Today the Medicare program faces a long-range and fundamental financing problem driven by known demographic trends and projected escalation of health care spending beyond general inflation. The lack of an immediate crisis in Medicare financing affects the nature of the challenge, but it does not eliminate the need for change. Within the next 10 years, the first baby boomers will begin to retire, putting increasing pressure on the federal budget. From the perspectives of the program, the federal budget, and the economy, Medicare in its present form is not sustainable. Acting sooner rather than later would allow changes to be phased in so that the individuals who are most likely to be affected, namely younger and future workers, will have time to adjust their retirement planning while helping to avoid related “expectation gaps.” Since there is considerable confusion about Medicare’s current financing arrangements, I would like to begin by describing the nature, timing, and extent of the financing problem. As you know, Medicare consists of two parts—HI and SMI. HI, which pays for inpatient hospital stays, skilled nursing care, hospice, and certain home health services, is financed by a payroll tax. Like Social Security, HI has always been largely a pay-as-you-go system. SMI, which pays for physician and outpatient hospital services, diagnostic tests, and certain other medical services, is financed by a combination of general revenues and beneficiary premiums. Beneficiary premiums pay for about one-fourth of SMI benefits, with the remainder financed by general revenues. These complex financing arrangements mean that current workers’ taxes primarily pay for current retirees’ benefits except for those financed by SMI premiums. As a result, the relative numbers of workers and beneficiaries have a major impact on Medicare’s financing. The ratio, however, is changing. In the future, relatively fewer workers will be available to shoulder Medicare’s financial burden. In 2002 there were 4.9 working-age persons (18 to 64 years) per elderly person, but by 2030, this ratio is projected to decline to 2.8. For the HI portion of Medicare, in 2002 there were nearly 4 covered workers per HI beneficiary. Under their intermediate 2003 estimates, the Medicare Trustees project that by 2030 there will be only 2.4 covered workers per HI beneficiary. (See fig. 1.) The demographic challenge facing the system has several causes. People are retiring early and living longer. As the baby boom generation ages, the share of the population age 65 and over will escalate rapidly. A falling fertility rate is the other principal factor underlying the growth in the elderly’s share of the population. In the 1960s, the fertility rate was an average of 3 children per woman. Today it is a little over 2, and by 2030 it is expected to fall to 1.95—a rate that is below replacement. The combination of the aging of the baby boom generation, increased longevity, and a lower fertility rate will drive the elderly as a share of total population from today’s 12 percent to almost 20 percent in 2030. Taken together, these trends threaten both the financial solvency and fiscal sustainability of this important program. Labor force growth will continue to decline and by 2025 is expected to be less than a third of what it is today. (See fig. 2.) Relatively fewer workers will be available to produce the goods and services that all will consume. Without a major increase in productivity, low labor force growth will lead to slower growth in the economy and slower growth of federal revenues. This in turn will only accentuate the overall pressure on the federal budget. This slowing labor force growth is not always recognized as part of the Medicare debate, but it is expected to affect the ability of the federal budget and the economy to sustain Medicare’s projected spending in the coming years. The demographic trends I have described will affect both Medicare and Social Security, but Medicare presents a much greater, more complex, and more urgent challenge. Unlike Social Security, Medicare spending growth rates reflect not only a burgeoning beneficiary population, but also the escalation of health care costs at rates well exceeding general rates of inflation. The growth of medical technology has contributed to increases in the number and quality of health care services. Moreover, the actual costs of health care consumption are not transparent. Third-party payers largely insulate covered consumers from the cost of health care decisions. These factors and others contribute to making Medicare a greater and more complex fiscal challenge than Social Security. Current projections of future HI income and outlays illustrate the timing and severity of Medicare’s fiscal challenge. Today, the HI Trust Fund takes in more in taxes than it spends. Largely because of the known demographic trends I have described, this situation will change. Under the Trustees’ 2003 intermediate assumptions, program outlays are expected to begin to exceed program tax revenues in 2013. (See fig. 3.) To finance these cash deficits, HI will need to draw on the special-issue Treasury securities acquired during the years of cash surpluses. For HI to “redeem” its securities, the government will need to obtain cash through some combination of increased taxes, spending cuts, and/or increased borrowing from the public (or, if the unified budget is in surplus, less debt reduction than would otherwise have been the case). Neither the decline in the cash surpluses nor the cash deficits will affect the payment of benefits, but the negative cash flow will place increased pressure on the federal budget to raise the resources necessary to meet the program’s ongoing costs. This pressure will only increase when Social Security also experiences negative cash flow and joins HI as a net claimant on the rest of the budget. The gap between HI income and costs shows the severity of HI’s financing problem over the longer term. This gap can also be expressed relative to taxable payroll (the HI Trust Fund’s funding base) over a 75-year period. This year, under the Trustees’ 2003 intermediate estimates, the 75-year actuarial deficit is projected to be 2.40 percent of taxable payroll—a significant increase from last year’s projected deficit of 2.02 percent. This means that to bring the HI Trust Fund into balance over the 75-year period, either program outlays would have to be immediately reduced by 42 percent or program income immediately increased by 71 percent, or some combination of the two. These estimates of what it would take to achieve 75-year trust fund solvency understate the extent of the problem because the program’s financial imbalance gets worse in the 76th and subsequent years. As each year passes, we drop a positive year and add a much bigger deficit year. The projected exhaustion date of the HI Trust Fund is a commonly used indicator of HI’s financial condition. Under the Trustees’ 2003 intermediate estimates, the HI Trust Fund is projected to exhaust its assets in 2026. This solvency indicator provides information about HI’s financial condition, but it is not an adequate measure of Medicare’s sustainability for several reasons. In fact, the solvency measure can be misleading and can serve to give a false sense of security as to Medicare’s true financial condition. Specifically, HI Trust Fund balances do not provide meaningful information on the government’s fiscal capacity to pay benefits when program cash inflows fall below program outlays. As I have described, the government would need to come up with cash from other sources to pay for benefits once outlays exceeded program tax income. In addition, the HI Trust Fund measure provides no information on SMI. SMI’s expenditures, which currently account for about 43 percent of total Medicare spending, are projected to grow even faster than those of HI in the near future. Moreover, Medicare’s complex structure and financing arrangements mean that a shift of expenditures from HI to SMI can extend the solvency of the HI Trust Fund, creating the appearance of an improvement in the program’s financial condition. For example, the Balanced Budget Act of 1997 modified the home health benefit, which resulted in shifting a portion of home health spending from the HI Trust Fund to SMI. Although this shift extended HI Trust Fund solvency, it increased the draw on general revenues and beneficiary SMI premiums while generating little net savings. Ultimately, the critical question is not how much a trust fund has in assets, but whether the government as a whole and the economy can afford the promised benefits now and in the future and at what cost to other claims on available resources. To better monitor and communicate changes in future total program spending, new measures of Medicare’s sustainability are needed. As program changes are made, a continued need will exist for measures of program sustainability that can signal potential future fiscal imbalance. Such measures might include the percentage of program funding provided by general revenues, the percentage of total federal revenues or gross domestic product (GDP) devoted to Medicare, or program spending per enrollee. As such measures are developed, questions would need to be asked about actions to be taken if projections showed that program expenditures would exceed the chosen level. Taken together, Medicare’s HI and SMI expenditures are expected to increase dramatically, rising from about 12 percent of federal revenues in 2002 to more than one-quarter by midcentury. The budgetary challenge posed by the growth in Medicare becomes even more significant in combination with the expected growth in Medicaid and Social Security spending. As shown in figure 4, Medicare, Medicaid, and Social Security have already grown from 13 percent of federal spending in 1962 before Medicare and Medicaid were created to 42 percent in 2002. This growth in spending on federal entitlements for retirees will become increasingly unsustainable over the longer term, compounding an ongoing decline in budgetary flexibility. Over the past few decades, spending on mandatory programs has consumed an ever-increasing share of the federal budget. In 1962, prior to the creation of the Medicare and Medicaid programs, spending for mandatory programs plus net interest accounted for about 32 percent of total federal spending. By 2002, this share had almost doubled to approximately 63 percent of the budget.