Obama's health care reform: VAT or Sinkhole?

(Fortune) -- In President Obama's 2011 budget, a kind of fiscal "cigarette warning" appears in a box on page 146 under a table displaying a future of big deficits and mounting debt. The Administration, the warning declares, is creating a "Fiscal Commission" to "achieve sustainability over the long-run."

With those bland words, the Administration is acknowledging that the immense weight of the national debt poses a dire threat to the economy, unless America takes radical action. Yet with the signing of the $931 billion healthcare overhaul, fixing future budget problems becomes far more difficult. The reform will immensely swell the amount of federal borrowing, even while the Administration touts the bill as a model of fiscal responsibility.

Even before the bill became law, many economists -- and this writer -- argued that only one tax could raise the giant revenues needed to escape a ruinous rise in debt: a European-style Value-Added Tax, or VAT. "The healthcare bill makes the logical case for the VAT stronger, because it's not clear that Congress will make the difficult spending reductions the bill mandates," says William Gale, an economist with the Brookings Institution. "The Fiscal Commission will give significant support for a VAT," says Brian Riedl of the conservative Heritage Foundation.

Both Riedl and Gale agree that a VAT would most likely be enacted in the wake of a crisis, where Asian and other foreign investors dump our debt, causing the dollar to collapse and interest rates to soar. Gale thinks such a crisis is "a low probability event," but still possible. He adds that a Ross Perot-style politician could champion the VAT, and possibly win broad populist support for it. Riedl believes a debt crisis is a big possibility if the U.S. continues to shun the spending reductions he favors. For now, the VAT doesn't have much political support. But it's virtually certain to become perhaps the most hotly debated budget issue of the next few years, precisely because of health care reform.

Tripartite increases in debt

Health care reform swells future debt in three big ways: First, reform plans to pay for the long list of subsidies and benefits by using new revenues from Social Security taxes and other entitlements. In fact, that money is only being borrowed from the Social Security "lockbox." Social Security and the other programs will need it back later to pay out benefits.

Second, the plan has several measures aimed at raising revenues and lowering costs that will probably never happen, either because they impose draconian price controls that will force hospitals to close and doctors to flee, or because they're too unpopular to become law. It also ignores inevitable cost increases by moving them into different legislation. Call that one "phantom funds."

Third, projections on the number of Americans who will collect subsidies are completely unrealistic. That figure will be double or triple the official projections, swamping the already big spending forecasts. Call this one, "lowballing the costs."

To gauge the amount of new debt, it's necessary to add up the lockbox money, phantom funds, and lowballing of costs for two separate periods: the bill's first decade, from 2010 to 2019, and the next one.

2010-2019: $1.2 trillion in health care borrowing

For the first decade, the CBO is projecting a $143 billion reduction in deficits. But in the bill, the Democrats failed to include a more than 20% increase in physician payments called the "Doc Fix," moving it to a separate measure instead. In a letter to Congressman Paul Ryan (R-Wis.), the CBO said that including the over $200 billion Doc Fix, a big phantom funds item, would erase the fiction of deficit reduction, and create shortfall of $54 billion.

The Administration is also counting on lockbox savings. They total almost $520 billion in new Medicare savings and taxes, Social Security levies, and revenues from a long-term entitlement program called The CLASS Act. But none of that lockbox money can be used to pay for healthcare, even though it's officially counted towards "deficit reduction" by the CBO. In fact, the Administration needs to borrow that money from the Medicare, Medicaid and CLASS Act trust funds.

The "lowballing" issue is the biggest, and most overlooked, threat to the entire edifice. The bill grants lavish subsidies, paying most of the premiums for lower and middle class earners who aren't covered by employers. The CBO forecasts that just 24 million Americans will receive these subsidies in 2019. The rub is that companies with lots of medium-to-low-paid workers, in everything from mining to retailing, will be tempted to drop their plans for basic reason: those workers get a far better deal in the subsidized "exchanges" than under employer plans. "About 100 million workers covered by employer plans would be eligible for those subsidies," says James Capretta, a budget official in the second Bush Administration. "You'd see the 'out of the woodwork' effect as employees rush into the subsidized plans."

If the number of subsidized customers doubled to 50 million, the bill's costs would increase by about $580 billion. Adding the $53 billion shortfall from the Doc Fix, the $520 billion in lockbox items, and the $580 billion from raising the number of exchange participants to a 50 million -- replacing lowballing with a more realistic forecast -- and new borrowing required in the first ten years rises to around $1.2 trillion.

2020-2029: A 10% increase in the national debt

In the second decade, the picture is even more perilous. Here, phantom funds become a huge problem. Reform contains three additional measures that theoretically lower future costs, but will probably never happen. First, an excise tax on high-cost plans is slated for 2018. But it's so wildly unpopular with unions that it's been delayed twice, and may never be enacted. Second, the plan would index increases in subsidies at rates well below medical inflation, a plan concocted at the last minute to lower the CBO's "score." This would force Americans in the exchanges to pay a higher percentage of their salaries in insurance premiums, which contradicts the whole point of reform. Third, the legislation creates a "Payment Advisory" board to hold Medicare spending at unrealistically low levels. Medicare's actuary warns that the bill would drive hospitals and doctors out of business, causing shortages in care.

In its letter to Ryan, the CBO forecast the price of the bill if all three of those restrictions were dropped. Their conclusion: The surpluses forecast in the bill would be replaced with roughly $600 billion in deficits in its second decade. In addition, deducting Medicare taxes and savings, which can only be used for Medicare benefits, would add an estimated $1.2 trillion in borrowing.

The bill also faces the lowball problem. Once again, if we forecast that 50 million people will collect subsidies -- a conservative estimate -- the bill's price will increase another $1.3 trillion.

So for the second decade, the bill would swell spending by $600 billion from improbable price controls, $1.2 trillion from eliminating lockbox items, and $1.3 trillion from the flood of new enrollees in subsidized plans, for a total of $3.1 trillion. Add that number to the $1.2 trillion for the first ten years, and the grand total rises to $4.3 trillion.

The VAT fix

Now, let's examine why the healthcare bill makes a VAT at least more probable. The biggest problem with our budgets is the relentless rise of debt, to which the healthcare bill will add significantly. In 2020, the U.S. debt will stand at a dangerous 129% of GDP, counting the amounts borrowed from the Medicare, Social Security and other entitlement trust funds. Interest on the debt will absorb one dollar in seven of Federal spending. The government will collect $4.6 trillion in revenues, and spend $5.7 billion, leaving a gigantic, $1.3 trillion deficit. And that's before the healthcare bill. By 2029, the Government Accountability Office projects the debt will rise to well over $40 trillion, and that interest payments will approach 30% of all spending. The healthcare bill will add $4 trillion or around 10% to that debt load.

Why is the VAT the only tax that can close the gap between spending and revenue, and hence reverse the rising debt? By 2020, income taxes will total around $2.2 trillion. That means it would take a 60% rise in the total take, by far the biggest source of federal revenue, just to erase the deficit. "That could only happen if we get rid of deductions for the big items such as mortgage interest and property taxes," says Gale. "That's highly unlikely to happen." By contrast, says Gale, a large VAT could easily increase revenues by 5% or 6% of GDP, totally erasing the budget shortfall.

If the government continues to insist on entitlement spending programs like health care reform, economists Gale and Riedl both think the VAT is the only permanent solution. Though while Gale likes the principle, Riedl thinks it a looming disaster that would permanently swell the size of government. Either way, the Fiscal Commission will help make consideration of a VAT a big issue. And with the healthcare bill in place, the next "cigarette warning" should be set in bright red, giant type.