Improving Medicare Financing: Are We Up to the Challenge?

By Marilyn Moon

Medicare is one of the most successful programs of the federal government. It has achieved nearly universal coverage of healthcare for the most difficult populations to serve—people ages 65 and older and those with permanent disabilities. It ranks well above private insurance in satisfaction ratings from enrollees (Davis et al., 2012). And while critics point to its rapid cost growth over time, its per capita rates of growth are lower than those attributable to private health insurance for comparable services (Medicare Payment Advisory Commission, 2013). Yet Medicare is nearly always a target of federal budget-cutting efforts.

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In an era of government distrust and opposition to any tax increases, Medicare has been a target because of its size and rate of growth since its inception fifty years ago. In the early 1970s, Medicare represented only 3.5 percent of the federal budget but, by 1990, accounted for 7.8 percent. The share has grown steadily such that Medicare took up 14.6 percent of the 2014 federal budget (Office of Management and Budget, 2015). That alone makes it a target when there is enormous reluctance to raise taxes. In terms of overall spending, Medicare has gone from $7.5 billion in expenditures in 1970 to $583 billion in 2014 (Centers for Medicare & Medicaid Services [CMS], 2014). By 2020, that figure is expected to reach $883 billion.

This growth makes it easy for opponents to argue for “trimming” the program regardless of whether that growth has been appropriate and necessary to meet the needs of the older adult and disabled populations. This debate is coupled with claims that the trust fund for Part A will be insufficient in the future to pay all benefits. Together, these create the perfect conditions to argue for changes in Medicare.

What often is missing from this discussion, however, is any serious consideration of increasing funding for the program. Ultimately, Medicare will need more financing unless the program is to face substantial and likely harmful cuts in benefits. We need a thoughtful debate about how to pay for healthcare for older adults and people with disabilities into the future. Who should be responsible for those costs?

One way to think about who should pay over time is to consider whether we should retain the current distribution of burden. The Medicare program pays about 70 percent of the costs of services it covers, while individuals and their families are responsible for the remainder (Moon, 2006). Additional revenues would be required if the federal government continued with its current share of healthcare spending for this group. But keep in mind that beneficiaries’ burdens also will rise as healthcare spending rises, even if shares remain constant. Both taxpayers and beneficiaries will have to pay more in the future. If one group is deemed better able to pay than another, we, as a society, might decide to change that share over time. However, opponents of adding revenue sources to Medicare are arguing implicitly that the burden should be shifted increasingly to beneficiaries. They have bypassed the discussion about who should pay.

Past and Future Changes in Medicare

While from the beginning it was recognized that Medicare would grow in the coming years, some factors affecting Medicare’s costs have risen more quickly than anticipated. Some of this reflects improvements in treatments and their outcomes, but inflation in healthcare has been substantially higher than for other services. And, costs from inflation do not translate into a higher level of benefits; rather, it is simply ever more costly to pay for healthcare. Higher spending does not mean that each generation is getting greater and greater benefits, with the exception of the prescription drug benefit in 2006 and some modest improvements in protections for those with lower incomes.

Even with the addition of a drug benefit, the federal government continues to pay about 70 percent of the costs of care. and with the passage of time, that share has become more expensive, as is the 30 percent that beneficiaries are required to pay (Cubanski et al., 2014). Another key factor in Medicare’s growth is the increase in life expectancy since 1965—in part a tribute to the success of Medicare (Social Security Administration, 2014). The consequence is that people use more health services over time.

Since the late 1970s, Medicare has been subjected to substantial changes in an effort to slow its growth and, so far, these changes have achieved those goals without major damage to the program. Some changes, such as the payment system reforms for hospitals and physicians, have improved efficiency for both Medicare and much of the rest of the healthcare system in the United States. Most of the changes have reduced payments to care providers, although there also has been a shift in costs to beneficiaries in the form of income-related premiums and some benefit limitations (Kaiser Family Foundation, 2009). While there is no controversy over seeking innovations and reforms to improve care delivery, even substantial improvements in efficiency cannot reverse the higher costs that will result from the rise in the number of beneficiaries as baby boomers turn age 65, coupled with expected growth in per capita program costs.

Payroll taxes represent the main revenue source for Part A (hospital insurance). The current rate is 1.45 percent each for employers and employees and it has been at the same level since 1987, despite the extraordinary growth in the program. Although the Affordable Care Act did increase the tax on those with very high incomes, the base to which the tax is applied rose to include all wages after 1994. Parts B and D of Medicare (Supplementary Medical Insurance and the drug benefit, respectively) are funded by general revenues and beneficiary contributions. At present, these premiums and general revenue contributions rise, by law, to keep Parts B and D fully funded. With no change in policy, Part A will face financing difficulties when its trust fund is depleted by 2030 (CMS, 2014), but Parts B and D would continue, albeit drawing on a greater share of general revenues in ensuing years.

While there still are good options for holding down spending—such as innovations to better control spending, proposals to reduce payments to private plans and to negotiate prescription drug discounts from pharmaceutical companies—most of the major changes proposed to “reform” Medicare have focused on increasing the share that beneficiaries pay or reducing the number of people eligible for the program. Because people still must get care somewhere, such options basically are asking beneficiaries to pay more. For example, a higher eligibility age is essentially a cut in benefits, especially for those who do not have access to subsidized insurance from employers or the federal government. Higher premiums or co-pays largely shift costs onto beneficiaries. Providing vouchers to purchase private insurance that are subject to limits on how fast federal subsidies can grow (an option referred to as premium support) also is a way to shift costs and risk to beneficiaries. Even some of the “efficiencies” that limit access to care may shift costs if they do not improve the way care is delivered, but restrict access to needed services. Thus, most reforms under discussion would lower the share the federal government contributes to Medicare’s costs, unless revenue changes are added into the mix.

Should Financing Options Be on the Table?

While Medicare’s critics claim that reforms must be undertaken to keep the program solvent for the future, they generally reject the option of asking taxpayers to pay more. But if the program is to remain intact, it is essential to consider financing options. Given the importance and popularity of this program, all financing options need to be on the table for discussion.

Increasing taxes to support Medicare is consistent with the program’s original intent. Even in the 1960s it was known that the ratio of workers to retirees would decline over time and that increases in healthcare spending occurred more rapidly than costs of other goods and services and wages (Ball, 2000). But the idea of fully funding the system to plan for these changes was rejected because it would create a drag on the economy. Rather, the intent was that tax rates would be adjusted upward periodically to keep the system sound (Myers, 1970). It was thought to be difficult to anticipate the full extent of future spending needs, creating the risk of over-taxation and fiscal drag on the economy. The growth of the economy (and incomes) was expected to make it possible to fund healthcare spending for successive waves of older adults. Are we in a position today to afford such contributions? That question is the essential one to consider when deciding what changes Medicare should undergo in the future.

Medicare’s popularity suggests that there is continued strong support for the social insurance approach it represents. Determining the appropriate balance between revenues and spending needs to be part of the discussion for sustaining Medicare into the future. This issue was expressed eloquently in 1968 by Joseph Pechman, Henry Aaron, and Michael Taussig in the context of Social Security, but applies equally well to the Medicare program:

Benefits of the currently retired need not, and should not, depend on their past taxes; they should be based on decisions reached by democratic political processes as to how much of the nation’s total income should be allocated for retirement, disability, and survivor benefits. Similarly, the tax should not be regarded as an insurance premium, but rather as a financing mechanism—to be judged on its own merits—for a large, essential government program (Pechman, Aaron, and Taussig, 1968).

There are two ways in which the relative burdens of taxpayers and beneficiaries can be adjusted over time: first, determining whether new revenues will be considered and, if so, which taxpayers will be tapped. Beneficiaries still could be asked to bear a substantial burden from new taxes, if any new taxes fall disproportionately on older Americans, for example.

Who Should Pay?

A critical issue for public policy is to figure out who should pay. There are many ways to contrast the abilities of future taxpayers to pay more as compared to future Medicare beneficiaries, and not all assumptions lead to the same conclusions. In general, living standards during Medicare’s history have not risen as fast for those who are out of the labor force as for those who remain in the labor force (as shown in Table 1, below). Estimates of the growth in Social Security benefits (even if they remain unchanged) indicate slower growth than in the incomes of the working population. However, the recent Great Recession and its aftermath reversed this trend—at least temporarily—as wages for the middle class have stagnated (Moon, 2014).

Table 1

Median Per Capita Income and Change in Median Per Capita Income,
1997–2012 (Adjusted for Inflation)
Age Group Median per capita income (adjusted for inflation)
1997 2002 2007 2012
Younger than age 65 29,502 31,805 32,787 29,788
Age 65+ 18,230 18,190 19,294 20,380
  Change in median per capita income (adjusted for inflation)
  1997-2002 2002-2007 2007-2012
Younger than age 65 7.8% 3.1% -9.1%
Age 65+ -0.2% 6.1% 5.6%
Source: U.S. Census Bureau, 2014.

One way to look at this would be to consider how the current shares of the cost of Medicare borne by working-age families and older Americans will compare to their respective median incomes over time. As noted earlier, beneficiaries pay about 30 percent of the costs of Medicare, with the remaining 70 percent borne by taxpayers. The dollar value of burdens on both groups has increased; the percentage is slightly higher for the taxpayer group because the share of Americans receiving Medicare has gone up. On the other hand, the burden has risen as a proportion of the incomes of people ages 65 and older at a faster rate than the burden on taxpayers (Moon and Storeygard, 2002). This is, of course, a simplistic measure because comparing income levels between beneficiaries and younger taxpayers can be problematic. A range of factors, such as burdens on the young of raising families and caring for children, and burdens on Medicare beneficiaries from unusually high healthcare costs, need to be considered.

What about future ability to pay? It is important also to consider how relative resources will likely change in the future. Will the balance between old and young remain in place? This is difficult to answer, but somewhat easier for older Americans because we already have a strong sense of that cohort’s earnings history, savings, and pension accumulations. Projections for older adults are that resources likely will grow only very slowly for the foreseeable future (Jacobson et al., 2014). Prospects for younger families are somewhat brighter if wage growth again begins to accelerate and we can avoid downturns such as we recently experienced in the Great Recession.

Perceptions of who can afford to pay will be key. The definitions of high income or moderate income usually are not consistent when comparing cuts in benefits with higher taxes. For example, Medicare beneficiaries with incomes above $80,000 have been treated as well off, and those individuals now pay a higher income-related premium to enroll in Parts B and D benefits. In contrast, many politicians justify tax-rate reductions for those with incomes of $250,000 or more, arguing that this figure is the upper limit for the middle class. It is important to arrive at some consensus on a fair trade-off across options.

It may make sense to pair tax increases with beneficiary contribution increases to spread the burdens of future financing, but it is important to carry this discussion forward on a realistic basis. There are no magic bullets that can spare us from the choices that need to be made.

Assessing Revenue Options

If, as a society, we decide to retain the current approximate level of sharing of Medicare’s costs between taxpayers and beneficiaries, additional revenues would be needed in the future. And even if beneficiaries are asked to take on a greater share, it is difficult to avoid revenue increases. When looking for new revenues, the potential options differ substantially and alternatives require a thorough airing. Choices affect the degree of redistribution that Medicare would sustain moving forward and specific options each have advantages and disadvantages. A number of key criteria should be considered, including:

  • The rate of growth of revenue into the future, which will determine whether resources will keep up with growth in Medicare spending. If not, further revenue adjustments will be needed periodically.
  • The sufficiency of the revenue source. It is always simpler to consider just one new tax, but many revenue sources may already be heavily tapped, or the amount feasible from one source may require using a combination of sources. Some analysts have suggested a new source, such as a value-added tax.
  • The extent to which a revenue source creates desirable or undesirable incentives because taxes can distort individual decision-making. “Sin taxes” sometimes are proposed because they discourage undesirable consumption, while payroll taxes often are criticized because they may discourage employers from hiring when labor costs rise.
  • The degree of progressivity of the tax. Asking higher income people to pay more, relative to lower income individuals, was a strong principle in the design of Medicare. This would tend to favor income taxes over payroll taxes.
  • The perception that revenue is directly linked to benefits. Support for payroll taxes often has been higher among the public than for other taxes because of the linkage between revenues and benefits. Similarly, sin taxes offer the appeal of taxing those activities that tend to raise the costs of healthcare.

Perhaps the most likely change would be a modest increase in the payroll tax. The financing structure for Part A requires balance of the trust fund, which primarily is fed by dedicated payroll taxes. Consequently, the need for new revenues shows up acutely when the trust fund solvency annual reports are released. The basic payroll tax rate supporting Part A of Medicare has not risen since 1986, despite the fact that Part A Medicare costs have gone up by more than a factor of four. Revenues to Part A of Medicare, which come largely from the payroll tax, have gone up because, in 1994, the base on which the tax is applied was increased and revenues from some of the taxation of Social Security were added to the mix. More recently, high-income individuals have been assessed an additional amount when their incomes exceed $250,000 per year. All of these sources come from those with higher-than-average resources, and in the case of Social Security taxation, from beneficiaries.

Although revenues were sufficient for a long stretch of time (reinforced by changes that slowed the growth in Part A spending), the date of exhaustion of the Part A trust fund likely will move closer without further changes in the program. One way to improve the certainty and stability of the funding stream would be to increase the basic payroll tax rate. An increase from 1.45 percent of wages to 1.95 percent would raise substantial revenue—about $800 billion over the next ten years (CBO, 2014).

It is important to note that although Part A financing has fallen short over the last two and a half decades, general revenue contributions into Medicare for Parts B and D rise as needed. Under current law, the financing both for Parts B and D requires general revenues to be increased as needed. And these two portions of Medicare constitute an increasing share of total spending because care has moved out of institutional settings and because of the addition of the new drug benefit in 2006. In 2012, Parts B and D totaled 55 percent of Medicare spending, compared to 30 percent in 1970. Without explicit changes in the benefit structure, general revenue contributions will continue to rise over time to cover Parts B and D liabilities. If the Medicare program is to rely on general revenue support, an increase in the income tax would be appropriate to ensure that Medicare spending does not increase the federal deficit.

To bolster Part A funding and to supplement Parts B and D, a range of other revenue enhancers could be undertaken, perhaps specifically earmarked for Medicare. Part of the popularity of the payroll tax is that people recognize that it goes to support Medicare and Social Security, so those paying the tax understand what they are paying for.

Many other options have been suggested, ranging from higher sin taxes to energy taxes. Consider a few examples from a recent CBO (2014) report on revenue and spending options (see Table 2, below). It is interesting to contrast the differences in magnitude of the revenues that would be raised. Very large amounts would come from payroll or income tax changes that are applied to the full base. Restricting various tax advantages, such as the preferential treatment of capital gains and the deductibility of mortgage interest in the income tax, would raise considerably less, but are sometimes mentioned because they would affect older high-income families. And most of these options would raise substantially higher amounts of revenue than would a change to increase Parts B and D premiums in Medicare by 40 percent.

Table 2

Options for Enhancing Medicare’s Revenue Sources Over Five or Ten Years (Billions of Dollars)
Revenue Options 2015–2019 2015–2024
Increase the payroll tax rate by 1 percentage point $346 $800
Increase all individual income tax rates by 1 percentage point 293 689
Raise tax rates on long-term capital gains and dividends by 2 percentage points 22 53
Convert mortgage interest deduction to a 15 percent tax credit 9 113
Increase the excise tax on cigarettes by 50 cents per pack 18 35
Increase all taxes on alcoholic beverages to $16 per proof gallon 31 66
Increase premiums for Parts B and D of Medicare* 65 299
*Technically, this is a negative outlay because it reduces Medicare spending. It is shown here to contrast with the revenue options.
Source: CBO, 2014.

Making any decision to ask some groups within the population to pay more likely will be challenging. However, when polled, most Americans indicate a willingness to pay for protecting the very popular Medicare program. Because Americans want to protect and pay for the program, it makes sense to move forward immediately with new revenue options. It is destabilizing for the program to be constantly criticized as too large and in need of “reform”—which often is shorthand for cutting the program even more. Further, immediate action would still ask many baby boomers to contribute to new revenues because most remain in the labor force.

A modest increase in the payroll tax for Part A likely is the most reasonable first step. To address whether or not general revenues increasingly are being consumed by Parts B and D, additional taxes that are specified as being raised to support Medicare also would be useful. This is where the balance between younger and older taxpayers should be addressed. The most promising would be a combination of sin taxes (perhaps including the gasoline tax) and loophole-closing in the income tax for items that disproportionately aid older taxpayers (such as the preferential treatment of capital gains).

When paired with other reasonable reforms for Medicare, it should be possible to put the program on a strong financial footing, going forward. Polling would suggest that this would be acceptable to most Americans—but whether it will prove politically viable is yet to be known.

Marilyn Moon, Ph.D., is the director of the American Institutes for Research (AIR) Center on Aging in Washington, D.C., and is an AIR Fellow.

Editor’s Notes:

The entire Summer 2015 issue of Generations is available on AgeBlog thanks to the generous support of The Benjamin Rose Institute on Aging, Compassion & Choices and Robert Wood Johnson Foundation President's Grant Fund of the Princeton Area Community Foundation. Click here to read more.

This article is taken from the Summer 2015 issue of ASA’s quarterly journal, Generations, an issue devoted to the topic, “Medicare at 50.” ASA members receive Generations as a membership benefit; non-members may purchase subscriptions or single copies of issues at our online storeFull digital access to current and back issues of Generations is also available to ASA members and Generations subscribers at Ingenta Connect. For details, click here.

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