Social Security and Medicare have accumulated unfunded benefit liabilities totaling $24 trillion -- a massive lien on the future seven times greater than the public debt. Yet for decades, you couldn't find these liabilities officially acknowledged anywhere in a government report.

That's beginning to change. Two years ago, in accordance with a ruling by the Federal Accounting Standards Advisory Board or FASAB, the Treasury's Financial Report began to include estimates of unfunded benefit liabilities. Just this year, the President's Budget and the Social Security Trustees' Annual Report followed suit. Meanwhile the FASAB, which is jointly sponsored by the GAO, the OMB, and the Treasury, recently voted to give the estimates more prominence by reclassifying them as “basic financial” rather than “supplementary stewardship” information.

All of this highlights an apparent contradiction in administration policy. On the one hand, eager to justify the new tax cut, the administration is busy downplaying the importance of debts and deficits. On the other hand, it is pushing for a more complete accounting of the federal government's long-term obligations.

The new honesty about unfunded liabilities is welcome. The usual measures of budgetary and trust-fund accounting say little about the sustainability or generational equity of senior entitlements. Unfunded liabilities say a lot -- and the news is sobering.

A More Meaningful Measure

In general, the federal budget uses cash-in cash-out accounting, which means that it records outlays when money is disbursed rather than when obligations accrue. This framework makes sense for discretionary programs, whose spending levels are determined each year in the appropriations process. But it is misleading when applied to entitlement programs, whose operation is governed by authorizing legislation that remains in force indefinitely and whose participants accrue claims to benefits payable many decades in the future.

Increasingly, it is entitlement programs that dominate the budget. Since the mid-1960s, entitlement spending has risen from one-third to two-thirds of noninterest outlays, with most of it going to retirement and health-care benefits for the elderly. And this is before retiring Boomers begin presenting their benefit claims just beyond the official ten-year budget horizon. The growing dominance of senior entitlements, in the words of Fed Chairman Alan Greenspan, renders traditional budgetary accounting “progressively less meaningful as the principal indicator of the state of our fiscal affairs.”

The Social Security Trustees have developed their own system of trust-fund accounting to measure the program's long-term financial status. The official measure of Social Security's solvency is its seventy-five-year “actuarial balance,” which the Trustees define as the present value of trust-fund revenues over the next seventy-five years, plus accumulated trust-fund assets, minus the present value of trust-fund outlays over the same period. According to the Trustees, Social Security's actuarial balance is a deficit of $3.8 trillion.

Trust-fund accounting, however, greatly understates Social Security's true burden on the budget, the economy, and future generations. The actuarial balance measure perpetuates the fiction that past trust-fund surpluses that were never saved can be drawn down to finance future trust-fund deficits. Moreover, it suffers from the same shortcoming as cash accounting -- namely, the failure to record benefit claims as they accrue. Actuarial balance counts all tax contributions payable within its arbitrary seventy-five-year projection horizon as assets, while failing to count the trillions of dollars of future benefits “earned” by those contributions, but payable beyond the projection horizon, as liabilities.

Is there a better way to measure the federal government's long-term benefit obligations? Yes, it turns out there is. The measure is called an unfunded liability. FASAB requires that the government calculate a standard type of unfunded liability called a “closed-group liability.” The closed-group measure assumes that Social Security and Medicare will be closed to all new entrants. It then determines what today's workers and retirees are due to receive in future benefits over and above what those same workers and retirees are due to pay in future contributions. Private pension plans calculate something similar called a “termination liability.” Indeed, federal law requires them to do so.

As of 2002, the closed-group liability for Social Security was $11.2 trillion. Add in Medicare, and the combined liability for the two major senior entitlements comes to a staggering $24.1 trillion, a sum more than twice the size of the entire U.S. economy.

Sunk Debt

These liability figures are of great practical significance--and not just as indicators of Social Security's and Medicare's future fiscal burden.  Economists look at the closed-group liability measure to gauge the effect of senior entitlements on private-sector savings, and hence ultimately on capital formation, productivity growth, and living standards. Remember: What's a net liability to government is a net asset to households. Because Social Security and Medicare promise future unfunded benefit income, households put less into other fully funded forms of savings.

The closed-group liability measure is also crucial for understanding how senior entitlements transfer resources between generations. Closed-group liabilities measure the subsidy that today's adults expect from future generations -- which, in the case of Social Security and Medicare, is another way of saying that they measure the extent to which future generations will fail to get a fair return on their contributions.

Finally, the closed-group liability measure tells us the cost of transitioning from today's pay-as-you-go entitlement system to a new funded system. To the extent that we wish to fund Social Security without repudiating currently promised benefits, Social Security's unfunded liability will come due. It is the sunk debt that future generations will have to liquidate before they can invest their own contributions free and clear.

Legislated Entitlements

Some defenders of the status quo say that taxpayers need not be concerned about unfunded benefit liabilities because, unlike a private firm, the federal government cannot go out of business and so will never have to pay off the liabilities all at once. This entirely misses the point. It is precisely because the federal government is a sovereign and perpetual institution which can always obligate future taxpayers that honest accounting for its unfunded benefit liabilities is so important. To the extent that these benefit promises are deemed unbreakable, they must be paid off -- just like the official national debt.

Others say that taxpayers need not be concerned since government has no contractual obligation to pay benefits. This is a better argument. Social Security and Medicare are legislated entitlements, not contracts. Congress has often changed the programs in the past without prior notice and will certainly change them again in the future. In strict legal terms, the federal government's accrued liabilities for Social Security and Medicare are zero -- which is why the FASAB requires that government report the numbers, but does not require government to put them on its balance sheet.

Still, so long as the underlying statutes remain in force, accrued benefits are paid out automatically. Its contributory nature, permanent appropriation, and immense popularity give Social Security -- and, to a somewhat lesser extent, Medicare -- a special protected status. The whole terminology of social insurance, from “trust funds” and “insured status” to “earned benefits,” implies that participation in the programs confers property rights on workers. Much of the electorate believes this to be the case and votes accordingly. As a consequence, no one seriously doubts that Social Security's and Medicare's unfunded benefit promises constitute some sort of government obligation.

The requirement to report unfunded liabilities is limited to Social Security, Medicare, and other assorted retirement programs. Although some economists have suggested extending an accrual accounting framework to the entire budget, this is a dubious proposition. Unfunded liability calculations make sense for Social Security and Medicare because they involve promises spanning generations. Most other federal policies
come and go as economic circumstances and political priorities change.

Difficult Tradeoffs

The new focus on long-term liabilities may be a sign that the public is worried about the future. With the recovery stalled, the budget sinking deep into deficit, savings rates hovering near zero, and the Baby Boom's retirement fast approaching, Americans are beginning to review their balance sheets, both public and private.

Unfortunately, it's easier to acknowledge the economic and generational challenge facing an aging America than it is to confront it. Lasting reform will require difficult tradeoffs that few politicians in either party are yet willing to contemplate. It won't happen until America's leaders show as much passion for reforming senior entitlements as they do for cutting taxes.