Security's looming financial crisis has received much attention
over the past few months. However, Medicare, the other major
program intended to ensure the well-being of older Americans,
represents an equal if not greater threat to the long-term fiscal
health of the federal government.
numbers speak for themselves. Providing promised Medicare benefits
is projected to require over $2.7 trillion (in nominal dollars) in
new tax revenues over just the next 10 years and a
mind-boggling $29.9 trillion (in 2005 dollars) over the next
75 years. Providing promised Social Security benefits is projected
to cost much less. Combined annual Old-Age, Survivor, and
Disability Insurance (OASDI) benefits are not expected to exceed
OASDI income from payroll taxes and other sources until 2017, and
unfunded OASDI obligations to America's seniors are expected to
total roughly $5.7 trillion (in 2005 dollars) over the next 75
other words, Medicare's financing problems will arise sooner and
ultimately surpass Social Security's financing problems. They
will also require difficult choices about both the size of
public health-care spending for the elderly and the burden borne by
future workers in paying for that care. For these reasons, Thomas
R. Saving, a public trustee for the Medicare program and a senior
fellow at the National Center for Policy Analysis, has argued that
"the single biggest reason for Congress to reform Social Security
is the existence of Medicare."
report focuses on the economic and budgetary effects of using
higher taxes to finance promised Medicare benefits. It first looks
at the effects of raising personal income and payroll tax rates to
fund promised Medicare benefits through 2015. It then considers the
effects of raising only payroll tax rates to finance promised
Medicare benefits through 2079.
policy changes were analyzed using Global Insight's short-term
U.S. Macroeconomic Model. The results show that the economic costs of
raising taxes to finance Medicare through even 2015 could be
prohibitive. Assuming that new tax revenues are used to fund
Medicare and not to offset higher spending elsewhere in the
federal budget, between 2006 and 2015, total job losses could
average almost 816,000 annually, and real (inflation-adjusted)
gross domestic product (GDP) could be, on average, nearly $87
billion lower per year.
employment and output losses would be much greater if payroll taxes
were raised sufficiently to finance all of the health-care
benefits promised to Americans through 2079. Total job losses could
average almost 2.7 million, and the drop in real GDP could approach
an average of $248 billion per year over the first 10 years that
higher payroll tax rates are in place.
federal government faces huge unfunded liabilities because of the
promised health-care benefits now available to current and
future generations of older Americans. Those liabilities are a
product of the Medicare program, which consists of two separate
components: Hospital Insurance and Supplementary Medical Insurance
(including the new prescription drug benefit).
Hospital Insurance (HI) component, also known as Part A, helps to
pay for the hospital, home health, nursing home, and hospice care
of the elderly and disabled. HI benefits are financed primarily
through a 2.9 percent payroll tax on the earnings of all covered
workers. Unlike contributions to Social
Security's retirement program, the Medicare payroll tax has been
applied to total covered wages, salaries, and self-employment
income since 1994. In addition, taxes on the Social Security
benefits of high-income individuals and interest income from the
investment of past HI trust fund surpluses play a small role in
funding HI benefits.
income flows from payroll tax and other revenues have exceeded
Part A benefit payments in all but a handful of the past 40 years.
As a result, the HI trust fund had accumulated surpluses totaling
$269.3 billion by the end of 2004. This amount is earmarked to
fund the Part A benefits of future retirees.
there is little reason to be sanguine about the future of
Medicare's HI trust fund. Today, the HI trust fund (aside from
small cash balances) consists almost entirely of special
public-debt obligations purchased using trust fund surplus dollars.
Those special obligations are credited to the trust fund by the
federal government and represent a claim on future tax revenues. In
2004, they totaled roughly the accumulated positive differences
between payroll tax (and other) receipts and trust fund spending
since the HI trust fund's inception in 1965.
payroll tax revenues in excess of current program needs could be
used to reduce budget deficits. The subsequent decline in
government borrowing would increase national saving and help
to reduce the tax burden on future workers. Historically,
however, rising payroll tax revenues and trust fund surpluses
have not been accompanied by declining federal deficits.
number of researchers have attributed the buildup of public-debt
obligations in the federal trust funds to the switch to a unified
budget in 1970. Under unified budget accounting, trust fund
income is combined with federal personal income taxes, corporate
income taxes, and other federal receipts to arrive at unified
federal revenues. Similarly, trust fund spending is lumped
together with all other federal spending to arrive at unified
budget debate revolves around the unified budget balance. Until
recently, payroll tax revenues (and other income) in excess of
benefits have generated trust fund surpluses. Those surpluses
have helped to offset increased federal spending by the rest of the
government and the resulting on-budget and federal-funds
deficits. In the late 1990s and early 2000s, they
contributed greatly to unified budget surpluses.
according to the Medicare trustees' report, promised HI benefits
began to outstrip current payroll tax collections and other
trust fund income (excluding interest income) beginning in 2004.
Actuarial imbalances in the HI trust fund are expected to expand in
every year thereafter as a result of the retirement of the
baby-boom generation and the inflation of health-care costs,
among other factors. To help fund current benefits, Medicare
will begin to redeem the special public-debt obligations held in
the HI trust fund. The 2005 Medicare trustees' report projects that
Medicare will deplete those special obligations by 2020. However,
the exact date matters little in one important sense. Both
before and after 2020, ever larger transfers of federal corporate
and personal income tax collections and other federal receipts will
be needed to fund the gap between current HI income and promised
general revenue transfers already constitute the bulk of
Supplementary Medical Insurance (SMI) trust fund financing.
Medicare's SMI program consists of two separate components.
Part B covers physician, outpatient, home health, and other
services for the elderly and disabled who are enrolled. Part D, a
product of the Medicare Modernization Act of 2003, initially
provides a prescription drug discount card to low-income
Medicare beneficiaries. Beginning in 2006, the discount card
will be replaced by subsidized drug insurance coverage that is
available to all enrolled beneficiaries. Premium and cost-sharing
subsidies will be available to all enrollees, with substantially
larger subsidies for those with low incomes.
and Part D benefits are funded out of two separate accounts within
the SMI trust fund. Under law, each account is automatically in
balance because benefits are financed using a combination of
premiums paid by recipients and authorized general revenue
transfers set to cover the next year's estimated fund expenditures.
In fiscal year 2004, premiums accounted for roughly 25 percent of
Part B trust fund income, and general revenue transfers from the
Treasury accounted for the remaining 75 percent. Total funding for
basic drug insurance coverage under Part D is calculated to follow
a similar formula beginning in 2006.
only revenues earmarked for financing the HI and SMI trust funds
are those raised by the existing payroll tax, the tax on Social
Security benefits, and premiums. Any gap between those
earmarked revenues and expected benefit payments must be
filled with transfers of federal personal and corporate income tax
collections and other federal receipts. Assuming that the benefits
promised to current and future retirees will be provided, that gap
constitutes a staggering unfunded liability. (See Charts 1 and
the trustees' intermediate economic and demographic assumptions,
the HI trust fund's actuarial imbalance is projected to exceed $8.8
trillion (in 2005 dollars) over the next 75 years
(2005-2079). Over the same period, general
revenue transfers to SMI Parts B and D are projected to total
$12.4 trillion and $8.7 trillion, respectively. To put those
totals in perspective, fully funding the benefits promised to
present and future beneficiaries through 2079 would require
permanently and immediately increasing the Medicare
payroll tax rate to roughly 13.4 percent of all wages,
salaries, and self-employment income. (See Appendix A for the
funding the benefits promised to retirees over the next 10
years implies steep tax hikes. Closing HI trust fund
imbalances through 2015 could require general revenue transfers
totaling an estimated $134 billion (in nominal
dollars). More ominously, funding benefits promised
under SMI Parts B and D over the same period could easily require
total general revenue transfers approaching $2.6 trillion.
SMI Part D will likely account for nearly 40 percent of that $2.6
trillion unfunded liability.
Medicare's Unfunded Liabilities
course, estimating the economic and budgetary effects of
putting Medicare on a firmer financial footing is difficult because
of the high degree of uncertainty surrounding long-term trends in
life expectancy, birth rates, productivity, and wage growth.
Trends in life expectancy and birth rates will determine the number
of elderly and the pool of available workers to support them.
Trends in productivity and wage growth will determine workers'
ability to pay the taxes needed to fund promised
there is no single approach that the federal government can
take to fund Medicare's promised benefits. Some argue that the
government can simply raise taxes with almost no effect on the
economy. Others argue that tax increases would have beneficial
effects on output and employment because they would reduce the need
for federal borrowing and debt accumulation after the baby-boom
1993 Omnibus Budget Reconciliation Act (OBRA-93) is often used to
bolster the case for higher taxes. OBRA-93, among other
revenue-raising measures, put in place two new, higher
marginal tax rates for individuals (36 percent and 39.6
percent) and repealed the wage cap on Medicare payroll taxes. In
the five years following its passage, real GDP expanded at an
annual average rate of almost 3.8 percent, and private-sector
employment grew at an annual average rate of over 2.9 percent.
At the time, the Clinton Administration credited the deficit
reduction facilitated by OBRA-93 with setting the stage for
there are reasons to be skeptical of such arguments. First, the tax
increases needed to put Medicare on firmer financial footing would
be many orders of magnitude larger than those included in OBRA-93.
In August 1993, the Joint Committee on Taxation (JCT) estimated
that the revenue provisions in OBRA-93 would increase federal tax
collections by almost $241 billion over five years (1994-1998). As
the Congressional Budget Office (CBO) noted at the time, the
higher revenues were not even expected to alter "the underlying
trends of deficits that, after falling from the high levels of
the early 1990s, [would] rise steadily" as the decade neared its
end. In comparison, funding all of Medicare's
unfunded obligations through just 2015 would require increasing tax
collections by more than $2.7 trillion.
economic analysis of OBRA-93 has indicated that it potentially
slowed rather than facilitated a nascent economic expansion. Beach
et al. used the Washington University Macro Model (WUMM) to
simulate U.S. economic performance assuming that Congress had not
raised taxes in 1993. Their comparison of OBRA-93 to a
current-law baseline forecast (see Appendix A) concluded
that the tax increase slowed the pace of economic growth and job
creation and cut the growth in real disposable income and saving.
As a result, the economy did not perform well when compared to
similar points during previous economic expansions of similar
this regard, continental Europe provides a cautionary tale.
Since the 1970s, continental European countries have experienced
declines-often dramatic declines-in employment rates, average
annual hours worked, and the growth rates of real per capita GDP.
As a result, European per capita GDP in 2000 remained fixed at
roughly 70 percent of U.S. per capita GDP (measured in terms of
purchasing power parity), roughly its level in 1970. Over the same
period, European taxes on labor income (income and payroll taxes)
either have increased relative to or have remained
persistently higher than the equivalent U.S. labor income taxes.
for Europe's sluggish economic performance abound. Prescott
and Cardia et al. recently argued that high labor taxes
played a central role in driving down hours worked in Europe.
Alesina et al. and Blanchard attributed the bulk of Europe's
decline in hours worked to greater preferences for leisure among
Europeans, but also allowed that high tax rates on labor income
could explain at least part of the decline in annual average hours
into the future, Kotlikoff et al. estimate that U.S. payroll
and income taxes would need to climb to almost 40 percent of wages
to provide future retirees with promised health care and
pension benefits. In their calculations, lower after-tax
income to workers reduces hours worked, disposable income, and
therefore personal saving. Over time, the implied decline in
capital formation negatively affects labor productivity and
wages. The result is an estimated 25 percent drop in the U.S.
standard of living by 2030.
any policy that reduces future job opportunities and economic
growth will complicate the problem of providing future generations
of older Americans with health-care benefits.
Economic and Budgetary Effects of Raising Payroll and Personal
section focuses on the effects of raising taxes to finance
Medicare's unfunded liabilities. It first considers the
economic and budgetary effects of immediately raising payroll tax
rates and personal income tax rates to finance HI and SMI benefits
through 2015. Payroll taxes would be increased to finance projected
imbalances in the HI trust fund over only the next 10 years.
Personal income taxes would be increased to cover general revenue
transfers to the SMI trust fund over the same period. It
then looks at the economic and budgetary effects of raising payroll
tax rates permanently and immediately to finance HI and SMI
benefits through 2079.
taxes to finance Medicare's unfunded liabilities over either
the next 10 or the next 75 years would undoubtedly have economic
and budgetary effects from the beginning. The size of those effects
would depend largely on whether the new tax revenues are used
to pay down debt or to finance higher spending elsewhere in the
federal government's budget.
example, raising payroll and personal income tax rates just enough
to fund general revenue transfers to HI and SMI through 2015
(see Table 2 in Appendix B) could push real GDP an average of
$105.5 billion below base levels between 2006 and 2010.
Private-sector employment over the same period would be reduced by
an average of over 921,000 jobs per year, increasing the
unemployment rate by an average of 0.4 percentage points over
the five-year period.
payroll and personal income taxes would continue to be a drag on
the economy between 2011 and 2015. However, the magnitude of lost
output and jobs would be moderate relative to the first five years.
This is because, within any given budget year, the federal
government is assumed to allocate new revenues earmarked for
Medicare toward deficit reduction and not increased spending.
by 2015, the federal government's projected unified budget
deficit would have become a substantial unified budget surplus, and
privately held federal debt as a share of GDP would have dropped
over 15 percentage points to 19.4 percent.
deficit spending, along with cuts in the federal funds rate by the
Federal Reserve, would in time lower interest rates and the overall
cost of capital to businesses. The result would be a temporary
rebound in non-residential investment and an increase in capital
formation. However, personal income and consumption would remain
depressed, as would private-sector employment. Higher taxes on
labor would in turn contribute to a gradual decline in labor-force
participation. As a result, by 2015, real GDP is estimated to be
over $116 billion lower than it would be without the tax
economic and budgetary effects would be much larger if the
government raised payroll tax rates sufficiently to fund general
revenue transfers to HI and SMI through 2079. (See Table 3 in
Appendix B.) Raising the Medicare payroll tax rate to the required
13.4 percent of all wages, salaries, and self-employment income
would generate substantial amounts of new federal tax
revenues. (See Appendix A.) Assuming that the new revenues are used
to reduce deficits and pay down debt, the federal government's
unified budget deficit would very quickly become a unified budget
surplus, and privately held federal debt would drop below 10
percent of GDP before 2015. The ensuing lower interest rates
would in time encourage higher non-residential capital spending and
the unified budget surpluses would be the result of increased
payroll tax revenues and lower interest payments on the federal
debt. Both personal and corporate incomes, and thus personal and
corporate federal income tax collections, would fall below their
base levels in every year between 2006 and 2015. Consistent with
lower personal income, personal consumption expenditures would
decline steadily, helping to push real GDP down an average of over
$204 billion per year between 2006 and 2010. Private-sector job
losses would in turn average nearly 1.8 million annually over the
negative economic effects of raising payroll tax rates to fund HI
and SMI through 2079 would be more pronounced if the federal
government used new tax revenues to finance higher spending instead
of paying down debt. (See Table 4 in Appendix B.) This is because
lower personal and corporate incomes would again give way to lower
personal and corporate income tax collections, but increased
payroll tax revenues, instead of offsetting declining federal
income tax receipts, would offset greater spending elsewhere in the
federal government's budget.
result, privately held federal debt would expand as a share of GDP,
tending to make it more difficult for businesses to finance new
capital spending. Non-residential investment and, ultimately,
capital formation would still rebound, but only because the Federal
Reserve is assumed to lower the federal funds rate aggressively to
offset rising unemployment rates. By 2015, real GDP would be over
$283 billion lower than it would be without tax increases, and
almost 2.8 million private-sector jobs would have been lost
because of higher payroll tax rates.
Medicare is the less costly of the two major government programs
intended to ensure the well-being of older Americans. However, an
aging population and other factors will make it a primary concern
of policymakers in the coming years. How policymakers meet the
long-term fiscal challenges of Medicare's unfunded liabilities
could have profound economic and budgetary effects. Any policy that
reduces future job opportunities and economic growth will compound
raising taxes to finance promised Medicare benefits would
likely prove counterproductive because the economic costs would be
prohibitive, even assuming that policymakers are prudent and use
new tax revenues to pay down deficits and debt. In the estimates
presented in this report, raising payroll and personal income
taxes to finance Medicare over just the next 10 years could reduce
total employment by an average of nearly 816,000 jobs and depress
real GDP by an average of almost $87 billion per year through 2015.
(See Table 1 and Chart 3.)
economic costs would increase if policymakers follow
historical patterns of using new tax revenues to offset new federal
spending. Under such circumstances, raising taxes to finance
Medicare over the next 75 years could reduce total employment
by close to 2.7 million jobs and real GDP by an average of almost
$248 billion over the first 10 years that higher payroll taxes are
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
three-step procedure was followed in analyzing the economic
and budgetary effects of raising taxes to finance Medicare's
static increases in payroll tax and personal income tax
revenues needed to fund promised benefits were estimated.
These estimates were based on data from the 2005 Annual Report
of the Boards of Trustees of the Hospital Insurance and the
Supplementary Medical Insurance Trust Funds and the 2005
Annual Report of the Board of Trustees of the Federal Old-Age and
Survivors Insurance and Disability Insurance Trust
9 of the Global Insight U.S. Macroeconomic Model was
calibrated to the baseline economic and budgetary assumptions and
forecasts published in the Congressional Budget Office's
August 2005 The Budget and Economic Outlook: An
calibrated, that model and its CBO-like baseline were used to
simulate how the general economy would likely respond to the
implied changes in federal tax and spending policies.
Congressional Budget Office produces a current-law baseline. A
current-law baseline includes projections of personal incomes,
corporate profits, GDP, prices, employment, consumption,
investment, etc. that are consistent with no changes in federal
outlays and receipts other than those specified by laws that have
already been enacted. For example, the CBO's current-law
baseline assumes the expiration of the Economic Growth and Tax
Relief Reconciliation Act (EGTRRA) of 2001 and the Jobs and Growth
Tax Relief Reconciliation Act (JGTRRA) of 2003. However, it
excludes any new legislation that would increase federal spending,
even when such legislation is likely to be enacted.
CBO's current-law baseline treats the outlays and receipts
associated with Medicare somewhat differently. CBO federal spending
projections include expected outlays for Medicare Parts B and D.
However, its revenue projections do not include any offsetting
general revenue transfers to the SMI trust funds. These transfers
are instead captured residually in CBO projections of unified
federal budget surpluses/deficits. From a modeling standpoint,
this means that any simulated increases in revenues earmarked for
Medicare will affect deficit reduction and not spending on federal
Static Revenue Estimates
separate sets of static revenue estimates were made. Both are
consistent with the intermediate economic and demographic
assumptions outlined in the 2005 Medicare and the 2005 OASDI
additional payroll tax revenues needed from 2005 to fund HI and SMI
benefits over the next 75 years were calculated using projections
of taxable payroll taken from the 2005 OASDI trustees' report
and estimates of payroll tax rate increases from the 2005 Medicare
trustees' report. The calculated gains in payroll tax revenues were
then translated into corresponding increases in the effective
federal social insurance tax rate used in the Global Insight
2005 Medicare trustees' report estimates the present value of HI's
75-year actuarial imbalance to be 3.09 percent of taxable
It then suggests that HI's "long-range
financial imbalance could be addressed" by immediately and
permanently raising the 2.9 percent payroll tax rate to 5.99
percent of all wages, salaries, and self-employment income.
report estimates the present value of the general revenue transfers
needed to fund Part B through 2079 to be 4.34 percent of taxable
It estimates the present value of the
general revenue transfers needed to fund Part D over the same
period to be 3.04 percent of taxable payroll.
payroll taxes to fund Parts B and D combined would imply an
immediate and permanent jump in the Medicare payroll tax rate
to roughly 10.3 percent of total wages and salaries. Combining the
unfunded obligations of SMI Parts B and D with HI's actuarial
imbalance would immediately push the Medicare payroll tax rate to
an estimated 13.4 percent.
revenue estimates were obtained by multiplying OASDI
projections of taxable payroll by the difference between that 13.4
percent and the current 2.9 percent Medicare payroll tax rate.
Between 2006 and 2015, in calendar years, the result would be an
increase in payroll tax revenues exceeding $8.1 trillion. Obtaining
the same increase in payroll tax revenues in the Global Insight
model required a permanent 10.8 percentage point increase in the
model's effective federal social insurance tax rate by the end of
increases in payroll tax and personal income tax revenues needed to
pay promised HI and SMI benefits over just the next 10 years were
calculated using data taken from the 2005 Medicare trustees'
in 2005, payroll taxes were increased by the amount of HI's
projected (nominal) annual deficits. These deficits are defined as
the difference between HI income, excluding interest, and HI
They sum to almost $134 billion between
2006 and 2015, implying an increase of more than 0.4
percentage point in the Global Insight model's effective
federal social insurance tax rate by the end of 2015.
in 2005, federal personal income taxes were increased by the amount
of (nominal) projected general revenue contributions to SMI
Parts B and D.
Those projected general revenue
contributions sum to nearly $2.6 trillion between 2006 and
2015, implying a rise of more than 4.2 percentage points in the
Global Insight model's average effective federal personal
income tax rate by the end of 2015.
the Economic and Budgetary Effects of Financing Medicare's Unfunded
Liabilities with Higher Taxes
in payroll and personal income tax revenues were introduced
into the Global Insight model by:
the effective federal social insurance tax rate on wages and
salaries and the effective federal personal income tax rate on the
model's taxable personal income.
several of the model's labor supply variables to capture the
potentially negative effects of higher payroll and personal income
taxes on labor force participation and average weekly hours
Those adjustments were relatively minor.
For those 65 years old and older, a total wage elasticity between 0
and 0.3 was assumed.
This total wage elasticity includes a
participation elasticity falling between 0.1 and 0.2 and an
average-hours elasticity not exceeding 0.1. For those between
16 and 64 years old, a participation elasticity not exceeding 0.15
was assumed. The average number of hours worked was assumed to be
unresponsive to changes in tax policy. A weighted average of these
elasticities was used to determine the full-employment labor
force's responsiveness to changes in tax rates. The weights applied
equaled each age cohort's share of the total civilian labor
that the Federal Reserve Board follows historical behavior
patterns when reacting to a change in either payroll or personal
income tax rates. This
assumption was implemented in the Global Insight model using an
econometrically estimated reaction function that
determines the effective interest rate on federal
how sensitive the results are to using the new payroll tax revenues
to pay down debt versus to finance higher spending.
Global Insight model assumes that the federal government uses
every additional dollar of higher payroll tax revenues to reduce
debt. Increases in tax revenues negatively affect employment,
income, and personal consumption. However, in the Global
Insight model, reduced deficit spending pushes down interest rates
and the cost of capital, causing a "crowding-in" effect for
non-residential investment. The result is an increase in the
stock of non-residential capital and in the economy's
However, historically, payroll tax revenues
collected in excess of current benefits have not been used to
fund future benefits. Rather, they have been used to offset higher
spending elsewhere in the federal budget. In exchange for
those revenues, the HI trust fund, like the Social Security trust
fund, has been given special public-debt obligations.
has already begun to redeem those obligations and is expected to
continue to do so over the next 10 years as benefits increasingly
outstrip income from payroll tax and other revenues. Thus,
future Congresses will be forced to borrow, cut spending elsewhere
in the budget, raise taxes, or enact some combination of those
policies to finance the benefits promised to today's
financing situation confronting Medicare's SMI is similar. SMI is
composed of two separate trust fund accounts: one for Part B and
one for Part D. Both accounts largely finance current benefit
payments with premium income from beneficiaries and general
revenue transfers from the Treasury. In any given year, premiums
finance 25 percent of SMI's Part B benefits, and general revenue
transfers finance the remaining 75 percent. Part D funding is
expected to follow a similar formula beginning in 2006.
simulations were run to test the sensitivity of the results to
assumptions about how the government uses higher payroll tax
revenues. Both simulations assumed a permanent and immediate
increase in payroll tax rates to fund general revenue transfers to
the HI trust fund and the SMI trust fund through 2079.
first simulation assumed that the government used new payroll
tax revenues to pay down debt. The result was a drop in privately
held debt as a share of GDP. The second assumed that the
government used new payroll tax revenues to offset increases
in other spending. The higher spending was matched by an offsetting
increase in the model's variable for federal debt held by other
government agencies, an approximation here for the special
public-debt obligations currently held in the HI trust
government spending was introduced into the Global Insight model
using a variable denoting the difference between national income
and product account federal outlays and unified budget
federal outlays. The government spending represented by that
variable has no short-run stimulative effects in the model. All
other mandatory and discretionary federal spending in the
model was kept at baseline levels.
The Effects of Raising Taxes to Fund Medicare's Unfunded