Friday, June 1, 2012

The Fiscal Cliff, Medicare and Medicaid

 The Fiscal Cliff: Witching Hour is set for January 1, 2013

As Federal Reserve Chairman Ben Bernanke has noted, at the end of 2012 “there’s going to be a massive fiscal cliff of large spending cuts and tax increases.”  These include the expiration of the 2001/03/10 tax cuts, the activation of a $1.2 trillion across-the-board spending “sequester,” an immediate and steep reduction in Medicare physician payments, the imposition of new taxes, and the end of current alternative minimum tax (AMT) patches. The need to once again increase the country’s debt ceiling will also occur around the end of the year. The “cliff” is largely the result of prior legislative policies to reduce the apparent deficits being created by tax and spending enactments by including “sunset” provisions in them.

Everyone agrees that that the tax increases, spending reductions, and other policies set to take effect at the end of the year will seriously harm the economy unless Congress and the President can agree on changes.  The Congressional Budget Office (CBO) predicts that if all of the scheduled tax hikes and spending cuts go into force the total 2013 fiscal drag on the economy will be $560 billion. The CBO estimates that the economy would contract at an annual rate of 1.3 percent in the first half of 2013, which would be an economic recession. 

Extreme political partisanship and resulting gridlock has meant that Washington has been unable to agree on measures to address our debt or strengthen the economy over the long-term.  At this point in time it is difficult to see how this will change before the November election.

While it is difficult to predict the eventual political outcome, possible scenarios include (1) Congress allows us to fall off the fiscal cliff; (2) Congress repeals the sequester and again “kicks the can down the road” (in Representative Boehner’s words) via a short-term extension of existing tax and spending policies; (3) a “grand bargain” is made where the House, Senate, and President agree on tax and spending policies that reduce the growth of the debt in a manner that attempts to minimize negative impacts on short term economic growth. Scenarios 2 and 3 appear unlikely to happen before the election which means that much uncertainty, damage and pain and the start of a recession are increasingly likely to be inflicted on the economy before the end of this year.

The policy uncertainty in Washington certainly makes it difficult for individuals to engage in planning on issues such as gift and estate tax planning.

Here is a listing of some of the changes that are set to occur at the end of the 2012 calendar year.[1]

The Expiration of the 2001/2003/2010 Tax Cuts
On December 31st, the set of tax cuts enacted in 2001 and expanded in 2003 and 2010 will expire. As a result, the top income tax rate will rise from 35 percent to 39.6 percent and other rates will rise in kind. The 10 percent bracket will disappear. The estate tax will return to the 2001 parameters of a $1 million exemption and a 55 percent top rate. Capital gains will be taxed at a top rate of 20 percent and dividends will be taxed as ordinary income. Marriage penalties will increase, and various tax benefits for education, retirement savings, and low-income individuals will disappear. But a decision to back away from the cliff by extending the current favorable tax rates will be expensive: 
  • The increase in the federal estate tax from 35% over $5 million to 55% over $1 million would save an estimated $35 billion in 2013 and $430 billion between 2013 and 2022.
  • The increase in income tax rates from 25|28|33|35 to 28|31|36|39.6 would save $95 billion in 2013 and $730 billion between 2013 and 2022.
  • The increase in capital gains taxes from 15% to 20% and dividend taxes from 15% to being taxed as ordinary income would save $25 billion in 2013 and $315 billion between 2013 and 2022.

The End of AMT Patches
Congress generally “patches” the Alternative Minimum Tax (AMT) every year to help it keep pace with inflation. As a result, just over four million tax returns currently pay the AMT. If a new patch is not enacted retroactively for 2012, that number will increase to above 30 million for that year and would exceed 40 million by the end of the decade.

The End of Jobs Measures
In February, the President signed an extension of a two percent payroll tax holiday and extended unemployment benefits through year’s end. Under current law, both will disappear at the end of the year, causing employee payroll taxes to increase from 4.2 percent to 6.2 percent, and reducing the number of weeks individuals can collect unemployment insurance. Allowing the expiration of the 2% payroll tax holiday would save $120 billion in 2013.

The End of Doc Fixes
The Sustainable Growth Rate formula calls for a substantial reduction in Medicare payments to physicians – a reduction lawmakers have deferred through continued “doc fixes” since the early 2000s. At the end of the year, the current doc fix will end, leading to a nearly 30 percent immediate reduction in Medicare physician payments. Restoring the Medicare payment “Doc Fixes” would cost $30 billion in 2013 and $270 billion between 2013 and 2022.

The Activation of the Sequester
Beginning on January 1, 2013, an across-the-board $1.2 trillion spending sequester over ten years is scheduled to go into effect. The sequester will immediately cut defense spending across-the-board by about ten percent, will cut non-defense discretionary spending by about eight percent, and will reduce Medicare provider payments by two percent

Through 2021, the sequester will put in place cuts totaling $455 billion in defense, $295 billion in non-defense discretionary, $90 billion in Medicare, and $50 billion in other programs.  Other than the Medicare provider payment reduction, most transfers and entitlement programs are exempt from the sequestration spending cuts. 

Programs that would be exempt from these automatic sequester cuts include Medicaid, CHIP, Social Security, SSI, most of Medicare, veterans’ benefits, some other means tested programs, federal retirement, and tax credits. This means substantial cuts would be required in education, infrastructure, and research and development.

The Expiration of Various “Tax Extenders”
Various normal “extenders,” such as the research and experimentation tax credit and the state and local sales tax deduction, expired at the end of 2011. Some of these extenders are likely to be reinstated retroactively at the end of this year, but will disappear under current law.

New Taxes go into Effect

  • New Medicare Tax on Investment Income begins - a new 3.8% tax will be imposed on high levels of investment income
  • An additional 0.9% Medicare Hospital Insurance Tax will be imposed on high-income wage earners.
  • Medical Expense Deduction Threshold will Increase to 10% for individuals under 65s

Reaching the Debt Ceiling
The debt ceiling agreement reached last summer is likely to allow continued borrowing through the 2012 election. However, the debt ceiling will need to be increased again near year end in order to avoid a potential default. Government shut-down is a possibility although that is unlikely until after the election.

If implemented, the default changes in law set to occur at the end of the year will affect most Americans but are not particularly targeted on seniors. Seniors may be more directly impacted by the policies implemented as part of a “grand bargain” between Republican and Democratic leaders, or by the policies implemented by a new Congress, especially if control of both houses and the Presidency is in the hands of one party.  

How a Grand Bargain might Affect Medicare

The elements of a “grand bargain” are likely to be largely dependent on the results of November’s election. How to cut the future cost of Medicare will be a primary consideration. The Democratic approach in general is to cut costs through a combination of government regulation and competitive incentives such as those set forth in the healthcare reform law.  The Republican approach, championed by Representative Paul Ryan (R-Wis.) is toward privatization and reliance on free-market pressure applied through insurance companies.

In simplified terms, Ryan's plan would be to issue every Medicare beneficiary a voucher to buy a private insurance policy and rely on insurance companies to keep costs down. This privatized Medicare model (sometimes referred to as "premium support") may or may not be presented as an optional choice for beneficiaries. Medicare would rely on competition among insurance companies to keep basic costs below the value of the voucher, which could rise each year within a limit set by Congress.

Most Democrats reject the Ryan approach as shifting too much of the burden of rising costs onto the elderly. The Democrats focus more on changing the behavior of drug companies and health care providers through the imposition of payment cuts, the strengthening the new Independent Payment Advisory Board (a federal panel that is supposed to make healthcare spending more efficient but is barred from recommending restrictions in benefits), and innovative delivery and payment methods like “accountable care organizations.”

Unfortunately, the debate over the future of Medicare is polarized by current political partisanship, which does not provide a good forum for intelligent problem solving. Both sides do agree, however, that the growth of Medicare costs needs to be controlled.  There seems to be significant support from both sides on some measures such as (1) raising the age of eligibility and (2) increasing the cost of Medicare for more affluent beneficiaries. These measures will be likely elements of any grand bargain.

Although big changes may be legislated for Medicare during the next 12 months, this is apparently not what the electorate wants. Polling continually shows that most Americans don't think Medicare needs to be cut at all.

Republican Proposals for Medicaid

As of this writing (June 1, 2012) Governor Mitt Romney has proposed to cap total federal spending at 20% of GDP by 2016, boost defense spending, cut taxes, and balance the budget. To his opponents it is apparent that his proposals, if implemented, would require extraordinarily large cuts in Medicaid and other programs supporting seniors. The liberal leaning Center on Budget and Policy Priorities estimates that if policymakers exempted Social Security from the cuts, as Romney has suggested, and cut Medicare, Medicaid, and all other entitlement and discretionary programs by the same percentage — to meet Romney’s spending cap, defense spending target, and balanced budget requirement — then non-defense programs (other than Social Security) such as Medicaid would have to be cut 29 percent in 2016 and 59 percent in 2022. 

To reduce Medicaid spending by the federal government, the Republican controlled House of Representatives has approved a budget this year that would make fundamental changes to the delivery of long-term care services and support under the Medicaid program. The House proposal would convert Medicaid to a block grant, and would ultimately dramatically cut the growth of the federal Medicaid funds distributed to states. Governor Romney has expressed his support for transforming Medicaid to a block grant model.

While a block grant can be structured in a number of ways, block grants generally provide fixed federal allotments to states that are based on current expenditures and a pre-determined growth rate. A block grant is likely to provide additional flexibility for states to make changes in Medicaid such as cuts in eligibility, premiums, increases in co-payments, and restructuring of benefits that would be beyond the scope of what is allowed under current state options. 

The House block grant would cut federal Medicaid funding by an estimated $810 billion — or 22 percent — over the next ten years (fiscal years 2013-2022), relative to what states would receive under current law.  The House budget would also repeal the Affordable Care Act’s (ACA) Medicaid expansion. 

States would have to offset these federal funding shortfalls by substantially boosting their own contributions to Medicaid or, as is more likely, using the greater flexibility that a block grant would provide to make deep cuts to eligibility, health and long-term care services, and/or provider reimbursement rates.

Conversion of Medicaid to a block grant has been pretty adamantly opposed by Congressional Democrats.  At this point, its future seems dependent upon the political winds.  

It appears that November's election is likely to be quite significant for the future of Medicare, Medicaid, and other programs that support seniors.   

[1][1] (Sources for the materials in this section include: Congressional Budget Office, Economic Effects of Reducing the
Fiscal Restraint That Is Scheduled to Occur in 2013 (May 2012); The Committee for a Responsible Federal Budget, Between a Mountain of Debt and a Fiscal Cliff  (March 2012)

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