[Economic Report of the President (2007)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]


 
CHAPTER 4


The Fiscal Challenges Facing Medicare

Social Security, Medicare, and Medicaid are three vital entitlement
programs in the United States that provide people with important
economic security against the financial risk associated with
retirement, disability, and medical expenses. In 2006, the Federal
Government spent $1.1 trillion on these entitlement programs; this
amount is projected to grow to $1.5 trillion by 2012. In the absence
of reforms to either raise more revenue or restrain future spending,
excess growth in entitlement spending will need to be offset by
reductions in discretionary spending, putting signif-icant pressure
on other important programs. As history has shown, there is no
uncontroversial way to reform these entitlement programs. Reforms
to increase tax revenue will have negative effects on the economy.
At the same time, it is crucial that any spending reforms preserve
the protection against financial risk that these programs provide.
Thus, improving the efficiency of these programs is crucial to
slowing the growth of entitlement spending.
This chapter focuses on Medicare. It begins with a brief overview
of the program and then examines the main reasons for the projected
financial pres-sures facing Medicare. It concludes with a
discussion of ways to improve the efficiency of Medicare spending
and thus the long-term financial outlook of this important program.
The key points in this chapter are:
 The projected long-term growth in entitlement spending,
including Medicare, is unsustainable because of the
pressures it places on future Federal budgets and by
implication, on the economy.
 Medicare spending is growing quickly, primarily because
of the demo-graphic shift to an older society and the
increases in per-beneficiary medical spending driven
largely by new technologies.
 Rewarding providers for supplying higher quality care
and improving incentives for patients to choose higher
value care can both increase the efficiency and slow
the growth of Medicare spending.


Entitlement Spending and Medicare

Social Security, Medicare, and Medicaid are entitlement programs;
that is, individuals who are eligible for these programs are entitled
to particular bene-fits. Social Security provides income to seniors,
the disabled, and surviving spouses and dependents. Medicare provides
health insurance to retirees and the disabled. Medicaid provides
health insurance to certain lower income groups. Workers and their
spouses are entitled to receive Social Security and Medicare benefits
if they make sufficient payroll contributions while working, and
citizens and qualified aliens are entitled to Medicaid benefits if
they meet certain income and other demographic criteria.
Chart 4-1 shows spending on Social Security, Medicare, and
Medicaid in 2006 as a percent of the total Federal budget. The $549
billion in Federal spending on Social Security benefits was 21
percent of total Federal outlays. The $330 billion in federal
spending on Medicare benefits was 12 percent of outlays. The $191
billion in federal spending on Medicaid was 7 percent of outlays.
Because Medicaid is jointly funded by the Federal and State
governments, State governments also spent about $139 billion on
Medicaid.
For those not covered by Medicare or Medicaid, the federal
government also helps with the purchase of private health insurance
coverage in a variety of ways, including the exclusion of employer
contributions towards health insurance premiums from personal income
taxes. These tax expenditures are included in the Federal budget and
are estimated to equal $133 billion in 2006. The Presidentï¿½s 2008
budget includes a proposal to replace the existing exclusion for
employer-provided health insurance with a flat standard deduc-tion
to all families who purchase health insurance that meets minimum
requirements for catastrophic coverage, in order to improve the
efficiency and equity of these tax expenditures. The Presidentï¿½s
policy proposal is described in Box 4-1.








_____________________________________________________________________
Box 4-1:The Presidentï¿½s Proposal to Improve the Tax Treatment
of Private Health Insurance

The current tax treatment of private health insurance coverage is
both inequitable and inefficient. Employer contributions (and in most
cases, employee contributions) toward private health insurance
coverage are exempt from income and payroll taxes. This is
inequitable because it does not offer the same tax break to families
that do not have access to employment-based insurance and instead
purchase a private plan in the individual health insurance market.
It is also inefficient because it provides a larger tax break to
families with more generous health insurance policies, which in
turn can drive the inefficient use of medical care of low value.
For more detail about these inefficiencies, see Chapter 4 of the
2006 Economic Report of the President.
The Presidentï¿½s 2008 Budget has proposed reforming the current
open-ended tax exclusion for employment-based health insurance
coverage, effective in 2009, with a flat $15,000 standard deduction
for health insurance to all families (or $7,500 for individuals),
whether that insurance was obtained through their employer or on
their own. The amount of this standard deduction would be independent
of the actual amount spent on the premium, so families who obtain
insurance poli-cies for less than $15,000 (but satisfying a set of
minimum requirements for catastrophic coverage) would still be able
to exempt the full $15,000 of compensation from income and payroll
taxes. The annual increase in the standard deduction for health
insurance would be linked to the Consumer Price Index, and the
policy would be roughly budget neutral.
This policy would reduce inequity in the tax code by providing the
same tax treatment of health insurance purchases to families with or
without access to employment-based health insurance. Those who are
currently insured in the individual health insurance market would
see a reduction in taxes commensurate with those insured in the
group market, and those who are currently uninsured would be given
a strong incentive to purchase coverage. For instance, for an
uninsured family of four with $50,000 in income facing a 15 percent
marginal income tax rate and a 15.3 percent total combined payroll
tax, the value of the $15,000 exclusion would be worth about $4,500,
and would thus offset the cost of roughly half of a health insurance
plan costing $9,000.
This policy would also reduce the inefficiency of the current tax
treat-ment of employment-based health insurance. An insured
wage-earning family of four with $50,000 in income currently receives
a tax break of about $3,000 toward a $10,000 policy but about $6,000
toward a $20,000 policy, because the current value of their
exemption equals their roughly 30.3 percent marginal tax rate times
the actual amount of the premium. The advantage of the standard
deduction policy is that it provides the same tax treatment to all
types of health insurance plans. While it would provide a strong
incentive to obtain at least some basic level of coverage, it would
not encourage families to obtain inefficiently expensive health
insurance that covers low-value services.
_____________________________________________________________________

Spending on Social Security, Medicare, and Medicaid is projected
to increase and claim an even more significant share of the federal
budget in the future. Examining total spending as a fraction of gross
domestic product (GDP) is especially relevant because this measures
the portion of the overall economy devoted to each particular
program. For instance, Social Security spending was 4.2 percent of
GDP in 2005 and is projected to be 6.3 percent of GDP in 2080. Total
Medicare spending was 2.7 percent of GDP in 2005 and is projected to
be 11.0 percent of GDP in 2080. Total health care spending in the
United States by private and public sources combined was
16.0 percent of GDP in 2005, equaling almost $2.0 trillion or $6,697
per person. Although national health expenditures have grown at a
slower rate than the previous year for the prior 3 years, health
spending has still consistently grown at a faster rate than general
inflation.
While Social Security, Medicare, and Medicaid share some common
features, each also poses its own opportunities and challenges,
warranting detailed specific analysis. Chapter 5 of the 2002 Economic
Report of the President examined Medicaid coverage for low-income
families, Chapter 6 of the 2004 Economic Report of the President
examined Social Security, and Chapter 4 of the 2006 Economic Report
of the President examined health care spending generally. This
chapter focuses primarily on Medicare.


The Basics of Medicare

A primary motivation behind the passage of Medicare in 1965 was
that many of the elderly at the time had no health insurance.
Medicare was struc-tured to mimic the prevalent form of private
health insurance at the time, Blue Cross and Blue Shield. Blue Cross
plans covered inpatient hospital serv-ices, and Blue Shield plans
covered physician and hospital outpatient services. The "Blues" were
the basis for separate Part A and Part B plans that reimburse
hospitals and physicians on a fee-for-service basis, respectively.
Seniors who have worked at least 40 quarters in qualified employment
are automatically

enrolled in Part A at age 65. Seniors who lack 40 quarters of
employment can buy into Part A by paying a monthly premium. People
under the age of 65 with certain disabilities or end-stage renal
disease are also eligible for Medicare. Enrollment in Part B is
optional and requires a premium contribu-tion, although there is
a penalty for not immediately enrolling and the amount is higher
for individuals making more than $80,000 per year. The Centers for
Medicare and Medicaid Services (CMS) administers the Medicare program
by implementing the statutes that determine the form of payments to
hospitals, physicians, and outpatient providers.
Most outpatient prescription drugs were not covered by Medicare
until the implementation of the Medicare Modernization Act (MMA)
of 2003, which created Part D of Medicare. Like Part B, Part D is
optional, requires a premium contribution, and has a penalty for
late enrollment. Unlike Part B, however, Part D is administered by
private health insurance plan sponsors. Seniors have the alternative
option of enrolling in a private Medicare Advantage insurance plan if
one exists in their region. These are private health insurance plans
that provide Part A, Part B, and, in most cases, Part D serv-ices.
These plans often provide additional benefits to seniors at lower
costs. The Medicare Advantage program is described in more detail
in Box 4-2.


_____________________________________________________________________

Box 4-2:The Medicare Advantage Program

Approximately 16 percent of Medicare beneficiaries are enrolled in
private managed-care health plans, including primarily health
mainte-nance organizations (HMOs) but also preferred provider
organizations (PPOs) and private fee-for-service plans. These
Medicare Advantage plans contract with Medicare to provide the
services covered by Part A and Part B and usually offer additional
benefits such as relatively lower cost sharing and additional covered
services. Enrollment into these plans is voluntary but requires that
a local plan is available. As of 2006, all Medicare beneficiaries had
the option of enrolling in a Medicare Advantage plan, including plans
that provide prescription drug coverage.
Prior to 1997, Medicare HMOs received a capitated payment based on
95 percent of the average Medicare beneficiary spending in the
county, adjusted only for age, gender, Medicaid enrollment, and
disability status. Studies suggest that healthier beneficiaries were
more willing to enroll in these plans, because HMOs typically place
restrictions on care. As a result, the program increased total
Medicare expenditures because the payments to the HMOs were generally
higher than the actual costs of their enrollees in the fee-for-
service program.
The 1997 Balanced Budget Act eliminated the direct link between
plan payment rates and local fee-for-service expenditures and sought
to expand the types of plans available to beneficiaries beyond the
urban areas where they had generally been available. The 1997
Balanced Budget Act also mandated the use of risk adjustment to vary
the payments to insurers based upon the health status of its
enrollees by 2000. As a result, incentives to engage in wasteful
competition for rela-tively healthier enrollees were mitigated so
that insurers would instead engage in competition to provide higher
value care at a lower cost for all enrollees. Because of some of the
limits on the growth in payments in the 1997 Balanced Budget Act,
many private insurers withdrew from the Medicare market. Enrollment
declined by about 25 percent from 1999 to 2003.
The 2003 Medicare Modernization Act expanded the Medicare Advantage
program in two important ways (in addition to changing the name from
"Medicare+Choice" to "Medicare Advantage"). First, the 2003 Medicare
Modernization Act increased the payment levels to the plans to
encourage participation across all Medicare Advantage plans. Second,
the 2003 Medicare Modernization Act created new regional preferred
provider organizations that offer a uniform deductible and an upper
limit on out-of-pocket spending to increase both the number of
choices avail-able to Medicare beneficiaries (especially in rural
areas) and special needs plans to target certain beneficiaries (such
as those with dual eligibility, those with chronic conditions, and
the institutionalized).


_____________________________________________________________________


Medicare spending is financed by a combination of payroll taxes,
general revenue, and premiums paid by beneficiaries. Part A of
Medicare is financed by a Hospital Insurance (HI) payroll tax of
2.9 percent. The HI payroll tax is split evenly between employees and
employers, but economists generally believe the employer tax is
ultimately paid by workers in the form of relatively lower wages.
Part A is a pay-as-you-go system in which payroll taxes on current
workersï¿½ wages finance the benefits of those currently retired. If
the payroll tax revenues exceed spending for the year, the difference
is placed into the HI Trust Fund. If taxes are lower than spending,
money is withdrawn from the HI Trust Fund. Parts B and D constitute
the Supplementary Medical Insurance compo-nent of Medicare and are
financed by general Federal government revenues and beneficiary
premiums, which are set to equal approximately 25 percent of total
Part B and Part D spending, respectively.

Nations around the world provide various forms of social insurance
for their elderly populations. One of the purposes of health
insurance is to ensure that people are protected against the
financial risk associated with uncertain medical spending. Economists
generally attempt to justify government inter-vention into private
market outcomes by suggesting potential market failures that may
exist in the absence of any government intervention. Many econo-mists
would justify the existence of Medicare (and its government provision
of health insurance for the elderly and disabled) with three
potential explana-tions. The first potential explanation is that many
people may lack sufficient information to plan properly for the
financial hardships that would otherwise arise from expensive medical
treatment when they age or become disabled. Medicare requires workers
to pay a premium during their working years toward future costs and
thus the program can be considered a form of forced savings. In this
way, Medicare is similar to Social Security, which requires people
to set aside some of their wages now in exchange for a promise of
income at retirement. But this reason alone is insufficient to
explain the provision of health insurance as opposed to additional
income.
A second potential explanation for government intervention in the
provision of health insurance for seniors is to avoid having
seniors in poor health pay considerably more toward their health
care. In the United States, most people participate in health
insurance plans through their place of employment. Most people
lose these plans upon retirement. (Private retiree health insurance
plans only cover what Medicare does not.) Because about 40 percent
of people at age 65 have at least one serious preexisting chronic
health condition, initiating coverage in a private individual
health insurance market after retirement (under the assumption
that the Medicare program did not exist) would force insurers to
charge higher premiums to those in poor health. Younger people
face uncertainty that they may develop a chronic condition in
the future (and thus they would face variable premiums in the
absence of Medicare). This suggests that there may be efficiency
gains from providing future insurance coverage with pooled
contributions. (Private health insurance markets handle this
intertemporal uncertainty of developing a chronic health condition
with "guaranteed renewal at class average rates" provisions that
ensure that premiums do not vary with the onset of illness for
those with coverage.)
A third potential explanation for government intervention in the
provision of health insurance is related to the redistribution of
resources toward low-income people. Economic theory suggests that
unconditional transfers of wealth are generally more efficient than
in-kind transfers of goods or services for achieving any desired
redistribution. In an ideal world, the poor would use some of this
transferred wealth to purchase health insurance. However, if the poor
believe that society will provide them with additional resources in
the

event of an uninsured loss, they may have an incentive to forego
buying insurance. This precommitment problem, sometimes called the
"Samaritanï¿½s Dilemma," has been demonstrated to be alleviated by the
direct provision of health insurance rather than a direct transfer
of wealth. This economic argu-ment, however, justifies the
subsidization of, or requirement for, insurance but does not justify
a government-run plan.



Increases in Medicare Spending over Time


Projections of Future Medicare Spending and Revenue


Sources of Spending

Since Medicare was created in 1965, total spending on all of its
programs has grown steadily. As noted above, total Medicare
spending was 2.7 percent of GDP in 2005 and is projected to be
11.0 percent of GDP in 2080. These values for Medicare spending,
however, actually understate the total spending for Medicare
beneficiaries because the private payments for cost sharing are
not included. For instance, in 2006, Part A requires individuals
to pay $952 of the cost of each hospitalization (this $952 is called
a deductible), and Part B generally requires them to pay 20 percent
of the Medicare-approved payment (this 20 percent is called
coinsurance) in addition to a deductible. Some beneficiaries pay
Medicare deductibles and coinsurance amounts from their own pockets,
while others obtain private insurance to cover these costs. Some of
this private coverage is included in employer-sponsored retirement
benefits, while some is provided by directly purchased Medigap plans.
Some low-income Medicare beneficiaries are also eligible for
Medicaid. For these dually eligible people, Medicaid covers most of
these cost-sharing amounts required by Medicare.
Chart 4-2 shows historical and projected private and public spending
for Medicare-covered services as a percentage of GDP for 1966 through
2050. Including private spending by Medicare beneficiaries and
Medicaid spending on Medicare beneficiaries presents a more complete
picture of beneficiariesï¿½ total consumption. In 2006, beneficiaries
bore about 37 percent of Medicare-related spending, and about 63
percent was financed by payroll taxes and general revenues. However,
these amounts shown here do not include the portion of Medicaid
spending on long-term care services, such as nursing homes, because
this type of care is not covered by Medicare. More detail about
coverage of long-term care is provided in Box 4-3.








Medicare Solvency

The Medicare program does not have enough projected revenue to
cover projected future spending. Under current projections made
by the Medicare Actuaries and presented in the 2006 Medicare
Trustees Report, the Medicare HI Trust Fund is projected to be
exhausted in 2018. The projected 75-year deficit for the Medicare
HI Trust Fund is 3.51 percent of taxable payroll. That is, the
Medicare HI payroll tax would have to be immediately increased
from 2.90 percent to 6.41 percent to cover all projected spending
over the next 75 years. Alternatively, a reduction in Medicare Part
A expenditures by 51 percent would be necessary to make the Medicare
Trust Fund solvent. As a comparison, this Medicare deficit is
relatively larger in magnitude than the Social Security Trust Fund
deficit. An increase in the Old Age, Survivors, and Disability
Insurance (OASDI) payroll tax from 12.4 percent to 14.4 percent or a
reduction in Social Security benefits by 13 percent is projected to
make the Social Security program solvent over 75 years.
The Medicare Supplementary Medical Insurance (SMI) program is
considered to be solvent by the Medicare Trustees only because Part
B and Part D spending is required by law to be financed by general
revenues. However, the consequences of increased spending on
Medicare SMI may be




____________________________________________________________________
Box 4-3: Long-Term Care

Nine million people use long-term care (LTC) to alleviate the
hardships accompanying old age or disability. LTC is medical care
required over a long period of time by someone with a chronic
illness or disability. An estimated 70 percent of people who reach
the age of 65 will need some form of LTC before they die. Medicare
does not have a large LTC component, as it only covers post-acute
care in skilled nursing facilities and some home health care, which
total less than 20 percent of all LTC. Private, noninsured spending
covers about 25 percent of LTC expenditures, while private insurance
pays for less than 10 percent. Many Medicare beneficiaries obtain LTC
after they have depleted their assets and become eligible for
Medicaid. Medicaid LTC eligibility is often tied to receiving
Supplemental Security Income and having very few assets, but states
have the discretion of easing eligibility criteria. Medicaid covers
over 45 percent of all LTC expendi-tures. About one-third of Medicaid
expenditures go to LTC.
The average price for 1 year in a nursing home is $70,000. This
cost is high enough to strain even middle-income families, yet few
people prepare financially for potential LTC expenses. Studies
generally attribute failure to purchase LTC insurance to a lack of
awareness about the potential costs of LTC, the benefits of coverage,
and a mispercep-tion that Medicare covers all LTC. Adverse selection
in the market (by those who expect to use long-term care being more
likely to purchase insurance) results in very high premiums and
relatively fewer insurance companies offering LTC policies. Many
seniors forgo obtaining private coverage and instead become
Medicaid-eligible by sheltering their assets through income
annuities, trusts for their children, and asset transfers to family
members. In response to these loopholes, States and the Federal
government have tightened Medicaid eligibility. Because of the
pressure LTC places on State budgets, many policy-makers believe
that changes should be made to LTC administration.
Encouraging the purchase of private long-term care insurance may
be a valuable step in reducing Medicaid spending on LTC while
protecting seniors from poverty. For example, New York currently has
a 20 percent tax credit available toward the purchase of LTC
insurance. Such a subsidy should generally make LTC insurance more
attractive to middle-aged people. Medicaid spend-down insurance,
which permits people who purchased and used LTC insurance to keep
some assets and still qualify for Medicaid, could also increase the
attractiveness of private LTC coverage.
_____________________________________________________________________



just as dire. Without large reductions in Medicare SMI spending or
increases in taxes, either Federal budget deficits will grow rapidly
or dramatic reduc-tions in spending for other Federal programs will
have to be made.
Spending on Medicaid is also funded by general revenues. The
elderly and disabled covered by Medicare account for about
one-quarter of Medicaid enrollees, but they account for about
two-thirds of Medicaid spending, mainly because of spending on acute
and long-term care. An additional chal-lenge for funding Medicaid is
the inverse relationship between the proportion of the population
eligible for benefits and the tax base available to fund the program.
During economic downturns, lower personal income causes State
governments with balanced-budget requirements to face the strain of
both a decrease in tax revenue and a higher number of residents who
meet the low-income eligibility threshold and are thus in need of
assistance.


Implications for Reform

In light of the mounting fiscal pressures on entitlement spending,
it is critical to increase the efficiency of spending on benefits.
Reforms of the Medicare program should aim to reduce the growth of
spending by redi-recting resources toward the highest value uses
and away from inefficient care of low value. Controlling cost
growth while preserving the vital financial and health protections
offered by the program is particularly important in light of the
large negative consequences of raising taxes. An increase in the
payroll tax rate would decrease incentives to work, increase
efforts to receive compensa-tion in forms not subject to taxation,
and be a drag on economic growth.
As noted above, Medicare taxes on current workersï¿½ wages
essentially fund an insurance pool from which benefits are paid on
behalf of retired or disabled workers. A pay-as-you-go system of
intergenerational transfers is consistent with the basic idea
behind insurance if the aggregate amount paid into the pool (in
the form of taxes on workers) equals the aggregate amount of
expected benefits to be paid from the pool. In private insurance
markets, policyholders must have confidence that future claims
will be covered by the insurer. To help alleviate consumer concerns,
government regulations often place solvency requirements on insurers
that require them to have enough assets to cover their liabilities.
Thus, for Medicareï¿½s pay-as-you-go financing mechanism to function
as a social insurance program, younger generations must have
confidence that the government will indeed meet its future insur-ance
obligations to them. The rapid increase in Medicare spending over
time clearly threatens the confidence that younger generations have
in the solvency of the program. Indeed, a recent survey found that
almost two-thirds of workers are "not too confident" or "not at all
confident" that Medicare "will continue to provide benefits of at
least equal value to the benefits received by retirees today".



The next section of this chapter examines the reasons behind this
projected growth in Medicare spending. The average annual growth rate
of Medicare spending is projected to be 2.8 percentage points higher
than GDP growth per year between 2006 and 2040. Part of this increase
in spending is due to growth in the number of Medicare beneficiaries,
and part of this increase in spending is due to growth in real
(inflation adjusted) Medicare spending per beneficiary.


Reasons for the Changes in
Medicare Spending over Time


Increases in the Number of Medicare Beneficiaries

The proportion of the United States population covered by Medicare
has increased over time. This has resulted from the normal
eligibility age remaining fixed at 65 combined with the aging of
the population. The aging of the popu-lation is due to both
increased life expectancy and decreased fertility. In 1965,
65-year-old retirees could expect to live for 14.7 more years;
by 2006, they could expect to live for 18.6 more years. In 1965,
the fertility rate was 96.3 births per 1,000 females aged 15 to
44; by 2004, it had fallen to 60.7 births. (These changes in
demographics have a similar effect on Social Security.)
The worker-per-beneficiary ratio illustrates the portion of the
population which provides revenue to cover the needed spending on
Medicare benefici-aries. In 1965, there were about 4.6 workers for
each Medicare beneficiary. In 2005, there were about 3.8 workers for
each Medicare beneficiary. In 2050, there are projected to be only
2.2 workers for each Medicare beneficiary.
In addition to being affected by long-term increases in longevity
and decreases in fertility, the worker-per-beneficiary ratio during
the upcoming years is also affected by the aging of the baby boom
generation, which is made up of those born between 1946 and 1964.
(The baby boom generation can be viewed as a temporary change in
fertility rates.) The baby boom generation explains the relatively
steady worker-per-beneficiary ratio between 1975 and 2005 and the
dramatically decreasing ratio between 2010 and 2040. After 2050, most
benefits owed to the baby boom generation will have been paid, and
the worker-per-beneficiary ratio is projected to be relatively steady
though 2080 as long as current assumptions hold.
Unlike Medicare, the full retirement age for Social Security is 65
for those born in 1937 and earlier, and will rise slowly to 67 for
those born in 1960 or later. However, the effect of increasing the
eligibility age for Medicare would not have a very large effect on
total Medicare spending, because Medicare



spending increases with age as people become less healthy. For
instance, while people ages 65 and 66 represent about 9 percent of
the Medicare population, they are the recipients of only about 4
percent of total Medicare spending.


Increases in Spending per Beneficiary

Real growth in Medicare spending per beneficiary has averaged about
4 percent per year between 1996 and 2006, roughly 2 percentage
points greater than real per capita growth in GDP. For the Medicare
Trustees Report, the Medicare actuaries assume that the annual growth
rate of Medicare spending per beneficiary during the period between
25 and 75 years from now will decrease to equal the growth rate of
GDP per capita plus an average of 1 percentage point. In addition to
this so-called "intermediate" assump-tion, these actuaries also
consider a "low-cost" assumption, in which annual Medicare spending
growth equals per capita GDP growth and a "high-cost" assumption, in
which annual Medicare spending growth equals per capita GDP growth
plus 2 percentage points.
One way to evaluate the affordability of these projected increases
in Medicare spending is to consider the effect of applying this
growth rate to overall medical spending in the United States and
examine the resulting growth in consumption of all other goods and
services in the future economy (that is, nonmedical consumption). One
study estimated that applying the intermediate assumption of
long-term medical spending growth, equal to the growth rate of per
capita GDP plus 1 percentage point, would still result in positive
real growth in the level of nonmedical consumption over the next 75
years. However, the high-cost assumption of long-term medical
spending growth, equal to the growth rate of per capita GDP plus 2
percentage points (and, as noted above, roughly equal to the growth
rate of Medicare spending in recent history), would cause the level
of real nonmedical consumption to increase only until year 2040 and
decrease thereafter. During the period between 2010 and 2040, an
average of over 60 percent of the annual increase in income would be
allocated toward health care spending.
Research suggests that most of the increase in medical spending
over time has been driven by the advent of new technologies. New
technologies make available new treatments, some of which are more
effective than others. Research also suggests that the increased
medical spending has, on average, resulted in improvements in
health with additional value exceeding the addi-tional costs. For
instance, the real cost of treating heart attacks increased by
about $10,000 for Medicare beneficiaries between 1984 and 1998,
driven by technological advances such as catheterization and
angioplasty. Life expectancy for heart-attack patients increased
by about 1 year during this same period. Although it is difficult
to measure the value of human life and

it is not clear that this relationship is causal, an estimate of
the value of these added health benefits is about $70,000, far in
excess of the added costs.
Economists have suggested that an increase in medical spending
over time is not necessarily problematic, in and of itself, so long
as the marginal bene-fits exceed the marginal costs. A simple
cross-national comparison of the fraction of GDP devoted to health
care spending suggests that the United States is a high-expense
outlier relative to other developed countries. However, it is
plausible that the marginal benefits of improved health are dependent
on income, so that as a countryï¿½s GDP increases, it may be rational
for that country to devote a relatively higher share of its GDP to
health care. This perspective suggests that it may make sense for
the United States to spend more than other countries because it has
higher per capita income and health care can be a valued use of those
higher resources.


Improving the Efficient Allocation of
Resources in Medicare

The remainder of this chapter considers ways to improve the
efficiency of spending in the Medicare program, in order to slow
the projected growth in spending. Policymakers face the challenge
of enacting policies that limit inef-ficient health care spending
but do not limit efficient health care spending or the development
of beneficial new technologies. This section begins by providing
several examples of sources of inefficiency in health care spending
and concludes by suggesting several ways to improve the incentives
that providers and Medicare beneficiaries face. Improving the
efficiency of health care spending is critical to improving both
the long-term fiscal strain on the Medicare program and the quality
of care to patients, and it is likely that a multipronged approach
will be necessary.


Inefficient Health Care Spending

While some of the greater health care spending may be attributed
to technological improvements that enhance the quality of care and
to increases in national wealth, there are also many findings that
are consistent with some degree of inefficiency associated with
relatively higher health care spending. Health outcomes in the
United States are often not substantially better than those in
other developed countries that spend far less on health care. The
Rand Health Insurance Experiment found that increased medical
spending led to only limited health improvements. The Dartmouth
Atlas of Health Care shows wide variations in Medicare spending
within the United States without associated variation in health
or health outcomes.

It may, at first, appear to be difficult to reconcile the research
findings that new technologies over time produce valuable health
benefits with the research findings that higher spending does not
yield better outcomes. It is likely that there is significant
overconsumption of health care that provides little marginal benefit.
Consider a costly new technology that provides very large health
benefits to specific patients in need. Suppose, however, that it is
also consumed by patients who benefit very little from the treatment.
If the bene-fits to "appropriate" patients are very large, the
increase in spending over time on both "appropriate" and
"inappropriate" patients combined can still imply that the new
technology is cost effective. However, because some "inappro-priate"
patients also receive the treatment, some of the variation in
spending is due to inefficiency. If this characterization is
accurate, the technology is not as cost effective as it should be.
This overconsumption of health care is frequently thought of as
being caused by poor incentives such as overly generous health
insurance coverage. That is, patients often face marginal prices
for costly treatments that, due to insurance coverage, are lower
than the true marginal costs of treatment. (More detail on optimal
forms of private health insurance and the effect of increasing cost
sharing by consumers is provided in Chapter 4 of the 2006 Economic
Report of the President.) The presence of generous health insurance
may also influence the research and development of certain
technologies with questionable cost effectiveness.
There is also evidence of significant underuse of valued health
care. For example, there is a large body of medical literature
demonstrating the cost effectiveness of beta blockers for patients
recovering from a heart attack. Due to their effectiveness, they are
prescribed in over 90 percent of cases. However, studies have shown
that persistence in use of beta blockers declines rapidly even in the
first year of treatment. Moreover, the U.S. Preventive Services Task
Force recommends that all women over 40 receive mammograms every 1 to
2 years, that all adults over 50 receive regular colorectal
screenings to detect colon cancer, and that all adults over 50
receive annual immunizations against influenza. Compliance, however,
is low: 68 percent of women receive recommended mammograms, 35
percent of adults receive recommended colorectal cancer screenings,
and 65 percent of adults over 65 receive annual influenza vaccines.
These data suggest that there are two main ways in which the
efficiency of Medicare spending could be improved, because there is
both a relationship between the insurer and beneficiaries and a
relationship between the insurer and providers. One is to encourage
the use of cost-effective care that is currently underconsumed.
Medicare now covers an initial preventive physical examination and
many preventive screenings, but there are still potential
improvements to be made. Policies to achieve this goal should aim to
improve


the incentives for health care providers and insurers to provide
high-quality care. A second way to improve the efficiency of Medicare
spending is to discourage the use of ineffective care that is
currently overconsumed. Policies to achieve this goal should aim to
improve the incentives that Medicare bene-ficiaries face regarding
their consumption of care. More detail on these policies is provided
in the next two sections.

Better Incentives for Health Care Providers and Insurers

Medicare generally pays providers of the same service the same fee,
regard-less of the quality of care. If hospitals and physicians
were paid amounts that reflected objective measures of the quality
of care provided, with differential payments tied to higher quality
and more efficient care, ideally many prob-lems of underuse and
misuse of care could be reduced. In practice, while "pay for
performance" holds a great deal of promise, it may be difficult
to fully implement because of the complexity of producing objective
measures of quality. For instance, tying payments to process
measures--such as rewarding cardiac physicians based on the
proportion of their heart attack patients using beta blockers--may
cause providers to place too much emphasis on limited aspects of
providing high-quality care. Alternatively, tying payments to
outcomes measures--such as rewarding cardiac surgeons whose patients
have lower post-discharge mortality rates--may cause providers to
face perverse incentives to avoid treating high-risk patients most in
need. Adequate pay-for-performance measures will require
sophisticated techniques to control for underlying differences in
patient health, which highlights the importance of developing systems
to collect detailed information about the kind of care that patients
receive. With the advent and adoption of better health information
technology and the development of rigorous and well-tested measures,
using pay-for-performance techniques to reimburse providers may
become a vital contributor toward higher quality and more efficient
care.
High-quality health care may also be encouraged by providing
patients with valuable information so they may compare various
providers to one another. Competition among health care providers
may improve incentives to provide high-value care in two ways:
higher quality and lower price. If patients have access to the
providersï¿½ price and quality information, they will have incentives
to choose those providers with the highest value of care, and
physicians and hospitals will have strong incentives to reduce
their fees and improve the quality of care to attract more
patients. There are two parts of Medicare where this kind of
information is available and these incentives are in place. Private
Medicare Advantage plans have strong incentives to offer higher
quality care at lower beneficiary premiums to encourage enrollment.
The new Part D prescription drug benefit provides information about
the

price of prescriptions by plan and by pharmacy, provides access to
customer service information by plan, and also benefits from price
competition among insurers. More detail on the structure of and
experience with the new Medicare Part D benefit is provided in
Box 4-4.

_____________________________________________________________________

Box 4-4: Medicare Part D Prescription Drug Benefit

The Medicare Part D prescription drug benefit went into effect
January 1, 2006, as a result of the 2003 Medicare Modernization Act.
Prior to that date there was almost no coverage for outpatient
prescrip-tion drugs in Medicare, except in Medicare Advantage plans.
(Part B does cover drugs in certain instances.) Part D beneficiaries
may now enroll in their choice of plans in their region. In 2007, the
34 regions will offer between 45 and 66 standalone prescription drug
plans at different prices with varying levels of coverage at or above
the minimum benefit package. If an individual seeks greater benefits,
they will generally pay a higher premium. Individuals with incomes
below 150 percent of the Federal Poverty Level who meet eligibility
requirements receive addi-tional assistance in the form of reduced
premiums, deductibles, and coinsurance. The premium subsidies are on
a sliding scale to better target those with the lowest incomes. By
June of 2006, over 38 million Medicare beneficiaries had some form
of prescription drug coverage.
One important feature of the Part D program is the competitive
premium bidding process by insurers. Each year insurers submit
premium bids for the following year to Medicare. These premium
bids are weighted by enrollment to determine the weighted average
bid; this amount is referred to as the benchmark premium. The
basic premium that nonpoor Medicare beneficiaries pay for a
specific plan is the differ-ence between the planï¿½s bid and 75
percent of the weighted average bid (that is, the federal direct
subsidy). Some low-income beneficiaries are automatically enrolled
in plans whose premiums are at or below the regional
enrollment-weighted average. Thus, there are significant incentives
for insurers to submit low bids. Early projections suggested that
the average premium in 2006 would be $37 per month, but premiums
ultimately averaged $24 per month. In 2007, the average premium is
expected to remain about the same.
Competitive bidding appears to be a successful model for providing
low costs to both beneficiaries and the government without
govern-ment interference in determining drug prices. Satisfaction
with the Part D program is high. Several surveys have shown that at
least 75 percent of enrollees are pleased with the Part D benefit.

_____________________________________________________________________


Better Incentives for Medicare Beneficiaries

In addition to the competition induced by the new Part D benefit,
its pricing structure and associated subsidy for premiums provide
good incen-tives for Medicare beneficiaries to obtain relatively more
efficient forms of insurance coverage. Because the Federal subsidy
toward the prescription drug plan is generally a fixed proportion of
the average premium bid each year, beneficiaries receive the
additional benefits of choosing plans that are less generous than the
average benchmark plan. Thus, beneficiaries appropriately receive the
full marginal benefits from either a higher amount of cost sharing or
a more restrictive list of covered medicines. This mechanism for
having Medicare beneficiaries pay lower amounts for less generous
coverage therefore improves the incentives for insurers to design
more optimal products.
A potential downside to this mechanism for determining beneficiary
premiums, however, is that it could lead to relatively higher premiums
for people with higher expected expenses due to chronic health
conditions if these high-risk people gravitate toward plans with
relatively more generous benefits. As a result, these plansï¿½ higher
premiums would reflect a relatively sicker pool of people covered by
the plan, in addition to the underlying value of more generous
benefits. However, these potential problems can be allevi-ated by the
use of risk-adjusted payments to plans, as described in Box 4-2.
This mechanism for determining the premium contribution toward
different plans, currently in place for Part D, could potentially be
applied to the entire Medicare program. Providing beneficiaries with
a choice of compre-hensive plans and having the premium contribution
for each plan vary in relation to a benchmark plan has potential for
improving the efficiency of overall Medicare spending. A key
difference between Medicare Part D and the entire Medicare program,
however, is the combination of the government-run fee-for-service and
Medicare Advantage components of the latter. This bench-mark
mechanism is likely to be successful only if the same premium
contribution is made toward both the fee-for-service component of
Medicare and the private Medicare Advantage plans, putting them on
equal footing. Just as described above, this mechanism for
determining premium contribu-tions would cause beneficiaries to
receive the appropriate marginal benefits when choosing plans with
levels of coverage that are less generous than the benchmark plan.
It could therefore help to allow beneficiaries to determine the
optimal forms of out-of-pocket cost sharing and the optimal adoption
of new technologies over time. These two specific issues are explored
below.


Premiums versus Out-of-Pocket Payments

The level of out-of-pocket cost sharing that would induce
beneficiaries to consume the optimal level of care is difficult to
determine. The share of out-of-pocket spending that will lead to an
efficient amount of care would be set

at the level at which the marginal cost of being exposed to more
financial risk through relatively more cost sharing is less than the
marginal benefits from reducing the overconsumption of medical care
resulting from relatively more cost sharing. In practice, it is
difficult to quantify these competing interests. Nevertheless,
Medicare currently may be missing this balance at both the high-cost
and low-cost extremes. Medicare currently does not provide
protec-tion against certain catastrophic health care costs (except
in some Medicare Advantage plans). For example, there is increased
beneficiary cost sharing after a hospitalization exceeds 60 days,
and a cessation of benefits after 120 days. While these upper limits
on benefits presumably have the advan-tage of reducing incentives to
over consume, they appear to expose beneficiaries to excessively high
levels of financial risk.
While many seniors have private retiree health or Medigap plans to
cover Medicareï¿½s gaps in catastrophic coverage, these plans also
frequently cover the first-dollar cost sharing, such as the
hospitalization deductible and the 20 percent of physician fees.
These plans limit the cost-consciousness of consumers and therefore
increase total spending. However, neither insurers nor consumers bear
the full marginal costs of the increased spending induced by these
generous Medigap plans, because Medicare covers most of the increased
spending.
If beneficiaries were to receive the marginal benefits of less
generous coverage in a way that puts the fee-for-service component
and the Medicare Advantage component on equal footing, there would be
improved incentives for private plans to offer and beneficiaries to
select plans with more efficient levels and forms of cost sharing.
Beneficiaries, rather than Medicare adminis-trators, should be the
ones to decide the optimal mix of deductibles, coinsurance, and
out-of-pocket maximums that best meets their needs and preferences
under neutral incentives.


Appropriate Levels of Spending Over Time

If Medicare beneficiaries were to receive the marginal benefits of
choosing a more efficient plan, the incentives to adopt costly new
technologies would be improved over time. As noted earlier, costly
new technologies are efficient if the value of the additional
benefits from improved health exceed the additional costs of that
technology. People may not be willing to spend a great deal of money
on new treatments with very minor benefits. If Medicare
bene-ficiaries were to receive the marginal benefits when selecting
less technology-intensive plans that delivered higher value care at
lower cost, the adoption of new technologies by health plans over
time would be driven by whether new technology delivers substantial
enough health benefits. As a result, consumers, rather than the
government, would decide the extent to which health care spending
should increase over time.



Conclusion

Medicare has significant long-term unfunded obligations. Although
Social Security spending is currently much greater than Medicare
spending, the unfunded obligation for Medicare is much greater than
that for Social Security. Eliminating the projected 75-year actuarial
deficit for Medicare Part A would require an immediate 3.51 percent
increase in the HI payroll tax or a reduc-tion in projected Medicare
expenditures by 51 percent. Projected increases in Medicare
Supplementary Medical Insurance (SMI) funding may appear less
transparent because they are funded out of general revenues, but
the economic significance of these obligations for Medicare SMI is
just as great.
Policymakers face the challenge of reducing the growth of Medicare
spending while preserving access to life-saving health care and the
important financial protections that Medicare provides, and they
cannot do so without ensuring that Medicare funds are spent more
efficiently. Increases in Medicare spending over time are driven
by an increasing population of aged Americans and increasing
per-beneficiary spending on health care. While much of the increase
in medical spending over time is driven by valuable new technologies,
there also appear to be significant inefficiencies in the system.
Therefore, future policies to control the growth in Medicare spending
should target the sources of inefficient spending but not discourage
the use medical care that is costly but delivers greater health
benefits. This tension is the primary dilemma that policymakers face.
Policymakers may want to consider restructuring Medicare so that
the direct spending by Medicare beneficiaries, in the form of
premium contribu-tions and out-of-pocket spending for medical care,
yields a more efficient allocation of resources. Revising the
Medicare fee-for-service program and the Medicare Advantage program
to be more like Part D with a fixed-dollar subsidy provided toward
the premium, has the potential for improving incen-tives for Medicare
beneficiaries to consume optimal levels of care. When individuals
receive the full benefits of selecting less expensive coverage, they
will be more likely to select plans with optimal arrangements that
balance both financial protection and technological adoption.