A Critique of Mr. Leonhardt’s Case for Tax Increases

Earlier this week, David Leonhardt presented his case for why “taxes will rise in the end” to accommodate the government’s spending (and debt) trajectory. Here is the key excerpt:

Not so long ago, nobody was talking about tax increases or Medicare cuts, and the federal budget seemed to be in fine shape. If only we could get back to the past — get spending under control, as the cliché goes — we’d be O.K. The debt ceiling, with its harsh finality, offers the chance.

Unfortunately, this nostalgic view depends on a misunderstanding of the budget. It imagines a budget in which the United States indefinitely has the world’s highest medical costs, its largest military, an aging population and, nonetheless, taxes that are among the world’s lowest. Economists have a name for that combination: a free lunch.

Free lunchism is ultimately the problem with the no-new-taxes pledge that so many politicians have adopted. A refusal to raise taxes, no matter how principled, cannot take us back to the good old days. It would instead lead to a very different American society. For taxes to remain where they are, Washington would need to end Medicare as we know it, end Social Security as we know it, severely shrink the military — or do some combination of the above.

There are lots of problems with this narrative, but let’s start at the beginning. First, entitlement reform has been on everyone’s mind for decades. In 1999, the National Bipartisan Commission on the Future of Medicare (led by Senator John Breaux and Rep. Bill Thomas) proposed a "premium support" model for Medicare. They patterned their plan after the Federal Employees Health Benefits Program (FEHBP), which still provides health insurance for federal employees and their dependents. You would have had to be “out to lunch” – for a very long time – not to realize that entitlements were a huge and growing problem. It’s also worth noting that President Bush campaigned on Social Security reform in both the 2000 and 2004 elections and then put the topic on the national agenda in 2005.

Second, entitlement reform is fundamentally about restraining the growth of spending. The government’s spending and debt explosion over the last few years has certainly pushed up the timeline for having to enact meaningful reforms of Medicare, Medicaid and Social Security. From 1971 to 2010, spending on these three programs rose from 4.3% of GDP to 10.3%. Absent reform now, spending on these three programs is set to consume 15-16% of GDP by 2035. This is simply not a sustainable trend line.

Third, the source of our entitlement problems is not aging so much as the automatic increases in real (inflation adjusted) benefits. For example, the effective Social Security tax rate equals the wage replacement rate divided by worker-to-beneficiary ratio. Today, an average 42% wage replacement is financed by a 3.4 worker-to-beneficiary ratio, which works out to about a 12% payroll tax. When the ratio drops to 2 workers per beneficiary, we can't maintain the replacement without increasing taxes to 21%.

Much the same is true with Medicare, except that program also suffers from the very poor design of its payment system – an open-ended fee-for-service design that incentivizes more, not less, health care spending. The 2010 health care reform debate was an opportunity to address the structure of Medicare and its unfunded liabilities, but Obamacare ultimately relied on the same approach to limiting health care costs while adding on a brand new entitlement.

Later in Mr. Leonhardt’s oped, Rep. Paul Ryan’s plan to reform Medicare is targeted for criticism:

To make the numbers come close to adding up, the plan [Mr. Ryan’s] also called for eliminating the current Medicare and replacing it with a system in which the elderly would buy less generous private insurance plans. Such is the price of no new taxes.

This brings us to the fourth point: to the extent that progressives have offered solutions in this area, they have generally argued in favor of suppressing markets further by introducing new price caps. As Medicare's chief actuary Richard Foster explains, this will lead to denial of care by providers.

At a recent House Budget Committee hearing, Congressman Tom Price pressed Mr. Foster about the practical impact of the President’s new health care law in which savings are realized by paying health care providers less for the same amount of care. Providers of Medicare services are set to see cuts in their reimbursements that would push them past the point where they can continue to provide care to seniors. For example, physicians will be reimbursed for their services at roughly 50 cents on the dollar by 2020.

Here is the key part of the exchange between Rep. Price and Mr. Foster:

PRICE: What happens when Medicare payments are inadequate?

FOSTER: Um, we’d like not to find out. But as you can imagine, especially in your situation – or any of us: if we have a job, if we are paid a certain amount for the services or the goods we provide, and what we’re paid ends up not being adequate to keep us in business, then we’re going to go out of business, or turn our business elsewhere. So, the potential access problems could be very serious. We see with the Medicaid program, of course, in some states the payment rates - particularly for physicians - are quite low and the access to care is quite low.

PRICE: So the access that patients have to physicians may be markedly limited?

FOSTER: Well if the 30% reduction went through, for example come January 1st, I think there would be a noticeable reaction – very noticeable.

How does Mr. Ryan’s plan (which resembles again the Breaux-Thomas proposal from 1999) represent savage cuts, but outright denial of care is a good solution?

A few high level details to keep in mind about Ryan’s Medicare plan.

• Today’s Medicare enrollees and those that enter the program over the next 10 years would be exempt.
• In 2022, the new program would provide the health care entitlement in the form of “premium support credits.”
• The credits could then be applied to several competing private insurance plans.
• The government would oversee all the different plans to make sure they meet standards for quality and accessibility.
• Those who need extra support – low-income individuals – would get extra financial support.
• Moving forward, the premium support credits would rise commensurate with inflation (as measured by CPI).

Most critics of Mr. Ryan’s plan have focused on this last point – the indexation of the credits to CPI – arguing that this is unfair because health care costs are projected to increase at a faster clip. As Jim Capretta has argued, “this is sheer hypocrisy on their part because the indexing of government-financed premium credits below cost growth is in the president’s plan too, and yet not a complaint has been heard about that from its advocates.”

If the government’s costs for premiums and cost-sharing subsidies exceed roughly .5% of GDP after 2018, the new health care law requires the government's contributions toward coverage to rise with GDP growth. The bottom-line is that critics of Mr. Ryan’s plan contend that the premium support credits will not keep pace with expectations of rising health costs – but this is the same problem faced under Obama’s 2010 health law. Here is the key excerpt from Mr. Capretta’s defense:

Critics contend that the Ryan plan would shift huge new costs onto Medicare beneficiaries for reasons beyond the indexing of the credits, and they cite CBO's analysis of the Ryan budget as proof. But this analysis is based on two flawed assumptions. First, it assumes that traditional Medicare can keep cutting what it pays to hospitals and doctors with no consequences whatsoever for the beneficiaries. CBO's assessment is that in 2022 traditional Medicare could provide the insurance benefit for just 66 percent of what a private insurance plan would cost. This is sheer folly based entirely on deep payment reductions for services. If those cuts really were to go into effect as scheduled, Medicare rates would be well below those of Medicaid, and seniors would have very restricted access to care. CBO's analysis also assumes no savings from establishing rigorous competition in the Medicare program. But the cost-cutting in the prescription drug program demonstrates that the potential is there for massive savings from a functioning marketplace.

Lastly, let’s review exactly what Mr. Ryan proposed in his budget on taxes. Today, tax collections are down due to the recent recession. But, absent some changes – taxpayer burdens will rise dramatically when many of the current income tax rates expire at the end of 2012. As Mr. Leonhardt notes towards the end of his oped, President Obama would prevent some of these increases but not those for higher-income individuals and families. Here is a good chart (also below) that compares the trend lines for tax revenue collections. Note, the Mr. Ryan’s budget would have revenue increase as the economy recovers, but would then keep the total amount near historic norms thereafter.

On tax reform, Mr. Ryan’s budget aims to make the code simpler and flatter. It sets the top rates for individuals and businesses at 25% and attempts to improve incentives overall for investment, savings, and economic growth. To achieve lower rates, however, Mr. Ryan would end deductions that go overwhelmingly to higher-income individuals. The plan also eliminates corporate loopholes and other exclusions to try and get the government out of the (distorting) business of picking winners and losers through the tax code.

On net, the tax reform component of Mr. Ryan’s plan is revenue-neutral – and by going in this direction he is trying to make the U.S. more competitive (because the current rate is the highest in the developed world) without imposing new (net) tax burdens on employers (or the entities that everyone agrees should be encouraged to hire more given how high unemployment is today).

Fundamentally, Mr. Leonhardt’s critique of Mr. Ryan’s budget is that it lacks the political or substantive balance of the plan offered by the Simpson-Bowles fiscal commission. It’s certainly true that Mr. Ryan would try and solve the U.S. deficit problem by constraining spending without raising taxes. But, if Mr. Leonhardt believes the Simpson-Bowles plan is probably the best option on the negotiating table right now, why is he not directing his criticism towards the President? Remember, it was the President who convened the commission in the first place. Then, once the Simpson-Bowles plan was released – the White House backed away from it publicly. The Administration had a second opportunity to give the effort a hat-tip when it rolled out its FY2012 budget proposal early this year. 64 Senators even sent the President a letter urging him to lead on this topic with the Simpson-Bowles plan as his foundation. Chuck Blahous has made some of these same points here at e21 before, concluding that Mr. Ryan should be applauded for having the courage to present a full and detailed plan.

So, where does this leave us? Well, the rest of July in D.C. should be very interesting – that’s for sure. There will be no shortage of political theater surrounding the debt ceiling show-down. In retrospect, however, it’s worth asking whether tensions would be as high as they are today if only the President had embraced his own fiscal commission’s work back in December?