Medicare in the Twenty-First Century
Seeking Fair and Efficient Reform

Medicare in the Twenty-First CenturyThis book is about a topic that many Americans are trying to ignore--how to save our popular Medicare program. Despite the fact that 17 members of the National Bipartisan Commission on the Future of Medicare, which was established by Congress as part of the Balanced Budget Act of 1997, are meeting regularly to devise a reform plan, Medicare reform is receiving relatively little attention among politicians and in the press. In fact, a recent poll found that only 39 percent of Americans knew that the Medicare Commission existed (Kaiser Family Foundation, 1998). Following the 1996 national elections when Medicare was used by both political parties in a series of rhonchus political advertisements, political strategists are advising their politicians not to take the political risks of talking about Medicare. Public opinion polls indicate that Medicare is not a leading concern of most people (Kaiser Family Foundation, 1998).

This inattention to the problems of Medicare cannot last. Medicare is our second largest government entitlement program providing medical care to 39 million elderly and disabled people with annual expenditures of approximately $214 billion in 1998 or 2.65 percent of gross domestic product (GDP). If the expert opinions of actuaries, academics, and numerous health policy researchers count for anything, Medicare cannot survive the first half of the 21st century without major reforms. In their most recent report, the trustees of the Medicare trust funds project that the hospital insurance (HI) trust fund, which covers hospital care, will run out of funds in 2008 and the supplementary insurance (SMI) trust fund, which pays for physician and other outpatient services, will require increasing subsidies from general revenues to cover its expenses (HI Trustees’ Report, 1998, 2-4; SMI Trustees’ Report, 1998, 2-3). Program expenditures for the HI and SMI programs combined are projected to increase to 3.5 percent of GDP in 2010 and to 5.9 percent in 2030 (HI Trustees’ Report, 1998, 78). Meanwhile, neither the number of workers nor the taxes they pay will grow nearly as fast as the number of Medicare enrollees and the costs of their medical care (HI Trustees’ Report, 1998, 2-3).

Additionally, there are approximately 9.6 million people working in the health sector, and given the importance of medical care for the aged and disabled, it is reasonable to assume that most of these professionals are directly affected by the Medicare program (U.S. Bureau of the Census, 1997, 122). From almost any perspective, Medicare has something in common with an 800-pound gorilla–it cannot be ignored! Yet, when it comes to politics, that is what appears to be happening.

The authors of this volume take as a given that Medicare must be reformed and that this reform will require an intense political debate before some kind of compromise is reached. The timing of this debate is uncertain, but will be driven by the cycle of presidential and congressional elections, the declining balances of the Part A trust fund, and the continuing aging of the baby boom generation that begins to become eligible for Medicare after 2010.

Another factor affecting the Medicare debate will be the debate about Social Security reform. Since Medicare was passed as an amendment to the Social Security Act (Helms), it shares many common features in its operation, financing, and plans for reform. Even though the Medicare benefit is more complicated than Social Security’s cash benefit, both programs are substantially funded by a commonly administered payroll tax and both programs provide benefits to the same cohorts of people. And because both programs face significant long-term deficits, as well as consume a growing portion of the federal budget, any discussion of reform of one program must invariably involve the other (Weaver; Peterson; and Robertson). In 1997, federal spending on social security and Medicare (Parts A & B) alone amounted to $570 billion or one- third of the entire federal budget. The Congressional Budget Office estimates that by 2030 spending on these two programs will account for half of all federal spending (CBO, May 1998, xvi; CBO, Jan. 1998, 70).

This volume does not seek consensus about how to reform Medicare. But the authors in this volume do have one thing in common–they have each done serious research and thinking about how to make Medicare a better program. Each author, or set of authors, was asked to write a relatively short essay about how they would like to see the program reformed. They were instructed to spend little time on what was wrong with the current program and instead to demonstrate how a reformed Medicare program could be made more efficient and still be fair to all those affected. As the following chapters will show, there is still some disagreement regarding the principles of reform even among those who think about incentives and share the common objective of improving the efficiency of Medicare.

Fairness and Efficiency

Fairness and efficiency will be at the heart of the political debate about Medicare reform. The debate over these issues will be further confounded by the fact that fairness and efficiency mean different things to different people. There are many competing interests involved—the young and the old, taxpayers and beneficiaries, patients and providers—who stand to gain or lose depending on the nature of the reforms; what may be "fair" to one group of people will be "unfair" to the other. Ultimately this concern for fairness and the economic reality of Medicare’s financing problems are the two forces that will drive this debate.

The political imperative. To better understand the concern for fairness that continually exerts its influence in all political debates, let us first consider one future scenario that is unlikely to meet anyone’s definition of either fairness or efficiency, a continuation of the status quo. This in essence is what the Medicare actuaries estimate each year and include in the annual trustees’ report. These projections are their best guess about what will happen to the program under varying economic and demographic assumptions if no changes are made in the laws governing Medicare. The actuaries have been reporting for several years that the program is not sustainable under present law. As the following quotes from the 1998 report illustrate, they point out the basic imbalance of current-law Medicare in several ways:

  1. "The HI program still fails by a wide margin to meet our long-range test of close actuarial balance. To bring the HI program into actuarial balance, over just the next 25 years under the intermediate assumptions, would require either that outlays be further reduced by 18 percent or that income be increased by 22 percent (or some combination of the two) throughout the 25-year period.... Over the full 75-year projection period, substantially greater changes in income and/or outlays are needed, in large part as a result of the impending retirement of the baby boom generation (HI Trustees’ Report, 1998, 16-17)."
  2. "HI expenditures are projected to grow rapidly as a fraction of workers’ earnings, from 3.4 percent in 1997 to 7.8 percent in 2070 (HI Trustees’ Report, 1998, 2)."
  3. "SMI benefits have been growing rapidly. Outlays have increased 48 percent over the past 5 years (37 percent on a per-beneficiary basis). During this period the program grew about 14 percent faster than the economy as a whole, despite efforts to control SMI costs. SMI expenditures are expected to continue to grow faster than the economy as a whole. SMI outlays were less than 1 percent of the Gross Domestic Product (GDP) in 1997 and are projected to grow to about 3.3 percent by 2070 (SMI Trustees’ Report, 1998, 2)."

Since these are actuarial estimates about future events, there is no guarantee that they will be completely accurate. But few experts doubt that they will be far from the mark since it is generally easier to imagine unforeseen events that may turn out to be worse than estimated (for example, an economic recession, an unexpected disease outbreak, a new expensive medical technology) than better than estimated (for example, unexpected economic growth, an unexpected improvement in the health of the elderly, large savings in costs from the increased use of the new Medicare + Choice options added in the Balanced Budget Act, or a new medical technology that reduces the cost of treatment). Maybe this view is too pessimistic, but the shortfalls in projected revenues compared to projected expenditures in the second and third decades of the next century are so large that it is unlikely that minor adjustments to the actuaries’ basic assumptions are going to substantially change the picture. Further, it is widely accepted among many economists that the actuaries’ intermediate projections are too optimistic and that it is more likely that their pessimistic projections will actually occur (King).

In the unlikely event that there is literally no congressional action to change either the revenue or expenditures under current law, HCFA would have no authority to continue paying Medicare claims once the HI trust fund became exhausted sometime in 2008. Based on the rate of inflow of payroll taxes, they might decide to pay some fraction of each claim, but this would be unlikely to save the program for very long because of two likely reactions from hospitals and physicians submitting the claims: one, an increase in the volume of claims submitted as providers seek to make up for the missing revenue; and two, a refusal on the part of many providers to continue treating at least some of their Medicare patients if the government refused to pay the legal amount for each claim. Such a situation would not be politically stable and certainly would not meet anyone’s definition of fairness or efficiency. These circumstances would deny needed medical services to Medicare recipients and payments to medical professionals and institutions providing that care.

A variation on this scenario which seems likely based on past congressional actions, is one in which the congress would act to reduce Medicare payments for services without doing anything to fundamentally reform the program (CBO, 1997; Kahn and Kuttner). Such a series of tighter price controls might extend the life of the HI trust fund for a few years, but faces the high probability of also being politically unstable as the baby boom generation begins to join Medicare after 2010 and as the level of access and quality begin to deteriorate due to the reduced payments1. The result would be an increase in wasteful economic behavior by providers and patients, less medical care for eligible Medicare recipients, and payments to providers that they will consider unfair.

But fairness is not just a matter of keeping the Medicare program operating. While Medicare beneficiaries are required to pay some out-of-pocket expenses, including Part B premiums and co-payments, taxpayers support a significant portion of the health expenses of the elderly and disabled (HCFA). In 1998, taxpayers paid $120 billion in payroll taxes to finance Part A and an additional $60 billion in income taxes to fund the part B program through general revenues—that is 90 percent of the Part A income and 75 percent of the Part B income (HI Trustees’ Report, 1998, 38; SMI Trustees’ Report, 36). While a relatively small number of working elderly still pay Medicare and income taxes, the majority of the funding for Medicare comes from younger taxpayers. And as the baby boom generation ages and the proportion of the population over age 65 mushrooms, this disproportionate burden on the young will only increase. In 1997 there were nearly 4 workers per Medicare beneficiary. In 2010 when the first baby boomers join the Medicare rolls, this proportion will have dropped to 3.6, and it will rapidly decline thereafter, falling to only 2.3 in 2030 as the last of the baby boom generation reaches age 65 (HI Trustees’ Report, 2, 14).

This aspect of fairness is usually referred to as, "intergenerational equity," a term associated with the empirical work of Larry Kotlikoff (Gokhale and Kotlikoff; Kotlikoff; and Auerbach, Gokhale, and Kotlikoff). As his work illustrates, the issue of fairness is dominated by the future liabilities that the current method of financing places on future generations of workers. In a recent study, Kotlikoff and Gokhale find that those who are currently middle-aged and older will fare quite well under the present system when comparing the present value of their taxes with the present value of expected Medicare benefits, while newborns and future generations of workers stand to lose a great deal. They estimate that in order to achieve "generational balance," the Medicare program would have to be permanently cut by 68 percent today. In another five years, the program would have to be permanently cut by 78 percent and by 2016 even the total elimination of the program would not be enough to achieve generational balance (Gokhale and Kotlikoff, 1998, 18).

The Congressional Budget Office has made similar calculations estimating the net transfers under Medicare for single men and women with average earnings by discounting the value of future lifetime benefits and lifetime taxes2. For a single man with average earnings reaching age 65 in 1985, the net transfer was $32,222–this is the difference between the present value of the benefits he can expect to receive from Medicare and the total lifetime taxes he has paid into the system. Stated another way, the present value of his total lifetime taxes were only 29 percent of his lifetime benefits. For men reaching age 65 in 1995 and 2005, the net transfers are even larger–$51,813 and $71,868 respectively. And for women, who have longer life expectancies, the transfers are greater than for men. The net transfers were $41,355 for the 1985 retiree, $68,777 for the 1995 retiree and $91,594 for a single woman with average earnings retiring in 2005. And these calculations are for individuals who qualify for Medicare benefits on the basis of their own work histories. But up to 20 percent of Medicare beneficiaries qualify on the basis of their spouse’s work history, and for these people net lifetime transfers would be substantially higher because they have paid little or no HI taxes (Committee on Ways and Means, 1998, 126).

Looked at in this way, it should be obvious that the present method of financing Medicare will not be sustainable in the next century. While both income and payroll taxes have somewhat different effects on incentives, substantial increases in either would have significant detrimental effects on the incentives of taxpayers. High marginal rates of income taxation encourage tax cheating and take away much of the incentive to earn additional income. High rates of payroll taxes fall disproportionately on younger workers and have direct detrimental effects on employment and incentives to work.

Another aspect of fairness that has played a strong role in Medicare debates is the financial burden imposed on the elderly by their relatively high use of medical services. The use and expense of medical care is strongly related to age. In 1996, average yearly Medicare expenditures for those aged 85 and over were estimated to be $7,132, nearly twice the average yearly expenditures for beneficiaries aged 65 to 69 (Moon 1997). Out-of-pocket expenditures for drugs and chronic health conditions not covered by Medicare also increase with age. When compared to the typically declining income of the elderly, the financial burden of medical expenses seems to increase with age. However, when compared to the increasing wealth of the elderly, the burden looks more manageable (Weicher, 1996; National Bipartisan Commission, 1998).

These two discussions of the burden of medical expenditures, first on taxpayers and then on the elderly, illustrate why the issue of fairness plays such an important role in Medicare reform debates. Not only is fairness difficult to define, but it is often in the eye of the beholder. Policies that seem fair to the young will not be considered by many to be fair to the elderly because more moderate taxes on active workers mean reduced benefits and increased financial obligations on Medicare recipients. Political theory might suggest that the process of political compromise will induce politicians to settle on a solution that minimizes the damage to all the affected groups, a solution that no one seems to be very happy about, but wins out simply because conditions demand a solution and the compromise seems better than prolonging the debate.

The economic imperative. Economists are fond of saying, "there is no such think as a free lunch." When talking about Medicare, maybe we should now add, "especially for politicians!" The political struggle to balance the interests of large groups of voters must take into account the economic reality of Medicare financing. Political debates that take on the appearance of competition between candidates to see who can offer the most in additional benefits tend to obscure the real economic costs of the Medicare program. In the most fundamental sense, any service provided to a Medicare recipient uses up real economic resources that cannot be used for other purposes. Even in a segment of the economy with relatively large volunteer and philanthropic inputs, most nurses, physicians, and other medical personnel have to be paid for the value of their time and training. Investments in research and development and in capital structures require rates of return sufficient to divert these resources to medical uses. And, in terms of the federal budget, tax resources devoted to entitlement programs such as Medicare reduce the amount of resources that are available for other discretionary parts of the budget (CBO, January 1998). Everything has a cost, and the only excuse for elaborating on such an elementary concept is that there is abundant evidence that political debates often proceed with little acknowledgment of economic reality.

How bad is the economic plight facing Medicare? There is little disagreement with the official government projections that the current program with its current tax base and current benefits cannot survive into the second decade of the next century. In fact, the main disagreement about the actuarial projections is that the basic economic assumptions are too optimistic (Reischauer; Wilensky and Newhouse). But there is substantial disagreement about how to reform the system, especially how to restructure consumer and provider incentives and the capacity of various groups of taxpayers to give up the real resources necessary to keep the program going (Moon, 1999, 107-117). Some of this disagreement is reflected in this volume.

Not only is there an economic imperative to reform Medicare, but there is an economic imperative to improve the efficiency of the program. As stated above, the authors in this volume are a set of people who have done research about the efficiency of medical markets and are seeking in these essays to improve both the efficiency and the fairness of the program. But just what do we mean by economic efficiency? Unfortunately, the concept of economic efficiency is often mentioned and more often misunderstood. It is not simply the reduction of costs since, as costs are reduced, at some point the owners of labor and capital have incentives to divert their resources away from medical care so that the benefits that consumers desire are also reduced. Neither is economic efficiency the maximization of medical benefits to patients, as ironic as that may seem to some observers. As more resources are added to improve medical benefits, at some point the value of the additional benefits become less than the value placed on non-medical benefits that must be given up. And, economic efficiency is not paying the maximum amount to those who supply the inputs to medical care, the physicians, nurses, and managers who work in the system and those investors who supply the capital for physical facilities and medical equipment and products. As more is paid for inputs, at some point the additional output produced becomes less than the value of the alternative products and services that could have been produced.

What all of these misleading statements have in common is the notion of maximizing some objective without any constraints. Obviously, in the real world, a balance must be reached among competing objectives. The concept of economic efficiency is defined in terms of a balance at the margin–it is achieved when the marginal cost of producing an additional unit of output is just equal to the marginal benefit of that output as evaluated by consumers. The formal theory of economic efficiency, commonly referred to as welfare economics, also shows how non-market distortions such as price control, tax subsidies, cost-increasing regulation, or collusive behavior on the part of producers can prevent the attainment of economic efficience and impose dead-weight losses on the economy.

The application of this formal theory to medical markets and health policy has recently been strongly attacked in a book by Tom Rice (1998) and, in my view, ably defended by Martin Gaynor and William Vogt, Mark Pauly, and Bryan Dowd (Gaynor and Vogt, 1997; Pauly, 1997, 467-473; Dowd, 1999, 266-269). This volume will not attempt to settle this largely theoretical dispute, but proceed with the notion that the concept of economic efficience has something to contribute to the search for efficient Medicare reform.

What is most misunderstood about the concept of economic efficience is the emphasis it places on efficient adjustment to changing consumer preferences and production technology. The beauty of the concept is in the seeking. Economic efficiency does not imply that each consumer gets all of everything they want, but it does imply that an economic system with the correct incentives will continually adjust itself to account for changing consumer demands and changing conditions in the production of the desired output. If a new medical technology allows for cheaper production of an existing medical service, or of a new medical procedure desired by consumers, those seeking their own gain (Smith) will assure that the new technology is developed, tested, and introduced into the market at the most efficient rate3. Even if we cannot empirically identify an efficient medical market, the theory tells us that policies that allow market forces to continually adjust market prices will induce all market participants to seek to improve the cost-effectiveness of their decisions, consumers to seek value in the purchase of medical goods and services, and producers to seek to produce what consumers want using the most efficient technologies and combinations of inputs. An improvement in economic efficiency means we get more of what we want for the resources we give up, a worthy goal in Medicare reform.

Still, as these essays will show, there is much room for improvement. Neither the present Medicare program nor the U.S. health care system within which it operates are models of efficiency. A short list of its major impediments to efficiency include:

  1. Cost sharing features whose effectiveness have been seriously eroded by medical inflation during Medicare’s 34 year history;
  2. Administered hospital and physician price controls that inhibit the ability of the market to ration care and create incentives for improved quality;
  3. A system of mandated benefits that reduces the incentives of providers and patients to consider the cost-effectiveness of both old and new technologies and procedures;
  4. An antiquated system of paying for managed care that inhibits the growth and increases the costs of this method of organizing and delivering care and causes sever geographical distortions in payment rates and enrollment;
  5. An open-ended funding mechanism for Part B that places unlimited liabilities on the general U.S. budget and reduces the incentives of all participants (patients, providers, program administrators, and politicians) to control the cost of the physician care;
  6. Payroll financing for Part A which places an increasing burden on younger workers thereby causing increased unemployment, inefficient employment arrangements, and more workers without health insurance.

This list could be expanded indefinitely in scope and detail, but the point is, for various historical and political reasons, Medicare policies cause a number of costly inefficiencies and, as Ted Frech points out, have prevented the program from adopting many of the market innovations found in the private sector.

Seeking Fairness and Efficiency: A Review of Reform Proposals

The essays in this volume were all written independently without knowledge of what any of the other authors might write. Therefore, the order in which the essays appear is somewhat arbitrary so that they can be read in any order that appeals to the reader. However, the order in which they appear reflects the editor’s judgement that there is a logical progression in the history, background analysis of issues, and topic detail presented in the seven essays. This order should not be interpreted by the reader as any indication of the relative importance of any of the essays, only that the editor thinks the present order has a slight advantage over the common practice of arranging chapters in alphabetical order of the author’s last name. The following summaries are not exhaustive but are intended only to give the reader some indication of the approach and topics in each of the essays.

Antos and Bilheimer. This chapter is placed early in the volume because of its comprehensive discussion of reform options. The authors use recent CBO studies and projections to analyze the inventory of policy reforms that might be considered to correct the financial and structural deficiencies of the current program. They discuss the many varieties of reform ideas using three broad categories: (1) policies that reduce costs without improving efficiency; (2) policies that reduce costs and improve program efficiency; and (3), policies that restructure Medicare’s financing. A central theme that runs through their analysis is the need to address what they refer to as the "archaic and dysfunctional" aspects of the Medicare’s basic design. Provider payment reductions and infusions of new revenue may result in temporary improvements in the reported status of trust funds, but they do nothing to change the behavior of beneficiaries who presently have little incentive to control their utilization of services. They analyze several reforms that are designed to affect consumer behavior (for example, cost sharing, vouchers, and more use of managed care) pointing out controversies and design features that must be addressed to make each effective. Their analysis of The Balanced Budget Act of 1997 shows that some of these issues were addressed in that act, but not in a way that is likely to bring about the fundamental reform that Medicare requires if it is to survive. They conclude that there is no magic bullet to guarantee that the expectations the baby boom generation has about the future of Medicare will be met. With 85 percent of Medicare beneficiaries still in the traditional fee-for-service sector, it is unrealistic, in their view, that Medicare can be preserved without fundamental reform.

Rettenmaier and Saving. When compared to the existing and growing body of literature about Medicare, this chapter in unique in two ways. First, it starts with some interesting history of issues raised by some key players in the debate leading up to the passage of Medicare in 1965, issues relating to the viability of a system of financing based on payroll taxes. Second, the authors concentrate on the financing of Medicare, an issue that they argue is relatively ignored in the reform debate. They explain the economic effects of our present system of financing Medicare through a transfer of funds from active workers to retirees and compare this to what would happen if Medicare were prefunded, this is, if current workers were required or induced to save for their medical care during retirement. They show that a prefunded system would result in a larger capital stock in the economy than would occur under our present transfer system and that the increased income from this larger capital stock could be used to ease the transition from one system to the other. They present an illustration complete with revenue and cost estimates of how a transition to a prefunded system might be achieved. One alarming implication of their illustration is the importance of starting any transition sooner rather than later. The longer we put off starting to reform Medicare, the more costly it will be.

Pauly. Mark Pauly analyzes an issue that is at the center of the debate about fairness, the ability of higher-income beneficiaries to pay a higher portion of the cost of Medicare. To set the stage, he first considers the pros and cons of two alternative approaches to reform, the prefunding proposal by Rettenmaier and Saving (see Chapter 3) and a policy relying on reductions in provider payments. While he sees some advantages to prefunding, he questions both the political viability and the fairness of the requirement that the middle generation of workers has to take on the double burden of paying for the current elderly while building a fund to pay for their own retirement benefits. He argues that his proposal, outlined below, is highly compatible to Rettenmaier and Saving’s proposal since it would reduce the burden current policy places on the current generation and the burden it is expected to place on the younger generation in future years.

He also argues that there may also be some advantages to Medicare from further reductions in provider payments. Given Medicare’s large market share, it can act like any large purchaser with market power and cut provider rates even further since there is little evidence that providers are refusing to service Medicare beneficiaries at present payment levels. But his principal criticism of both approaches is that neither improves the efficiency of Medicare financing or delivery.

To achieve this improvement, Pauly proposes that we develop a system of income- and risk-related vouchers or subsidies so that we provide more complete coverage for the poorer and sicker but scale down the coverage for those who are relatively more healthy and wealthy. If the original purpose of Medicare was to help the elderly to receive more medical care than they would have been able to afford, the current system is both inefficient and inequitable since it encourages excessive use and ends up redistributing income from the poor to the rich. He presents data showing that the income of the elderly has grown substantially since 1965 so that a larger proportion of those on Medicare have the ability to pay more of the costs. Medicare is inferior to a progressive income tax as a way to redistribute income since a uniform medical benefit set to cover the needs of the low income will induce the higher income to consume excessive care. If Medicare benefits were set to decline with income, gains in efficiency would come from both a reduction in excess consumption and a reduction in the negative effects of the payroll tax on work effort and savings. He also points out that a defined contribution that declines with income would be easier to administer than trying to means test deductibles and cost sharing in the present benefit package.

Pauly also discusses problems presented by the supplementation of Medicare coverage through the purchase of Medigap policies. Among other things, he points out that the degree of purchase of such policies by higher income beneficiaries is strong evidence that the present subsidy to these beneficiaries is too large. He also argues that Medicare’s financial problems are so large that relatively small steps will not solve the problem and presents some estimates of the size of the financial changes that would be required to restore both the efficiency and the soundness of the program. In one particularly telling sentence, he provides a strong rational for his proposal: " . . . low income elders need comprehensive insurance coverage, more generous than current Medicare, high income elders need catastrophic coverage at a reasonable price, and middle class people of all ages need moderate taxes."

Nichols. Len Nichols starts his essay by pointing out that Medicare has become our most popular public program but that it is in need of "structural repair" if it is to fulfill its promises in the 21st century. He uses a few equations and some relatively simple data on rates of growth of key variables to paint a powerful illustration of why controlling the growth of cost per beneficiary is the policy variable with the most promise for maintaining the quality of Medicare services and keeping tax increases within reasonable bounds.

Before giving us his prescription for creating effective competition, Nichols reminds us of some of the realities of Medicare that will make it difficult to bring about rapid reform. Among his "caveats" are:

  1. approximately 16 percent of Medicare enrollees are also enrolled in Medicaid;
  2. almost two-thirds of Medicare beneficiaries live in households with incomes below $20,000;
  3. 87 percent of Medicare beneficiaries are in the fee-for-service (FFS) part of the program;
  4. few managed care plans currently participating in Medicare are prepared to care for the chronically ill and disabled elderly;
  5. we presently know relatively little about how to design effective risk adjusters and competitive bidding practices, both of which will be necessary to establish effective competition in Medicare markets.

With these caveats in mind, Nichols presents us with six steps to achieving "value-based purchasing of health insurance." He assumes that FFS will remain an option for beneficiaries and that competitive bidding will replace the current Average Adjusted Per Capita Cost (AAPCC) system for paying competing health plans. Nichols’ six steps are:

  1. Define benefit packages, where he rejects the notion of a single benefit package for everyone, but argues that specifying a set of basic benefits, some cost-sharing options, and a small number of specific additional service packages will be necessary to "keep competition focused on the twin dimensions of price and quality and not risk selection."
  2. Define enrollment and marketing rules, where he calls for a one-year open enrollment policy and careful supervision by HCFA of the production of consumer information.
  3. Collect and disseminate enough information to inform enrollees about comparative quality measures and to facilitate plan or provider switching. Here Nichols discusses the imperfect art of measuring medical outcomes and quality, but argues that effective competition depends on creating the incentives to learn how to make these measurements and present them in useful form to consumers.
  4. Negotiate competitive bids with plans, where he argues that HCFA should use its large market share and market strength to get lower prices and accountability from competing plans.
  5. Give consumers incentives to choose efficient plans. In what he calls the most complicated and controversial step, Nichols discusses the need to establish a fixed government payment in order to give consumers an incentive to shop for efficient plans. He discusses the difficulty of establishing a fixed contribution based on a percent of the lowest bid from competing plans, and suggests a variation to overcome these difficulties.
  6. Risk adjust plan payments. Nichols discusses both the need for effective risk adjusters and the current state of knowledge for constructing them. He suggests several approaches that show promise for the improvement of risk adjusters and calls for additional research on them in the upcoming demonstrations.

Nichols, who, unlike the editor, is a certified baby boomer, concludes his essay with the following cogent reminder: "A competitive health plan market can be the Medicare program’s best long run friend, but only if we structure the relationship carefully. We can do so, and the time to start is this afternoon. We will all be Medicare beneficiaries soon enough."

Frech. Ted Frech starts his analysis by lamenting the fact that managed care dominates health policy discussions while traditional FFS medicine dominates Medicare. Using a popular expression, and now a movie title, he reminds us that in Medicare, managed care is only the tail while traditional FFS is the dog. In his view, traditional Medicare is the most promising place to begin thinking about reform. He reviews data on the movement to managed care in the private sector, but argues that the movement to managed care will likely be slower in Medicare. As a consequence, traditional FFS will continue to dominate Medicare for the next several decades.

Frech traces the history of Medicare based on Blue Cross and Blue Shield plans of the mid-1960s and contrasts it with the private insurance market’s change in benefit design and movement to managed care. He points out that both Medicare and tax policy have subsidized supplemental insurance (Medigap, broadly defined) which have raised the annual costs of the Medicare program by 20 percent, approximately $30 billion per year. To correct the basic problems with Medicare, he analyses three broad areas for reform:

  1. Prohibit or discourage supplemental insurance. To restore the cost control features originally designed into Medicare, Frech discusses several approaches designed to prohibit or change supplemental insurance: direct regulation of Medigap policies; taxing Medigap policies; integrating Medicare and Medigap (by requiring Medigap policies to cover the entire range of Medicare benefits); and, modernizing Medicare benefits in order to reduce the demand for supplemental insurance. These approaches are not mutually exclusive and might be combined to restore the cost-effective incentives one would expect with more cost sharing and better catastrophic benefits.
  2. Introduce options for expanded cost-sharing. Frech suggests that Medicare should offer more choices for beneficiaries to choose plans with more catastrophic benefits and more cost sharing, policies that would meet their needs while reducing their demand for supplemental policies. While this approach is not likely to be controversial for those with enough income to bear the risk, he suggest the use of medical saving accounts or retroactive rebates for good experience as ways to take care of the poor or unlucky.
  3. Speeding the transition to Medicare managed care. Frech points out that Medicare payment policies and regulations have favored traditional HMO-type managed care over the less-structured forms such as Preferred Provider Organizations (PPOs) and Point of Service (POS) plans that are likely to be more attractive to the elderly. He encourages the continuation of the changes put into the Balanced Budget Act to encourage the more rapid development of these alternative forms of managed care.

Dowd and Feldman. Going right to the bottom line, Dowd and Feldman explain in their last two paragraphs that their proposal is designed to improve the efficiency of Medicare. They point out that Medicare faces "an intolerable problem of intergenerational fairness," which will not likely be solved by increased taxes. They propose a new way to set the government’s contribution that is both a defined contribution and an defined benefit, a fixed payment across all plans that is based on the lowest cost qualified health plan in each market area. Their rationale for this proposal is based on their analysis of two ways to reduce the cost of Medicare, placing a limit on the government’s contribution to Medicare premiums and creating incentives that induce beneficiaries to choose more cost-effective plans.

The authors point out that the terms, "defined contribution" and "defined benefit," borrowed from the terminology of employee pension plans, can be confusing when applied to multiple health plans and to Medicare. While a defined contribution would promote both competition and budget control, it would not necessarily guarantee any level of Medicare benefits unless it was somehow tied to the cost of providing those benefits. To achieve the twin objectives of improving efficiency and maintaining the value of the benefit, they propose that the government solicit bids from qualified health plans to deliver a specified level of benefits. The government’s premium contribution would be based on the lowest bid for that package of benefits in each market area. By requiring the FFS sector to participate in the bidding, the government would greatly improve its chances of establishing an undistorted price for the purchase of the set of benefits it wishes to guarantee. They point out that both consumer preferences (demand) and medical technology (supply) can change over time, so their proposal would assure that Medicare continues to purchase an efficient level of benefits over time.

The authors next address the difficult problem of risk selection, the "fly-in-the-ointment" argument in any discussion of achieving efficiency in health markets. From the point of view of their proposal, even if the government has established an efficient price through competitive bidding, is there a threat to the system if high risk patients tend to choose either the cost-effective plans or the cost-ineffective plans? They use a graphical model to illustrate why HCFA’s requirement that plans use an average cost community rating results in too few beneficiaries choosing cost-effective health plans. Their conclusion is that efficiency would be improved if plans were allowed to charge beneficiaries their marginal cost for each plan. Such individual experience rating may result in high risk beneficiaries paying higher out-of-pocket premiums, which may be considered unfair, but it is more efficient.

Dowd and Feldman point out that the empirical evidence shows that, on average, high risk individuals prefer cost-ineffective care. They analyze this situation and show that average cost community rating without risk adjustment would produce an equilibrium with too many beneficiaries in cost-effective plans, the situation we seem to be in when high-risk individuals forgo the extra benefits of managed care to stay in FFS.

They also analyze the role that information plays in promoting efficient consumer choice. They argue that if the government has better information about quality than beneficiaries do, providing it to beneficiaries would improve the efficiency of their choices. And, they are doubtful that the government can use information more efficiently than individuals.

Francis. Walt Frances, the author for 19 years of Checkbook’s annual comparison of health plans (Francis and editors), examines the use of the Federal Employees Health Benefits Program (FEHBP) as a model for Medicare reform, a topic that has taken center stage in the congressional debate about the future of Medicare. He reviews the present operation of the FEHBP and compares it to the performance of the Medicare program over the last two decades. He argues that FEHBP has dramatically outperformed Medicare with lower cost increases, modernization of its benefits, and more efficient administration. He gives special attention to risk selection, distinguishing between desirable risk selection reflecting consumers preferences and destructive risk selection that leads to market failure in insurance markets. While some FEHBP plans have gone out of business, he points out that destructive risk selection has been a rare event in the history of the program and that the program has remained remarkable stable despite the fact that it has been given few tools to deal with risk selection. The political nature of changes in Medicare is in strong contrast to the relative efficiency by which FEHBP adjusts to change.

With this as background, Francis analyzes both the opportunities and pitfalls of using the FEHBP as a model for Medicare reform. He reviews the potential of Medicare + Choice established in the Balanced Budget Act of 1997 but reminds us, like other authors in this volume, that the potential to establish a competitive market under existing law is quite limited as long as traditional fee-for-service Medicare remains dominant. In the process of discussing the major policy dilemmas in Medicare reform, he presents several practical suggestions of ways to solve these problems. The following examples illustrate the nature of these suggestions:

  1. There is much concern that if Medicare contributions were tied to benefit costs, there would be strong incentives for the Congress or the Administration to either reduce benefits to save costs or raise our-of-pocket payments by enrollees. To avoid this problem, Francis suggests that annual contributions be based on a rolling average of benefit costs. This would allow plans to adjust to changing consumer demands without having a major effect on either the next budget or payments by enrollees.
  2. To protect Medicare recipients against the loss of benefits now guaranteed under current law, but to allow plans to compete on the basis of benefit design (a major advantage of the FEHBP), Francis suggests that benefits could be tied to actuarial measures of performance, similar to the practices now used in the FEHBP program.
  3. To help manage risk selection, he suggests a reinsurance system that would make retrospective adjustments to federal contributions based on the actual distribution of high- cost cases. Such a system would be especially important to small plans and would help alleviate the problems with inaccurate estimates of plan costs.
  4. To protect traditional Medicare against adverse selection, he suggests that Medicare’s administrative agency be given some latitude to change benefits, cost sharing, and geographic premiums in traditional Medicare in order to compete with choice plans. One of the major advantages of the FEHBP over Medicare has been that it has not had to return to Congress in order to make small changes in the program.

One of the central themes in this chapter is that the FEHBP has outperformed Medicare because it has been able to take advantages of the effects of competition and consumer choice. It is not a perfect system, but it has had the flexibility to respond to its problems in a way that has not been possible in Medicare. The principle lesson to be learned from the FEHBP is that achieving a perfect plan for Medicare reform may not be possible. But it is realistic to assume that we can design a new Medicare program that is fair to beneficiaries, is more efficient than the current program, and has the ability to solve whatever problems it may encounter in the future.


If we look at the history of Medicare, especially the 20 years of contentious political debates that preceded its passage in 1965, we should not be surprised by the highly political nature of today’s debate about how to reform the program (Helms 1999). The economists who have contributed the essays in this volume can do little to calm the political waters surrounding Medicare. Our modest objective is to remind everyone who is interested in reform that to the extent we can improve the efficiency of the program, there will be more resources available to improve the fairness of the program. As Len Nichols says, the time to start seeking fair and efficient reform is this afternoon.


American Enterprise Institute, "The New Medicare Trust Fund Report," Conference Summary, April 13, 199, p. 4.

Auerbach, Alan J., Jagadeesh Gokhale, and Laurence J. Kotlikoff, "Generational Accounts: A Meaningful Alternative to Deficit Accounting," in David Bradford, ed., Tax Policy and the Economy 5 (Cambridge: MIT Press, 1991), pp. 55-110.

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, 1998), pp. 2-4

Board of Trustees of the Federal Supplementary Medical Insurance Trust Fund, 1998 Annual Report of the Board of Trustees of the Supplementary Medical Insurance Trust Fund (Washington, D.C.: Government Printing Office, 1998), pp. 2-3.

Committee on Ways and Means, 1998 Green Book. Washington, D.C.: U.S. Government Printing Office, May 19, 1998.

Congressional Budget Office, Long-Term Budgetary Pressures and Policy Options, (May 1998), p. xvi,

Congressional Budget Office, The Economic and Budget Outlook: Fiscal Years 1999-2008 (January 1998), pp. 63-79.

Congressional Budget Office, "Budgetary Implications of the Balanced Budget Act of 1997" (Washington, D.C.: Congressional Budget Office, December 1997)

Dowd, Bryan, "An Unusual View of Health Economics," Health Affairs, vol. 18, no. 1 (January/February 1999), pp. 266-269.

Francis, Walton, and the Editors of Washington Consumer Checkbook, CHECKBOOK’s Guide to Health Insurance Plans for Federal Employees. Washington Center for the Study of Services, Washington, DC (1998 and annually for the previous 19 years).

Gaynor, Martin, and William Vogt, "What Does Economics Have to Say About Health Policy, Anyway? A Comment on Evans and Rice," Journal of Health Politics, Policy and Law, vol. 22, no. 2 (April 1997), pp. 475-496.

Gokhale, Jagadeesh, and Laurence J. Kotlikoff, "Medicare from the Perspective of Generational Accounting," National Bureau of Economic Research Working Paper 6596, June 1998.

Health Care Financing Administration, The Profiles of Medicare: Chart Book, (May 1998), pp. 29 and 45-47.

Helms, Robert B., "The Origins of Medicare," The World & I, vol. 14, no. 3 (March 1999), pp. 40-45.

Kahn, Charles N., III, and Hanns Kuttner, "Budget Bills And Medicare Policy: The Politics of the BBA," Health Affairs, vol. 18, no. 1 (January/February 1999), pp. 37-47.

King, Roland, "The New Medicare Trust Fund Report," American Enterprise Institute, Conference Summary, April 13, 199, p. 4.

Kaiser Family Foundation/Harvard University, "Public Opinion Update: Medicare," released October 20, 1998.

Kotlikoff, Laurence J., Generational Accounting (New York: The Free Press, 1992)

Moon, Marilyn,"Restructuring Medicare’s Cost-Sharing," paper presented at National Academy of Social Insurance Study Panel on Medicare’s Long-term Financing, Washington, D.C., November 18-19, 1997, Table 2.

Moon, Marilyn, "Will the Care Be There? Vulnerable Beneficiaries and Medicare Reform," Health Affairs, vol. 18, no. 1 (January/February 1999), pp. 107-117.

National Bipartisan Commission on the Future of Medicare, Income and Assets of the Elderly and Near Elderly. (Washington, D.C.:, 1998).

Pauly, Mark, "Who Was That Straw Man Anyway? A Comment on Evans and Rice," Journal of Health Politics, Policy and Law, vol. 22, no. 2 (April 1997), pp. 467-473.

Peterson, Peter G., Will America Grow Up Before It Grows Old?: How the Coming Social Security Crisis Threatens You, Your Family, and Your Country (New York: Random House, 1996)

Reischauer, Robert D., "Medicare: Beyond 2002," in Policy Options for Reforming the Medicare Program: Papers from the Princeton Conference on Medicare Reform," July 1997, p. 97.

Rice, Thomas, The Economics of Health Reconsidered. Chicago: Health Administration Press, 1998.

Robertson, A. Haeworth, The Big Lie: What Every Baby Boomer Should Know About Social Security and Medicare (Washington, D.C.: Retirement Policy Institute, 1997).

Smith, Adam, The Wealth of Nations, New York: The Modern Library, 1937, p. 423.

U.S. Bureau of the Census, 1997 Statistical Abstract of the United States (Washington, D.C.: 1997), p. 122.

U.S. House of Representatives, Committee on Ways and Means, 1998 Green Book (Washington, D.C.: U.S. Government Printing Office, 1998), pp. 125-126.

Weaver, Carolyn L., Social Security and Its Reform (Washington, D.C.: AEI Press, forthcoming).

Weicher, John C., "The Distribution of Wealth: Increasing Inequality?" Federal Reserve Bank of St. Louis Review, vol. 77, no. 1, January/February 1995, pp. 5-23.

Weicher, John C., "Wealth and Its Distribution, 1983-1992:Secular Growth, Cyclical Stability." Federal Reserve Bank of St. Louis Review, vol. 79, no. 2, January/February 1997, pp. 3-19.

Wilensky, Gail R., and Joseph P. Newhouse, "Medicare: What’s Right? What’s Wrong? What’s Next?" Health Affairs, vol. 18, no. 1 (January/February 1999), pp. 92-106, especially p. 97.


1. A large body of economic literature predicts that when price controls create shortages, there will be an increase in non-price discrimination on the part of providers. How each provider would choose to allocate their available time among all those seeking their services would be determined by their own preferences, including their willingness to provide free care and to treat difficult medical conditions. As long as some physicians chose not to treat some Medicare patients, it would become increasingly difficult for other physicians not wishing to discriminate to do so.

2. Contributions include the employee’s and employer’s share of HI payroll taxes, interest, and SMI premiums. Values are discounted using the average interest rate on the HI Trust Fund over the same period (Committee on Ways and Means, 1998, 126)

3. There is a time dimension to economic efficiency since it may be wasteful to make any market change too quickly or too slowly. In medical markets, the efficient introduction of new technologies may be affected by the desire on the part of consumers and producers to determine the relative effectiveness and safety of the each innovation.

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