Trust-Fund Dysfunction

Published July 26, 2007

National Review Online

Medicare spending remains on course to single-handedly bankrupt the federal government. Effective reform of the program has been a top priority of Federal Reserve Board chairmen, Treasury secretaries, Budget directors, and other government officials for many years, going back to at least the mid-1990s. But don’t hold your breath waiting for one of the presidential candidates to propose a serious reform plan, or even mention the need for reform during one of the debates. Why should they? If nothing is done, Medicare can continue paying full benefits for at least a decade, well beyond another two-term presidency.

Indeed, Congress was able to vastly expand the Medicare entitlement in 2003 in the form of drug coverage without precipitating a financial crisis in the program. Understanding how this happened helps explain why serious Medicare reform remains so elusive.

According to the 2007 Trustees’ report (in a table found on page 120), the drug benefit is expected to cost a staggering $22 trillion, in present value terms. This cost is partially offset by premiums paid by beneficiaries as well as payments from the states to the federal government to compensate for the federalization of some Medicaid drug costs. These two sources of program income are estimated to raise $4.9 trillion, again in present value terms.

So, with spending of $22 trillion and revenue of $4.9 trillion, one might expect the new program to have an unfunded liability of $17.1 trillion. But the Trustees report states that the new drug benefit’s “unfunded obligations” are “$0.” How can a program with revenue covering less than 20 percent of costs have no unfunded obligations? Alice in Wonderland trust funds, that’s how.

Federal trust funds are of limited value even when they are structured properly. Unfortunately, Medicare’s trust funds are not structured properly, and never have been, making them virtually useless.

Of course, the only real value of any federal trust fund is political, not economic. Trust-fund reserves are just paper — promises by the government to repay itself. Still, the political value of trust funds should not be overlooked. With a trust fund in place to track a program’s income and outgo over many years, unfinanced new spending could make it go “bankrupt.” Similarly, if previous projection assumptions prove faulty, the prospect of insolvency may be enough to force Congress and the president to make tough budgetary decisions that they otherwise would avoid.

Indeed, the only reason Congress has ever taken up significant Social Security legislation in recent years has been to keep the trust funds solvent. No one knows for sure what would happen to benefits if Social Security’s reserves were ever completely depleted, but it doesn’t really matter. What matters is that politicians don’t want to be accused of bankrupting Social Security. In both 1977 and 1983, Congress passed substantial benefit cuts — and some tax increases — as insolvency loomed. Without the trust funds forcing legislative action, it is highly unlikely that political leaders would have pursued such unpopular steps.

But for a trust fund to work as a restraint, the income into it must be restricted to real income — that is, taxes or other payments from the public that actually increase government receipts. With this restriction, trust fund spending is held in check by the economic pain imposed on the voters who must pay for it.

Unfortunately, with Medicare, much of the program’s income is not real income to the government. The missing $17.1 trillion in the drug benefit account is covered with “general revenue financing.” This is nothing more than a bookkeeping entry in the trust funds, not income taxes earmarked for Medicare. The drug benefit will spend what it will spend. Spending not covered by the premiums or state payments is automatically financed by “general revenue,” which is to say it isn’t financed at all. This rather flexible approach to trust fund income made it a breeze to pass the largest entitlement expansion in a generation without uttering a word about how the benefit will be paid for in coming decades.

To be fair, using general revenue to inflate Medicare trust fund income didn’t originate with the drug benefit’s authors. From its inception in 1965, financing for the trust fund which pays physician and other outpatient services — the Supplementary Medical Insurance, or SMI, trust fund — was supposed to be split 50/50, with beneficiary premiums paying for half of the costs and general revenue the rest. The beneficiary share, however, was dropped to 25 percent shortly after enactment, as costs soared, and the split has stayed at roughly 25/75 ever since. The 2007 Trustees’ report estimates the present value of SMI spending at $37.7 trillion, with beneficiary premiums covering $10 trillion of the cost and general revenue financing the other $27.7 trillion.

Medicare’s other trust fund — Hospital Insurance, or HI — is financed primarily with payroll taxes, like Social Security. But even HI discipline is compromised by general revenue. In 1997, as the HI fund faced insolvency, President Clinton proposed, and Congress accepted, a major shift in funding of home health costs out of HI and into the SMI trust fund. The shift made HI look much more solvent, as home health costs were one of the fasting growing segments of Medicare spending. Of course, the shift did not alter Medicare spending at all; it only moved the burden from payroll taxpayers to “general revenue” taxpayers, whoever they are.

It is often said that politicians will not act on difficult entitlement reform until there is a crisis. But, with Medicare’s dysfunctional trust funds, what will trigger such a crisis? As matters stand, more than half of the program — for drug, physician, and other SMI spending — is permanently solvent, by definition. And, as the HI fund heads toward insolvency, now projected to occur in 2019, there is nothing to stop Congress from again using a gimmick like the home health shift to avoid painful reforms.

In a commendable attempt to force political leaders to take up serious Medicare legislation, the 2003 drug law established a new, theoretical ceiling on general revenue at 45 percent of Medicare’s total costs. If the trustees determine in two successive reports that the 45 percent ceiling will be breached within seven years, then the president must send legislation to Congress erasing the overage. The 2007 report made the second such determination, triggering the requirement for presidential proposals next February. Some procedural steps were also put in place to permit streamlined consideration in Congress, but that’s as far as the law went. If Congress decides to do nothing, there will be no consequences for any beneficiaries or taxpayers. It is not difficult to predict what is likely to come of this process — not much.

Fixing Medicare’s trust funds will not be easy. One approach — floated during the 2003 drug benefit debate — would consolidate the program into a single trust fund and limit general revenue to a fixed contribution tied to economic growth. Over time, if program costs grew faster than the economy, the new trust fund would head toward bankruptcy, perhaps rapidly. Of course, it would be difficult to fully prevent a future Congress from undoing this discipline, but it would be better than current law. Another approach would be to dedicate some existing tax to pay for Medicare and eliminate general revenue financing entirely. Such a switch would certainly make the trust funds real, but finding a suitable, existing tax source is a challenge.

Medicare-spending growth is the most significant long-term threat to a philosophy of low tax rates and limited government. Already, Medicare costs have risen from about 1.0 percent of GDP in 1975 to 3.1 percent in 2006. By 2030, spending on Medicare is expected to reach 6.5 percent of GDP. To become sustainable, Medicare needs an extreme makeover. But, unfortunately, reform of the program may need to follow a necessary first step, which is to fix the trust funds so that they conform to the commonsense reality of limited resources.

 — 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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