A Framework for Medicare Reform

Policy Reports | Health

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

Distribution of Costs and Benefits

Under Social Security, contributions (taxes) are a percent of wages and so are retirement benefits. In a sense, the structure of Social Security mimics the structure of a private pension plan in which workers mainly fund their own benefits with their own contributions. This is why a pay-as-you-go system can be replaced with a funded pension system (as it has, say, in Chile) without changing its fundamental appearance. Medicare is different. There is virtually no relationship between contributions and benefits in this program — either over time or within an age group.

The Current Financing System. Under the current arrangement, workers pay a 2.9 percent payroll tax — which means that contributions are proportional to income. At the time of eligibility for enrollment, however, all seniors essentially get the same package of benefits over a lifetime. High-income beneficiaries, therefore, pay more payroll taxes — substantially more — than low-income beneficiaries for the same insurance plan. In addition, general revenues (primarily from corporate and individual income taxes) support 75 percent of Medicare Parts B and D. These taxes tend to be paid by higher income workers and owners of capital.

Reformed Financing System: Medicare SCP Plans. Under the new, partially funded Medicare system, we retain the practice of making contributions proportional to income. For those who elect to cede their HIRA funds to the government and enroll in a SCP at age 65, the price of enrollment will vary with income — since higher income workers will accumulate larger HIRA accounts. As under the current system, people the same age will incur vastly different costs for the same benefit package.

Reformed Financing System: Private SCP Plan. For those who enroll in private SCPs, the government’s role is to top up their 15 percent premium plus their annual HIRA amount (annuity payment or withdrawal) to reach a total risk-adjusted premium needed to buy the SCP package of benefits. This means the government will contribute more to the health insurance of low-income seniors (who have smaller HIRA amounts) than it will for high-income seniors. It will also contribute more to insurance for the sick (who will require larger risk-adjusted insurance premiums) than for the healthy. In this sense, the role of the government is to redistribute from high-income to low-income and from the healthy to the sick within each age cohort.

Long-Term Financing Arrangement. Ultimately, we would like a system in which the average worker accumulates sufficient funds over his worklife to completely finance his own post-retirement health insurance (in addition to the 15 percent annual premium payment made from retirement income). But if we achieve this goal for the average worker, we will have saved too much or too little for every worker who is nonaverage. The government will have to supplement the premium payments of seniors who are relatively poorer and/or sicker. In order to do this, it will need to take from the HIRA payments of the relatively richer and/or healthier. This will involve a “tax” (or negative subsidy) on the HIRA accounts of wealthier and healthier seniors.

Changes in Tax Rates Through Time. In general, we want each age cohort to make contributions over their worklife sufficient to fund their SCPs during the years of retirement (in addition to the 15 percent annual premium payment made from retirement income). Since it is impossible to accurately predict the cost of health care 40 years into the future, there is no particular reason to believe that the initial mandatory contribution rate will need to be kept constant. Every five or 10 years we expect adjustments to be made, as new information about the future becomes available.

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