The pressure the Medicare program puts on the federal budget has been much discussed, but financing Medicare also has broader implications for the economy. Medicare expenditures currently account for 15% of federal spending and 3.6% of the total gross domestic product (GDP).¹Moreover, Medicare spending grew an average of about 2.5 percentage points faster than the GDP from 1975 through 2008,² consuming a rapidly increasing share of the country’s total resources.

Health care services provided to Medicare beneficiaries are paid for by a combination of dedicated taxes and general revenues — in addition to the care financed by supplemental plans and the 25% of care that beneficiaries pay for through premiums or out of pocket.³ Medicare Part A (mainly for inpatient expenses) accounts for about 1.7% of the GDP and is largely financed by a dedicated tax on wages (2.9% of earnings, split evenly between workers and their employers but ultimately all coming out of workers’ wages). Starting in 2013, high-income workers are scheduled to pay an additional 0.9% tax imposed by the Affordable Care Act (ACA). The payroll taxes are paid into a trust fund, but since 2009 spending has grown more quickly than the revenue stream, and the Part A trust fund is forecast to be exhausted in 2024.¹ At that time, benefits would need to be reduced or other revenue sources found, since there’s no provision for filling the projected long-range (75-year) gap between resources coming in and benefits promised (almost 1% of the GDP, under realistic assumptions).

Program costs for Medicare Parts B (physicians and other outpatient care) and D (drugs) are financed mostly through general revenues (about 75%) and beneficiaries’ premiums. The cost of these two Medicare components is about 1.9% of the GDP, and it’s projected to rise to 3.4% by 2035 — even under the improbable assumption that substantial cuts to physician payments under the sustainable growth rate (SGR) formula will be implemented.¹ Since spending on these components of the program is rising rapidly, the share of financing from general revenues is also rising rapidly (see graph).

The public financing of Medicare has particular implications for the economy. Specifically, raising taxes to pay for public insurance exerts a structural drag on the economy even if the revenue is spent on care; the same is not true of unsubsidized, privately purchased care or insurance. The net size and timing of the economic consequences depend on how the taxes are raised and how the revenue is spent. Deficit spending on health care also carries an economic cost: taxes are required to pay back any borrowed money (with interest), and rising debt-to-GDP ratios may have calamitous effects on the country’s future ability to borrow. Moreover, increased spending on health care is not necessarily good for the economy even if it increases health care employment: spending on low-value health care diverts resources from other uses that could do more to boost the GDP and create jobs.

Although the economy can probably bear some tax increases to help finance Medicare, if recent rates of spending growth continue, taxes would have to increase precipitously. An analysis performed by the Congressional Budget Office (CBO) before the ACA was passed suggested that income tax rates would have to increase by more than 70% to finance health care spending that grew just 1 percentage point faster than the GDP — and by more than 160% to finance growth at the historical rate of 2.5 percentage points faster than GDP growth, increasing the income tax rate in the top bracket, for example, to 92% from 35%.² Even with just 1 percentage point excess growth in health care spending, the CBO estimates that the tax increase would reduce the GDP by 3 to 16%.²

Of course, such tax-financed spending may be worthwhile — the cost of raising the revenue must be weighed against the good done by the program, and Medicare has many costs and benefits beyond its effect on the GDP. Its pooling of risk is crucial to the functioning of insurance markets. If sicker people are disproportionately likely to obtain insurance, premiums will increase, even fewer people will enroll, and insurance markets may eventually collapse. Before Medicare, health insurance was purchased almost exclusively through employers that provided the main source of risk pooling. In 1963, only an estimated 25% of seniors had comprehensive insurance, but shortly after Medicare was created in 1965, virtually all did.⁴ The heavy public subsidy of Medicare coverage ensures wide participation and risk pooling.

Although this coverage provides important financial protection and access to care, Medicare’s design generates inefficient utilization, which imposes broad indirect costs on all patients. For example, fee-for-service payment discourages coordinated care, and if Medicare benefit or payment design encourages investment in inefficient resources or inefficient care patterns, that can also drive higher and inefficient private spending.

On paper, the ACA significantly reduces the fiscal burden associated with Medicare: the Centers for Medicare and Medicaid Services estimates that it will slow per-beneficiary spending growth to about the rate of GDP growth, largely by reducing payments to providers and health plans. The ACA also establishes pilot mechanisms for transforming fee-for-service Medicare into a bundled-payment system with broader integration of care, which could promote cost containment by enabling providers to better capture practice efficiencies. Nevertheless, Medicare spending would still consume a growing share of the GDP because of increasing numbers of beneficiaries. Thus, even if the ACA achieves its ambitious goals, Medicare would still need extra resources to solve this demographic problem. Although some additional resources could come from reducing waste in the system, no industrialized country has ever achieved sustained growth rates of health care spending below that of the GDP, so it seems unlikely that Medicare’s growth could be reduced below the projected ACA trajectory.

More important, it’s unclear how successfully the ACA’s fiscal provisions will be implemented. Political will may wane, and the projected savings may not materialize. The use of temporary “patches” to the SGR rather than a longer-term fix illustrates the political challenges involved, and relatively disappointing results from many Medicare demonstration programs illustrate the difficulty of achieving savings.

If the payment-reform and delivery-system strategies in the ACA fail, alternatives will probably involve shifting costs and risk to beneficiaries. One avenue for enacting such a shift would be fixed vouchers (or premium support), which would limit federal liability but, by relying on market mechanisms, place a greater burden on beneficiaries to control spending. The use of market competition is not new: the rationale for the Medicare Advantage (Part C) program included introducing more competition among plans to improve the program’s value. Consumers’ ability to “discipline the market” depends on the competitiveness of insurers and providers, however, and there is limited evidence that competition among Medicare Advantage plans can sufficiently control spending growth.

Reforms might make competition more effective. For example, competitive pressure might be increased by increasing beneficiaries’ incentives to choose low-cost plans, but shifting financial responsibility to beneficiaries can also exacerbate disparities and expose beneficiaries to greater financial risk as health care costs rise relative to their vouchers’ value. Or responsibility can be shifted by increasing beneficiaries’ cost sharing, a strategy that could discourage the use of lower-value care and limit the program’s economic drag — but that must be well designed and operating in a well-regulated environment, particularly if it’s to avoid discouraging use of high-value care.

Although Medicare provides invaluable financial protection and access to care for almost 50 million beneficiaries,¹ there’s a limit to what we can finance with limited public resources — public programs cannot pay for all possible care for all people. Different plans for limiting Medicare’s public resources impose risk on different stakeholders: bundled payments shift financial responsibility and risk to providers; fixed premium support shifts them to beneficiaries. Ultimately, benefit and payment structures must be improved in a clinically informed way that’s consistent with high-value care but that also moderates spending growth to keep the program — and the economy — afloat.

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This article (10.1056/NEJMp1107671) was published on July 13, 2011, at NEJM.org.