Means Testing Entitlements as a Path Forward for Solving Long-Term Budget Challenges

October 9, 2010

My former colleague Josh Barro, now with the Manhattan Institute, had a piece in Real Clear Markets last month on how best to solve both the short-term and long-term problems U.S. fiscal policy is facing.

In summary, Barro argues that given the size of the fiscal gap, both spending and revenue solutions have to be on the table and that the best solution may generally be spending reductions that move our spending policy in a more progressive direction (e.g., means-testing some spending programs more than they currently are) along with higher taxes from less progressive sources (e.g., relying more on broad taxes to raise revenue as opposed to having a skewed distribution of the tax burden that sometimes comes at the expense of efficiency).

Under a world of perfect competition in all markets and rational expectations, there would be little efficiency improvement from such a move that makes the tax system more efficient by cutting high marginal tax rates and replacing them with implicit taxes in the form of means-testing of retirement programs. That’s because the prospect of lower spending benefits upon reaching entitlement age (i.e., Social Security and Medicare) for high-income earners would deter work and investment decisions in the income-earning years. However, to the extent that a significant fraction of the retirement income earned by those with high-incomes is the result of infra-marginal returns (i.e., those high-income retirees who are the beneficiaries of stock market or other investments that exceeded any normal required rate of return when invested), such a shift from the inefficient and explicit high marginal tax rates to the more efficient and implicit means-testing “tax” would be welfare-enhancing.

Overall, regardless of the policies the Fiscal Commission recommends (if any), the public cannot take Republicans seriously when they stick to their no new taxes pledge while at the same time promising to protect Medicare from cuts. Similarly, the public cannot take Democrats seriously when they promise to protect entitlement programs while at the same time promising not to raise taxes on those outside the top 3 percent.


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