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Saving Medicare
January 1999
Medicare's Long-Term Financial Crisis
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"Medicare's future expenses exceed its projected income by $8.9 trillion over the next 75 years." "Medicare's unfunded liability is more than twice that of Social Security and more than twice the total federal debt." "A child born today will pay federal taxes far in excess of any expected federal benefits."
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Baby boomers are currently at their peak earning power and therefore at their peak tax-paying capacity. As a group they contribute more than 60 percent of all federal tax revenues. As they retire, they will be replaced by a much smaller generation whose tax rates will have to be far higher. And because baby boomers will then be net consumers of federal revenues rather than net contributors, the tax burden on the smaller generation will be even larger.
Medicare's Unfunded Liability.
To appreciate the magnitude of this problem, consider Medicare's unfunded liability (present value of expected future spending minus expected future revenues).8 As Table I shows:
- Medicare's future expenses exceed its projected income by $8.9 trillion
over the next 75 years.
- This unfunded liability is more that two times the size of the total
federal debt currently held by the public ($3.8 trillion).
- Medicare's liability also is more than twice the size of Social Security's unfunded liability. [See Figure III.]
Although the need to reform Social Security has been far more visible in public policy discussions, Medicare clearly has the more serious financial problem. If they are not addressed, both elderly entitlements will consume an increasing portion of the nation's output.
Generational Accounting. Medicare's commitments can also be measured using the generational accounting techniques developed by Alan Auerbach, Jagadeesh Gokhale and Laurence Kotlikoff.9 Generational accounting identifies the net tax payments - that is, lifetime taxes paid less lifetime benefits received - for each existing age group and for future generations. Ideally, at birth each new generation should expect to receive benefits equal to the taxes it will pay. Under the current system, however, current newborns will pay federal taxes far in excess of any expected federal benefits. Indeed, Gokhale and Kotlikoff estimate that in order to make Medicare benefits equal to lifetime taxes for newborns and future generations, Medicare benefits would have to be cut 68 percent beginning in 1998. If reform is postponed until 2003, benefits would have to be permanently cut by 78 percent. If the program were not reformed until 2016, just five years into the retirement of the oldest group of baby boomers, even its complete elimination would not produce generational balance!10
Actuarial Imbalance. A third way to look at the problem is to analyze the Medicare trust funds the way actuaries would analyze a private pension fund. Proceeding in this way, the Medicare trustees estimate that to balance the books for the next 25 years, the Part A tax rate would have to be increased immediately from the current 2.9 percent to 3.62 percent. To bring about actuarial balance over the next 75 years, the tax rate would have to be increased immediately to 5 percent.11
The problem with this approach is that it ignores the pay-as-you-go nature of Medicare financing. Medicare payroll tax revenues are spent almost as quickly as they are collected. They are mainly spent on elderly health care. But if Medicare tax revenues (inflow) exceed Medicare spending (outflow) the difference is accounted for by depositing special, interest-bearing government bonds into the Medicare (Part A) trust. From an accountant's point of view, these bonds are an asset; and if the payroll tax rate were higher, the trust fund would accumulate more such assets. However, every increase in the assets of the Medicare trust fund increases the liabilities of the U.S. Treasury. Summing over both parts of government, they net out to zero. Put another way, the trust funds consist of IOUs the government has written to itself. Regardless of the state of the trust funds, in order to pay more benefits in the future the government will have to tax or borrow.
Projected Future Taxes. A fourth way of looking at the problem is to focus on the tax revenues that will have to be collected in future years to pay promised benefits. According to the most recent trustees' report, Part A spending as a percent of payroll will climb to 4.62 percent in 2020 and 6.72 percent in 2040. If Part B spending is expressed as a percent of payroll, the implied total Medicare tax would be 9.78 percent and 13.63 percent in 2020 and 2040, respectively. [See Figure IV.]
Need for Change. Because the crisis we are discussing will become more evident in the future, many people think that Medicare's financial problems will occur only when the trust fund is exhausted or when the baby boomers retire. But the crisis is here and is best dealt with today. What the present value calculations, the generational accounting estimates and the trustees' projected tax rate increases all show is that waiting to secure Medicare's financial position is courting disaster.
A Private Sector Solution
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"An alternative to the pay-as-you-go approach is a system under which each generattioin pays its own way." "In order for today's college students to collect their own benefits, future workers will have to pay one out of every seven dollars they earn just to cover medical bills for the elderly." "Each individual would be required to make annual deposits to a Personal Retirement Insurance for Medical Expenses (PRIME) account." "Those whose deposits fall short because of low earnings would have their accounts topped up by the government." |
An alternative to Medicare's current pay-as-you-go approach is a system under which each generation prefunds its retirement health care expenditures and pays its own way. Prefunding Medicare could be accomplished by requiring each age cohort (all individuals born between January 1 and December 31 in any given year) to pool together, making deposits to private savings accounts and eventually paying premiums that would insure against postretirement medical expenses. What follows is a brief description of how the reform would work. [See Saving Medicare: A Ten-Point Plan.]
Private Savings (PRIME) Accounts.
Each individual would be required to make annual deposits to a Personal Retirement Insurance for Medical Expenses (PRIME) account. These private savings accounts would grow until retirement and would accumulate sufficient funds to allow the purchase of basic health insurance during the years of retirement. The same dollar contribution to PRIME accounts would be made by all members of the same age group, and the required amount would be adjusted from year to year to insure sufficient funds for postretirement health care.12 For example:- To replace Medicare, a 25-year-old would need to deposit about $668
a year, every year, until retirement - an amount equal to about 2.4 percent
of the average person's wage over the next 40 years.
- A 35-year-old would have to contribute about $1,098 - a larger amount
since he or she has only 30 years over which to accumulate the necessary
funds.
- A 45-year-old would need to contribute about $2,008 each year for the next 20 years.
These deposits would be funded by dollar-for-dollar reductions in the workers' payroll tax liability. Roughly speaking, workers would put money aside in their own accounts rather than paying taxes to Medicare. A more complete discussion of the required contribution amounts and the assumptions behind them is provided below.
Since participation in Medicare is compulsory, participation in any private-sector alternative also would be compulsory. Whether or not compulsion is justified, it solves two important problems. First, mandatory participation eliminates a potential "free rider" problem. As a society, we have decided that individual access to health care will not depend on ability to pay. Yet knowing that society will take care of them, individuals have an incentive to save less than they may need to fund their retirement medical care expenses. Mandatory participation also addresses the adverse selection problem that would result if individuals could opt into the system only when they expected to incur large medical expenses.
Accounts for Low-Income Workers. Those whose deposits fall short of the required amount because of low earnings would have their accounts topped up by the government. The required contributions of those who earn more than enough to fund their accounts would support the topping up. Taken as a whole, as each age group reaches retirement age there would be enough money to cover their retirement health care insurance premiums.
Accounts for Spouses. Married workers also would have to divert a portion of their Medicare payroll taxes to the PRIME accounts of nonworking spouses. These deposits would be accounted for separately so the nonworking spouses would be fully protected in cases of death, separation or divorce.
Investment of PRIME Accounts. Individuals would select a manager for their PRIME account from among competing financial institutions, which would be required to invest PRIME funds prudently and conservatively in a diversified portfolio.
Postretirement Health Insurance. Sometime before their 65th birthday, individuals would have to use their PRIME account funds to purchase postretirement private health insurance. Such insurance could consist of an HMO, PPO, MSA or some other plan, but the chosen plan would include catastrophic coverage for basic medical care. The proposed insurance would be similar to today's Medicare in that it would pay no death benefit. Funds not used for third-party insurance could be placed in a Medical Savings Account to purchase medical care directly or to pay for long-term care.
Death Benefit. Unused MSA balances and other PRIME account funds not used to purchase catastrophic insurance could be transferred to an individual's heirs at death.
Medicare Buy-In Option. As an alternative to private insurance, individuals could use their PRIME account funds to buy back into Medicare during the transition period.
Funding the Transition. Throughout the transition period, Medicare taxes would be kept at their current level. Tax revenue not diverted to PRIME accounts would fund Medicare benefits for those already retired or near retirement and retire any debt incurred as a result of the transition.
The medical care risks of current and future retirees will exist regardless of who acts as the insurer. What medical care will encompass and what proportion of total resources will be dedicated to it in the future is unknown. Yet it does not follow that the government must be the insurer or that transfer payments must fund retirement medical expenses. The real question is whether future retirees will pay for their own retirement medical purchases or rely on their children and grandchildren to pay. Pay-as-you-go financing shifts the risks from medical care consumers to taxpayers. Prefunding links the consumers of medical care to its funding.