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Why Medicare Expansion Threatens the Bush Tax Cuts and Undermines Fundamental Tax Reform

by Daniel J. Mitchell, Ph.D.
Backgrounder #1672

July 25, 2003

The House and Senate have approved legislation adding a prescription drug benefit to Medicare, and a conference committee is now attempting to reconcile these two bills. If the two chambers do manage to iron out their differences, the resulting bill will represent the biggest unfunded entitlement expansion in nearly 40 years.

Unfortunately for taxpaying Americans, however, the projected 10-year $400 billion cost is just a down payment that will not produce the necessary Medicare improvements and needed reforms. Instead, Congress will have passed a bill that in future years will require huge new taxes--new taxes that will threaten the recently enacted tax plan.

Moreover, this massive new entitlement significantly endangers future tax reductions and undermines the campaign for a fair and simple system such as the flat tax.

The Medicare prescription drug proposal is bad health policy, exacerbating the flaws in a system that has almost no market-based incentives to improve service and control costs. But the House and Senate bills also will undermine sound tax and economic policy in several ways. Specifically:

The size of government will expand
A new entitlement will take America even faster down the road that has caused so much economic damage in Europe's welfare states. Indeed, the unfunded Medicare expansion is essentially a huge future tax increase since the population of Medicare recipients will nearly double once the baby-boom generation retires. Ironically, just when some European countries are waking up to the problem and restraining unfunded entitlements, America will be creating an enormous new entitlement.
President Bush's recently enacted tax cut and tax reform package will likely be the first casualty
Because of arcane budget rules, the bulk of the 2001 and 2003 tax cuts expire at the end of 2008 and the end of 2010. Extending these tax cuts or making them permanent will be enormously difficult in an environment of skyrocketing spending for government-provided health care. Indeed, the creation of a prescription drug entitlement may be akin to repealing the Bush tax cuts.
By adding to the deficit, the huge new unfunded liability will likely be the death knell of further tax relief and fundamental tax reform
A prescription drug benefit means bigger deficits--a problem that will intensify as the baby boomers start to retire in the next decade. Once these demographic and fiscal variables become part of the budget forecast, lawmakers seeking to cut taxes and create a simple and fair tax code, such as the flat tax, in all probability will face insurmountable political obstacles.

A new entitlement means bigger government, and bigger government means higher taxes, especially when politicians are expanding the welfare state and neglecting much-needed Medicare reform. Simply stated, the prescription drug benefit will make America more like stagnant European nations such as France.

The Problem

Entitlement spending is the fastest growing part of the federal budget, and this pattern will continue even if there is no expansion of so-called mandatory programs In just the past 40 years, entitlements have nearly doubled as a share of federal outlays, climbing from 32 percent of total outlays in 1962 to 60 percent of the federal budget in 2002.¹

The elderly will be a much bigger share of the population once the baby-boom generation retires. And since the elderly consume most entitlement spending, the fiscal outlook will worsen--even if there are no changes to the underlying programs. According to the Congressional Budget Office, mandatory spending for Social Security and Medicare will nearly double as a share of the gross domestic product (GDP) over the next 40 years.²

Although Social Security and Medicare spending are projected to explode, payroll tax revenues to finance these programs will remain relatively constant as a share of GDP. The net result will be huge long-term deficits, and Medicare is the main problem. According to the trustees' reports on Social Security and Medicare,³ the combined deficit of the two programs will swell to more than 8 percent of national economic output in 2075, with Medicare accounting for about three-fourths of the red ink. According to government data, the Social Security cash-flow deficit through 2075 is $25.3 trillion in today's dollars. But this is spare change compared to the Medicare cash-flow deficit, which is a staggering $66.8 trillion over the same period.⁴

While the long-term outlook is grim, even the short-term prognosis is sobering. The baby-boom generation will begin to retire in about 10 years, and the fiscal consequences will be profound. The combined deficit will rapidly expand, climbing to 1 percent of GDP in 2015, 2 percent of GDP in 2020, and 3 percent of GDP in 2025. To put that figure in perspective, 3 percent of GDP today would be more than $325 billion, or $3,072 per household.

The tax implications of these big deficits should concern all responsible lawmakers as well as taxpayers. Raising revenue by just 1 percent of GDP next year would require an annual tax increase of more than $100 billion.⁵ Over the next 10 years, the tax increase needed to finance such a deficit would be more than $1.5 trillion.⁶ Such a tax increase would be a body blow to the economy, threatening European-style stagnation and higher unemployment.

The Enormous Cost of a New Prescription Drug Entitlement

In the absence of program reform, creating a new entitlement for prescription drugs is akin to pouring gasoline on a fire. And it will be very expensive gasoline. The 10-year cost of the new benefit is projected at $400 billion, but it is quite likely that the real cost will be much larger since public and private-sector estimates of drug costs in recent years have been well below actual spending levels. But the $400 billion is trivial compared with the situation when the baby boomers start to retire--just after the 10-year estimating window used by Congress.⁷

There are several reasons to expect that any prescription drug benefit will cost far more than official estimates indicate. Three are particularly important.

Behavioral changes will drive up costs
Government budget estimators have been notoriously inaccurate in predicting how individuals will respond to changes in fiscal policy. This is why tax cut estimates frequently overstate the revenue loss associated with lower tax rates.⁸ But it also explains why government prognosticators understate the cost of new entitlement programs.
When government begins to offer a benefit, individuals have an incentive to alter their behavior to maximize the amount that they will receive
Moreover, it is impossible to predict the development of breakthrough drugs that will enhance the quality of life, but it is safe to assume that seniors will want such drugs if they become available, particularly if Medicare subsidizes them. This explains, at least in part, why both Medicare and Medicaid have cost taxpayers several times as much as first predicted.⁹
Politicians will come under increasing pressure to expand the program
The House and Senate prescription drug bills offer haphazard coverage to seniors. Both have deductibles and then offer partial reimbursement up to a specified level. Once seniors reach that level of drug expenditure, they then are responsible for all costs up to another specified level, at which point the government picks up almost all of the costs. As a result of this spotty coverage, the $400 billion in the two bills will cover less than one-fourth of the total prescription drug cost for the elderly over the next 10 years.¹⁰

This patchwork system will generate enormous pressure on politicians to make coverage more uniform, and special-interest groups most likely will demand that three-fourths of the program be financed by general tax revenue, which could triple projected expenditures. It is worth noting Senator Ted Kennedy's view: "This is only a down payment. Hopefully, we can use this down payment in an effort to fulfill our responsibility to seniors over the years."¹¹

Demographic trends mean higher spending. The baby-boom generation begins to retire in about 10 years. Today, there are over 40 million people on Medicare; by 2030, that number will jump to almost 80 million, nearly doubling in less than 30 years.¹² Yet, because Congress is using 10-year budget estimates, this ticking fiscal time bomb is not part of the prescription drug debate.

Making long-run projections is, by necessity, somewhat speculative. The final legislation--if any--is still unknown, as is exactly how behavioral changes and future program expansions will affect costs.

Nonetheless, estimating the probable range of fiscal effects is quite possible: It has been done by Thomas Saving, one of the trustees of the Social Security and Medicare Trust Funds. Based on data from the Medicare Trustees' Report and the Congressional Budget Office and estimates from Texas A&M University, he estimates that the Medicare deficit will consume 20 percent of federal income taxes in 2026 and 33 percent of income taxes in 2042.¹³

If a prescription drug entitlement is created, those numbers will become even more startling. Under a best-case scenario, with government paying only 25 percent of drug costs, the Medicare deficit will climb to 24 percent of income tax revenues in 2026 and 39 percent in 2042. Using more realistic assumptions, however, the fiscal burden will become much more ominous. If Medicare pays 75 percent of prescription drugs, the program's overall deficit will consume 35 percent of income tax receipts in 2026 and 54 percent of those revenues in 2042.¹⁴

Medicare expenditures already are projected to climb dramatically, and creating a new entitlement will boost spending even faster. If lawmakers enact this legislation without considering the consequences, they will put their successors in an extremely difficult position, leaving them with three politically unpopular options. Future lawmakers could:

Raise taxes to make up the shortfall
Payroll taxes would have to be increased by more than 100 percent to make up the overall financing shortfall in Medicare. Lawmakers could choose higher income tax rates, of course, but the net result will still be more money in Washington and less money for the productive sector of the economy. The additional per household tax burden would be $1,168 in 2010, climbing quickly to nearly $4,000 in 2030.¹⁵
Accept enormous additional deficits
If politicians do not want to raise taxes or premiums, they can borrow money from the private sector to pay benefits. This will mean deficits approaching 8 percent of national economic output on a permanent basis. Deficits are not necessarily a bad thing, particularly if they are incurred to facilitate a policy with long-term benefits to the nation (such as winning World War II, lowering tax rates, or creating personal Social Security accounts). A new prescription drug entitlement, however, does not fall in this category.
Scale back benefits and/or ration care
The last choice is to reduce or renege on promised benefits--the least likely choice by future politicians. The creation of an entitlement today makes it very difficult for future lawmakers to cut it.

Creating Obstacles to Permanent Tax Reduction

In a political environment of rising costs and demands for more benefits, the most likely scenario is action by Congress to repeal existing legislation that would reduce tax revenue while concomitantly dampening enthusiasm for future tax reduction and reform. The remaining Bush tax cuts would likely be the first target.

The bulk of the 2001 tax cuts expire at the end of 2010, and most of the 2003 tax cuts expire at the end of 2008. Good economic policy suggests that these provisions should be made permanent to maximize the economic benefit of lower tax rates. At the very least, however, they should be extended to protect the economy from a significant tax increase in either 2009 or 2011.

If the temporary tax cuts are allowed to expire, the economy will be hit with a $775 billion tax increase between today and 2013.¹⁶ This tax increase would have serious economic consequences, particularly since much of it would be in the form of higher penalties on work, saving, and investment.

Yet, is it reasonable to assume that lawmakers will make the Bush tax cuts permanent when future budget projections will be adversely affected by the upcoming retirement of the baby boomers? Even extending the tax cuts will be much more difficult in that environment, and making the Bush tax cuts permanent might be impossible. For example:

The 15 percent tax rate on dividends and capital gains will expire at the end of 2008, and static revenue estimates will show an annual "cost" of nearly $25 billion to continue these rate reductions.¹⁷
Extending the 2001 tax cuts would be even more problematical. According to the Treasury Department, extending those tax cuts for just three years would "cost" nearly $500 billion. Making just the income tax rate reductions permanent would "cost" more than $270 billion.¹⁸
Permanent repeal of the death tax would be particularly vulnerable. This unfair levy finally ends in 2010, but will reappear in 2011 under current law. Since permanent repeal would "cost" about $40 billion per year, that goal will be extremely difficult to achieve.

Equally important, the baby-boom generation will be closer to retirement when the 2001 tax cuts expire; therefore, the future cost of providing benefits for these soon-to-be seniors will have a bigger effect on 10-year budget projections.

One need only imagine the demagogic political environment that might develop. Advocates of class warfare will argue that the death tax should be brought back to life to help pay for "life-saving drugs." Supporters of such politics also will argue that personal income tax rates on the "rich" should be raised to avoid "deficits as far as the eye can see."

Goodbye to Future Tax Reform

The tax cuts enacted in 2001 and 2003 are already at risk, and adding a prescription drug entitlement would magnify that risk. Further tax relief and fundamental tax reform would also be jeopardized if entitlements continue to consume an ever-larger share of national economic output.

All of the following tax cuts are necessary steps on the road to fundamental tax reform--and all will be much harder to achieve if prescription drugs become an entitlement:

Corporate tax rate reduction
The United States has the highest corporate tax rate of any developed nation. This punitive levy undermines the competitiveness of U.S.-based companies. Based on static scoring, reducing the tax rate by just 1 percentage point will "cost" more than $50 billion over 10 years, but can law-
makrs "afford" to drop the rate when budget choices are dominated by rising entitlement expenditures?
Alternative minimum tax (AMT) repeal
The alternative minimum tax is a "Catch-22" system that forces an ever-larger number of taxpayers to calculate their tax burden a second time using the AMT.¹⁹ If this results in a higher tax liability, the taxpayer must pay more tax. Is it reasonable to think that this unfair tax--with its $600 billion price tag--will be repealed when prescription drug spending is consuming a huge share of income tax revenue?²⁰
Universal IRAs
People should not be taxed twice on income that is saved and invested, which is why individual retirement accounts should be universal. Back-ended IRAs (Roth IRAs) are particularly attractive to politicians since they increase tax revenue in the short run, but will lawmakers be willing to adopt a system eliminating the second layer of tax on saving and investment when it might mean lower revenues in the long run?
Expensing of business investment
Companies should be allowed to fully deduct investment expenses when calculating taxable income (expensing), but the current system only allows them to deduct a portion of expenses in the year they are incurred (depreciation). This depreciation system creates a bias against capital formation and reduces worker productivity. Extending expensing for small businesses through 2013 will "cost" $23.7 billion.²¹ Providing this neutral treatment for all businesses would require an even bigger tax cut, but will Congress do anything when Medicare expenses are climbing much faster than inflation?
Territorial taxation
The United States has the world's worst treatment of foreign-source income. The greedy hand of the Internal Revenue Service reaches out to tax labor income, capital income, and corporate income earned in other nations--even though this income already is subject to foreign tax. This "worldwide" tax reach hinders U.S. competitiveness and is largely responsible for many companies' deciding to re-charter in jurisdictions with better tax law, such as Bermuda and the Cayman Islands. Territorial taxation--the common-sense notion of taxing only income earned inside national borders--would solve this problem, but is this solution feasible when prescription drug costs take an ever-larger share of national income?

In an environment of entitlements crowding out good tax policy, none of these reforms would be possible.

What Congress Should Do

Rather than enacting a huge new drug entitlement that will undermine sensible tax policies, lawmakers should pause to consider how best to address the shortcomings of Medicare in a responsible manner. A lack of drug insurance is not a widespread problem. Most seniors already have private coverage. Thus, a sweeping new government program covering every senior is not needed to address the genuine problems of a minority of generally lower-income seniors. Moreover, the lack of drug coverage in the existing Medicare program actually indicates deficiencies in the program's process of overhauling and modernizing benefits, and that problem requires structural reforms of Medicare, not an expensive add-on.

The best model to use to address these problems is Congress's own health plan, the Federal Employees Health Benefits Program (FEHBP), in which market competition and consumer choice leads to cost-effective plans with benefits that reflect enrollee needs--quite unlike Medicare.²²

Specifically, Members of Congress should address these shortcomings in ways that preserve two critical principles:²³

A Medicare drug bill should impose no net new unfunded liabilities on future generations.
The program should be revamped to resemble the FEHBP so that drug benefits and other features can become common and cost-effective features of plans through consumer choice and competition.

Conclusion

The House and Senate prescription drug bills will hurt America by making the health care system less responsive to market forces, but the damage will extend far beyond the health care system. The fiscal policy consequences of entitlement expansion are staggering.

Almost surely, a new drug entitlement will endanger the 2001 and 2003 Bush tax cuts. In the future, as lawmakers examine the need to extend those tax cuts and make them permanent, they will be haunted by budget projections showing an enormous expansion in Medicare spending. This will create a political environment that hinders the enactment of supply-side tax policy.

In the long run, entitlement expansion also threatens fundamental tax reform. Many of the reforms needed to bring the tax code closer to a simple and fair flat tax involve a reduction in tax revenue. This will be a daunting challenge. A bigger Medicare system--particularly one insulated from market-based reforms--will make it more difficult to replace the Internal Revenue Code with a pro-growth flat tax.

Daniel J. Mitchell, Ph.D., is McKenna Senior Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.