The Economics of Medicare Reform

Since it was signed into law by President Lyndon Johnson in 1965, Medicare has fulfilled its purpose by providing older Americans access to modern health care in a way that neither drains their life savings nor puts undue financial stress upon their children. Today, however, despite the nation's flourishing economy, Medicare is in trouble of going broke as the ratio of workers paying into the system to those receiving benefits declines.

Professors Andrew J. Rettenmaier and Thomas R. Saving propose a means for preserving Medicare as we know it. After detailing the reasons for Medicare's financial troubles, they present a cohort-based financing plan for Medicare that represents a fundamental departure from the generation transfer method currently used.

The system they propose requires each age cohort (all individuals born between January 1 and December 31 in any given year) to insure itself against retirement medical expenses. This requires workers of each cohort to contribute to accounts that, by the time of their retirement, would contain a large enough sum to pay for their cohort's remaining lifetime health care expenditures. This method, they say, eliminates the cohort size risk that faces us now due to the retirement of the baby boom generation. If there should be a bulge in any particular age distribution due to increased fertility or immigration, the overall contribution to the account increases in step with the expanded population in that cohort. Therefore, the same per-capita value of the account is maintained regardless of the size of the cohort.

"By moving to prepaid financing," say the Rettenmaier and Saving, "we remove the disincentives to invest, and the nation will experience an increase in its capital stock and income. It is this increase in the capital stock and national income that provides most, but not all, of the current system's unfunded liability." There is no free lunch, they conclude, "but there is a considerably cheaper lunch that is of better quality than the one we are currently committed to buying."