The New Medicare Drug Entitlement’s...

The Medicare debate has focused almost exclusively on what for of drug benefit to provide to senior citizens. Lost in the debate is what the huge new unfunded liability implicit in the drug legislation would mean to American taxpayers. There are no free lunches, and future taxpayers will have to pick up the commitment to senior citizens.

To appreciate what this means, Americans should consider the fact that the unfunded portions of the Medicare drug bills currently being considered by Congress would:

  • Cost taxpayer a total or $2 trillion through 2030 alone, with escalating costs thereafter. (All dollar amounts are adjusted for inflation and expressed in 2003 dollars.)
  • Mean that a 40-year-old head of household in 2003 could expect his or her family to pay $16,127 in extra taxes until retirement to pay for other people’s drug benefit before paying for his or her own drug coverage. This is on top of taxes already needed to pay for existing unfunded Medicare obligations, as well as taxes for the Social Security shortfall.
  • Mean that a baby born today would inherit at age 27 an extra tax burden averaging $1,125 per household in 2030. That annual cost would increase every year, and it would be in addition to Medicare payroll taxes and any taxes needed to cover the projected shortfalls in Social Security and the current Medicare program.
  • By 2030, cost the average household $3,980 per year in higher taxes when combined with Medicare’s current $5 trillion projected shortfall through 2030. (The Medicare shortfall is defined as the portion of Medicare spending not covered by payroll taxes and premiums, which must eventually be covered by raising taxes and/or premiums.)

The Budgets of mandatory programs, such as Medicare, are classified as “uncontrollable” because the government cannot directly control how much is spent. Lawmakers merely set eligibility requirements and benefit levels, and the program’s cost is determined by how many eligible individuals enroll in the program. Reducing program spending requires that Congress rewrite the eligibility and benefit levels.

Popular mandatory programs typically experience increased enrollment. This in turn creates pressure for Congress to expand eligibility to a wider constituency and increase benefit levels. With no brakes, costs soar, forcing Congress either to raise taxes or to reduce benefits.

The uncontrollable, unknowable costs of mandatory programs explain how Medicare could be created in 1965 based on a projected annual cost of %10 billion and end up costing $244 billion by 2003. Medicare spending is on pace to double in the next decade, and that growth rate will accelerate when the baby boomers begin retiring. With the payroll tax insufficient to fund Medicare’s costs, the program will run a $5 trillion deficit through 2030.

Adding an expensive new drug benefit will substantially worsen Medicare’s already shaky finances. Estimating the long0term cost of a drug benefit is difficult, but it would be irresponsible for Congress to create this benefit without attempting to calculate its long-term costs and producing a credible plan to pay for it.

The 10-year cost estimates performed by the Congressional Budget Office (CBO) do not capture the substantial cost that will likely be felt by taxpayers in 15, 20, and 30 years. This paper estimates the costs.

The Total Shortfall
Like the CBO, the authors estimate that the current Medicare drug bills would cost approximately $328 billion over the next 10 years ($400 billion without adjusting for inflation). Yet costs accelerate substantially beyond the 10-year budgeting window. In the following 10 years, from 2014 through 2023, the drug benefit is projected to cost $772 billion. That rapid growth rate continues through 2030.

The Medicare drug benefit is projected to face a shortfall of:

  • $42 billion in 2010,

  • $83 billion in 2020

  • $148 billion in 2030.

Adding in the projected shortfall of the current Medicare program, the combined shortfall is:

  • $132 billion in 2010,

  • $276 billion in 2020, and

  • 525 billion in 2030.

For 2003 through 2030, the current Medicare program faces a total shortfall of $5 trillion. The drug benefit would add appropriately $2 trillion to this amount.

What the Shortfall Means for Taxpayers
When the baby-boom generation enters Medicare and causes it to plunge deeper into the red, Congress will likely use deficit spending to fund the shortfall. Deficits, however, must eventually be repaid through either taxes or fees. Lawmakers will likely resist massive increases in Medicare premiums, leaving the taxpayers to cover the $5 trillion Medicare shortfall as well as the $2 trillion shortfall created by a drug benefit. The effects of the combined shortfall on two typical households are detailed below.

Example 1: A married couple, both 40 years old.
This couple already pays the 15.3 percent payroll tax to fund current Medicare (and Social Security) beneficiaries. Because the payroll tax will not provide enough revenue to fund Medicare for all retirees, this couple also faces $39,894 in additional taxes between now and their own retirement in 2030.

The proposed Medicare drug benefit will add $16,127 to that tax burden, but none of these taxes – neither the payroll tax, the tax need to fund the current Medicare shortfall, nor the tax needed to fund a drug benefit shortfall – will be set aside for their own retirement. Every dollar will fund spending for current Medicare recipients.

Example 2: A couple with a baby born in 2003.
By age 27, the child has likely married, begun a career, and started a family – and inherited an overwhelming tax burden. In 2030, when the child is 27, the person’s household would pay $1,125 in taxes just to cover the unfunded drug benefits of seniors. This is in addition to the 15.3 percent payroll tax, plus the $2,855 in additional taxes needed to cover the shortfall in the current Medicare program. These taxes will increase rapidly over the next 40 years before this person’s own retirement.

To cover Medicare’s prescription drug shortfall, taxes must be raised by:

  • $371 per household in 2010,

  • $690 per household in 2020, and $1,125 per household in 2030.

How Such New Taxes Could Be Levied
Taxpayer funding of the Medicare drug benefit shortfall would require raising individual income taxes by approximately 5 percent through 2030. Raising that amount of income could be done in one of the following ways or some combination of them:

  • Raising the current 25, 28, 33, and 35 percent income tax brackets by 2 or 3 percentage points each;

  • Eliminating most of the home mortgage interest tax deduction;

  • Repealing the earned income tax credit; or

  • Repealing the child tax credit.

When combined with the shortfall in the current Medicare program, the necessary income tax increase is 18 percent through 2030. Examples of such tax increases include:

  • Repealing every tax cut enacted since 2001 – including marriage penalty relief, the expanded child tax credit, the expanded adoption tax credit, and the reduced 10 percent tax bracket for lower-income families – and imposing additional taxes elsewhere;

  • Raising the current 25, 28, 33, and 35 percent income tax brackets by 7 to 9 percentage points each; or

  • Repealing the tax exclusion that exempts employees from paying taxes on the value of their health insurance.

Two thirds of these tax increases would fund the current Medicare shortfall, and one-third would fund the new drug benefit.

What Congress Should Do To Avoid This New Tax
Most seniors already have private drug coverage. Thus, targeted help to those who need it would make much more sense than a large new unfunded drug benefit for all seniors. Moreover, the absence of drug coverage in today’s Medicare program is the result of deficiencies in the way Medicare benefits are modernized over time.

Currently, revising key benefits takes an act of Congress. It would be much more sensible to enact reforms that allow revised benefits, such as drug coverage, to be introduced into Medicare gradually over time, paid for with changes in other less valuable benefits, and done so in a way that reflects the preferences of seniors. The best model for this is Congress’s own health plan, the Federal Employees Health Benefits Program (FEHBP). In the FEHBO, marked competition and consumer choice leads to plans that reflect enrollee needs.

Congress should address the needs of some seniors for drug coverage in a way that preserves two critical principles:

1. A Medicare drug bill should impose no new unfunded liabilities on future generations.
2. Medicare should be revamped to resemble the FEHBP so that drug benefits and other features can become common and cost-effective features of plans driven by consumer choice and competition.

President George W. Bush and many in Congress cite tax relief as the centerpiece of their economic agenda. Lawmakers who vote for the Medicare drug benefit are voting for a $2 trillion tax increase. Responsible lawmakers who oppose such substantial tax increases should look beyond the 2004 election and examine the burden that a Medicare drug burden will impose on future generations.

Brain M. Riedl is Grover M Hermann Fellow in Federal Budgetary Affairs in the Thomas A Roe Institute for Economic Policy Studies, and William W. Beach is Director of the Center for Data Analysis, at the Heritage Foundation.

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