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WebMemo #880 on Health Care

October 11, 2005

Paying for Medicare: An Economic Look at the Program's Unfunded Liabilities

By and

Social Security is in crisis. Paying Social Security's promised benefits over the next 75 years will require $5.7 trillion more than the existing payroll tax provides, and raising taxes by that amount would reduce employment, slow economic growth, and devastate working families.

 

Social Security, however, is not the gravest fiscal crisis that America faces. The 2005 Medicare trustees' report estimates that providing promised Medicare benefits over just the next 10 years could require over $2.7 trillion in new tax revenues. Raising taxes by that amount would eliminate almost 816,000 jobs per year, on average, and shave an average of nearly $87 billion from the real (inflation-adjusted) gross domestic product (GDP) between 2006 and 2015. Even worse, the Medicare trustees project that providing promised Medicare benefits over the next 75 years would require $29.9 trillion in new tax revenues. Raising taxes to meet Medicare's 75-year shortfall would cost an average of 2.3 million jobs and well over $190 billion in real GDP annually through 2015.

 

Historically, lawmakers have confronted new federal spending with tax increases. The economic costs of addressing Medicare in this way are, to say the least, prohibitive.

 

The Spending Side

As with Social Security, Medicare's unfunded liabilities are its promises to current and future retirees. For budgetary purposes, Medicare has two components, Hospital Insurance (HI) and Supplementary Medical Insurance (SMI).

 

HI is the part of Medicare that helps to pay for in-patient and nursing home care for the elderly and disabled. It is financed in large part with a 2.9 percent payroll tax. In the black for most of its 40 years, HI's benefit payments began to outstrip its income in 2004, according to the Medicare trustees, and those deficits will continue to grow in size every year for the foreseeable future. HI does have a trust fund, but it contains only IOUs that will have to be covered by taxpayers, just like Social Security's trust fund. Over the next 75 years, the HI trust fund will face a shortfall of $8.8 trillion, according to the trustees.

 

SMI consists of Medicare Part B, which covers physician, outpatient, and other medical services, and Medicare Part D, which is the new drug benefit. Those enrolled in Part B and, beginning in 2006, Part D, pay premiums covering 25 percent of Part B and Part D benefits; the remaining 75 percent of benefits are made up with general revenue transfers. Over the next 75 years, general revenue transfers for Part B and Part D are projected to total $12.4 trillion and $8.7 trillion, respectively.

 

Add it all up, and Medicare's unfunded liabilities amount to $29.9 trillion over the next 75 years-more than five times as much as Social Security's unfunded liabilities.

 

The Tax Side

Medicare's unfunded liabilities for Parts A, B, and D could be financed with higher taxes. Using the Global Insight U.S. Macroeconomic Model, we estimated the economic and budgetary effects of raising payroll and personal income taxes to cover Medicare's shortfalls over the next 10 years and the next 75 years.[1]

 

The 10-year forecast is bleak. Raising payroll and personal income taxes to cover Medicare's unfunded liabilities through just 2015 would, on average, reduce GDP by $105.5 billion per year and private-sector employment by over 921,000 jobs per year between 2006 and 2010. By 2015, real GDP would be more than $116 billion lower than without the tax increases.

 

Raising payroll taxes to cover Medicare's shortfalls through 2079 would cause even more economic damage. Between 2006 and 2010, higher taxes would reduce GDP by over $204 billion per year and cost more than 1.7 million private-sector jobs annually, boosting the unemployment rate by almost a percentage point. By 2015, real GDP would be nearly $208 billion lower than without the tax increases.

 

The above two scenarios assume that Congress uses new tax revenues to reduce deficits and pay down debt. The subsequent decline government borrowing would increase national saving and help reduce the tax burden on future workers by expanding the wealth available to retirees.

 

We also consider a third scenario. Imagine instead that Congress raises taxes to cover Medicare's shortfalls through 2079 but then uses the new revenues to finance additional spending.

 

Such a scenario is not so unlikely. The same rationale led to the creation of the Social Security and HI trust funds, both of which are now empty but for special public-debt obligations that the government issued to replace the "surplus" money that it spent. If Congress were to pursue this course for Medicare, real GDP would be over $283 billion lower and almost 3.3 million jobs would have been lost by 2015.

 

Conclusion

Economist Laurence Kotlikoff estimates that U.S. payroll and income taxes would need to rise to almost 40 percent of wages to cover future retiree's promised health and pension benefits.[2] This would put the United States in the economic territory now occupied by continental Europe, whose countries have had far higher taxes on labor income for decades. Europe also provides a cautionary tale: its countries have experienced declines in employment rates, average hours worked, and GDP growth since the 1970s-outcomes that many economists, such as Nobel laureate Edward Prescott, attribute to higher taxes.[3] Kotlikoff estimates that the result of raising taxes to fund promised old-age benefits would be a 25 percent drop in the U.S. standard of living by 2030.

 

How Congress meets the long-term challenge of Medicare will have profound effects on the federal budget and the national economy. Simply raising taxes to pay for future Medicare benefits is strategy that comes with enormous costs, in terms of forgone economic growth and jobs. Choosing to raise taxes would be very damaging.

 

Tracy L. Foertsch, Ph.D., is a Senior Policy Analyst in the Center for Data Analysis at The Heritage Foundation, and Joseph R. Antos, Ph.D., is the Wilson H. Taylor Scholar in Health Care and Retirement Policy at the American Enterprise Institute.



[1] For complete methodology and results, see Tracy L. Foertsch, Ph.D., and Joseph R. Antos, Ph.D., "The Economic and Fiscal Effects of Financing Medicare's Unfunded Liabilities," Heritage Foundation CDA Report No. 05-06, October 11, 2005. The Global Insight model is frequently used by private-sector and government economists to estimate how changes in government spending and tax policy are likely to impact the general economy. The methodologies, assumptions, conclusions, and opinions in this memo are entirely the work of Heritage Foundation analysts. They have not been endorsed by, and do not necessarily reflect the views of, the owners of the Global Insight model.

[2] See Laurence Kotlikoff, Hans Fehr, and Sabine Jokisch, "Aging, the World Economy, and the Coming Generational Storm," National Center for Policy Analysis Policy Report No. 273, February 2005, at http://www.ncpa.org/pub/st/st273.

[3] See Edward Prescott, 'Why do Americans Work So Much More Than Europeans?," National Bureau of Economic Research Working Paper No. 10316, February 2004.

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