The Coming Crisis for Medicare

The trustees of the nation's Medicare trust funds have just released their 2007 annual report, and once again the news is grave. As the result of health care costs increasing at a much greater rate than wages, the hospital insurance trust fund is projected to be exhausted by 2019. Indeed, Medicare is in far worse shape than the Social Security trust funds, which are also ailing but are not projected to run dry until 2041.

The one glimmer of hope in this bleak picture is that a "Medicare funding warning" has been triggered for the first time by the numbers in the trustees' report. This action will finally force Washington to address Medicare seriously -- to figure out how to fix a system that threatens to bring our economy to its knees not many years from now.

Medicare's main source of money is supposed to be the dedicated revenues generated by premiums and payroll taxes. But because of the rapid growth of Medicare expenditures, program costs financed by general revenues are projected to exceed 45 percent in 2013.

Under the 2003 Medicare reform law, whenever a forecast says that the 45-percent threshold will be crossed within the next seven years, the trustees are to issue a determination of "excess general revenue Medicare funding." That determination has now been made in two consecutive years, so a "Medicare funding warning" has now been declared.

The warning requires President Bush to propose legislation that responds to the alert within 15 days of the release of the fiscal year 2009 budget -- in other words, in early February 2008. The law then requires Congress to consider the president's proposals on an expedited basis.

No one can predict the outcome of this exercise. But it will at least focus lawmakers' attention -- and the public's -- on an incontrovertible fact: Medicare is not just undercapitalized; it's a severely flawed system. Revenues and spending are inherently mismatched. Medicare is largely funded through a payroll tax of 2.9 percent and through premiums from Supplementary Medical Insurance, or SMI . Payroll revenues are tied to the rate of business growth and have proved insufficient and undependable. Supplementary Medical Insurance premiums were never intended to provide enough money for the SMI benefit, and they only cover 12 percent of total Medicare costs.

Exacerbating the problem is the fact that over the past 40 years, medical costs have outstripped economic growth by 3 percentage points annually. Dramatic advances in medical technology and patient treatment have been a chief driver of this trend; while the benefits of these advances are obvious, the price tag is huge.

With this crisis looming, why have no serious efforts been made to treat the root of the Medicare problem? For one thing, there are few, if any, incentives to prudently control the cost of medical treatment. It is well documented that retirees will undertake treatment as long as the value of that care is more than the co payment for which they are responsible. As for providers of medical care, such as doctors, nurses, and hospitals, any desire to restrain costs through cheaper treatment alternatives is often overridden by self-interest or the perception that more expensive treatments are in order.

Finally, politicians have virtually no short-term incentives to tackle the Medicare problem. The reason is clear: any change that leaves the elderly worse off than before will lead to swift condemnation and ballot box reprisals by a large and vocal segment of the population. Meanwhile, pressure from much younger workers who fund Medicare is nearly non-existent.

However, more encouraging signs may come from individual states' experiments with healthcare, particularly those of Massachusetts and California . If a state can build a comprehensive medical care solution, it can provide guidance and even encouragement for a national approach.

Given the magnitude of the problem, there is unlikely to be a silver bullet. To bring costs and benefits closer together, policies need to target the inequities caused by incentives that tend to increase costs at an alarming rate.

Even this may be insufficient. Increases in taxes, cuts in benefits, and possibly means-testing of beneficiaries may be needed. Implicit in such policy change is the realization that all stakeholders -- not just the young -- need to bear the burden of making Medicare sustainable. It may be tough medicine to swallow, but we can't keep blindly passing Medicare's costs on to future generations.

Thomas J. Healey, a retired partner of Goldman Sachs, is a senior fellow at the Kennedy School of Government.