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Sizing Up the Fiscal Challenge

How changing the government’s accounting method—and reforming the congressional budgeting process—could start to improve the federal budget outlook.
March 7, 2022
Sizing Up the Fiscal Challenge
President Joe Biden arrives for his State of the Union address to a Joint Session of congress on Capitol Hill on Tuesday, March 1, 2022 in Washington, DC. (Kent Nishimura / Los Angeles Times via Getty Images)

As President Joe Biden prepares to send his fiscal year 2023 budget to Congress in the coming days, Russia’s brutal aggression in Ukraine is creating much uncertainty about what the future may hold. Meanwhile, House and Senate leaders are still haggling—nearly halfway through the current fiscal year—over the parameters of appropriations for 2022, including for the nation’s military and intelligence agencies, which are on high alert.

It is another indication of the absence of an effective budgetary order. Indeed, the federal budget process is in a state of such disrepair—neither party has used it as intended for at least a decade—that it no longer seems fanciful to contemplate entirely novel reforms.

Among other things, the appropriations process needs to be streamlined to become less of a focus, and to require a lighter workload, each year. Congress writes omnibus measures running thousands of pages with language that is repetitive with prior laws while making minor adjustments in spending for most agencies and programs. A major reason to downsize this process is to make room for what matters, which is much greater attention to developing and enforcing a fiscal plan that avoids a perilous debt spiral.

Targeted use of accrual accounting—as opposed to cash accounting—is one idea that should be explored to help redirect the budget debate toward meaningful objectives.

With cash accounting, activities appear in financial statements when transactions occur—for instance, when the Treasury actually makes a cash payment pursuant to a contract or benefit obligation, or when it collects a tax payment from an individual or business. By contrast, in accrual accounting, the focus is on the moment when a binding commitment occurs, not when the money actually changes hands. This is an important distinction as many government programs “entitle” individuals to benefit payments in future years (sometimes many decades hence) based on meeting the applicable eligibility requirements found in current law. Shifting the focus toward the policies that create the obligations in the first place may help policymakers see more clearly what must be done to prevent financial problems from emerging in future years. (I explain this proposal further in a chapter in Public Debt Sustainability, a new collection edited by Barry W. Poulson, John Merrifield, and Steven H. Hanke.)

It is not that annual cash deficits are unimportant. After all, cumulative federal debt is just the sum of what has been borrowed in the preceding years. The problem is that most of the deficit-cutting policies that could have effects in the near term will be inconsequential over the long run. Congress needs to focus on the policies that will have significant effects on reducing the long-term gap between projected spending and revenue.

In his State of the Union address, President Biden touted the large projected reduction in annual federal borrowing—at least $1 trillion—that is expected to occur in fiscal year 2022 relative to 2021. But that improvement, welcome as it is, is not an indication of a fundamental shift in the budget outlook. In 2021, Congress provided extraordinary economic support to mitigate the effects of the COVID-19 pandemic. As the threat has receded, so too has the emergency spending. The underlying gap between federal spending and taxes that was there before the pandemic hit has not gone away, and will continue to widen in future years.

Further, the president did not mention that cumulative federal borrowing remains on track to reach twice the size of annual GDP by midcentury, as projected by the Congressional Budget Office (CBO) last year. Such a pace of debt accumulation is unprecedented in the nation’s history, and would precipitate a crisis, although with characteristics that it is not possible to predict with certainty.

The primary source of growing fiscal pressure is well known—population aging and the related increases in Social Security and Medicare spending. CBO expects the combined expenses for these two programs will reach 12.6 percent of GDP in 2050, up from 8.3 percent in 2021. There is some uncertainty around this forecast, but not much. The size of the beneficiary population over the coming decades can be projected with high accuracy, based on demographic trends. Further, health care inflation in Medicare has been close to income growth for several years. A spontaneous (and permanent) deceleration is possible but not likely given that it has not happened during the preceding half century.

The trust funds associated with these programs are supposed to help elected leaders keep spending in line with available revenue over many years, but there are two reasons to question whether they will work to prevent a debt crisis.

First, trust funds push the political conversation toward insolvency dates, which incentivizes procrastination. For example, last year’s trustees’ report for Social Security projected the program’s trust funds would be depleted of reserves in 2034, after which revenue would cover 78 percent of annual benefit commitments. Elected officials with two, four, or six-year terms may not be sufficiently attentive to problems that would emerge after they have finished their service. Waiting until a year or two before insolvency to act would force Congress to bail out the trust funds with more borrowing rather than fix them. Stalling reform also favors tax solutions over benefit restraint because reforms that slow spending will take many years to show substantial effects.

Second, one of the trust funds for Medicare—for Supplementary Medical Insurance (SMI), or part B—provides a misleading picture of the program’s financial burden. Under current law, beneficiary premiums cover 25 percent of SMI costs, and the general fund of the Treasury pays for the rest. This setup ensures SMI will never go insolvent.

But that does not mean SMI is a nonfactor in the projected debt spiral; the general fund transfers to it must come either from current taxpayers or creditors. In the 2021 report, Medicare’s trustees projected they would total $5.3 trillion over the period 2021 to 2030. With the government running deficits outside of Medicare, these transfers push up what it must borrow each year to fully cover its obligations.

Accrual accounting provides a condensed measure, using today’s dollars, of the financing gap that should be of concern to policymakers. In the private sector, accrual accounting is used to assess whether sufficient funds are being set aside to cover accumulating obligations. For instance, if a company runs a pension plan, current workers earn future pension commitments based on seniority and wage replacement rates. As pension commitments build, companies are supposed to set aside funds today to cover their anticipated future obligations. If invested reserves are less than a present-value calculation of expected pension payments, the plan is said to have an unfunded liability. (The present value of future pension spending is the sum of nominal spending in the future reduced by a discount factor which is usually tied to projected interest rates.)

For Social Security and Medicare, some modifications to the private sector’s procedures would be necessary. Both programs are financed on a pay-as-you-go basis, which means there has never been an expectation that the federal government will set aside funds today sufficient to meet all accumulating obligations. Further, the federal government is not like a business that might cease to exist in five or ten years; funded private-sector pensions are supposed to protect workers whose companies might shrink or dissolve altogether for any number of reasons. With Social Security and Medicare, program revenue from future workers can be reliably counted on to cover program spending.

As it happens, the federal government already produces an annual report based heavily on the accrual method—the Financial Statement of the United States Government, produced by the Treasury Department in consultation with the Office of Management and Budget and Government Accountability Office. That report incorporates a modified version of the accrued unfunded liabilities for Social Security and Medicare. In the most recent release, from last month, Treasury estimated the present value of the unfunded liability for Social Security over the next 75 years at $22.7 trillion, and for Medicare at $48.2 trillion. Combined, that’s $70.9 trillion.

While these absolute amounts are worrisome enough, it is the trend over time that should be setting off alarms among policymakers. In 2017, Treasury estimated the unfunded liability for Social Security at $15.4 trillion, and for Medicare at $33.5 trillion, for a total of $48.9 trillion, or $23.0 trillion less than the estimate from the fiscal year 2021 report. In other words, with each passing year, the government is making new benefit commitments worth trillions of dollars without also imposing the taxes (or premiums) to pay for these obligations when they come due.

The Treasury’s calculations take into account program income and outgo for all current and future program beneficiaries. For Medicare, it is a measure of spending relative to tax and premium receipts, with general fund payments placed in a special category so that the reader can either include or exclude them from the equation.

It is implausible that Congress would ever halt such general fund support for Medicare entirely, but measuring the unfunded liability of the program exclusive of these payments highlights the scale of the fiscal challenge that lies ahead. The only money coming into Medicare from the public is due to the taxes and premiums dedicated, and spending in excess of these collections must be paid from non-Medicare taxes or more borrowing. With the government running large deficits outside of Medicare, other taxes are needed to pay for the government’s many other financial commitments. Still, Congress may want to specify an unfunded liability calculation for Medicare that assumes a level of general fund support that is affordable over time (perhaps by tying it to a fixed percentage of annual GDP).

The incorporation of accrual accounting for Social Security and Medicare into the federal budget process is a topic complex enough to deserve its own careful, and separate, discussion. However, in sum, the laws governing both the executive branch and congressional budget processes would need to be amended to make managing the unfunded liabilities of these programs a central objective and focus. Ideally, new requirements would build automatic adjustments—tax hikes, benefit restraints, and medical-service payment reductions—into program operations to keep accruing liabilities from rising more rapidly than funding over time. Building such automatic stabilizers into the laws governing these programs would be highly controversial, but, if successfully adopted, they would spare policymakers in the future from having to grapple with these contentious matters on a continual basis. Further, with automatic adjustments, benefits could be expanded too, if the factors affecting what is affordable improve over what was previously assumed.

Critics will contend that no process will make a difference when there is a lack of political will. In other words, if Congress is determined to run up borrowing to pay for Social Security and Medicare to avoid imposing unpopular tax hikes and benefit restrictions, whatever rules stand in the way will get set aside.

While that is obviously true, highlighting the unfunded liabilities of Social Security and Medicare might alter the political incentives for some elected officials. Many in Congress profess to be concerned about deficits and debt, and also about sustaining Social Security and Medicare. They may be reluctant to vote for budget plans which highlight the ongoing rise in the unfunded liabilities of the government’s most popular programs.

There also is not much to lose in contemplating sharp departures from existing practices. The budget process now on the books is imposing very little restraint. New rules won’t make the problem worse.