Social Security and Medicare are in a meltdown. In their recently published Trustees Reports, Social Security is facing a $25.4 trillion shortfall and Medicare is facing a $52.8 trillion shortfall, a combined total of $78.2 trillion—a daunting figure that is not included in calculations of our national debt.

　　It sometimes seems like the only existing bipartisan consensus in Washington is both parties’ agreement to ignore this impending disaster. But Social Security and Medicare cannot continue to function in their current iterations. To avoid a catastrophic cut in benefits, serious reforms must be made to both programs to account for fiscal and demographic changes.

　　Unfunded obligations are a measurement of the difference between program income and promised future benefits. When the promised future benefits exceed income, there is an unfunded obligation. Both programs are funded by a “trust fund,” yet these trust funds do not contain economic assets.

　　By law, payroll tax revenue collected for Social Security and Medicare must be invested in US Treasury securities. When the trust funds redeem these Treasury securities, they must be paid for by tax increases, more borrowing, and/or taking funds from other government programs.

　　As it stands, Social Security’s Old Age and Survivor’s Insurance (OASI) is expected to exhaust its reserves by 2032. If Social Security uses funds from the Disability Insurance Trust Fund (SSDI) to cover OASI payments, both funds will be exhausted by 2033. Medicare Hospital Insurance (funded by Medicare Part A) is expected to go insolvent by 2036, while the rest of Medicare is expected to experience major stress over the coming years.

　　Spending on entitlement programs, especially Social Security and Medicare, are the largest contributors to the national debt growth. As the fiscal situation of the US deteriorates, borrowing costs will increase. Net interest costs are already set to surpass every spending category except Social Security starting in FY 2024. These programs are sending fiscal policy into a death spiral.

　　Taxing the rich will not improve funding. The top 1 percent of income earners pay 45.8 percent of all federal income taxes and the top 5 percent pay 65.7 percent of all federal income taxes. Research shows that taxing the rich would, in the best-case scenario, raise $6.9 trillion. Taxing the wealthiest income earners would barely make a dent in closing Social Security’s funding gap while killing jobs, wages, and economic growth, since high earners typically invest in businesses that hire workers and otherwise drive the economy.

　　Curtailing improper payments (such as overpaying benefits) is a start. The federal government estimates that Social Security made $6.5 billion in improper payments during FY 2023 (0.5 percent of the $1.4 trillion spent in FY 2023). The report emphasized the importance of the Social Security Administration sharing “its full death data” with the Department of Treasury’s Do Not Pay working system to reduce fraudulent payments. Medicare has a much higher improper payment rate of 7.38 percent or $31.2 billion of the $423 billion of total Medicare spending.

　　While curtailing improper payments and fraud would help both programs, more serious reforms are needed. This funding shortfall is also fueled by declining birth rates. The Wall Street Journal recently reported on declining fertility rates worldwide, with the United States falling well below replacement rates since 1972. In 2023, American fertility rates dropped to their lowest rate since 1979.

　　Research on fertility points to a myriad of factors for declining birth rates. Some research claims that it is due to families not meeting fertility goals (i.e. earning a certain income) until later in life or a shift toward a desire to have children later in life for some other reason. A 2021 survey from the Pew Research Center found that reasons range from “just not wanting to have kids to concerns about climate change and the environment.”

　　These unfunded obligations are a symptom of a much larger problem in Washington: in order to win votes, politicians promise generous spending without the means to pay for it, knowing they will probably not be around when the final bill comes due.

　　The economic literature also points to an income effect: as GDP per capita increases, fertility rates decrease. There are several possible reasons for this. For one, leaving work to care for children has a lower opportunity cost for parents in less developed nations. Also, children are an expensive investment and may require more to be successful in developed nations (i.e. higher levels of education, extracurricular activities) than in developing countries. Infant mortality can also play a role, as children are more likely to survive into adulthood in developed nations than in developing nations. Furthermore, the outsourcing of elder care from families to government services (i.e. Social Security and Medicare) also decreases a family’s reliance on children in their old age.

　　Regardless of why fertility rates are declining, for now at least, it is a reality we must accept and to which we must adapt. The best reform for both programs is to change how benefits are indexed. Research shows that if Social Security benefits received upon retirement are indexed to inflation instead of average wage growth, about 80 percent of the shortfall would be closed. Additional research finds that changing Medicare cost-of-living adjustments from the Consumer Price Index to the chained Consumer Price Index would save the program $256 billion over 10 years.

　　In addition, changing Social Security benefits to a flat benefit aimed at fighting poverty while encouraging greater private retirement savings will reduce costs dramatically as well. Currently, Social Security is indexed by the amount of taxable income and age at retirement. Changing to a flat benefit can reduce unfunded liabilities. In addition, if taxpayers were allowed to increase contributions to a private retirement account, they could earn a higher return on investment than had they just put the money into Social Security.

　　Encouraging private retirement savings would also create what Social Security promises but fails to deliver: an account where retirement savings can be invested and grow. Social Security accounts, on the other hand, are simply records of tax payments and contain no funds. Research shows that the introduction of 401(k)s resulted in an increase in retirement savings. Expanding opportunities for Americans to invest in private retirement savings (such as raising the allowable pre-tax contribution limit) could help Americans save even more for their sunset years.

　　Medicare costs can be reduced by moving coverage of unpaid services outside of Medicare to other poverty-focused programs and having Medicare pay the same rate for routine services whether at a doctor’s office or in a hospital. Economists have long stated that overpayments are a key source of Medicare spending growth. Research recommends reducing government subsidies for wealthier beneficiaries by adjusting income thresholds at which means-testing applies, expanding definitions of wealth for means-testing, and using alternative mechanisms of means-testing (such as using Medicare Part A premiums based on income).

　　In the end, these unfunded obligations are a symptom of a much larger problem in Washington: in order to win votes, politicians promise generous spending without the means to pay for it, knowing they will probably not be around when the final bill comes due.

　　As my colleague Vance Ginn and I discussed in a previous post, constitutional spending limits on the entire budget would help reduce wasteful spending. With proper constraints, even the worst politicians will have an incentive to make fiscally responsible choices.

　　If any politicians in Washington had the political courage to think in the medium- and long-term, and make the necessary reforms, they could provide an incredible benefit both for retirees today and for younger Americans who would be empowered to save more for their future.