The Medicare fiscal time-bomb

The present value of the unfunded obligations for Medicare over the next 75 years totals $33.9 trillion, according to the 2007 Medicare trustees’ report. Over the infinite horizon, Medicare’s present-value unfunded obligation totals $74.3 trillion. These totals represent the difference between projected benefits, on the one hand, and the sum of the 2.9 percent payroll tax for Medicare Part A (hospital insurance) and the premium payments by beneficiaries in Medicare Part B (outpatient services) and Part D (prescription drugs), on the other. In order to meet current-law Medicare commitments, $33.9 trillion (over 75 years) and $74.3 trillion (over the infinite horizon) represent the present values of the financing that must come from one of four sources (or a combination): (1) general tax revenues; (2) increased borrowings; (3) lower government spending elsewhere; (4) Medicare reforms that reduce the unfunded obligations.

Worth noting is that these are the intermediate projections of Medicare’s actuaries and trustees. And they incorporate a very optimistic assumption. As Medicare public trustees Thomas Saving and John Palmer reported earlier this year, “The most important Medicare-specific assumption embodied in the trustees’ long-term projections is that health care cost inflation, which has historically exceeded the growth in GDP on a per capita basis by more than 2 percentage points, will gradually decline over the 75-year projection period until it simply equals GDP growth at the period’s end.”

Based on which statistical analysis do they justify such a monumental assumption? It “seems reasonable,” the public trustees explain, “since per capita expenditures on health care cannot grow faster than per capita GDP indefinitely without all other forms of consumption trending to zero.” The trustees quickly add that “there is, as yet, no clear evidence of when, or even how, this trend might abate. But if it does not do so soon, then the bleak fiscal picture [present-value unfunded obligations of $33.9 trillion over 75 years and $74.3 trillion over the infinite horizon] portrayed in these reports will be bleaker still.”

As the Congressional Budget Office (CBO) recently noted, between 1960 and 2004, the average rate of growth in national health expenditures per person exceeded the rate of growth of per capita GDP by 2.6 percentage points. If that trend were to continue, CBO concluded in its December 2005 “Long-Term Budget Outlook,” “[f]ederal costs for Medicare and Medicaid as a percentage of GDP would nearly double — [from 4.2 percent in 2005] to 8.1 percent in 2020 — and reach 21.9 percent in 2050.” Thus, if the 45-year trend in health care costs were to continue unabated, the Medicare-Medicaid share of GDP (4.2 percent in 2005) would more than quintuple to nearly 22 percent over the next 45 years.

In his June 21, 2007, statement before the Senate Budget Committee, CBO Director Peter Orszag delivered the bottom line: “[T]he rate at which health care costs grow relative to income is the most important determination of the long-term fiscal balance.” Indeed, if the rise in health-care costs could miraculously be instantly limited to the rise in nominal per capita income, the CBO projected in December 2005 that the Medicare-Medicaid share of GDP would increase to only about 7 percent of GDP in 2050 (compared to 4.2 percent in 2005).

Mr. Orszag has outlined the changes in tax policy that would be needed if revenues from individual and corporate income taxes were used to bridge the fiscal gap caused by health-care costs rising by 1 percentage point and 2.5 points faster than per capita GDP in the long run. In the 1-percentage-point scenario, “individual income tax rates would have to rise by at least 70 percent to finance the increase in spending” on Medicare and Medicaid. The middle-income tax rate of 25 percent would rise to 43 percent; and the top individual and corporate rates would both increase from 35 percent to 60 percent.

In the 2.5-percentage-point scenario, Mr. Orszag estimated the lowest tax bracket would increase from 10 percent today to 26 percent; the 25-percent bracket would jump to 66 percent; and the top individual and corporate tax rates would soar from 35 percent today to 92 percent. As he noted, such tax rates “would significantly reduce economic activity and would create serious problems with tax avoidance and tax evasion.”