A Framework for Medicare Reform

Studies | Health

No. 315
Friday, September 12, 2008
by John C. Goodman


Executive Summary

Health care is the most serious domestic policy problem we have, and Medicare is the most important component of that problem. Every federal agency that has examined the issue has affirmed that we are on a dangerous, unsustainable spending path:

  • According to the Medicare Trustees, by 2012 the deficits in Social Security and Medicare will require one out of every 10 income tax dollars.
  • They will claim one in every four general revenue dollars by 2020 and almost one in two by 2030.
  • Of the two programs, Medicare is by far the most burdensome — with an unfunded liability five times that of Social Security.
  • Nor is this forecast the worst that can happen:
  • The Congressional Budget Office notes that health care costs overall have been rising for many years at twice the rate of growth of our incomes.
  • On the current path, health care spending (mainly Medicare and Medicaid) will crowd out every other activity of the federal government by midcentury.

There are three underlying reasons for this dilemma:

  • Since Medicare beneficiaries are participating in a use-it-or-lose-it system, patients can realize benefits only by consuming more care; they receive no personal benefit from consuming care prudently and they bear no personal cost if they are wasteful.
  • Since Medicare providers are trapped in a system in which they are paid predetermined fees for prescribed tasks, they have no financial incentives to improve outcomes, and physicians often receive less take-home pay if they provide low-cost, high-quality care.
  • Since Medicare is funded on a pay-as-you-go basis, many of today’s taxpayers are not saving and investing to fund their own post-retirement care; thus, today’s young workers will receive benefits only if future workers are willing to pay exorbitantly high tax rates.

To address these three defects in the current system, we propose three fundamental Medicare reforms:

  • Using a special type of Health Savings Account, beneficiaries would be able to manage at least one-fifth of their health care dollars (and up to 40 percent under the “Intermediate Model”) — thus keeping each dollar of wasteful spending they avoid and bearing the full cost of each dollar of waste they generate.
  • Physicians would be free to repackage and reprice their services — thus profiting from innovations that lower costs and raise the quality of care.
  • Workers (along with their employers) would save and invest 4 percent of payroll — eventually reaching the point where each generation of retirees pays for the bulk of its own post-retirement medical care.

These reforms would dramatically change incentives. Whether in their rôle as patient, provider or worker/saver, people would reap the benefits of socially beneficial behavior and incur the costs of socially undesirable behavior. Specifically, Medicare patients would have a direct financial interest in seeking out low-cost, high-quality care. Providers would have a direct financial interest in producing efficient, high-quality care. And workers/savers would have a financial interest in a long-term financing system that promotes efficient, high-quality care for generations to come.

With assistance from Andrew J. Rettenmaier, an NCPA senior fellow, we have been able to simulate the long-term impact of some of these reforms. The bottom line: Under reasonable assumptions, we can reach the mid-21st century with seniors paying no more (as a share of the cost of the program) than the premiums they pay today and with a taxpayer burden (relative to national income) no greater than the burden today. Along the way, the structure of Medicare financing will be totally transformed:

Whereas today, 86 percent of all Medicare spending is funded through taxes, by 2080, taxes will be needed for only one out of every four dollars of spending.

  • Whereas there is no prefunding of Medicare today, 60 percent of all Medicare spending will eventually be funded through savings generated by beneficiaries during their working years.
  • In terms of the impact of Medicare on the economy as a whole:
  • With no reform, the size of the Medicare program will more than triple (relative to national income) over the next 75 years.
  • With reform, Medicare will take no more of national income than it does today.
  • Of the savings brought about by reform (Intermediate Model), 70 percent are due to the effects of prefunding, 20 percent are due to improved demand-side incentives and 10 percent are due to better supply-side incentives.

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