To be successful, healthcare reform must pay for extending coverage to the uninsured while credibly controlling future costs. Current proposals include a mandate for employers, a public insurance option, and tax increases on high-income households. A better fiscal option would involve scaling back the tax break on employer-provided health insurance plans. Without policy changes, health care costs will drain government coffers and drive public debt to unsustainable levels.

Done right, health care reform will be a boon to the U.S. economy. Done wrong, it will be an economic albatross. The right kind of reform will insure the uninsured, but it will also provide a credible way to pay the added cost. Even more vital, reform must significantly slow future growth in health care costs. Without meeting these financial requirements, reform will do more harm than good, preventing the nation from solving its increasingly daunting fiscal problems.

Reform’s Financial Requirements

Reform will be very expensive. Extending insurance to a meaningful share of the nearly 50 million uninsured will cost somewhere between $100 billion and $150 billion annually. The ultimate price depends on how many of the uninsured will actually obtain coverage and how much more healthcare these newly insured will consume. The uninsured are diverse, including some 10 million illegal immigrants, and not all will get insurance. There will be some savings such as fewer uninsured people showing up in expensive emergency rooms. But these savings will be overwhelmed by increased use of the healthcare system as a whole.

Reform must also substantively lower the trajectory of future healthcare costs. This is critical to reining in projected long-term budget deficits. Far and away the largest reason federal debt threatens to balloon out of control is that healthcare costs are set to grow a consistent 1 to 2 percentage points per year faster than overall inflation. Without policy changes, these rapidly growing costs – combined with the aging of the population – will push federal outlays on Medicare and Medicaid from 5 percent of GDP this year to 6 percent a decade from now and 8 percent in two decades. For historical context, in 1970, spending on these programs amounted to only 1 percent of GDP.

It is important to recognize that any forecast related to the nation’s healthcare system is especially uncertain. Policymakers’ track record in this area is notably poor. The 2003 expansion of Medicare to cover prescription drugs, for example, has been about 50 percent more costly than originally expected. It’s thus probably best to assume that insuring the uninsured will cost closer to $150 billion a year, and to be skeptical that reform will substantively impact the long-term growth in healthcare costs.

What Policymakers Are Considering

Policymakers are debating a number of aspects of healthcare reform that bear on whether it will ultimately satisfy these financial requirements. The most important include employer mandates, a public insurance option, the adoption of various cost-cutting initiatives, and personal income tax increases on high-income households.

An employer mandate, including monetary penalties for employers who don’t provide workers with health insurance, will defray some of the costs of insuring the uninsured. Such a mandate will impose a significant burden on small firms, at least initially, and it would ultimately mean lower wages for employees. The cost would eventually be borne by workers, since all compensation, including health insurance, is determined by demand and supply in the labor market. Employees’ preferences, tax considerations, and government rules – such as the proposed mandate – determine the mix between wages and benefits.

A public option will help pay for extending insurance and also lower the future growth in health care costs. A public insurer would pay for services at Medicare rates, which are as much as 20 percent to 25 percent less than the market rate paid by private insurers. This could potentially put the health care system on a path toward a government-run, single-payer system. Proponents of the public option say that is not the intent; however, for the public provider to have a meaningful impact on healthcare costs, it will have to be a formidable competitor. It is difficult to know what this would mean for private insurers’ viability, and the prospect of change troubles many Americans who, surveys say, are satisfied with their existing private insurance plans.

Gambling On Cost Savings

Substantive cost savings could be wrung out of the health care system to help extend insurance and rein in future inflation. Examples include cutting Medicare and Medicaid reimbursement rates, using comparative effectiveness research, and implementing information technology more efficiently. But given the dearth of experience, it is a gamble to count on such efforts for substantive future cost savings. Moreover, it isn’t clear that such measures will be incorporated into reform legislation to an extent that it would really make a difference.

The biggest source of new revenue currently being considered to pay for reform is an increase in marginal tax rates for high-income households. Proposed legislation in the U.S. House of Representatives would raise the tax rate by 1 percentage point for those with incomes above $350,000 and by as much as 5.4 percentage points for those with incomes over $1 million. But this does nothing to address the long-term growth in health care costs. Unless other policy efforts can bring cost escalation down so it matches the growth rate in the taxable incomes of the wealthy, reform will increase future budget deficits.

What Policymakers Should Do

None of this sounds particularly encouraging. The plans under consideration do not appear to credibly pay for insuring the uninsured while meaningfully slowing future healthcare cost growth. Moreover, most of what is on the table carries significant downsides and uncertainties. So what should policymakers do to reform the healthcare system?

The single most important step policymakers could take to make reform work is to scale back the tax exclusion on employer-provided healthcare insurance for those with very expensive health care plans. This would raise lots of money to pay for insuring the uninsured, and it would also force higher-income households to shop for care more carefully.

There is no bigger expenditure in the tax code than the exclusion for employer-provided health insurance, which will cost the U.S. Treasury approximately $155 billion next year. For context, allowing homeowners to deduct mortgage interest will cost the Treasury less than $110 billion. Reasonably scaling back the tax exclusion could easily raise as much as half the cost of insuring the uninsured. Moreover, the tax savings would increase at about the same pace as the cost.

Without the tax break, large health insurance packages would be less attractive to employers and their employees. Higher-income households would feel the cost of consuming health care more directly. This would create more health care shopping, in turn forcing providers to price more competitively. The principal economic failing of the nation’s health care system is that big consumers of health care don’t directly feel the cost of their decisions. This would change if there weren’t a tax benefit attached to expensive health care packages.

Scaling back the tax exclusion may be politically difficult, however. A reasonably good alternative, which has gained some traction in the recent debate, would be a tax on expensive insurance policies paid by insurance companies and/or firms that offer them to their employees. This wouldn’t be as effective as directly raising the tax burden on those who consume lots of health care, but it would be worthwhile.

Independent Cost Watchdogs?

Second, policymakers could help ensure reform works by establishing an independent body with substantive control over Medicare and Medicaid reimbursements. If a new public insurer is part of the reform, it too should be under the auspices of this new agency. Congress consistently relaxes reimbursement rates under withering political pressure that understandably comes with such authority. This makes it all but impossible to make substantive cuts in these programs, but such cuts are necessary to force productivity gains and constrain health care costs in the long run.

The administration’s proposed new Independent Medicare Advisory Council falls well short of what is needed. This panel would make recommendations for spending cuts to the president, and could implement them unless Congress intervened. The political pressure would thus shift from Congress to the president. This might or might not lead to substantive cuts. The panel as currently envisaged would also be largely or entirely composed of physicians; hardly a prescription for a real cure.

It is likely President Obama will sign health care reform legislation before the year is over. The political costs of not passing something are too high. The reform will cover a majority of the currently uninsured and be paid for by some combination of employer mandates, a public insurance option, and lower Medicare and Medicaid payments to hospitals, HMOs and pharmaceutical companies. Reform will also include a tax increase, probably an excise tax on insurance companies for expensive plans. A panel of doctors will be created to recommend further cuts in federal health care spending to Congress.

Get It Right Or Forget It

The electorate may take some time to pass judgment on health care reform, but global investors won’t. Investors view reform as a litmus test for whether U.S. policymakers are serious about addressing the nation’s long-term fiscal ills. Markets have given the U.S. a pass on the trillions being borrowed to quell the financial crisis and avoid a more severe recession. Interest rates remain low. But this won’t last long if investors come to believe the deficits won’t recede quickly after the crisis ends. And the deficits will only recede if health care reform is paid for and slows long-term growth in costs.

Policymakers won’t have a second chance to get reform right. Once legislation is passed, revisiting it will be politically all but impossible – until things go badly awry. Policymakers must get health care reform right the first time, or it is not worth doing at all.

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As a leading nonprofit health care research and consulting institute dedicated to improving human health, Altarum encourages open discussion and debate about the many challenges in health care today. All postings to the Health Policy Forum (whether from employees or those outside the Institute) represent the views of the individual authors and/or organizations and do not necessarily represent the position, interests, strategy, or opinions of Altarum Institute. Altarum is a nonprofit, nonpartisan organization. No posting should be considered an endorsement by Altarum of individual candidates, political parties, opinions, or policy positions.

* This post is provided courtesy of Moody’s/Economy.com