Health-care reform's fatal assumption

NEW YORK (Fortune) -- At the bipartisan health-care summit scheduled for February 25th, President Obama is pledging to champion the voluminous bills passed by the House and Senate as the foundation for reforming the $2.2 trillion medical marketplace.

But each piece of legislation comes with a deadly expectation that could cost taxpayers dearly: the benevolence of corporate America.

"Many people say Americans will like the bills once they pass," says Edmund Haislmaier of the conservative Heritage Foundation. "But what they're more likely to get is a surprise in the form of hundreds of billions a year in extra spending."

That surprise comes from an assumption made by the Congressional Budget Office: that few employers will drop their plans even when the government offers generous subsidies and imposes penalties that are absurdly low.

Both the House and Senate measures lay out the subsidies that the federal government is obligated to grant lower-income and middle-class health-care consumers when the plans would go into effect in 2014. It's a big contractual entitlement, but it's likely cost is vastly understated.

Let's examine the size of the subsidies. The House and Senate bills both set caps on the percentage of income Americans pay for premiums. They also subsidize the out-of-pocket costs of deductibles and co-pays.

Since the plans are quite similar, we'll use the one in the House legislation. For a family of four, the bill puts a limit of between 3% and 12% of income from $20,500 to $82,000 a year on a sliding scale. The lower a family's income, the higher the share paid by the taxpayer.

For a household in the middle of America's income spectrum, earning $61,500, the CBO reckons that the average yearly premiums and out-of-pocket costs for a family policy will reach $20,500 by 2016. When the plans are fully implemented, the family is obligated to cover $10,500, and the government pays the balance of $10,000. For a family making around $40,000 the government contributes even more -- around $19,000.

The CBO projects that these subsidies will cost $93 billion in 2016. But that assumes that just 29 million Americans collect them, and that the number of people covered by their employers actually increases. And that number is likely to decrease sharply.

Why? Here's where the fatal flaw comes in. Companies that drop their plans face relatively minor penalties under the provision that's won the most Congressional support, an annual fine of $750 per worker.

Most big industrial companies are already paying around $15,000 per family in health-care costs. Hence, they could shoulder the fine and reduce their costs by 95%, simply by dumping their workers into the subsidy pools the plans mandate.

Using the CBO numbers, the government's subsidy per person comes to $3,200 in 2016. Say just half of all employers cancel their plans, throwing 80 million Americans into the pools. That would cost an extra $256 billion.

But those workers would presumably get raises, since in a free labor market employers are likely to put what they now pay for health care into paychecks. The government would collect extra income and payroll taxes, as well as the yearly fine of $750. All told, the extra revenue from taxes and the penalty would harvest around $100 billion to partly offset the additional subsidies -- but only partly.

So the net extra cost would be $156 billion ($256 billion minus $100 billion). Meanwhile the total spending on subsidies would soar from the projected $93 billion to almost $250 billion, an increase of 170%. That's the $93 billion the CBO is already predicting, plus the additional $156 billion from the tens of millions of employees who would lose their corporate plans and receive subsidies instead.

The $250 billion represents a permanent, structural spending increase of 1% of GDP, and it's headed higher from there. Message to taxpayers: The House and Senate bills rest on a fatal assumption. Believe it at your peril.