The main question to answer in health care policy is what, if anything, should be done to slow cost escalation.

Of course, rising costs are not a problem per se. It should not be surprising that a wealthy country would want to devote an ever larger share of its resources to improved health. But it is widely recognized that much spending for health care in the United States is for low-quality and inefficiently-provided care. Moreover, we finance health care mainly with third-party insurance, and for the working age population, the premiums for this insurance are paid by households. Thus, cost growth in excess of wage gains puts great financial pressure on middle and low income families trying to maintain coverage and pay their other bills too.

The most common way to discuss cost escalation among health policy analysts is to blame the “system.” That is, health care costs are rising because we have inadequate health information technology, insufficient investment in prevention, feeble management of care for those with expensive chronic illnesses, too few primary care physicians, too much new technology, etc. When the cost problem is framed this way, the proposed policy solutions tend to be new government programs aimed at correcting these deficiencies and other “centralized” efforts to change the “system” uniformly for everyone.

But there is another, entirely different way to look at the issue. Current federal policy subsidizes health insurance in three important ways, all of which are “open-ended” in that the amount of the subsidy per person is driven by decisions made outside of the federal government. First, current federal tax law exempts employer-paid health insurance premiums from income and payroll taxation, no matter how costly the employer plan. Second, Medicare provides seniors with government-run and subsidized insurance, the cost of which is driven in large part by usage outside of the government’s control. And third, the federal government provides matching funds for Medicaid, which the states run.

The vast majority of Americans get health coverage that is subsidized by one of these three sources of taxpayer funds. On the margins, these subsidies encourage more expansive and expensive coverage. Why should consumers get less expensive insurance if the federal government is effectively paying for a third or more of the premium charged by more expensive plans?

The way to get started on slowing cost escalation is to reform health care entitlements and the tax law so that consumers have stronger incentives to enroll in less expensive coverage.

Would this kind of reform actually slow cost growth? A 2006 study by Amy Finkelstein at MIT may help answer the question. (It’s available in PDF format here.) She found that the enactment of Medicare had a dramatic impact on the supply of services in regions with low levels of insurance coverage pre-1966. When Medicare started paying the bills, hospitals were built and other providers opened up offices to provide services to the elderly. In effect, the Medicare program facilitated the development of a new and more robust infrastructure for health care. This was, of course, a good development in many ways. But it is also fair to note that, if health care delivery is fragmented and inefficient in the United States, it is allowed to remain so in part because Medicare continues to pay the bills, much as it has since 1966. Finkelstein offers the back-of-the-envelope estimate that about half of the real increase in health spending between 1950 and 1990 is due to the spread of third-party insurance, particularly employer-sponsored plans and Medicare.

Instead of new federal programs, policymakers in Washington should take a hard look at what’s already on the books. If they do so honestly, they will see that in order to slow cost escalation in health care, we will have to start with sensible reforms of our existing health entitlements and tax policy.