[Economic Report of the President (2009)]
[Administration of Barack H. Obama]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 6

The Long-Run Challenges of
Entitlement Spending

Federal spending on entitlement programs is expected to increase
dramatically in the coming decades, particularly for Social Security,
Medicare, and Medicaid. Taken together, these programs currently
constitute 45 percent of Federal non-interest spending; assuming there
are no major changes to these programs, this share is projected to
rise dramatically in coming decades. An aging population and rising
health care spending per person are major reasons for these projected
increases. The primary objective of this chapter is to highlight the
budgetary challenges facing each of the three major entitlement
programs and to outline possible strategies for addressing these
challenges.
The key points of this chapter are:
 Federal entitlement spending is on an unsustainable path.
Spending on the three major entitlement programs--Social
Security, Medicare, and Medicaid--is projected to increase
much faster than tax revenues or than the overall economy
over the coming decades. Paying all scheduled benefits would
eventually require substantial reductions in other
Government spending, or major tax increases, or both.
 The aging population is a major cause of the expected
increase, especially for Social Security, representing a
permanent, as opposed to temporary, shift in the entitlement
landscape. Currently, one out of six adults is age 65 or
older; by 2020, one out of five adults will be 65 or older;
and, by 2030, one out of four adults will be age 65 or older.
 The pay-as-you-go financing structure of Social Security,
coupled with the aging population, creates a sizeable
structural imbalance that will cause current and future
generations of workers to bear increasing costs, or receive
smaller benefits than now scheduled, or both.
 Over the past 30 years, real per capita health care spending
has grown considerably faster than real gross domestic
product (GDP) per capita. Real growth in Medicare spending
is being driven by increasing enrollment, greater
utilization of more expensive high-technology medical
treatments, and expansion of the goods and services covered
by the program.
 Long-term care expenditures for low-income elderly and
disabled persons represent a large and growing share of
total Medicaid spending. The demand for long-term care is
expected to grow in the United States as a result of the
aging population. In turn, this will place even greater
financial strain on Federal and State budgets.

Background Facts About Entitlement Programs

Social Security, Medicare, and Medicaid are key components of the
U.S. social safety net. This section briefly reviews the evolution and
current structure of each program.

Social Security

The Social Security system protects people from income loss due to
life events such as retirement, a period of disability, or the death
of a household wage earner. This system was introduced in 1935, when
it is estimated that over half of the elderly lacked the income needed
to care for themselves. In 2007, approximately 50 million
beneficiaries received $585 billion in benefit payments. Approximately
$486 billion of these benefits was paid to over 40 million retirees
and survivors, and $99 billion was paid to 8.9 million disabled
workers and their families. Nearly 90 percent of all individuals aged
65 and over received some benefit from Social Security in 2006 (the
most recent year for which these data are available). Social Security
benefits provided about 58 percent of all income received by
individuals age 65 and older and for 32 percent of recipients, Social
Security benefits provided over 90 percent of their entire income.
Social Security is largely a pay-as-you-go program, meaning that
current benefits are financed primarily with a payroll tax on wages
earned by current workers. Employers and employees each pay 6.2
percent of wages--although economists generally believe the
employer's portion is passed on to workers in the form of lower
wages--up to a maximum amount of taxable wages. This maximum,
called the contribution and benefit base, increases each year as
average wages increase; it was $102,000 in 2008, increasing to
$106,800 in 2009. Self-employed individuals pay the entire 12.4
percent.
As a result of legislation enacted in 1983, Social Security began
collecting more revenue than was needed to pay benefits each year,
thereby requiring current workers to partially prefund future
retirement benefits. The annual surpluses have been placed in the
Social Security Trust Fund, which is invested in special U.S. Treasury
bonds, used only for this purpose. In 2007, Social Security ran a
surplus of $190 billion, which brought the balance in the Trust Fund
to over $2.2 trillion. Because the value of the assets accumulated in
the Trust Fund is exactly offset by the liability of the general fund
to repay the special Treasury bonds, the Social Security Trust Fund
has zero net value for the Government.
The Social Security benefit a worker receives in retirement is based
on the average wage he or she earns when working and paying the Social
Security payroll tax. Workers who earned higher wages get larger
benefits, but the portion of preretirement income replaced by Social
Security declines as preretirement wage income rises. An individual
must have worked and paid Social Security taxes for 40 quarters (10
years of employment) to be eligible for retirement benefits.
Individuals become eligible for a reduced benefit at age 62, while
those who work past full retirement age can receive a larger benefit
for each year worked up to age 70. Once a retiree's initial
benefit has been determined, it increases each year with annual cost-
of-living adjustments that are based on the inflation rate for the
previous year.
More than one in six recipients of Social Security benefits receive
their benefits through the Disability Insurance program. This program
provides monthly benefits to workers and their families for workers
who are unable to work for a year or more. The Social Security
Administration has guidelines about the conditions that must be met
before an individual can receive this benefit.

Medicare

Beginning in the 1930s and for several subsequent decades,
policymakers considered legislation that would create a larger role
for Government in the provision of health insurance for Americans,
particularly for those who faced financial barriers to medical care.
Before Medicare was created in 1965, almost 50 percent of older adults
lacked health insurance. Originally, only people age 65 and older were
eligible for Medicare. In 1972, eligibility was expanded to include
those receiving Social Security Disability Insurance payments for 2
consecutive years and those with end-stage renal disease who meet
specific eligibility requirements. Today, nearly 45 million
individuals are enrolled in Medicare, including approximately 38
million elderly and 7 million disabled beneficiaries.

Medicare has four parts:
 Part A, also known as Hospital Insurance, provides coverage
for inpatient hospital services, some home health care,
hospice, and up to 100 days in a skilled nursing facility
after a qualifying inpatient stay. Individuals who have
worked at least 40 quarters in qualified employment are
automatically enrolled in Part A upon reaching age 65.
Individuals who lack 40 quarters of employment can buy into
Part A when they reach 65 years of age by paying a monthly
premium (plus a late penalty if enrolling after the initial
eligibility period); in 2009, the maximum monthly premium is
$443.
 Part B provides coverage for outpatient services, including
outpatient provider visits, emergency room services, and
certain preventive screening measures. Enrollment in Part B
is optional (there is a penalty for enrolling after the
initial eligibility period) and requires a premium
contribution, which is higher for individuals who make more
than $85,000 per year, based on their most recent Federal
income tax return.
 Part C, also called Medicare Advantage, uses private health
plans to provide Part A and B and, in most cases, Part D
benefits. Medicare Advantage plans often include benefits
not covered by traditional Medicare. The Medicare
Prescription Drug, Improvement, and Modernization Act of
2003 changed how the Government reimburses health plans for
the coverage they provide to enrollees. This resulted in an
increase in the number of private plan choices available to
beneficiaries in every county in America. Enrollment growth
has been steady, most likely due to improved access to
Medicare Advantage plans and more generous benefits. Current
enrollment is nearly 10 million beneficiaries, representing
over 20 percent of all Medicare beneficiaries.
 Part D, also created by the 2003 legislation, is an
optional, outpatient prescription drug benefit. This benefit
is administered by private health insurance plan sponsors
that contract with the Federal Government. In 2008, 32
million Medicare beneficiaries were enrolled in stand-alone
prescription drug plans, Medicare Advantage prescription
drug plans, or employer/union plans receiving the Retiree
Drug Subsidy.
Medicare is financed primarily through a combination of payroll taxes,
general revenues, and premiums paid by beneficiaries. Part A is
financed primarily by a dedicated payroll tax of 2.9 percent, which is
split evenly between employees and employers. If total non-interest
revenues exceed Medicare Part A spending for a particular year, the
difference is placed into the Hospital Insurance Trust Fund. If non-
interest revenues are lower than spending, money is withdrawn from the
Hospital Insurance Trust Fund. At the end of 2007, the Hospital
Insurance Trust Fund had a balance of $326 billion; however, under the
Medicare Trustees' intermediate estimates, this balance is
expected to begin declining in 2008.
Medicare Part B is financed by general revenues and beneficiary
premiums, the latter of which are set to equal approximately 25
percent of total expected spending. Part D is also financed through
beneficiary premiums and general revenues, as well as State payments
for low-income beneficiaries who are also enrolled in Medicaid.
Medicare Advantage (Part C) is not separately financed; rather, it is
simply a vehicle for providing Part A, Part B, and typically Part D
benefits. Projections by the Medicare Trustees indicate that in 2010,
approximately 45 percent of non-interest income will come from payroll
taxes, 39 percent from general revenues, 12 percent from beneficiary
premiums, and the remainder from miscellaneous sources.

Medicaid

Medicaid provides medical assistance to low-income individuals,
including children and parents in working families, children and
adults with severe disabilities, and low-income Medicare
beneficiaries, who are known as ``dual eligibles'' because
of their eligibility for both programs. The Federal and State
Governments share responsibility for administering and funding
Medicaid. For States to receive Federal funding, their Medicaid plans
must cover specific populations, including children under the age of 6
and pregnant women whose family income is below 133 percent of the
poverty level; school-age children (ages 6 to 18) with family income
below 100 percent of the poverty level; parents with income below
States' July 1996 welfare eligibility levels; and certain other
low-income and disabled persons. In addition, with approval from the
Centers for Medicare and Medicaid Services, States have the
flexibility to expand Medicaid eligibility to other groups of
individuals, including those whose incomes exceed the mandatory
thresholds indicated above.
Medicaid programs cover a broad set of health care services, including
inpatient and outpatient services, dental care, family planning,
mental health, substance abuse treatment, home health care, and long-
term care services. In 2007, Medicaid monthly enrollment averaged
approximately 48.1 million people, including 23.5 million children.
Medicaid is jointly financed by the Federal Government and the States.
The Federal Government's share of each State's Medicaid
spending is based on the Federal Medical Assistance Percentage (FMAP),
which is calculated using a formula that incorporates data on average
per capita income for each State and for the United States as a whole
for the most recent 3 years. The FMAP formula is designed to provide a
larger Federal share of spending for States with lower per capita
income relative to the national average, with Federal shares ranging
from a minimum of 50 percent to a maximum of 83 percent. Overall,
Federal Government expenditures on Medicaid account for approximately
57 percent of total annual Medicaid spending. Unlike Medicare, the
Medicaid program does not have any dedicated revenue sources; rather,
Federal expenditures come from the general fund of the Federal
Government.
As part of the Balanced Budget Act of 1997, the State Children's
Health Insurance Program (SCHIP) was created to provide health
insurance to uninsured children under age 19 who live in low-income
families that are not eligible for Medicaid. In 2007, more than 7
million children enrolled in SCHIP. States have significant
flexibility in terms of their program design. In particular, they can
implement SCHIP by expanding their existing Medicaid programs,
creating separate programs, or using a combination of the two
approaches. States that implement SCHIP as a Medicaid expansion must
provide all of the benefits offered through their Medicaid programs,
while States that choose to have separate SCHIP programs must provide
benefits that meet specific Federal standards. Like Medicaid, the
SCHIP program is financed jointly by the Federal Government and the
States, although the Federal matching rate for SCHIP is higher than
the rate used for Medicaid, and ranges from 65 percent to 83 percent
of total spending.
Unlike Medicaid, SCHIP is not actually an entitlement program, but is
instead a matching grant program that has a fixed limit on Federal
spending, both nationally and State by State.

Major Entitlement Spending Over Time

Federal Government expenditures for Social Security, Medicare, and
Medicaid have grown from 3.8 percent of GDP in 1970 to roughly
8.4 percent of GDP in 2008. (For comparison, Federal revenue generated
from all sources averaged 18.3 percent of GDP over the last several
decades.) Estimates of expected future growth in entitlement spending
consistently predict sharply rising expenditures in coming decades,
although such projections depend on specific assumptions made for a
variety of economic and demographic variables. The Office of
Management and Budget (OMB) projects that in the absence of reforms,
by 2020, spending on these three programs will exceed 10 percent of
GDP; by 2040, it will reach 14.9 percent of GDP, and by 2080, it will
reach 18.9 percent of GDP. It is important to note, however, that
there is considerable uncertainty among long-run forecasts. For
example, under its Alternative Fiscal Scenario, the Congressional
Budget Office (CBO) projects that Federal spending will rise much
faster, reaching 11.2 percent of GDP by 2020, 16.8 percent of GDP by
2040, and exceeding 25 percent of GDP by 2080. The primary difference
between the OMB and CBO projections (and other projections) is in
their forecasts of future health care expenditures; in contrast, their
forecasts of Social Security growth are very similar. Chart 6-1 uses
the OMB projections to contrast the projected growth in these programs
with other Federal spending, which fell in the 1990s with declines in
defense spending, rose with increased Homeland Security spending over
the past few years, and is assumed to decline in the coming decades,
primarily due to declines in defense and other discretionary spending.
Two trends can be discerned from Chart 6-1. One trend is the growth in
Social Security spending expected over the next two decades. In 2008,
Social Security spending constituted approximately 4.3 percent of GDP.
CBO estimates this share will grow to 6.1 percent of GDP by 2030, with
OMB estimating growth to 5.9 percent of GDP by 2030. After 2030, the
share of GDP spent on Social Security remains relatively constant
under both forecasts. Population aging is the main cause of this
growth, a factor that also affects Medicare costs.
The second trend shown in Chart 6-1 is that after the period of
Social Security's rapid cost growth, health care expenditure
growth will cause Medicare and Medicaid spending to grow far more over
the long term. In 2008, Medicare and Medicaid respectively constituted
2.7 percent and 1.4 percent of GDP. CBO projects that, absent reforms,
in 2030 these



shares will rise to 5.9 percent of GDP for Medicare and 2.5 percent of
GDP for Medicaid. In comparison, OMB predicts that, absent reforms, in
2030 Medicare spending will be 5.0 percent of GDP and Medicaid
spending will be 2.4 percent of GDP. By 2060, CBO projects spending
for these programs will grow to 11.2 and 3.3 percent of GDP,
respectively, while OMB projects spending will grow to 7.7 and 3.2
percent of GDP, respectively. Note that the major difference between
the two forecasts lies in their estimates of the growth in health care
expenditures per beneficiary.
Even under the more optimistic OMB projections, expected growth in
entitlement spending will place a significant burden on the Federal
budget and will require policymakers to make hard choices about the
financing and benefit structures of these entitlement programs, as
well as other Federal spending.

Social Security

During the program's first four decades, spending for Social
Security benefits steadily increased relative to the size of the
economy, reaching about 4 percent of GDP in the mid-1970s. This
initial growth was driven largely by repeated program expansions that
broadened coverage to include benefits for spouses and dependent
children of retirees (1939), survivors of deceased workers (1939), the
self-employed (1950), and disabled individuals (1956). Since then,
annual spending for Social Security benefits has generally fluctuated
between 4.1 percent and 4.5 percent of GDP.
As shown in Table 6-1, the number of Social Security beneficiaries is
expected to more than double from 2000 to 2050, while the total
population will increase by roughly 50 percent. The relative growth of
the number of elderly individuals means that a larger share of the
adult (age 18 and over) population will be drawing Social Security
benefits in the years ahead. The demands imposed on the Social
Security program by the baby boomers will diminish by the middle of
the 21st century, but the expectation of a relatively constant
fertility rate in combination with increasing lifespans means the
portion of the adult population drawing Social Security benefits will
remain high by historical standards. Box 6-1 describes some of the
ways in which the Social Security program influences the saving
behavior and labor supply decisions of individuals.



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Box 6-1: Undesirable Consequences of Social Security

The specific taxation and benefit structure of Social Security
produces some undesirable consequences that may discourage
participants from working and saving.  Reduced work and saving levels
reduce national output (GDP) and gradually reduce the U.S. standard
of living over time from what it could have been.  Efforts to reform
Social Security should address each of these disincentives.
There are at least three ways Social Security discourages work and
saving. First, the system imposes high effective tax rates on
secondary earners.  The benefit available to a married couple is
either the sum of the benefits they are each individually eligible
for or up to 150 percent of the higher earnerï¿½s benefit, whichever is
larger. This structure means the lower earner in a couple receives very
little return on his or her Social Security tax contributions and,
if the low earnerï¿½s wage is low enough, may not realize any benefit
from his or her tax contributions.  This reduces the reward for the
second member of a married couple to work outside the home and can
contribute to a decision not to participate in the labor force at
all.  As an extreme example, this can also cause the Social
Security taxes paid by a low-income two-earner couple to subsidize
the benefits received by a high-income one-earner couple.Second,
the program encourages early retirement.  The existence of an Early
Eligibility Age encourages workers to retire earlier than they may
have done in the absence of Social Security.  In fact, while the
decision of when to retire probably depends on many factors, the
mere existence of a sure income source in retirement, via Social
Security benefits, could encourage people to retire earlier.  The
average age of retirement has been declining steadily, from over 67
in the early 1950s to under 63 in the early 2000s.  When workers
retire early, they pay less tax into Social Security and draw
benefits for a longer period of time.  This provision thus places
additional stresses on Social Security finances and reduces the
total amount of labor supplied to the economy. Few people work past
normal retirement age, perhaps because, in terms of oneï¿½s Social
Security benefit, the return to working past normal retirement age
is modest at best.  While a person who delays taking Social
Security benefits receives a larger monthly benefit, they receive
this benefit for a shorter period of time.  The actuarial present
value of the deferred payments is almost identical to the value of
the payments that could be taken at normal retirement age.  When
one considers the additional taxes a person pays on labor income
earned after normal retirement age, the return to working after
this age may even be negative.  This provides little incentive for
people to work past their normal retirement age.

Third, Social Security discourages private saving.  Social Security
is a system that effectively forces people to save for their retirement- portion of their wage is taken away and, in return, they expect
income during retirement.  From the perspective of an individual
planning for his or her retirement, it makes little difference
whether this income comes from a government program or from his or
her own investments.  However, when individuals do their own
saving, the money is used by the financial markets to expand the
economy.  With a pay-as-you-go Social Security system, the taxes
collected today are used to pay benefits for current retirees, and
no actual saving occurs in terms of money going into financial
markets.  This means that a pay-as-you-go Social Security system
actually reduces economy-wide saving, which reduces economic growth
from what it could have been.


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Medicare and Medicaid

Public spending on health care has increased as a share of total U.S.
personal health care expenditures over the past several decades, as
shown in Chart 6-2. In 1960, only 21 percent of personal health care
spending was paid for by Federal and State Governments. With the
introduction of Medicare and Medicaid in 1965, and SCHIP in 1997,
public spending as a share of total health care spending has more than
doubled to 45 percent. In contrast, the share of personal health care
spending that is paid out of pocket by individuals has fallen
dramatically from 55 percent in 1960 to just 15 percent of total
spending in 2006.
Medicare expenditures, which include benefit payments and
administrative expenses, were $432 billion, or approximately $10,500
per enrollee, in 2007. Between 1980 and 2006, real Medicare spending,
that is, spending adjusted for the effects of inflation, grew at an
average annual rate of 6.4 percent. This rate is higher than the 3.1
percent average annual growth rate for real GDP during that period.



Government spending on Medicaid and SCHIP includes benefit payments,
administrative expenses, and payments for the Vaccines for Children
program. Collectively, the Federal Government and States spent $352
billion on Medicaid and an additional $10 billion on SCHIP in 2008. Of
this total, Federal spending was approximately $190 billion for
Medicaid and $7 billion for SCHIP. The amount spent on different
Medicaid enrollee groups varies considerably. While the elderly and
disabled represent the smallest groups in terms of numbers of
enrollees (28.1 percent), they account for over 67 percent of
spending, as depicted in Chart 6-3. (See Box 6-2 for a discussion of
Medicaid and long-term care expenditures.) In contrast, children are
much less expensive to cover. In 2007, almost half of total Medicaid
enrollees were children, and yet they generated less than 20 percent
of total spending.
Between 1997 and 2007, real Federal Medicaid spending grew at an
average of 3.5 percent per year. This growth reflects a number of
factors, including increased enrollment from outreach efforts and
eligibility expansions, increased use of high-technology services
(such as advanced diagnostic imaging and prescription drugs), and
greater reliance on Medicaid to cover long-term care expenses.
Medicaid spending is expected to continue growing faster in real terms
than the overall economy throughout the coming decade.



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Box 6-2: Long-Term Care and Medicaid


Today, about 10 million Americans receive long-term care services.
Long-term care refers to medical care and support required by someone
with a chronic illness or disability over an extended period of time.
Typical long-term care services range from providing assistance with
eating, bathing, and dressing, to managing medications and
preparing food.  Most people who require long-term care are 65
years of age or older.  This demographic cohort is projected to
grow dramatically over the next several decades, greatly increasing
demand for long-term care services.

Current estimates suggest the average cost of nursing home care is
$68,000 per year, an amount high enough to strain most familiesï¿½
finances.  Private long-term care insurance represents one way
individuals can obtain financial protection from these costs.  Yet
most people do not purchase long-term care insurance. In 2005,
Medicaid expenditures for long-term care services were $101 billion, representing 49 percent of the Nationï¿½s spending on long-term care.
Under Federal law, State Medicaid programs must cover nursing home
care and home health care, and may opt to cover some personal care
services as well for qualified individuals.  In contrast, Medicare
covers only some home health care and limited recuperative care in
skilled nursing facilities following a qualified inpatient
hospitalization.  In 2005, Medicareï¿½s share of total U.S. long-term
care spending was approximately 20 percent.
Medicaid expenditures have grown rapidly in recent years with the
increasing cost of covering long-term care and a growing population
of elderly and disabled people.  Medicaid expenditures on long-term
care, including skilled nursing care as well as home- and
community-based services, are expected to grow at an average real
rate of approximately 6 percent per year over the next decade.
By 2017, Medicaid long-term care expenditures for the Federal
Government and States are projected to reach $228 billion. In the
absence of fundamental reforms, this enormous entitlement burden
will severely strain both Federal and State budgets.

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Factors That Drive Expenditure Growth
Over Time

Growth in expenditures for Social Security is expected to accelerate
as the baby-boom generation retires, after which it is expected to
level off. In contrast, expenditures for Medicare and Medicaid are
expected to continue rising faster than GDP. This section examines the
main factors that drive these expected increases in expenditures.

Demographic Shifts

The changing demographics of the United States population is an
important factor in the growth of entitlement spending. With slowing
birth rates and increasing life expectancy, the U.S. population is
aging. For example, in 1950, less than 12 percent of the adult
population was 65 or older; in 2008 this group constituted nearly 17
percent of the adult population. Demographers estimate that this trend
will continue and that by 2030, twenty-five percent of the adult
population--72 million people--will be at least 65 years of
age.
This demographic shift means there are fewer workers paying taxes
into the Social Security system for each retired person. To illustrate,
in 1950, there were 16 workers paying taxes into the Social Security
system for each Social Security beneficiary, meaning the effective tax
burden on each worker was only one-sixteenth of the average amount
paid to each beneficiary. In 2007, there were 3.3 workers per
beneficiary. The number of workers per beneficiary is expected to fall
further, to 2.6 workers per beneficiary in 2020 and to 2.1 workers per
beneficiary in 2035. As the number of workers per beneficiary falls,
the effective individual burden of taxes for both Social Security and
Medicare Part A increases. For example, for Social Security, the
payroll tax rate has been raised more than 20 times and the maximum
annual amount of taxable income has been increased statutorily 11 times
since the program's inception. This maximum is now (since 1981)
adjusted annually to reflect average wage growth.
It is important to note that the demographic shift is not a temporary
phenomenon brought on simply by the aging of the baby-boom generation.
That is, assuming stable fertility rates and immigration patterns, one
should not expect to return to a world with 16 workers--or even
5--contributing to each Social Security recipient's benefit
after the baby-boom generation stops collecting Social Security
benefits. Chart 6-4 shows that in the very near future, as the baby
boomers retire en masse, the share of the adult population that is
eligible for Social Security and Medicare will begin shifting from a
recent average of about 16 percent to over 25 percent, where it will
stay for the foreseeable future.



A clear implication of this trend is that there will be fewer workers
to pay taxes to support each Social Security and Medicare recipient.

Increased Health Care Spending per Beneficiary

Advances in medicine over the past few decades have created new
methods for diagnosing illness and disease, as well as new therapies
for preventing and treating medical conditions. While these advances
have contributed to improvements in quality of life and longer life
expectancy, they also have contributed to greater utilization of
complex, expensive treatments and higher spending per person. This
phenomenon is not restricted to Medicare and Medicaid enrollees, but
instead reflects broader health spending patterns among individuals in
the United States.
Although health insurance, including Medicare and Medicaid, provides
important financial protections, one consequence of comprehensive
coverage and a third-party payment system is that individuals have
little incentive to consider providers' costs when making
decisions about the medical care they receive. This moral hazard
effect can lead people to demand more medical care than they would
without insurance because their out-of-pocket cost at the point of use
constitutes only a small portion of the total cost of the service.
Among Medicare enrollees, moral hazard problems are exacerbated by the
widespread use of supplemental insurance, including retiree coverage,
private Medigap plans, and Medicaid (for dual eligibles). In effect,
the combination of Medicare and supplemental insurance means enrollees
pay only a very small portion or none of the total cost of care, and
as a result, price is removed as a factor in determining how much
medical care enrollees consume.

The Bottom Line

The permanent demographic shift and growth in per-person health care
spending suggest that there are two distinct aspects of these programs
that must be addressed. One aspect is program solvency: that is, how
will the Government finance the benefits scheduled to be paid over the
near term to current and future beneficiaries? Given the permanent
nature of the demographic shift and the likelihood that future health
care expenditures will grow, it will be impossible for the Government
to continue these entitlement programs indefinitely as they currently
exist. Thus, the second aspect that must be addressed is the long-term
sustainability of the programs.

The Financial Future of Social Security

The demographic transition to an older population that is already
underway in the United States will place increasing stress on the
financing of Social Security in the years ahead. This section examines
the issues inherent in ensuring that benefits can be paid in the near
term (solvency) and the issues that must be addressed to ensure long-
term sustainability of this important program.

Addressing Future Solvency

Projections by the Social Security Administration (SSA) indicate that
payroll tax revenues will exceed expenses through 2016, then,
beginning in 2017, it will be necessary to draw on Social Security
Trust Fund assets to pay all scheduled benefits. This would require
making increasing amounts of general revenue available from
2017-2041 to pay full scheduled benefits, after which time the
trust fund would be exhausted. Payroll tax revenues are projected to
be sufficient to pay 78 percent of scheduled benefits in 2041 and
beyond.
As Social Security costs continue to rise faster than revenues,
increasing pressure will be placed on the general fund of the Federal
Government. By purchasing Treasury bonds with its annual surpluses,
the Social Security Trust Fund has been effectively lending money to
the general fund of the Federal Government. As Social Security's
annual surpluses decline, beginning after 2009, less money will be
available to the Treasury Department from this channel and the
Government will increasingly be forced to find other revenue sources
or reduce spending. The problems for the Federal budget intensify in
2017, when Social Security will first need money from the general fund
to pay scheduled benefits. During the 2020s, Social Security will
require larger and larger transfers from the general fund as it
redeems the Treasury bonds that have accumulated in the trust fund,
putting greater and greater pressure on the Federal budget.
Most proposed solutions to the solvency issue involve some form of
revenue increases, or benefit reductions, or both. Social Security
revenues could be increased either by raising the payroll tax rate or
increasing the maximum amount of taxable earnings. However, as
discussed in the preceding chapter, imposing taxes distorts
markets--higher taxes would decrease economic efficiency by
worsening the adverse labor incentives discussed in Box 6-1.
There are a variety of ways Social Security benefits could be reduced,
such as further delaying the normal retirement age, or reducing
scheduled benefits, particularly for higher-income workers. To help
address the solvency issue, the President embraced the concept of
progressive price indexing for new retirees. Progressive price
indexing would reduce the growth in initial benefits for new retirees,
particularly for high-income workers, and thus would reduce projected
program costs in the decades ahead, while retaining currently
scheduled benefits for very low income workers.
Workers with higher preretirement earnings are eligible for a larger
initial benefit, but the marginal increase in the initial benefit
decreases as a worker's preretirement income gets higher and
higher. Progressive price indexing would further reduce the rate at
which benefits grow with preretirement income, which would slow the
year-by-year growth of initial benefits for high- and middle-income
retirees. This proposal would ensure that retirees of the future will
receive real benefits that are at least as high as those of
today's retirees who are at comparable positions on the wage
spectrum. Benefits for all recipients would still increase annually
via cost-of-living adjustments to maintain the purchasing power of the
benefits. Note that the current benefit formula would be preserved for
individuals with low preretirement income. Estimates suggest that
progressive price indexing would cover about 70 percent of the gap
between income and outlays over the long term. Benefits paid under the
Disability Insurance program would not be affected by this proposal.

Funding Future Benefits

The current Social Security system was designed in an era in which
average life expectancy was less than 65 years and few women
participated in the labor force. Today, average life expectancy is 78
years and about 60 percent of all women participate in the labor
force. The demographic and labor market changes that have occurred in
the last 70 years or so render the pay-as-you-go system of the 1930s
inappropriate for the 21st century.
A central feature of the Administration's 2005 proposals for
Social Security reform, the Personal Retirement Account (PRA), was
designed to pre-fund a portion of future benefit obligations.
Participation in PRAs would be entirely voluntary. Workers could
choose to have up to 4 percentage points of their current Social
Security taxes go into their own, individual account. The Federal
Government would administer these accounts, making contributions and
withdrawals as appropriate for each worker's wages and
individual choices.
Each worker could choose to have the funds in their account invested
in any of a set of prescreened, broadly diversified investment funds,
similar to those currently available to Government employees in their
retirement savings plan. Recent stock market declines raise concerns
about the desirability of investing even a portion of Social Security
assets in the stock market. However, market declines, like market
increases, are a normal part of stock market behavior and do not
negate the desirability of owning stocks as part of a long-term
investment strategy. From 1926 to 2000, even with several periods of
significant market decline, stocks generated an average annual return
of 10.7 percent.
Nevertheless, there is currently much concern about the risks of
investing Social Security assets in the stock market. One way to
mitigate these risks could occur automatically; as workers near
retirement age, their PRA investments could be moved to lower-risk,
life-cycle funds, which ensure the safety of the worker's
retirement benefits by progressively shifting more of the
worker's investment from growth funds to secure bonds as the
worker nears retirement age.
A PRA-based system offers a partially self-funded retirement benefit
while retaining the social safety net aspects of the current system. A
primary advantage of this system would be significantly reduced
intergenerational transfers from future workers entering the system.
This system would give workers a partial alternative to the current,
pay-as-you-go, Social Security system that, as discussed above, will
require reducing benefits when the Social Security Trust Fund is
exhausted or force workers to bear ever-increasing tax burdens as the
population continues to age.
PRAs could be phased in to ensure that current retirees and workers
nearing retirement would receive the full Social Security benefits
they are expecting. PRAs would offer those who want it individual
ownership and management of retirement assets and could be
transferable to family members if the worker were to die prematurely.
Finally, PRAs would reduce the disincentives the current system
generates regarding labor supply and saving decisions. (Box 6-1
describes the disincentives present in the current system.) For
example, PRAs reduce possible adverse labor supply effects for
secondary earners by giving them explicit rights to a portion of their
Social Security assets.

The Financial Future of Medicare and Medicaid

Medicare and Medicaid are currently responsible for purchasing health
care services for over 80 million individuals in the United States
annually--a number that is expected to exceed 100 million by
2017. This section takes a closer look at the future budgetary impact
of these programs and identifies possible strategies for promoting
long-term sustainability of Medicare and Medicaid.
Recall that Medicare is financed predominately by payroll taxes,
general revenues, and beneficiary premiums. Under current projections
in the 2008 Medicare Trustees Report, the Medicare Hospital Insurance
Trust Fund for Part A is projected to be exhausted in 2019. The
projected 75-year deficit for the Medicare Hospital Insurance Trust
Fund is 3.54 percent of taxable payroll. That is, the Medicare
Hospital Insurance payroll tax would have to immediately increase from
a total of 2.90 percent to 6.44 percent to cover all projected
spending for Part A over the next 75 years. Thus, one option for
keeping Part A solvent would be to more than double the Medicare
payroll tax rate. For Medicare Parts B and D, as well as Medicaid,
general revenues are the largest source of financing. This suggests
that, in the absence of significant reforms to slow spending growth,
spending on other government programs will have to be dramatically
reduced, budget deficits will grow larger, or income taxes will have
to increase.
Real spending growth for Medicare and Medicaid is on a much steeper
trajectory than projected growth for the economy as a whole. The long-
term sustainability of these programs is in question unless
policymakers implement a comprehensive set of reforms to slow both the
overall growth in health care spending as well as the Federal
Government's liabilities. Although key stakeholders have not yet
discovered a silver bullet for slowing overall spending growth,
insurers and providers are pursuing a variety of approaches in an
attempt to improve the efficiency of resource allocation and to slow
the growth of costs.
Some of these efforts focus on greater use of high-value health care
services by individuals, including preventive care (certain types of
screening for diseases), wellness initiatives (flu shots or smoking
cessation advice), and disease management for those with chronic
conditions. Other efforts target provider behavior, including adopting
health information technology that may reduce medical errors and
duplication of services, and participating in quality-measurement
activities and public reporting. In value-based purchasing, insurers
design payment systems that are tied more directly to the quality and
efficiency of care that is delivered by providers. One example
includes pay-for-performance programs, whereby providers may receive
financial rewards if the quality of care they provide achieves certain
outcomes (such as a physician making sure that all of his diabetic
patients receive HbA1c tests during the year) or if a provider shows
improvement over time in the quality of care he or she provides. Of
course, many of these initiatives are fairly recent and as a result,
the empirical evidence is not yet available to establish what impact
these particular initiatives might have for slowing overall cost
growth.
A second strategy directly targets Federal spending growth
vis-`a-vis structural changes to the designs of the Medicare and
Medicaid programs. Several types of reform proposals are specifically
aimed to reduce Federal spending by altering the current structure of
Medicare benefits. Increasing the age of eligibility for Medicare,
raising premiums, and modifying the benefit design are three examples.
Similar to the changes that were made to Social Security in 1983, the
age at which individuals become eligible for Medicare could gradually
increase. However, unlike Social Security, the savings generated from
delaying eligibility may not be substantial, since younger Medicare
beneficiaries have much lower average costs relative to older
beneficiaries.
Beneficiary premiums are an important source of income for Medicare
Parts B and D. Raising beneficiary premiums is one option for reducing
Federal spending, although raising premiums for all beneficiaries may
impose a significant financial burden on lower-income beneficiaries
who are not also eligible for Medicaid. One suggested proposal calls
for the broader use of income-related premiums, whereby higher-income
beneficiaries would pay more for their coverage. Income-related
premiums are already being used for Part B; however, as of 2007 the
threshold was set so high that it affected less than 3 percent of the
Medicare population. Using more stringent thresholds and adopting
income-related premiums for Medicare Part D are two possible
strategies for reducing the implicit subsidy that Medicare provides to
higher-income beneficiaries.
Modifying the benefit design offers another approach to limiting
Federal spending. Benefit design features, such as deductibles and
coinsurance, are typically used to address moral hazard concerns.
While increasing deductibles and coinsurance can reduce
beneficiaries' incentives to overuse care and reduce spending,
it may lead some beneficiaries to delay or forgo needed care due to
cost. A related issue is the widespread use of supplemental Medicare
insurance, which typically reimburses beneficiaries for deductibles
and coinsurance amounts when they seek care. With this additional
coverage, the price of medical care is effectively removed as a factor
from decision making. Some economists have suggested that private
supplemental Medicare insurance should be limited or eliminated
altogether. Since greater utilization of high-technology treatments is
a major driver of health care spending growth, an additional strategy
is to base coverage decisions about new medical treatments on their
comparative effectiveness and cost effectiveness relative to existing
therapies. Certainly, this may raise concerns by patients and
providers regarding the role of government in determining which
medical treatments are prescribed.
In addition to strategies that alter the existing program structure,
others have suggested more fundamental changes to promote long-run
sustainability. For example, some have suggested moving completely to
a market-based approach in which Medicare beneficiaries receive risk-
adjusted and income-adjusted vouchers that could be applied toward the
cost of private health plans. Such a reform could build upon the
strengths of the current Medicare Advantage program and potentially
strengthen competition in the market for health insurance. Moreover, a
voucher system would provide greater certainty in terms of the Federal
Government's future liabilities.
Medicare provider payment systems are complex and generally create
poor incentives for limiting spending growth. Fee-for-service payment
systems reward providers for how much they do rather than for the
value that they provide to Medicare patients. Furthermore,
administrative pricing may or may not necessarily reflect what would
be observed in a competitive market, due to inflation and
technological advances in medicine. Competitive bidding has been
proposed as one alternative method for setting prices. Specifically,
competitive bidding requires providers to submit bids that reflect
costs plus a normal rate of profit. Providers with the lowest cost can
be identified. Over time, this type of system can enable providers to
more easily adjust prices to reflect changes in production costs
resulting from changes in input prices (such as the wages of nurses)
or technology (such as MRI or CT scanners).
For Medicaid, one of the most pressing issues is the anticipated
growth in long-term care. While some people require the level of care
provided by nursing homes, many eligible Medicaid beneficiaries would
actually prefer less expensive community-based care. Transitioning
away from primarily institutional care and toward a more community-
based long-term care system is one potential cost-saving measure;
however, it is not clear to what extent overall demand for services
will rise when access to this option improves. Encouraging the
purchase of private long-term care insurance through tax credits or
Qualified State Long-Term Care Partnerships, which protect some assets
of those with long-term care insurance while still allowing them to
qualify for Medicaid, may both reduce the spending burden on Medicaid
and protect many seniors from poverty. Additionally, better
coordination of care between Medicare, which is often responsible for
financing initial nursing home stays through its post-acute care
coverage, and Medicaid, which often assumes responsibility for nursing
home patients after their Medicare benefits end, could also help
reduce costs.

Conclusion

There are no painless solutions to the budgetary challenges arising
from long-term projected growth in Social Security, Medicare, and
Medicaid. While there is no specific year when one can be sure a
crisis is imminent, it is clear that these problems will only grow
larger the longer policymakers delay in developing and implementing
reform strategies. The environments in which Social Security,
Medicare, and Medicaid were created no longer exist, and the
Legislative and Executive branches of the Federal and State
Governments need to take up the budgetary challenges entitlement
programs present and ensure that these programs are adapted to their
new realities.