Tax Edge

By Robert Steere, Toolkit Staff Writer

What do you do when the "check engine" warning light blinks on in your car as you are traveling down the road? Do you stop and have it checked immediately to protect against serious damage and major repair costs? Or do you tell yourself that it is probably just a malfunction in the warning light, and you will have it checked when it is convenient?

Well, the trustees of the Social Security and Medicare trust funds have turned on the fiscal "check engine" light, warning in their 2009 annual report that the two programs are in serious financial trouble. In fact, for the third year in a row, the trustees have issued a "Medicare funding warning" which is triggered when the Medicare system becomes too reliant on general revenue funds instead of premiums. However, the trust funds supported by FICA payroll taxes are in even greater danger of exhaustion of assets than the main Medicare trust fund. It is only a matter of time before an increase in taxes or a decrease in benefits must be implemented to correct the imbalance in these funds.

What did the trustees report?

In their report, the trustees said, "Projected long run program costs are not sustainable under current program parameters." Describing the combined condition of the two Social Security trust funds (the Old Age/Survivor Fund and the Disability Fund), they said that cash flow deficits will begin in 2016 and will continue each year thereafter, until trust fund assets will be used up by 2037. Unfortunately, the picture is worse for the Disability Fund (the smaller of the two funds) when considered separately. "DI [disability] program costs have exceeded tax revenue since 2005, and trust fund exhaustion is projected for 2020," say the trustees. Moreover, the unfunded obligations of the Social Security trust funds increased by more than 20 percent in 2008 to a present value of $5.3 trillion as of December 31, 2008.

Because of rapidly growing health care costs, the financial condition of the Medicare program is worse yet. Like the Disability Fund, Medicare's Hospital Fund is already running at a deficit, as payroll taxes paid into the fund are outpaced by program costs. "Growing annual deficits are projected to exhaust the HI [Hospital Fund] reserves in 2017," the trustees conclude. The larger Medicare fund, the Supplementary Medical Insurance Trust Fund (Medical Fund), may be under the greatest financial pressure of all. However, because current law automatically provides financing each year from general revenues to meet the next year's expected costs, the trust fund is expected to remain adequately financed. The unfunded obligations of the Hospital Fund rose by nearly 10 percent in 2008 to a present value of $13.4 trillion as of December 31, 2008; the present value of the future general revenue obligations of the Medical Trust Fund as of the same date stands at $24.2 trillion.

What does all this mean, and why is it important?

Let's put this report into context in a couple of different ways. First, consider the three trust funds that are financed through the FICA payroll taxes (and SECA taxes for the self-employed). Of the 15.3 percent combined FICA tax rate, 12.4 percent applies to social security--10.6 percent funding the Old Age/Survivor Fund and 1.8 percent funding the Disability Fund. The other 2.9 percent of the FICA tax rate funds the Hospital Fund.

If the current FICA and SECA tax rates are insufficient to meet the future demands of these trust funds, what choices do policymakers have? They can either increase FICA tax revenues to meet the demand for benefits, or reduce the benefits to fit the available tax revenues. Thus, we must recognize that payroll tax increases could be part of the price for facing reality rather than living in denial of the dire financial condition of the trust funds. Otherwise, revenues will have to come from some other source (general revenue) or benefits will have to be cut.

In their report the trustees indicate, "Social Security could be brought into actuarial balance over the next 75 years with changes equivalent to an immediate 16 percent increase in the payroll tax (from a rate of 12.4 percent to 14.4 percent) or an immediate reduction in benefits of 13 percent, or some combination of the two." Such changes substantially impact everyone, whether worker or retiree, employer or employee, small business or large. And, if our government begins to face the hard reality, such changes could happen soon.

Second, for perspective on the immense size of the social security and Medicare obligations, compare the unfunded obligations of the trust funds with the federal debt. These unfunded obligations don't appear as part of the debt in the federal budget. However, our government has made a long-term commitment to pay these future benefits in accordance with the law.

The trust funds financed by the FICA taxes have unfunded future obligations with a present value totaling $18.8 trillion--nearly twice the amount of the gross federal debt, which stood at $9.986 trillion at the end of FY 2008. The present value of unfunded future obligations of the Medical Fund equals $24.2 trillion dollars. In all, $43 trillion would have to be set aside in the trust funds today to fully fund the unfunded portion of the social security and Medicare benefits that our government has committed to pay. When combined with the gross federal debt, the present value of debt plus trust fund obligations totals $53 trillion.

These massive obligations dwarf the "mere" $10 trillion gross federal debt. And while the gross federal debt grew by $1 trillion in FY 2008, the present value of unfunded social security and Medicare obligations increased by $2.7 trillion. What can be seen is that our government's fiscal challenges may be more severe off-budget (in the trust funds) than they are on-budget. However, addressing these off-budget concerns will have huge implications on the federal budget, requiring either dramatic increases in revenues or major decreases in benefits before too much time passes.

What lies ahead?

Without significant action, the burden of debt (on-budget and off-budget) will continue growing dramatically. The government will be forced to borrow more and more to cover the growing annual shortfalls in the trust funds. As of December 31, 2008, for the first time, the combined present value of our federal debt and the unfunded future obligations for social security and Medicare ($53 trillion) exceeded household net worth ($51.5 trillion) in the United States. As the old commercial used to say about taking care of your car, "You can pay me now, or you can pay me later." The cost gets steeper and steeper as the scope of the damage needing repair grows over time. The repair - and the payment - for fixing the system can begin now, or it can be left for later, to be fixed at a higher cost on another day.

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Posted June 8, 2009.