The
House and Senate have approved legislation adding a prescription
drug benefit to Medicare, and a conference committee is now
attempting to reconcile these two bills. If the two chambers do
manage to iron out their differences, the resulting bill will
represent the biggest unfunded entitlement expansion in nearly 40
years.
Unfortunately for taxpaying Americans,
however, the projected 10-year $400 billion cost is just a down
payment that will not produce the necessary Medicare improvements
and needed reforms. Instead, Congress will have passed a bill that
in future years will require huge new taxes--new taxes that will
threaten the recently enacted tax plan.
Moreover, this massive new entitlement
significantly endangers future tax reductions and undermines the
campaign for a fair and simple system such as the flat tax.
The
Medicare prescription drug proposal is bad health policy,
exacerbating the flaws in a system that has almost no market-based
incentives to improve service and control costs. But the House and
Senate bills also will undermine sound tax and economic policy in
several ways. Specifically:
- The size of
government will expand
A new entitlement will take America even faster down the
road that has caused so much economic damage in Europe's welfare
states. Indeed, the unfunded Medicare expansion is essentially a
huge future tax increase since the population of Medicare
recipients will nearly double once the baby-boom generation
retires. Ironically, just when some European countries are waking
up to the problem and restraining unfunded entitlements, America
will be creating an enormous new entitlement.
- President Bush's
recently enacted tax cut and tax reform package will likely be the
first casualty
Because of arcane budget rules, the bulk of the 2001 and
2003 tax cuts expire at the end of 2008 and the end of 2010.
Extending these tax cuts or making them permanent will be
enormously difficult in an environment of skyrocketing spending for
government-provided health care. Indeed, the creation of a
prescription drug entitlement may be akin to repealing the Bush tax
cuts.
- By adding to the
deficit, the huge new unfunded liability will likely be the death
knell of further tax relief and fundamental tax reform
A prescription drug benefit means bigger deficits--a
problem that will intensify as the baby boomers start to retire in
the next decade. Once these demographic and fiscal variables become
part of the budget forecast, lawmakers seeking to cut taxes and
create a simple and fair tax code, such as the flat tax, in all
probability will face insurmountable political obstacles.
A
new entitlement means bigger government, and bigger government
means higher taxes, especially when politicians are expanding the
welfare state and neglecting much-needed Medicare reform. Simply
stated, the prescription drug benefit will make America more like
stagnant European nations such as France.
The Problem
Entitlement spending is the fastest
growing part of the federal budget, and this pattern will continue
even if there is no expansion of so-called mandatory programs In
just the past 40 years, entitlements have nearly doubled as a share
of federal outlays, climbing from 32 percent of total outlays in
1962 to 60 percent of the federal budget in 2002.
The
elderly will be a much bigger share of the population once the
baby-boom generation retires. And since the elderly consume most
entitlement spending, the fiscal outlook will worsen--even if there
are no changes to the underlying programs. According to the
Congressional Budget Office, mandatory spending for Social Security
and Medicare will nearly double as a share of the gross domestic
product (GDP) over the next 40 years.
Although Social Security and Medicare
spending are projected to explode, payroll tax revenues to finance
these programs will remain relatively constant as a share of GDP.
The net result will be huge long-term deficits, and Medicare is the
main problem. According to the trustees' reports on Social Security
and Medicare, the combined deficit of the
two programs will swell to more than 8 percent of national economic
output in 2075, with Medicare accounting for about three-fourths of
the red ink. According to government data, the Social Security
cash-flow deficit through 2075 is $25.3 trillion in today's
dollars. But this is spare change compared to the Medicare
cash-flow deficit, which is a staggering $66.8 trillion over the
same period.
While the long-term outlook is grim, even
the short-term prognosis is sobering. The baby-boom generation will
begin to retire in about 10 years, and the fiscal consequences will
be profound. The combined deficit will rapidly expand, climbing to
1 percent of GDP in 2015, 2 percent of GDP in 2020, and 3 percent
of GDP in 2025. To put that figure in perspective, 3 percent of GDP
today would be more than $325 billion, or $3,072 per household.
The
tax implications of these big deficits should concern all
responsible lawmakers as well as taxpayers. Raising revenue by just
1 percent of GDP next year would require an annual tax increase of
more than $100 billion. Over the next 10 years, the
tax increase needed to finance such a deficit would be more than
$1.5 trillion. Such a tax increase would be
a body blow to the economy, threatening European-style stagnation
and higher unemployment.
The Enormous Cost of a New Prescription
Drug Entitlement
In
the absence of program reform, creating a new entitlement for
prescription drugs is akin to pouring gasoline on a fire. And it
will be very expensive gasoline. The 10-year cost of the new
benefit is projected at $400 billion, but it is quite likely that
the real cost will be much larger since public and private-sector
estimates of drug costs in recent years have been well below actual
spending levels. But the $400 billion is trivial compared with the
situation when the baby boomers start to retire--just after the
10-year estimating window used by Congress.
There are several reasons to expect that
any prescription drug benefit will cost far more than official
estimates indicate. Three are particularly important.
- Behavioral changes will drive up costs
Government budget estimators have been notoriously
inaccurate in predicting how individuals will respond to changes in
fiscal policy. This is why tax cut estimates frequently overstate
the revenue loss associated with lower tax rates. But it also
explains why government prognosticators understate the cost of new
entitlement programs.
- When government
begins to offer a benefit, individuals have an incentive to alter
their behavior to maximize the amount that they will receive
Moreover, it is impossible to predict the development of
breakthrough drugs that will enhance the quality of life, but it is
safe to assume that seniors will want such drugs if they become
available, particularly if Medicare subsidizes them. This explains,
at least in part, why both Medicare and Medicaid have cost
taxpayers several times as much as first predicted.
- Politicians will
come under increasing pressure to expand the program
The House and Senate prescription drug bills offer
haphazard coverage to seniors. Both have deductibles and then offer
partial reimbursement up to a specified level. Once seniors reach
that level of drug expenditure, they then are responsible for all
costs up to another specified level, at which point the government
picks up almost all of the costs. As a result of this spotty
coverage, the $400 billion in the two bills will cover less than
one-fourth of the total prescription drug cost for the elderly over
the next 10 years.
This patchwork system will generate
enormous pressure on politicians to make coverage more uniform, and
special-interest groups most likely will demand that three-fourths
of the program be financed by general tax revenue, which could
triple projected expenditures. It is worth noting Senator Ted
Kennedy's view: "This is only a down payment. Hopefully, we can use
this down payment in an effort to fulfill our responsibility to
seniors over the years."
Demographic trends mean higher spending.
The baby-boom generation begins to retire in about 10 years. Today,
there are over 40 million people on Medicare; by 2030, that number
will jump to almost 80 million, nearly doubling in less than 30
years.
Yet, because Congress is using 10-year budget estimates, this
ticking fiscal time bomb is not part of the prescription drug
debate.
Making long-run projections is, by
necessity, somewhat speculative. The final legislation--if any--is
still unknown, as is exactly how behavioral changes and future
program expansions will affect costs.
Nonetheless, estimating the probable range
of fiscal effects is quite possible: It has been done by Thomas
Saving, one of the trustees of the Social Security and Medicare
Trust Funds. Based on data from the Medicare Trustees' Report and
the Congressional Budget Office and estimates from Texas A&M
University, he estimates that the Medicare deficit will consume 20
percent of federal income taxes in 2026 and 33 percent of income
taxes in 2042.
If a
prescription drug entitlement is created, those numbers will become
even more startling. Under a best-case scenario, with government
paying only 25 percent of drug costs, the Medicare deficit will
climb to 24 percent of income tax revenues in 2026 and 39 percent
in 2042. Using more realistic assumptions, however, the fiscal
burden will become much more ominous. If Medicare pays 75 percent
of prescription drugs, the program's overall deficit will consume
35 percent of income tax receipts in 2026 and 54 percent of those
revenues in 2042.
Medicare expenditures already are
projected to climb dramatically, and creating a new entitlement
will boost spending even faster. If lawmakers enact this
legislation without considering the consequences, they will put
their successors in an extremely difficult position, leaving them
with three politically unpopular options. Future lawmakers
could:
- Raise taxes to
make up the shortfall
Payroll taxes would have to be increased by more than 100
percent to make up the overall financing shortfall in Medicare.
Lawmakers could choose higher income tax rates, of course, but the
net result will still be more money in Washington and less money
for the productive sector of the economy. The additional per
household tax burden would be $1,168 in 2010, climbing quickly to
nearly $4,000 in 2030.
- Accept enormous
additional deficits
If politicians do not want to raise taxes or premiums,
they can borrow money from the private sector to pay benefits. This
will mean deficits approaching 8 percent of national economic
output on a permanent basis. Deficits are not necessarily a bad
thing, particularly if they are incurred to facilitate a policy
with long-term benefits to the nation (such as winning World War
II, lowering tax rates, or creating personal Social Security
accounts). A new prescription drug entitlement, however, does not
fall in this category.
- Scale back
benefits and/or ration care
The last choice is to reduce or renege on promised
benefits--the least likely choice by future politicians. The
creation of an entitlement today makes it very difficult for future
lawmakers to cut it.
Creating Obstacles to Permanent Tax
Reduction
In a
political environment of rising costs and demands for more
benefits, the most likely scenario is action by Congress to repeal
existing legislation that would reduce tax revenue while
concomitantly dampening enthusiasm for future tax reduction and
reform. The remaining Bush tax cuts would likely be the first
target.
The
bulk of the 2001 tax cuts expire at the end of 2010, and most of
the 2003 tax cuts expire at the end of 2008. Good economic policy
suggests that these provisions should be made permanent to maximize
the economic benefit of lower tax rates. At the very least,
however, they should be extended to protect the economy from a
significant tax increase in either 2009 or 2011.
If
the temporary tax cuts are allowed to expire, the economy will be
hit with a $775 billion tax increase between today and 2013. This tax
increase would have serious economic consequences, particularly
since much of it would be in the form of higher penalties on work,
saving, and investment.
Yet,
is it reasonable to assume that lawmakers will make the Bush tax
cuts permanent when future budget projections will be adversely
affected by the upcoming retirement of the baby boomers? Even
extending the tax cuts will be much more difficult in that
environment, and making the Bush tax cuts permanent might be
impossible. For example:
- The 15 percent tax rate on dividends and
capital gains will expire at the end of 2008, and static revenue
estimates will show an annual "cost" of nearly $25 billion to
continue these rate reductions.
- Extending the 2001 tax cuts would be even
more problematical. According to the Treasury Department, extending
those tax cuts for just three years would "cost" nearly $500
billion. Making just the income tax rate reductions permanent would
"cost" more than $270 billion.
- Permanent repeal of the death tax would be
particularly vulnerable. This unfair levy finally ends in 2010, but
will reappear in 2011 under current law. Since permanent repeal
would "cost" about $40 billion per year, that goal will be
extremely difficult to achieve.
Equally important, the baby-boom
generation will be closer to retirement when the 2001 tax cuts
expire; therefore, the future cost of providing benefits for these
soon-to-be seniors will have a bigger effect on 10-year budget
projections.
One
need only imagine the demagogic political environment that might
develop. Advocates of class warfare will argue that the death tax
should be brought back to life to help pay for "life-saving drugs."
Supporters of such politics also will argue that personal income
tax rates on the "rich" should be raised to avoid "deficits as far
as the eye can see."
Goodbye to Future Tax Reform
The
tax cuts enacted in 2001 and 2003 are already at risk, and adding a
prescription drug entitlement would magnify that risk. Further tax
relief and fundamental tax reform would also be jeopardized if
entitlements continue to consume an ever-larger share of national
economic output.
All
of the following tax cuts are necessary steps on the road to
fundamental tax reform--and all will be much harder to achieve if
prescription drugs become an entitlement:
- Corporate tax
rate reduction
The United States has the highest corporate tax rate of
any developed nation. This punitive levy undermines the
competitiveness of U.S.-based companies. Based on static scoring,
reducing the tax rate by just 1 percentage point will "cost" more
than $50 billion over 10 years, but can lawmakers "afford" to drop
the rate when budget choices are dominated by rising entitlement
expenditures?
- Alternative
minimum tax (AMT) repeal
The alternative minimum tax is a "Catch-22" system that
forces an ever-larger number of taxpayers to calculate their tax
burden a second time using the AMT. If this results in a higher
tax liability, the taxpayer must pay more tax. Is it reasonable to
think that this unfair tax--with its $600 billion price tag--will
be repealed when prescription drug spending is consuming a huge
share of income tax revenue?
- Universal
IRAs
People should not be taxed twice on income that is saved
and invested, which is why individual retirement accounts should be
universal. Back-ended IRAs (Roth IRAs) are particularly attractive
to politicians since they increase tax revenue in the short run,
but will lawmakers be willing to adopt a system eliminating the
second layer of tax on saving and investment when it might mean
lower revenues in the long run?
- Expensing of
business investment
Companies should be allowed to fully deduct investment
expenses when calculating taxable income (expensing), but the
current system only allows them to deduct a portion of expenses in
the year they are incurred (depreciation). This depreciation system
creates a bias against capital formation and reduces worker
productivity. Extending expensing for small businesses through 2013
will "cost" $23.7 billion. Providing this neutral
treatment for all businesses would require an even bigger tax cut,
but will Congress do anything when Medicare expenses are climbing
much faster than inflation?
- Territorial
taxation
The United States has the world's worst treatment of
foreign-source income. The greedy hand of the Internal Revenue
Service reaches out to tax labor income, capital income, and
corporate income earned in other nations--even though this income
already is subject to foreign tax. This "worldwide" tax reach
hinders U.S. competitiveness and is largely responsible for many
companies' deciding to re-charter in jurisdictions with better tax
law, such as Bermuda and the Cayman Islands. Territorial
taxation--the common-sense notion of taxing only income earned
inside national borders--would solve this problem, but is this
solution feasible when prescription drug costs take an ever-larger
share of national income?
In
an environment of entitlements crowding out good tax policy, none
of these reforms would be possible.
What Congress Should Do
Rather than enacting a huge new drug
entitlement that will undermine sensible tax policies, lawmakers
should pause to consider how best to address the shortcomings of
Medicare in a responsible manner. A lack of drug insurance is not a
widespread problem. Most seniors already have private coverage.
Thus, a sweeping new government program covering every senior is
not needed to address the genuine problems of a minority of
generally lower-income seniors. Moreover, the lack of drug coverage
in the existing Medicare program actually indicates deficiencies in
the program's process of overhauling and modernizing benefits, and
that problem requires structural reforms of Medicare, not an
expensive add-on.
The
best model to use to address these problems is Congress's own
health plan, the Federal Employees Health Benefits Program (FEHBP),
in which market competition and consumer choice leads to
cost-effective plans with benefits that reflect enrollee
needs--quite unlike Medicare.
Specifically, Members of Congress should
address these shortcomings in ways that preserve two critical
principles:
- A Medicare drug bill should impose no net
new unfunded liabilities on future generations.
- The program should be revamped to resemble
the FEHBP so that drug benefits and other features can become
common and cost-effective features of plans through consumer choice
and competition.
Conclusion
The
House and Senate prescription drug bills will hurt America by
making the health care system less responsive to market forces, but
the damage will extend far beyond the health care system. The
fiscal policy consequences of entitlement expansion are
staggering.
Almost surely, a new drug entitlement will
endanger the 2001 and 2003 Bush tax cuts. In the future, as
lawmakers examine the need to extend those tax cuts and make them
permanent, they will be haunted by budget projections showing an
enormous expansion in Medicare spending. This will create a
political environment that hinders the enactment of supply-side tax
policy.
In
the long run, entitlement expansion also threatens fundamental tax
reform. Many of the reforms needed to bring the tax code closer to
a simple and fair flat tax involve a reduction in tax revenue. This
will be a daunting challenge. A bigger Medicare
system--particularly one insulated from market-based reforms--will
make it more difficult to replace the Internal Revenue Code with a
pro-growth flat tax.
Daniel J.
Mitchell, Ph.D., is McKenna Senior Research Fellow in the
Thomas A. Roe Institute for Economic Policy Studies at The Heritage
Foundation.