Imagine for a moment that America had a purely free-market health care system, with no Medicare, Medicaid, and without tax breaks for health care. The government currently pays for 62% of all health care spending, and without this support, our healthcare system would be much smaller. If a free-market approach to healthcare brought spending down to the OECD average, the US would spend $1.2 Trillion (48%) less on healthcare than it does today [1]. Without Medicare to pay for costly end-of-life care, it’s doubtful that $200,000 per year chemotherapy drugs would find a market, or that anyone would pay full price for replacements on hips implants. In short, a free market health care system would deliver less health care technology to America – though it would still deliver technology that proved itself worthy and affordable to patients.

Of course in the real world government-subsidized innovation isn’t going away – or is it? America’s long term budget problems are driven chiefly by health care spending, as acknowledged by the trustees of Medicare. The Soviet Union eventually went bankrupt by spending 40% of its GDP on defense. The United States is on track to spend 40% of its GDP on healthcare by 2050 [2], with much of that on high tech gadgetry with low marginal benefit, and with virtually all of that money coming from taxpayers. This is obviously not sustainable.

The newly enacted healthcare reform law begins cutting Medicare in earnest, but deeper cuts will be needed to prevent Medicare’s insolvency. These cuts will inevitably mean less spending, and less revenue opportunities for big pharma, biotech, and medical equipment companies. While many other countries already have highly regulated healthcare markets with lower profit margins, pharmaceutical and medical equipment companies have been able to achieve consistent growth by tapping the US market and US taxpayers. Regardless of how healthcare reform plays out, America’s huge and growing debt mean that this situation will come to an end. The golden age of subsidized medical innovation is drawing to a close.

[1] CMS estimates that 2009 health care expenditures were $2.5 Trillion, or 17.3% of GDP. If this were reduced to 8.9%, the OECD average, health care expenditures would be $1.29 Trillion, almost half of what they are today. While we don’t know exactly what US health care spending would be without government subsidies and programs, we do know that government spending and subsidies would drop by roughly $1.3 Trillion ($1.1 Trillion in direct spending plus $200 Billion in subsidies), leaving a number very similar to the OECD average.

[2] See Figure 4 of this CBO Report for long term health care spending projections.

Perhaps Americans just demand the best and priciest healthcare, with the most modern technology and treatments. If Americans paid for healthcare themselves, this would simply represent a rational spending choice. But the federal government now incurs 60% of all healthcare spending, meaning that taxpayers, and not individuals, pay for most of our healthcare. Medicare, Medicaid, and other direct government healthcare accounts for 46% of healthcare spending, while tax breaks on healthcare subsidize another 10-15% of healthcare spending [1].

At current growth rates, government healthcare spending will exceed the entire Federal budget by 2050 [2]. Total spending on healthcare will near one-third of GDP by 2030. It’s unlikely that the US can devote 1/3rd of all productive capacity to healthcare without crippling other sectors of the economy and reducing overall economic growth. The healthcare bubble thus dwarfs all previous bubbles in size, since the technology, real estate, and energy sectors are all so much smaller.

How will the bubble pop, and what will its effects be? Since most healthcare spending is federal, the bubble will pop when the government can no longer afford its healthcare outlays. The US has been able to borrow freely by issuing debt for many decades, but this will eventually end once our debt exceeds GDP. With the current downturn, government debt may actually exceed GDP by 2015 [3]. Thus the reckoning may come sooner than many expect.

Will healthcare reform contain costs and deflate the bubble gradually? Most reform plans focus more on increased coverage than on cost control, so they may exacerbate the problem. Eventually the hard choices will have to be made, and they will include some combination of reducing Medicare benefits, cutting provider reimbursements, openly rationing government health care, and limiting the tax break on health insurance. I just hope that some of the hard choices are made before we are collectively up against a fiscal wall.

[1] $200 Billion in taxes are foregone as a result of the employer-based healthcare tax deduction, equivalent to 10% of all healthcare spending. When this subsidy is included the government’s share of healthcare spending rises to 56%. This analysis does not include the exemptions on property taxes and sales taxes that healthcare providers receive; adding these subsidies in would likely drive the government’s share of health care spending over 60%.

[2] The CBO predicts that Medicare and Medicaid will account for 14% of GDP by 2050. This figure doesn’t include healthcare spending through the VA system, SCHIP program, and other federal healthcare programs, which total $100 Billion in spending today. If these programs also grow commensurately, total government spending may near 18% of GDP in 2050, roughly equivalent to total government revenue.

[3] This projection of public debt growth shows that US government debt will exceed gdp by 2050. This only takes into account debt held by the public, however. Gross government debt is already above 65% of GDP, and may grow to 75% by the end of 2010 as a result of the recession and stimulus spending. With deficits of $500B+ per year possible for several year, US total government debt could exceed gdp in less than 10 years.

A simple technique can be used to reveal the true* size of the annual Federal deficit. Since all federal revenue shortfalls (deficits) are paid for through increases in the total US debt, the increase in debt each year exactly equals that year’s real federal deficit.

Here is the amount of US Federal debt outstanding from 1997-2008, for Sept. 30th of each year:

Using this data, we can calculate the true Federal deficit for each year, and compare it to the publicly announced deficit for that year:

The Federal government’s need to borrow has been consistently understated in official deficits for the past decade, and has been as large as triple the official number! These numbers also show that the US government never actually ran a surplus at any time in the last decade. It appears that the first step to dealing with our government’s revenue shortfalls is to get our government to admit how large they are!

* Under US GAAP, federal deficits would be even larger, because they would take into account future Social Security and Medicare shortfalls. These programs are likely to be modified in the future, however, and so I believe that the method used above provides an accurate measure of the government’s cash deficit each year. This is a number most Americans would recognize – how much do you have to borrow to pay the bills each year?

** The argument might be made that during the “surplus” years of the late 90s, debt was increased simply to provide liquidity in treasury bond markets. This doesn’t make sense, however – if it had a cash surplus, the Treasury could easily have issued new debt while retiring old debt, leaving net debt unchanged. Economists generally take the view that government debt crowds out private sector borrowing, so why would the Treasury borrow if it didn’t need the funds?

Where then is the indignation regarding the two biggest subsidy programs of them all?

I’m talking about the home mortgage interest deduction and the employer health insurance deduction. The home mortgage interest deduction subsidizes homeowners at the rate of $100 billion per year, while employer health insurance is similarly subsidized at $250 billion per year. These subsidies carve a large hole in government revenue, which could otherwise be used to reduce the deficit or reduce taxes for everyone.

Both subsidies also have a more insidious effect – they raise prices for both homes and medical care, thereby making it harder for those with low incomes to afford either one. The mortgage deduction lowers the effective cost of a house for all buyers, thus increasing demand and raising prices. The net effect of the subsidy is to cause Americans to live in bigger houses than they otherwise would, without raising rates of home ownership significantly. Similarly, the employee health care deduction raises the cost of health care for everyone, and causes Americans to spend more on health care than they otherwise would.

Neither deduction is designed to help those with the greatest difficulty in getting a home or health insurance. Lower income families can’t afford the down payment required to avail themselves of the mortgage tax break, and most low-paying jobs don’t provide health care as a benefit.

These subsidies are popular because they target middle and upper-income America, but that doesn’t make them any more effective than much-maligned corporate subsidies. $350 Billion is a lot of money, and should either be given back to ALL American taxpayers, or spent paying for the deficit, recent wars, or other priorities.