Medicare is currently the third most expensive line-item in the federal budget, behind Social Security and national defense, but it will soon pass defense and rank second. The Congressional Budget Office (CBO) projects Medicare’s costs will rise from 3.1 percent of GDP today to 5.5 percent in 2040. Medicare reform is necessary to prevent federal deficits and debt from spiraling out of control over the coming years.
Most ideas for changing Medicare seek to improve the program’s operational efficiency without altering its basic design. For instance, many Republicans in Congress would like to inject more market-based incentives into Medicare to slow cost growth. Those reforms are necessary, but the savings, while potentially significant, do not measure up to the financial problem. Congress needs to consider more far-reaching changes too.
To identify potential options, it is useful to recall that Medicare serves two distinct purposes, only one of which requires federal resources.
Medicare is, first, a community-rated insurance plan. Americans age 65 and older, and the disabled, enroll in the program for a uniform premium regardless of their age or health status. This is a highly valuable feature of Medicare. In an unregulated market, many elderly would have to pay high premiums for coverage because of their expected need for services, or they would be denied coverage altogether based on their medical histories.
Medicare’s other role is that of a social-insurance, tax-and-transfer program, consciously modeled on Social Security.
After World War II, President Harry Truman tried to create a voluntary, federally administered National Health Insurance plan for all Americans, using a modified version of the plans put in place in much of Europe as a template. His effort stalled, however, due to adamant opposition from the American Medical Association and a public skeptical of expanding the government’s role in health care.
After the election of John Kennedy in 1960, the Democratic party looked to a different kind of model — Social Security — to expand the government’s role in health insurance coverage. The key to Social Security’s political success is, ironically, the payroll tax. Workers pay the tax during their working years, and then receive a benefit in retirement based, in part, on the wages that were taxed while they were working. Workers believe they have paid for their Social Security benefits and thus object when politicians suggest adjustments.
The architects of Medicare borrowed liberally from the Social Security playbook. Current workers pay a payroll tax, which, in turn, determines their eligibility for some of the program's benefits (namely hospitalization coverage) when they retire. And the taxes they pay are deposited into a dedicated federal trust fund, from which the benefits for current retirees are paid.
Using the Social Security template to design Medicare has meant importing into Medicare the same demographic pressures pushing Social Security toward insolvency. In 1970, there were 5.5 workers for every Medicare beneficiary. Today, there are just 3.5 workers for every person on Medicare; by 2050, the ratio will have fallen to just 2.4.
Medicare’s financial problems are compounded because Congress sweetened the Medicare deal with direct taxpayer subsidization for coverage of physician and other outpatient services — called Medicare part B. At enactment, these subsidies were supposed to cover half of part B spending, with enrollees paying monthly premiums covering the other half of costs. As Medicare spending soared in the 1970’s, Congress upped the federal subsidy to minimize premium increases for the program’s beneficiaries. Eventually, Congress established a new policy of setting beneficiary premiums to cover 25 percent of Medicare Part B costs. In 2003, Congress added a drug benefit to Medicare — called part D — which also receives transfers from the Treasury covering 75 percent of costs.
The subsidies provided to Medicare Parts B and D are enormous, totaling $4.4 trillion over the period 2017 to 2026. With the enactment of the drug benefit in 2003 and the aging of the baby-boom generation, the subsidies now account for 15 percent of all income-tax receipts (individual and corporate) and will consume 25 percent of income taxes at mid-century.
Congress has gradually required higher-income seniors to pay for more of the costs of Parts B and D. About 10 percent of all Medicare beneficiaries will pay income-tested premiums in 2019. That means 90 percent of all Medicare beneficiaries will continue to receive the maximum amount of taxpayer subsidy for their health care.
Most Americans, including the middle class, have sufficient incomes to finance their entire health insurance premium during their working years. They and their families are enrolled in employer-sponsored coverage. In a competitive labor market, the premiums for these plans, including what is paid by employers, come out of the total compensation firms are willing to pay their workers. Overall, the average worker is paying about $4,500 toward health care annually, and that amount grows every year with the rise in health expenses.
Medicare’s costs would be much lower if the workers who paid their entire health insurance premium while working were asked also to pay for most of their Medicare coverage in retirement. For instance, Medicare could be restructured to provide, in the future, a benefit worth about 20 percent of overall costs (current enrollees and those near retirement would be exempt from this change). Most future entrants into the program would be expected to pay, based on an assessment of their lifetime earnings, for the other 80 percent out of their retirement savings. While large additional subsidies would be given to enrollees with low wages throughout their lives, these subsidies would be phased out for those who earned more while working. There can be reasonable disagreements about how much to ask of workers when they reach retirement, but surely more than 10 percent of all Americans earned enough while working to pay for most of their health insurance premium when they retire.
This change could be implemented without undermining Medicare’s role as the nation’s community-rated insurance plan for the elderly. All workers would still get some benefit from enrollment in the program. Unregulated insurance, meanwhile, would remain too risky to entice beneficiaries away from Medicare’s uniform premiums and guaranteed access to coverage.
Reforming Medicare in this way seems improbable, of course, given the difficulty of getting Congress to enact less ambitious changes. But the federal government’s fiscal outlook is deteriorating, and Medicare is a big part of the problem. In that context, perhaps Congress will come to see that asking those who earned good wages while working to pay for most of their Medicare in retirement is a not unreasonable option given that a fiscal crisis could impose much higher costs on all Americans, including those without sufficient resources to weather the storm.
James C. Capretta is a RealClearPolicy Contributor and holds the Milton Friedman chair at the American Enterprise Institute. His essay “Rethinking Medicare,” is available in the Spring 2018 issue of National Affairs.
