The Effect of Health Care Cost Growth on the U.S. Economy. 3.3 Effect on Federal and State Government


For many years, the public sector has faced health care costs that are rising more rapidly than revenues. This exerts pressure on government to increase revenues by raising taxes or increasing borrowing and to curb other discretionary spending.  Higher taxes reduce the amount of income that firms and households are able to spend on other goods and services, save, or invest; higher taxes also create incentives to engage in activities to avoid taxes (Pauly, 2003).  Similarly, increased government borrowing to pay for health care leads to higher interest rates, which raises the cost of capital and reduces the ability of firms and households to obtain resources to invest in other productive activities. Below we summarize key findings from the literature on the effect of rising health care costs on government.

The share of health care expenditures financed by public sources (federal, state, and local governments) has risen steadily over the last decade. Data from the National Health Expenditure Accounts show that the share of health care costs financed by public sources increased from 40.2% in 1990 to 45.4% in 2005.

Effects also appear at state and local levels. As a result of rapidly rising health care costs, state and local health care spending as percent of state and local revenues rose from 14% in 1987 to 22% in 2000 (Cowan et al., 2002).  For example, a recent news report suggests that health care costs of the Nassau county in New York are rising at an unsustainable level and will consume nearly 40 percent of all property tax revenues, and 11 percent of the annual budget - by 2010 (Epstein, 2007).

Rising costs increase pressure to cut state medical spending. As a result of this increased burden, there has been mounting pressure at both Federal and state levels to curb spending on health care in several ways, including reducing physician reimbursement, increasing beneficiary cost sharing and reducing eligibility for public insurance programs such as Medicaid. For example, in 2005, eight states reduced or restricted Medicaid eligibility and seven reduced program benefits (Smith et al. 2005).

Rising health care costs also increase pressure to cut spending in other sectors—for example, transportation and education, that are necessary for sustained economic growth. Pressure on the government to curb other discretionary spending can result in reduced investment in publicly-funded activities that are ultimately necessary for sustained economic growth, such as transportation, infrastructure, and education.  Reduced spending on education is also part of a more general increase in intergenerational wealth transfers from younger to older segments of the population that results from rapid growth in health spending. For example, a news report in the San Francisco Chronicle suggests that rising retiree health benefit costs were a major financial strain for the school district, leaving little room for increasing resources devoted to the classroom (Knight, 2006). Similarly, Kane and Orszag (2003) estimate that each new dollar in Medicaid spending crowds out 6 to 7 cents of higher education appropriations. However, more research is needed to understand the relationship between health care costs and state spending in other areas.

Rising health insurance costs and changing demographics are the two main reasons for the financial woes of the Medicare program. The annual report by the Medicare Board of Trustees states that “Medicare’s financial difficulties come sooner and are much more severe than those confronting Social Security. While both programs face demographic challenges, the impact is more severe for Medicare because health care costs increase at older ages. Moreover, underlying health care costs per enrollee are projected to rise faster than the wages per worker on which payroll tax is paid.”

Rising health care costs might also increase public insurance coverage if private employers drop coverage. Not many studies have examined this relationship. However, Chernew et al. (2003) find that rising premiums for employer provided coverage are not associated with any change in public insurance coverage.

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