288 pages University of Chicago Press Publication Date: April 2004 Hardcover ISBN: 0226750760

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July 2004
Who Should Pay for Medicare?
By Daniel Shaviro

According to the information in the Medicare Trustees' latest annual report, Medicare's long-term fiscal gap now exceeds $60 trillion-nearly six times the amount that the entire U.S. economy produces in a year. Yet politicians of both parties keep making the problem worse, most recently by enacting a $16.6 trillion prescription drug benefit with no funding. Where is all this going to end up? How can we try to make Medicare sustainable, and what should the program really be doing to begin with? Who Should Pay for Medicare? speaks to seniors who feel entitled to expanded coverage, younger people who wonder what to expect from the government when they retire, and Washington policymakers who need a guidebook to Medicare's future.

Daniel N. Shaviro is the Wayne Perry Professor of Taxation at NYU Law School and a visiting scholar at AEI.

Suppose a car dealer were to approach you and ask: "Would you like a new car?" If you were to answer the question literally, you would almost have to say yes. After all, there is bound to be something nice about having a new car.

You surely would realize, however, that the dealer was actually asking you something rather different: "Do you want to buy a new car from me?" Even if the dealer had the right car and could be talked into a reasonable price, it is possible that your answer would be no. It would depend on whether you happened to want a new car badly enough to be willing to pay the price.

Unfortunately, in the context of Washington politics, this totally elementary point, which every consumer understands, verges on being revelatory. We give deserving or politically powerful groups--and above all seniors--huge and costly benefits that they do not have to pay for, rationalizing such action on the ground that the benefits are nice. We do not seriously ask whether the benefits are worth their cost, or whether it is fair to transfer wealth from the
payers--and there always must be payers, even if we simply run up the federal debt rather than identifying them promptly--to the beneficiaries.

This book seeks to restore some balance and needed perspective to discussion of Medicare-already the second-biggest government program, after Social Security, and on a path to become the biggest. The question it asks--who should pay for Medicare, or more precisely for seniors' health care--could not be more timely. On November 25, 2003, Congress passed the biggest new entitlement in the nearly forty years since Medicare itself was enacted by adding an unfunded new prescription drug benefit to the program. The Medicare Trustees have estimated the long-term cost of this benefit at $16.6 trillion, or about the value of all the output that the U.S. economy produces in twenty months. The enactment was Robin Hood in reverse, giving money to affluent seniors at the expense, in many cases, of poorer workers. It vastly increased the already huge wealth redistribution through our fiscal system from younger to older generations, in violation of the age-old covenant urging beneficence by each generation towards its children and grandchildren. Senator Judd Gregg (R-N.H.) called it "the largest tax increase one generation has put on another generation in the history of this country," contrived simply to "get us through the next election."

The Bush administration rejected out of hand any notion of providing financing for the benefit or even reining in its runaway tax cuts and spending increases by reason of the enormous fiscal burden it was adding. The Democrats, meanwhile, complained only that the new benefit was not generous enough. Just to put all this in perspective, neither Franklin D. Roosevelt, when he proposed Social Security in 1935, nor Lyndon B. Johnson, when he proposed Medicare in 1965, dared to suggest enactment without financing, even though they had two-thirds majorities in both houses of Congress and supposedly were reigning in the era of big government. Evidently, something in our political culture has changed.

Last November's bipartisan refusal to recognize that there is no free lunch cannot, however, indefinitely derail Medicare retrenchment and reform any more than it could prevent the tide from rising. At some point, painful changes will need to be made on both the tax and spending sides, and this book offers a framework for evaluating them.

Two types of issues need to be resolved in retooling Medicare as a viable program. The first, reflecting its impact on health care delivery, is who should make various choices about a given enrollee's covered care. The second, reflecting that Medicare is a fiscal system, is who should pay for the care. Who Should Pay for Medicare? emphasizes the latter (unlike most Medicare studies), reflecting the author's expertise in public economics and tax policy, rather than in health care policy. The book thus speaks to people with a general interest in U.S. public policy rather than just to the health care experts who inevitably have taken the lead in most detailed discussions of Medicare.

The book's main contributions are threefold: First, it offers an analytical framework for understanding what Medicare does as a fiscal system, and thus for breaking down the "who should pay" question into manageable parts. Second, it explains and places in perspective Medicare's long-term fiscal gap. Third, it offers suggestions for addressing Medicare's financing problems in as equitable and efficient (albeit inevitably painful) a manner as possible, along with some more pessimistic predictions regarding the actual likely course of events.

A Multi-Purpose Fiscal System

Like Social Security, Medicare is a forced-saving program for retirement that denies investment choice within the program and transfers vast resources between participants, such as from younger to older generations and from singles and two-earner married couples to one-earner married couples. While there are reasonable arguments for forcing people to save for retirement and for limiting investment choices, the intergenerational and inter-household transfers that Medicare mandates are hard to justify.

Medicare is also a national health care system, akin to that of England or Canada, but just for seniors, and with consumers in the driver's seat even though they are not paying for what they get. And it gives seniors medical insurance up front, but in a manner that is gravely compromised by its excessive low-end and inadequate high-end coverage, which makes it, to some extent, a straight handout rather than true insurance. Indeed, one could almost compare Medicare to a fictional form of car "insurance" that paid your daily gasoline bills but not the costs of high-speed collisions.

The Medicare (and Broader) Fiscal Gap

Who Should Pay for Medicare? shows that while righting the system's upside-down insurance structure might help its finances considerably, the underlying fiscal problem is more structural. It also examines Medicare's initial design as what may once have seemed to be a truly sustainable, non-exploding variant of a Ponzi scheme. Medicare shares with Ponzi schemes the idea of having the first group of participants get benefits for free with the resulting liability being rolled over indefinitely. Yet it also differs from them in an important way. Rather than requiring an exponential increase in participants, all Medicare requires to be indefinitely sustainable is demographic and a certain kind of technological stability. So long as the ratios of workers to retirees and covered health care expenditure to gross domestic product (GDP) remain constant, the program can just keep going indefinitely.

Regarding demographic stability, as Paul Samuelson famously explained concerning Social Security, each generation after the lucky initiators (who get their retirement support for free) receives a positive return on its tax contributions, with the rate of return depending on productivity growth in the workforce. In the Medicare setting, if health care expenditures stay in lockstep with GDP, retirees can use the funds available to them to pay for retirement health care that is fixed in its adequacy relative to contemporaneous treatment norms, yet ever-improving in absolute terms if the economy keeps growing and medical technology keeps improving.

Alas, these seemingly simple preconditions of demographic and technological stability have evaporated for the foreseeable future due to two ongoing shocks to the system. The first is increasing life expectancies, driven by improvements both in health care technology and in health-conscious behavior (such as in diet, exercise, and smoking). The second shock is costly yet valuable advances in health care technology that have improved treatment outcomes in many settings but caused medical expenditure to rise faster than the economy.

These two fiscally adverse trends are actually good things--the kinds of "shocks" that every society might like to have. Who would not welcome living longer and getting ever better medical treatment? Yet, welcome though they are, they are trends that one ought to "insure" against. Money is more valuable to you in states of the world where you will be retired for longer and more able to benefit from costly medical treatment. Unfortunately--yet all too predictably--the political system has failed to respond in the manner of a rational individual by saving more. In hindsight, this predictable failure has caused the Samuelson financing scheme for Medicare to be Ponzi-like and unsustainable after all.

Conclusions and Predictions

Closing the fiscal gap, both Medicare's and the larger general one, is likely to require huge changes in both expenditures and revenues. To a large extent, the question of how best to reduce the rate of increase in Medicare expenditure requires a detailed understanding of the health care industry, which, for reasons of comparative advantage, Who Should Pay for Medicare? mainly leaves to the health care experts. The book shows, however, that a public economics perspective can help in evaluating everything on the revenue side, including taxes and Medicare co-payments. Moreover, the book explores and illuminates the philosophical question, critical to Medicare policy, of how differences in attributes such as health status, age cohort, gender, life expectancy, and lifetime earnings should affect societal wealth distribution.

The book argues that steps to narrow the fiscal gap should be taken sooner rather than later, both to restrain current generations from leaving too little for their own retirement and to aid future generations. A variety of fiscal instruments could be used, in some respects interchangeably, toward this end. Our choices should reflect, however, both the fundamental issue of who ought to pay and the  more opportunistic question of what is likely to be politically feasible.

The book's principal conclusions include the following:

(1) Income and payroll taxes, as the main instruments in the United States fiscal system for distributing burdens based on some measure of ability to pay, should play a major role in narrowing the fiscal gap. While any increases would be hard to enact in the near term and would risk being dissipated by a congenitally imprudent and undisciplined Congress, various changes to our budgetary conventions might offer some hope of restraining these tendencies.

(2) Reducing or eliminating the existing income-tax exclusion for employer-provided health insurance would aid Medicare wholly apart from its being a tax increase. The income tax exclusion gives employees an incentive to over-insure, even if this results in wasteful expenditure that increases the cost of their coverage. When current workers and their families therefore join Medicare enrollees in being non-cost-conscious, the entire health care industry is affected. Medical treatment norms and medical technology firms' research agendas evolve against a background of limited cost-consciousness, thus contributing to rising health care costs that we all bear not just directly as consumers, but also through Medicare as taxpayers.

(3) Current seniors ought not to be exempted from sharing in the pain that younger Americans must bear in narrowing the fiscal gap. Retirees, however, are past the point where they can be much affected by income and payroll tax increases. One politically convenient way to make seniors pay their share would be to enact a value-added tax (VAT) on consumption, perhaps with some gesture towards earmarking revenues to pay for Medicare benefits. A VAT may function upon enactment as a one-time wealth tax (borne in large part by the elderly because they hold so much of our wealth). While this may have distorting effects that are comparable to those from a fully pre-announced tax, there may be no better way of helping to pay for Medicare.

(4) Seniors also ought to be required to bear increased co-payments for routine expenditures. This would increase cost-consciousness in addition to narrowing the fiscal gap. Increased cost-sharing could perhaps be made less politically unpalatable by mingling it, as a matter of political presentation, with more popular changes to address gaps in Medicare's coverage.

(5) Cost-sharing by Medicare enrollees should increase with some measure of their means, to mitigate the burden on seniors who are less well-off. Taxable income, modified by the exclusion of wages up to a ceiling (to limit incentives to retire), might be used as the means test. Even if means-testing undermined Medicare's political appeal as an ostensibly "universal" program, this would not be all to the bad, since at present political support for the program is, if anything, too strong relative to support for competing priorities.

(6) Shifting from the book's affirmative proposals to its more pessimistic predictions, at some point soon the Medicare-driven fiscal gap is likely to start choking off economic growth by requiring tax increases on current workers so as to keep the benefits to seniors flowing. This will reduce our already low national saving, possibly making it negative, and darkening the prospects for vigorous economic growth. Moreover, bouts of hyperinflation and a banana republic-style collapse of the U.S. government's credit-worthiness are highly possible. And Medicare is likely to become a second-class program, characterized by informal and poorly managed rationing and queuing, from which the best doctors and wealthiest seniors increasingly opt out.

Need for Improved Political Discourse

More important than the specific recommendations and predictions in Who Should Pay for Medicare? is the way of looking at Medicare and other government programs that it suggests. Its public economics perspective, rooted in the understandings that there is no free lunch, that every distributional winner implies a distributional loser, and that incentives matter, is hardly novel among experts but has been too little heard in the public policy debate. If nothing else, the book aims to improve our political discourse and thus to help create the preconditions for a more rational policy.

 This summary is available in Adobe Acrobat PDF format.