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Why Slower Healthcare Cost Inflation Isn’t Fixing Medicare Finances

Charles Blahous | 01/14/2014 |

Followers of the national healthcare policy debate may have noticed an interesting recent turn. After the Affordable Care Act (ACA)’s troubled rollout, the law’s supporters shifted to a new line to promote it: specifically, crediting the ACA with slowing the growth of national healthcare costs. This line is being pushed aggressively by the White House and its outside advisors. There is not much basis for this claim, as I have explained before. For one thing, the cost slowdown predated the ACA’s enactment; for another, there is more evidence suggesting the ACA is on balance increasing health expenditure growth than decreasing it. In any event, no one knows precisely why healthcare cost growth has slowed. The best we can say with certainty is that most of the slowdown has nothing to do with the ACA.

Closely related to this discussion is another ongoing one: specifically, whether the health cost slowdown will improve Medicare’s long-term financial picture relative to current projections. Today the Mercatus Center is publishing a study I have written on this subject. Unfortunately the answer is almost certainly no: Medicare’s long-term financing problem is much more likely to be worse than currently projected than it is to be better. Suggestions to the contrary fail to account for important realities underlying the current projections. This piece attempts to summarize some of those realities and to explain why, irrespective of the reasons for the recent cost slowdown, a change of Medicare policy course will be needed.

#1: For the next two decades—well beyond the projected date (2026) of Medicare Hospital Insurance (HI) insolvency—Medicare cost growth will be driven primarily by population aging, not by health cost inflation. While slower health cost inflation would certainly be helpful, it will not change the biggest contributor to Medicare’s cost growth: namely, Baby Boomer retirements swelling the beneficiary rolls. Moreover, due to longevity growth the Boomers will collect benefits longer than any previous generation, since Medicare’s eligibility age of 65 has not changed since the program’s inception. 

One result is that, whereas in 2012 there were 3.3 workers to support each Medicare HI beneficiary, there will only be 2.3 by 2030. Largely due to this demographic shift, Medicare costs are projected to rise from 3.6 percent of GDP in 2013 to 5.6 percent by 2035. Even if excess health cost inflation were completely eliminated, Medicare costs would still rise faster than national economic growth for decades due to population aging alone. Thus, whether policymakers adjust Medicare’s eligibility criteria to reflect these changing demographic realities will long remain a much more important financial factor than incremental changes in health cost inflation.



#2: While a continued cost slowdown could improve future Medicare finances, so far the slowdown period has left Medicare finances weaker, not stronger. We do not yet know the extent to which the Great Recession was responsible for the recent slowdown in Medicare cost growth. We do, however, know this; the recession caused a lot of things to slow down—not only health cost growth, but also general price inflation, GDP growth, worker wage growth, and Medicare tax revenue.  Our national discussion is failing to place appropriate emphasis on the fact that, while Medicare’s costs have indeed slowed, its revenue growth has slowed by even more. On balance, Medicare is now in weaker financial condition than projected before the recession.  

For example, Medicare’s HI Trust Fund is now in weaker condition than was projected in the 2008 Trustees’ report. Its “trust fund ratio” (the ratio of trust fund assets to annual expenditures) declined to 81 (i.e., 0.81 years’ or about 10 months’ worth of benefit payments) at the start of 2013. In 2008, before the recession, the projection for the 2013 trust fund ratio was 95. While actual expenditures were somewhat lower than previous projections, revenues fell by more. 



The other side of Medicare, Supplementary Medical Insurance (SMI), is financed differently. It is funded primarily from general revenues and voluntary premiums, and is kept solvent by statutory construction. Financing strains on the SMI side of Medicare result in greater pressures on the general federal budget and on premium payments. Relative to GDP SMI costs have risen, not fallen, compared with previous projections.  



As a result, Americans are actually spending a higher percentage of their economic output on Medicare than was projected before the cost slowdown: 



Again, the primary reason for this is that the recession depressed Americans’ earnings and Medicare’s tax revenues by more than it has lowered Medicare costs. Slower cost growth is a good thing and may ultimately improve Medicare finances but, correlated as it has been with slower revenue growth, it has not done so yet. Medicare’s financial picture darkened during the cost slowdown; it has not yet brightened.

#3: Shifting our view from the present to the future, we find that long-term Medicare costs are much more likely to be higher than currently projected than lower. Medicare HI’s projected insolvency date of 2026 might move closer or it might move further out. But the Medicare trustees caution annually that over the long term, “Medicare’s actual future costs. . . are likely to exceed those shown by the current-law projections in this report.” To understand why requires a basic understanding of ongoing legislative practices and the trustees’ projection methods.

One factor is the legislative history of the statutory Sustainable Growth Rate (SGR) formula for Medicare physician payments. Legislators have been overriding this formula every year since 2003, a pattern that is widely expected to continue. Were current law allowed to bite, there would be sudden cuts in Medicare physician payments of 20-25 percent. The trustees’ report refers to continued overrides of the SGR formula as a “virtual certainty” that will likely raise actual costs well above current projections.

The other reason has to do with the interaction between the trustees’ projection methods and certain provisions of the ACA. The trustees assume (and indeed have assumed since well before the ACA’s enactment) that over the long term, national healthcare expenditure growth will slow to ultimately converge with the rate of per capita GDP growth. This reflects a model in which, as health prices rise, we become relatively less inclined to further increase our healthcare spending. 

At the same time, the ACA requires aggressive annual reimbursement rate reductions for most Medicare Part A and some Part B services, relative to prices faced by providers. Combining these annual payment reductions with the trustees’ assumptions of a continuing health expenditure slowdown results in a projection that many Medicare payments will actually shrink relative to per capita GDP over the long run.



Experts fiercely debate whether these Medicare reimbursement reductions would eventually result in politically untenable disruptions of seniors’ access to adequate care. But that debate aside, a belief in the current projections is in effect a belief that over a period of decades, Medicare payments can be successfully limited to grow not only substantially slower than providers’ input prices, but also slower than per-capita GDP and ultimately general price inflation as well. Accordingly, a belief that Medicare’s long-term finances will improve relative to current projections is implicitly a belief that ultimately payments in these various Medicare categories will, in effect, shrink even more rapidly than that, without triggering a political backlash.

Most experts would not consider such an improvement to be a credible scenario, which is why the trustees warn annually that actual costs are likely to be higher than under current projections. They will almost certainly be higher because of anticipated overrides to the SGR formula, and are also reasonably likely to be higher because current projections assume that much Medicare spending will shrink relative to GDP perpetually, at odds with historical experience. 

We should all hope for success in slowing health cost inflation, no matter who or what is credited for that success. But so far the slowdown has actually weakened Medicare finances by lowering its revenues more than its costs; plus, there is every reason to believe the future picture will be worse, not better, than current projections. It would be a dire mistake to conclude that the work of repairing Medicare finances has yet been done.


Charles Blahous is a senior research fellow for the Mercatus Center, a research fellow for the Hoover Institution, a public trustee for Social Security and Medicare, and a contributor to e21. 

Read the full Mercatus Center study here.

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