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A Hidden Stash?


Anyone who takes a look at the long-term forecast for federal spending comes away profoundly depressed. As baby boomers age, they will collect Social Security checks en masse and run up enormous Medicare expenses. Long-term forecasts from the nonpartisan Congressional Budget Office show federal spending soaring from 18% of gross domestic product today to 24% in 2040 -- way ahead of expected tax revenues. In order to avoid colossal budget deficits, many economists say, the U.S. will need to slash benefits, raise taxes, or both.

But that budget forecast is incomplete and perhaps overly pessimistic because it doesn't take adequate account of the growing wealth -- and future tax payments -- of America's Investor Class. Ordinary Americans and their employers are socking away huge sums in tax-deferred accounts such as Individual Retirement Accounts, 401(k)s, and traditional pensions. The total in such accounts is roughly $11 trillion today, with hundreds of billions in new contributions pouring in every year. Under current law, retirees will pay ordinary income taxes as they withdraw money from these accounts. Surprisingly, official long-term budget estimates ignore most of these projected tax receipts -- and the amounts are simply staggering.

In a new, as-yet-unpublished paper, Stanford University economist Michael J. Boskin estimates that the value of these deferred taxes through 2040 is roughly $12 trillion in today's dollars. By comparison, the official estimate of the unfunded Social Security liability is $3.5 trillion in today's dollars, while the unfunded Medicare liability for hospital insurance is $5.9 trillion. Boskin, who served as chief of the Council of Economic Advisers in the first Bush Administration and was a key economic adviser to George W. Bush in his 2000 campaign, concludes that much of the anticipated long-term budget gap may not exist -- if current tax laws remain on the books. "Deferred taxes already accrued are large and will likely grow substantially in the future," Boskin told BusinessWeek, "and they are not appropriately accounted for in long-run budget forecasts and academic studies that rely on them."

Others have pointed out that the government would gain from taxing withdrawals on 401(k) plans and the like. But Boskin's findings, first reported in the June 16 issue of Barron's, represent the first serious effort to put a value on this future revenue potential.

How could this elephant in the room have been overlooked? One reason is that the necessary calculations are highly complex and built from a variety of assumptions about the future that are necessarily imprecise, says University of California at Berkeley economist Alan Auerbach, another prominent public-finance economist. While Auerbach argues that Boskin's forecast of the windfall is probably too large, he believes the direction of Boskin's work is correct. "This has been sort of a black box," says Auerbach. "You have to do the calculation from Square One, and Michael has done that."

Political reality is the other reason no one before has produced numbers like Boskin's. Many political analysts and economists simply don't believe boomers will ever actually pay all the taxes on withdrawals they owe under current law. If the laws remain unchanged, Boskin projects that federal tax revenue of all kinds would rise to 24% of GDP by 2040, roughly matching outlays. But that's way above the long-term historical average of 19%, which is the figure the Congressional Budget Office uses in its long-term forecasts. Boskin himself acknowledges that the tax-revenue reservoir he projects could dry up quickly if Congress cuts taxes on withdrawals from tax-deferred savings accounts.

Still, Boskin's paper is beginning to get notice. Congressional Budget Office Director Douglas Holtz-Eakin says his agency already considers income taxes on savings withdrawals in its 10-year outlook. He says the agency is studying the paper's "potential contribution" to studies of the longer-run fiscal outlook.

Clearly, Boskin's paper has the potential to shake up the budget debate and refocus discussion on how the country will pay for Social Security and Medicare. Until now, it has been portrayed as an intergenerational conflict between young, working taxpayers and old, retired beneficiaries of government transfer payments. Boskin demonstrates that there may also be a conflict among retired boomers with differing levels of savings. Upper-crust boomers will control a large share of the nation's wealth. If that wealth is taxed as it's supposed to be under current law, there may not be a serious problem covering the costs of Social Security and Medicare, whose stability is crucial for middle- and lower-income retirees. Yet wealthy boomers may fight to have tax rates cut in order to keep more of their retirement savings.

Boskin, a respected conservative economist, has avoided partisan battle thanks in large part to the clarity and power of his arguments. In addition to his close ties to both Bush Administrations, he led the influential "Boskin Commission," which concluded in 1996 that the consumer price index overstated inflation by more than a percentage point. Advocates for the elderly, union members, the poor, and others whose benefits are adjusted for the cost of living complained. But Boskin made his case persuasively. Canadian economist Erwin Diewert called the Boskin Commission's conclusions "probably...the most important measurement paper of the century in terms of its impact."

Boskin's latest work grows out of a 20-year interest in measuring both sides of the government's long-term balance sheet, ranging from liabilities such as Social Security to assets such as mineral rights and buildings. This time, he is zeroing in on an issue that has escaped the notice of the vast majority of economists, politicians, and investment experts. Tax-deferred accounts such as 401(k)s are enormously popular because they allow people to escape taxes on the portion of their income that they stash in the accounts. Plus, the money accumulates in the accounts tax-free.

That tax-free status, however, disappears the instant retirement funds are cashed out. Money withdrawn by retirees is treated by the government as ordinary income and taxed like wages and salaries. True, if a person's income falls in retirement, he or she could benefit by landing in a lower bracket. Even so, in return for not extracting taxes up front, Uncle Sam will ultimately grab a healthy share of whatever the Investor Class earns on its retirement savings. In effect, says Boskin, the government is a co-investor -- or "silent partner" -- in the retirement-savings plans of millions of investing Americans.

The government isn't just likely to get its hands on some of the Investor Class's assets someday -- it's guaranteed to do so by law. Statutes governing tax-deferred accounts require people to take payouts from them at a certain age, thus triggering income-tax payments.

The tax take on retirement accounts will have multiple benefits, according to Boskin's calculations. Every extra dollar of revenue collected cuts down on the amount the government has to borrow, reducing interest payments. Moreover, Boskin projects that by borrowing less, the federal government will free up more savings for business investment. This will increase overall economic activity, and that, too, will add to the government's tax take.

Auerbach, Gale, and other economists who have seen Boskin's paper quibble with several of his assumptions. For example, Boskin assumes that investors will receive a 7.5% return on their investments, before inflation. That's in line with the historical return on a portfolio of 60% stocks and 40% bonds. Nevertheless, a long-term bear market could lower the amount to be collected in taxes.

Boskin freely concedes his numbers are only rough approximations. Moreover, he doesn't argue that deferred taxes on savings will solve all the government's problems. Indeed, Boskin thinks the long-term costs of funding Social Security and Medicare may be larger than the official estimate, especially if people live longer than expected.

Still, the amount of additional tax revenue is big enough to matter, even using more conservative economic assumptions. In truth, the bigger unknown about the budget outlook is not economic but political. That is, will wealthy baby boomers be willing to pay all the taxes they owe once they retire, or will they vote themselves a big tax cut? Most likely, boomers will manage to fight off part of their tax bill -- but not all of it. Boskin has put his finger on an issue that is likely to roil the Investor Class for decades to come. By Peter Coy in New York


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