The Six Daunting Financial Problems Facing America

Solutions to the economic problems that the U.S. faces are unpalatable, and there's a dangerous temptation to avoid dealing with fundamental issues.

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The choice of Paul Ryan as the presumptive Republican candidate for Vice President has ensured that budgetary arithmetic will be a central issue in the election campaign. But it’s important to remember, as the Mock Turtle says in Alice in Wonderland, that arithmetic consists of four basic operations – Ambition, Distraction, Uglification and Derision. Of these, Distraction is likely to be the tactic employed most frequently this election season. The economic problems that America faces are fairly clear, but all the possible solutions are unpalatable. So the candidates will probably try to avoid getting too specific or, alternatively, divert discussions into debates over technicalities. But even where technical questions are important, basic decisions about policy — and values — have to be made first. To see this in practical terms, it’s worth taking a quick look at six of the most daunting financial issues that need to be dealt with.

The National Debt. Federal government debt now stands at 73% of annual GDP, not counting money the government owes to itself, such as the Social Security Trust Fund. If current spending and tax rates (including the Bush tax cuts) are extended, debt will reach 93% within a decade, and will go into the danger zone in 15 years, according to the Congressional Budget Office. In 25 years, it will reach nearly 200%, at which point the Federal debt will be insupportable, unless it is devalued significantly through inflation.

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Taxes. Total federal taxes are around 18% of GDP today, roughly what they’ve been since the 1950s. State and local taxes, however, have increased substantially over that period. Total taxes from all sources are now a bit more than 34% of GDP, up from a low of 26% in the mid-1950s, but below highs of more than 36% reached several times in the past 15 years. So by historical standards, total taxes are not especially low. On the other hand, there is room to raise taxes a bit without going into unprecedented territory. To have a substantial impact, however, tax increases would have to fall on the middle class as well as the affluent. Extending the Bush tax cuts for the middle class and allowing taxes to rise to Clinton-era levels only for households with incomes over $250,000 (and singles over $200,000) would raise enough money to cut the deficit by just around 10% over the coming decade.

Social Security. Benefits are paid mostly from current Social Security payroll taxes. The Trust Fund is largely an accounting device of money the government owes to itself. In any event, the Trust Fund will be exhausted in less than 25 years, well before today’s youngest workers retire. Eventually taxes will be sufficient to pay only 75% of the benefits that are currently promised. Either benefits have to be cut, Social Security taxes have to be raised, or the growing gap between the two has to be paid for with revenue from other taxes. By tinkering with various formulas, the 25% gap could be closed without too much pain. But the burden will still have to be spread between more and less affluent people, current and future retirees, and taxpayers in general.

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Pension Funds. Everyone knows that many pension funds for public-sector employees are in trouble. The shortfall between the amount that should have been saved to pay for future benefits and the amount that actually has been saved totals hundreds of billions of dollars. But even that is a massively understated figure – the real shortfall is probably more than five times as big, or more than $4 trillion. The reason: Pension funds are greatly overestimating their likely future investment returns. Many funds assume a 7% to 8% compound annual return, when in fact 5% to 6% would be more realistic.

Medicare. The cost of Medicare and Medicaid is projected to rise from 5.4% of GDP to 7.2% in a decade and to at least 9.6% of GDP in 25 years. The Affordable Care Act tries to prevent even faster growth partly by trying to make the American health-care system more efficient. But it also shifts some costs to the states, which will not reduce the total tax burden over the long term. And it reduces payments to doctors and hospitals, which could lead to fewer doctors, longer waiting times or a two-tier system in which people who can pay cash receive significantly better care. Even if the positive aspects of the new health-care law succeed in containing costs as planned, Medicare and Medicaid are projected to consume more than 40% of Federal revenues in 25 years, substantially outpacing the growth of tax receipts even if all of the Bush tax cuts are allowed to expire — including those for the middle class.

Defense. Military spending was more than 10% of GDP in the 1950s and hit a low of 3.7% in 2000 before the 9/11 attack on the World Trade Center. Since then, the figure has more than doubled in dollar terms, after adjustment for inflation, and now accounts for more than 5.5% of U.S. GDP. At $900 billion a year, defense is a huge chunk of the Federal budget, and trimming it could lessen the need to raise taxes or cut social programs. But any consequential cuts to the defense budget would require a broad consensus for a significantly paired down U.S. defense mission, and such consensus does not exist right now.

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While any of these specific figures can be debated, collectively they make three things clear, in my view. First, America’s biggest challenges are not solely financial – they include the lack of clear objectives that are broadly supported by the electorate. Second, there are powerful political incentives to avoid facing the most fundamental problems – or to evade them with endless debates over minor policy changes. Third, if these problems are not dealt with seriously, the U.S. economy will slide along for a while with below-average growth and above-average unemployment until debt and other financial problems become insupportable. In the end, no amount of denial and evasion can overcome the power of basic arithmetic.