Medicare's approaching financial distress is enormous and well publicized. The Medicare trustees calculate Medicare's total excess costs at $85.6 tril­lion.[1] This is the amount in present value by which Medicare's future spending exceeds its dedicated and internal revenues, such as payroll tax receipts and premium income. As this calculation illustrates, the Medicare program is unsustainable. Medicare's finances are not the only reason to reform the pro­gram, but they are a compelling one.

As with any difficult task, it is important to have a simple, bottom-line measure of success. Eliminating the program's excess costs is an obvious goal for Medicare reform. Medicare's projected total excess costs reflect the extent to which Medicare funds promised benefits by drawing on general revenues of the U.S. Treasury, that is, tax collections from all other sources. Eliminating Medicare's excess costs entirely would eliminate all general fund support. In 2007, that would have meant eliminating a $179 billion transfer from the general fund to Medicare.

While eliminating Medicare's total excess costs would be ideal, it is more than what is necessary to achieve sustainability. A lesser fiscal goal would be sufficient, and there are several from which to choose. As with all budget matters, the reduction to be achieved is a matter of setting priorities and weighing financing demands against other revenue and spend­ing priorities.

While Medicare's drain on the economy and on the federal government's general revenues is signifi­cant, it has so far been manageable. This suggests that a rule to guide Medicare reform could be to hold constant Medicare's level of general revenue as a share of gross domestic product (GDP). In effect, such a rule would hold the budget pressures Medi­care imposes at today's levels relative to the size of the economy.

In 2007, Medicare's claim on general revenues amounted to 1.3 percent of GDP. Establishing a rule that Medicare not claim more than this share of GDP reduces the dollar amount by which reforms must cut costs by more than 25 percent, leaving a more achievable $63.4 trillion in needed Medicare reform savings.[2]

The Necessity of Reform

As a basic element of the nation's social safety net, Medicare is a vital program for senior citizens. Yet the needs of seniors change over time, as do health care markets and the practice of medicine. Medicare needs to change accordingly, and many dimensions of the program should be reviewed as part of reform. Modernizing Medicare by adding a drug benefit, for instance, was sound, despite the serious flaws in design and implementation.

Reforms are needed for many reasons, but the compelling fact is that Medicare is unaffordable in its current form. Already expensive to seniors and burdensome to taxpayers, its costs will soon out­strip its own resources by a wide margin, putting enormous pressures on the federal budget and the economy. Left unchecked, Medicare's claim on national resources will rise from 2.7 percent of GDP in 2007 to 5.9 percent in 2030, and eventually to 15.6 percent in the following years.[3] Making Medi­care fiscally sustainable challenges the nation's will and capacity to act.

One element driving Medicare spending is the imminent retirement of the baby boom generation, an enormous demographic bulge tracing back to the end of the World War II. Americans qualify for Medicare on their 65th birthday, and the first baby boomers turn 65 in 2011.

A second and more important driver of Medicare spending is health care inflation--which has exceeded inflation in the rest of the economy for many years and is expected to continue to do so. This relative excess in health care inflation has many causes, and is itself a main cause of the growing interest in reforming the broader health care markets. If health care markets are substantially reformed, and if the reforms reduce the rate of health care infla­tion, these reforms would significantly reduce the rate of growth in Medicare spending.[4]

However, health care reform will take time to devise, legislate, and implement, and its conse­quences will take time to materialize. In the mean­time, the retirement of the baby boomers remains an abiding problem. Thus, even with highly suc­cessful reforms to the nation's health care markets, Medicare will still require major reforms to achieve long-run sustainability.

A Suitable Budget Rule and an Attainable Goal

In every endeavor, especially a difficult one, it is important to set goals that reflect success and jus­tify the effort, but also to set goals that are achiev­able and not unduly aggressive or unrealistic. Setting an appropriate goal for Medicare reform is all the more important because of the related and equally difficult tasks of reforming Social Security and Medicaid.

In 2007, Medicare tapped the general fund of the Treasury for $179 billion, or about 1.3 percent of GDP. To put this in perspective, this was equivalent to about half of all federal corporate income receipts. On the spending side, this was more than enough to cover the total outlays of the Departments of Home­land Security, Housing and Urban Development, Interior, Justice, Labor, and State. By any measure, $179 billion in general revenue support for Medi­care represents a substantial use of resources.

Budgeting is an exercise in setting priorities. Medicare is already placing enormous demands on the federal budget, limiting the government's ability to dedicate resources to other purposes or to cut taxes. However, given the lack of outcry or comment to the contrary, Medicare's claim on general revenues equal to 1.3 percent of GDP was apparently manage­able from both budgetary and economic perspec­tives, suggesting that this level of support is a reasonable and feasible limit for Medicare reform.

A second important aspect is that by limiting Medicare revenues to 1.3 percent of GDP, reforms can proceed without risk that these reforms would make Medicare's financial condition worse, and with­out entanglement in debates about Medicare's effects on competing budget priorities. Once Medicare's sustainability is assured, subsequent debates may address questions of competing budget priorities.

Holding Medicare's general fund support at 1.3 percent of GDP is a practical rule for Medicare reform consistent with long-term sustainability. Following the rule would reduce the amount of Medicare's excess costs that must be cut by about 25 percent to about $63.4 trillion. This is still an enor­mous sum, but a more attainable goal.

Can the Medicare Goal Approach Extend to Social Security and Medicaid?

Setting an appropriate goal for Medicare reform is especially important because the nation must also confront the similarly daunting and crucial tasks of reforming Social Security and Medicaid. Can the approach offered here for Medicare be applied to these two programs?

Social Security is supposed to be funded through payroll taxes and interest earned on amounts held in the Social Security trust fund. Yet according to the 2008 Social Security trustees' report, beginning in 2017 Social Security's outlays will exceed payroll tax receipts.[5] By 2041, the Social Security trust fund will be depleted and Social Security will be unable to pay promised benefits in full.

The Social Security trustees estimate the program's total excess promised benefits in present value terms to be $13.6 trillion.[6] This figure is comparable in nature to Medicare's $85.6 trillion excess costs. Social Security reform efforts typically assume the entire $13.6 trillion must be eliminated. But is there a more limited, sustainability-based goal for Social Security analogous to the one proposed for Medicare?

Unfortunately, no. Eliminating Social Security's excess costs requires a combination of reducing the growth of promised benefits and increasing the growth of dedicated tax receipts. Social Security reform that retains some level of excess costs implies using non-payroll tax revenues to cover these costs.[7] This would be inappropriate for at least two reasons:

1. Using tax revenue from sources other than payroll taxes to fund Social Security would be a fundamental and unwarranted departure from the basic premise that Social Security is to be a self-contained pension program, not a wel­fare program.
2. Social Security today operates at a cash surplus. Allowing it to operate at a perpetual cash deficit financed by other tax revenues would necessarily and permanently deprive all other budget priori­ties of these resources. This would be inconsistent with the advantage of the proposed Medicare sus­tainability approach, which is the reform's neu­trality with respect to other budget priorities.

The federal portion of Medicaid, on the other hand, was always intended to be funded predomi­nantly with general revenues, so it is reasonable to establish a practical sustainability goal for Medicaid reform. In 2007, the federal government spent $191 billion on Medicaid,[8] equal to about 1.4 percent of GDP. Like for Medicare, Medicaid's costs are pro­jected to outpace economic growth. According to the Medicare trustees, under current law the federal government's expenditures on Medicaid are pro­jected to increase an average of 7.9 percent a year over the next 10 years, reaching $673.7 billion in 2017--roughly doubling as a percentage of GDP.[9]

While no long-run projection is yet available for Medicaid comparable to Medicare's $85.6 trillion in total excess costs, projected growth in Medicaid spending in just the next decade clearly indicates that Medicaid's present drain on the general fund is in the tens of trillions of dollars. Reforming Medic­aid to bring its federal costs under control is as important as reforming Medicare and Social Secu­rity. As with Medicare, Medicaid reform should be guided by reasonable goals that restore the program to sustainability. And, similar to Medicare, a reason­able policy-neutral goal for Medicaid is to hold fed­eral expenditures equivalent to the current level of 1.4 percent of GDP.

Conclusion

The Medicare program is in great need of mod­ernization, but above all, it must be put on a sus­tainable financial footing. Medicare today is grossly unaffordable. To succeed, the debate on Medicare needs a clear, achievable measure of success for cor­recting Medicare's long-term finances. The Medicare trustees' estimate of Medicare's excess costs provides the basis for such a measure. This estimate shows the extent of general fund support necessary to pay projected Medicare claims.

Eliminating Medicare's future excess costs entirely, while ideal, is also a more difficult undertaking than necessary. Medicare receives a significant amount of general fund support, equal to 1.3 percent of GDP today. This diversion of resources constrains other budget options, such as tax relief and funding other spending priorities, yet this level of support for Medicare appears manageable. Therefore, a suitable rule for Medicare reform is to hold Medicare's level of general fund support at 1.3 percent of GDP. A second important advantage of this rule is that it allows Medicare reform to proceed without risk that other reforms would worsen Medicare's financial condition, and without the need to address Medi­care's effects on other spending priorities. This rule implies a 25 percent reduction in costs that must be cut through Medicare reform, leaving a still-difficult task, but one that is sufficient to do the job and sus­tainable--and more likely to be achieved.

J. D. Foster, Ph.D., is Norman B. Ture Senior Fellow in the Economics of Fiscal Policy in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation. See also Medicare Path to Sustainability.