"In 2009, health care reform is not a luxury. It's a necessity we cannot defer. Soaring health care costs make our current course unsustainable. It is unsustainable for our families ... It is unsustainable for businesses."

– President Barack Obama

President Obama is correct when he says that soaring health care costs make our current course unsustainable.  Adjusting for the growing U.S. population, the dollar level of expenditures on health care has exceeded the growth in overall consumer prices in the economy every year for nearly the past 50 years. Such a trend cannot continue forever.

Americans agree that health care reform is necessary. For instance, 55 percent of respondents to a recent CNN poll think the U.S. health care system needs a great deal of reform.¹ Yet more than 8 out of 10 Americans are satisfied with their current health care arrangements.² 

Such results are not contradictory. Consumers are satisfied with their current health care arrangements because they are receiving quality medical care at little direct cost to themselves. Yet they understand that the runaway costs driven by this arrangement have to be addressed before the system collapses.

Part of the blame falls upon waste, fraud, and abuse in the health care system itself. These factors cost the system an estimated $700 billion in 2007, or more than $2,300 per legal U.S. resident. Another primary cost driver is a large and growing government health care wedge — an economic separation of effort from reward, or consumers (patients) from producers (health care providers), caused by government policies.

The health care wedge is one way of thinking about government involvement in the economy. When the government or a third party spends money on health care, the patient's not. The patient is then separated from the transaction in the sense that the costs are no longer his concern. This separation - how far the supplier and consumer are separated from one another - is what the economic wedge is measuring. The wedge measures the deadweight loss from this separation in higher costs that do not improve efficiency.

In the case of health care, the wedge also separates patients from doctors in determining what type of care should be provided. Decisions are made by government, insurers, and judges deciding medical malpractice liabilities. The government, lawyer, and third party wedge in our current health care system causes higher costs and diminished efficiency.

Health care reform should be based on policies that diminish, not increase, this wedge. 

From a macroeconomic perspective, a tax wedge diminishes incentives to work, save, and produce; consequently less work, savings, and production results. Yet at the same time, the wedge increases incentives to consume and spend, since the costs of consumption are not directly borne by the one making the decisions. Such basic fundamentals of economics are not repealed at the entrance to the hospital or the doctor's waiting room. The result: higher costs and diminished efficiency.

The primary government policy causing the wedge is the ever-increasing role of the government in funding health care, a factor that corresponds directly with the diminishing role of the private sector, particularly the consumers of health care. 

Since 1967, the private sector has been funding less and less of total national health expenditures- less than 54 percent as of 2007. Public outlays (at the federal and state levels) now account for nearly one-half of total U.S. health care expenditures. Meanwhile, total out-of-pocket expenditures have been plummeting even faster as a share of total health expenditures.

Taken together, these trends illustrate the complete reversal of the way health care is purchased in the U.S. In 1960, the private sector funded over three-quarters of the national health care expenditures. Individuals paid from their own pockets nearly half of these costs. Today, individual patients covered just over $1 of every $10 spent on health care.

Although reform is necessary, ill-advised reforms can make things much worse. Health care policy reformers should proceed in the same manner that doctors treat patients. Doctors must properly diagnosis the disease or affliction so as to understand the likely effects of a proposed course of treatment. Likewise, health care reformers who have the public interest in mind will correctly diagnose the problem, showing how reform will restore a flagging health care system to robust health.

A proper diagnosis begins with the 85 percent of Americans who say they are satisfied with their current health care arrangements and thereby remind us that we are not facing a crisis in access to health care or in health insurance coverage. Reformers must ensure that changes to help the remaining 15 percent of Americans do not make the vast majority of Americans worse off.

In fact, the disease weighing down the health care industry is costs that are spiraling out of control. These care costs are driven to a large extent by the health care wedge. Rising government expenditures on health care are one of the main factors driving the growth in the health care wedge.

The President and his advisors have misdiagnosed the problems of the health care system. Health care reforms based on President Obama's criteria fail to address the fundamental driver of health care costs-the health care wedge.

The likely impact from the combination of generous federal subsidies and a new public insurance option is a significant reduction in people's incentives to monitor costs and a significant increase in the costs of administering the public program. In short, these policies will further increase the wedge. The growing health expenditure wedge is strongly correlated with inflation in medical costs.

Reforms based on President Obama's priorities can thus be expected to weaken the health care system and increase medical price inflation.

The actual health care reform proposal under consideration is fluid as of this writing. Proposals range from:

• A gross $1.6 trillion expenditure contained in Senator Edward M. Kennedy's healthcare reform proposal, and
• A $1 trillion expenditure in the House Tri-Committee Group reform.
• A simple expansion of Medicaid eligibility at an estimated cost of $600 billion, much or all of it borne by state governments.

The exact impact on the states will vary depending upon which route is taken and whether the federal reform proposal attempts to cover the costs or shift these costs to the states.

We assess here the impact of a reform proposal that significantly expands government's role in the health care market through 1) providing an additional $1 trillion in federal subsidies over 10 years, and 2) offering incentives to move current Medicaid recipients into a new federal health insurance program.

Such a program would:

• Increase national health care expenditures by an additional 8.9 percent by 2019.
• Increase medical price inflation by 5.2 percent above what it would have been otherwise due to the higher national expenditures by 2019.
• Pressure the federal and state budgets due to the increased expenditure levels and increased medical inflation.

o   The current net present value of funding health care reform based on President Obama's priorities would be $1.3 trillion, or $4,354 for every man, woman, and child in the U.S. These figures include:

•   A net present value of all additional federal government expenditures through 2019 of $1.2 trillion, or $3,900 per capita; and
•   A net present value of all state government expenditures through 2019 of $138 billion, or $454 per capita.

Reduce economic growth in 2019 compared to the baseline scenario by 4.9 percent for the nation as a whole.

Sharply higher health care costs would force people off private insurance and into the government plan. Further, as we know, the government rarely competes on a level playing field with private companies and firms. Always, the government tilts the field in its favor. A government plan embodying the Obama priorities would operate with guaranteed taxpayer subsidies. These would pressure the health care industry to price at uneconomical levels in order to meet political goals regardless of economic merit or viability. This would further reduce the number of Americans with private health care insurance.

In consequence, the increase in the number of people on the government plan would not reflect a corresponding decrease in the number of uninsured individuals. A $1 trillion plan based on President Obama's criteria would still leave 30 million people uninsured.³ The cost to reduce the number of uninsured, as estimated by the Congressional Budget Office, is $62,500 per person.

Such a negative economic assessment is consistent with the Massachusetts experience following the state's recent health care reforms. These share common ground with the Obama principles of a government sponsored health care exchange, an individual mandate, and generous subsidies. 

For all the hopeful rhetoric they occasioned, the Massachusetts reforms have seriously strained the state budget. Although supporters claimed that the reforms would reduce the price of individual insurance policies, insurance premiums rose by 7.4 percent in 2007, 8-12 percent in 2008, and are expected to rise 9 percent this year.⁴

The analysis below links the problems in our current health care system to the rising wedge between patients and medical providers. From this link it is clear that reforms based on President Obama's priorities would only exacerbate our health care problems. Reform efforts need to be more carefully crafted and considered than have been the plans based on President Obama's priorities.

Congress needs to focus on reform that promotes protection of what Americans want and demand most: immediate, measurable ways to make health care more accessible and affordable without jeopardizing quality, individual choice, or personalized care.

¹ (2009) CNN Poll: Americans worry Obama health care plan will increase costs CNNPolitics.com, July 1, 2009.

² Author calculations based on: Steinhauser, Paul (2009) Poll: Healthcare costs too expensive, Americans say CNN Politics.com,http://www.cnn.com/2009/POLITICS/03/19/health.care.poll/index.html;DeNavas-Walt, Carmen, Bernadette D. Proctor, and Jessica C. Smith (2008)Income, Poverty, and Health Insurance Coverage in the United States: 2007U.S. Census Bureau (August 2008) Current Population Reports, 60-235.³ DeNavas-Walt, Carmen, Bernadette D. Proctor, and Jessica C. Smith (2008)Income, Poverty, and Health Insurance Coverage in the United States: 2007U.S. Census Bureau (August 2008) Current Population Reports, 60-235.

⁴ Tanner, Michael (2009) Massachusetts Miracle or Massachusetts Miserable What the Failure of the Massachusetts Model Tells Us about Health Care Reform Cato Briefing Papers, June 9, 2009.