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Saving Medicare
January 1999
Introduction
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"Medicare has an unfunded liability of $8.9 trillion."
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In their 1997 report, the Medicare trustees predicted that the Hospital Insurance Trust Fund (Medicare Part A) would be depleted by the year 2001. Since then Congress has taken a few steps to shore up the fund and postpone its depletion until 2008 - just 10 years away. However, Medicare's long-term prognosis remains bleak.1
Although the trust fund's imminent bankruptcy is getting all of the attention, the real story is the magnitude of the unfunded commitments we have made to future generations of retirees. The trust fund's bankruptcy is merely a symptom of Medicare's real financial problems. Under the current system, the growth in the tax base will not and cannot keep up with the projected growth in promised benefits. Using the Medicare trustees' most recent estimates, the total unfunded liability (the present value of expected benefits minus expected tax revenues) is $8.9 trillion. This huge unfunded liability has several causes. Primary among them is the rapid growth of the elderly population relative to the population of working taxpayers. This, of course, is the same problem faced by Social Security. But Medicare's problems are made worse by two additional factors: rapidly expanding medical technology and increased health care utilization.
With a liability of this magnitude, Americans face tough choices. Most of the proposals for solving the problem are aimed at stemming the growth in benefits while keeping the structure of the current system intact. These include increasing HMO enrollment, raising the retirement age and expanding retirees' choices of insurance plans. While these steps can go some of the way towards addressing Medicare's short-term financial crisis, they offer no permanent solution.
Real reform means replacing a pay-as-you-go system under which the elderly depend on younger taxpayers to pay their benefits with a system under which each generation pays its own way. This reform would allow people to set aside money in personal accounts during their working years from which to purchase health insurance and pay medical bills during the years of their retirement.
Medicare's Imminent Financial Crisis
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"Unlike ordinary health insurance, Medicare has gaping holes in its coverage." "Medicare expenditures have increased 1,040 percent since the program's inception." "The level of earnings subject to the payroll tax has risen from $6,600 to the current unlimited level." |
The bill establishing the Medicare program was signed into law on July 30, 1965, by President Lyndon B. Johnson. Medicaid, the program covering the health care costs of low-income families, was signed into law during the same year. Proponents of Medicare argued that it was needed because medical care costs were growing rapidly and retirees were caught unprepared and with insufficient income to cover these costs. Further, it was suggested that the market had failed to provide prepaid retirement medical insurance that individuals could purchase during their years in the labor force.
How Medicare Works.
The original legislation created a two-part structure that has remained intact. Hospitalization Insurance (HI), or Medicare Part A, is financed by a 2.9 percent payroll tax, paid in equal parts by the employer and employee. Supplemental Medical Insurance (SMI), or Medicare Part B, is a voluntary program that pays for physician expenses and outpatient care. Monthly premiums paid by the elderly cover about 25 percent of the program's cost; the remaining 75 percent is funded by the government from general tax revenues.Unlike ordinary health insurance, however, Medicare has gaping holes in its coverage. A senior on Medicare can face thousands of dollars in out-of-pocket expenses. For example, according to the Health Care Financing Administration, 1.7 percent of seniors will spend more than $5,000 out of pocket on health care expenses.2 To avoid this possibility, about three-quarters of the elderly purchase (either directly or through their employers) medigap insurance - to pay deductibles, copayments and other expenses not covered by Medicare Part A or Part B.3 The result is a mixed blessing. On the one hand, most of the elderly are fully protected for Medicare-covered items.4 In fact, for these items they pay virtually nothing out of pocket. On the other hand, the first-dollar coverage afforded by private medigap insurance encourages elderly patients to spend more on medical care than they otherwise would. Indeed, one study estimates that medigap insurance increases total Medicare spending by 28 percent.5
Recent Medicare Reforms. Almost all health economists and health insurance industry analysts believe that the tripartite structure of elderly health insurance - Medicare Part A, Medicare Part B and medigap - is inefficient and contributes to rising health care costs. Thus Blue Cross or some other insurer should be able to replace the three insurance plans with a single plan that provides reasonable coverage at a lower cost. To exploit this opportunity, most senior citizens for several years have been able to opt out of Medicare and join a private HMO, and about 13 percent are currently doing so. Beginning next year the elderly will have even more alternatives - ranging from HMOs to Medical Savings Account plans.
There is considerable debate about what impact these reforms will have. On the one hand, the 1998 trustees report estimates that their enactment, along with other reforms, will reduce Medicare's long-term actuarial deficit by one-half. On the other hand, studies show that the contracting out that has occurred so far has increased, not reduced, overall Medicare spending.6
Rising Costs. Since its inception, Medicare has been primarily financed by taxing workers to pay benefits for retirees. In essence, one generation is paying for another generation's health care. Under this approach, to keep tax rates from rising benefits must grow no faster than the growth in the tax base. This kind of financing seemed feasible in 1965. At that time, there were only 17 million retirees, real wages were rapidly rising and more than 77 million future workers were less than 19 years of age. Two subsequent events have conspired against the rosy outlook that prevailed at the system's beginning. First, the growth in Medicare spending has consistently exceeded the growth in the tax base. 7 Second, the baby boomers who made pay-as-you-go financing look good in 1965 make this kind of financing look bad today as they approach retirement age.
- From 1967 to 1997, the number of Medicare enrollees almost doubled,
from 19.5 million to 38 million.
- Over the same period, average Part A expenses per retiree grew 481
percent (or 5.37 percent per year) in real terms, and per-retiree Part B
expenses grew 641 percent (or 6.39 percent per year).
- The combination of the growth in the retired population and the growth in real per capita Parts A and B expenditures has resulted in an increase in all Medicare expenditures of 1,040 percent since the program's inception.
Overall, real Medicare expenditures have grown at an annual rate that is three times higher than the growth rate of real wages (8.12 percent versus 2.22 percent). As a result, the Medicare payroll tax has been increased several times, starting at 0.7 percent in 1966 and reaching its current level of 2.9 percent in 1986. [See Figure I.] Besides the growth in the tax rate, the level of earnings subject to the tax rose from $6,600 in 1966 to the current unlimited level in 1994. [See Figure II.] In spite of these efforts to increase Medicare tax revenues, the system currently pays out more in benefits than it receives.
Avoiding Fundamental Reform. The two-part structure and the multiple funding sources have allowed Congress to tinker with the system without making lasting reforms. For example, the shifting of home health care costs from Part A to Part B in the Balanced Budget Act of 1997 helped to postpone the bankruptcy of the Part A trust fund until 2008, thereby hiding some of Medicare's financial problems. Even with those accounting changes, the bankruptcy still comes three years before the first baby boomer begins to draw benefits.