The Magazine

The Train Wreck Ahead

Medicare is rolling toward disaster, and there is no easy way to fix it.

Jun 16, 2008, Vol. 13, No. 38 • By JAMES C. CAPRETTA
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Social Security reform plans are a dime a dozen, but credible Medicare reform proposals are scarce. Why? Because Medicare's financial problems are so immense as to seem beyond resolution, and the policy environment is complex. Would-be entitlement reformers decry the lack of courageous leadership from politicians, but, truth be told, even the so-called experts are at a loss over how to begin closing Medicare's yawning financing gap.

The most recent report from the program's board of trustees, issued in late March, only adds to the sense of hopelessness. Medicare's liabilities are expected to exceed revenue dedicated to paying for the program by $36 trillion over the next 75 years, and the trust fund that pays for hospital services is expected to go bankrupt in 2019. Total Medicare spending is projected to more than triple as a share of the national economy, rising from 3.2 percent of GDP in 2007 to 6.3 percent in 2030, 8.4 percent in 2050, and 10.7 percent in 2080. Federal individual income tax collections amount to only about 8.5 percent of GDP. Covering just the increase in Medicare spending expected by 2030 would require a 36 percent across-the-board individual income tax hike.

It is often said that Social Security will be easier to fix than Medicare because Social Security's problems are "just math." What is meant by this is that Social Security's financial problems stem entirely from shifts in easily measured demographic variables. In a pay-as-you-go pension program, the implicit rate of return that can be paid out in benefits is determined by productivity growth in the economy and changes in the ratio of pensioners to potential workers--the so-called "aged dependency ratio"--over time. Longer life spans and falling fertility are projected to drive up this ratio in the United States from .21 today to .34 in 2030. Consequently, previous Social Security benefit commitments, based on overly optimistic assumptions, are no longer affordable and must be changed to head off insolvency. But relatively modest changes could accomplish this.

Medicare is a pay-as-you-go program too, and the aging of the population is an important reason program costs will soar in coming years, especially as the baby boomers retire. But, unlike Social Security's problems, Medicare's go well beyond shifting demographics. The Medicare entitlement is not defined by a mathematical formula tied to payroll taxes. Rather, those enrolled get government-sponsored insurance coverage, the cost of which is mainly a function of ever-changing standards and technologies of medical practice. Today, Medicare pays for many services, diagnostic tests, operating procedures, and products that did not exist when the program was created by Congress in 1965. And there is no limit on the quantity of services Medicare beneficiaries can use each year, so both the volume and intensity of care provided can go up over time without Congress acting to expand benefits.

Still, it is possible to see Medicare's financial problem as fairly simple math too. The Congressional Budget Office estimates that, between 1975 and 2005, Medicare's cost per enrollee went up, on average, 2.4 percentage points faster than per capita GDP did each year. Medicare's -trustees make the reasonable assumption that, absent new information, this long-standing trend of costs outpacing the source of program income (i.e., the U.S. economy) will continue into the indefinite future (though the trustees do expect cost growth to moderate somewhat from its recent trajectory). Compounding is indeed a powerful force; even a small differential in cost and revenue growth rates will, if assumed to continue over many years, produce a massive projected deficit, especially when such a differential is applied to sums as large as those involved in the Medicare program.

Medicare, of course, was never expected to be fully funded with dedicated taxes and premiums. Federal taxpayers have always subsidized coverage for physician services, and Congress extended this subsidy, much to the chagrin of many fiscal conservatives, to prescription drug coverage in 2003. Enrollees are required to pay their own premiums if they elect to enroll in these parts of Medicare, but the premiums now cover only about 25 percent of costs, with the balance financed automatically from the U.S. Treasury. This annual subsidy is set to rise dramatically in coming years, from 1.5 percent of GDP in 2007 to 4.7 percent of GDP in 2050. (The entire budget for the Department of Defense now stands at about 4 percent of GDP.)