How curbing health care spending will affect the deficit

Rapidly growing health care costs have been a major driver of federal budget deficits. Could a decline help solve the nation's long-term fiscal problem? 

Rapidly growing health care costs have been a major driver of actual and projected federal budget deficits and the national debt. In recent years, the rate of growth in medical spending has slowed, leading many to ask whether a permanent decline could solve the nation’s long-term fiscal problem.

Along with University of California at Berkeley economist Alan Auerbach, we recently examined the role of health spending in budget projections. Our conclusions: Yes, a long-term slowdown in medical cost growth could have a dramatic positive impact on future deficits. But no decline within the realm of our historical experience could fix the nation’s fiscal imbalance.

We take no position on whether the current slowdown will continue—and, in fact, recent evidence suggests costs may again be bumping up. Rather, we incorporated different health cost scenarios into a budget calculator to see how they change fiscal outcomes.

We did this by modeling a range of possible changes in health spending using a concept known as “excess cost growth” or ECG. The Center on Medicare and Medicaid Services defines this measure as the growth rate of health spending after adjusting for population aging, sex composition, and overall economic growth. Thus, excess cost growth captures the rate of growth in both per-person utilization and prices, controlling for demographics and the economy. Absent demographic changes, excess cost growth of zero means that health care spending would grow at the same rate as GDP.

Annual excess cost growth has averaged 1.9 percent between 1975 and 2011, but has varied a lot; the five-year averages range from -0.3 percent in 1995–2000 to 2.7 percent in 2000–2005. The overall rise in excess cost has been driven by a diverse set of factors, including improved medical technology, expanded health insurance coverage, and growth in personal income–which increased utilization.

ECG has been lower recently, averaging 1.3 percent in 2005-11, and many believe this could be the beginning of a new long-term trend. For example, the Congressional Budget Office recently revised downwards its ten–year estimates of Medicare and Medicaid spending.

Our simulations highlight two key points. First, even if health care costs are brought under control immediately and permanently, the nation still faces a sizable fiscal imbalance. Under a scenario in which excess cost growth immediately falls to zero and stays unchanged for the next 75 years, the deficit in 2040 will still grow to more than 6 percent of GDP—leading public debt to rise to 112 percent of GDP. The nation would still face a long-term fiscal gap of 2.6 percent of GDP—about $400 billion per year, every year in the future.

However, even a change in medical spending that is “small,” in the sense that it is within the range of recent historical values, could nonetheless have enormous impact on the size of the fiscal shortfall. If excess cost growth is 2.5 percent over the next 75 years—a high rate of growth to be sure, but still within historical range—deficits shoot up to 15 percent of GDP by 2040 and public debt skyrockets to 187 percent of GDP.

Even though the short-term federal budget outlook has improved markedly in recent years—with steep reductions in discretionary spending, repeal of tax cuts for high-income households, and an improving economy driving deficits down to 2.8 percent of GDP in 2014—underlying challenges remain. As we show, steady excess cost growth in health spending—even at relatively low levels by historical standards—still will put strains on the federal budget and US economy barring higher taxes or substantial cuts in other spending.