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Growth Won't Save Entitlements

Article by Ike Brannon October 31, 2013 //   5 minute read

While it may be hard to find a silver lining in the recent battle over the government shutdown, I’d like to nominate the apparent realization by some prominent liberals that there may very well be a long-term budget crisis, and that economic growth is a key ingredient in any solution.

Ezra Klein, writing in the Washington Post, approvingly quoted Larry Summers saying that a little extra economic growth would go a long way towards solving the long-run budget shortfall, and that we ought to pursue policies that buy us more growth. While I’m glad that important voices on the left are beginning to see the light, there’s still plenty to argue over.

First, growth by itself can’t solve the problem. Of course, economic growth brings in more tax revenue: For instance, between 1996 and 2000, when economic growth averaged a whopping 4% per year, tax revenue increased by nearly 40% without tax rates going up at all. Revenue went up at an even faster clip from 2004-2007, when growth averaged a little over 3% per year.

Growth also lessens how much the government spends on unemployment insurance, food stamps, and other poverty-reducing programs such as the Earned Income Tax Credit.

However, economic growth also causes some costs to go up, the most notable in this category being Social Security benefits. Social Security’s costs go up with economic growth because wages historically increase with economic growth as well, and benefits are directly tied to wages.

The Social Security Administration computes the benefits of a new retiree using an average of the individual’s top 35 earning years. If it is aggregating incomes over such a long time period it must adjust for inflation in some way: Social Security does so not by deflating nominal incomes by the CPI or some other price index, but instead by using a measure of wage growth.

Congress was the entity that directed them to use this measure, although it is not entirely clear why. Some insist it was actually a mistake in the legislative language while others insist Congress did it deliberately because when the legislation was being debated in the mid-1970s, wages were rising more slowly than inflation, and a few staffers concluded that using wage growth would be a way to keep Social Security solvent for longer.

Soon after this happened, wages began growing faster than inflation, as inevitably happens if economic growth exceeds population growth. And since the initial benefits of new retirees are pegged to wage growth, these go up as well. As a result, the initial Social Security benefits go up faster than inflation each year, by an average of roughly one percentage point over the last 40 years. To put it another way, two individuals who earn the same income (measured in inflation-adjusted dollars) but who are 10 years apart will not receive the same inflation-adjusted benefit: The younger person will receive about 10% more.

The arithmetic link between economic growth, wages, and benefits is so strong that there is no level of economic growth that can return the Social Security system to solvency. Cato Institute economist Jagadeesh Gokhale, author of the magisterial book “Social Security: A Fresh Look at Policy Alternatives,” estimates that only long-term growth in excess of 8% per year would bring the system into balance — a virtual impossibility for a mature economy such as our own.

Growth is indeed a necessary ingredient for fixing our long-term budget problem, but it’s not enough — Larry Summers’s remarks that an additional smidgen of economic growth may be enough to push the long-term budget into balance is flat-out wrong. What’s more, the policies that Democrats have been touting as pro-growth  — such as the boost in infrastructure spending that Ezra Klein championed — tend to conflate short-term stimulus and long-term economic growth. We need more people working, but economic growth means increasing the productive capacity of the U.S.

Growth is necessary but it’s not sufficient. The fight over reforming entitlements has no easy out.