Saving Medicare
Medicare's Long-Term Financial Crisis
Baby boomers are currently at their peak earning power and therefore at their peak tax-paying capacity. As a group they contribute more than 60 percent of all federal tax revenues. As they retire, they will be replaced by a much smaller generation whose tax rates will have to be far higher. And because baby boomers will then be net consumers of federal revenues rather than net contributors, the tax burden on the smaller generation will be even larger.
Medicare's Unfunded Liability. To appreciate the magnitude of this problem, consider Medicare's unfunded liability (present value of expected future spending minus expected future revenues).8 As Table I shows:
- Medicare's future expenses exceed its projected income by $8.9 trillion over the next 75 years.
- This unfunded liability is more that two times the size of the total federal debt currently held by the public ($3.8 trillion).
- Medicare's liability also is more than twice the size of Social Security's unfunded liability. [See Figure III.]
"Medicare's future expenses exceed its projected income by $8.9 trillion over the next 75 years."
Although the need to reform Social Security has been far more visible in public policy discussions, Medicare clearly has the more serious financial problem. If they are not addressed, both elderly entitlements will consume an increasing portion of the nation's output.
Generational Accounting. Medicare's commitments can also be measured using the generational accounting techniques developed by Alan Auerbach, Jagadeesh Gokhale and Laurence Kotlikoff.9 Generational accounting identifies the net tax payments - that is, lifetime taxes paid less lifetime benefits received - for each existing age group and for future generations. Ideally, at birth each new generation should expect to receive benefits equal to the taxes it will pay. Under the current system, however, current newborns will pay federal taxes far in excess of any expected federal benefits. Indeed, Gokhale and Kotlikoff estimate that in order to make Medicare benefits equal to lifetime taxes for newborns and future generations, Medicare benefits would have to be cut 68 percent beginning in 1998. If reform is postponed until 2003, benefits would have to be permanently cut by 78 percent. If the program were not reformed until 2016, just five years into the retirement of the oldest group of baby boomers, even its complete elimination would not produce generational balance!10
"A child born today will pay federal taxes far in excess of any expected federal benefits."
Actuarial Imbalance. A third way to look at the problem is to analyze the Medicare trust funds the way actuaries would analyze a private pension fund. Proceeding in this way, the Medicare trustees estimate that to balance the books for the next 25 years, the Part A tax rate would have to be increased immediately from the current 2.9 percent to 3.62 percent. To bring about actuarial balance over the next 75 years, the tax rate would have to be increased immediately to 5 percent.11
The problem with this approach is that it ignores the pay-as-you-go nature of Medicare financing. Medicare payroll tax revenues are spent almost as quickly as they are collected. They are mainly spent on elderly health care. But if Medicare tax revenues (inflow) exceed Medicare spending (outflow) the difference is accounted for by depositing special, interest-bearing government bonds into the Medicare (Part A) trust. From an accountant's point of view, these bonds are an asset; and if the payroll tax rate were higher, the trust fund would accumulate more such assets. However, every increase in the assets of the Medicare trust fund increases the liabilities of the U.S. Treasury. Summing over both parts of government, they net out to zero. Put another way, the trust funds consist of IOUs the government has written to itself. Regardless of the state of the trust funds, in order to pay more benefits in the future the government will have to tax or borrow.
Projected Future Taxes. A fourth way of looking at the problem is to focus on the tax revenues that will have to be collected in future years to pay promised benefits. According to the most recent trustees' report, Part A spending as a percent of payroll will climb to 4.62 percent in 2020 and 6.72 percent in 2040. If Part B spending is expressed as a percent of payroll, the implied total Medicare tax would be 9.78 percent and 13.63 percent in 2020 and 2040, respectively. [See Figure IV.]
Need for Change. Because the crisis we are discussing will become more evident in the future, many people think that Medicare's financial problems will occur only when the trust fund is exhausted or when the baby boomers retire. But the crisis is here and is best dealt with today. What the present value calculations, the generational accounting estimates and the trustees' projected tax rate increases all show is that waiting to secure Medicare's financial position is courting disaster.