects of an aging population and concluded that reforms will have to be found for U.S. health care and Social Security if Americans want to avoid heavy tax increases for themselves and for their children.

The problem doesn't exist only in the United States. Each of the G-7 countries—Canada, France, Germany, Italy, Japan, the United Kingdom, and United States—faces the same dilemma to varying degrees, Chang said.

In the United States, the political debate over balancing the budget has focused on health care (primarily Medicaid and Medicare) and Social Security. The reason for this focus is that other, discretionary expenditures have already been cut, Chang said. But also, health care and Social Security will represent an increasing percentage of the budget as the American population ages and the ratio of dependent people increases.

Projections from the OECD (Organisation for Economic Cooperation and Development) show the primary fiscal deficit—that is, the difference between revenue and spending without including accumulated debt service—remaining fairly stable for the United States until 2015, when the cost of health care and Social Security for the baby boomers will begin straining the budget.

To analyze possible options, Chang discussed the future of pension plans in detail. The gap between pension plan payments and contributions already is evident for several of the G-7 countries and, as a percentage of gross domestic product (GDP), is projected by the OECD to increase dramatically in the future (see charts).

Chang presented OECD calculations of three options for alleviating the projected deficit in public pension plans: reducing benefits, increasing taxes, and raising the retirement age. For its calculations, the OECD focused on changes that would have a large impact on the gap without exceeding the limits of social acceptance.

Raising the retirement age seems to be the most effective solution for most nations, Chang said, because it would simultaneously reduce the proportion of dependent people and increase contributions to the pension system.

For the United States, for example, the effect of a set of alternative options for the Social Security system is given in the table below. The first column, the base case, describes the present value of doing nothing: it says that, in the absence of other measures, the United States should put aside 31 percent of its 1994 GDP in order to cover the projected Social Security deficits. The second and third columns show that reducing benefits by 10 percent or raising Social Security taxes by 3 percent would still result in a shortfall. But, as the fourth column shows, increasing the retirement age by five years would result in a present value surplus of about 8 percent of the 1994 GDP, according to the OECD.

The pension systems of some nations, however, would still have deficits even if they increased the retirement age by five years.

In Japan, the present value of the deficit between contributions and payments would be equal to about 41 percent of GDP if the retirement age were increased by five years. But that option still looks better than reducing benefits by 10 percent, which would result in a deficit equal to 83 percent of the GDP, or increasing taxes by 3 percent, which would result in a deficit equal to 90 percent of GDP.

At the same time that financial pressure is increasing among G-7 nations on pension and health care plans, these nations also are wrestling with national debt problems.

The U.S. national debt averaged 37 percent of GDP in the 1980s, but it jumped to more than 55 percent of GDP in the early 1990s and has stabilized there.

The United States isn't the worst of the G-7 pack, though it isn't the best either, Chang noted.

Japan and Germany have seen their national debts increase steeply since the beginning of the decade. Japan's debt stood at about 5 percent of GDP in 1991 but is projected to be about 14 percent this year and is expected to continue rising. Germany started the decade with a national debt of about 21 percent, and its debt soared to more than 50 percent in 1995.

Italy has a huge debt problem—its national debt has been more than 100 percent of GDP since 1992.

Canada's national debt has deteriorated from about 30 percent of GDP at the beginning of the decade to about 65 percent in 1995. France and the United Kingdom also have experienced rising debts, although their levels are not as bad as some—about 43 percent and about 42 percent, respectively.

The more money a nation must spend to repay debt, the less it has to address rising needs such as pensions and health care.

In conclusion, Chang said the United States is not alone with its problem of meeting the needs of an aging population, and reforms in health care and Social Security-type programs will have to occur sooner or later.

U.S. Social Security Options
(Net present value as a percentage of 1994 GDPa)
Base Case Reducing benefits by 10 percentage points Raising taxes by 3 percentage points Raising retirement age by 5 years
Contributions 136 136 164 143
Pension Payments 167 141 167 135
Balanceb -31 -5 -4 8
a Taxes and pension payments discounted at 5 percent. Productivity growth assumed to be 1.5 percent.
b Excludes preexisting assets of 5.8 percent of GDP.

Source: Organisation for Economic Cooperation and Development.

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