Financing Medicare: A General Equilibrium Analysis

Abstract

This paper develops a general equilibrium, overlapping-generations model of the U.S. economy where households face random fluctuations in health status. Health status determines households’ productivity, mortality rate and their medical expenditures. Households make consumption and labor supply decisions, and can imperfectly insure medical expenditure shocks through markets. In addition, the government provides partial insurance against expenditure shocks through Medicare and a “social assistance” programs, and it runs a pay-as-you-go social security system. We calibrate the model based on the projected demographic and medical expenditure trends for the next 75 years. The model is used to study the macroeconomic and welfare implications of alternative funding schemes for Medicare. In the baseline closed-economy model, we find that the labor income tax will have to increase from 23% in 2005 to 36% in 2080 to finance the rising costs of Medicare. However, under an open-economy scenario, the tax would have to rise by much less. Limiting the increase in the wage tax through either a rise in the Medicare premium or a delay in the age of retirement is welfare improving.