A Framework for Medicare Reform

Policy Reports | Health

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


The most important domestic policy problem this country faces is health care. The most important component of that problem is Medicare. Forecasts by every federal agency that produces such simulations — the Congressional Budget Office (CBO), the Social Security/Medicare Trustees, the General Accounting Office (GAO) — show that we are on a dangerous and unsustainable path. Indeed, the question is not: Will reform take place? The question is: How painful will reform have to be?

In what follows, we propose short-term and long-term reforms. Although these reforms are far from painless, they are far less burdensome than the cost of putting off reform many years into the future. This plan builds on a series of studies and detailed policy proposals by the National Center for Policy Analysis over the past 25 years that have analyzed prefunding the health expenses of the elderly.1

Here’s the bottom line: In return for making small sacrifices today, very realistic simulations show that we can reach midcentury — when today’s teenagers reach retirement age — with a Medicare system no more burdensome (relative to national income) than the program is today.

The Size of Unfunded Entitlement Debt. The 2008 Social Security and Medicare Trustees Reports show the combined unfunded liability of these two programs has reached $101.7 trillion in today’s dollars. [See Table I.] That is more than seven times the size of the U.S. economy and 10 times the size of the outstanding national debt. The unfunded liability is the difference between the benefits that have been promised to retirees and what will be collected in dedicated taxes and Medicare premiums. Although Social Security’s projected deficit has received the bulk of attention from politicians and the media, Medicare’s future liabilities are far more ominous. In fact, Medicare’s total unfunded liability is more than five times larger than that of Social Security.

Causes of the Problem. Medicare is in trouble for two reasons. First, health care spending has been growing at twice the rate of growth of national income for the past four decades and that trend shows no signs of abating. One doesn’t need a spreadsheet or a computer program to know that if this trend continues, health care will eventually crowd out every other form of consumption. Second, elderly entitlement programs are based on pay-as-you-go finance rather than a funded system in which each generation saves and invests and pays its own way. Pay-as-you-go means every dollar collected in Medicare payroll taxes is spent. Nothing is saved. Nothing is invested. The payroll taxes contributed by today’s workers pay the benefits of today’s retirees. Without reform, however, today’s workers will receive their retirement benefits only if the next generation of workers is willing to pay much higher taxes.

Effects on Federal Government Cash Flow Finances. Until recently, the effect of Social Security and Medicare on the rest of the federal government was relatively small. However, the combined deficits of both programs will require about 7.1 percent of general income tax revenues in 2010. [See Figure I.] As the baby boomers begin to retire, that number will soar, primarily because of the expansion of Medicare. As a result, it will be increasingly difficult for the federal government to continue spending on other activities:

  • In the absence of a tax increase or benefit cuts, by 2012 the federal government will require one out of every 10 dollars of general income tax revenues to keep its promises to seniors and balance its budget.
  • That means, roughly speaking, the federal government will have to stop doing one in every 10 other things it has been doing by 2012.
  • By 2020, the federal government will have to stop doing one in every four things it has been doing.
  • By 2030, about the midpoint of the baby boomer retirement years, the federal government will have to stop doing almost one in every two things it does today.
  • Education, national defense, housing, energy, Social Security — all of these activities of government will have to be put aside, if health care promises to the elderly are to be met.

Along the way, Medicaid spending threatens to crowd out every other activity of state and local governments, and private health care spending threatens to crowd out every other form of consumption.

Bad as these projections are, the reality could be even worse. According to the Congressional Budget Office (CBO), if Medicare and Medicaid spending continue to grow at their historical growth rates relative to national income, health care spending will consume nearly the entire federal budget by midcentury.2

What About the Trust Funds? Like other government trust funds (highway, unemployment insurance and so forth), the Social Security and Medicare Trust Funds exist purely for accounting purposes: to keep track of surpluses and deficits in the inflow and outflow of funds. The accumulated Social Security surplus actually consists of paper certificates (non-negotiable bonds) kept in a filing cabinet in a government office in West Virginia. (Medicare saves paper by keeping all of its records electronically.) These bonds cannot be sold on Wall Street or to foreign investors. They can only be returned to the Treasury. In essence, they are IOUs the government writes to itself.

Every payroll tax check signed by employers is written to the U.S. Treasury. Every Social Security benefit check and every Medicare reimbursement check comes from the U.S. Treasury. The trust funds neither receive money nor disburse it. Moreover, every asset of the trust funds is a liability of the Treasury. Summing over all three agencies (both trust funds and the Treasury), the balance is zero. For the Treasury to write a check, the government must first tax or borrow.

The Need for Change. If policymakers wait to address these problems until they are out of control, the solutions will be drastic and painful. It is prudent to act now. What can be done?

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