Base Medicare Premiums on Lifetime Earnings

Base Medicare Premiums on Lifetime Earnings

Since 2003, Congress has tried to lower the cost burden of Medicare by requiring beneficiaries with high incomes in retirement to pay higher premiums for their coverage. Requiring beneficiaries who can pay more to do so is certainly a sensible and necessary step toward making the program more affordable for taxpayers. But the current method of assessing ability to pay based on the retirement incomes of Medicare beneficiaries is faulty. It would be far better, in terms of both fairness and economic efficiency, to base Medicare’s income-related premiums on workers’ lifetime earnings.

In its current form, the Medicare program is a principal cause of the nation’s deteriorating fiscal outlook. Total spending on Medicare will reach $714 billion this year (second only to Social Security), and grow to more than $1.5 trillion by 2028, according to the Congressional Budget Office. Under these circumstances, there is little choice but to require higher premiums from those beneficiaries with the means to pay them.

Many retirees assume they have already fully paid for their Medicare coverage through payroll taxes. But the Medicare payroll tax only covers the cost of Part A of the program, which pays for inpatient hospital services and the care provided in other institutionalized settings. Parts B and D of Medicare, which cover physician and outpatient services and for prescription drugs, respectively, tap into the general fund of the Treasury for most of their costs. In other words, taxpayers subsidize these parts of Medicare with their income tax payments.

All Medicare beneficiaries are required to pay a base-level premium for enrollment in Part B. Further, to get coverage under Part D, beneficiaries must select from among competing, privately administered plans and again pay a monthly premium (low-income beneficiaries get additional assistance to pay for their Part B and D premiums). These base-level premiums cover, on average, about 25 percent of the total costs of Parts B and D, and the rest is financed with transfers from the general fund of the Treasury. The trustees who oversee the finances of the program project that, over the period 2018 to 2027, these transfers will total $4.7 trillion.

To lessen Medicare’s burden on taxpayers, Congress began imposing income-related premiums for Part B of Medicare as part of the 2003 prescription drug law. Later, in amendments enacted as part of the Affordable Care Act in 2010 and other health and budget-related bills, Congress required income-related premiums for Part D, and increased the amounts that higher-income beneficiaries must pay. In 2019, all beneficiaries with annual incomes above $85,000 for individuals and $170,000 for couples must pay for at least 35 percent of the cost of their Part B and D coverage. The percentage that is required to be covered by beneficiary premiums increases in stages at higher levels of income. Individuals with annual incomes of $500,000, and couples with annual incomes of $1 million, pay for 85 percent of Part B and D costs.

Retirees tend to have lower annual incomes than workers because they lack earnings and rely more heavily on income earned on invested capital, which is not necessarily realized on a steady, annualized basis. Therefore, the vast majority of beneficiaries have annual incomes below $85,000 ($170,000 for couples) and are exempt from paying anything above the base-level premiums. Currently, only 8 percent of all Medicare enrollees pay an income-related premium, and that percentage is expected to rise to only about 10 percent in the coming years.

Andrew Samwick of Dartmouth College has provided a useful analysis suggesting lifetime earnings are a fairer and more effective measure of the ability of Medicare beneficiaries to pay higher premiums.

First, using lifetime earnings instead of current income wouldn’t penalize work. The current approach strongly incentivizes Medicare enrollees to lower their earned income when they reach age 65, or to retire altogether, in order to keep their total incomes below the thresholds established for income-related premiums. Samwick estimates that the current approach imposes an implicit tax of between 2.3 and 3.6 percent on all income above the initial threshold and below $500,000 for individuals ($1 million for couples). This implicit tax comes on top of the regular income and payroll taxes paid by these workers. That’s certainly enough of a disincentive to affect the behavior of some Medicare beneficiaries. 

Second, switching to lifetime earnings would also eliminate the penalty on savings associated with current law. Retirees depend heavily on withdrawals from retirement accounts and the realized gains from invested capital for their incomes. Imposing higher Medicare premiums based on realized income from these sources is equivalent to imposing a penalty on savings, which is both ill-advised as a policy matter and generally unfair. Using lifetime earnings as the basis for setting income-related premiums would allow workers to save as much as they wanted for their retirement without fear of losing some of it to a government-imposed income test.

Third, switching from current income to lifetime earnings would make ability-to-pay determinations more stable and less easily manipulated. Retirees have significant discretion over the timing of their retirement account withdrawals and their sales of stocks and other investments to boost their incomes. Using current income provides an incentive for Medicare beneficiaries to minimize their Medicare premiums by consolidating all of their withdrawals into a limited number of years, and to invest in stocks that pay less in annual dividends. Using lifetime earnings would eliminate these distortions and allow retirees to deplete their capital without having to account for the effect of this income on their Medicare premiums.

Switching to lifetime earnings would not be a complicated matter. The government already has every worker’s lifetime earnings through the payroll tax system. Further, the government uses a formula to calculate average lifetime wages when determining a retiree’s Social Security benefit; a similar calculation could be made for workers as they are enrolling in Medicare. A one-time calculation at initial eligibility could be used to establish a retiree’s income-related premium obligation, which would then remain in effect throughout his or her eligibility for the program.

Using lifetime earnings rather than current income to charge higher premiums for some beneficiaries would produce fewer economic distortions, and it might also allow Congress to expand the number of beneficiaries required to pay something more toward their Medicare coverage. After all, the 80th-percentile working-age household has an income that is over $100,000 annually. Workers with earnings in that range before they reach age 65 are very likely to have sufficient resources in retirement to be self-sufficient, or close to it, and thus less in need of financial support from other taxpayers than retirees who earned less when they worked. 

James C. Capretta is a RealClearPolicy Contributor and a resident fellow at the American Enterprise Institute.

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