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Saving Medicare
January 1999
Transition to the New System
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"During the transition, the commitments to those currently retired and near retirement must be kept." "A transition to a funded system is less costly than maintaining the status quo."
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During the transition to a private, prefunded postretirement health care system, the commitments to the currently retired population and those close to the retirement age must be kept. At the same time, workers' contributions to PRIME accounts in lieu of Social Security taxes will increase the size of the federal deficit. The following simulations evaluate the transition costs, assuming a real rate of return of 5.4 percent and real per capita medical expenditures growth of 1 percent.
Transition Plan.
Transition to the new system would be structured in the following way. All baby boomers would be shifted to the new system, so everyone born in 1946 and later would be in the new system. Everyone older than 51 in 1997 would remain in the old system. Thus Medicare would continue to fund benefits as it currently does for each new cohort that would reach age 65 through the year 2010. After 2010 no new beneficiaries would be added to the old system. As a result, Medicare spending after 2010 would continuously decline and approach zero by 2046. The current Medicare tax of 4.39 percent would remain in effect throughout.Each cohort would contribute to their PRIME accounts based on an estimate of what would be needed to fund their postretirement health care. As Table II shows, new labor force entrants contribute an amount equal to between 1.78 percent and 2.27 percent of their average wage income, assuming a real rate of return of 5.4 percent and per capita medical expenditure growth of 1 percent. Older workers would make larger contributions. Those ages 38 to 42 would contribute an amount equal to the entire Medicare tax for the average worker, while those between 43 and 51 would contribute more than the current average-wage Medicare tax. For these age groups, the extra contributions are incorporated into the following estimates of the transition cost.
Cost of the Transition. Since workers will be able to divert part of the taxes they now pay to fund Medicare benefits to current retirees, the cost of the transition will be the funds needed to replace this revenue loss. If the federal government funded this revenue gap by borrowing, that would increase the size of the federal debt. However, as the baby boom generation dies off Medicare expenses decline. Eventually, the Medicare tax collected will be more than sufficient to pay benefits and this surplus can be used to retire the debt.
Given that younger workers will be able to prefund their retirement insurance, under reasonable assumptions, by contributing less than their current Medicare taxes, part of the transition cost can be offset by the difference between the Medicare tax rate and the PRIME account contribution rate.20 Thus throughout the entire transition period, the difference between the Medicare tax of 4.39 percent and the contributions to PRIME accounts will provide transition funding. For example, if new entrants to the labor market are required to contribute 1.78 percent of the average wage to their PRIME accounts, then 2.61 percent (4.39 - 1.78) of their earnings will be available to fund the transition.
Effects on Medicare's Unfunded Liability. As Figure IX shows, a transition to a funded system is less costly than maintaining the status quo. The present values are calculated using a 2.7 percent real rate of return, the rate used by Medicare's trustees in their 1997 report, and the revenue and liability series are extended out to the year 2080. As the figure shows, the status quo unfunded liability is $5.9 trillion. This number is less than the one presented in Table I for two reasons. First, the 1 percent growth rate in health care expenditures is less than the growth rate assumptions used by the actuaries. Second, the status quo liability presented in Figure IX reflects the liability associated with Medicare for the aged population only, not including the Medicare costs of the disabled (about 13 percent of the total costs). Under all reform scenarios, the present value of the systemwide unfunded liability is much lower. If PRIME accounts are used to prefund (low-cost) high-deductible insurance, the present value of the transition liability is $398 billion. With (high-cost) high-deductible insurance, the transition liability is $712 billion. The cost of prefunding Medicare's current benefits is $1.5 trillion.
Funding the Transition. The additional cost of the three transition scenarios could be covered by a tax increase of .22, .40, and .86 percent, respectively. These compare to the tax increase of 3.39 percent that we calculate would be needed to maintain the status quo under the same assumptions.
Conclusion
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"In 10 years, Medicare as we now know it will not exist." |
In 10 years, Medicare as we now know it will not exist. The system's huge unfunded liability and generational imbalance will force significant changes. How society will pay for future retirement health care and how much is actually expended on this care need to be seriously and soberly addressed. Making a bold move today to a prefunded system will give individuals ownership in their retirement medical insurance, link the consumers to the amount of care they purchase and bring market forces - largely absent in the current system - to the delivery of medical care to the aged.
NOTE: Nothing written here should be construed as necessarily reflecting the views of the National Center for Policy Analysis or as an attempt to aid or hinder the passage of any bill before Congress.