[Economic Report of the President (1997)]
[Administration of William J. Clinton]
[Online through the Government Printing Office, www.gpo.gov]

[DOCID: f:erp_c3._]
Economic Report of the President - - - - - - - - - - - - H. Doc. 105-002
[From the online service of the U.S. Government Printing Office]
[wais.access.gpo.gov]


CHAPTER 3--Economic Challenges of an Aging Population

IN 1993 THE ADMINISTRATION'S first job was to get the economy
moving. The deficit reduction package enacted that year helped to reduce
interest rates and restore business confidence. Since then the Federal
deficit has been cut by more than half, and the economy has expanded
robustly. The next task is to complete the work of deficit reduction. In
1995 and 1996 the Administration and the Congress both put forward plans
to balance the Federal budget, but could not reach agreement at that
time. The Administration is now submitting another proposal to balance
the budget while protecting important national priorities. Legislation
should be enacted this year to accomplish this goal.
Balancing the budget in the medium term, however, is not the end of
the story. The United States faces two important economic challenges now
and after the turn of the century. First, without changes in current
policy, as the baby-boom generation retires, entitlement spending,
particularly for health care, will rise rapidly and budget deficits will
increase. Second, the Nation needs to raise its overall rate of saving
to improve long-term economic growth. These two issues are closely
related. The President believes that action on these issues can come
about only from a carefully considered, bipartisan process. This chapter
discusses these challenges.

THE AGING OF THE POPULATION

The proportion of the elderly in the U.S. population will rise
sharply in coming decades. This aging of the population is the
inevitable result of a long-term decline in fertility rates and an
enormous improvement in life expectancy.
Over two centuries, the fertility rate--the number of children that
an average woman will bear over her lifetime--has declined fairly
persistently, from 7.0 in 1800, to 3.6 in 1900, to roughly 2.0 today
(Chart 3-1). The post-World War II baby boom and the immediately
preceding baby bust, associated with the Great Depression and World War
II, were temporary aberrations in a long-run trend of declining
fertility. As the baby boom ended, the fertility rate resumed its
decline, reaching a low point of 1.7 in 1976 before rebounding to
roughly 2.0 in recent years.


The sequence of baby bust and baby boom thus has no impact on the
elderly dependency ratio (the ratio of elderly Americans to those of
working age) projected for 2070 and beyond; it does, however, alter the
path to that ultimate ratio, and this has important implications for the
medium term. The baby bust will produce a relatively constant ratio of
retirees to workers over the next 15 years, as the small cohort born in
the 1930s and 1940s reaches retirement, but the baby boom will produce a
rapid swelling of the ranks of retirees after about 2010, as the large
cohort born in the period from 1946 through 1964 retires.
Gains in life expectancy have been just as dramatic as the decline
in fertility but have shown less fluctuation over time. In 1935, when
Social Security was enacted and the retirement age was set at 65, life
expectancy at 65 was about 12 years for men and 13 years for women
(Chart 3-2). Today those figures are 15 years and 19 years,
respectively, and by 2070 they are projected to be 18 and 22. The
probability that a young adult just entering the workforce will survive
to collect benefits has also risen dramatically. In the mid-1930s the
probability of a 20-year-old man surviving to age 65 was only 58
percent, and that for a woman 66 percent. By the mid-1990s these
fractions had increased to 77 percent and 87 percent, respectively, and
by 2070 they are projected to rise to 86 percent and 92 percent.


Declining fertility and mortality together produce a permanent
increase in the elderly dependency ratio (Chart 3-3). Most of the
increase in this ratio occurs by the time the last of the baby-boomers
retires around 2030; the ratio drifts only slightly higher thereafter.

THE IMPACT OF DEMOGRAPHICS ON NATIONAL SAVING

Demographics can affect future national saving through effects on
personal saving and on public saving. The first effect is captured in
the simple life-cycle model. In this model younger people are expected
to save some of their income in anticipation of retirement, and older
people are expected to dissave--that is, to spend more than their
income. According to this theory, the shift in the elderly dependency
ratio should produce a dramatic increase in dissavers relative to
savers, substantially reducing national saving. Even if the elderly do
not dissave but only save at a lower rate than the


working-age population, these demographics would be expected to affect
national saving.
Given the already low U.S. saving rate, this prediction of the life-
cycle model is a source of concern. The evidence, however, suggests that
demographics may not be as important a determinant of saving patterns as
the theory suggests. For example, several studies of individual behavior
have been unable to document dissaving among the elderly. And during the
1980s the aggregate saving rate was quite low, even though the life-
cycle model says that it should have risen because the increase in the
proportion of the population in its prime saving years swamped the
increase in the proportion that was old. Some simulations predicted that
the personal saving rate should have been as high as 12.8 percent in the
1980s; instead it averaged 4.3 percent. Economists have been at a loss
to explain much of the behavior of personal saving during the 1980s. (In
fact, it is difficult enough to explain variation among households at a
given point in time. One study using a variety of variables and models
was able to explain only 7 percent of the total variation in the level
of saving among households reported in the Federal Reserve's Survey of
Consumer Finances.)
However uncertain the impact of demographics on private saving, its
likely impact on public saving--unless significant changes are made in
programs for the elderly--is clear. Growing deficits in the Social
Security program and the increasing costs of Medicare and Medicaid will
tend to raise Federal outlays--that is, they will reduce government
saving for any given level of revenue. Some economists have argued that
lower government saving might cause an offsetting rise in private
saving, as individuals anticipate an eventual rise in taxes due to the
government's chronic failure to save. However, evidence for such a large
offset is lacking. Thus, the most likely effect of demographically
driven expenditure increases would be a net reduction in national
saving.

THE IMPACT OF DEMOGRAPHICS ON THE BUDGET

Without changes in policy, the costs of government programs that
provide the elderly with retirement income and insure their health and
nursing home care will rise rapidly as the number of elderly increases.
In addition, social insurance taxes and contributions are likely to be
pinched somewhat, because the number of people working--and paying
taxes--will be growing more slowly.
The largest increases in programs benefiting the elderly are
projected to be for Medicare and Medicaid. The Trustees of the Medicare
program project spending to increase from 2.7 percent of gross domestic
product (GDP) in 1996 to 8.1 percent in 2050. The Office of Management
and Budget projects that under current policy Federal Medicaid outlays
will rise from 1.2 percent of GDP to 4.9 percent over the same period.
And the Social Security Trustees estimate that spending will grow from
4.7 percent of GDP to 6.3 percent between 1996 and 2050. This is a
smaller increase, both absolutely and relative to current levels, than
that projected for the health programs. Nevertheless, in combination,
these forecasts suggest a more than doubling of expenditures on these
key programs, from under 9 percent of GDP to roughly 19 percent in 2050
(Chart 3-4). By 2070 expenditures for the three programs are expected to
reach 22 percent of GDP.
By contrast, Federal revenues have historically been around 18
percent of GDP. Hence, absent any changes, expenditures on Social
Security, Medicare, and Medicaid could consume all government revenues
by 2050 and exceed them thereafter.
The effect of these rising expenditures on the unified Federal
deficit--the broadest measure of the deficit, which includes these
programs and all other revenues and spending--is even more powerful than
these numbers suggest: deficits in the early years must be funded with
borrowing, and the interest on that borrowing will require even larger
outlays in later years. Most long-term budget projections based on
current policy show the deficit mounting to around 20 percent of GDP by
2050, while the debt held by the public reaches a level somewhere
between two and three times GDP.


In fact, no one believes that the economy could withstand such large
deficits and increases in debt, with their adverse effects on interest
rates and growth. Something will be done before the deficits and debt
reach these levels. The only questions are what will be done, and when.
Delay has two consequences. First, as already noted, borrowing to cover
shortfalls in the near term boosts later deficits as interest charges
accumulate. Second, any reform that is adequate to the problem will need
to be phased in gradually, to allow citizens time to adjust their
personal financing plans accordingly. Thus, the most useful exercise is
to examine the financial situation of each individual program separately
and explore the various approaches to restoring balance.

SOCIAL SECURITY

Of the several financing problems to be solved, that of Social
Security is the most tractable. Without changing current law in any way,
Social Security can pay full benefits well into the next century.
Thereafter, without any changes in the structure of the program, funding
will be sufficient to cover about 70 percent of benefits even 75 years
from now. Nevertheless, the program faces a funding gap over the 75-year
projection period and permanent imbalance after 75 years. The challenge
is to restore balance to the program, raise national saving, and allow
Social Security to continue to fulfill its many missions.
For almost 60 years, Social Security has provided elderly Americans
with a basic level of retirement security. Currently, about 90 percent
of ``aged units''--married couples one of whom is aged 65 or older, and
nonmarried persons aged 65 and over--get Social Security benefits. These
benefits are the only form of retirement pension for about half of these
households. Social Security is particularly important for the low-income
elderly. For example, more than three-quarters of the money income
(which includes earnings from work and interest, as well as retirement
benefits) of households in the bottom two income quintiles comes from
Social Security benefits. The comparable shares are about a quarter for
the highest income quintile and about half for the second-highest.
Social Security benefits keep some 15 million people above the
poverty line and millions more from near poverty. As recently as 1959,
when these data began to be collected, the poverty rate among the
elderly was more than twice that for the rest of the adult population.
Since then this rate has trended lower and is now slightly below that
for other adults. Social Security has been a key factor behind this
drop. Moreover, although the benefit schedule is progressive and some
benefits are subject to partial taxation, Social Security benefits are
not subject to an explicit means test. The lack of means testing allows
many people to add other resources to their Social Security benefits and
achieve a level of income not too far below that when they were working.
Social Security also provides protection against loss of family
income due to disability or death. Roughly 5 million disabled adults and
3 million children receive monthly benefits; about half the children
receiving benefits have lost one or both parents. In short, Social
Security is an extremely valuable program that has raised the living
standards of millions of Americans and markedly increased their sense of
economic security by providing fully indexed annuities in the event of
retirement, disability, or death of a breadwinner.

THE SIZE OF THE PROBLEM

In their annual report, the Trustees of the Social Security system
publish projections of the system's revenues and outlays for the next 75
years. Three sets of projections are made, corresponding to three sets
of assumptions about future levels of system costs. The intermediate
cost projections in the 1996 report show that, from now through 2011,
the Social Security system will bring in more money than it pays out.
That is, payroll tax receipts plus receipts from income taxation of
Social Security benefits will exceed outlays.
By that time the baby-boomers will have begun to retire, and growth
in the labor force will slow, reflecting the decline in the fertility
rate that occurred after 1960. The resulting increase in the ratio of
retirees to workers will cause the outlays of the system to rise above
taxes. In the relatively short period from 2012 through 2018, the annual
interest income on assets in the Social Security trust funds will,
together with tax receipts, produce enough revenues to cover benefit
payments. After that, if no action is taken, total income will fall
short of benefit payments, but the shortfall can be covered by drawing
down trust fund assets until the funds are exhausted in 2029. Of course,
the exhaustion of the trust funds does not mean the end of Social
Security benefits. Even if no changes are made on the tax or the benefit
side of the equation, payroll and benefit taxation at current rates will
provide enough money to cover 75 percent of promised benefits in 2040
and nearly 70 percent in 2070.
The financing of Social Security is projected to put increasing
pressure on the Federal budget before the trust fund balances are
exhausted, however. In the near term, Social Security reduces the annual
unified budget deficit. The amount of that reduction and the number of
years it encompasses depend on the budgetary treatment of interest
payments from the Treasury to the Social Security trust funds. For
example, Social Security income, excluding interest, exceeded Social
Security outlays by $30 billion in fiscal year 1996. Thus, the effect of
Social Security's current operations was to lower the deficit by $30
billion. This operating surplus remains at about that level for about a
decade, then drops sharply. As noted earlier, by 2012 Social Security
outlays exceed taxes. However, in 1996 the Treasury also paid more than
$36 billion in interest to the Social Security trust funds, and this
interest can be viewed as payments that the Treasury would have had to
make to the public were it not for past Social Security surpluses. If
they are included in the calculation, one can say that the current and
past operations of the Social Security system shaved $66 billion from
the unified budget deficit in fiscal year 1996. By this measure, the
deficit-reducing effect of Social Security is projected to rise to more
than $100 billion in less than a decade, remain above that level for
more than 10 years, and then drop rapidly. Regardless of the treatment
of intragovernmental transfers, by 2019 outgo exceeds income. Between
2019 and 2029, the subsequent shortfalls can be met by drawing down the
investments in the trust funds, but this puts pressure on the unified
deficit. This pressure gets progressively worse over time. Using the
broader measure of Social Security's contribution to the unified
deficit, Social Security currently reduces the deficit by nearly 1
percent of GDP, but by the time the trust funds are exhausted in 2029 it
will boost the deficit by nearly 1.5 percent of GDP.
When the Social Security surpluses in the early years are combined
with the deficits in the later years, projected income falls short of
projected benefit payments over the 75-year forecast period as a whole.
Projecting the size of this shortfall over such a long horizon is very
difficult. One measure provided by the Social Security Trustees, based
on their intermediate assumptions, is that the 75-year deficit amounts
to 2.19 percent of taxable payroll over that period. One way to think
about a deficit of this magnitude is in terms of the hypothetical tax
increase that would be required to eliminate it. That is, if the gap
over the next 75 years were to be financed solely by raising taxes,
today's combined employee-employer tax rate of 12.4 percent would have
to be raised to 14.6 percent right away. No one proposes to meet the
deficit in this way, but it provides a way to think about the solvency
problem.
Social Security's long-term financing problem is somewhat more
complicated than just described. Under current law the tax rate is fixed
while costs as a percentage of payroll are rising, and this pattern
produces surpluses now and large deficits in the future. As a result of
this profile, each passing year adds another year with a large projected
deficit to the 75-year projection period. Assuming nothing else changes,
this phenomenon increases the projected 75-year deficit slightly (by
0.08 percent of taxable payroll with today's projected deficits) each
year.

How Reliable Are the Projections?

Projecting costs for the next 75 years is necessarily an uncertain
exercise. Imagine actuaries and economists in the Harding Administration
trying to project fertility rates, life expectancies, wages, and so on
from 1922 until the present. They would have had no idea about the
coming Great Depression, World War II, or a host of other demographic,
economic, and social developments. Nevertheless, such long-range
planning is a useful exercise. Precisely because Social Security is such
a long-run program, major demographic trends are important factors in
its solvency. Short-run fluctuations in, say, fertility or mortality
rates will not fundamentally alter the long-run financial picture. The
usefulness of the exercise depends crucially, however, on the
reasonableness of the underlying assumptions and on the ability to
modify them as new information becomes available. The actuaries'
calculations involve numerous variables, but two demographic assumptions
and one economic relationship are key.
On the demographic side the primary issues are fertility and
mortality; fluctuations in immigration and emigration are expected to
have only modest effects. Fertility tells us how many people will be in
the labor force paying taxes, and mortality how many people will be
receiving benefits and for how long. As already noted, the total
fertility rate is currently about 2.0 children over a woman's lifetime.
Demographers generally believe that U.S. fertility rates, like those in
most other industrialized nations, will remain low. The intermediate
estimates in the 1996 Trustees' report are based on the assumption that
the total fertility rate in the next 75 years will be 1.9 children per
woman, slightly below its recent level. The consensus is that mortality
will continue to decrease; the question is how fast. For the 75-year
projection, life expectancy at 65 is projected to reach 18.4 years for
men by 2070 and 22.2 years for women.
On the economic side the important variables relate to changes in
wages and prices. The system operates more or less on a pay-as-you-go
basis, whereby taxes currently received from workers are used to pay
old-age, survivors, and disability insurance (OASDI) benefits to current
beneficiaries. In 1997, workers and their employers each pay taxes of
6.2 percent on the first $65,400 of earnings. Benefits are calculated by
applying a progressive benefit formula to an average of the
beneficiary's historical earnings, which have been indexed to reflect
overall increases in average wages. After benefits are awarded, they are
adjusted annually to keep up with inflation. In this type of pay-as-you-
go system, a key relationship is the difference between the rate at
which tax revenues rise (which, assuming no change in tax rates, is
equivalent to growth in covered wages) and the rate at which benefits
increase after retirement or disability (that is, the rate of increase
in the consumer price index, or CPI). This difference is called the
real-wage differential.
The assumption about the size of the real-wage differential is often
viewed as the most controversial in Social Security forecasting, as the
actual value has varied dramatically over time. During the 20-year
period before 1973, when productivity growth was high, the real-wage
differential averaged 2.2 percentage points. From 1973 to the present,
however, it has averaged 0.3 percentage point. The question is how much
weight to put on recent years as compared with the pre-1973 period. The
Trustees have roughly split the difference and adopted a long-run
assumption of 1.0 percentage point. What if they are wrong? By how much
would a real-wage differential of 0.6 percentage point (the average for
the 1980s and 1990s), rather than the assumed 1.0 percentage point,
raise the 75-year deficit? Sensitivity analysis shows that such a
miscalculation would increase the 75-year deficit by roughly 0.5 percent
of taxable payroll. In other words, a relatively large error in this
assumption, taken in isolation, would worsen long-term Social Security
financing by a relatively modest amount during the next 75 years.
Of course, if a large number of assumptions all turn out optimistic,
or all pessimistic, their cumulative effect could be quite large. The
Trustees' reports show the results for two extreme cases: a ``high-
cost'' alternative in which all of the main assumptions take pessimistic
values, and a ``low-cost'' projection that assumes optimistic values.
According to the 1996 report, under the high-cost alternative, the 75-
year balance is in deficit by 5.67 percent of taxable payroll, more than
twice the 2.19 percent deficit under the intermediate assumptions. In
contrast, the balance under the low-cost assumptions is a small surplus
of 0.46 percent of taxable payroll.
These two projections give a sense of the level of uncertainty about
the long-term projections. Nonetheless, a 1994-95 Technical Panel to the
Quadrennial Advisory Council on Social Security evaluated each
individual assumption and concluded that, ``The `intermediate'
projection . . . for the OASDI program provide[s] a reasonable
evaluation of the financial status. Although the Panel suggests that
modifications be considered in various specific assumptions, the overall
effect of those suggestions would not significantly change the financial
status evaluation.''
In 1983 the Congress enacted legislation based on the
recommendations of the National Commission on Social Security Reform.
The Commission's reforms were intended to keep the Social Security
system solvent for 75 years, with positive trust fund balances through
2060. Only a year later, however, the Trustees began to project a small
deficit. The projected deficit has grown more or less steadily since
then, to its current level of 2.19 percent of taxable payroll. How did
this happen?
Three factors account for most of the projected increase in long-
range costs. The first one was discussed earlier. That is, as time
passes, the 75-year valuation period ends in a later year, so that more
of the higher cost outyears are included in the projections. Including
more deficit years raises the 75-year deficit. The second is that the
disability caseload grew much faster than anticipated, primarily because
of legislative, regulatory, and judicial action that made it easier for
individuals to qualify for disability benefits. The third source of the
post-1983 deficit reflects the net effect of one-shot changes in the
methodology used in the projections.
Changes in economic and demographic assumptions are not on balance
responsible for the reemergence of the deficit since 1983. Most of the
discussion of Social Security's financing problems is couched in terms
of the demographic shifts that will occur as the baby boom ages. Indeed,
the numbers are impressive: whereas today 3.3 workers support each
retiree, by 2040 that number drops to 2.0; it stabilizes around 1.8 in
2070. The problem with this story is that the projected decrease in the
ratio of workers to retirees, frequently cited as the cause of the
emerging deficit, is little changed from 1983. This decrease was fully
incorporated in the estimates at that time. Demographic developments
since 1983 have been, if anything, positive--at least from the program's
perspective. Life expectancy is lower and birth rates have been higher
than were assumed in 1983, thereby reducing long-range costs. The
positive impact on long-range costs from changing demographic
assumptions was roughly offset, however, by changing economic
assumptions. In particular, the Trustees gradually lowered the assumed
rate of real wage growth as it became clear that the slower trend in
productivity growth was likely to continue. On balance, the economic and
demographic changes have roughly offset one another.

RECOMMENDATIONS OF THE QUADRENNIAL ADVISORY COUNCIL

The Quadrennial Advisory Council on Social Security was charged in
1994 with finding ways to eliminate the current deficit in the OASDI
program. It released its report in January 1997 after more than 2 years
of deliberations. Instead of offering a single set of consensus
recommendations, this 13-person panel split and presented three very
different visions for the future of the Social Security system.
All three are designed to restore 75-year balance, stabilize the
trust funds in the 76th year, and address the decline in the rate of
return to Social Security contributions that has occurred as the system
has matured. It is important to remember that, although the Advisory
Council distilled these three specific sets of options, many
alternatives are possible. The report characterizes the three
alternatives as the ``Maintenance of Benefits,'' ``Individual
Accounts,'' and ``Personal Security Accounts'' proposals. The following
descriptions are summaries of the three proposals and should not be
viewed as endorsements of particular approaches.

The Maintenance of Benefits Proposal

The Maintenance of Benefits (MB) plan is designed to eliminate the
Social Security deficit without altering the basic nature of the
program. Roughly half the savings comes from long-discussed--but never
accepted--proposals. These include extending coverage to State and local
government employees hired after 1997 who under current law would not be
covered by Social Security; making Social Security benefits taxable to
the extent that they exceed worker contributions (this would make the
program comparable in that respect to other contributory defined-benefit
plans); lengthening the averaging period for the Social Security benefit
calculation from 35 years to 38 years; and incorporating technical
corrections in the CPI made by the Bureau of Labor Statistics in 1995
and 1996, which reduced the upward bias in measured inflation by about
0.2 percentage point per year. These proposals are expected to eliminate
about half of the 75-year deficit.
To reduce the rest of the financing gap MB proponents suggest three
new proposals. The first is to explore the possibility of investing 40
percent of trust fund assets in corporate equities on a graduated basis
beginning in 2000. The implications of such a change are discussed in
greater detail below. Second, the plan would redirect into the OASDI
fund the share of revenues from the taxation of Social Security benefits
that are currently paid into the Medicare hospital insurance trust fund,
phasing in the change between 2010 and 2019. Finally, to correct the
tendency of the fund to drift out of balance, this plan would, if
necessary, increase the payroll tax by 0.8 percentage point each on
employers and employees starting in 2045.

The Individual Accounts Proposal

The Individual Accounts (IA) plan has two components: it would make
certain changes to balance the existing program, and it would create a
system of supplementary required savings accounts for all participants.
The first part of the plan begins with three proposals that are also in
the MB plan: coverage of newly hired State and local government
employees, taxation of benefits that exceed contributions, and
incorporation of the CPI changes. In addition, the IA plan would raise
the normal retirement age to 67 faster than under current law and index
it to longevity thereafter. Finally, benefits for middle- and upper-
income recipients would be cut by roughly 20 percent to allow the
current 12.4 percent payroll tax rate to cover the program's 75-year
cost.
The mandatory savings portion of the IA plan would increase the
employee's payroll contribution by 1.6 percentage points to fund
government-administered individual accounts, beginning in 1998.
Proponents of the IA proposal recommend that the funds in these accounts
be allocated by workers to a relatively small number of government-
managed index funds, which would provide a variety of investment
alternatives at low cost. At retirement, the savings would be paid out
as an annuity, with payouts adjusted for inflation, and added to the
regular Social Security benefit. Total retirement benefits would thus
depend on the returns achieved by the savings accounts.
Supporters of the IA plan argue that it would directly boost funding
for retirement (although they acknowledge that individuals might reduce
their non-Social Security saving to some extent). In terms of national
saving, they view it as superior to increased funding through the Social
Security trust funds because they fear that annual surpluses in the
trust funds would simply be used to cover deficits in the non-Social
Security part of the budget. They also believe that adding an individual
account component is a way to introduce equity investments without
raising all the issues associated with direct investment of Social
Security in stocks, as suggested in the MB plan. It should be noted that
under the proposal the accounts would be held by the government, and the
government would constrain the range of investment alternatives in the
individual accounts.

The Personal Security Account Proposal

The Personal Security Account (PSA) plan calls for a more extensive
change in the structure of the system, phased in over a period of time.
It would divert 5 percentage points of the 12.4 percent payroll tax into
mandatory ``personal security accounts.'' Unlike the individual savings
accounts described above, which would be held by the government and
annuitized upon retirement, these accounts could be placed with private
investment companies, and individuals would have broader choice over how
the savings are paid out during retirement. The remaining 7.4 percentage
points of the payroll tax would pay for a flat retirement benefit for
full-career workers equivalent to $410 a month in 1996 (and indexed for
future wage growth beginning in 1998) and for reduced disability and
survivor benefits. The $410 flat benefit by itself would provide an
income about one-third below the poverty line for an elderly person
living alone; the proceeds of the personal accounts would supplement the
flat benefit.
The plan also would reduce the financing gap through many of the
same features as the MB and IA proposals: it would expand coverage to
newly hired State and local government workers, alter the taxation of
benefits, speed up the increase in retirement age and index it to
longevity (as in the IA proposal), and incorporate adjustments made to
the CPI.
Social Security has, for the most part, operated on a pay-as-you-go
basis, with benefits coming from workers' current contributions rather
than from accumulated trust fund savings. Therefore moving to personal
accounts to the extent provided for in the PSA plan would require the
handling of substantial transition costs. Today's younger workers not
only would have to support those already retired or nearing retirement,
but would also have to contribute to a savings account for themselves.
The PSA plan spreads these costs over 72 years, paying for them with a
tax equal to 1.52 percent of payroll during this period. Because a level
tax rate is used to finance the transition, the plan is underfunded in
the early years and overfunded in the later years. This smoothing of the
transition costs requires that the trust funds borrow roughly $2
trillion in 1995 dollars from the Treasury between now and 2035,
repaying this debt with the proceeds of the 1.52 percent tax thereafter.
Supporters of the PSA proposal claim three main advantages over the
others. First, their proposal would lead to greater national saving and
investment by fully funding in advance a major component of the Social
Security system. Second, it would avoid the potential for politicizing
the investment decisions that they believe could arise with direct trust
fund investment in equities. Third, they believe that private accounts
would increase confidence in the system.

ISSUES FOR FURTHER STUDY

The Advisory Council's three proposals differ on a variety of
dimensions and raise a host of issues that need to be considered. These
issues include:
 the social insurance that Social Security provides in
addition to retirement benefits
 the issue of defined benefits versus defined contributions
 the effect of Social Security on national saving
 the desirability of further changes in the normal
retirement age
 the rate of return on Social Security contributions (the
``money's worth'' issue), especially for younger workers
 the risks and benefits of investing a part of the Social
Security trust funds in equities
 the relative importance of other structural features of the
Social Security system, and
 other considerations.

Social Insurance

Social Security plays an important role not only in providing
retirement pensions but also in offering social insurance features that
are of great value to both individual households and the Nation. The
design of the reforms will determine the extent to which the system can
continue to provide progressive benefits and other social insurance
components.
At the beginning of our careers none of us know whether we will be
financially successful or will have to struggle to make ends meet, or
whether we will die early and leave behind a family, or become disabled,
or live long into retirement. Social Security has an important
redistributive dimension, whereby those with low lifetime incomes
receive higher returns on their contributions than their higher paid
counterparts. Social Security was intended to free the elderly from
poverty, and in that it has made great progress (see Chapter 5). Social
Security also offers protections against other risks. For example, it
provides income for disabled workers and benefits to deceased workers'
families. Public attitudes toward maintaining these protections will
play an important role in evaluating the Advisory Council's proposals
and other options.

Defined Benefits Versus Defined Contributions

The current Social Security system is a defined-benefit plan,
whereby the insurer--in this case the government--guarantees a benefit
based on a prescribed formula. Under the MB proposal Social Security
would continue to be a defined-benefit plan, but under the IA plan, and
to an even larger degree under the PSA plan, a portion of Social
Security would become a defined-contribution plan. A defined-
contribution plan is one in which the insurer prescribes periodic
contributions, and the size of the benefit depends on the size of the
contributions and the returns they earn.
Proponents of a move toward a defined-contribution arrangement cite
several possible advantages. First, they assert individuals would be
more directly involved in the investment of their funds, which may allow
them to make investment choices that more closely match their
preferences for risk and other investment features. Second, they believe
that by creating a more direct link between contributions and benefits,
defined-contribution plans may alleviate some labor market distortions
of the current system. Finally, proponents argue that giving workers
ownership rights over their contributions reduces political uncertainty
surrounding the future level of benefits.
Critics of this approach claim that the primary result of a shift
toward defined-contribution plans would be to transfer risk from the
government to the individual. Payments under this system would depend on
the performance of the investments selected. Individuals might opt for
all low-yielding investments and end up with much less than anticipated,
or load up with high-risk assets and be forced to claim benefits at a
market low. In addition, critics claim that returns on contributions
would be hurt by relatively high administrative costs: the Advisory
Council estimates that administrative costs for PSAs would be about 1
percent of invested assets annually, as opposed to just 0.1 percent for
the IA plan accounts and less than 0.01 percent for the MB plan. Some
critics are also concerned that, if participants are not required to
annuitize their withdrawals, some might underestimate the amount of
money they need over their retirement years and use the funds for other
purposes. Private annuities should help alleviate this problem, but so
far the market is underdeveloped, in part because of adverse selection
problems (see Box 3-1 later in this chapter). Finally, one of the major
arguments cited in favor of defined-contribution plans in the private
sector is portability, but Social Security already follows workers from
employer to employer.

The Effect of Social Security on National Saving

When thinking about the impact of the Social Security system on
national saving, it is useful to consider three time periods: the
system's startup phase, the current mature system, and the future.
The Startup. The Congress enacted the Social Security legislation in
1935. Payroll taxes were first collected in 1937, and the first monthly
benefits were paid in 1940. In 1939 the Congress made a series of
decisions that slowed the buildup of reserves, and the system has
operated mostly on a pay-as-you-go basis since then.
This meant that the first generation of retirees received benefits
far in excess of their tax payments. According to the life-cycle model,
whereby individuals or households plan to consume all their income and
wealth over their expected lifetimes, such an increment to lifetime
income would increase consumption and reduce saving. That is, workers
would perceive that they have received a wage increase in the form of a
future annuity, and they would choose to consume part of that increase
in the present. To increase their current consumption, they would have
to either reduce saving or increase borrowing. Lower personal saving,
without any offsetting accumulation of reserves within the Social
Security system, would be expected to reduce national saving and leave
future generations with a lower capital stock than they otherwise would
have had.
A great many other things were happening in the economy at the same
time Social Security was introduced; therefore isolating the program's
effect on national saving is a daunting task. This might explain in part
why a thorough review of the literature shows no compelling evidence of
a sharp decline in saving in the wake of the introduction of Social
Security. On the other hand, several plausible explanations are possible
for the lack of any impact on saving. The first is that Social Security
may have changed retirement expectations at the same time that it
increased lifetime income. That is, before Social Security workers may
have expected to work until they died, but after Social Security was
enacted retirement at age 65 became the norm. To the extent that Social
Security encouraged people to retire earlier, they may have chosen to
save over a shorter working life for a longer retirement. This
retirement effect would have increased personal saving. Similarly,
before Social Security most elderly people lived with their children;
after Social Security they were in a position to maintain their own
households. The increased demand for independent living in old age could
also have increased saving. Finally, many individuals save little or
nothing at all, with or without Social Security. The only way they could
have increased current consumption in response to the program's
introduction would have been through borrowing. But these same
individuals are likely to have had low or moderate incomes; as such,
they may have been unable to borrow enough to achieve their ideal
distribution of consumption over time. For such individuals, the
introduction of Social Security would have left savings unaffected,
dampening the effect on aggregate saving.
The Mature Pay-As-You-Go System. The existence of a mature pay-as-
you-go Social Security system is one of many factors influencing the
national saving rate. The permanent effect of a pay-as-you-go system on
saving is determined primarily by its initial impact on saving and the
capital stock; that impact then tends to be perpetuated through time.
The permanent effect on the saving rate is thus likely to be small if
the initial effect was small; similarly, the permanent effect is likely
to be substantial if the initial effect was large. In addition, there is
no reason to believe that the effect--whatever its size--will be
exacerbated over time. Of course, it is still the case that a transition
from a pay-as-you-go to a funded system could be expected to lead to
some increase in the national saving rate and the capital stock.
The Future. Although the introduction of a pay-as-you-go Social
Security system may not have had a discernible effect on national saving
or the capital stock because of a variety of mitigating factors, moving
toward a funded system could increase saving. This increase would
reflect the lowered consumption of workers in the ``transition
generation,'' who pay the taxes to support benefits for the elderly
while also saving for their own retirement. Even though the resulting
increase in the saving rate is temporary, the higher capital stock is
permanent. Once the transition to a fully funded system is complete, the
saving rate is likely to drop back to near its level before the shift.
Prior to the question of whether particular changes in the Social
Security system will increase national saving, however, is a more basic
question: is this the best way to raise saving, or should it be done
through other means--for example, through reductions in the non-Social
Security budget deficit? Even if it is determined that changes to the
Social Security system are the best way to boost national saving, that
decision does not resolve the issue of how best to structure the
program. The effect on national saving results from shifting Social
Security further from a pay-as-you-go toward a funded system. This can
be done through the trust funds--net of any offsetting effect on the
non-Social Security portion of the Federal budget--or through individual
accounts.

Raising the Retirement Age

Under current law, the normal retirement age is scheduled to
increase in two steps from 65 to 67 years. It will rise gradually to age
66 for workers who attain age 62 in 2005, remain at age 66 for 11 years,
and then start rising again to 67 for workers who reach 62 in 2022. Two
of the Advisory Council's three proposals would raise the normal
retirement age to 67 more quickly than scheduled under current law and
then index it for increases in longevity thereafter.
The rationale for this change is that, since life expectancy has
increased, so should the length of the work life. As was noted earlier,
since Social Security was enacted in 1935, life expectancy at age 65 has
increased by 3 years for men and 6 years for women. Moreover, these life
expectancies are projected to rise by a further 3 years for both men and
women by 2070. Proponents of a more rapid rise and indexation of the
normal retirement age argue that a portion of these increases in
longevity should be matched by additional years in the workforce.
Increasing the retirement age would ease the pressure on Social Security
financing by offsetting some of the increase in the elderly dependency
ratio caused by the aging of the population.
Opponents of raising the retirement age offer two main arguments.
First, greater longevity has not so far been accompanied by an increase
in years worked; indeed, people are retiring earlier and earlier.
Therefore, we should wait to see how people accept the currently
scheduled increase to age 67. Second, opponents are concerned that
accelerating the change in the retirement age would hurt those who are
forced by poor health or lack of employment opportunities to retire
before 65. The law already provides for an actuarial reduction in
benefits of 20 percent for those who retire at age 62; this reduction
will rise gradually to 30 percent with the scheduled increase in the
normal retirement age to 67. Increasing the retirement age beyond 67
would reduce the age-62 benefit further still.
Two key issues emerge here. The first is empirical: how many people
who retire at age 62 would find it a serious hardship to extend their
work life? A preliminary analysis of early retirees shows them falling
into two groups. One consists of relatively prosperous individuals with
some wealth, who tend to be in good health. The other is made up of less
wealthy, less healthy individuals, some of whom have irregular
preretirement work histories. Raising the retirement age for the first
group creates few problems; raising it for the second may well produce
hardship. The second issue, therefore, is how to protect low-income
individuals with no work possibilities. Those who cannot work because of
physical disability might be eligible for disability insurance. Of
course, a shift of early retirees to the disability insurance program
would reduce the savings realized from the higher normal retirement age.
A variety of options are possible, but any proposal to increase the
retirement age should consider those unable to work the additional
years.

The Rate-of-Return Issue

All three of the Advisory Council's proposals rejected an increase
in current and future tax rates sufficient to establish long-term
balance. In part this alternative was rejected because it would increase
the costs of the program for current workers relative to the benefits
that they will receive. Current workers already face the prospect of
making greater Social Security contributions relative to their lifetime
earnings than was required of workers in the past without a fully
compensating increase in their benefits. The consequent decline in the
ratio of benefits to costs (commonly referred to as the ``money's
worth'' ratio) is primarily the consequence of the maturation of a pay-
as-you-go system. Workers retiring early in the program's history had
only a few years of wages subject to the Social Security payroll tax.
Over time, new retirees had more and more years of wages subject to
taxation, and the additional tax payments sharply reduced the rate of
return. The situation is actually somewhat more complicated in that
benefit levels were raised several times over the period. Analytically,
these increases in benefits can be seen as introducing new pay-as-you-go
programs on top of the old, temporarily boosting returns. But the
essence of the story is the maturation of a pay-as-you-go system.
In a mature pay-as-you-go system financed by a fixed tax rate on
wages, the rate of return on payroll tax contributions depends on the
rate of growth of aggregate real wages. Slower growth in aggregate real
wage income, owing to slower population and productivity growth, has
reduced the return that can be obtained from a mature pay-as-you-go
system. Looking forward, with a constant or slow-growing working-age
population, the rate of growth of aggregate wages will depend primarily
on the rate of growth of productivity.
To address the problem of declining rates of return, all three plans
at least consider allowing individuals to have some of their Social
Security contributions invested in equities. Proponents of the
Maintenance of Benefits approach suggest further study and evaluation of
having the Social Security trust funds invest directly in equities. In
the Individual Accounts proposal equity investments would be done
through newly created private accounts, and the assets would be held by
the government. In the Personal Security Account proposal individuals
could invest in equities through individually owned and privately
managed accounts. Because equities on average earn higher returns than
other financial assets, proposals that produce the largest equity
holdings yield the highest projected returns on Social Security
contributions. Investment in equities also raises concerns about risk,
as noted in the discussion of defined-benefit versus defined-
contribution plans above, and in the following section.

Investing the Trust Fund in Equities

Proponents of the MB proposal suggest giving serious consideration
to investing a share of the trust funds in equities. They argue that
such investments are necessary to increase the return on the funds,
which are currently invested entirely in Treasury securities. Both
private pension plans and many State and local systems invest a
substantial portion of their assets in stocks. The Advisory Council
estimates that investing 40 percent of the trust funds in equities could
raise the ultimate projected return on trust fund assets from 2.3
percent to 4.2 percent. Proponents note that, if the higher returns on
equities over long holding periods that have prevailed in the past
continue, the change in investment strategy would extend the life of the
trust funds, perhaps substantially.
Critics point out that investing a portion of the trust funds in
equities would increase risk as well. Eight times in the last 70 years,
a broad index of equity returns has declined by more than 10 percent
over 1 calendar year; on three occasions the drop over a year or two was
more than 35 percent. Such declines could cause anxiety among both
retirees and those nearing retirement, undermine public confidence in
the system, and possibly even lead to pressure to divest equities after
a substantial drop. Proponents respond to this concern by arguing that,
at least based on historical experience, the Social Security system is
in a good position to wait out fluctuations in market value,
particularly as the trust funds increase in size. Critics argue that the
past may not be prelude and just as the last 15 years have seen an
eightfold increase in the market, it is conceivable that the market
could experience a dramatic multiyear decline. (For example, a broad
index of Japanese stock prices fell more than 50 percent during the
1990-92 period.) Any proposal for equity investment must consider the
consequences when markets fall.
Another criticism of allowing the trust funds to invest in equities
is that such investments would primarily represent a reallocation of
assets between those held in the trust funds and those held--either
directly or indirectly--by households. It could improve the financial
position of the trust funds, because of equities' historically higher
average returns, but for a given level of saving it would not increase
the returns for the Nation as a whole. Investing a portion of the trust
funds in equities would raise the price and lower the return on
equities, and lower the price and raise the return on Treasury
securities. Higher Treasury yields would raise Federal interest costs
and, all else equal, the non-Social Security portion of the deficit. No
one can say with any certainty by how much interest rates on Treasuries
would rise, and therefore what would be the likely impact on the
deficit. (It should be noted that the MB plan incorporates other
measures that do increase national saving; as a result, the net effect
of that plan on the interest rates paid by the Treasury is ambiguous.)
The analysis is complicated because the initial effects on rates of
return could be moderated as corporations restructured their finances to
take advantage of cheaper equity financing, and as international buyers
increased their purchases of now-higher-yielding Treasury securities.
The size of these feedback effects is an important issue that would have
to be explored in a thorough assessment of any equity investment
proposal.
An additional set of issues involves the practical operation of the
trust funds. For example, critics claim that political interference in
investment decisions could hurt returns. Proponents argue, however, that
this problem could be addressed by having the trust funds hold a broad
portfolio whose performance mimics an index of the overall market. They
suggest that an expert board could select, through competitive bidding,
one or more private sector managers to achieve this end. An obvious
concern, however, is that although such an arrangement could be
implemented as part of a reform package, changes could be made later
that would allow much political influence on investment policies.
Another issue is how the government should vote the shares it holds.
Proponents of the MB plan suggest that once the portfolio shift was
complete, the trust funds' equity holdings would still be less than 5
percent of the market, but such projections are uncertain, and the
actual share could well be higher. In any case, advocates of equity
investments contend that so long as legislation provided that government
shares were either not voted, or voted in the same pattern as other
common shareholders, government ownership could be structured so as to
not affect private control. Critics respond that, because this policy
could be changed in the future, government-owned shares could allow the
government to influence firms regardless of the protections in existing
law. It is clear that the administrative aspects of investing in
equities would require solving some tough problems.
Investing a portion of the Social Security trust funds in equities
would be a dramatic departure from current procedure. All the
considerations discussed above demonstrate that such a proposal would
require careful scrutiny.

Structural Issues

Although the Advisory Council focused most of its attention on the
financing aspects of the Social Security system, it recognized that the
structure of the program also raises some equity and efficiency issues.
Household Composition. Under current law, Social Security benefits
for spouses are equal to either the amount that they could receive on
their own, or 50 percent of the benefits of the primary earner,
whichever is greater. When the primary earner dies, the surviving spouse
receives 100 percent of the primary earner's benefit. Married couples
with a single earner do better under this system than unmarried single
earners or two-earner married couples with similar earnings. The
spouse's benefit was introduced at a time when most wives stayed home
and cared for children; today, however, married couples in which both
husband and wife work make up the majority of families. The Advisory
Council's IA and PSA proposals include reductions in benefits for
nonworking spouses and increases in survivors' benefits when one member
of a couple dies.
Effect on Labor Supply. As already noted, some Advisory Council
proposals would increase the retirement age, but in general, issues of
labor supply were not a focus. Social Security is thought to have little
effect on the labor supply of younger workers for two reasons. First,
although economists profess a range of views, most believe that labor
supply generally is not very sensitive to changes in after-tax wages.
Thus, to the extent that Social Security is viewed as a tax, the
substitution effect, by which the lower after-tax wage discourages work
in favor of leisure, is roughly offset by the income effect, whereby
lower after-tax wages require individuals to work more to maintain their
consumption. Second, to the extent that individuals view their Social
Security taxes as a form of forced saving, those taxes exert even less
of the modest disincentive effects usually associated with a tax.
It is possible that Social Security, in combination with private
pensions and nonpension wealth, encourages retirement at age 62, the age
of first eligibility. Economists remain divided, however, concerning the
size of this effect. Most previous research has found little evidence to
suggest that even substantial changes in the structure of Social
Security would have much effect on the average retirement age as long as
benefits continued to be available at age 62. Critics of this research
argue, however, that it is difficult to capture the impact of large
benefit changes with existing models. They also cite the increased
generosity of Social Security benefits and the expansion of private
pension benefits as a major reason for the shift toward age-62
retirement.
One Social Security provision that formerly provided an incentive to
withdraw from the labor force was the sharp decline in the lifetime
value of benefits for those who retire after age 65 as compared with the
lifetime value for those retiring at age 65 or earlier. Although
benefits have long been fully actuarially reduced for retirement before
age 65, until 1983 no parallel provision was made for retirement after
65. The 1983 amendments will eventually raise the delayed retirement
credit to a full actuarial adjustment of 8 percent a year for each year
benefits are postponed after age 65; that credit will be phased in
completely by 2008. Although the increase in the credit will increase
the system's costs somewhat, it will remove a disincentive for
postponing retirement beyond 65.

Other Considerations

The economic analysis presented earlier makes it clear that the
impact of the Advisory Council's three proposals on national saving
depends primarily on how benefits and contributions are changed. That
is, the impact depends on how far the proposal would move Social
Security from a pay-as-you-go toward a funded system. Whether the
accumulated reserves are held by Social Security trust funds or by
individuals should, according to economic theory, have little impact on
overall national saving. Therefore, the economics alone cannot explain
why proponents of the various positions argue their cases so vehemently.
Although the Economic Report of the President generally focuses on the
economic aspects of issues, in this case some additional considerations
raised in the Advisory Council's report need to be noted in order to
understand the debate.
Proponents of individual accounts argue that economics is only half
the story. They contend that ``The IA plan provides...new saving and the
MB plan does not.'' Since the MB plan does boost funding, this argument
must be based on the assumption that either the public is unwilling to
see large surpluses build up in the public sector or, if such surpluses
emerge, they would be used to cover deficits in the rest of the budget.
This has occurred since 1983, and IA supporters may view it as likely to
continue in the future. Therefore, they conclude, the only way to
increase national saving is to fund retirement saving through individual
accounts.
Supporters of the PSA proposal also contend that investing the
Social Security trust funds in equities would be harmful to the economy:
``We believe that with the accumulation of such vast equity
holdings...the pressures to use the funds for socially or politically
`desirable goals' would be tremendous, putting at risk not only workers'
taxes and retirees' benefits, but also the allocation of capital in the
economy.''
Proponents of the MB proposal put much less weight on these
arguments and instead focus on what they see as the dangers of moving
toward individual accounts. First, in addition to the economic arguments
advanced above, they foresee a good chance that funds in the IA and PSA
accounts will not be held until retirement: ``If the money is seen as
belonging to the individual as it builds up during the worker's career,
he or she will feel aggrieved if access to the funds is denied.'' They
believe that ``[E]xceptions will undoubtedly be sanctioned, and in many
cases the individual's PSA funds will have been reduced or exhausted
before retirement, with the individual left to rely on the low-level
flat benefit.'' Second, they contend that even the more modest IA
proposal contains the ``seeds of dissolution'': ``...[A]s the plan
developed over time, with beneficiaries doing less and less well under
the reduced Social Security plan compared to individual accounts (at
least those of the more successful investors), there would be every
reason for many average and above-average earners, particularly, to
press for further reductions in contributions to Social Security in
order to make more available for their individual accounts. Thus, the IA
plan is inherently unstable, and could lead to the unraveling of the
redistributional provisions that are so integral to Social Security and
so crucial to its effectiveness.''
Whatever weight one assigns to these political economy
considerations, they help explain the strength of feeling about the
future direction of Social Security.

CONCLUSION

Social Security retirement and disability benefits now equal 4.7
percent of GDP. According to the intermediate assumptions in the 1996
Trustees' report, outlays will amount to 6.6 percent of GDP in 2070.
Although this is a substantial increase, it can be explained entirely by
the growth in the elderly as a share of the total population. With no
changes to current law, the Social Security system will be able to meet
all of its obligations well into the next century, and a large portion
of those obligations indefinitely. Nonetheless, the Social Security
program is running a deficit over a 75-year projection period and faces
a permanent imbalance thereafter. These long-term challenges to Social
Security need to be addressed in a bipartisan manner, as was done in
1983. A variety of approaches should be considered, but any possible
changes must also ensure that the benefits of reduced poverty and
increased economic security for the aged and disabled are not put at
risk.

MEDICARE

Medicare is the largest public health program in the United States.
It covers virtually all Americans age 65 and older and most recipients
of Social Security disability benefits. Since its enactment in 1965 it
has contributed substantially to the health and well-being of older and
disabled Americans. Medicare operates with relatively low administrative
costs and enjoys widespread public support. Today, however, Medicare
faces serious financing problems and continues to have important gaps in
coverage. This Administration has taken significant first steps to
address Medicare's short-term financing and has proposed additional
reforms to strengthen Medicare's trust fund to 2007. This will provide
more than enough time to establish a bipartisan process to develop
additional reforms to guarantee the strength of the program for future
generations.
Medicare presents a much greater challenge than Social Security,
both in the magnitude of the projected deficits and in the complexity of
the issues. Unlike with Social Security, reform involves not simply
selecting among a list of plausible options, but rather figuring out how
to control long-run costs and ensure the efficient delivery of quality
care in one component of a very complicated health care system.
Medicare is composed of two parts. Part A (hospital insurance)
covers inpatient hospital services, care at skilled nursing facilities,
home health care, and hospice care. Part B covers primarily physician
and outpatient hospital services. Part A is financed by a 2.9 percent
payroll tax, shared equally by employers and employees. Like their
Social Security counterparts, the Medicare Trustees project the status
of the hospital insurance trust fund over a 75-year period. These
projections are highly uncertain given the time horizon and the
difficulty in estimating future medical costs. Nevertheless, they
constitute the best available estimate of the status of the Part A
portion of Medicare. The projected 75-year deficit in Part A is more
than twice the Social Security deficit in absolute terms, and many times
larger relative to the size of the program. As a fraction of GDP, Part A
expenditures are projected to triple over the next 75 years, from 1.7
percent in 1996 to about 5 percent in 2070.
Medicare Part A is also facing a pressing short-term problem. If no
action is taken, the Part A trust fund is projected to be exhausted by
2001, and the gap between revenues and benefit payments widens very
rapidly thereafter. Medicare reforms proposed by this Administration
would extend the life of the Part A trust fund well into the next
decade. Enacting these reforms is an absolutely necessary first step,
but none of the current proposals completely solves the long-run
problem.
Medicare Part B is financed primarily from general revenues and
enrollee premiums. In 1996, premiums contributed about 25 percent of
Part B income, with most of the remainder from general revenues.
Although spending from this fund has grown rapidly, insolvency is not an
issue, since general revenues are required to cover any shortfalls.
However, the growth in Part B spending increases Federal expenditures
and contributes directly to the unified deficit.
Reforming Medicare will require slowing the growth in health care
prices and utilization. Since either Medicare or private insurance pays
for most health care expenditures for the elderly, individuals have
little incentive to seek out the most cost-effective delivery of medical
care. Moreover, fee-for-service payment still dominates the Medicare
market. Approximately 90 percent of Medicare beneficiaries have fee-for-
service care, compared with fewer than 30 percent of the nonelderly.
Hence, some Medicare providers may have an incentive to supply costly
services that offer uncertain medical benefits. This potential
misalignment of incentives is reinforced by the fact that the relative
effectiveness of alternative treatments is often poorly understood, and
consumers generally rely on providers' recommendations.
For the nonelderly, any tendency toward overuse of medical services
is increasingly kept in check by employers and their insurers. The
dramatic movement toward managed care (discussed below) reflects
determined efforts to ensure that health care is delivered in a cost-
effective manner. Some working individuals may also have incentives to
keep costs down because they face substantial out-of-pocket payments.
These incentives may be muted for retirees, who frequently have
virtually complete insurance coverage on a fee-for-service basis for an
array of services.
In short, incentive issues are likely to be more important for
Medicare than for Social Security. Any changes in incentives, however,
must recognize the system's important advantages, such as the wide array
of choices available to beneficiaries and their ability to continue
longstanding relationships with physicians and other providers.
Moreover, altering incentives is not a call to reduce benefits.
Discussions of Medicare are often framed as if the program were
excessively generous and the problem one of cutting back. In fact,
Medicare's coverage is less comprehensive in some ways than much private
sector insurance. For example, Medicare does not cover prescription
drugs and provides only very limited mental health benefits. Nor does
Medicare place an upper bound on cost-sharing responsibilities for
hospital stays, skilled nursing care, or physician services. As a
result, participants who have long and complicated illnesses and lack
insurance (called medigap insurance) to cover what Medicare does not may
incur tens of thousands of dollars of out-of-pocket expenses. Thus, the
challenge is not only to control the costs of the benefits currently
provided by Medicare, but also to create some room for improvement in
the benefit package.

SOURCES OF THE FINANCING PROBLEMS

The easiest way to understand the nature of Medicare's financing
problems is to contrast Social Security with Medicare. Both programs
provide a defined benefit--the one cash, the other insurance for a
package of medical services--to roughly the same population: the aged
and disabled. In recent years the Congress has not changed significantly
either the population covered or the benefits provided under either
program. (The 1988 Medicare Catastrophic Coverage Act added a drug
benefit, limits on out-of-pocket expenditures, and an income-related
premium to the program, but those provisions were repealed shortly after
enactment.) Yet whereas Social Security is expected to remain solvent
for more than 30 years and faces a relatively modest 75-year deficit,
Medicare's hospital insurance trust fund, as already noted, is projected
to be exhausted in 2001 and to deteriorate rapidly thereafter, if no
action is taken.
This very different outlook can be explained by two factors. First,
whereas the cost of Social Security is precisely defined by the benefit
provided, the cost of Medicare's bundle of health services depends on
health care prices in the economy at large and the volume and intensity
of services used by Medicare beneficiaries. Thus, even though the types
of services reimbursed by Medicare have remained substantially
unchanged, outlays have soared, as overall health care costs per capita
(not just those paid for by the government) have risen at twice the rate
of inflation. Second, as a result of these accelerating costs, Medicare
financing has been aimed at staving off short-term insolvencies; Social
Security, in contrast, was put in projected long-run actuarial balance
in 1983. As a result, Social Security tax rates were set taking into
account the upcoming retirement of the baby-boomers, while Medicare's
Part A tax rates were set only to cover short-range outlays, and no
prefinancing is provided for Medicare Part B. The result is that the
demographic shifts looming after the turn of the century, when the baby-
boom generation retires, have a much more profound impact on the long-
run outlook for Medicare than for Social Security.
For most of Medicare's history, the increase in outlays per capita
reflected the general rise in health care prices and a general increase
in the volume and intensity of health services, rather than a particular
problem with Medicare. As Chart 3-5 shows, Medicare and private health
insurance costs per enrollee have tracked each other closely since the
early 1970s, despite considerable year-to-year fluctuations. On a per-
beneficiary basis, Medicare's average annual growth rate was actually
lower than that of the private health insurance market between 1969 and
1994 (10.9 percent versus 12.2 percent).
For the last few years, however, health spending per capita in the
private sector has slowed. One reason is rapidly increasing enrollments
in managed care plans, but the slowdown is not limited to these plans.
The growth of expenditures in private fee-for-service plans has also
declined, as these providers have responded to the greater competition
from the managed care segment of the market. Medicare spending has not
slowed commensurately, in part because the current system for setting
managed care payments probably raises rather than lowers program costs.
Program costs have also been pulled up by rapid growth in services such
as home health care that private insurance often does not cover.
Two other factors complicate Medicare reform. First, more players
are involved than with Social Security. Social Security has two main
stakeholders: taxpayers and current beneficiaries. Besides these two
groups, Medicare must deal with health care providers--


doctors and hospitals--and, to some extent, the private insurance
industry. More players mean more decisionmakers and more sets of
incentives and disincentives to consider.
Second, adverse selection plays a far more important role in the
Medicare program than it does in Social Security (Box 3-1). For any
structure of premiums, insurers have a strong incentive to cherry-pick
the healthiest individuals. Healthy beneficiaries also have an incentive
to opt for low-cost programs, since they pay a low price and still get
all the health care they need. Although government can reduce adverse
selection through risk-adjustment mechanisms, which peg the payment made
by the government to the health status of the individual, risk
adjustment is currently, and is likely to remain, very imperfect. Any
proposed reform, therefore, must limit the extent to which insurers can
cherry-pick and to which individuals can select health plans based on
their health status.

SHORT-TERM OPTIONS

As explained above, until recently Medicare's short-run problems
were caused mostly by the same factors that were increasing health
expenditures in the private sector. The long-run problem, discussed in
the next section, is driven both by the projected continuing rise in
expenditures per capita and by demographic factors

Box 3-1.--The Problem of Adverse Selection

Adverse selection is a potentially serious problem for many types
of insurance markets. It commonly occurs when the purchasers of
insurance have more information about their risks than do insurance
companies. Those who expect to incur losses are more likely to buy
insurance than those who do not. This raises average expenses per
beneficiary and forces insurance companies to raise premiums. Higher
premiums discourage persons with lower risks from buying insurance. A
cycle of increasing insurance premiums and decreasing participation
could ultimately make the insurance unavailable. This is one
justification for public provision of some types of insurance.
Adverse selection problems are likely to be particularly severe
for health insurance, and there they may take several forms. When
employers offer a number of different insurance plans, healthier workers
are likely to choose less generous plans than workers who expect to
require more health care. Similarly, if public health insurance programs
such as Medicare offer more than one type of coverage, with rebates
going to those choosing lower cost plans, sicker individuals (or
households) will probably choose policies with more comprehensive
coverage, whereas those with lower anticipated risks are likely to
select less generous plans. As a result, those with higher risks will
incur higher costs or may lose coverage altogether. Conversely, if the
total premium expense is the same for all types of insurance, plans will
have strong incentives to seek out those individuals expected to have
relatively low health expenditures. Plans that are less able to select
beneficiaries with low expected costs are then likely to be left with
those with high average expenses. Adverse selection may also occur over
time. For instance, individuals may select a relatively low cost
insurance plan with limited coverage when they are healthy, but then to
switch into a more comprehensive plan when they get sick.
Adverse selection can be eliminated if all individuals are placed
into a common insurance pool. However, doing so reduces or eliminates
choice and, under some circumstances, may reduce incentives for plans to
operate efficiently. Alternatively, the problem could be avoided by
risk-adjustment mechanisms that take into account all differences in
risk that are known by the individual. However, mechanisms with the
required degree of precision do not currently exist and are likely to be
extremely difficult to develop.
that will increase the number of beneficiaries. When the demographics
kick in, a broad array of options, including changes in eligibility and
benefit design, are likely to be considered in a bipartisan context to
resolve the program's financing problems. Short-run changes are required
immediately, however, to extend the solvency of the hospital insurance
trust fund. These changes, which are likely to focus mainly on
reimbursement rates and policies, will also help balance the Federal
budget. The Administration proposed a set of reforms along these lines
last year and has submitted similar reform proposals in its current
budget.

Controlling Provider Payments

Medicare's major tool for controlling short-run costs is adjusting
payments to providers. Indeed, this represents the primary source of
Medicare savings in the 1980s and 1990s. The two important payment
innovations during this period were the prospective payment system for
inpatient hospital care and the relative value scale for physician
services. The prospective payment system substantially altered the
incentives of hospitals by providing a fixed payment for an entire
episode of care. Since hospitals no longer received additional revenue
for additional services, they had a strong incentive to limit lengths of
stay and unnecessary procedures. The reform in physician payments based
on relative value scales tied physician payments to a schedule, which
placed additional limits on the amount they could charge.
These innovations have helped control inpatient costs and physician
prices, but they have not succeeded in curbing total Medicare spending,
because they have little effect on the volume and intensity of certain
services and because the types of services provided change rapidly.
Also, spending on the portions of the Medicare program not yet subject
to reform--outpatient services, skilled nursing facilities, and home
health care--has risen at a rapid pace. Several factors may explain this
outcome. First, many of these services, particularly home health care,
differ from traditional medical services in ways that may make demand
for them more sensitive to price and raise uncertainty regarding the
medically appropriate level of care. Moreover, the supply of home health
care providers is virtually limitless given that they do not require
extensive training as do doctors and other medical personnel. Second,
improvements in technology have made it easier to substitute outpatient
care for hospitalization. Finally, spending controls on physician and
inpatient hospital services create incentives for providers to
substitute other types of services in order to maintain their incomes.
As noted above, most previous efforts to hold down price increases
have been aimed at inpatient hospital care and physician services.
Partly as a result, these are now the two slowest-growing components of
Medicare. Some additional savings are achievable in these areas, but
squeezing down on prices has its limits. If prices become too low,
physicians and hospitals might eventually become less willing to accept
Medicare patients. Moreover, as already noted, it is hard to curb
expenditures by focusing on prices alone. For example, the introduction
of the Medicare fee schedule in 1992 placed additional limits on the
reimbursements physicians could receive for services to Medicare
beneficiaries. Yet until the last year or so Part B spending continued
to increase markedly, in part because of higher volumes and new
technologies.
The limit to how much Medicare can save by controlling payments to
hospitals and physicians is likely to be determined by what happens in
the private sector. Historically, Medicare payment-to-cost ratios have
been well below those of private payers. However, as employers have
turned to managed care in order to constrain costs, this gap has
narrowed considerably: between 1991 and 1994, the private insurer-
Medicare differential for hospitals fell from 48 percent to 28 percent.
The reduction in the gap between public and private sector payments
makes providing care to Medicare beneficiaries relatively more
attractive than in the past. On the other hand, even if Medicare were
able to hold down fees, total expenditures could rise if the volume of
services provided increased. Moreover, if Medicare remains the primary
insurer of fee-for-service care, cost containment efforts in the private
sector may tempt providers to supply extra services to Medicare
enrollees in order to maintain their incomes.

Expanding Prospective Payment--Getting Providers to Control Costs

Medicare has paid for inpatient hospital care on a prospective basis
since 1983. Acute care hospitals receive a fixed fee for most inpatient
episodes, regardless of how long the patient stays or how many services
are performed. The fixed payment encourages hospitals to control the
costs of treatment and has been credited with reducing Medicare
inpatient costs. Despite concerns that prospective payment might lead to
too little treatment, evidence suggests that hospitals have not
compromised quality in their efforts to reduce costs. However, the
prospective payment system may encourage hospitals to transfer patients
quickly out of the acute care hospital and into a skilled nursing
facility or long-term care hospital, which continue to be paid on a fee-
for-service basis. This incentive could be contributing to the high
growth rates of Medicare spending in these areas.
Some have suggested bundling more services together as a method of
combating these perverse incentives and controlling costs. In general,
the broader the set of services in the bundle, the stronger the
incentive to reduce costs and the greater the scope for trading off
treatment alternatives in a cost-effective manner. Some analysts
advocate, for example, incorporating services for care following
hospitalization into the fixed amount provided under the prospective
payment system. Hospitals would be paid a fee for both the hospital stay
and for all related medical services for a limited period of time
thereafter. This might lower costs by preventing premature discharges
that move patients from prospective payment hospitals into fee-for-
service facilities. Bundling acute and postacute care, however, raises a
number of challenges. For instance, it may be more difficult to set the
reimbursement rate appropriately when a more diverse set of services is
covered. Also, the need for postacute care may depend on factors beyond
the hospital's control, such as the quality of care available at home,
and this may place some hospitals at financial risk, unless appropriate
adjustments can be made in the payment rate.
An alternative to bundling is to extend some type of prospective
payment to those areas of Medicare where costs are increasing most
rapidly. As already discussed, prospective payment reduces or removes
the financial incentive for providers to supply additional services, and
so may reduce costs. The Administration has proposed significantly
expanding the use of prospective payment for Medicare services. New
long-term care hospitals (defined as those with average stays of more
than 25 days), which are currently paid on a fee-for-service basis,
would become subject to the hospital prospective payment system. Skilled
nursing facilities would also be moved quickly to prospective payment.
Similarly, a prospective payment system would be established for home
health services, one of the fastest growing areas of Medicare
expenditure. Finally, a prospective payment system for hospital
outpatient services is proposed, with implementation around the turn of
the century. One challenge associated with reimbursing these services
prospectively is that the episode of care, on which the fixed payment is
based, may be harder to define than for hospital visits.

Improving Medicare Managed Care

The dominant form of Medicare managed care is the health maintenance
organization (HMO), which receives a fixed payment for each covered
beneficiary. The government's payment to a Medicare HMO is 95 percent of
fee-for-service Medicare spending per capita in the same county,
adjusted for a limited number of risk factors. Only about 10 percent of
Medicare beneficiaries are enrolled in managed care plans, compared with
74 percent of workers in large companies, and the evidence suggests that
those Medicare beneficiaries who do switch to managed care probably
cost, rather than save, the program money. Part of the reason is flaws
in the reimbursement formula, which exacerbate the problem of adverse
selection, and part relates to the inherent difficulty of preventing
adverse selection.
HMOs tend to enroll relatively healthy people at low risk of
requiring expensive care (Chart 3-6). The payment made to HMOs for
Medicare patients should reflect the lower costs associated with serving
this relatively healthy population. To the extent it does not, Medicare
payments may be higher than if the patients were in fee-for-service
plans. Previous health history is a good indicator of future health
expenditures, and one study indicates that the medical expenses of
seniors shifting into HMOs were 25 to 30 percent lower than those of the
average Medicare enrollee in the year or so immediately prior to their
enrollment in the plan. Another analysis estimates that the introduction
of managed care has increased Medicare costs by 7 percent per HMO
beneficiary.


The selection problem is exacerbated by two additional factors.
First, if healthier individuals migrate into managed care, average costs
in the fee-for-service sector will rise. Since the reimbursement rate
for managed care is based upon fee-for-service costs, this will drive up
the HMO per capita payment. Second, HMOs have an incentive to offer
coverage in counties with high reimbursement rates and to avoid counties
in which the per capita payment is low. The current reimbursement
formula results in payments that are almost four times larger in some
counties than in others. By contrast, local input prices (labor and
supply costs) vary by only a factor of two.
HMOs' incentives to cut costs may be limited somewhat because they
are not allowed to earn higher profit margins on plans covering Medicare
beneficiaries than on those for their private sector enrollees. In cases
where the allowed per capita payment would generate a higher rate of
profit, the HMO has the option of providing coverage not normally
included in Medicare, such as for prescription drugs, or waiving some or
all of the premium that it could otherwise charge. Thus, profit margins
will not directly increase if HMOs develop or implement more cost-
effective methods of providing care for Medicare beneficiaries. However,
total profits may increase because of larger numbers of plan
participants or economies of scale that raise profits on private sector
enrollees.
To address selection bias, the Administration has proposed reducing
the size of local variations in per capita payments, testing new risk-
adjustment methodologies aimed at linking reimbursements more closely to
predicted expenses, and making the reimbursement formula less generous.
The use of more-uniform payment rates should lessen the tendency of HMOs
to locate mainly in high-cost areas. But the likelihood of identifying
risk-adjustment mechanisms accurate enough to eliminate the remaining
selection bias is poor. The best currently available risk-adjustment
mechanisms are likely to account for only a fraction of the variation in
annual health care spending that individuals or insurers can anticipate.
A less generous reimbursement formula further recognizes and attempts to
take account of the remaining tendency of HMOs to enroll relatively
health people.
To provide better incentives for cost reduction, the Administration
has proposed some experimentation with competitive price setting and
with the creation of partial payments, whereby plans would be paid on a
fee-for-service basis but would also share in any cost savings achieved
beyond some minimum threshold. The Administration has also proposed to
broaden the range of managed care plans available to Medicare
beneficiaries by adding options for coverage by preferred provider
organizations, provider service networks, and for expanded availability
of point-of-service plans, all of which are increasingly popular in the
private sector. The goal in offering these new plans is both to expand
the choices available to beneficiaries and to encourage plans to compete
on the basis of quality of care rather than risk selection.

Increasing Part B Premiums

When Medicare was enacted, Medicare enrollees were required to pay a
premium equal to 50 percent of the costs of Part B. The costs of
physician services rose so quickly, however, that legislation in 1972
limited premium increases to inflation. As Medicare costs soared, the
premium dropped rapidly to 25 percent, and would have fallen further had
legislation not been enacted to maintain this level. Most Medicare
beneficiaries also pay a premium for their supplemental medigap
policies. These premiums plus copayments and deductibles bring total
out-of-pocket expenses to about 20 percent of family income for the
typical elderly household and cover about 40 percent of their total
costs of medical care. Proposals to increase Part B premiums have
included both across-the-board increases and income-related options.

Shifting the Financing of Home Health Care

Since 1981 home health care has been financed under Medicare Part A.
The rapidly increasing expenditures for these services are therefore
contributing to the deteriorating financial condition of the hospital
insurance (Part A) trust fund. The Administration proposes to continue
reimbursing under Part A the first 100 visits following a hospital stay
of 3 days or more, but shift the payment for all other home health care
services to Part B. This change is consistent with the notion that Part
A should be dedicated to hospital-related services, and Part B to
expenditures for ambulatory care. Although this shift would not reduce
total Medicare spending, it would extend the life of the hospital
insurance trust fund, without excessive reductions in payments for
hospitals, physicians, or other providers, and would restore the
apportionment of home health care payments between Part A and Part B to
that existing in law before 1980. It would not affect the Part B
premium.

Global Budget Caps and Medical Savings Accounts

Two options sometimes considered for reforming Medicare are global
budget caps and medical savings accounts (MSAs). In a global target
system, the budget cap would limit total Medicare spending per enrollee
at a congressionally mandated amount. Typically, separate spending
targets would be established for HMO and fee-for-service Medicare
expenditures. Projected spending (for example, in the fee-for-service
category) would then be calculated by using estimated services and
allowable prices. If total spending exceeded the sector target, prices
for all services in the sector would be reduced proportionately to
achieve the target level of spending.
MSAs combine a high-deductible insurance policy with a tax-
advantaged savings account to cover expenditures below the deductible. A
fixed dollar amount would be allocated to each beneficiary, out of which
Medicare would then pay the premium for the high-deductible insurance
policy and deposit any remaining funds into the beneficiary's savings
account. Withdrawals from this account could be made for qualified
medical expenses on a tax-free basis--or for other types of consumption
as taxable income. Since individuals covered by MSAs would be
responsible for all medical expenses up to the deductible, MSA
proponents say they would have incentives to avoid care in circumstances
where the costs exceed the benefits.
Global targets and MSAs have some attraction, but both also have
potentially serious problems. In particular, unless risk-adjustment
methodologies become much more sophisticated, selection bias could
create grave difficulties under either approach, especially (for the
former) if a separate budget cap were established for fee-for-service
and managed care plans. If relatively healthy persons enrolled in
managed care in disproportionate numbers, and the risk-adjustment
methods failed to capture fully the differences in expected costs, fee-
for-service spending per capita would rise relative to that in managed
care. The fee-for-service budget cap would likely be reached, leading to
relatively large reductions in prices. Pressure on providers would be
likely to lead to lower quality of service and would encourage more
beneficiaries to enroll in managed care. This process could continue in
a vicious cycle, until only the sickest individuals remained in the
traditional Medicare program, and the allotted prices might then be far
too low to address their medical needs. The end result could be, in
effect, more limited choice for most individuals and, if prices were too
low, queuing for some types of medical care, as some providers became
less willing to provide services to Medicare enrollees.
MSAs have a similar problem. Relatively healthy individuals may have
a strong incentive to opt for the MSA, since payments into their savings
accounts would exceed their expected medical costs. This would leave the
less healthy in the fee-for-service part of Medicare, raising costs
there. Higher costs might encourage further shifts to MSAs and could set
up a dynamic similar to that created by the global caps. In addition,
individuals in MSAs who fell ill might want to switch back into the fee-
for-service program. Thus, Medicare would be likely to pay higher costs
for the healthy individuals who accept the MSA option than it would if
they stayed in fee-for-service, but the program would still have to pay
the high expenses of sicker individuals. For example, in 1996 the
Congressional Budget Office projected that one Medicare MSA proposal
would have increased Medicare spending by $5 billion over 7 years.

LONG-RUN OPTIONS

Incremental changes in Medicare such as those outlined earlier can
provide substantial budget savings in the short term, create incentives
for more efficient delivery of health care, and extend the life of the
hospital insurance trust fund. Nonetheless, in the long run, the
combination of demographic developments and continued cost pressures
resulting from improvements in medical technology and increased volume
of services will require additional reforms. The President has proposed
policies to address Medicare's short-term financing and has called for a
bipartisan process to develop solutions for Medicare's long-run
challenges.
The remainder of this section briefly reviews some of the approaches
that analysts outside this Administration have proposed to improve the
long-term financing of Medicare. None of them is a magic bullet; claims
of spectacular benefit from any single approach should be viewed with
skepticism. Some combination of policies is likely to be needed to meet
the long-run challenges. All raise issues that must be examined and
resolved in a bipartisan fashion.

Increasing the Age of Eligibility

Some have suggested raising the age of first eligibility for
Medicare in order to reduce the number of beneficiaries and cut
expenses. Retirees are now eligible for Medicare benefits at age 65;
some have suggested raising this to 67 to reflect the scheduled increase
in Social Security's normal retirement age. As with Social Security,
this is likely to pose few problems for those persons who retire early
because they have considerable wealth, good pensions, and retiree health
insurance from their former employers. Others, however, have low
incomes, poor job prospects, and poor health.
Denying health care coverage to this latter group could produce
considerable hardship, because some elderly people may not have access
to any protection other than Medicare. Unless other measures were taken
in tandem, raising the eligibility age would probably increase the
number of uninsured, and at least some of those losing coverage would be
likely to have high medical costs. To reduce these problems, persons
retiring before the age of 67 would have to be guaranteed some way of
getting health insurance. One possibility would be to extend existing
continuation-of-coverage provisions, whereby individuals who leave jobs
are able to purchase group health insurance through their previous
employer for a limited period. This could allow persons retiring at age
62 or later to maintain continuous coverage until they become eligible
for Medicare. However, since individuals using this option would pay the
full coverage premium plus a small administrative charge, the costs of
obtaining health insurance might be quite high. Employer health expenses
would also rise if older and less healthy individuals were added to the
insurance pool.
Alternatively, some have suggested that Social Security
beneficiaries between the ages of 62 and 67 could be allowed to buy
Medicare coverage at unsubsidized rates. Although this would improve
access to insurance, Medicare might still lose money on these
beneficiaries, since persons in poor health would have particularly
strong incentives to enroll. Some provision would also have to be made
to reduce the burden on low-income individuals, probably through
Medicaid, which might reduce the financial savings and introduce other
complexities.

Increasing Cost Sharing

The annual Medicare deductible for physician services is $100,
whereas that for inpatient hospital care is $736. The former is
relatively low by historical and private sector standards, but the
latter is relatively high, especially when combined with substantial
copayments for lengthy hospital stays. Home health care coverage has no
deductibles or copayments of any kind. This means that Medicare has very
high cost sharing on those services where inappropriate use is
unlikely--namely, inpatient hospital services--and very low cost sharing
where individuals have a lot of discretion--namely, physician visits and
home health care. Since one goal of cost sharing is to give individuals
the incentive to use services carefully, the current structure might at
first glance seem in need of immediate reform.
The difficulty is that Medicare does not operate in isolation.
Approximately three-quarters of senior citizens have some type of
medigap coverage, either provided by their former or current employer or
purchased directly. Medigap insurance pays for some or all of the cost-
sharing requirements of Medicare and often covers services not included
in Medicare, such as prescription drugs or preventive care. In addition,
some 13 percent of enrollees with low incomes have secondary coverage
through Medicaid. For those individuals with the lowest incomes,
Medicaid covers all Medicare copayments and deductibles, as well as the
entire Part B premium. Those with slightly higher incomes can also have
their Part B premiums paid through Medicaid but are responsible for the
other types of cost sharing.
Since so many beneficiaries have secondary sources of insurance,
changes in Medicare cost-sharing arrangements may be unlikely to reduce
total medical expenditures unless accompanied by changes in the
structure of the supplemental coverage. The most likely effect would be
merely to shift some of the expense away from the Federal Government and
onto individuals (in the form of higher medigap insurance premiums) or
State governments (in the form of higher Medicaid expenses).

Secondary Insurance Reform

Because medigap policies and Medicaid provide first-dollar coverage
for most services, they shield individuals from the incentive effects of
cost sharing. When individuals are not responsible for any of the costs,
they tend to consume more health care and incur higher expenses. Thus,
medigap policies and Medicaid coverage are likely to raise Medicare
costs.
Several reforms have been suggested to avoid the problems associated
with current medigap policies. One possibility would be to require any
medigap policy to cover Medicare's basic package as well as any
supplemental coverage. The insurance company would receive a payment
from Medicare equal to the expected costs of the basic package and would
bear any additional cost caused by incentives for overuse. This approach
is quite similar to that currently used in Medicare's managed care
plans, which frequently combine Part A and Part B coverage with
additional insurance, and is fully consistent with efforts to increase
the use of managed care arrangements. However, adverse selection may
again be a problem since the health plans would have incentives to
cherry-pick the healthiest beneficiaries.
Alternatively, some have argued that medigap policies could continue
to be used as a supplement to Medicare but with a payment assessed to
compensate for the overuse caused by first-dollar coverage, or with
restrictions to prevent the policies from covering the initial
copayments or deductibles for some types of services. Were this done,
new types of medigap policies would presumably emerge that would
mitigate the adverse incentives in the current system while providing
some of the types of protection found in current policies. The challenge
would be to find the right balance between incentives and protection.
Others have suggested that Medicare require at least some cost
sharing for Medicare beneficiaries who also receive Medicaid. They argue
that even modest deductibles are associated with significant reductions
in health expenditures for individuals with average incomes. Deductibles
and copayments for Medicaid beneficiaries could perhaps be set at levels
considerably below those faced by other Medicare enrollees. Even low
levels of cost sharing may be sufficient to induce more careful use of
services among those with limited incomes. But they also might place
some persons with low incomes at additional financial risk or deter them
from seeking medically necessary care.

Switching from a Defined-Benefit to a Defined-Contribution Plan

Medicare currently offers a defined package of services to all
enrollees. This places the government at significant risk for any rise
in the cost of these services, whether it is related to changes in
technology, prices, or volumes. Some have suggested that the government
could limit future expenses by guaranteeing a specified contribution
toward health insurance expenses for the elderly, while leaving the
choice of the specific insurance plan to the individual.
For such a proposal to have any chance of being viable, the size of
the fixed payment would have to be carefully determined. If the amount
were set in a base year and simply indexed thereafter, it could quickly
become inadequate (if, for example, technological improvements led
health expenditures per capita to rise faster than the rate of
inflation) and place the elderly seriously at risk. To surmount this
problem, some advocates have proposed asking health plans in a given
geographical market to bid on the cost of insuring a minimum package of
services and then using the average of the bids to set the dollar
payment for each Medicare beneficiary in that market. Beneficiaries who
wanted lower deductibles or copayments could then use their own money to
buy more expensive policies, whereas those who wished to save money
could join cheaper plans and receive the difference between the fixed
payment and their premium contribution. The competitive bidding process
is likely to tie the average payment somewhat more closely to costs.
Success, however, would depend crucially on defining the market
appropriately: defining it too large might result in considerable
heterogeneity in medical costs within the region, whereas defining it
too small could lead to inadequate competition in the bidding process.
Switching to a defined-contribution system has a number of other
potential problems, the most serious of which is selection bias. Unless
sophisticated risk-adjustment methods, which currently do not exist,
could be used to vary the government payment rate with the level of
expected medical expenses, market forces would put those in poor health
at particular risk. Healthy individuals would have incentives to take
policies with low premiums and limited coverage, which would drive up
costs in the more comprehensive plans favored by less healthy persons.
Better risk-adjustment mechanisms are needed. But solutions should be
constructed with an understanding that our ability to adjust for risk is
currently quite poor and may be inherently limited.

CONCLUSION

The conclusion that emerges from this brief overview of Medicare's
financing problems is that, whereas short-term savings are currently
achievable, long-run viability will require consideration of innovative
reforms that will need to be agreed upon in a bipartisan process. Bold
but thoughtful efforts to solve some of the issues raised here could lay
the foundation for addressing one of America's greatest long-run
challenges.
The most constructive approach would be to implement the structural
reforms and savings proposals included in the President's budget and to
continue the Administration's use of demonstration projects to explore
different approaches to reining in costs and ensuring protection.
Efforts are also needed to develop risk-adjustment mechanisms to
alleviate the adverse selection problems. The Administration's proposals
to extend the life of the Part A trust fund and to control Part B
spending should buy enough time to allow careful evaluation of a range
of alternatives in a bipartisan process. With more evidence under its
belt, the Nation will be able to proceed with more confidence.

MEDICAID FINANCING OF LONG-TERM CARE

Medicaid was enacted, along with Medicare, in 1965 to provide health
and custodial care for people with extremely low incomes. It continues
to finance much of the medical care for the worst off in our society.
Medicaid also pays for nursing home care for those who have low incomes
and few assets. Since nursing home residents are typically quite old,
the program provides significant financial support to the sick elderly.
In 1995 roughly one-third of total Medicaid expenditures went to those
aged 65 and over; the remaining two-thirds were split about equally
between people with disabilities and the nonelderly, nondisabled poor.
About half of all nursing home expenditures are paid for by Medicaid.
Medicaid expenditures have been growing rapidly over time, as a
result of rising numbers of beneficiaries combined with higher costs for
each. The nursing home component of Medicaid has also increased rapidly
over the last 25 years, although at a slightly slower pace than other
program expenses.
The aging of the population will significantly increase the number
of people needing long-term care assistance. Not only will the number of
older people increase, but so will the average age of those over 65.
People over 85 made up about 10 percent of the elderly population in
1994; the Census Bureau projects that by 2050 this figure will be almost
24 percent. The very old are much more likely to reside in nursing
homes: in 1993, about 25 percent of those 85 and older were in nursing
homes, compared with just 5 percent of the general population over 65.
If this rate of nursing home utilization is maintained, population aging
will bring significant increases in the nursing home population and in
expenditures on long-term care.
Some analysts suggest that one way to hold down future Medicaid
nursing home outlays is to shift the financing of long-term care to some
form of insurance. By its nature, insurance is particularly desirable
for events that are rare but expensive. A majority of persons reaching
age 65 can expect never to receive care in a nursing home. Of the rest,
most are likely to stay a relatively short time. Only 9 percent will
spend more than 5 years in a nursing home (Chart 3-7). With the cost of
skilled nursing home care averaging over $35,000 per year and rising
over time, a lengthy stay can be extremely expensive. Therefore the need
for long-term nursing home care is an event for which insurance may be
appropriate.


Yet even though nursing home stays are relatively rare, and the
costs high, the market for private nursing home insurance is
underdeveloped. Just 3 percent of nursing home expenditures were paid by
private insurance in 1994. Several factors are likely to account for the
limited importance of private long-term care policies.
First, Medicaid pays the long-term care expenses of persons who have
no financial assets or who spend down their assets after entering a
nursing home. To the extent that people think government will pick up
the tab, they have less incentive either to engage in precautionary
saving or to purchase insurance for long-term care.
Second, premiums for private insurance are relatively high. One
reason is that the vast majority of long-term care policies are
individual rather than group policies, and individual policies have
higher administrative costs. Another is that those who do purchase long-
term care insurance, especially when they are older, may be less healthy
than others their age, and this will be reflected in premiums. This is
another example of the familiar problem of adverse selection, discussed
above. Finally, premiums will be higher to the extent that people with
insurance use nursing home care in situations where they would not if
they had to pay the full cost at the time of use.
Third, many disabled elderly persons are currently cared for by
family members. Senior citizens who consider nursing homes less
desirable than living with family might not be interested in purchasing
insurance that reduces out-of-pocket nursing home expenses if, as
evidence suggests, this makes their families less willing to care for
them.
A limited private insurance market means that most people reaching
age 65 remain vulnerable to catastrophic nursing home costs that could
potentially wipe out their assets. It also means that Medicaid outlays
are larger than they would be if the private insurance market were more
extensive. Medicaid outlays are also higher to the extent that seniors
needing long-term care are able to find ways to transfer assets to
family members, despite provisions in current law designed to prevent
this, rather than spend them on nursing home care before becoming
eligible for the program.
The proportion of the elderly with long-term care insurance could be
increased in a number of ways, although all raise serious issues. One
possibility would be for the government to require universal coverage,
either directly through Medicare or indirectly through the purchase of
private insurance (ideally at a young age and possibly through one's
employer). Alternatively, individuals could be provided with stronger
incentives to buy insurance within the current voluntary system. To a
large degree, the recently enacted Kassebaum-Kennedy legislation (the
Health Insurance Portability and Accountability Act of 1996) does so by
offering tax advantages for some long-term care insurance expenses
similar to (and in some ways more generous than) those previously
provided for other medical costs or health insurance premiums. A third
possibility would be to increase the ability of individuals to exempt
some of their assets from the ``spend-down'' requirements of Medicaid if
they purchase sufficient amounts of long-term care insurance.
Insurance of nursing home care for individuals with a lifetime of
low income is a good example of a program that the private sector is
unable or unwilling to supply. However, the presence of a safety net for
the poor may also reduce the incentives for those who are better off to
save for nursing home expenses. Unless people can be encouraged to put
aside more money for this purpose, the aging of the baby boom is likely
to put an increasing burden on the Medicaid system--and thus on the
finances of the Federal Government and the States.

CONCLUSION

Each of the government programs for the elderly discussed in this
chapter poses different policy challenges. The costs of providing Social
Security benefits are going to increase as the population ages. Although
this trend has largely been taken into account through 75-year
budgeting, the system needs additional revenue or benefit changes to
restore long-run balance. A range of options has already been described
and proposed.
The problems facing Medicare, and those facing Medicaid's financing
of long-term care, are more complicated and the solutions more elusive.
Unless action is taken, the Part A trust fund is projected to be
exhausted by 2001, and to face growing deficits thereafter. Adequate
provisions have not yet been made for Part B spending increases, or for
future Medicaid nursing home outlays. Innovative approaches are needed
to provide quality health and nursing care to an increasing number of
elderly Americans.
Many of the key elements of any solution are already known. We must
improve the incentives for individuals to seek and providers to supply
quality care in a cost-effective manner. Better risk-adjustment
mechanisms are needed to mitigate adverse selection. Where possible,
market-oriented approaches should be used to help determine the size and
form of third-party payments.
The various government programs supporting our elderly represent
different ways in which each generation of taxpayers offers assistance
to its parents. In combination, these intergenerational transfers limit
the resources available for other worthwhile purposes. Historically,
Federal revenues have averaged around 18 percent of GDP. In 1970, Social
Security, Medicare, and Medicaid expenditures were equivalent to 4
percent of GDP; in 1996 they stood at about 9 percent; they are
projected to grow to roughly 19 percent of GDP in 2050. These programs
as currently structured ultimately could crowd out virtually all other
government spending.
Examining how society distributes its resources between the aged and
the rest of the population provides one lens through which to view these
programs. Economics cannot answer how the allocation should be made, but
it does offer the fundamental lesson that society faces choices. The
choices are often difficult because the tradeoffs are between two or
more worthy objectives. Economics can help illuminate the nature of the
choices and provide theoretical arguments and empirical evidence about
the impacts of alternative policies. Armed with this information, we
must then make the hard decisions within a bipartisan process and with
full awareness of the difficult tradeoffs they imply. The choices we
make will say a great deal about the kind of society we are and the kind
of society we aspire to become.