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.)

Boiling Medicare's financial predicament down to its mathematical essence--per capita spending rising faster, perpetually, than the program's revenue base--may add to the despair of some. Is it even reasonable to think such a long-standing trend can be reversed? But there really is no other choice. It should be self-evident that the country cannot afford a Medicare entitlement that outpaces the economy forever. Shouldn't Congress get on with fixing the problem?

In the past, opponents of Medicare reform have argued, effectively, that it would be unfair to penalize Medicare enrollees with a reform of Medicare alone. To these critics, Medicare is just one of many railcars hooked onto a runaway cost train. The solution is therefore not Medicare reform but a concerted effort, led by the government, to implement reforms that will improve efficiency and eliminate low value services for everyone buying insurance and services, including employers.

This is the kind of thinking behind the health care plan of the Democratic presidential candidate. Senator Barack Obama has not offered any substantive reform for Medicare beyond perfunctory calls to cut payments to private insurers and impose price controls on prescription drugs. Rather, he supports a laundry list of measures that he asserts will solve the cost problem for employers and public programs alike: more and better health information technology, new efforts to coordinate care for those with chronic illnesses, and better prevention.

These efforts, which most Republicans also support, may, in fact, modestly ease cost pressures, but they do not come close to solving the problem of costs rising faster than income. And there is certainly no expectation that they would narrow Medicare's financing gap in any significant way. With plans for massive new spending on insurance subsidies, the Democratic candidate, if he won, would have little choice but to turn to the kinds of cost controls his party favors (but does not advertise) anyway: caps on premium increases each year, enforced with price controls governing private and public payments for services. The end result is predictable: deterioration in the quality of care, fewer suppliers of services, and waiting lists.

The irony is that the federal government has been trying to slow Medicare spending with tighter payment regulations for nearly three decades, with almost no success. So even if one were to assume that price controls in the private sector might cut costs, it is hard to see how the government could make further headway on Medicare spending using price controls given their already extensive, and ineffective, use by program administrators.

A heavily governmental approach to cost control can and should be rejected simply for the damage it would do to the quality of health care services provided to patients. But it should also be rejected because it is based on a flawed understanding of what lies beneath today's cost pressures. Most notably, it fails to account for the role of Medicare's current design in the rapid escalation of costs in American health care.

In an important 2006 study, Amy Finkelstein, an economics professor at the Massachusetts Institute of Technology, demonstrated that the creation of Medicare in the mid-1960s triggered an explosion in the health care infrastructure in regions with previously low levels of insurance enrollment among seniors. Hospitals were built, and physicians and others opened up offices to provide newly enrolled Medicare beneficiaries with a much improved level of service. This was, of course, all to the good, as the primary purpose of Medicare was to improve the quantity and quality of health care services provided to seniors. But, four decades later, with cost escalation now the cause of so much financial distress for families and governments, policy-makers must also understand that expansive insurance is the fuel for expensive care and rising costs.

Medicare is not solely to blame. Employer-provided insurance also expanded rapidly in the postwar era. And demand for more and better health care naturally grows with increasing wealth and higher incomes. But Medicare is a large part of the cost problem. In her paper, Finkelstein offered the rough estimate that about half of the real cost increase in health care spending in the United States from 1950 to 1990 can be attributed to the spread of Medicare and other expansive third-party insurance.

Medicare's important influence on how health care services are delivered is often overlooked or understated. Medicare is the largest purchaser of services in most markets today. Four out of five enrollees are in the traditional program, which is fee-for-service insurance. That means Medicare pays a preset rate to any provider for any service rendered to a program enrollee, with essentially no questions asked. Nearly all Medicare beneficiaries also have supplemental insurance, from their former employers or purchased in the Medigap market. With this additional coverage, they pay no charges at the point of service because the combined insurance pays 100 percent of the cost. This kind of first-dollar coverage provides a powerful incentive for beneficiaries to use as many services as their physicians suggest might help improve their health. Whole segments of the U.S. medical industry have been built around the incentives embedded in these arrangements. To be sure, Medicare's payment rates are low, but political pressure ensures they are just high enough to protect the status quo and allow doctors, hospitals, labs, and outpatient clinics to continue operating autonomously, each with its own paperwork and billing arrangements, thus underwriting continued fragmentation.

No one is suggesting turning the clock back to pre-Medicare America in order to control costs. Rather, what is needed is a sensible reform for the program that retains security for seniors even as it fundamentally alters the financial incentives in the marketplace to improve the efficiency of health care service provision.

The outline of such a reform has been clear for some time (indeed it was proposed by a largely forgotten Medicare Commission in the late 1990s, chaired by former senator John Breaux and former congressman Bill Thomas). The Medicare entitlement would be converted into a limited government contribution toward insurance, offered by private plans or the government. The government contribution would be set at a predetermined percentage of the average cost of an insurance plan in the area. Enrollees would be free to select whatever plan they found most attractive, including a public option, but if they selected a plan that was more expensive than the average, they would have to pay the additional premium themselves. This type of reform could be phased in, applied to new Medicare entrants so as to avoid disruption for those settled in their current arrangements.

This redesigned Medicare would look a lot like the new drug benefit, now in its third year. By any measure, the drug program's competitive features are working well to keep costs down for enrollees as well as the government, and the vast majority of beneficiaries like the program and the choices it has made available.

Would such a reform bring Medicare spending growth quickly into line with the economy? Official estimates during consideration of the reform or even during the first years of implementation are unlikely to reflect significant improvement from today's gloomy outlook. The dynamic possibilities of the marketplace are real, but quantifying the benefits beforehand is more a matter of judgment than data analysis. Policymakers should not give more weight to such estimates than they deserve. In a market with strong price competition, insurers who found ways to work with more efficient and higher quality provider networks could gain market share with lower premiums. Beneficiaries would also likely enroll in more managed-care settings if they saw lower premiums as a result. In time, these incentives would force real changes in the way services are delivered to patients. And when that happened, the power of compounding would begin to work in the direction of improved solvency instead of looming financial disaster.

No one should be under the illusion that reducing the size of Medicare's financial imbalance could be done without controversy or financial sacrifice, which is why it is not high on the political agenda. But sooner or later Congress will have to tackle the problem anyway. A reform that promotes consumer choice and strong price competition, much like today's drug benefit, has the potential to significantly improve the program's financial outlook and limit the scope of other changes that might be needed (like means testing or a delayed eligibility age). But if Congress is unwilling to rely on the marketplace to weed out inefficiency, for political or other reasons, bringing Medicare spending into line with what is affordable over the long-run will be unpleasant work indeed.

James C. Capretta is a fellow at the Ethics and Public Policy Center and a consultant to private health insurers.