Phil Gramm, U.S. Senator, Texas

Landon Lecture
October 17, 1997

How to Reform Medicare and Social Security

I always feel comfortable at a college lectern. I taught economics at Texas A&M, I taught for l2 years. I've tried to teach the same subject in Congress for 19 years. You won't be surprised to hear me say that my students at Texas A&M were a lot smarter than the people I'm working with now in Congress.

The ultimate measure of a great university is not its faculty, not its library, not its football team, and not its facilities. The ultimate measure of a great university is its graduates, and I know Kansas State University through two of your graduates, your two great United States Senators. And I want to take this opportunity to tell you in the words of the old Hallmark card commercial, that when you elected Pat Roberts and Sam Brownback you cared enough to send the very best and we appreciate it.

Pat Roberts has branded his name indelibly on American farm policy and provided the pivotal leadership in what I hope and believe will dramatically change and hopefully bring to an end 130 years of policy where the federal government was the dominant decision maker in American agriculture. No new member of the Senate in my career has had a bigger impact quicker than Sam Brownback, and I know that you know those two honored sons of your great university, and I know you're proud of them, and they're really your representatives to the nation's capital and to the nation of what Kansas State is all about, and you couldn't be better representatives than you are.

I never knew Alf Landon, but I did know Nancy Kassebaum, and I think I know a little bit of her dad through her. And so it is a very special privilege for me to be a Landon lecturer and I have looked forward to this opportunity, John and I have discussed it, giving me a chance to come here and visit your university and be here for tomorrow's football game.

I want today to talk about Social Security and Medicare. I want to talk about the threat that they pose to the future of your prosperity and your freedom, in a very real sense posing the greatest financial threat that we have ever faced to the future of the country in the history of the republic. Now let me outline what I want to try to say and then I'll say it.

I want to first give you the bad news about how real the financial crisis is that we face in Social Security and Medicare, how menacing it is to our future, both our prosperity and our freedom. I want to try to explain to you where the problem came from, and then I want to give you the good news, which is that we can fix it. And then I'd like to deviate from my background as a school teacher to be brief, so that we can have time for some questions, I want to explain to you how I believe we can fix it.

In beginning, I want to begin with an analogy, and I hope as you listen to what I have to say today - and what I have to say I believe is alarming - I want you to think about this analogy. And the analogy is the following: Our problems with Medicare and Social Security are very much akin to the situation if you go to a doctor to get a physical exam, and the doctor looks you over and checks out all vital parts and calls you in and says, "I've got some bad news, and I have some glorious news. The bad news is you have a debilitating disease that is going to ruin your life. The glorious news is I can cure it, but to cure it, you must go on this diet." And that basically is the message I want to talk about today.

In 1935 when we started Social Security the average life expectancy in the country was less than 65 years of age, so we were guaranteeing a benefit that the majority of Americans would never get. Today the average life expectancy is 82 years of age. It is not only a benefit that most Americans will get, but they will get it for a very long time. In 1950 there were 16 workers for every Social Security beneficiary, and we were paying about 2 percent of twice the average wage in the country as the maximum amount that anybody paid into Social Security. To begin with the maximum amount anyone paid was $50 in a year. Today there are 3.9 workers per retiree and each worker is paying 12.4 percent of their wages into the Social Security system. 25 years from today there will be 2 workers per retiree and we are looking at between 16 and 18 cents out of every dollar earned by every worker being paid into Social Security to keep the system solvent. That number will rise to about 20 cents out of every dollar over the next 40 years.

Medicare started in 1965. For the last 15 years there's been no program of the federal government that has grown as fast in cost as Medicare. It has averaged 11 percent growth for 15 years in a row. When we started Medicare it was funded by paying a tax of .7 percent of the first $6,600 you earned. Today Medicare takes 2.9 cents out of every dollar earned by every American, and still with this level of taxing Medicare will represent a drain on the general treasury of $1.1 trillion in the next ten years.

When we started Medicare we were in a period where the first baby boomer was entering the labor market in 1965, and as Congress looked at this huge mass of people who had been born from 1946 to 1964, 76 million of them, it looked as if that tidal wave of workers would never end. In fact, had they gone down to the Census Bureau in 1965 and asked, they would have discovered that it already ended. But when we started Medicare we had this huge influx of new workers, and when we started Medicare there were 5.5 workers for every beneficiary. There are now 3.9 workers per beneficiary and we are headed over the next 25 years to 2 workers per beneficiary. The unfunded liability of Social Security, the amount of money that we would have to pay a consortium of retirement funds to take over Social Security, to take the taxes being paid in, and to pay the premiums that we are committed to, if any such consortium existed, we would have to pay them $11 trillion today to absorb the unfunded liability in Social Security. The unfunded liability in Medicare is $2.9 trillion. Together that is twice the registered value of the national debt of the United States, and in trying to get people to understand it, is the problem. I have one constituent who knows what $1 billion is, Ross Perot. I don't know anybody who knows what $1 trillion is, but even in Washington, it is a lot of money.

Now, let me explain where the crisis came from. Otto Von Bismarck, the chancellor of Germany, in fact, he was chancellor from 1871 to 1890, a brilliant politician, a product of the German socialist school of economics, came up with the idea in the 1880s of creating entitlements that would be funded on a pay-as-you-go basis, that would be funded by taxing current workers and paying benefits to people who had already worked, where nominally there would be a claim that people were paying for their own benefits, but in reality there would be no trust fund, no investment, no power of compound interest creating an asset base to pay for the benefit. Germany in the 1880s had an exploding population, it was becoming a world power, very high birth rates, and the program looked in that period as if it would be successful. It certainly was successful politically.

From Germany our modern Social Security and Medicare spread first to Europe, then to the Americas, interestingly enough it didn't come to America first, it came to Chile first in 1925. Social Security was adopted in the United States in 1935, and Medicare in 1965. It's interesting to note that in Germany today 20.3 cents out of every dollar earned by every worker goes into their Social Security program, and when you combine their retirement health care program and their Social Security program, it takes roughly 26 cents out of every dollar earned by every worker in Germany. Interestingly enough, that's almost precisely what the estimate is that our two programs will take 25 years from now when these programs are as old in America as they are in Germany. Also it is important to know that Germany has not created one net new job in 15 years and it has an unemployment rate of 12 percent.

Now, the pattern of pay-as-you-go financed entitlements is the same world over, and so I want to talk about it in terms of our experience in the United States. There are three major problems with it. Number one, pay-as you go financing has no trust fund, and as a result it does not benefit at all from the most powerful economic force in history, and that's the power of compound interest. While nominally we have told the American people since l935 that we have a trust fund, the trust fund is an accounting entry, there's no investment, it creates no jobs, it generates no wealth growth. The trust fund is the debt of the federal government, yet it is not carried on the books of the treasury as being a debt of the government. The payment of interest is not carried as an outlay of the federal treasury. There is no trust fund. Secondly, life expectancy as part of the good news has exploded worldwide and in the United States, as I mentioned, growing from less than 65 when Social Security came into effect in 1935, to roughly 82 today.

And finally, and most menacingly, there is a dramatic change in the population makeup of the whole western world, and particularly in the United States of America, and that population makeup is being affected dramatically by what we call the baby boom.

When Social Security started in 1935, the birth rate started to rise, it had a spike during World War II, but Americans came home from winning World War II with great confidence in the future, and beginning in 1946 there was an explosion in the birth rate in America. Seventy-six million babies were born between 1946 and 1964. That baby boomer generation made it possible for us to fund Social Security and to greatly increase benefits in the 1940s and 1950s. It made it possible for us to start Medicare at a fairly nominal tax rate and to provide benefits such as the world had never seen before. The baby boomer generation in short made possible the two most loved and most important programs of the federal government, and the baby boom generation, unless we reform Medicare and Social Security dramatically, will destroy both of those programs, because we are now 14 years away from the first baby boomer retiring and it is a double-edged sword, it's fewer people working and it is more people drawing benefits.

Let me just give you one figure and I could numb your mind with them, but I'll just give you one good one. The babies that are retiring this year were born in 1932. And 1932 at that point was a historic low in the birth rate in the country. This should be a period where Medicare and Social Security are flush. Only 200,000 people will turn 65 this year. Fourteen years from today 1.6 million people will turn 65 and that number will not change for 20 years. The birth rate by 1970 was half the birth rate in 1947, and there is no sign on the horizon that we are about to have an increase in the birth rate, and even if we did, we're 22 years away from that increase in the birth rate affecting the labor force.

Now, let me summarize the crisis. If you assume that the American economy grows as fast for the next 30 years as it is growing today - and that's a heroic assumption - if you assume that the level of immigration, both legal and illegal, stays as high as it is today, a record level, something Congress shows every evidence of changing, we will still in 30 years have to have a payroll tax twice as high as the payroll tax is today. In other words, up from 15 percent to 30 percent, to fund Medicare and Social Security. And what that will mean is, as incredible as this sounds, average income American families making between $39,000 and $49,000 will have marginal tax rates of between 57 and 60 percent.

Now, if you assume that having a marginal tax rate for average families of 60 percent will have an impact on the willingness of people to work; if you assume that a 30 percent payroll tax will have an impact on the demand for labor, we could easily be in a situation where the payroll tax would have to triple in order to fund Medicare and Social Security under a more pessimistic scenario, and that would mean a marginal tax rate of 73 percent. And we're not talking about rich people, we're talking about a family of four, $39,000. That's the problem.

So what is the good news? Well, there's a lot of good news. First of all, we can fix it, and not only can we fix it, we can make it better than it ever was. How? Well, first of all, the first bit of good news is if the average American worker 22 years of age could put one percent of their wages into a private investment through a mandatory program, and if that investment would grow at 4 percent a year, which is half of the rate of growth in the value of Standard & Poors 500 over the last 70 years on average, they could fully fund their health care retirement benefit. Now they're paying 2.9 percent of their income. They're paying roughly three times the amount they would have to pay if they could simply make investments to fund their own retirement. That's the first piece of good news.

The second piece of good news is that at a very modest interest rate, very modest rate of return on investment, 4 percent, that the average 42-year-old in America could transfer from Medicare to a program where by putting 2.9 percent of their wages into a real investment fund, where the government regulated on safety and soundness, they could fully fund their own health care retirement, paying only the amount they're currently paying for Medicare. And yet as startling as those numbers are, it is an absolute certainty that no 22-year-old under the current program will get anything like the benefits that current retirees are getting and virtually no 42-year-old will either.

I'm not proposing a transition path. There are a lot of ways to get out of the old system and into the new one, but I'll simply give you some numbers that on their face sound pretty shocking, but when you think about it, they're not that shocking. If we let everybody 42 years old or younger convert over to a system where Medicare benefits were based on investment - I call it investment-based Medicare, investment-based Social Security - the federal government would regulate the investments on safety and soundness, you'd have to have a broad portfolio, the companies that sold the investments would be very strictly regulated for safety and soundness. If we let everybody 42 years of age and younger convert from the current system to an investment-funded system, so their benefits would be forever guaranteed, and it would be independent of the population distribution. If you let each cohort, that is each person 42 years of age, if their investments were pooled to pay for the benefits of everybody 42 years old, and the 22-year-olds all paid for everybody 22 years old, they would have their health care insured by these private investments. And you had people who were 42 put the whole 2.9 percent they're now paying in Medicare taxes into an investment-based Medicare system, and then younger people would put the amount needed to fund the program, a real program, into their real program, and then the difference between 2.9 percent and what they're paying now would go to help pay benefits to people who are already in the system, you would have an unfunded liability of $734 billion Medicare. You could borrow that money and pay it off over 50 years in annual installments of $31 billion.

This is simply one path of transition that could forever get us out of a bankrupt system, that would avoid in the process an ultimate payroll tax of roughly 14 percent to pay for Medicare, by making the transition to an investment-based system, if we did it now. If you wait, the cost explodes, because the sooner you get people into an investment-based system, the more you unleash the most powerful economic force in history, which is the power of compound interest. Throughout history very few people have ever had the ability to put wealth to work. We would let every worker put wealth to work to pay for their retirement and to pay for their Medicare.

Now, on Social Security the good news is that at the rate of return that we have gotten on average over the last 70 years in Standard & Poors 500, you could pay for your same benefit that you're getting under Social Security with a 2 percent of salary investment. In other words, workers today, young workers, let's say someone who graduates from Kansas State University this year, will next year pay 12.4 cents out of every dollar they make into Social Security. If they could put 2 percent of every dollar they made into a real investment, it would pay for retirement benefits equal to what is currently being given to people on Social Security, but greatly in excess of anything under the current system that you could ever hope to draw. Because by the time you retire, the baby boomers will have all retired and we'll have two workers per retiree.

Martin Feldstein in Harvard has worked out a plan where if for 15 years we raise the payroll tax on Social Security from 12.4 percent to 14.9 percent, and we had younger workers put 5 percent into a real investment, the rest of the money going to pay off existing debt in Social Security, in 15 years we would have the payroll tax down below the level that exists today. In 40 years we would have it down to 5 percent and the entire system would be converted over to an investment-funded system. How is it that we could pay for Medicare with a 1 percent investment instead of a 2.9 percent, and Social Security for 2 percent investment rather than a 12.4 percent investment, and that it could be guaranteed? The difference is the power of compound interest. The power of putting capital to work. The power of making every working American a wealth owner.

Finally, on this point let me point out how unfair Social Security is in one sense. This is the first time I've ever spoken on this subject, but in talking to people about it I'm often asked, "Well, what about poor people?" The current system is very unfair to poor people. First of all, the money you put into Social Security doesn't even count toward your retirement until you're 30 years of age, because it's only based on 35 years of your highest wages. So if you graduate from K-State and you go to law school and then you go on and get an advanced degree in law, and you go to work when you're 28 years old, it's not bad. But if you went to work when you were 16 years old, the blue collar worker, from 16 to 30 you paid Social Security taxes you got absolutely nothing from it.

Social Security is one of the few programs in America that transfers money from poor people to rich people, because poor people start working sooner and don't live as long. One of the powers of investment-financed Social Security is, is that people that start working at 16, that money is going to compound with the power of compound interest all those years until they turn 65.

I'm not talking about something that has never happened before, it happened in Chile, it has now happened in Australia, it is now being done in England, it is being done in Argentina. Even Mexico is beginning to look at investment-based Social Security.

Let me explain very briefly how the Chilean experience worked. Chile started Social Security in 1925, 10 years before we did. By 1950 they had 10 workers per retiree. By 1980 they had 2 workers per retiree. They had reached the point where over 20 cents out of every dollar for every worker was going into their Social Security system, and that was funding about 60 percent of the cost, the other 40 percent was being borne by general tax revenue. They were on the verge of an economic collapse. Under the guidance basically of a group of economists in the University of Chicago they redid their system. They gave people a choice. You could stay in the old system or you can convert to a new system, and here's how the new system would work.

Let's say you're 40 years old and let's say you've paid $40,000 into Social Security. You stay in Social Security, you stay under the existing Social Security program, but if you get out they give you a government bond, what's called a discount bond, with a face value of $60,000, which builds-up internal interest, that it will pay you, they guarantee, 4 percent real interest, the day you turn 65 years of age. Then they took 15 percent of every dollar of earnings paid in, 10 percent went into private investments for an investment-based system. People in Chile chose initially among 12 companies that provided investment funds, they now have 20. They have averaged a rate of return on investment of 9 percent since 1980, and they have literally turned Marx on his head, because in Chile a house painter or a taxicab driver will have $70,000 or $80,000 of real wealth that belongs to them.

Their program has been so successful that they can't invest the money in Chile, because they've inflated the stock value of the very small companies, and they're now the largest investor in South America. Their program is so successful that they now let people decide when they retire. So you have to put 10 percent, but you're allowed to put as much as 20 percent, and anytime you can equal 50 percent of your last ten years of earnings in retirement, you can retire. So it is very common for people to say, "Well, I'd like to retire at 58." Each month they get a printout of where they are on their investment and by simply changing what they're putting in, they're able to change their retirement age.

Now, those are basically the two options, and I tried to come up with sort of an analogy of where we are and I came up with a strange one. And it's the Christmas Carol. You all remember Ebenezer Scrooge, probably the most maligned person in literature, however, in reality, Scrooge at the end is a wonderful person. We all remember him for what he was in the beginning, but the two things I want to call your attention to and then make this quote are, if you'll remember when the ghost of Christmas Present comes and carrying Scrooge around and goes to Bob - I always screw these names up, Wendy always yells at me - I think it's Bob Cratchett, is that right, Wendy? They go to Bob Cratchett's house and poor Tiny Tim is there and Scrooge, who is already being transformed by what he's seeing, says to this ghost of Christmas Present, "Spirit, tell me if Tiny Tim will live." And the ghost of Christmas Present says if things continue as they are, "the child will die."

And then as you remember as you got into this Christmas Future, who's a very unhappy guy, and Scrooge is going - he's about to read his own gravestone, and he gives a quote that really says where we are with the future of our country. He says, "Men's courses will foreshadow certain ends, to which, if persevered in, they must lead. But if the course be departed from, the ends will change."

And as we all know from that story, he changed, he changed the course of lives, Tiny Tim lived.

Now, I've been talking today about the future of America. There's no reason that we should not be the dominant country in the world in the 21st century. The competition in the 21st century is our kind of competition, it's not who will stand the longest on an assembly line bored to death, it's not who can punch the most punches out or sew the largest number of shirts, it's who can think, who can innovate, who can come up with new ideas, and who can transform those ideas into reality. That's something we do better than anybody else in the world, and that's what the competition is going to be about in the 21st century. We can dominate the 21st century.

Americans can be richer, freer and happier than we've ever been, but we cannot dominate the 21st century if the average tax rate of families of four, earning $39,000 a year is 58 percent.

In reality the crisis I'm talking about threatens a very bright future. I'm not talking about making up predictions about the future, I'm not trying to sound like the guy who's predicted 12 of the last two recessions. I'm talking about the cold facts, with the population makeup of the country, that if we continue Medicare and Social Security as they are, two things are going to happen, and it is certain they are going to happen. Number one, taxes are going to explode.

Today we're having debates about cutting taxes, when in reality we know 30 years from now the tax rate will be double what it is today to pay for Medicare and Social Security unless we change it. The question is, do we have the will to change it? I think we know how to do it. Clearly there are going to be those voices who say, "Well, there's no problem, just leave it alone." It will be a question of American leadership, it will be a question of the ability of the American people to ferret out the truth and understand it.

It is going to be a very important debate. And I wanted to talk about this subject for the first time here at Kansas State in front of young people because it is your future we're talking about. Those people who are over 50 are going to be affected by this mostly through their children. I have two sons, one 24 and one 22, I have a big stake in the future of this debate. My sons cannot and will not have the opportunity that I've had unless we deal with this problem.

And so the bad news is we have a debilitating disease that will ruin our country and spoil the most promising future that America has ever had. The good news is we know how to solve the problem, and when we're debating Medicare and Social Security we've got to stop talking about the impact of it just on my mother and your mother, we have got to start talking about it as an impact on our mothers, our fathers and our children as well. Thank you very much.

Phil Gramm
Landon Lecture
October 17, 1997