The revolution comes home

George Bush's second term

Jan 13th 2005 WASHINGTON, DC
From The Economist print edition

From the pensions system to the tax code, George Bush wants to overhaul America's economic institutions. Does his radicalism stand a chance?

MOST two-term American presidents lose steam in their second four years. If scandal doesn't get them (Watergate, Iran-contra, Monica Lewinsky), weariness does. Sitting presidents rarely campaign on a revolutionary agenda, just feel-good blather: Ronald Reagan's “Morning in America”, or Bill Clinton's “Bridge to the 21st century”. And a re-elected president is a lame-duck long before his second term ends, leaving little time to get much done.

George Bush seems determined to be different. He has laid out a second-term domestic agenda more ambitious than anything seen in the first term, and that was hardly a lull. It brought the biggest tax cuts since 1981, the broadest education reform in a generation and the costliest expansion of Medicare, the state health system for the elderly, since it was set up in 1965.

If the first-term legacy is largely a deficit, the second term promises to shake some of the country's economic pillars. At the Republican convention last September, Mr Bush spoke of transforming America's fundamental economic institutions for the 21st century, and offered two broad organising themes. The first was to make the United States the best place in the world to do business. That covered changes from tort reform (fewer burdensome lawsuits) to a simpler tax code, spurring more economic growth. The second theme was to foster an “ownership society”, by giving individuals greater control over, and responsibility for, their own health care and pensions. In particular, it meant restructuring Social Security, America's public pension system, by basing it partly on private accounts.

Empty campaign promises? Not so. At his post-election press conference, the president left no doubt that he regarded his victory as a mandate for reform. “I earned capital in the campaign, political capital”, he said, “and now I intend to spend it.”

In recent weeks, priorities have been set. Tort reform is top of the list of first-term left-overs. In early January Mr Bush gave three speeches pushing laws to curb frivolous lawsuits. Top of the new list of second-term priorities is Social Security reform. Tax reform has been put off until a bipartisan presidential commission under two ex-senators, John Breaux and Connie Mack, has studied the issue; they have been asked to report by the end of July. No one expects much action on tax until 2006. In contrast, the White House has hinted that it wants to move on pension reform within the next few months.

There is more, though the other topics may be even more contentious. Judicial appointments are a top priority for Mr Bush's conservative base, but are certain to create a poisonous battle in the Senate. Immigration reform, particularly the creation of a guest-worker programme, will cause painful divisions within Republican ranks. Mr Bush may attempt them, all the same.

The president's ambition, coupled with increased Republican majorities in both the House of Representatives and the Senate, makes for heady expectations. Right-wing activists talk of a “conservative New Deal”, with Mr Bush changing America as profoundly as Franklin Roosevelt did in the 1930s. Democrats, equally exercised, accuse Mr Bush of fabricating a crisis in the pensions system, in particular, in order to destroy the fabric of modern America.

But just as the scale of the project has emerged, so the political landscape has become more difficult. According to Gallup polls, Mr Bush has the weakest job-approval rating of any newly re-elected president since 1948. High casualties in Iraq are the main reason, but the public also seems uninspired by much of this reform agenda. The Democrats are also surprisingly united in their opposition, particularly to Social Security reform. In the case of tax cuts, in the first term, several Democrats switched sides early on; but virtually none has defected in favour of private retirement accounts. Even centrist Democratic groups have come out against them. At the same time, congressional Republicans are both nervous about supporting pension reform and divided on how to go about it.

As a result, Washington's punditocracy has been whispering about over-reach even before the inauguration. Nasty comparisons are being made between Mr Bush's Social Security plan and Bill Clinton's disastrous efforts to overhaul America's health-care system in 1993. And Cassandras are crowing that Mr Bush's second term will be a spectacular failure.

The hyberbole on both sides is misplaced. Mr Bush's agenda combines the incremental and the radical, the sensible and the reckless, the politically doable and the impossible. Even under the most favourable circumstances, not everything will get done: Mr Bush has simply put too much on the table. But unless the White House loses its political touch entirely, some reforms will be pushed through.

Of torts and taxes

A few early signs are good. Of the various unfinished jobs from the first term, tort reform is the right one to focus on. The tort system—designed to compensate accident victims and deter negligence—is expensive, economically distorting and hideously inefficient. America spends over $230 billion a year, or around 2% of GDP, on these kinds of legal actions, far more than any other advanced economy. But victims of negligence get a remarkably bad deal. Over half the compensation is eaten up by administrative costs.

Trial lawyers apart, few deny that America's tort system needs reform. And Mr Bush's basic ideas, though clearly a boon for his corporate cronies, are sensible. He wants to cap non-economic damages at $250,000; shift national class-action lawsuits from state to federal courts to stop plaintiffs shopping among the states for the highest pay-outs; and reform the rules for asbestos compensation. (Asbestos claims, by themselves, explain much of the recent rise in tort costs.)

Shaking up the tort system will not revolutionise America's economy. But it would save billions of wasted dollars and might boost productivity growth. The House has already passed Mr Bush's proposals; the sticking point has long been the Senate. That remains the case, but, with a bigger Republican majority and some judicious compromises, tort reform might actually happen.

That is more than can be said for other left-overs from the first term, particularly Mr Bush's first-term tax cuts. These officially expire by the end of 2010. Passing new legislation to make them permanent (or at least permanent until the size of the deficit forces a rethink) is high on the president's second-term agenda.

This obsession goes down well with conservative activists, who want all taxes cut at all times. From an economic and strategic perspective, it is misplaced. First-term tax cuts have already helped to reduce America's tax revenue, as a percentage of GDP, to its lowest level since the 1950s (see chart 1). If Mr Bush's new-found fiscal prudence is genuine (he promises to halve the budget deficit), he has no business making America's fiscal problems worse. More important, setting his first-term tax cuts in stone makes his bigger second-term goal of broad tax reform considerably harder to achieve. And although tax reform is likely to be much less ambitious than many conservatives now imagine, it will still be tough to do.

Mr Bush is right that America's tax code is a mess. The tax laws and their attendant regulations run to 60,000 pages, 10,000 of which were created during Mr Bush's first term. The annual cost of tax compliance is estimated at $115 billion. Simplifying the system by slashing its myriad deductions would be a big step forward.

And that is a large part of what Mr Bush intends to do. Although conservative ideologues dream of killing off the income tax and replacing it with a flat tax or national sales tax, the White House has little truck with such radicalism. Mr Bush wants to improve today's system, not junk it. He approves of tax breaks for mortgage interest, as well as the need to keep incentives for charitable giving. His commission, tellingly, includes no prominent advocates of fundamental tax reform.

Incrementalism does not rule out ambition. If a simpler tax code is one Bush goal, the other is a code friendlier to savings and investment. The president's first-term tax cuts have already pushed in that direction, by slashing tax rates on dividends and capital gains. He would like to protect yet more investment income from taxation and allow firms to deduct investment spending up-front, rather than charging the depreciation of capital over time.

Paying for such changes (assuming Mr Bush has given up his first-term recklessness) means eliminating deductions. Two targets that the White House is said to be considering are the state-income-tax deduction and the tax-break firms receive for providing health benefits to their employees. Eliminating either would involve a huge political battle. Most Washington budget veterans scoff at the very idea, particularly since Mr Bush has already put off any action until 2006.

Some reform looks likely, however, thanks largely to the Alternative Minimum Tax. The AMT, which was originally designed to prevent rich Americans avoiding taxation, will hit 24m taxpayers by 2008, up from fewer than 3m in 2003. With luck, Mr Bush will marshal the political pressure from angry AMT-payers to push for some base-broadening reform. A clear political bargain could be arranged: elimination of the AMT in return for scrapping favoured deductions. The tax code will not be rewritten, but even modest improvements would be well worth having.

The Big Enchilada

On Social Security, in contrast, Team Bush has no truck with incremental change. A recent (leaked) White House memo described the reform project as one whose “scope and scale...are hard to overestimate”. Success in revamping Social Security, it went on, would “rank as one of the most significant conservative governing achievements ever”.

Social Security, created in 1935 by Franklin Roosevelt, is America's biggest and most popular government programme, providing pensions to the elderly and disabled. Thanks to Social Security, poverty among the elderly has been virtually eliminated. Most Americans rely on the programme for much of their retirement income.

As in most of the rest of the world, the combination of longer life expectancy and lower birth-rates will put increased financial pressure on this pay-as-you-go social insurance system. Over the coming decades, Social Security's payments will rise much faster than its revenues, which come from payroll taxes. The net present value of this financial imbalance over the next 75 years is $3.7 trillion, less than 1% of cumulative GDP. Over an even longer horizon, the present value of the permanent imbalance is estimated at around $10 trillion, a number Mr Bush loves to repeat.

These numbers can be hard to interpret, but the larger point is that Social Security is on an unsustainable trajectory, one that goes well beyond the retirement of the baby-boomers. It is not an immediate “crisis”. In fact, payroll-tax revenues will exceed pension payments until 2018, masking America's overall fiscal imbalance. Nor is it America's biggest long-term fiscal problem. The financial burden from Medicare will be much bigger (see chart 2). Mr Bush's first-term decision to introduce a prescription-drug benefit for retirees worsened Medicare's long-term financial imbalance by more than twice as much as the entire Social Security problem. Nonetheless, Social Security needs fixing. And that means either boosting revenues (for instance, by raising payroll taxes) or reducing promised benefits.

But cutting the pension fund's deficit is not what makes conservatives excited. Their most treasured objective is to restructure the system into one based partly on private accounts. Individuals would be allowed to divert a share of their payroll taxes into such accounts, gradually building up a pre-funded retirement nest-egg in return for a lower guaranteed benefit from the government.

Diverting payroll taxes would shrink America's biggest government programme and change the nature and scope of social insurance. According to its proponents, it would create a nation of investors (and hence, fear Democrats, of Republican voters), foster a savings culture and boost work incentives. On this logic, Americans would work harder, regarding the diversion of money into their own accounts as equivalent to a tax cut.

The scale of the change would depend on how big a share of payroll taxes was diverted. According to proponents, large accounts would not only have more emphatic effects on work and saving incentives, but, by capturing higher returns in equity markets, would do more (though at higher risk) to address Social Security's financial imbalance. On no plausible assumption, however, could private accounts eliminate it.

A small but vocal “free lunch” group of conservative Republicans disagrees. Large private accounts, they claim, can fix Social Security's finances with no need for benefit cuts or tax increases. Legislation proposed by John Sununu, a Republican senator, and Paul Ryan, a Republican congressman, proposes diverting half of payroll tax revenue with no reductions in promised Social Security benefits. The plan relies on permanent subsidies from the rest of the budget and wholly implausible cuts in spending outside Social Security to make its numbers add up.

Fortunately, Mr Bush has not been tempted by the free-lunch route, at least not yet. Though he has ruled out raising payroll taxes, the White House memo made clear it was a “bad idea” to push individual accounts alone. Instead, the White House is keen on a plan first proposed by the Bush-appointed Commission to Strengthen Social Security in 2001. This would allow individuals to divert an average of one-sixth of their payroll taxes into individual accounts. It would cut Social Security's future liabilities by indexing the calculation of initial retirement benefits to prices rather than wages. Although future retirees' pensions would stay constant in real terms, they would no longer rise in line with average wage growth. Over time, Social Security would replace an ever smaller share of workers' pre-retirement income, from 42% today for a typical worker to 20% in 2075 and ever less thereafter. This plan would involve substantial transitional borrowing (around $2 trillion over the next decade alone), although this would be offset by a reduction in the government's obligations to future retirees.

Judging the risks

Until the details become clearer, it is hard to judge the merits of any White House plan. Economically, the benefits of private accounts—at least in the early years—are likely to be modest. A debt-financed transition will not boost national savings; though the accounts will imply higher private savings, government borrowing will rise by the same amount. The gain from private accounts might be eroded by high management fees or poor risk-management by account-holders. But, in principle, Mr Bush could craft a package that shores up Social Security's financial health and reaps the benefits of individual accounts, without sacrificing the basic nature of social insurance.

Less obvious is whether that is politically possible. Americans are increasingly concerned that Social Security is in trouble (in a recent Washington Post poll, more than seven out of ten said the system faced “major problems”). But while younger people like the sound of private accounts, polls suggest that Americans overall are almost evenly divided over whether people should be allowed to invest their payroll taxes in financial markets.

Mr Bush's success will depend on how well he explains his ideas. Interest groups are massing on both sides of the debate. The AARP, America's huge pensioners' lobby, is leading the opposition against the “risky” privatisation scheme. But money is also piling up on the other side, particularly from well-financed conservative lobby groups.

At present, the congressional maths does not look good. Congressmen who face re-election next year are terrified of talking about benefit cuts. Other Republicans are nervous about the upfront borrowing involved. To protect their political flank, party leaders have told Mr Bush that this scale of social change must be done with bipartisan support. But embattled Democrats are loth to give Mr Bush an inch, and the compromises that might appeal to them—such as raising payroll taxes—will appal conservative ideologues.

For all these reasons, Social Security reform will be a long, tough battle. Failure need not sink Mr Bush's whole agenda, but it will overshadow any progress elsewhere. Without pension reform, Mr Bush's second term will be as disappointing as most others. Success, in contrast, could place him beside Ronald Reagan as a true conservative revolutionary.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.