The Medicare Trustees' Annual Report released earlier this year projects Medicare's excess costs to be $85.6 trillion.[1] This amount is six times the U.S. econ­omy in 2007. Worse, as the Trustees' Report suggests repeatedly, by rule their analysis reflects a badly flawed assumption and so their calculations understate the magnitude of the problem.[2]

The flawed assumption is that the Trustees are pro­jecting unreasonably low rates for physician compen­sation under Medicare Part B. Fully acknowledging the problem, the Medicare Office of the Actuary has pro­vided a memorandum discussing the flawed assump­tion and describing two illustrative alternatives.[3] Using these alternatives, it is then possible to estimate the additional amount of Medicare's excess costs attribut­able to more realistic assumptions regarding physician compensation.[4] Under one assumption, Medicare's excess costs rise by about $3 trillion in present value; under the somewhat more generous assumption, Medicare's excess costs rise by about $5.9 trillion, to a total of $91.5 trillion.

There is now broad agreement that Medicare must be fundamentally reformed to preserve this vital program for seniors without bankrupting the country. These estimates suggest the full extent of Medicare's fiscal woes is even greater than previ­ously believed.

Medicare in Brief

Medicare's original elements, Hospital Insurance (Part A) and Supplemental Medical Insurance (Part B) were enacted into law in 1965. The Medicare drug benefit (Part D) was added to the Supplemental Medical Insurance program in 2004.

Part A-Hospital Insurance. Part A primarily provides health insurance coverage for inpatient care in hospitals, inpatient stays in skilled nursing facilities, and related services. It is largely funded by a 2.9 percent tax on wages, salaries, and related compensation associated with employment.

Part A total outlays will exceed total income by around the year 2011 according to the Medicare Trustees' Report, and that gap is projected to grow steadily. Part A will have exhausted its Trust Fund by 2019, evidence that the Medicare payroll tax has long been inadequate to cover the costs of the benefits promised.

After 2019, Congress may allow Part A to draw on the Treasury's general fund comprising various revenue sources such as corporate and individual income taxes, or it may legislatively reduce Part A benefits to align costs with income. If Congress fails to act, then Medicare will be forced to reduce outlays to match revenues administratively. For ease of discussion, in the following analysis Medicare Part A is assumed to make up any shortfall in income by tapping the Treasury's general fund.

Parts B and D-Supplemental Medical Insur­ance. The Supplemental Medical Insurance ele­ment of Medicare includes Parts B and D. Part B primarily covers physicians' fees and outpatient care. Current beneficiaries offset 24.8 percent of Part B's costs through premiums; 74 percent of the cost is subsidized by drawing on the Treasury's gen­eral fund; and the balance is covered by miscella­neous sources. The basic Part B premium in 2008 is $96.40 a month, though the premium is higher for upper-income seniors.

Part D provides a drug benefit as part of Medi­care coverage. Part D also provides a sizable subsidy when seniors purchase a drug benefit plan from Medicare-approved private companies.  In 2007, premiums charged under Part D offset 25.5 percent of the total cost, with the federal government subsi­dizing the balance of 74.5 percent by drawing on the Treasury's general fund. In 2007, the average Part D monthly premium was $27.39.[5]

Medicare's projected excess costs are the sum of the projected shortfall in Part A that begins after 2019, plus Part B and D's ongoing draw on the gen­eral fund. In 2007, Medicare drew $179 billion from the general fund primarily to cover costs asso­ciated with Parts B and D. By 2017 this figure is expected to reach $353.3 billion.[6] In effect, seniors are paying a portion of Medicare's total costs through their premiums, workers are paying a por­tion of Medicare's costs through the payroll tax, and a large and growing subsidy is drawn from the pool of all other taxes paid to the Treasury.[7]

Estimating Medicare's Excess Costs

Medicare is the primary health insurance system for America's seniors and for non-seniors meeting special health and economic criteria. It is a govern­ment-run national health insurance company with a specified customer base. With rapidly changing technologies and fast-rising costs, health insurance is an extraordinarily difficult business to manage under the best of circumstances. These difficulties are heightened by Medicare's core customers- seniors-who typically have more complex, diffi­cult, and costly health care issues than do younger individuals. For Medicare the difficulties are further elevated by the need to operate as a government agency subject to repeated changes in executive management, cumbersome government procure­ment and management rules, and the vagaries of congressional oversight.

Despite these issues, taking a step back to view Medicare as a health insurance company simplifies the essentials of the matter. Medicare has adminis­trative expenses and it incurs costs when paying health insurance claims. On the income side, Medi­care receives dedicated revenues from the Medicare portion of the federal payroll tax and, for a few more years, it will receive a modest amount of interest income from a Trust Fund. Medicare also receives premium income from beneficiaries. Medicare's organic revenue sources, which include dedicated tax revenues, premium income, and a handful of minor revenue sources, covered almost 60 percent of Medicare's costs in 2007.

The difference between its total costs and its organic sources of income is derived from general revenues. That is, all taxpayers collectively contrib­uted through their individual income, corporate income, and other non-payroll tax payments to sup­plement Medicare's other income sources to cover costs of administration and claims. In 2007, Medi­care's total costs amounted to $431.5 billion, and taxpayers collectively contributed $179 billion through general revenue transfers.

There are many ways to calculate and refer to Medicare's long-term financial status. One of the simplest, most intuitive ways is to begin by project­ing Medicare's total costs into the future, and sub­tracting projections of its organic revenue sources. The result is a year-by-year projection of excess costs to be met by general revenues. Taking the present value of these year-by-year estimates yields estimates of the excess costs of Medicare Parts A, B, and D of some $34.4 trillion, $34 trillion, and $17.2 trillion, respectively.[8] In total, under current law Medicare faces excess costs of $85.6 trillion. How­ever, these figures understate the true magnitude of the problem because they reflect the flawed assumption discussed below.

The Flawed Assumption

In their Report, the Trustees warn that their estimate of projected excess costs reflects a flawed assumption regarding doctors' compensation. The Trustees' estimates reflect current law, under which payments to doctors in 2009 would be sig­nificantly lower than 2008 levels and would grow from that lower level in all future years. Congress has already acted to prevent this dramatic cutting of costs for 2009 through what is sometimes called "doc fix" legislation and will almost cer­tainly prevent such a cut in physician payments in all future years as the Trustees' Report notes repeatedly. For example:

Part B outlays were 1.3 percent of GDP in 2007 and are projected to grow to about 4.1 percent by 2082.  These cost estimates, how­ever, are understated as a result of the substan­tial reductions in physician payments that would be required under current law [emphasis added]. Actual future Part B costs will depend on the steps Congress takes to address the situation but could exceed the current-law projections by 7 to 8 percent in 2010 and by roughly 10 to 20 percent for 2030 or later.

     -2008 Medicare Trustees' Report, p. 3.

Doc Fix Explained. Medicare payments for physicians' services under Part B are based on a fee schedule which is updated each year. In 1997, in a poorly conceived but well-intended attempt to con­trol growth in Medicare spending on doctors' ser­vices, Congress enacted the Sustainable Growth Rate (SGR) system. The principle behind SGR is to constrain the rise in physician payments so total spending grows no faster than the overall economy. In every year since 2002, the SGR formula has called for a significant reduction in Medicare physi­cian payment rates. However, Congress has thwarted the SGR process and prevented these reductions from taking effect through doc fix legis­lation, enacting legislation either to freeze payment rates at current levels or allow a small increase.

Congress has repeatedly overridden the SGR cuts through legislation that often increased pay­ment rates. One consequence is a growing gap between the payment rates to physicians and those specified by the SGR. Absent doc fix legislation for 2009, physician payment rates would drop by 10.6 percent under the SGR.[9] While Congress must decide what alternative to legislate, such a large drop in payments to physicians who treat Medicare patients is entirely unreasonable and highly improbable.

The Trustees refer to the near certainty of recur­ring doc fix legislation as the source of the flawed assumption incorporated into their long-run finan­cial analysis. Their estimates reflect current law, not their best guess of Congress' legislative correction. But the Trustees also reference in their report a staff memorandum describing the problem and provid­ing estimates of the addition to Medicare outlays under either of two doc fix alternatives.

Alternative Assumptions

It is impossible to know how Congress will update the physician payment schedule each year, but the Medicare Actuaries offer two useful, illustra­tive alternatives. The first assumes Congress voids the SGR system and freezes physician payment rates at their current level, preventing the cuts to physi­cian payments that follow if SGR were allowed to go into effect, but also not allowing any increase. The second alternative updates physician payment rates each year according to the increase in medical infla­tion as projected in the Medicare Economic Index (MEI). The MEI is projected to rise by about 2 per­cent per year. (See Table 1.)

The effect of either alternative is to raise Medi­care Part B outlays permanently, with the MEI update having the greater effect. This means that Part B premiums would also be somewhat higher in each future year, and general fund contributions would be significantly higher than under current law. In the case of the MEI-based update, outlays would be $73.2 billion higher after 10 years, income from premiums would be $19.6 billion higher, and the general fund of the Treasury would be tapped for an additional $55.0 billion.

Data provided by the Actuaries also make it pos­sible to estimate the increase to Medicare's excess costs from either of these physician fee update alter­natives using the same methodology the Actuaries use when calculating Medicare's excess costs:

• If physician payments are permanently frozen, the present value of the additional excess costs would be about $3.0 trillion.
• If physician payments rise with the MEI, Medi­care's excess costs would rise by about $6.7 tril­lion; in this case for a total of $91.5 trillion.[10]

Conclusion

Medicare is the federal government's third-larg­est program by level of spending after Social Secu­rity and defense spending, and a vital program for the nation's elderly. It is also unsustainable in its cur­rent form. The Medicare Trustees' estimate of the program's long-run excess costs quantifies the prob­lem. The Trustees make a point to acknowledge that their own estimates are based on an assumption of dramatic and highly unlikely cuts to physician com­pensation rates.

The Medicare Actuaries released a public memo drawing further attention to the flawed assumption and provided therein two illustrative alternatives as to how doctors' fees might be updated each year, including projections of the consequent year-by-year increases in Medicare costs. Estimates derived from this information of the additional excess costs suggest the figures included in the Medicare Trust­ees' Report understate the magnitude of the prob­lem by perhaps $3.0 trillion to $5.9 trillion. These figures underscore the reality of the need to reform Medicare quickly and substantially while providing a more realistic measure of the consequences of the necessary changes.

J. D. Foster, Ph.D., is Norman B. Ture Senior Fellow in the Economics of Fiscal Policy in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation. See also Medicare Path to Sustainability.