Observers got a jolt when Medicare's Board of Trustees released its annual report on March 17 showing the program in worse shape than expected. Despite a decrease in physician fees of 5.4 percent in 2002, Medicare expenses shot up by 8.5 percent to $266 billion.

Spending over the remainder of this decade is now projected to be substantially higher than what was estimated just one year ago. The outlook is even more worrisome when two additional factors are taken into account.

The projections do not include any sort of prescription drug benefit and the baby-boom generation begins entering Medicare at the end of the decade, at which time the program becomes really expensive. In short, Medicare is on a slippery slope and, without serious reform, a downward acceleration will ensue.

Serious observers should forget all talk about the Medicare "trust fund." This exists as the result of fraudulent government accounting that is worse than anything dreamed up by Enron executives. To understand what's happening, consider that any money-losing enterprise can create its own trust fund. All it has to do is split its income statement into two parts - call them Part A and Part B.

In Part A, it would allocate most of its revenue but only about half its costs, thereby creating a "surplus" and - presto! - a trust fund. Part B, on the other hand, would run large deficits because it would receive just a small amount of revenue, but also get the other half of the costs. This is how the government accounts for Medicare, with one added element: general tax revenues are used to cover the deficit in Part B.

Not content to stop there, the government actually goes one step further by creating a trust fund for Part B as well. It does this by making general revenue "transfers" that are greater than necessary to cover the Part B deficit. Thus, Part B often records a "surplus" and it has its own trust fund.

If one ignores the fraudulent accounting and looks at Medicare as one program, there are no surpluses and no trust funds. Instead, Medicare is funded by four sources of revenue: (1) a payroll tax on wages and salaries; (2) a tax on Social Security benefits; (3) premiums paid by beneficiaries; and (4) general tax revenues. The main source of revenue is the payroll tax.

As recently as 2000, this tax paid for 65 percent of Medicare expenses. But last year, payroll tax revenue covered only 57 percent of expenses. By 2025, it will pay for only about 39 percent of Medicare expenses. General tax revenues will have to replace most of this decline, putting severe strain on the federal budget. Yet, little can be done to alter the demographic shift that will produce this change. The real action must come from the spending side, and it's here that the annual report spells big trouble.

One factor driving expenses in 2002 was an unexpected jump in enrollment of more than one million. The fastest growing segment continues to be disabled beneficiaries, who increased by more than five percent compared with two percent growth in elderly beneficiaries. Disabled beneficiaries first must qualify to receive Social Security disability benefits, and then, after two years, they become eligible for Medicare.

While Medicare had six million disabled beneficiaries in 2002, there were seven million people receiving Social Security disability, indicating that one million disabled persons could potentially enter Medicare over the next two years. The government should step up its efforts to periodically verify the status of the disabled beneficiaries.

Medicare also saw a substantial increase in inpatient hospital admissions and the complexity of these admissions, which triggered a greater number of large "outlier" payments. But the spike in inpatient hospital spending was also helped along by a "managed care shift effect," which refers to hospital admissions by former Medicare+Choice patients who returned to the government-run plan after being dropped by their HMOs. This would seem to refute the claim that Medicare HMOs have been enrolling only healthy seniors. When HMOs were increasing their Medicare enrollment during the 1990s, the managed-care shift effect reduced the number of inpatient hospital admissions.

Over the long term, projections of Medicare spending rely on some shaky assumptions. Per-enrollee costs are predicted to equal per-capita GDP growth plus one percent. Yet, historically, per-enrollee Medicare spending has outpaced per-capita GDP growth by three percent or more.

The annual report makes it abundantly clear that the defined benefit format of Medicare cannot control costs. Despite a battalion of price controls that are causing doctors to abandon the program, spending is outpacing the predictions of the actuaries. Why should we expect a tacked-on drug benefit to be any different? Reform of Medicare requires more advanced thinking.

Chris Middleton is the Senior Policy Analyst for Health Care Studies at the Pacific Research Institute in San Francisco. He can be reached via email at cmiddleton@pacificresearch.org.

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