Two years ago, I and John Mantus, and Gaobo Pang (collectively, “WMP”) created a long-range macroeconomic growth simulation model to project the fiscal condition of the US government under current broad policies and economic trends. Although similar in many of its assumptions and methodologies to those used by the Social Security and Medicare Trustees in their annual Reports, and especially to the Congressional Budget Office (“CBO”) in its periodic 10- and 30-year projections, a unique aspect of the WMP model is its explicit inclusion of the production of health care services as a separate sector in a growth model with capital and labor. This addition was done in recognition of the large and growing share that health care plays in the US economy (now approaching a fifth), the significant federal budget burden it represents (covering half of health spending), and especially in light of the inefficiency of the sector: It uses relatively little capital and a lot of labor with low productivity growth, leading to increasing relative prices of health care and lower consumer welfare. In this blog post, I report on the results of the updated model, comparing it to last year’s results and to CBO’s most recent projections. In short, the fiscal outlook is slightly improved because real interest rates are now projected to rise less, yet compared to CBO’s projections, which are based largely on current law and not policy and incorporate some unreasonable assumptions, the outlook is more dire.
The main input changes for the model this year are a lower projected population and labor force, slightly higher initial capital stock, slightly lower initial real interest rate, near-complete elimination of taxation on Social Security benefits, and other small technical fixes. Recent major changes in tax and health care law are reflected only to the extent they appear empirically in broad aggregates and trends. This makes sense because these changes are often temporary (tariffs ruled illegal by the Supreme Court), representative of current policy (2017 tax cuts made permanent last year), offset by behavior responses (tax avoidance or increased health care utilization), countervailing (Medicare enhancements versus Medicaid cuts), or unsustainable (price controls in the health care sector eventually undone by legislation). Unlike CBO, which assumes that defense and non-defense discretionary spending will decline as a share of GDP over time, the WMP model uses more realistic assumptions: Defense spending will remain constant as a share of GDP and non-defense discretionary will scale with the population. Also, CBO and conventional government accounting overstate the deficit by ignoring the implicit inflation tax that erodes the real value of government debt held by the public. The smaller projected labor force now is the key because it reduces demand for capital outside of the health care sector, lowering the real interest rate. Model results for WMP last year and this, compared to CBO’s most recent projections, over the next 10 and 30 years, are shown below.
According to the WMP model, the deficit is projected to increase from about four percent of GDP currently (six percent in conventional terms, ignoring the implicit inflation tax) to 7.5 percent in 10 years. The ratio of federal debt held by the public will rise from about 100 percent currently to 138 percent in 10 years. Beyond that, current policy is clearly unsustainable, with deficits and debt at nearly 14 and 270 percent of GDP, respectively, in 30 years. Even without igniting a crisis, such high levels of debt combined with increased spending on inefficiently produced health care (from 18 percent of GDP currently to almost 26 percent) substantially reduce consumer welfare growth, eventually turning it negative.
The deficit and debt projection in WMP is uniformly higher than CBO’s, controlling for the inflation tax effect, for several reasons. First, real interest rates in WMP are higher, in recognition of current relatively high rates, the competition for funds that increasing deficits represent, and the inefficiency of the health care sector drawing away labor from the productive “all other” sector. Second, the projection for federal benefit spending, which includes Social Security, Medicare, Medicaid, and other federal health programs, is higher in WMP because CBO estimates the effect of current law on federal health spending, which constrains payments to hospitals, physicians, and drug manufacturers unsustainably in the current inefficient health sector environment. CBO also does not seem to recognize the demographic uptick in Medicaid from long-term care, and it assumes that the increase in relative health care prices will subside over time. Third, as mentioned, CBO projects unrealistically low spending on defense and non-defense discretionary items and projects higher tax revenues from bracket creep, which history shows is always effectively undone by legislation.
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