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III Social Security, Medicare, and U.S. Fiscal Prospects

Author(s):
Martin Mühleisen, and Christopher Towe
Published Date:
January 2004
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Author(s)
De Masi Paula, Ivaschenko Iryna and Towe Christopher 

The reemergence of large U.S. budget deficits in recent years has heightened concern about the implications of demographic trends for the longer-term fiscal position.1 In particular, with the tax cuts enacted in 2001 and 2003, and the higher levels of spending that have been introduced, substantial budget shortfalls are projected over the coming decade. With federal debt now rising as a share of GDP, the fiscal position seems to be considerably less well prepared to cope with the impending retirement of the baby boom generation, especially in view of the substantial actuarial deficits facing the Social Security and Medicare systems. In this section we describe the long-term fiscal challenges that result from these trends and briefly discuss recent Social Security and Medicare reform proposals.

Fiscal Consequences of Social Security and Medicare

Social Security and Medicare are the two principal federal programs in the United States that offer support for the elderly (Box 3.1). Social Security provides retirement income to the aged and is funded by the payroll taxes on the working-age population. The Medicare system, which provides medical insurance for the elderly, is only partly funded by payroll taxes and retirees’ premium payments, relying on transfers from the federal government for the balance of its resources.

Demographic and other pressures on these systems are expected to increase significantly in the coming decades. In particular, the retirement of the baby boom generation, a decline in the fertility rate, and an increase in longevity are projected to raise the dependency rate—the ratio of retirees to the working-age population—from around 20 percent at present to nearly 40 percent by the middle of the century. This will significantly increase the number of beneficiaries relative to the number of contributors in the Social Security system. Similar demographic pressures face the Medicare system, but in this case they are compounded by the rapid increases in medical care costs.

The trust funds for these systems currently run cash surpluses, but they are in significant deficit from an actuarial perspective. In FY2002, the combined Social Security and Medicare surplus was estimated at roughly 1 percent of GDP (excluding interest receipts), and the balances in their trust funds totaled over 15 percent of GDP. However, the programs are expected to run into deficit within the next two decades, which implies that the trust fund assets would eventually be exhausted. Indeed, over a 75-year projection period, Social Security and Medicare are estimated to have a combined unfunded liability—the shortfall between current assets and the net present value of projected inflows less projected payments to beneficiaries—at $16 trillion, or 160 percent of GDP:2

  • The Old-Age, Survivors, and Disability Insurance (OASDI) system is projected to fall into deficit (excluding interest receipts) before 2020, with deficits rising to over 2 percent of GDP by the end of the 75-year projection horizon. The assets held by the OASDI trust funds are expected to be exhausted just after 2040, and the system has an unfunded liability estimated at around 35 percent of current GDP, equivalent to the revenue that would accrue to the system from an immediate and permanent increase in the payroll tax of 1.87 percentage points.
  • The situation of the Medicare hospital insurance (HI) system is somewhat more difficult because its current surplus is more modest, the assets in its trust fund total only around 2 percent of GDP, and the rapid increase in health care costs is compounding the pressure of an increasing elderly population. The system is also projected to run annual deficits before 2020, which would grow to over 3½ percent of GDP by the end of the 75-year projection period. As a result, its unfunded liability is estimated at around 50 percent of GDP, equivalent to a 2.02 percentage point increase in the contribution rate.
  • The position of the Medicare supplementary medical insurance (SMI) system is even more worrisome. The SMI system is run purely on a pay-as-you-go basis—that is, there are no trust fund assets that have been accrued—and premium payments cover only a part of its outlays. The administration’s FY2003 budget estimated that the unfunded liability of the SMI system would be roughly an additional 80 percent of GDP, equivalent to a 3.37 percentage point increase in the payroll tax.

Box 3.1.Social Security and Medicare Systems

Social Security (OASDI)

  • The Social Security system consists of the Old-Age and Survivors Insurance and the Disability Insurance systems. These two schemes are referred together under the acronym OASDI.
  • Participation in the OASDI system is mandatory and near-universal. The programs are funded by a 12.4 percent payroll tax on labor income up to an inflation-adjusted ceiling—$87,000 in 2003. Although retirement benefits may be drawn as early as age 62, an unreduced pension is provided at the normal retirement age. The normal retirement age was 65 in 2002, but is scheduled, beginning in 2003, to increase gradually to 67 by 2027.
  • Benefits are based on the average of monthly earnings of a worker’s 35 highest-earning years prior to eligibility. In calculating postretirement benefits, preretirement earnings are indexed to average wage growth and postretirement benefits are indexed to CPI inflation. Monthly benefits are subject to a monthly maximum, which in 2003 was set at $1,404 for persons retiring at age 62, rising to $2,045 for persons retiring at age 70. Significant benefits are also paid in the event of death or disability prior to retirement.
  • Both contributions and benefits are subject to tax. The employee’s portion of the payroll tax—6.2 percentage points—is included in earned income for tax purposes. Benefits are included in taxable income according to a graduated formula—they are 100 percent excluded below a certain income threshold, with the exclusion rate falling to a minimum 15 percent at higher incomes. Taxes paid on up to 50 percent of benefits are returned to the OASDI system.
  • The cash surpluses of the OASDI system are held in trust funds and invested in nonmarketable, interest-bearing government securities.

Medicare

  • The Medicare program provides health insurance coverage for the elderly and disabled.
  • Part A provides hospital insurance (HI) and is funded by a 2.9 percent payroll tax, which applies to income without a ceiling.
  • Part B provides supplementary medical insurance (SMI) that covers the cost of physician and other services, and is funded in part by premiums paid by retirees. These cover only around 25 percent of SMI costs, with the balance coming from general government revenues.
  • Typically, the Medicare system operates on a fee-for-service basis. Payment rates to providers are set by the Medicare system, and a deductible and copayment (typically 20 percent) by beneficiaries applies.
  • The Medicare+Choice system was established to provide Medicare participants with the option of joining private managed care or fee-for-service plans. These privately run plans typically have lower copayment rates and allow a somewhat broader range of covered services but limit beneficiaries’ access to prescribed providers. Enrollment in this program has been declining in recent years and it covers only around 10 percent of Medicare beneficiaries.
  • The cash surpluses of the HI system are also held in a trust fund and invested in nonmarketable, interest-bearing government securities.

Figure 3.1 illustrates the longer-term pressures on the system. For example, in the baseline scenario, both the OASDI and HI systems begin to run significant primary deficits in the next 20 years, with a substantial buildup of liabilities resulting soon thereafter. An immediate increase in payroll taxes to meet the actuarial deficit by the amounts described above would improve the situation but—despite tax rate increases that would total over 7 percentage points—the systems would still be left with substantial cash flow deficits in the longer run. By contrast, more modest cuts in benefit growth—for example, reducing the growth of OASDI benefits by ½ percentage point beginning in 2010 and slowing the pace of HI benefits by 1½ percentage points in the same year—would achieve actuarial balance and keep the cash flow deficits relatively modest over the 75-year projection period.3

Figure 3.1.Social Security and Medicare Projections

(In percent of GDP)

Source: Staff estimates based on long-range projections in the 2003 OASDI and Medicare Trustees’ reports.

Note: OASDI = Old Age, Survivors, and Disability Insurance; HI = Hospital insurance. Benefit adjustments assume that, beginning in 2010, OASDI and HI benefits grow 0.5 percent and 1.6 percent slower than the baseline. The primary balance is equal to the difference between noninterest receipts and expenditure.

The longer-run fiscal implications of these trends are significant. In the absence of reforms, outlays on Social Security and Medicare programs are projected to rise rapidly from around 7 percent of GDP at present to nearly 10 percent by 2023, increasing further to nearly 16 percent of GDP by the end of the 75-year horizon (Figure 3.2). Simple budget simulations show that, beginning in the next decade, these trends would cause the unified federal budget balance to erode sharply.4 As a result, federal debt held by the public would increase rapidly after 2020 as spending pressures intensified.

Figure 3.2.Budget Projections

(In percent of GDP)

Source: IMF staff estimates.

Note: SMI = Supplementary medical insurance.

The financial situation of the U.S. Social Security and Medicare systems is serious but still less dire than in many other industrial countries. In a recent OECD (2001) study, the United States was considered among the “slower-aging economies,” compared with other industrial countries, because of its relatively high immigration and fertility rates, and relatively modest life expectancy. As a result, the projected increase in its age-related spending, including outlays for pensions and health care, was estimated to be at or somewhat less than average. In view of the U.S. system’s relatively large trust fund assets and substantial contribution rate, its unfunded liability is also typically viewed as smaller than in other industrial countries. For example, Kohl and O’Brien (1998) estimate the unfunded liability of the Japanese, Italian, and Swedish systems as a share of GDP at 70 percent, 60 percent, and 132 percent, respectively.

President’s Social Security Reform Commission

In early 2001, a presidential commission was established to examine options for reforming Social Security. Reform proposals were expected to adhere to several principles, which included (1) maintaining benefits for retirees and near-retirees, (2) avoiding any increase in social security taxes, (3) maintaining the survivor and disability benefits, (4) offering personal retirement accounts as a supplement to Social Security, and (5) avoiding investing Social Security trust funds in the stock market.

The Commission reported its findings in December 2001 (Social Security Commission, 2001) and suggested that reforms should include the following key elements:

  • Personal retirement accounts (PRAs). Participants would be permitted to divert a portion— up to 4 percentage points—of their OASDI contributions to personal retirement accounts. OASDI benefits would be reduced by the amount of direct contributions to PRAs plus an implicit real return of up to 3½ percent.
  • Indexation. The Commission suggested moving to a system in which the pensionable earnings of future retirees would be indexed to prices rather than wages, which, as illustrated above, would tend to lower the growth of benefits substantially. In addition, the formula for calculating benefits could be adjusted to increase its progressivity.
  • Minimum benefit. In some of the reform options considered, a worker with 30 years of employment would be provided a minimum benefit of up to 120 percent of the poverty line.

Although the report argued that PRAs would have important advantages, including increasing the rate of return on employee contributions and possibly adding to national saving, it also illustrated that PRAs would exacerbate the system’s insolvency. For example, diverting 2 percentage points from the OASDI payroll tax to fund PRAs would significantly reduce the cash flow available to meet current obligations. As a result, “transition payments” from general revenues to the trust funds would be needed over an extended period until benefit outlays were reduced to their new steady-state level. The net present value of these payments over the 75-year period would be equivalent to 10 percent of GDP.

The report also illustrated that reducing the generosity of the indexation of OASDI benefits would significantly improve the financial situation of the system, but that significant additional funding would still be required to close the system’s actuarial deficit. For example, one reform option considered—which assumed amending the benefit formula, a relatively modest PRA, and the diversion of only 2½ percentage points of payroll taxes—would still require significant transition payments as well as a permanent increase in system financing equivalent to 0.63 percent of taxable payrolls.

In addition to these considerations, significant technical and administrative issues would need to be resolved before such a system could be introduced:

  • Guarantees. The Commission’s reform proposals explicitly do not include a guaranteed minimum return on PRA investments. Since PRAs would be seen as a replacement of at least part of the existing OASDI entitlement, there may be pressure to attach at least some insurance to these accounts, which would increase their fiscal cost.
  • Tax issues. The tax treatment of OASDI is somewhat anomalous because both contributions and benefits are taxable, and benefits are combined with other income in a formula that increases the progressivity of the system. It is unclear how PRAs would be treated, but to the extent that participants are able to voluntarily increase their contributions, there is a strong argument for affording these contributions a tax treatment similar to that of other retirement savings instruments, such as IRAs, 401(k)s, and so on.
  • Administrative issues. The Commission appeared to favor PRAs held in the form of investment vehicles that would be somewhat constrained in both their portfolip allocation and payout schedule. This would minimize moral hazards related to excessive investment risk taking by participants and allow lump-sum distributions, as opposed to annuity payments, only to those retirees with demonstrably sufficient wealth. However, as a number of authors have noted, a system of annuities could be expensive to administer and would pose challenges for regulatory and tax policies.5
  • Benefits. The report offers relatively limited options regarding cuts in OASDI benefits, and more stringent alternatives could be considered. For example, preretirement earnings and post-retirement benefits could be indexed to the CPI less an ad hoc adjustment for the bias it contains, or by the national accounts deflator for consumer expenditures. Consideration could also be given to increasing the pace at which the normal retirement age is increased or to lengthening the computation period for calculating benefits.
  • Supplemental security income (SSI). The SSI system provides income support to low-income, elderly, and disabled persons, and is funded and administered separately from the OASDI system. The Commission’s report acknowledges that reforms of the OASDI system should take into account the SSI system, and increases in the minimum OASDI benefits would likely need a corresponding increase in the SSI benefit.

There has been little progress toward implementing these or any other reforms since the Commission’s report was issued, and the administration has simply called for further dialogue and debate on the way forward.

Medicare Reform

The last major revision of the Medicare system, which was included in the Balanced Budget Act of 1997, stemmed from a growing public awareness that the longer-term fiscal pressures facing the system were becoming more immediate. The 1997 legislation introduced a number of reforms that were mainly geared at containing costs.6 For example, payments to physicians and hospitals were reduced, and to promote competition in health care delivery a wider variety of private plans, including health maintenance organizations (HMOs), provider-sponsored organizations, and preferred provider organizations, were permitted to contract with Medicare.

Since then, pressures have built to expand Medicare benefits, culminating in legislation in December 2003 that added a new prescription drug benefit. The benefit would involve copayments of 25 percent for initial annual payments up to $2,250, with a gap in coverage thereafter until out-of-pocket expenses reached $3,600, when copayments of only 5 percent would apply. Low-income retirees would be provided a more generous benefit, and significant subsidies would be directed to private plans to discourage employers from scaling back retiree benefits in response to the increase in Medicare coverage. The legislation also boosted Medicare premiums for high-income retirees and introduced, on a demonstration basis, a plan for private sector health plans to compete with the traditional Medicare system.

These proposals would significantly worsen Medicare’s financial position, and estimates by the Congressional Budget Office (CBO, 2003) suggest a total budgetary impact of $400 billion over 10 years, or ¼–½ percent of GDP annually by 2013. Moreover, concerns have been raised regarding the impact of the legislation on employers’ willingness to retain retirees on existing plans, the absence of mechanisms for containing the growth of drug prices, and the risk that political pressures will cause a further enrichment of the benefit.

Recent studies have also raised significant doubts about the likely efficacy of private health care plans in controlling costs. For example, Gold and Achman (2003) examine the experience of participants in the “Medicare+Choice” system—an HMO-style system that has been running parallel to the traditional fee-for-service system since 1997. They find that out-of-pocket costs for enrollees have been significantly higher than in the traditional Medicare system. A study by the Medicare Payment Advisory Commission (2002) suggests that Medicare payment rates to health care providers are considerably lower than payment rates by private insurers—Medicare rates were found to be just under 80 percent of the private rate—reflecting the substantial market power that the Medicare system has been able to exert in setting rates.

CBO (2001a) laid out a comprehensive set of options for restoring the solvency of the Medicare system. These included increasing premium revenues; changing eligibility conditions to reduce the number of beneficiaries; reducing costs per beneficiary; and increasing payroll taxes. However, the question remains of whether even these measures would be sufficient in the absence of more fundamental reforms of the health care system, given the broader problem of a substantial uninsured population and a private health insurance system that has helped push overall health care spending in the United States to levels that exceed the OECD average by several percentage points of GDP.

Concluding Remarks

The Social Security and Medicare systems are likely to place significant longer-term pressures on the U.S. fiscal system, given demographic and other trends. Little progress has been made toward addressing the financial problems of the Medicare system, despite the very large deficits of the SMI and HI systems. The focus instead has been on expanding benefits in the area of prescription drugs rather than addressing the fundamental reforms that would assure the programs’ longer-term solvency.

Specific proposals for reform of Social Security have recently been put forward by the President’s Reform Commission. The Commission’s report usefully illustrated that relatively small changes in benefit formulas could substantially improve the financial position of the system and directing contributions to private retirement accounts would result in significant transition costs. Whether this will help trigger the broader reforms that are needed remains to be seen.

References

    Congressional Budget Office (CBO), 2001a, Budget Options (Washington: U.S. Government Printing Office).

    Congressional Budget Office (CBO), 2001b, Social Security: A Primer (Washington: U.S. Government Printing Office).

    Congressional Budget Office (CBO), 2003, The Budget and Economic Outlook: An Update (Washington: U.S. Government Printing Office).

    De Masi, p.,C.Towe,2002, “Social Security, Medicare, and Long-Term U.S. Fiscal Prospects,” in United States: Selected Issues, IMF Staff Country Report No. 02/165 (Washington: International Monetary Fund).

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    Diamond, P.A., and P.R.Orszag,2002, “An Assessment of the Proposals of the President’s Commission to Strengthen Social Security,” NBER Working Paper No. 9097 (Cambridge, Massachusetts: National Bureau of Economic Research).

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    Gold, M., and L.Achman,2003, “Average Out-of-Pocket Health Care Costs for Medicare+Choice Enrollees Increase 10 Percent in 2003,” Issue Brief (New York: Commonwealth Fund).

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    Kohl, R., and P.O’Brien,1998, “The Macroeconomics of Ageing, Pensions, and Savings: A Survey,” OECD Economics Department Working Paper No. 200 (Paris: OECD).

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    Medicare Payment Advisory Commission, 2002, “Comparing Medicare and Private Sector Payment Rates for Physicians Services,” Meeting Brief (Washington).Available via Internet: www.medpac.gov.

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    Medicare Trustees (Board of Trustees, Hospital Insurance and Supplementary Medical Insurance Trust Funds), 2003, Annual Report (Washington: U.S. Government Printing Office).

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    OASDI Trustees (Board of Trustees, Old-Age, Survivors, and Disability Insurance Trust Funds), 2003, Annual Report (Washington: U.S. Government Printing Office).

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    Organization for Economic Cooperation and Development (OECD), 2001, OECD Economic Outlook, Vol. 2001/1, No. 69 (Paris: OECD).

    Social Security Commission, President’s Commission to Strengthen Social Security, 2001, “Strengthening Social Security and Creating Personal Wealth for All Americans,” December21.Available via Internet: www.csss.gov/reports/Final_report.pdf.

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1

This section is a slightly revised and updated version of De Masi and Towe (2002).

2

This estimate is contained in the administration’s FY2004 budget. The subsequent discussion is based on IMF staff calculations, which in turn was based on the actuarial estimates contained in the Old Age, Survivors, and Disability Insurance (OASDI) and Medicare Trustees’ reports (2003). Section IV contains an alternative calculation based on a generational accounting framework.

3

As detailed in the Trustees’ reports, the projections are sensitive to underlying macroeconomic and demographic assumptions. Moreover, the projections assume that real interest rates remain significantly higher than the real growth rate of the economy, which significantly exacerbates the systems’ debt dynamics.

4

The simulations are based on the assumption that the balance for the non-Medicare, non-OASDI, and noninterest federal budget remains constant as a share of GDP after 2012; net interest payments on federal debt increase in line with the stock of debt; and OASDI and Medicare spending as a share of GDP rise in line with the projections made in the 2003 Trustees’ reports.

5

The Congressional Budget Office (CBO, 2001b) notes, for example, that there would be a strong incentive for providers to discriminate among retirees according to risk class. Diamond and Orszag (2002) also note that the administrative costs of PRAs would likely be significantly larger in the initial years than assumed by the President’s Commission, and these could be prohibitive when the size of accounts is small.

6

The Balanced Budget Act also established a National Bipartisan Commission on the Future of Medicare that was charged with making recommendations by March 1999 to “strengthen and improve” the Medicare system in time for the retirement of the baby boom generation. The 17-member commission failed to reach consensus on a single plan and, therefore, was unable to make any formal recommendations.

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