Can America afford to get sick?

INTRODUCTION

Eighteen years ago, Henry Aaron, Barry Bosworth, and Gary Burtless posed the question, "Can America afford to grow old?" That study was seminal because the long-term budget projections were explicitly tied to a macroeconomic/ demographic model of long-run growth. (1) The question raised in the Brookings study focused primarily on the issue of Social Security financing, with little attention devoted to health care outlays. The question of whether America can afford to "grow old" has now come of age, and although there are still outstanding financing issues in the area of Social Security, those problems pale in comparison to the question of whether we can afford to get sick.

Health care spending is expected to consume a growing portion of the nation's GDP over the next few decades, which could have significant implications for federal tax and budget policy. Not only are Medicare and Medicaid outlays expected to increase rapidly, but increased total health care costs and the provision and cost of private health insurance also have the potential to affect tax revenues. For example, employment-based health insurance premiums and some out-of-pocket costs are paid with pre-tax income, driving down total income tax receipts. As health insurance costs increase, workers may receive even less of their compensation as cash wages. These factors have the potential to reduce tax revenues and force America to decide how these reduced tax revenues should be spent.

Outlays for Medicare and Medicaid increase over time because of the interaction between demographics and program eligibility. However, the magnitude of the increase in both history and projections is dominated by a factor known as "excess cost growth." Excess cost growth is basically an unexplained residual--the gap between growth in per-beneficiary program outlays and growth in GDP per capita that is not explained by demographics alone. In the last several decades, excess cost has been positive and significant on average, though the year-by-year pattern is volatile. Given uncertainty about the future of the residual, this paper considers the implications of alternative assumptions about excess cost growth for federal budget and tax policy.

Thirty years ago, federal spending on the two main government-financed health care programs--Medicaid and Medicare--accounted for about one percent of GDP; by 2005, this figure had risen to 4.2 percent. The projections below show that health care costs will continue to consume a growing share of the nation's GDP, but these projections are very sensitive to assumptions regarding excess cost growth: the rate at which growth in costs per beneficiary exceeds growth in GDP per capita.

PUBLIC HEALTH INSURANCE PROGRAMS IN THE UNITED STATES

Medicare and Medicaid are the two primary government-financed health care programs that provide health insurance coverage for the elderly, the disabled and the poor. Together, they cover 25 percent of the U.S. population and finance over 45 percent of national health spending, rising from 37 billion dollars in 1980 to 408 billion in 2006.

Medicare primarily provides health benefits to the nation's elderly population, although about 15 percent of the current Medicare population is disabled and under age 65. In 2005, there were more than 42 million Medicare beneficiaries, and the share of disabled beneficiaries has been growing slowly over time. As the baby boom generation ages, Medicare enrollment is projected to increase to 78.6 million by 2030 (Centers for Medicare and Medicaid Services and Office of the Assistant Secretary for Planning and Evaluation, 2007). Also affecting Medicare outlays is the changing composition of costs. In 1980, inpatient hospital services accounted for 68 percent of total costs (see Figure 1) and physician costs accounted for 24 percent of costs. By 2006, inpatient hospital services accounted for only 36 percent of total costs; physician costs had fallen to 14 percent of the total; and prescription drug costs account for 12 percent of costs. This changing composition of Medicare costs could have implications for future costs.

Medicaid is jointly funded by the federal and state governments and pays for health care services for a variety of low-income individuals. (2) In terms of enrollment, it is the government's largest health care program, covering more than 60 million people or about 20 percent of the U.S. population. In particular, it pays for 40 percent of all births and provides health insurance to one-third of all children. Medicaid is also the main financer of nursing home care, paying for two--thirds of all nursing home stays by the time of patient discharge. (3)

While children and non-elderly, non-disabled adults make up almost three-quarters of Medicaid recipients, the elderly and the disabled account for 75 percent of total spending (see Table 1). One-third of Medicaid's spending goes towards long-term care, with elderly and disabled populations accounting for virtually all of that cost. In fact, the disabled account for under 20 percent of beneficiaries and almost 50 percent of costs.

Between 1999 and 2004, total Medicaid spending increased by 70.2 percent, rising from $140 billion to $238 billion. Increases in both the number beneficiaries and the cost per beneficiary helped generate this growth. During this period, the number of beneficiaries grew by 39.2 percent, while cost per beneficiary rose by 22.3 percent. Of the four main Medicaid-eligible groups--children, adults, elderly and disabled--it was the adult population that grew the fastest during this period, increasing by 69 percent. Cost per beneficiary, on the other hand, grew the fastest for the disabled population (a 52 percent increase), a group that only makes up about 19 percent of the total Medicaid population.

Four main factors contribute to the growth in total spending in the Medicaid and Medicare programs: increases in the number of beneficiaries, real increases in the cost per beneficiary, changes in the composition of beneficiaries, and general inflation in prices. Federal Medicaid benefits are projected to double in nominal terms over the next ten years, increasing from $172 billion in 2007 to $353 billion by 2016 (Congressional Budget Office, 2007). This aggregate increase is expected to be partly being driven by growth in enrollment (especially in the elderly and disabled populations) and growth in costs per beneficiary (especially for prescription drugs and non-institutional long-term care services) (Congressional Budget Office, 2006).

DEFINING EXCESS COST GROWTH

We refer to the unexplained residual growth in health spending that exceeds demographic and economic growth as "excess cost growth." The excess cost growth concept allows historical cost growth trends to be summarized and is often used as the basis for health spending projections. For example, the Medicare Trustees use an excess cost growth assumption of one percent in their intermediate long-run projections of Medicare spending (Medicare Trustee Report, 2007). Similarly, the Congressional Budget Office used an excess cost growth assumption of one percent in their intermediate spending scenario for long-run projections of spending on Medicare and Medicaid (Congressional Budget Office, 2005). (4)

While there is uncertainty in both economic and demographic projections, the dominant source of uncertainty in projecting Medicare and Medicaid is residual growth in spending per enrollee relative to the growth of per capita GDP. Assumptions about the level of excess cost growth can have large effects on long-run projections of federal health spending. For example, suppose that Medicare excess cost growth is zero percent. Here, Medicare spending per beneficiary (within any given age group) would grow at the same rate as per capita GDP. Thus, although per beneficiary spending and per capita GDP would continue to grow, the increase in Medicare's share of GDP would only reflect the aging of the population. In the case of one percent excess cost growth, spending per beneficiary would grow at the rate of GDP growth plus one percentage point, which in the long-run could generate large differences in Medicare's share of GDP.

ESTIMATING AND PROJECTING HEALTH CARE COSTS

The projection methodology has four steps. First, micro data are used to create point-in-time spending estimates by individual characteristics such as age, sex, time until death, and beneficiary type. Second, these spending estimates are combined with aggregate beneficiary counts to infer excess health cost growth in history and in the ten-year CBO budget window. Third, the ratio of aggregate beneficiary counts to the overall population are calculated and fixed, allowing us to predict beneficiary populations beyond the ten-year projection window. Finally, long-run excess cost growth rates are assumed, which ultimately generates the overall projections of federal health outlays.

Step 1: Create Spending Indices

For both Medicare and Medicaid, the first step is to develop point-in-time spending indices that vary by relevant characteristics. For Medicaid, the indices vary by age, sex, and population group. For Medicare, those characteristics are age, sex, and time until death.