Medicare Time Bomb

While the private sector seems to have gotten health care costs under control, the same is not true of Medicare – the federal program that pays medical bills for the elderly. Throughout the 1990s, Medicare costs have risen at double-digit rates. And although the latest report from the trustees of the Medicare trust funds is teeming with optimism compared with reports in the recent past, it confirms that the spending path we are on is unsustainable.

Although President Clinton and congressional leaders talk as though Social Security is our biggest national problem, it pales in comparison to the financial nightmare we face from the rising costs of health care for the elderly. By the time today's college students retire, the federal government will be spending as much on elderly medical bills as on Social Security, according to the trustees' intermediate forecast. It will be spending far more, according to the pessimistic (and more realistic) forecast.

To understand our predicament, it is important to appreciate that, like Social Security, Medicare is a pay-as-you-go program. Every dollar of Medicare payroll taxes that is collected is spent – the very minute, the very hour, the very day it comes in the door. No cash is stored away in bank vaults. No investments are made in real assets. As a result, to pay future benefits the federal government will have to collect taxes from future workers. How high will future tax rates have to be?

Cost for Today's 18-Year-Olds

Take today's 18-year-olds, who will qualify for Medicare in 2043 and for Social Security in 2045 at the retirement age of 67. According to the trustees' report, funding Medicare Part A (which pays hospital bills) in 2045 will require 6.9 percent of workers' pay. The federal subsidy for Medicare Part B (which pays physician fees) is funded through general taxation. But if Part B also is expressed as a percentage of payroll, the total Medicare burden will be 12.1 percent. Add in Medicaid and other health programs for the elderly, and the burden climbs to 16 percent – more than the entire payroll tax today. Throw in Social Security and the total rises above 34 percent.

Will as-yet-unborn taxpayers willingly fork over more than one-third of their incomes to pay benefits for elderly retirees? Will they be willing to pay even more? According to the trustees' pessimistic assumptions, by 2045 Medicare will gobble up one of every five payroll dollars. Toss in other benefits, and those future taxpayers will face a whopping 55 percent tax – more than one out of every two dollars they earn!

Nor is this the worst that can happen. This year's report concludes that the Part A long-run (75-year) deficit has been cut in half by last year's budget act. The reason? The act allows the elderly to leave Medicare and enroll in private plans, which presumably will do a better job at controlling costs. That rosy prediction follows last month's announcement by private insurers that private plans other than HMOs may not be available to Medicare recipients because of Medicare's bureaucratic interferences. Also, independent studies show that the 15 percent of seniors who are now enrolled in private sector HMOs are costing Medicare more money, not less.

Those who remain skeptical of this year's Panglossian revisions are on firm ground. The Chief Actuary of the Health Care Financing Administration appends a statement to this year's report that is almost apologetic. The report's assumptions, says Richard Foster, in a classic case of actuarial understatement, may "not be optimal." Last year's trustees' report implied mid-21st century tax burdens of one-half (intermediate) and two-thirds (pessimistic) of payroll.

Nonexistent Trust Funds

What about the Medicare trust funds? Like the Social Security trust funds, Medicare trust funds are an accounting fiction designed to conceal the fact that elderly entitlements are all based on pay-as-you-go financing. Technically, the funds hold interest-bearing U.S. government bonds, representing the accounting surplus of payroll taxes collected minus benefits paid. But these are very special bonds. The trustees cannot sell them on Wall Street or to foreign investors. They can only hand them back to the Treasury. In this sense, the bonds are IOUs the government has written to itself.

On paper, the Medicare Part A trust fund is expected to run out of IOUs in about 2008. Currently it has enough to "pay" benefits for about ten months. In reality, it cannot pay anything. Handing IOUs back to the Treasury does not increase the size of Uncle Sam's bank account one iota. Every trust fund asset is a Treasury liability. For the government as a whole, the assets and liabilities net out to zero. If the trust funds were abolished, there would be no effect on private bondholders or economic activity. The government would not be relieved of any existing obligations or commitments.

For the Treasury to write a check, it must first tax or borrow. Solution: Privatization

The problem of Medicare has only one fundamental solution. We must move rapidly to a fully funded retirement system in which each generation pays its own way. Texas A&M economists Thomas R. Saving and Andrew J. Rettenmaier have calculated that under reasonable assumptions, today's young people could replace Medicare with private insurance if they put less than $1,000 a year (about 3 percent of an average worker's earnings) into private accounts. For each dollar deposited in the private account, the Medicare payroll tax could be reduced by one dollar. The federal government would then deposit the difference for those who do not earn enough to fully fund their accounts.

The accounts should be privately managed but required to invest conservatively so they would grow along with the economy as a whole. At the time of retirement, people could choose from a number of options – ranging from HMOs to Medical Savings Accounts. A vastly scaled-down Medicare program could serve as an insurer of last resort, and retirees could use their accumulated health savings to buy back into Medicare. Very few, I suspect, would exercise that option.

Medicare has been a bonanza for the current generation of retirees. Someone reaching 65 years of age today gets health insurance worth about $70,000 – far in excess of any payroll taxes the retiree and his or her employer paid. Young people entering the labor market face a different future, however. Boston University economist Laurence Kotlikoff has shown that they can expect to pay considerably more in Medicare taxes than they will receive in Medicare benefits, even if all promises are kept.

The private option described above would secure health care benefits for these young people. But only if we act now. If we wait until the middle of the next century, only two options will remain: draconian and probably uncollectable taxes or severe rationing of health care for the elderly.