Health care: Going from broken to broke

NEW YORK (Fortune) -- A few nights ago in the historic Renaissance Grand Hotel in St. Louis, Mo., President Obama reassured a crowd of Senator Claire McCaskill supporters that health-care reform wouldn't just be good for their health, it would be good for the health of the country: "I said at the beginning of this thing we would not do anything that adds to our deficit," he said to the clapping audience. "This plan does not do anything to add to this deficit. And that's how we should be operating."

What he didn't discuss was what kind of accounting he was using to generate such applause lines. And the answer to that sheds new light on whether the nearly $900 billion measure really delivers the savings -- or, as many fear, does exactly the opposite.

The issue is critical, because America is hurtling towards a debt crisis. On March 5th, the Congressional Budget Office released a report stating that the federal debt will grow far faster than the president is predicting, reaching a staggering 90% of GDP by 2020. That's comparable to the load now crippling Greece. In a decade, says the CBO, one dollar in six of federal spending would go towards paying interest almost equaling expenditures on Medicare.

President Obama is claiming that his health-care plan will substantially lower future deficits. Naturally, it's the huge budget shortfalls that cause the debt problem by forcing the U.S. to borrow more and more money to bridge the gap between spending and revenues. For proof, he cites the CBO report from March 11 forecasting that the Senate bill -- the basis of the president's proposal -- will pare the deficit by $118 billion over the next decade.

That forecast, however, doesn't mean that what the CBO counts as lower deficits will lead to less debt, as taxpayers might expect. In fact, it appears that it would require the Treasury to borrow almost 40 cents of every dollar in new spending the bill requires.

How to lower a deficit and raise a debt

It's not an easy trick to reduce deficits and yet borrow more money. CBO does it because it has to. By law, the CBO is required to use "cash" or "unified budget" accounting. Under that system, the CBO projects all the new revenues and new expenses from the legislation it's requested to "score." If the extra revenues exceed the additional outlays, the bill is deemed to reduce deficits. That's the case with the health-care bill. The rub is that the measure gets a large portion of its revenues from new Social Security and Medicare taxes -- plus levies it collects upfront to pay for a long-term care entitlement program.

Counting those taxes as deficit reducers presents two problems. First, the extra revenues are mainly needed to pay for higher benefits in the future. Second, they cannot be used to fund the lavish subsidies, tax credits for small employers, and other spending the bill mandates. "The law is clear," says Donald Moran, a former Reagan Administration budget official who runs a Washington, DC-based health-care consulting and research firm. "Revenues from those entitlement taxes must go into their trust funds. That money is not available to pay for the spending commitments of the health-care bill."

So let's use the definition of "deficits" that most Americans follow in their own budgets: Any time you increase spending -- on buying a two-story colonial or taking a vacation at Club Med -- and you need to borrow to pay for it, you're running a deficit. For families, the best way to measure those deficits is the amount it adds to what they owe on their credit cards, car loans or home equity lines.

Now apply the same standards to the health-care bill. If it really reduces deficits, it should lower the federal debt. It does the opposite. How? First, it doesn't raise nearly enough revenues to pay for itself. Second, it vastly understates future costs.

Fixing the Doc Fix

Let's start with the second issue. A law dating from 1987 sets strict limits on total physician payments for Medicare. The main mechanism for restraining costs is a formula that lowers the fees Medicare pays for everything from angioplasties to checkups. But since 2002, Congress has been postponing those cuts and allowing modest increases in reimbursements instead. The official budget assumes that Congress made the cuts every year, and hence starts with a far lower spending number. But that's fiction. Each year, Congress passes what it calls the "Doc Fix," which today requires spending about $25 billion a year more than the budget projects.

The House included the "Doc Fix" in the bill it presented in July, but not the Senate. And now it's reappeared -- but in a different piece of legislation. The administration estimates that the Doc Fix will cost $371 billion over 10 years. Yet the CBO doesn't talk about that cost when it comes to health care -- because it can't. It's not in the bill it's scoring.

"The bill has many changes in Medicare, but this is the only one Obama wants to do separately," says James Capretta, who served in the Office of Management and Budget under President George W. Bush. "It's an attempt to hold the official cost below $1 trillion, when it's really far higher."

Messing with a lock box

The White House is also counting on three sources of revenue that, in fact, cannot be used to pay for the bill's spending: A new entitlement, Social Security taxes, and higher Medicare levies. The new entitlement is the Community Living Assistance Services and Supports program, or CLASS Act. The CLASS Act is a long-term care plan for people who can't perform basic daily tasks such as feeding themselves. Over the next 10 years, the CLASS Act mainly collects payroll contributions from new enrollees, and pays only small amounts in benefits.

But the program needs all of that money to cover the costs it will accrue when those new enrollees start needing home-nursing services. In fact, it will almost certainly need a lot more. The American Academy of Actuaries warns that the program will be insolvent by 2021. The HHS actuaries conclude that it faces "significant risk of failure." In October, Kent Conrad, D-N.D., chairman of the Senate Budget Committee, called the CLASS Act "a Ponzi scheme of the first order, the kind of thing that Bernie Madoff would have been proud of."

But remember, the CBO counts new revenues, even if they're owed later for another purpose, towards "deficit reduction." Hence, using the CBO report, the administration is, in effect, touting the $70 billion the CLASS Act raises between 2010 and 2019 as money that's available to spend on subsidies for premiums and coverage for the uninsured.

The higher Medicare and Social Security taxes come from one of the bill's central features, the "Cadillac Tax" on expensive health-care plans. The levy would prompt companies to provide more modest coverage, giving workers higher wages in lieu of richer benefits. That would lead to higher taxable income, and hence, bigger revenues from Social Security and Medicare taxes. In addition, the Senate bill would raise the Medicare tax rates on high earners, and the president's new proposal would raise those rates even higher. The bill would raise an extra $52 billion in Social Security taxes, and $113 billion in Medicare taxes over 10 years. (Those numbers are the most recent breakdown available and come from a previous score released by the CBO on December 19th.)

As the president's February 22nd proposal states, the extra Medicare taxes will all go to the Medicare trust funds, as required under law. Neither that money, nor the revenues from Social Security taxes, can be used to pay for the new health-care spending. In fact, the Social Security windfall is needed to pay future benefits, since retirement payments generally rise in tandem with taxable income. By contrast, the Medicare taxes aren't required to cover additional future spending, since high earners will pay them and get nothing in return. But their contribution to bolstering the long-term solvency of Medicare -- which is underfunded by some $38 trillion -- is feeble.

How the math adds up

So how much must the government borrow to pay for reform? That's the true measure of future deficits. Let's start with the CBO's "deficit reduction" estimate of $118 billion.

First, we'll subtract the Doc Fix of $371 billion, which Obama does not pay for and must be borrowed. That wipes out all of the theoretical decline in the deficit and leaves a shortfall of $253 billion.

Then we'll subtract the tax revenues that are owed for entitlements, and therefore excluded from paying for the bill: $70 billion from the CLASS Act, $52 billion for Social Security, and $113 billion for Medicare. That subtotal: $235 billion.

So the full amount that must be borrowed by 2019 is $488 billion. (That's 39% of the total cost, composed of the $875 billion official estimate plus the Doc Fix of $371 billion, for a total of $1.25 trillion.) Add in interest, which is excluded from the official CBO cost, and the total amount approaches $600 billion. So the U.S. will need to borrow an additional $600 billion to pay for a new medical system -- one that won't be up and running until 2014.

Only by using the crazy math of health care can a bill both "lower deficits" and enormously raise debt. America's struggling households know what real deficit reduction looks like, and this isn't it.