July 25, 2003 | Backgrounder on Health Care
The House and Senate have approved legislation adding a prescription drug benefit to Medicare, and a conference committee is now attempting to reconcile these two bills. If the two chambers do manage to iron out their differences, the resulting bill will represent the biggest unfunded entitlement expansion in nearly 40 years.
Unfortunately for taxpaying Americans, however, the projected 10-year $400 billion cost is just a down payment that will not produce the necessary Medicare improvements and needed reforms. Instead, Congress will have passed a bill that in future years will require huge new taxes--new taxes that will threaten the recently enacted tax plan.
The Medicare prescription drug proposal is bad health policy, exacerbating the flaws in a system that has almost no market-based incentives to improve service and control costs. But the House and Senate bills also will undermine sound tax and economic policy in several ways. Specifically:
A new entitlement means bigger government, and bigger government means higher taxes, especially when politicians are expanding the welfare state and neglecting much-needed Medicare reform. Simply stated, the prescription drug benefit will make America more like stagnant European nations such as France.
Entitlement spending is the fastest growing part of the federal budget, and this pattern will continue even if there is no expansion of so-called mandatory programs In just the past 40 years, entitlements have nearly doubled as a share of federal outlays, climbing from 32 percent of total outlays in 1962 to 60 percent of the federal budget in 2002.1
The elderly will be a much bigger share of the population once the baby-boom generation retires. And since the elderly consume most entitlement spending, the fiscal outlook will worsen--even if there are no changes to the underlying programs. According to the Congressional Budget Office, mandatory spending for Social Security and Medicare will nearly double as a share of the gross domestic product (GDP) over the next 40 years.2
Although Social Security and Medicare spending are projected to explode, payroll tax revenues to finance these programs will remain relatively constant as a share of GDP. The net result will be huge long-term deficits, and Medicare is the main problem. According to the trustees' reports on Social Security and Medicare,3 the combined deficit of the two programs will swell to more than 8 percent of national economic output in 2075, with Medicare accounting for about three-fourths of the red ink. According to government data, the Social Security cash-flow deficit through 2075 is $25.3 trillion in today's dollars. But this is spare change compared to the Medicare cash-flow deficit, which is a staggering $66.8 trillion over the same period.4
While the long-term outlook is grim, even the short-term prognosis is sobering. The baby-boom generation will begin to retire in about 10 years, and the fiscal consequences will be profound. The combined deficit will rapidly expand, climbing to 1 percent of GDP in 2015, 2 percent of GDP in 2020, and 3 percent of GDP in 2025. To put that figure in perspective, 3 percent of GDP today would be more than $325 billion, or $3,072 per household.
The tax implications of these big deficits should concern all responsible lawmakers as well as taxpayers. Raising revenue by just 1 percent of GDP next year would require an annual tax increase of more than $100 billion.5 Over the next 10 years, the tax increase needed to finance such a deficit would be more than $1.5 trillion.6 Such a tax increase would be a body blow to the economy, threatening European-style stagnation and higher unemployment.
In the absence of program reform, creating a new entitlement for prescription drugs is akin to pouring gasoline on a fire. And it will be very expensive gasoline. The 10-year cost of the new benefit is projected at $400 billion, but it is quite likely that the real cost will be much larger since public and private-sector estimates of drug costs in recent years have been well below actual spending levels. But the $400 billion is trivial compared with the situation when the baby boomers start to retire--just after the 10-year estimating window used by Congress.7
This patchwork system will generate enormous pressure on politicians to make coverage more uniform, and special-interest groups most likely will demand that three-fourths of the program be financed by general tax revenue, which could triple projected expenditures. It is worth noting Senator Ted Kennedy's view: "This is only a down payment. Hopefully, we can use this down payment in an effort to fulfill our responsibility to seniors over the years."11
Demographic trends mean higher spending. The baby-boom generation begins to retire in about 10 years. Today, there are over 40 million people on Medicare; by 2030, that number will jump to almost 80 million, nearly doubling in less than 30 years.12 Yet, because Congress is using 10-year budget estimates, this ticking fiscal time bomb is not part of the prescription drug debate.
Making long-run projections is, by necessity, somewhat speculative. The final legislation--if any--is still unknown, as is exactly how behavioral changes and future program expansions will affect costs.
Nonetheless, estimating the probable range of fiscal effects is quite possible: It has been done by Thomas Saving, one of the trustees of the Social Security and Medicare Trust Funds. Based on data from the Medicare Trustees' Report and the Congressional Budget Office and estimates from Texas A&M University, he estimates that the Medicare deficit will consume 20 percent of federal income taxes in 2026 and 33 percent of income taxes in 2042.13
If a prescription drug entitlement is created, those numbers will become even more startling. Under a best-case scenario, with government paying only 25 percent of drug costs, the Medicare deficit will climb to 24 percent of income tax revenues in 2026 and 39 percent in 2042. Using more realistic assumptions, however, the fiscal burden will become much more ominous. If Medicare pays 75 percent of prescription drugs, the program's overall deficit will consume 35 percent of income tax receipts in 2026 and 54 percent of those revenues in 2042.14
Medicare expenditures already are projected to climb dramatically, and creating a new entitlement will boost spending even faster. If lawmakers enact this legislation without considering the consequences, they will put their successors in an extremely difficult position, leaving them with three politically unpopular options. Future lawmakers could:
In a political environment of rising costs and demands for more benefits, the most likely scenario is action by Congress to repeal existing legislation that would reduce tax revenue while concomitantly dampening enthusiasm for future tax reduction and reform. The remaining Bush tax cuts would likely be the first target.
The bulk of the 2001 tax cuts expire at the end of 2010, and most of the 2003 tax cuts expire at the end of 2008. Good economic policy suggests that these provisions should be made permanent to maximize the economic benefit of lower tax rates. At the very least, however, they should be extended to protect the economy from a significant tax increase in either 2009 or 2011.
If the temporary tax cuts are allowed to expire, the economy will be hit with a $775 billion tax increase between today and 2013.16 This tax increase would have serious economic consequences, particularly since much of it would be in the form of higher penalties on work, saving, and investment.
Yet, is it reasonable to assume that lawmakers will make the Bush tax cuts permanent when future budget projections will be adversely affected by the upcoming retirement of the baby boomers? Even extending the tax cuts will be much more difficult in that environment, and making the Bush tax cuts permanent might be impossible. For example:
Equally important, the baby-boom generation will be closer to retirement when the 2001 tax cuts expire; therefore, the future cost of providing benefits for these soon-to-be seniors will have a bigger effect on 10-year budget projections.
One need only imagine the demagogic political environment that might develop. Advocates of class warfare will argue that the death tax should be brought back to life to help pay for "life-saving drugs." Supporters of such politics also will argue that personal income tax rates on the "rich" should be raised to avoid "deficits as far as the eye can see."
The tax cuts enacted in 2001 and 2003 are already at risk, and adding a prescription drug entitlement would magnify that risk. Further tax relief and fundamental tax reform would also be jeopardized if entitlements continue to consume an ever-larger share of national economic output.
Rather than enacting a huge new drug entitlement that will undermine sensible tax policies, lawmakers should pause to consider how best to address the shortcomings of Medicare in a responsible manner. A lack of drug insurance is not a widespread problem. Most seniors already have private coverage. Thus, a sweeping new government program covering every senior is not needed to address the genuine problems of a minority of generally lower-income seniors. Moreover, the lack of drug coverage in the existing Medicare program actually indicates deficiencies in the program's process of overhauling and modernizing benefits, and that problem requires structural reforms of Medicare, not an expensive add-on.
The best model to use to address these problems is Congress's own health plan, the Federal Employees Health Benefits Program (FEHBP), in which market competition and consumer choice leads to cost-effective plans with benefits that reflect enrollee needs--quite unlike Medicare.22
Specifically, Members of Congress should address these shortcomings in ways that preserve two critical principles:23
The House and Senate prescription drug bills will hurt America by making the health care system less responsive to market forces, but the damage will extend far beyond the health care system. The fiscal policy consequences of entitlement expansion are staggering.
Almost surely, a new drug entitlement will endanger the 2001 and 2003 Bush tax cuts. In the future, as lawmakers examine the need to extend those tax cuts and make them permanent, they will be haunted by budget projections showing an enormous expansion in Medicare spending. This will create a political environment that hinders the enactment of supply-side tax policy.
In the long run, entitlement expansion also threatens fundamental tax reform. Many of the reforms needed to bring the tax code closer to a simple and fair flat tax involve a reduction in tax revenue. This will be a daunting challenge. A bigger Medicare system--particularly one insulated from market-based reforms--will make it more difficult to replace the Internal Revenue Code with a pro-growth flat tax.
Daniel J. Mitchell, Ph.D., is McKenna Senior Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.
1. Congressional Budget Office, "Historical Budget Data," January 29, 2003, at www.cbo.gov/showdoc.cfm?index=1821&sequence=0.
2. Congressional Budget Office, "A 125-Year Picture of the Federal Government's Share of the Economy, 1950-2075," revised July 3, 2002, at www.cbo.gov/showdoc.cfm?index=3521&sequence=0.
3. For more information, see Centers for Medicare and Medicaid Services, Table II.A5--Medicare Sources of Income and Expenditures as a Percentage of the Gross Domestic Product, at www.cms.hhs.gov/publications/trusteesreport/2003/tabiia5.asp, and "Appendix F: Estimates for Oasdi and HI, Separate and Combined," in OASDI Board of Trustees, 2003 OASDI Trustees Report, Table VI.F5, at www.ssa.gov/OACT/TR/TR03/VI_OASDHI_GDP.html#wp108957.
4. Calculations based on 2003 Social Security Trustees' Report and 2003 Medicare Trustees' Report. See Social Security Administration, "Single-Year Tables Consistent with 2003 OASDI Trustees Report," Tables VI.F7, at www.ssa.gov/OACT/TR/TR03/lr6F7-2.html and Table VI.F10, at www.ssa.gov/OACT/TR/TR03/lr6F10-2.html.
5. Congressional Budget Office, "CBO's Current Economic Projections," at www.cbo.gov/showdoc.cfm?index=1824&sequence=0.
7. For an overview of this problem, see Robert E. Moffit, "What's Wrong with the Senate Medicare Drug Bill," Heritage Foundation Web Memo No. 297, June 18, 2003, at www.heritage.org/Research/HealthCare/wm297.cfm, and Nina Owcharenko, "Time to Draw the Line on Medicare 'Reform,'" Heritage Foundation Web Memo No. 300, June 23, 2003, at www.heritage.org/Research/HealthCare/wm304.cfm.
8. Daniel J. Mitchell, "The Correct Way to Measure the Revenue Impact of Changes in Tax Rates," Heritage Foundation Backgrounder No. 1544, May 3, 2002, at www.heritage.org/Research/Taxes/BG1544.cfm.
10. Congressional Budget Office, letter to interested parties, February 3, 2003, at www.cbo.gov/showdoc.cfm?index=4056&sequence=0.
12. 2003 Annual Report of the Board of Trustees of the Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Fund, March 17, 2003, p. 24, at cms.hhs.gov/publications/trusteesreport/2003/tr.pdf.
13. Tom Saving,
"Perspectives on the 2003 Social Security and Medicare Trustees
Reports," presentation at program on
"The 2003 Medicare Trustees' Report: One Year Closer to Crisis?" American Enterprise Institute, March 24, 2003, at
15. Brian M. Riedl and William W. Beach, "The New Medicare Drug Entitlement's Huge New Tax on Working Americans," Heritage Foundation Backgrounder, forthcoming July 2003.
16. Office of Management and Budget, Mid-Session Review of the Budget, July 2003, at www.whitehouse.gov/omb/budget/fy2004/pdf/04MSR.pdf.
19. The alternative minimum tax was originally designed for 155 taxpayers but is projected to affect 36 million taxpayers by 2010. See Chris Edwards, "10 Outrageous Facts About the Income Tax," Cato Institute, April 15, 2003, at www.cato.org/dailys/04-15-03-3.html.
20. Congressional Budget Office, "Budget Options," March 2003, at www.cbo.gov/showdoc.cfm?index=4066&sequence=17.
22. Robert E. Moffit, "Road Map to Medicare Reform: Building on the Experience of the FEHBP," testimony before the Special Committee on Aging, U.S. Senate, May 6, 2003, at www.heritage.org/Research/HealthCare/test050603.cfm.
23. See Stuart M. Butler, Ph.D, "The Crucial Elements of an Acceptable Medicare Bill," Heritage Foundation Backgrounder No. 1667, July 16, 2003.