Obama health plan could stop California rate hike. But be careful what you wish for.

A big rate hike by an insurance company in California’s market for individually purchased health insurance provided a rationale for the new Obama care proposal. As Paul Krugman explains, the key issue is adverse selection: people who retain coverage tend to be those with high medical expenses.

Those with low expenses tend to drop out in hard times. That increases costs, causing premiums to rise, so even more people drop out—an insurance death spiral.

The solution proposed in the administration bill – as in previous Congressional bills – is to make insurance mandatory. With healthy people in the pool to share the costs, presumably premiums can be kept down. But even passionate proponents of compulsory insurance don’t really believe this, so the President proposes a new federal agency, the Health Insurance Rate Authority, to control price increases.

At this week’s NYU Market Institutions and Economic Processes colloquium, Gene Callahan made a comment that’s the best descriptor I’ve heard for the health insurance situation, though he was speaking of another topic: “However bad our current situation may seem, there is always some reform available that could make it even worse.”

Gene’s adage should be emblazoned on the walls of the room where the President’s health summit will take place this Thursday.

Let’s start with the possibility that the Health Insurance Rate Authority keeps a lid on insurance premiums while the cost of medical services continues to rise faster than inflation and people use more services, as has been the case for decades. Insurance companies will have to either reduce the services they cover– but regulators and courts will hinder that – or go out of business.

The likely process is a different sort of death spiral: as private insurers go out of business, the government will take their place. Obama et al don’t want to admit this is the logical end point of the so-called “reform” because it is not popular, but it’s not a bad outcome if you like big and even bigger government.

We have a sort of preview of this scenario. According to recent government estimates, US health care spending reached $2.5 trillion in 2009. Was this because of private insurance? No, it was because of a huge burst in Medicaid spending. According to the report in Health Affairs, spending by public payers grew much faster (8.7%, to $1.2 trillion) than spending by private payers (3% percent, to $1.3 trillion).

This happened mainly because more people enrolled in Medicaid while private insurance shrank—a microcosm of the process that the Obama proposal will set into motion. Total spending on healthcare grew 5.7% since 2008 even as GDP declined. What it shows is that state and federal agencies can’t control the medical costs they pay for.

What will they do if they became the only payers? Judging from the past, they will raise taxes. We’re looking at substantial growth in the $1.2 trillion public healthcare tab. The particular taxes in the new bill – such as penalties on businesses that don’t offer coverage and individuals who don’t carry insurance – are unfair but comically inadequate in terms of revenue that can be raised.

But suppose the proposed Health Insurance Rate Authority is captured by insurance companies – as happened to utility regulators – and rubber stamps the rate increases insurers want. Insurance companies will then survive in symbiosis with the government. Prices won’t be any lower, our choices won’t be any better and there will be yet another bureaucracy to brighten our existence.

The way to tackle the adverse selection problem is to equalize the tax treatment of employer-mediated vs. individually purchased insurance. A proper tax credit for the latter would bring a lot of people back into insurance pools.

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