The latest report from Medicare’s trustees, released yesterday drives home what many already know: Medicare poses a serious long-term budgeting challenge. But a close look look at the report also suggests that, while reforms and savings are clearly needed in the Medicare program, it would also be worthwhile and realistic to look at options for increasing revenues to protect the welfare of vulnerable beneficiaries.

What Is Medicare’s Financial Situation?

The trustee’s report is a detailed accounting and projection of Medicare’s trust funds over the short and long term that has important information for policymakers seeking a path forward on solvency. In 2012, the Hospital Insurance (HI) Trust Fund received income of $228.9 billion and paid out $256.7 billion in benefits and administrative expenses, leaving a deficit of $27.7 billion for the year. The HI Trust Fund has been running a deficit since 2008, when annual expenditures first exceeded income. (See Note 1 below) At the end of 2011, however, the HI Trust Fund still held $244.2 billion in assets. Table 1 presents 2011 data for each part of the Medicare program. (Click to enlarge tables and figures.)

Table 1. Trust Fund Results in 2011 (in billions)

Source: Board of Trustees, 2012. Table II.B1

Each year, the Trustees estimate the continued length of solvency for the HI Trust Fund, i.e. the year through which reserves are sufficient to cover 100 percent of costs. The 2012 report finds that the HI Trust Fund will be solvent through 2024, the same as last year’s projection. If no changes are made by 2024, the HI Trust Fund will still be able to cover 87 percent of HI expenditures that year.

The estimation of the HI Trust Fund’s solvency is based on a number of economic factors, including changes in demographics and the health care system. As shown in Figure 1, since 1990, estimates of continued HI solvency have ranged from four years to 28 years, with the length of continued solvency averaging 13.6 years. Projections of HI solvency in 2012 fall just below the average over the last 23 years. In the past, HI insolvency has been avoided through frequent adjustments to the program to ensure that spending and resources are in balance.

Source: National Academy of Social Insurance, based on data from Board of Trustees (various years).

The Supplemental Medical Insurance (SMI) Trust Fund, on the other hand, is always adequately financed because beneficiary premiums and general revenue contributions together are set annually to cover the expected cost of Part B and Part D benefits. The rapid growth in the cost of Part B and Part D benefits is projected to place increasing financial demands on both beneficiaries (to pay the premiums) and taxpayers (to provide the general revenues).

What Are the Long-Range Trends in Medicare Costs?

The Trustees Report includes a long-term projection of Medicare’s income and expenditures over the next 75 years. There are several ways of making comparisons over such a long period of time. Here we examine two of them.

1. Medicare Income and Expenditures as a Percent of Gross Domestic Product (GDP).  One way to express the growth in the total Medicare program is as a percentage of GDP, which is the total value of all goods and services produced in the United States. This reflects society’s current resources devoted to Medicare and provides a broader context for the combined costs of HI and SMI.  Under the Trustees’ intermediate assumptions total Medicare expenditures will grow from 3.7 percent of GDP in 2011 to 4 percent of GDP in 2020 and 6.7 percent of GDP in 2086, as shown in Figure 2. The components of the bars show projected HI income (payroll taxes, tax on benefits, premiums, state transfers and drug fees and general revenue) and projected HI expenditures through 2086. While payroll taxes will remain relatively constant as a share of GDP, other relatively minor sources of financing will increase slightly. The HI deficit (the difference between HI income and HI expenditures) will increase from 0.26 percent of GDP in 2011 to 0.73 percent in 2086, and will average 0.63 percent of GDP over the next 75 years.

Source: Summary of Board of Trustees 2012, Chart C.

2. HI Income and Expenditures as a Percent of Taxable Payroll. Medicare’s long-range HI deficit could be avoided by increasing the standard Medicare payroll tax by 0.67 percent for workers and employers (an increase from 1.45 percent to 2.12 percent). (See Note 2 below.) This measure, known as the actuarial balance, is the difference between annual income and costs expressed as a percentage of total earnings and self-employment income that is subject to Medicare taxes over the 75-year projection period. According to the Trustees’ intermediate assumptions, HI income will average 3.86 percent of taxable payroll, while costs will average 5.21 percent, leaving a deficit of 1.35 percent over the next 75 years. (See Note 3 below.)

How do the 2012 Projections Compare to Last Year’s?

There are small, but significant changes in Medicare’s financial outlook. The projected insolvency date for the HI Trust Fund remains at 2024. The projection of the 75-year HI deficit increased from 0.79 percent to 1.35 percent of taxable payroll. This was the result of revised short range spending assumptions and revised methodologies for estimating long range costs. The Trustees revised upward by 0.3 percentage points Medicare’s long range annual growth rate, based in part on faster assumed growth in volume and intensity of services per beneficiary. These higher costs were partially offset by a projected 2 percent reduction in program outlays between 2013-21 as required by the Budget Control Act of 2011. Medicare spending is now projected to total 6.69 percent of GDP in 2080, compared to 6.25 percent in last year’s report.

What Is the Unfunded Obligation?

Medicare’s unfunded obligation is another way of summarizing the funding shortfall in a single dollar amount. Technically speaking, it is the difference between the present value of the projected cost of a program over a specified time period and the present value of projected income (including the initial value of the Trust Fund). In other words, the unfunded obligation is the amount by which expenditures would have to be reduced or the amount that would have to be added to the HI Trust Fund to make the program financially sound for the next 75 years.

The 2012 Trustees Report estimates that the unfunded obligation of the HI Trust Fund for past, current, and future participants is $5.3 trillion over the next 75 years. This is the equivalent of 1.3 percent of the HI taxable payroll and 0.6 percent of GDP over that period. Although the SMI Trust Fund has no unfunded obligation, the Trustees Report also provides an estimate of the present value of the required general revenue contributions to Parts B and D of Medicare, equal to $21.6 trillion (2.4 percent of GDP).

Why Is Medicare Spending Growing So Rapidly?

Medicare spending is growing for many of the same reasons health care spending in the private sector is growing — higher prices for providers, intensity of services and new medical technology. Medicare, however, has an additional reason for its rapid growth: the projected increase in individuals eligible to enroll as the baby boom generation ages.

Figure 3 compares per capita spending in Medicare and private health insurance over time. Medicare’s per capita costs have grown more slowly than those of the private sector in some periods and more rapidly in others; since 1997, however, Medicare spending, on average, has grown more slowly than private health spending.

*Common benefits refers to benefits commonly covered by Medicare and Private Health Insurance. These benefits are hospital services, physician and clinical services, other professional services and durable medical products.

Source: Centers for Medicare & Medicaid Services, 2010.

A Path Forward?

Medicare’s importance is undeniable but so is the future growth of the program. Medicare costs are driven not by an increase in per capita costs but by an increase in the total number of enrollees. By 2030, the number of enrollees will almost double, bringing the total to 80 million. Long before 2030, however, we need to figure out how to strengthen Medicare’s solvency.

Progress has been stymied by political gridlock. Some believe we can replace the guarantee of access to care that is the heart of Medicare with a guarantee of financial assistance to purchase private insurance. This would of course shift financial risk to beneficiaries and erode Medicare’s basic guarantee of access to care. Others believe we can rely on the Affordable Care Act (ACA), whose delivery system reforms may indeed improve care and constrain costs but are unlikely to close the funding gap.

Caught in the middle of this debate is a vulnerable population that by and large is not well-off and has limited chance of getting private insurance through employers or the individual market, just as was true when Medicare was enacted in 1965.

The 2012 Medicare Trustees report is a reminder that sometimes we can be so focused on what seems like an impenetrable forest that we miss the helpful trees right in front of us.

The deficit between expected expenditures and expected revenues for the HI Trust Fund is 1.35 percent of taxable payroll or $5.5 trillion. That sounds like an extraordinary amount (and it is significantly more than last year’s 0.79 percent), but how much is it over 75 years in a $15 trillion economy that will eventually regain its footing and return to historical levels of growth? Before we start cutting benefits, shouldn’t we consider what it would take to close the revenue gap?

Currently, a worker earning $40,000 pays $22.30 every two weeks in Medicare payroll taxes and her employer pays a matching amount. According to the latest data in the Trustee’s Report, closing the actuarial deficit for Part A requires an additional 75 cents a day or $11.25 biweekly. (See Note 4 below.) That’s not an insignificant amount – it would increase a person’s HI contribution by approximately half – but it less than average cost of a cup of coffee ($1.38). For individual workers, this may well be an affordable – even attractive – investment in one’s healthcare.

This observation comes with a number of  caveats. The Medicare Payment Advisory Commission (MedPAC) has already identified savings that should be considered before we think about raising payroll taxes. Raising taxes in a still-fragile economy, even if politically feasible, might not be a wise move, especially given the likely expiration of the Bush-era tax cuts and restoration of the temporarily reduced Social Security payroll tax at the end of 2012. But what about in three or four years? Many Americans would grasp the value of what they would get for their money – a guarantee of greater health security upon retirement – and would agree that the benefits outweigh the costs.

No one doubts that changes to Medicare are needed beyond those in the ACA. We need to move away from the silos in which Medicare services are financed, rationalize cost-sharing and address regional disparities in cost and access that Medicare has failed to remedy (and sometimes fueled).  Later in the decade, we should have a better sense of how well health exchanges – the model for some Medicare reform plans – can work, and can assess progress in implementing the ACA’s other Medicare reforms. Meanwhile, this incremental approach of improving the solvency of Part A would create some fiscal breathing room and foster renewed confidence that Medicare—and those who depend on it—won’t be interminably held hostage as politicians debate the program’s future.

Note 1. In years when there is an HI deficit, special bonds that are issued during surpluses are redeemed from the Treasury Department to pay for Medicare benefits. This requires a cash transfer from the general fund of the Treasury. The cash transfer, along with any interest earned on reserves, is used to pay benefits.

Note 2. The Trustees also calculate the 25- and 50-year actuarial balance. In 2012, these were 0.69 and 1.17 percent, respectively.

Note 3. The long-range HI deficit could also be eliminated by reducing HI expenditures by an amount equal to the difference between income and expenditures, though this is not an analysis the Trustees undertake.

Note 4. Employers would also pay the matching rate of 75 cents a day or $11.25 biweekly.