Financing Social Security and Medicare

The OASI, DI, and HI trust funds are all funded from payroll taxes assessed on current workers. Often called "FICA contributions" [for Federal Insurance Contribution Act], these taxes are nominally imposed equally on employers and employees. The tax base and the tax rate have increased over time with expansions of benefits and increases in costs.

The tax rates listed are paid by both employers and employees. Selfemployed individuals pay double these rates and, of course, it is worth noting that employees effectively pay both the employee and the employer shares because they must produce enough to allow the employer to pay wages, benefits, and taxes associated with their employment.

Two observations regarding these trends are notable. First, the maximum earnings subject to the FICA tax have increased over the lifespan of the programs. Part of this is due to inflation. The $3,000 maximum in 1937 is roughly the equivalent of $42,000 in 2006 dollars. However, the remaining increases and the increases in the tax rates are the result of expansions in the generosity of the programs, the growth of the elderly population, the decline in the working-age population and, for the HI trust fund, increases in the costs of medical care. Second, note that in 1991 the tax base for the Medicare HI trust fund was de-coupled from the tax base for the Social Security trust funds and became unlimited in 1994.

In contrast, the Medicare SMI trust fund is financed with both beneficiary-paid premiums and general tax revenues. Both Part B and Part D ordinarily require the beneficiary to pay 25% of the cost of the coverage. The other 75% comes from federal personal and corporate income taxes.

The FICA taxes are insufficient to cover the projected costs of the OASI, DI, and HI trust funds over time. Each year, the Social Security and Medicare trustees project the short-range outlook for the trust funds. For each future year, they estimate the revenues and expenses for each of the funds and compute the "trust fund ratio" for each. The ratio is simply the assets at the beginning of each year divided by the expected expenditures for the year times 100.

First, the impending retirement of the baby boomers will increase the number of people eligible for Medicare [and Social Security] benefits, increasing expenditures. Second, these retirements will leave fewer active workers to pay into the trust funds. In 2005, there were approximately 3.9 workers per beneficiary; by 2018, there will be approximately 3.0. As a result, revenues into the funds will decline. Third, the Medicare HI fund will also face substantially higher healthcare spending per beneficiary, due to rising trends in utilization, longevity, and medical care prices.

The SMI trust fund does not face the same financial stress, but this is only because it is financed from general tax revenues and beneficiary premiums. Retirement of the baby boomers and increasing medical expenses simply mean that premiums and, in particular, the allocation from general tax revenues increase! Indeed, because of the addition of Medicare Part D, SMI expenditures will grow more rapidly than any other portion of Medicare. Medicare Trustees' projections in 2006 of the trends in tax revenue, transfers, and deficits as a%age of gross domestic product [GDP] that result from their intermediate case assumptions for the overall Medicare program. Note that these are all premised on existing laws. They do not assume any changes in benefits or taxes that have not already been enacted [Palmer and Saving 2006]. Moreover, because the figure is defined in terms of GDP, it reflects current estimates in the growth of the U.S. economy over the same period.

These revenues increased as a%age of GDP between 1966 and about 2000, reflecting higher tax rates, the expanding tax base, and the growing taxable incomes of active workers. However, after 2000, they level off and decline as a% of GDP, due to the retirement of the baby boomers. "Taxes on benefits" are a minor share of revenue but increase due to the relative affluence of some future retirees.

"Premiums" are the share of Part B and Part D premiums paid by Medicare beneficiaries. These increase, reflecting baby boomer retirees' greater use of ambulatory and prescription drug benefits, which translates into higher premiums. "State transfers" are minor but reflect the payments that states make for certain Medicaid recipients. "General revenue" transfers reflect the single largest source of funds in the years to come.

These are the 75% share of Part B and Part D spending covered by general revenues. Indeed, as the Medicare Trustees put it "Soon after the Part D program becomes fully implemented in 2006, general revenue transfers are expected to constitute the largest single source of income to the Medicare program as a whole and would add significantly to the Federal Budget pressures".

Finally, the "HI deficit" reflects the shortfall in the Part A trust fund. For a number of years, this deficit would be satisfied by redeeming the government securities held by the HI trust fund, putting even further pressure on the rest of the federal budget.

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Financing Social Security and Medicare

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