A Solvent Medicare

Published October 20, 2008

Retirement Debate

The federal government is taking on substantial new debt in response to the crisis in the financial sector. Even so, these costs, though high, are likely to be temporary, which cannot also be said of rising costs for Medicare.

Federal government spending on Medicare increased from 1.0 percent of GDP in 1975 to 3.1 percent in 2008, according to the Congressional Budget Office (CBO). CBO recently projected that Medicare spending will reach 6.4 percent of GDP in 2030 and 10.2 percent in 2050. In other words, we could be facing public expenditures on Medicare that are double and triple the rate of today's spending, and these additional costs would occur every year, not once.

But what can be done?

It's important to understand that Medicare is really two programs. The most important feature of Medicare is that it is guaranteed-issue, community-rated insurance. Everyone (or nearly so) age 65 and older gets their insurance for the same premium, and they cannot be denied coverage based on their health status. These features of Medicare are highly valued by beneficiaries, and for good reason. Without a regulatory structure putting all seniors into the same risk pool, insurance would naturally move to cover healthier seniors at lower premiums than the unhealthy.

But Medicare is also a large tax-and-transfer program. Americans pay payroll taxes during their working years which make them eligible for hospitalization insurance in retirement. Retirees also pay monthly premiums which cover only 25 percent of coverage for physician and other outpatient services. It is these financial features of Medicare that are out of balance. Payroll tax collections are expected to fall far short of hospitalization costs in the years ahead, and the government’s open-ended promise to pay 75 percent for outpatient care escalates rapidly every year.

Medicare's unfunded liability could be contained with a simple change in structure. The program could continue to provide guaranteed issue, community-rated insurance, but future retirees would be eligible for premium subsidization commensurate with tax contributions during each generation’s working years (a large exception would be made for seniors in the lowest fourth or fifth of the wealth distribution). This change would ensure that program spending rose in tandem with the program’s revenue base.

Opponents would immediately argue that this kind of reform would be dangerous for future retirees because health-care costs would rise faster than the premium subsidies. But does it really make sense for the government to pre-commit health entitlement spending twenty-five and fifty years from today that is unaffordable for the country? Why not build a program that is solvent by definition, with ample room for future policymakers to make adjustments if evidence indicates that seniors need more subsidization to secure appropriate health care.

There is a self-fulfilling prophecy to Medicare rising costs. Because the program will pay for just about anything, it does. The program is largely fee-for-service insurance, and, with supplemental coverage, most beneficiaries pay little or nothing when they use more services. It should not be surprising that rising volume and more intense service use explain Medicare’s exploding costs.

The country can provide generous health insurance coverage for seniors in the future, even coverage that costs much more than it does today. But the program can’t double or triple in a generation. The sooner we face up to this reality, the better.

–James C. Capretta, a Fellow at the Ethics and Public Policy Center, was an Associate Director at the Office of Management and Budget from 2001 to 2004.

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