Where were you on July 30, 1965? I put that question to about fifty retirees in New Mexico last summer. None of them could remember precisely, bu t the events of that day affected them profoundly over the next thirty-three years. That was the day that President Lyndon Johnson went to Independence, Missouri, to be with former president Truman while he signed the bill that created Medicare.

The creation of Medicare was a major event in the long and bitter political struggle to create a system of government-financed health care in this country, a struggle that had its origins in Europe in the nineteenth century but intensified greatly after World War II.

Passage of Medicare did not end the struggle for government-sponsored health care, however. Instead, it created a new set of problems and changed the nature of the debate, a debate that can be expected to intensify within the next decade. If there is a lesson to be learned from the history of Medicare, it is that although government-financed health care has enormous appeal to most politicians, the popularity of a program does not repeal the laws of economics.

How It Began

The peculiar form that Medicare ended up with in 1965 was a result of a series of political compromises. To understand why these compromises took place, it is important to consider three broad economic and medical developments that occurred in the twenty-five years prior to Medicare’s passage.

The first, and by far the most important, was medical. Scientific medicine made substantial progress in the first half of this century, but much of this progress did not find its way into the effective practice of medicine for most of the population until the second half of the century. Prior to World War II, neither physicians nor patients believed that medical care could do much to affect the course of disease. As a consequence, both the demand for and the cost of care were relatively low.

This situation changed dramatically after the war, primarily with the development of penicillin during the war and other antibiotics in the 1950s. Many surgical techniques were developed because of this newfound ability to fight infection.

Annual hospital admissions per thousand increased from 56.7 in the 1923-1943 period to 99.4 in 1957-1958. Scientific improvements changed the average physician’s ability to improve the outcome of the average patient, a change that increased the economic demand for medical care and altered the politics of health policy.

Second, not only was there a reason to purchase health care but there was the means to do so. This was due partly to the growth of the economy following the war and partly to tax policy. The 1950s and 1960s were a period of strong growth in both employment and per-capita income. This growth in income helped increase the demand for almost all consumer products, including health insurance.

The purchase of health insurance through an employer was further encouraged by a tax policy adopted as a side effect of wage and price controls during the war. This policy excluded health insurance coverage from an employee’s taxable income, an implicit subsidy that increased with the growth in taxable income and the cost of health insurance. The tax subsidy greatly expanded the use of third-party insurance to pay for medical care—including services that would not have been purchased in the absence of insurance (the "moral hazard" effect)—and helped to drive up the cost of care for everyone, both the insured and the uninsured. It also made more noticeable the plight of the elderly, half of whom had no health insurance and almost all of whom had no access to tax-subsided health insurance from employers.

Illusions Concerning Payment

The third factor influencing the Medicare debate was the illusion of financial solvency created by the pay-as-you-go Social Security system signed into law in 1935. The number of people paying into and receiving benefits grew steadily in the postwar period, but the ratio of contributors to beneficiaries changed dramatically. In 1940, there were 24.2 million people receiving at least some cash payments supported by 35.4 million workers. By 1965, out of a total population of 194.3 million, 19.1 million (9.8 percent) were receiving Social Security bene fits supported by the payroll taxes of 80.7 million workers. The Social Security "trust fund" grew from $2 billion in 1940 to $18.2 billion in 1965.

While today we are engaged in a debate about how to pay for the future benefits of the Baby Boom generation, in 1965 most politicians, with the possible exceptions of Rep. Wilbur Mills and Sen. Stanley Kerr, could only see the prospects of bulging trust fund coffers as the baby boomers began to enter the workplace. Adding a medical benefit to Social Security seemed like an easy thing to do.

Restricting the new benefit to those eligible for Social Security and adopting the administrative and taxing structure of the existing program helped the proponents win popular support and overcome many of the technical criticisms of the Medicare proposal.

Given the fundamental difficulties faced by Medicare today, it is hard to understand why its proponents in 1965 had such undying faith in the power of government to finance and deliver health care and couldn’t heed the warnings of Democratic skeptics such as Mills. But there was a different attitude about the role of government in the early 1960s.

The push for government health care was part of a larger social-welfare agenda that had developed growing support among the public and members of Congress since the early part of the century. Robert Ball, a Health, Education, and Welfare (HEW) official during the Medicare debates, said, "Those who advocated Medicare wanted something more. The AMA was right. This was to be the entering wedge for a universal health plan."

The final push for Medicare was preceded by two serious debates about proposals to establish a system of national health insurance, the first immediately following World War I and the second following the surprise election of President Truman in 1948. The political struggle in 1949 and 1950 pitted liberal Democrats and organized labor against Republicans, southern Democrats, and the AMA and set the stage for the ongoing debates for the next fifteen years.

Proponents of government health care concentrated on the plight of the poor elderly, the failure of private health insurance to insure the elderly, and the failure of the states to use federal and state subsidies to cover the medical expenses of the elderly under the Kerr-Mills bill passed in 1960. Opponents, always led by the strong lobbying and public relations efforts of the AMA, raised the specter of "socialized medicine," the tax burden that would be placed on workers and taxpayers, and the advantages of private over government financing.

The intensity of the political debate led both sides to compromise. The proponents dropped their insistence on universal coverage and concentrated on adding a hospital benefit to Social Security. The opponents supported several extensions of government subsidies of the poor elderly as specified, for example, in the Kerr-Mills bill.

A Bizarre Twist

The political battles over Medicare took a bizarre twist in 1965, a twist that explains how we ended up with the two-part program that makes Medicare so difficult for most people to understand. In an effort to control the cost of their proposal and to reduce the opposition of doctors, the Johnson administration and congressional Democrats restricted their Medicare proposal to hospital care only.

To assure that Medicare would not develop into a threat to Social Security, the hospital benefit was to have its own separate trust fund financed by an addition to the Social Security payroll tax. Meanwhile, in their effort to build support for a private-sector alternative, the AMA and a number of Republicans proposed an alternative (Eldercare) plan that would have created a state-administered voluntary system of comprehensive be nefits, including coverage of outpatient doctor visits. This plan was then modified by the Republican leadership to substitute federal administration for state administration and submitted to the Ways and Means Committee.

In the Ways and Means Committee, Chairman Mills combined the two proposals into one bill that eventually became the basis for the final Medicare legislation. This development explains how Medicare ended up with two distinct parts: Part A automatically covering all Social Security recipients for hospital care and financed by payroll taxes, and Part B a voluntary program covering physician care but financed 50 percent (now 75 percent) from general revenues and 50 percent (now 25 percent) by premiums. Both parts had deductibles, and Part B included cost sharing, with patients paying 20 percent of all doctors’ bills.

As Andrew Rettenmaier and Thomas Saving have shown in The Economics of Medicare Reform, Mills played an important but changing role in the development and final passage of Medicare. Skeptical of the program, he had been a major opponent of all proposals to create a government-financed health benefit. Wilbur Cohen, one of the architects of Medicare and later Secretary of HEW (now the Department of Health and Human Services), said that Mills was "probably the only man out of the five hundred and thirty-five people in Congress who completely understands the actuarial basis of Social Security."

The Tail Wagging the Dog

Even in the face of strong political pressure from other Democrats, Mills had been so consistent in his opposition to adding a medical benefit to Social Security that many suspected him of being sympathetic to the AMA’s socialized medicine arguments. He used his detailed knowledge of Social Security to question both the Kennedy and Johnson administrations’ cost estimates and to point out that estimating future medical costs was a much more difficult task than estimating the future costs of a cash benefit.

In a 1964 speech he said: "In practical terms, this meant that if the hospital insurance system which would be created by the bill was to remain sound, the taxable wage base would have to be increased by $150 each year. Clearly, this would be a case of the tail wagging the dog." (The taxable wage base had increased an average of $46 per year from 1959 to 1964.)

In that same speech, he pointed out that hospital costs were increasing at a rate of 6.7 percent, while average earnings were increasing at only 4 percent (1955-1963), and that he saw no reason to assume that the situation would change. His support for the final version of Medicare in 1965 was apparently due to the effects of Democratic gains in the House in the elections of 1964, President Johnson’s personal appeals for support, and the many technical changes that he was personally able to insert into the bill during its various stages of development.

We now know that Chairman Mills’s skepticism was justified: In 1964 the administration projected that Medicare in 1990 would cost about $12 billion in 26 years (which included an allowance for inflation); the actual cost was $110 billion. We may not know until the year 2025 if today’s actuaries are any more accurate than those in 1964 in making twenty-six-year projections, but at least the current crew is leaving no stone unturned to tell everyone who will listen that the Medicare Part A trust fund does not meet their standards for short- or long-term actuarial soundness.

Former HEW official Ball recalls that the Johnson administration’s intent was to keep down opposition from hospitals by accepting the cost-based payment arrangements that had been worked out between the hospitals and the Blue Cross plans. This policy helped to gain passage of Medicare and to induce early participation of almost all hospitals, but as Ball himself says, "After-the-fact reimbursement for hospital costs clearly was a flawed policy."

As health economist Ted Frech points out, this attempt to adopt the practices of the private market as they existed in 1965 was already out of date even as Medicare was being implemented. The private market was beginning to move away from cost-based reimbursement, while the Medicare legislation locked the government program into a historical straightjacket.

In 1983, Medicare was forced to change hospital payments to a system of fixed amounts based on the average costs of almost 500 diagnosis-related groups. These rates are now carefully controlled by Congress in its attempt to control the federal budget, a policy that is generating complaints from hospitals about the inadequacy of Medicare payments. In recent years, Medicare has also significantly tightened up on its payment for Part B physician services, a practice that generates loud complaints from physicians, but little noticeable lack of participation.

A Radical Idea

My AEI colleague Carolyn Weaver has traced the history of the passage of Social Security in 1935 and points out that it was a radical idea that was almost not adopted by the Depression-era Congress. A similar situation existed with Medicare in the mid-1960s. The debate over Medicare was long and bitter, and without the intense push from President Johnson and the skillful handling of the process by Wilbur Mills, Medicare might not have passed, at least not in the complicated form it did. In the fifteen-year debate prior to 1965, almost every idea that Medicare reformers are now considering—vouchers, tax credits, more consumer cost sharing, means testing, catastrophic-only coverage, prefunding, individual consumer choice—were all considered and rejected.

After thirty-four years of experience, we now know that the basic design of Medicare was fundamentally flawed. Even when the creation of a government program creates great monopoly power in the purchase of services, government does not have the ability to control the cost of the program while keeping consumers satisfied. Ever tighter and more detailed regulation of reimbursement rates and private payments is a poor, and often perverse, substitute for the discipline of the marketplace.

Market-based approaches to reform have the advantage of keeping consumers’ and producers’ incentives in line and continually reminding everyone, even vote-seeking politicians, that there are limits on what even the wealthiest nation in the world can spend on medical care.

Additional Reading

Ball, Robert M., "What Medicare Architects Had in Mind," Health Affairs, Winter 1995, p. 62.

Board of Trustees of the Federal Hospital Insurance Trust Fund, 1998 Annual Report of the Board of Trustees of the Federal Hospital Insurance Trust Fund (Washington, D.C.: Government Printing Office).

Corning, Peter A., The Evolution of Medicare . . . from Idea to Law. Office of Research and Statistics, Social Security Administration, U.S. Department of Health, Education, and Welfare (Washington, D.C.: Government Printing Office, 1969).

Feldstein, Martin, Hospital Costs and Health Insurance (Cambridge, Mass.: Harvard University Press, 1981).

Frech, H. E., III, Testimony before the U.S. Senate Budget Committee, March 7, 1997.

Helms, Robert B., "The Tax Treatment of Health Insurance: Early History and Evidence," in Grace-Marie Arnett, ed., Health Care Reform: Solutions for a New Century (Ann Arbor, Mich.: University of Michigan Press, forthcoming).

Mills, Wilbur, Address to the Arkansas-Missouri District Kiwanis Convention, September 28, 1964; entered into the Congressional Record, October 3, 1964.

Rettenmaier, Andrew J., and Thomas R. Saving, The Economics of Medicare Reform (Kalamazoo, Mich.: W. E. Upjohn Institute for Employment Research, forthcoming).

Somers, Herman M., and Anne R. Somers, Doctors, Patients, and Health Insurance (Washington, D.C.: Brookings Institution, 1961).

Starr, Paul, The Social Transformation of American Medicine (New York: Basic Books, 1982).

Weaver, Carolyn, "Birth of an Entitlement," Reason, May 1996, pp. 45-48.

Zelizer, Julian E., "Learning the Ways and Means," in W. Elliot Brownlee, ed., Funding the Modern American State, 1941-1995: The Rise and Fall of the Era of Easy Finance (Cambridge: Press Syndicate of the University of Cambridge, 1996), p. 343.

Robert B. Helms is director of health policy studies at AEI.