Medicare: Past, Present and Future

Policy Reports | Health

No. 299
Sunday, July 01, 2007
by Andrew J. Rettenmaier and Thomas R. Saving

Medicare Funding Options


Medicare Funding Options

Assuming that paying projected Medicare benefits is the objective, and assuming that other federal programs are not cut, policymakers have these policy options:

1)         Raise payroll taxes,
2)         Raise all other federal taxes, 
3)         Increase the premiums paid by beneficiaries, or
4)         A combination of tax and premium increases. 

Figure 5

“The Medicare payroll tax could be raised from 2.95 percent of payroll to nearly 20 percent in 2080 to fund the additional deficit.”

None of these are popular with all of the various constituencies.  Taxpayers - particularly the young - will find it increasingly difficult to pay the taxes necessary to fully fund the program, while beneficiaries bristle at the suggestion of paying a larger share of the program's costs.  However, it is important to explore all the options and examine their implications.  To that end, this section examines funding projected Medicare spending by increasing taxes, increasing premiums or a combination of the two. 

“Paying the additional deficits through premiums would require half of retirees' Social Security benefits by 2030.”

Can the Funding Problem Be Solved with Higher Taxes?   The first Medicare funding option isolates and examines how high taxes must rise to meet Medicare's future deficits if other funding sources are held constant at the 2006 level of GDP.  The effects of two tax increases are estimated: (1) increasing general federal revenues other than the payroll tax and (2) increasing the payroll tax. 

The first estimate assumes that (a) payroll tax rates remain at their current levels, (b) beneficiary premiums continue on their current course and (c) general revenue transfers to Medicare continue at their current share of national income. 9  This exercise takes the general revenue funding requirements in excess of the 2006 level and benchmarks them relative to the 25-year average level of nonentitlement federal revenues.  With these assumptions, paying projected benefits will require substantial increases over time in all other sources of federal revenue.  As Figure IV shows:

  • By 2020, in just 13 years, all other federal taxes must increase 10 percent. 
  • By 2030, they must increase more than 20 percent, and by 2040 they must increase more than one-third. 
  • At the end of a 75-year horizon, all other federal taxes, including the income tax, must increase almost 60 percent. 

The second estimate assumes that Medicare deficits are covered solely by payroll tax increases.  As Figure V shows:

  • The current payroll tax of 2.9 percent would have to almost double (rising to 5.4 percent) by 2020.
  • By 2030, the rate would be almost 9 percent, more than three times the current rate, and by 2040 it would be more than 4 times the current rate. 
  • By the close of the 75-year period, the required Medicare payroll tax would be 19.7 percent, almost seven times the current rate. 

“By 2080, it would require premiums 30 times the current level to fund the additional deficit.”

Can the Funding Problem Be Solved with Higher Premiums Paid by Beneficiaries? The second Medicare funding exercise isolates and examines how high premiums would have to rise if payroll taxes and taxes on Social Security benefits proceed as projected in the 2006 Trustees Report and general revenue transfers are held constant at the 2006 level of GDP. 10  As Figure VI shows, the burden on Medicare beneficiaries would be substantial:

Figure 6
  • In 2006, seniors paid a monthly Medicare premium of approximately $121.
  • By 2030, under this option, monthly premiums will grow dramatically to $875 in 2006 dollars. 
  • By the close of the Trustees 75-year projection period, Medicare monthly premiums would rise to more than $3,700 - almost 30 times today's level.

Since Medicare premiums are directly deducted from retirees' Social Security checks, these premiums will leave retirees with much smaller checks. 

  • Today, Medicare premiums consume less than 10 percent of the average new retiree's Social Security check.  [See Figure VII.] 
  • By 2030, if Medicare deficits are covered by increasing premiums, premiums will consume more than half of the average retiree's Social Security check.
  • By the 2070, premiums will almost consume the entire Social Security check of an average new retiree.

Thus, having seniors bear the cost of increased Medicare spending is ultimately the equivalent to using Social Security benefits to fund Medicare. 

“If the additional deficits were funded exclusively by premiums, premiums would consume all of the average retiree's Social Security benefits by 2080.”

Can the Funding Problem Be Solved by Sharing the Pain?   Clearly, financing Medicare's deficits by relying solely on the young (higher taxes) or the elderly (higher premiums) does not appear to be feasible:  Either workers will face much higher taxes or seniors' Social Security benefits would be dedicated to paying Medicare premiums.  Thus, if policymakers seek to reform Medicare within the system's current structure, there must be some sharing in the funding burden between the young and the elderly.  

Figure 7

The most straightforward way of illustrating this sharing is to allow increases in the payroll tax rate to cover the projected Medicare Part A deficit and allow increases in premiums to cover the projected Medicare Part B and Part D deficits. 

Raising Premiums.  Figure VIII shows how sharing the burden between taxpayers and Medicare beneficiaries would affect beneficiaries' premiums.  The figure's top line is drawn from Figure VI and assumes the Medicare debt is financed solely by raising seniors' premiums:

  • Recall that if Medicare is financed solely by increases in premiums, the monthly premium will rise to $875 by 2030.
  • By contrast, if the price hike is shared by beneficiaries and taxpayers, the monthly premium will rise to $633 by 2030.
  • By 2080, the monthly premium level rises to $3,703, versus $2,428 if the increased spending is shared by beneficiaries and taxpayers. 

“Covering the additional deficit with payroll taxes and premium increases would require one-third of seniors' Social Security benefits by 2030.”

Even if workers shared the burden through payroll taxes that match the full cost of Part A spending, the elderly would still have to give up a significant portion of their Social Security benefits to pay the Medicare premiums to cover the projected deficits in Medicare Part B and Part D:

  • Current Medicare premiums require 9.8 percent of a new retiree's Social Security benefit.
  • By 2030, new retirees would have to lose more than one-third (34.7 percent) of their Social Security benefit to Medicare premiums.
  • Finally, at the close of the Trustees 75-year projection period, new retirees would be forgoing almost two-thirds (63.6 percent) of their Social Security benefit to pay their Medicare premiums.

Figure 8

“Premiums would be lower if payroll tax hikes cover the additional deficit in Hospital Insurance (Part A).”

Raising Payroll Taxes.   Under this funding option, payroll tax rates would not rise as high as under the second reform option, which balanced Medicare's debt with payroll taxes alone.  But the tax level would still rise substantially:

The payroll tax rate would rise from its current 2.9 percent level to 6 percent by 2030, more than double the current rate.

By 2080, the rate would swell to about 11.6 percent - four times the current rate.

Sharing the Pain.   If Medicare's projected shortfalls are shared by workers through higher payroll taxes and retirees through higher premiums, the result is more balanced than under the other two options.  As Figure IX shows:

In 2006, payroll taxes accounted for about 46 percent of all Medicare spending, seniors' premiums accounted for 13 percent and general revenues covered about 41 percent of the total.

By 2030, under this option, senior premiums as a share of the total would almost triple to cover about 37 percent of Medicare's spending, while payroll taxes would shrink somewhat to 42.7 percent and general revenues would decline to 20.2 percent of the total. 

Figure 9 

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