May 2006

Has the Drug Benefit Added to Medicare's Financing Woes?

Richard Foster
Centers for Medicare and Medicaid Services

The Medicare Trustees’ Report projects the financial status of both components of the Medicare program: Hospital Insurance (Part A) and Supplementary Medical Insurance (Part B and Part D prescription drug coverage). The Hospital Insurance (HI) Trust Fund is financed by payroll taxes and taxes on Social Security benefits. These tax rates are fixed in law, although the cost of the program can vary. In contrast, the Supplementary Medical Insurance (SMI) Trust Fund is financed by beneficiary premiums, general tax revenues, and state transfers, which are adjusted each year to match the following year’s estimated program costs.

This year’s report predicts that HI outlays will overtake income inflows around 2010, at which point the program’s assets will have to be drawn down to help cover the deficit. By 2018, two years earlier than reported last year, the assets will be exhausted and the trust fund will become insolvent. At the end of a seventy-five year period, scheduled income will not even cover a third of projected HI expenditures. Under current law, there is no provision to address this impending mammoth deficit. With baby boomers beggining to  retire in just five years, legislative action must be taken now. Currently, four workers pay HI taxes to support each beneficiary, but by the close of the baby-boom retirement in 2030, this ratio will be reduced by half.

The financial outlook for the SMI Trust Fund is less threatening because existing law precludes its insolvency. Nonetheless, Medicare Part B expenditures have grown on average 10.6 percent per year over the last six years and at a faster rate than the economy at large. To compensate for this rapid rate of growth, the trustees expect an 11 percent premium increase in 2007. In addition, Part D was fully implemented this year and will grow reasonably quickly hereafter at an annual rate of 11.5 percent through 2015. The good news, however, is that the total cost of Part D is now projected to be 20 percent lower than previously estimated. This is the result of less-than-expected prescription drug utilization and beneficiary enrollment, and greater-than-expected discounts negotiated by insurers.

The Medicare Modernization Act, which established the Part D drug benefit, also requires that the president propose legislation to reduce Medicare spending if the trustees predict in two consecutive reports that dedicated revenues will exceed 45 percent of total expenditures within seven years. For the first time, the trustees have projected that the 45 percent threshold will be met in 2012, the seventh year of the projections in this year’s report. If the trustees report similar findings next year, Congress must respond to the president’s proposed changes to Medicare on an expedited basis, which would only turn up the heat in the upcoming election year.

Even under the most promising of scenarios--rapid economic growth, high birth rate, relatively slow growth in health care costs--total Social Security and Medicare expenditures will still double as a share of gross domestic product seventy-five years from now. The projections continue to evince the need for timely and effective action that addresses the financial imbalance of HI and the rapid growth rates of Parts A, B, and D. Current efforts underway to alleviate these financial strains are only a down payment and far from a full solution to the Medicare crisis.

John Palmer
Syracuse University

There are four main points that I would like to highlight. First of all, it is interesting to note the unique nature of the Trustees’ Report. It is based on assumptions and methodologies that most experts would accept, and avoids politicized overtones. Due to the high degree of objectivity and professionalism in creating the projections, we can avoid arguing over specific numbers and the exact fiscal status of Medicare and can instead focus on what policy implications we can draw from the results.

The second point is that the magnitude of the fiscal challenge posed by Medicare is far more daunting than that posed by Social Security. Social Security expenditures are about 4.2 percent of the gross domestic product (GDP); they will grow to a little over 6 percent relative to GDP in twenty-five years. Expenditures will gradually increase to about 6.3 percent over the rest of the seventy-five year projection. Medicare expenditures are currently 3.2 percent of GDP, but in twenty-five years will more than double to 6.5 percent of GDP and then continue to go up and almost double again by the end of the seventy-five year projection. This greater fiscal challenge is due to the excess cost growth--the extent to which growth and age/sex adjusted health-care costs per capita are expected to exceed the rate of growth of GDP per capita.
 
The third point is that the steep growth path for Medicare expenditures is just as problematic for the finances of most beneficiaries as it is for the program, the budget, and the general taxpayer. The typical aging couple that spends about 20 percent of disposable income on out-of-pocket medical expenses will see that fraction rise to around 40 percent. If the couple is more heavily reliant on Social Security and not eligible for Medicaid, then it is currently spending over 20 percent and will be spending more than 50 percent in the next twenty to twenty-five years. The majority of the aged receive half or more of their income from Social Security. Therefore, options that may ask more of beneficiaries at or below the median income are highly problematic because those beneficiaries already face highly burdensome out-of-pocket costs for Medicare-covered services.

My final point is that despite the steep spending path of projected Medicare spending, the numbers reflect a considerable reduction in the excess cost growth relative to historical trends. Historical trends of the excess cost growth have been around 2 to 3 percent per year; we project a slowing down of that factor. The slowdown is based on the presumption that national health-care expenditures cannot indefinitely continue to increase faster than the economy. There is a limit to the share of disposable income people are willing to spend on health care. It is important to note that there is plenty of optimism inherent in the assumption that spending will begin to slow.

Thomas Saving
Texas A&M University

Depicting Medicare’s substantial funding shortfalls as a share of gross domestic product (GDP) gives the impression that the government owns GDP and permits constituents to take advantage of its worth. In a republic, the reality is quite the opposite. The government’s income is largely fueled by federal income taxes, yet a significant portion of these funds is immediately expended by entitlement programs. As a result, the government will quickly be confronted with substantial monetary deficits. In less than fifteen years, 23 percent of all federal income tax revenues will be allocated to Medicare, up from roughly 8 percent this year.

The seventy-five year present values of Medicare’s unfunded obligations indicate that if everyone who is currently age fifteen and older were allowed to advance through the system, it would require $27.9 trillion to pay for the health care promised by the government. The same workers who are expected to cover most of that cost through taxes will themselves use a great deal of health care. On average, they will cost another $45 trillion. Total Medicare debt will amount to draining 57.6 percent of all future federal income tax revenues into the program.
 
To illustrate the magnitude of this problem, if Congress were to set aside 57.6 percent of federal income tax revenues from now on and invest that in the world economy, they may manage to pay off their obligations. This, however, would require a permanent 50 percent reduction in federal expenditures outside the realm of entitlement programs, and thus a drastic attenuation of government.

At this point, financing Medicare’s shortfalls would entail raising the payroll tax rate or inflating premium costs, both of which would impose an untenable burden on workers or beneficiaries, respectively. Consuming more goods and services is generally to the advantage of individuals and society as a whole. Problems arise when profligate consumption must be financed by others, as is in the case of health care.

Douglas Holtz-Eakin
Council on Foreign Relations

Several technical improvements in the Trustees’ Report highlight the expertise and sophistication with which the projections are made. The first is the movement from a basic assumption of “GDP [gross domestic product] plus one percentage point” to an actual modeling of the underlying economic pressures behind the excess cost growth phenomenon (that is, Medicare spending that exceeds growth in the economy, on a per-capita basis).

Second is the particular transparency about the fiction known as the sustainable growth rate mechanism. It is highly improbable that Congress and the administration would cut provider payments by 4 to 5 percent per year, every year, as prescribed by current law. Nevertheless, the projections must embody that assumption, although the report explains that such a payment cut is unrealistic. In that respect these are very optimistic projections.

The third innovation is the funding warning introduced by the Medicare Modernization Act of 2003. The alarm will signal a large and impending drain on the general revenue from the Hospital Insurance and Supplementary Hospital Insurance Trust Funds. In the absence of a dramatic change, this alarm will be the first of many to come. However, the nature of such a dramatic change is uncertain.

Both Social Security and Medicare will produce budgetary stress over the foreseeable future. We should care about this stress for a number of reasons, but the main reason is that we do not understand the phenomenon of excess cost growth. It is unclear whether the growth is driven by positive factors such as higher quality of care, or by negative factors such as inefficiencies in the medical system. A better grasp of these fundamentals is necessary to create sensible public policy designed to reform Medicare.

Several simple messages come out of the report. The rising cost of health care is our nation’s single most important policy problem. Our economy will not grow out of this problem. Taxing ourselves out of the problem would be so damaging as to be counterproductive and backfire. Furthermore, we cannot legislate spending caps to fix the problem. We must have a deeper understanding of the economic mechanisms behind health-care cost increases in order to cut back on spending.

The report raises the intriguing possibility that we may be able to compete our way out of this problem. The preliminary experience from Part D points to the merits of competitive pressures and the benefits that they can bring. We need to find solutions from that program and apply them to the rest of Medicare and to the entire health-care system.

Despite the bad news, we are in the “good old days,” in budgetary terms, for the Medicare Trust Fund. We cannot avoid imbedding Medicare’s future budgetary ills in the politics of today.

AEI research assistants Elizabeth DuPré and Jonathan Stricks prepared this summary.