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Routing 
The Medicare drug benefit will soon set a dan-gerous trap. In January 2006 the federal govern-ment is scheduled to start purchasing prescrip-tion drugs for more than 40 million seniors anddisabled Americans through that new addition tothe Medicare program. The enormous tax burdenthat will be required to fund the drug benefit willput constant pressure on politicians to limitspending. Some observers argue that the federalgovernment should dictate the prices it pays fordrugs. Though cloaked in the rhetoric of “negoti-ated prices,” such proposals in fact amount toprice controls. Unless the new benefit is delayed orrepealed, it will set the stage for Congress to enactprice controls on pharmaceuticals.Economic theory and empirical evidenceshow that price controls cause enormous harm.Existing federal price controls have already cost Americans an estimated 140 million life-years. Applying such controls to Medicare purchasingwould eliminate approximately 40 percent of allfuture pharmaceutical research and develop-ment and cost another 277 million life-years.Rather than attempt to fix drug prices,Congress should reform Medicare by convertingit to a program that provides premium supportfor the purchase of private insurance policiesoffering a broad array of options, including pre-scription drug coverage. Washington also shouldpressure other nations to lift their price controls,encourage patients to be more careful drug pur-chasers, and reduce unnecessary regulatory costsby reforming the federal Food and Drug Administration.In the meantime, Congress should containthe spread of pharmaceutical price controls by delaying or repealing the Medicare drug benefitbefore it takes effect.
 Avoiding Medicare’s Pharmaceutical Trap
by Doug Bandow 
_____________________________________________________________________________________________________
 Doug Bandow is a senior fellow at the Cato Institute.
Executive Summary 
No. 556November 30, 2005
 
Introduction
Health care is expensive. Spending on healthcare continues to rise, though the rate of growth has started to moderate after sixstraight years of acceleration: outlays increased7.7 percent in 2003 compared to 9.3 percent theprevious year.
1
Nevertheless, medical expendi-tures continued to outpace economic growth.Thus, researchers for the Centers for Medicareand Medicaid Services report that “health carespending represented 15.3 percent of GDP in2003, up from 14.9 percent in 2002.”
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Moreover, those analysts forecast thatoutlays will continue to increase faster thanthe rate of inflation and the economicgrowth rate. They expect medical expendi-tures to rise from 15.7 percent to 18.4 percentof GDP from 2005 to 2013.
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“There is justnot much optimism that we know how tocontrol costs,” observes Paul B. Ginsburg,president of the Center for Studying HealthSystem Change.
4
 As a result, health insurancepremiums continue to increase; they were up11.2 percent in 2004 (though that rate of increase was down marginally from 13.9 per-cent the year before).
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Equally important, medical expenditurescontinue to increase federal government out-lays. The Congressional Budget Office warnsthat Washington’s biggest health care pro-grams, Medicare and Medicaid, threaten thenation’s long-term fiscal solvency.
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Outlaysfor the former “can be expected to increasesharply,” explain government analysts, whenthe Medicare drug benefit takes effect in2006.
7
The Bush administration was forcedto acknowledge that its Medicare bill, set totake effect next year, will cost far more thanoriginally projected. That admission set off widespread criticism from members of bothparties.
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Indeed, that program alone will addsome $18.2 trillion to Medicare’s unfundedliabilities, bringing the total to an astound-ing $68.4 trillion.
9
 Although hospital charges and profession-al fees are much larger than drug expendi-tures, the latter receive disproportionate pub-lic attention. People are more likely to blamepharmaceuticals for rising health care coststhan any other factor.
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Indeed, there may beno more politicized health care issue thanpharmaceutical prices. Between 1993 and2013 overall medical spending is expected to jump fourfold, but pharmaceutical spendingwill increase 10-fold.
11
Even though the rate of increase for drug outlays is falling, prescrip-tion drugs will “still be the fastest-growinghealth sector” between 2003 and 2005.
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The reasons for the rise are not mysterious.The elderly disproportionately consume drugs:Medicare beneficiaries (aged 65 or older and thedisabled) make up less than 15 percent of thepopulation but account for some 40 percent of all drug spending. The CBO predicts thatspending on medicines will rise 10 percentannually over the next decade, significantly faster than other Medicare expenses and infla-tion generally.
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The American Association of Retired Personsissues regular reports on rising pharmaceuticalprices. “Filling the same prescriptions from yearto year is taking an ever-increasing share of con-sumer income, particularly for older con-sumers,” complains the organization, a frequentcritic of the drug industry.
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 John Rother, AARP’s director of policy and strategy, declared:“Price increases hurt more than just AARPmembers. They break state Medicaid budgetsand strain employers and health insurers.”
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Indeed, aggregate pharmaceutical spendingfigures can be misleading. Throughout the1990s pharmaceutical spending increasednearly twice as fast as did medical spendinggenerally. But the bulk of the increase reflectsincreased use of newer and better drugs, notrising prices.
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Moreover, drug spending re-mains a small portion of overall medical out-lays—about 11 percent—and has started tomoderate. Pharmaceutical spending increased10.7 percent in 2003, down from a 14.9 percentincrease in 2002.
17
Those numbers includespending on generics and pharmaceutical dis-pensing costs (which are rarely ever recognized,let alone criticized). Strip those out and rev-enues to brand-name manufacturers runabout seven cents on the medical dollar.
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(Recognition that other factors inflate costs
2
Throughoutthe 1990spharmaceuticalspendingincreased nearly twice as fast asdid medicalspendinggenerally. But thebulk of theincrease reflectsincreased use of newer and betterdrugs, not risingprices.
 
has led some insurers to require patients to buy from mail-order or online pharmacies in orderto win bulk discounts.)
19
But the facts rarely matter when it comesto prescription drugs. In the 2004 electioncampaign, the Democratic presidential ticketfollowed recent tradition by attacking thepharmaceutical industry. Moreover, legisla-tors of both parties are proposing that UncleSam use his clout—derived from paying forabout 60 percent of all drug purchases whenthe Medicare drug benefit becomes effec-tive—to drive down pharmaceutical prices,creating a de facto system of price controls. Already, the Medicare formulary—that is, thelist of drugs that private insurance plans willhave to cover under the program—hasbecome a political battleground.
20
How the New MedicareDrug Benefit Works
The new pharmaceutical benefit, approvedin 2003, is ostensibly voluntary. Beneficiariescan enroll at any time but, in order to limitadverse selection, those enrolling after theirinitial eligibility period will pay a lifetimepenalty that increases the longer they delay enrollment. (Congress covered the gap in timebetween the new benefit’s enactment and itsimplementation in 2006 by creating a pro-gram offering government-approved industry discount cards and a $600 annual subsidy forlower-income beneficiaries.)Medicare beneficiaries who remain in thetraditional fee-for-service program will choosea new prescription drug plan (PDP), and otherbeneficiaries will choose a Medicare Advantagehealth maintenance organization (HMO) or a regional preferred provider organization thatcovers pharmaceuticals. The administrationhas approved 10 national PDPs, as well as a number of regional PDPs. Beneficiaries will beable to choose from between 11 and 20 PDPs,depending on their state.
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Medicare supple-mental insurers will be barred from offeringdrug coverage to new enrollees. The new Medicare Part D will be financed through a mixture of general revenues, state payments(for seniors also eligible for Medicaid), and ben-eficiary premiums (which will be set to cover25.5 percent of program costs).The Medicare drug program is poorly designed. Under the standard benefit, Medicarebeneficiaries will face a $250 deductible, beliable for 25 percent of the next $2,000 inexpenses, and then be liable for all of the next$2,850 in expenses. Beyond that point, when anenrollee’s total drug costs reach $5,100, thePDP will cover 95 percent of each enrollee’sdrug costs. The window during which benefi-ciaries will have no coverage has been termedthe “doughnut hole.” Plan premiums,deductibles, and limits on out-of-pocket expen-ditures will be indexed to plan spending. Additional provisions are intended toaddress potential harmful incentives.Companies providing retiree coverage willreceive billions of dollars in taxpayer subsi-dies to encourage them to continue to do so.PDPs will be paid on the basis of a combina-tion of expected and actual costs. Taxpayerswill underwrite PDPs suffering higher-than-expected expenses and will recoup money from PDPs if actual costs are lower thanexpected. Finally, taxpayers will finance 80percent of drug costs above the so-called cat-astrophic threshold ($5,100).Proponents of the new drug benefitexpect competition among PDPs to helplimit costs. Although the federal governmentwill not dictate the prices paid for prescrip-tion drugs, it will regulate the PDPs’ drug for-mularies, cost-containment measures, andpharmaceutical suppliers. It will also policeany efforts by PDPs to discourage enrollmentby sicker Medicare beneficiaries. Withinthose limits, PDPs will decide which drugs tocover and how much to pay for them. SincePDPs will be competing for consumers, they will have an incentive to obtain the best dealspossible. Proponents of Part D argue thatnegotiation among PDPs and drug makerswill put downward pressure on prices andwill result in a range of formularies, drugprices, authorization requirements, and planpremiums.
3
Legislators of both parties areproposing thatUncle Sam usehis clout to createa de facto systemof price controls.
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