Saving Medicare

Policy Reports | Health

No. 222
Friday, January 01, 1999
by Andrew J. Rettenmaier & Thomas R. Saving

Executive Summary

Although public attention is focused on how to solve the problem of Social Security, the future financial problems of Medicare are twice as great.

  • The unfunded liability (present value of obligations minus expected revenues) in Social Security over the next 75 years is about $4.3 trillion - a problem large enough to have captured the attention of the president, the Congress and the electorate.
  • Yet the unfunded liability in Medicare over the same period is $8.9 trillion - greater than the country's entire current output of goods and services and more than twice the size of our national debt.

Like Social Security, Medicare faces the problem of a growing population of beneficiaries relative to taxpayers. The baby boom generation, which currently pays more than 60 percent of all taxes, will begin retiring in just 13 years. But Medicare's problems are made worse by two additional factors: rapidly expanding medical care technology and increased medical care utilization. If we continue on the present course:

  • By the time today's college students reach retirement age, the tax burden created by Medicare will have grown from the current level of about 5.35 percent of payroll to almost 14 percent.
  • In order for these students to collect their own benefits, future workers - most of whom are not yet born - will have to pay one out of every seven dollars they earn just to cover medical bills for the elderly.

And this is by no means the worst that can happen. If the Medicare trustees' pessimistic forecast proves correct, future tax burdens will be much greater.

Fortunately, there is a better way. Instead of a pay-as-you-go system under which each generation of retirees looks to the next generation to pay its medical bills, we can have a funded system under which each generation pays its own way. A funded program would work like this:

  • Workers would deposit a portion of their Medicare tax dollars in Personal Retirement Insurance for Medical Expenses (PRIME) accounts to purchase their own health insurance and pay medical expenses directly during their retirement years.
  • All individuals in the same age groups would make the same size deposit, and if individuals were unable to deposit enough because of low incomes, government would make up the difference.
  • Sometime before their retirement, people would be required to use their PRIME account funds to purchase, at a minimum, catastrophic health insurance - choosing among competing private insurers much as seniors can choose among private health plans today.
  • Funds not used for health insurance could be deposited in a Medical Savings Account (MSA) to pay small medical bills, items not covered by ordinary insurance and long-term care.

Although the future cost of the current Medicare system promises to be enormously burdensome, the cost of prefunding postretirement health care is quite manageable - if we reform the system now. For example:

  • Under reasonable assumptions, young people entering the labor market today would need to deposit only about $600 a year - about half of what the average worker will pay in Medicare taxes, including Part B, under the current system.
  • By age 65, these deposits will grow to more than $90,000 ($180,000 for a couple) in today's dollars - more than enough to purchase a private plan that duplicates Medicare's promised benefits.
  • Even if medical expenses grow at a real rate of 2 percent, the required deposits to PRIME accounts will be less than the average worker would otherwise pay to Medicare even if the tax rate were to remain constant at today's rate.

Since the government must continue to fund benefits for current retirees, allowing those of working age to divert a portion of their Medicare taxes into PRIME accounts will cause an increase in the government deficit. However, this act will merely substitute explicit debt (outstanding government bonds) for the existing implicit debt (promises to pay future medical bills over and above expected tax revenues).

  • Ignoring those on disability (about 13 percent of Medicare expenses) and assuming only moderate growth in spending, Medicare's unfunded liability is about $5.9 trillion.
  • With the plan we propose, the unfunded liability would drop to $1.5 trillion or less.

Although the transition to a new system will be costly, failure to make the transition would be even more so.

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