The incidence of Medicare cuts

Another topic that's been getting attention on the campaign trail is the Romney campaign's insistence that the Obama Administration imposed a $700 billion Medicare cut in order to finance healthcare reform.  Some attention has gone to the comically overt hypocrisy of this claim, given both that Congressman Ryan supported exactly the same cuts until he was named the VP nominee-designate, and that the Republicans apparently are planning capped-growth voucherization of Medicare.

But another part of the story here is that the $700 billion in Obama Administration cuts were not directly on seniors' benefits, but rather were on payments to Medicare providers.  To make the distinction clear, suppose we have two alternative sets of Medicare changes.  Under the first, seniors must pay $700 billion more than previously (via co-payments, annual charges for Medicare coverage, etc.) for particular services.  Under the second, seniors pay the same as previously, but healthcare providers' reimbursements are slashed by $700 billion.

Under the Romney campaign's approach, both of these changes would be described as a $700 billion Medicare cut.  But they are obviously quite different.  The direct incidence of the first change falls on seniors, while the direct incidence of the second change falls on healthcare providers.

Okay, another term for direct incidence is "nominal incidence."  For example, the nominal incidence of the Social Security payroll tax is 50% on the employee, 50% on the employer.  Economists generally agree, in this setting, that this split of the nominal incidence has no long-term effect on the true economic incidence of the tax (i.e., who really bears it economically, in the sense of ending up with less money).  As it happens, workers are generally thought to bear pretty much the full economic incidence of the Social Security tax, even though the nominal incidence is split 50-50 with the employer.

Does this reasoning apply in the Medicare case as well, and show that the Romney campaign is correct to treat the direct or nominal incidence of Medicare cuts as irrelevant?  In a word, no.

The main reason for this is the difference between short-term and long-term incidence.  Consider the payroll tax "holiday" that we have had for the last couple of years.  The nominal incidence was to benefit the worker (i.e., their payroll tax liabiliies, rather than those of the employers, were reduced by the holiday).  But this probably did place a much larger share of the tax cut into their pockets, rather than into the employers' pockets, given that it would take time for wages to adjust in such a way as to make it all the same in the end.

For the same reason, even if the long-term incidence of the corporate tax falls on workers rather than either on shareholders or an investors generally, an unanticipated overnight repeal of the U.S. corporate tax would confer a windfall gain on shareholders.  Their stock would immediately gain value from eliminating the expected corporate tax liabilities, and only over time would it all wash out via investment changes.

In the Medicare setting, this "transition" point is extremely important.  The healthcare sector is characterized by massive sunk cost investment, whether we're looking at a medical research and technology firm, or at a 40-year-old doctor who is not realistically going to change his profession.  So there is a huge difference, persisting for many years, between the economic incidence of (a) giving healthcare providers less and (b) making seniors pay more.

What's more, since the healthcare sector is experiencing an unsustainable growth rate that we know will need to be addressed at some point, it is already clear that some combination of (a) and (b) will have to be enacted over the long run.  And when you take something out of one side's hide today (relative to the prior state of the law), you are not necessarily affecting the manner in which the two sides would be expected to split the impact of future necessary retrenchments.

In sum, we have here a case where the seemingly "naive" view, that nominal incidence is the same as true economic incidence, actually does pretty well as a shorthand description of what is happening.  Hence, the Romney campaign is being extremely misleading, and not just hypocritical, when it claims that the Obama Administration has imposed a huge hit on seniors via the $700 billion in Medicare cuts.