As the second-biggest entitlement program in the United States (after Social Security), Medicare has been the elusive target of many a budget-minded policymaker for decades. The health insurance program for seniors and the disabled accounted for 3.6 percent of gross domestic product in 2015, and with the older population growing, its trust fund is projected to run out of money in 2029.
Medicare has been pushed to the background as the Affordable Care Act (ACA) dominated policy debates. With some 52 million Americans receiving benefits, the program is hugely popular, and given the political risks, few legislators are willing to propose reforms to improve its fiscal viability.
Fortunately, economists go where elected officials may fear to tread. Timothy Kehoe, a Minneapolis Fed consultant and professor at the University of Minnesota, and his frequent collaborator Juan Carlos Conesa of Stony Brook University, along with five co-authors, have done just that in a recent staff report, “Macroeconomic Effects of Medicare” (SR 548), forthcoming in The Journal of the Economics of Ageing.
A thought experiment
They present a thought experiment—What if Medicare ceased to exist?—and calculate the effects on the overall economy, insurance enrollment, government spending and consumers’ well-being. Or as Kehoe put it in conversation, “Imagine that we’re starting in a world with Medicare, and we’re going to move to a world without. How much wealth does the government have to give you to make you feel good about this?”
As in all things health-related, age plays a major role. Most people, especially the young, would be better off not paying payroll taxes for Medicare and saving for their own health insurance in retirement. How much would these beneficiaries be willing to pay the government to eliminate Medicare? The economists’ calculation: $3,600.
But older folks would lose big; after all, their work and savings decisions had long assumed they could rely on Medicare as they aged. They would have to sell their assets and spend their savings to finance their health care, and their consumption levels would drop. To be willing to live in a world without Medicare, the economists estimate, the old would need to be paid $27,700 in compensation.
A majority of consumers, particularly the young, would support Medicare’s elimination, the economists calculate, because it would mean lower taxes and higher wages. Older consumers, however, are better off with Medicare.
Surprisingly, they find, eliminating Medicare isn’t entirely effective in cutting government spending. Many elderly consumers simply shift to Medicaid, sharply increasing its costs. The reform results in a net savings of just 46 cents for every dollar cut of Medicare spending.
What if Medicaid disappeared too? The authors found substantial macroeconomic benefits from eliminating payroll taxes and cutting government spending, but these benefits were swamped by a massive loss in aggregate welfare. On net, people would need to be paid $29,500 on average to be willing live in this world without Medicaid or Medicare. Less than 20 percent of the population would be better off lacking the programs.
A different medical model
This thought experiment is, of course, not an exact replica of reality. In this hypothetical world, the ACA never existed, so there are no public exchanges. In the model, insurance is provided by employers, government, private parties or consumers themselves. The model also includes a basic medical relief program for people who are not working and forfeit all assets. The authors simplify medical expenses into three categories: low, high and catastrophic, based on a sample of actual medical expenses from 1996 to 2010. There are no discretionary expenses and no borrowing.
In the first part of the experiment, Medicare is eliminated. As a result, payroll taxes would decrease 2.7 percent and capital per person would increase 4.4 percent as consumers realize they must save for higher medical expenses in old age. With more capital, wages move up 1.3 percent and the labor supply swells. This would boost the economy, with output per capita bumping up 2 percent.
So far, so good.
Now for changes in the insurance pool. The elimination of Medicare shifts most of the older population into one of three options: private insurance, self-insurance or Medicaid, with Medicaid taking the biggest hit. The proportion of all medical expenses paid by Medicaid rises from 22.1 percent to 32.3 percent, jumping from $545 billion to $796 billion. For every dollar the government saves by cutting Medicare, it spends another 51 cents on Medicaid. Altogether, the government trims spending by $223 billion—about 1.5 percent less in total government expenditure.
Others pay more: Private insurers pick up an additional $92 billion in medical costs, and self-insured people pay $141 billion more out of pocket, while employers and the medical relief program see modest increases.
A transition path over a half-century shows some disruption in the early years of the change. Consumption drops 0.7 percent in the first few years as consumers conserve assets, but recovers and shows positive growth within a decade.
Winners and losers
The economists evaluate consumer welfare, or well-being, for two groups of people: those who are not yet born, and those who are alive now. Without Medicare, lower payroll taxes and higher wages make future generations better off, with welfare increasing 2.1 percent in the first year of the reform and improving to 3.6 percent over 50 years.
The authors measure the impact on consumers alive now by population, dollars and consumption.
The majority of all age groups would be worse off if both [Medicare and Medicaid] were to be removed. The reform’s overall impact on consumers: a $29,500 loss of wealth per capita.
A majority of consumers, particularly the young, would support Medicare’s elimination, they calculate, because it would mean lower taxes and higher wages. Older consumers, however, are better off with Medicare, even though many of them would qualify for Medicaid under the reform.
(Politicians, take note: If consumers vote according to their own self-interest, ending Medicare could be popular. But beware: Its ultimate impact won’t be.)
The second measure divides the population into winners and losers. Without Medicare, the winners (about 57 percent of total population) would see an average uptick in their wealth of $3,600. But losers (the other 43 percent) would be dramatically worse off, suffering an average wealth drop of $27,700. That big loss far outweighs the winners’ gain, for an aggregate loss of $9,900 in wealth per capita.
In terms of consumption, the authors find a similar effect. The winners experience a 1.9 percent bump in consumption, but the losers fall 7 percent. Averaged out, that comes to a 2 percent decline. So by two of the three measures, the reform fails.
Eliminating Medicaid too
And if Medicaid wasn’t around either?
Payroll taxes would fall 10 percent, wages would go up 11 percent and output per capita would jump 14.5 percent. Capital per capita would soar nearly 38 percent as consumers accumulated more assets, an almost ninefold increase compared to eliminating Medicare alone.
Without Medicaid as an option, more medical expenses would be paid by private insurance plans. The elimination of Medicare and Medicaid would ultimately lead to an $832 billion reduction in annual government spending.
Sounds promising, but when the authors look at the reform’s overall impact on consumers, they find a $29,500 loss of wealth per capita—nearly triple the aggregate loss when Medicare alone is eliminated. “While our previous result showed that young consumers would benefit from the elimination of Medicare,” write the economists, “we find that the majority of all age groups would be worse off if both programs were to be removed.
Fixing Medicare won’t be easy, as politicians well know. But this paper is an important step toward an informed solution.