Highlights -
This week's commentary continues our series on the long-term U.S. budget problems and possible solutions. -
Mandatory spending on programs like Social Security, Medicare, and Medicaid are very popular and well entrenched in the American system, but they need to be addressed to fix the long-term budget problem. -
As in other large areas of the U.S. budget, there are no easy fixes, and hard choices will have to be made. Weekly Economic Calendar This Is Mandatory Reading As Congress and the President work together to avoid the looming fiscal cliff during the lame duck session of Congress, a more intransient problem remains in the background: the United States' structural budget deficit. In our Weekly Economic Commentaries of October 29, 2012 (Budget Debate), November 19, 2012 (Budget Myths), and November 26, 2012 (Budget Defense), we wrote about how often the budget was mentioned during the campaign season and how the nation's long-term budget problem cannot be solved by eliminating waste, fraud, and abuse, domestic discretionary programs, and foreign aid alone. In addition, we put the nation's defense spending in context of the larger budget picture. In our view-a view shared by most nonpartisan budget experts-all aspects of the budget must be on the table during the fiscal cliff deliberations, and again in 2013 as lawmakers hammer out a longer term fix to our budget mess that has led to the overspending of revenues by about $1 trillion per year over each of the past five years. Setting the Stage In late 2010, three different nonpartisan organizations released plans that would put the United States on a path toward a balanced budget, using a combination of revenue/tax increases and spending cuts to achieve that goal. These organizations are: 
While each plan differed on certain aspects of the longer term fix for our budget woes, they all generally agreed that there are no easy answers and no quick fixes. Both Democrats and Republicans populated the three commissions. Some hold (or once held) elected office, while others served in the federal government or were on the boards of the many think tanks in and around Washington. All were focused on finding bipartisan solutions to the problem. In early November 2012, the nonpartisan Congressional Budget Office (CBO) released a report called "Choice for Deficit Reduction," which "reviews the magnitude and causes of the federal government's budgetary imbalance, various options for bringing spending and taxes into closer alignment, and criteria thatlawmakers and the public might use to evaluate different approaches to deficit reduction." In general, the three commissions (and the CBO) concluded that in order to successfully tackle the longer term deficit problem, formerly politically untouchable areas must be on the table in any serious negotiation. These areas include: - Social Security;
- Defense spending;
- Farm subsidies;
- Medicare;
- Medicaid;
- Personal and corporate tax rates; and
- Tax expenditures, more commonly known as personal and corporate tax deductions (e.g., home mortgage interest, state and local real estate tax, or charitable contributions).
The plans put forth by the three deficit commissions did vary on the amount of revenue increases (via some combination of higher tax rates, higher premiums for Medicare, fewer deductions, and more income subject to taxation, etc.) relative to spending cuts (across all categories of federal spending) needed to achieve a long-term path toward fiscal stability. Slicing and Dicing: Mandatory Spending Is the Largest Slice of the Pie As we noted in prior budget-related commentaries, the federal budget can be sliced and diced several ways. One way to look at the budget is by function or cabinet post, such as the Department of Labor, Department of the Interior, Department of Defense, etc. Another way is to group the spending categories together by legislative mandate-mandatory spending and non-mandatory spending (also known as discretionary spending). Mandatory spending is all spending that is not controlled through Congress' annual appropriation process. For the most part, mandatory spending is based on eligibility criteria and benefit of payment rules set into law. Examples include Social Security, Medicare, Medicaid, the Affordable Care Act (aka "Obamacare"), and interest on the public debt. 
In recent fiscal years, mandatory spending has accounted for the majority of all federal spending, and this slice of the pie is set to rise dramatically in the coming decade. Therefore, curbing mandatory spending, or changing the way mandatory spending is funded, holds the key to addressing our long-term budget issues. This week, we will take an in-depth look at mandatory spending, and explore some of the options available to policymakers to address these programs over the long term. In fiscal year 2012 (which ended on September, 30, 2012), mandatory spending (Social Security, Medicare, Medicaid, etc.) totaled more than $2 trillion, or about 60% of total federal outlays. According to projections made in August 2012 by the nonpartisan CBO, mandatory spending will reach $3.9 trillion and will account for more than two-thirds of federal spending. The CBO projects that spending for Social Security benefits will increase by 75% over the next 10 years, and that Medicare spending will basically double over that same time. Medicaid costs are expected to more than double. By comparison, the CBO projects that GDP will increase by only 60% over the next 10 years and that federal tax revenue will increase by 117%. The major drivers of the rising costs are the aging population and rising per-patient medical costs. In a recent report, the CBO notes: "The increase in spending for health care programs is much greater than the increase for Social Security because the health care programs are affected by rising costs per beneficiary and legislated expansions in benefits, as well as by the aging of the population." The CBO notes that these three programs (Social Security, Medicare, and Medicaid) today account for 10% of gross domestic product (GDP). Under current law, these three programs alone will account for 16% of GDP by the mid-2020s. By comparison, the CBO noted, all federal spending (excluding interest payments but including these three programs) has averaged around 18% of GDP since 1970. Medicare: Medicare provides subsidized medical insurance for the elderly and for some disabled people. Spending for Medicare totaled about $555 billion in 2012, providing coverage for about 50 million people. The CBO projects that Medicare spending will continue to rise rapidly over the next decade, as baby boomers retire and spending per beneficiary continues to rise. Medicaid: Medicaid provides medical care for certain poor and low-income people. Children's Health Insurance Program (CHIP) provides coverage for children in low-income families that do not qualify for Medicaid. federal spending for Medicaid and CHIP was about $251 billion and $9 billion, respectively, in 2012, and over 58 million American receive Medicaid benefits. The CBO projects that federal Medicaid spending will rise rapidly over the coming decades because of expanding eligibility under the Affordable Care Act, the aging of the population, and rising costs per beneficiary. Social Security: Social Security, the federal government's largest single program, provides benefits to retired workers (through Old-Age and Survivors Insurance, OASI), to people with disabilities (through Disability Insurance, DI) and to their families as well as to some survivors of deceased workers. In all, more than 56 million Americans currently receive some type of Social Security benefit. Those benefits are financed primarily by payroll taxes collected on people's earnings. The CBO anticipates that starting in 2016, if current laws remain in place, the program's annual spending will regularly exceed its tax revenues, and by 2038, the Social Security trust fund will be exhausted (i.e., out of money). As we have noted in prior Weekly Economic Commentaries, policymakers face very difficult choices in dealing with the deficit in other areas of the budget (defense, non-defense discretionary, etc.). The choices faced in dealing with the runaway pace of mandatory spending are even more difficult, given that programs like Social Security and Medicare are both well entrenched and among the most popular federal government programs. Still, the commissions, think tanks, and the CBO have cited several options to rein in mandatory spending. The options for Social Security fall into five categories, as defined by the latest CBO report: -
Increases in the Social Security payroll tax; -
Changes in the way benefits are calculated; -
Increases in benefits for low earners; -
Increases in the full retirement age; and -
Reductions in the cost-of-living adjustments that are applied to continuing benefits. For example, combining the concepts underlying the bullets above, the CBO notes that if the Social Security payroll tax rate was increased immediately and permanently by 1.95 percentage points-from the current rate of 12.40% to 14.35%-or if scheduled benefits were reduced by an equivalent amount, then the trust funds' projected balance at the end of 2086 would equal projected outlays for 2087. As noted in the nearby box, under current policies, the trust funds would be exhausted by 2038. Short of eliminating the programs altogether, the policy options to slow the pace of spending on Medicare and Medicaid are similar to the options for Social Security and include concepts like: -
Raising payroll taxes that go toward funding Medicare; -
Cutting the rate of growth of payments to providers of Medicare services; -
Repealing some of the components of the Affordable Care Act; -
Raising Medicare premiums; -
Reforming Medicare cost-sharing rules; and -
Reducing Medicare and Medicaid fraud. While none of these options by themselves completely solves the problem of medical costs rising faster than the growth rate of GDP, some do make a sizable dent in the deficit. For example, the Bowles-Simpson budget commission noted that by combining several of the changes noted above, Medicare spending could be reduced by $110 billion over the next 10 years. But this policy option would likely come at a cost to both users of Medicare: seniors and doctors. Seniors would face sharply higher out-of-pocket health care costs, which has implications for many other parts of the economy. For example, seniors would likely cut back on other areas (housing, leisure activities, etc.) to fund their health care spending. Lower payments to providers of Medicare services (doctors) would see their income fall (or rise at a slower) rate, leading some doctors to leave the medical field, and others to cut back on their own spending, both business and personal. The bottom line is that much work remains to be done in order to address the real driver of the nation's long-term budget woes: mandatory spending, including Social Security, Medicare, and Medicaid. As with the other possible budget remedies, there are no easy choices in dealing with mandatory spending, but the longer we wait to address them, the more difficult it becomes to address them later on. IMPORTANT DISCLOSURES Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory. Federal Funds Rate is the interest rate at which depository institutions actively trade balances held at the federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Private Sector - the total nonfarm payroll accounts for approximately 80% of the workers who produce the entire gross domestic product of the United States. The nonfarm payroll statistic is reported monthly, on the first Friday of the month, and is used to assist government policy makers and economists determine the current state of the economy and predict future levels of economic activity. It doesn't include: - general government employees - private household employees - employees of nonprofit organizations that provide assistance to individuals - farm employees The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Stock investing involves risk including loss of principal. The index of leading economic indicators (LEI) is an economic variable, such as private-sector wages, that tends to show the direction of future economic activity. International investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors. INDEX DESCRIPTIONS China CPI: In total there are about 600 "national items" used for calculating the all-China CPI. The list of items is revised annually for representativeness based on purchases reported in the household surveys. The number of items can change from year to year, but rarely by more than 10 in any given year. The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The Michigan Consumer Sentiment Index (MCSI) ia a survey of consumer confidence conducted by the University of Michigan. The Michigan Consumer Sentiment Index (MCSI) uses telephone surveys to gather information on consumer expectations regarding the overall economy. The S&P/Case-Shiller U.S. National Home Price Index measures the change in value of the U.S. residential housing market. The S&P/Chase-Shiller U.S. National Home Price Index tracks the growth in value of real estate by following the purchase price and resale value of homes that have undergone a minimum of two arm's-length transactions. The index is named for its creators, Karl Chase and Robert Shiller. The Empire State Manufacturing Index is a seasonally-adjusted index that tracks the results of the Empire State Manufacturing Survey. The survey is distributed to roughly 175 manufacturing executives and asks questions intended to gauge both the current sentiment of the executives and their six-month outlook on the sector. This research material has been prepared by LPL Financial. To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity. Tracking # 1-126559 Exp. 12/13 | 
