How much do Americans spend on health care?

Why have the prices of healt h care services risen so

rapidly in recent decades?
What is likely to happen to health care prices and
expenditures in the future?
What can be done to improve the delivery of health
care services?
1
Mi ch:t ..:l nmn..:r. "\VIuu, \Vnmg wi th the CutTt.:nt Systclll: in J:.'mtmn't' 1'111t: 1/talth Cw't' Ctm.\' lii1Wn Til\ Ne(orm.
Arnell. cd. t:\ nn Llnivcr:-. ity of Michigan Pre:-..,, Jt)
1
)'>J.
S PECIAL
T 0 P I C
Americans increasingly have been
driven to pay for their health care
through third party insurers and
to purchase that insurance, when
possible, from their employers.
This, in turn, has led to rising
health care costs while making
it harder for Americans without
employer-provided insurance to
obtain coverage.
- Michael Tanner'
T
here is considera bl e dissatis fact io n with t he o perat io n of the healt h care industry in t he Uni ted
Sta tes. The Obama a dministrat ion ha s o utli ned a plan that would s ubsta nti al ly a lter the structure
of t he industry, a nd legisla ti o n refl ect ing these views has bee n int roduced. A "great deba t e" o n t he
future of healt h care in the United States bega n d uring t he summer of 2009. Thi s de bate is likely to
continue in t he years immedi a tely a head.
The attention given to thi s issue is understa nda bl e. Both the expendi tures o n a nd prices of hea lth care have
soared in recent decades. EXHIBIT 1 presents t he expend it ure fi gures as a sha re of GOP. Healt h care spend-
ing, including both private a nd government, jumped fro m 5.2 perce nt of GOP in 1960 to 9. 1 percent in 1980
a nd 16.2 percent in 20 07. Why has health care spending increased so rapid ly? Is thi s spending growth likely to
continue? Is t he hea lt h care industry in need of fun damental reform? Thi s s pecial topic will investigate these
quest ions a nd rela ted issues.
Some categories o f healt h care spending have substantial public good components. For example, t hi s is
t rue for expenditures o n pure research a nd activit ies t ha t retard, a nd in some cases elimi nate, the incidence
of communicable d iseases. In these cases, hea lt h care s pend ing ca n ge nerate spi llover benefit s for the general
popul ace, and it woul d be diffi cult, if not impossible, to exclude nonpaying consumers fro m the receipt o f t hese
benefi ts. As we d iscussed in Cha pter 5, under t hese condi t io ns, gove rnment acti o n might lead to a n improve-
ment in t he a llocat io n of resources. The Natio na l Institutes of Health a nd t he Centers for Disease Cont rol a nd
Prevention provide examples of government organizati o ns that justify their funding prima ril y o n t he basis of the
EXHIBIT 1
Health-Care Expenditures as a Share of GDP, 1960-2007
Total expenditures (including both private- and government-financed) on health care as a share of GOP
have persistently increased during the last four decades. In 2007, the United States spent 16.2 percent
of its GOP on health care, up from 9.1 percent in 1980 and 5.2 percent in 1960.
18%
16% 1-
14% 1-
13.8%
12.3%
r----:J
12% 1-
r--
0...
0
C)
10% 1-
9.1%
0
r--
~
8% 1-
7.2% <1l
.c.
~
(/)
6% 1-
5.2%
4% 1-
n
2% 1-
0%
I I I I
1960 1970 1980 1990 2000
Year
Source: htt p:/ j www. cms. hhs.gov.
722
-
16.2%
r--
'
I
2007
S P E C I A L T 0 P I C 9 71re Economics of Health Care 723
publ ic-good nature of t heir services. However, the vast majori ty of heal th care spe nding, incl ud ing t ha t of the
government, invol ves pri vate go ods, goods for which t he benefits accrue prima ri ly to the consumer. This fea ture
will focus o n t he provi sion of these persona l cons umpt io n health care services.
The Structure of the Health
Care Industry
As we di scussed in Chapter 6. goods and ser vi ces may be produced by either pri vate- or
government-operated fi rms. Correspondingly, they may be pai d for by the consumer
directl y or by the taxpayer or some other third party. (see Addendum to Chapter 6) .
Because it al ters incenti ves, the strucLUre of producti on and payment affects the operation
of an industry.
Health care in many countri es, including Canada and most or the hi gh-income coun-
tri es of Europe, i s a sociali zed industry." In these countri es, hospitals are operated by the
government. and thei r services are fi nanced through taxes. Physi cians, nurses, and other
health care workers are government employees. Of course, sociali zat ion docs not el i mi nate
scarcit y. costs, and the need to rati on the avail able supply. Resources must be attracted
to the health care industry, and thi s will involve a cost. No country i s abl e to provide as
much health care, free of charge, as it s citi zens would like. Therefore, when price plays a
secondar y role, nonpri ce factors will have to be used to rati on health care services. Thus.
in these countries, political rules, waiti ng li sts for vari ous treatments, and the absence (or
highl y restri cted availability) of ser vi ces such as MRi s that invol ve expensi ve equipment
are used to all ocate health care resources.
In the Unit ed States, there i s widespread use of both pri vate- and government-operated
enterpri ses i n the health care industry. Whereas the services of doctors are generally sup-
pl ied privately. hospitals are often operated by the government, particularl y local govern-
ments. Many communiti es. however, also have pri vatel y operated hospital s. Some of the
privately operated hospital s are for-profit businesses, whereas others are operated by chari -
table instituti ons. In contrast with other industri es. most health care spending (86 percent)
is paid for by a third party, either the taxpayer or a pri vate insurance company.
The Medi care and Medi caid programs have covered the bul k of the health care cost
of the elderl y and the poor since their establ i shment in the mi d- 1960s. Medicares hos-
pitali zati on program (Part A) uses a 2. 9 percent tax on the wages and sal ari es of current
workers to linance virtuall y all of the cost of hospitali zati on incurred by persons aged
si xty-li ve and older. Medicare's Part 8 Supplement ary Medi cal Insurance covers outpati ent
medi cal ser vices. and the recentl y enacted Part D subsidi zes the purchase of prescription
drug i nsurance. The l atter two programs are financed 75 percent by genernl revenues and
25 percent by benefi ci ary premiums. The Medicaid program provides low-income families
with access to health care either free or at a nominal cost. It is a combinati on federal-state
program financed from general revenues. The federal government covers 60 percent or the
Medicai d costs, whereas states cover the other 40 percent and have some di screti on regard-
i ng the structure and coverage of the program.
EXHI BIT 2 presents data for real expenditures (measured in 2007 dollars) on the
Medicare and Medi caid programs. From the very beginning, spending on the programs
2
For a cross-national comparison or spending on health ..:arc. Uwc E. ' I h.:ahh Care rnr Aging Uaby Boom: Lc.-.sons
from 1\broad: Journal of Ecmwmir Pa<pectil'es (Spring 2000):
724 PART 6 Applying the Basics: Special Topics in Econo111ics
E XHIBI T 2
Real Expenditures on Medicare and Me dicai d (Meas ure d in 2007 Dolla rs)
Expenditures on both Medicare and Medicaid have soared in recent decades. Adj11sted for inflation, the
2007 expendit11res on Medicare are three times the level of 7 981 and twelve times the figure for 7 910.
The real Medicaid expendit11res have increased even more rapidly.
500
450
400

350
.!!1
300
---
0
"
0 250
en
c

200
00
150
100
50
0
1966 1970 1980 1990 2000 2007
Year
Sources: http:/ ;www.cms.hhs.gov and http:;;www.bea.gov.
rose rapidly. By 1970, combined spending on the two summed to $57 billion. Real expen-
ditures on the Medi care program doubled between 1970 and 1980 and doubled again
between 1980 and 1990. Si nce 1990, lhey have increased by another 168 percent. In
2007, the total expenditures on Medicare summed to $431 bil lion. Whereas it started from
a lower base, spending on Medicaid has increased even more rapidly than Medicare. In
2007, government spending on Medicaid ($332 billi on) was more than three times the level
of 1990 and fo urt een Limes the fi gure for 1970. As Exhibit 2 shows, spending on Medicaid
is now more than three-fourths that of Medicare.
Discrimination against the Direct Purchase
of Health Insurance
Heallh insurance is also an integral part of the health care industry in the United States.
About two-thirds of nonelderly adul ts have health insurance through group plans offered
by their empl oyers. Employee compensation in the form of health insurance is not subject
to taxation. Thi s makes group health insurance programs provided through one's employer
particul arl y attraclive.
3
Interestingly, thi s favorable tax treatment of employer-provided
health insurance is a historical relic dating back to the wage and price controls of World
War 11. Because health insurance benefit s were not counted as wages, employers were able
to use them as a means to increase compensation and attract additional workers, while sti ll
compl ying with the wage controls imposed during the war.
In contrast with health insurance purchased through one's employer, both personal
medi cal bill s and the di rect purchase of insurance by an individual or family must be paid
addition to tht.! favnrablc tax trea tment. from the group purchase of health insurance may abo make
employer- provided plans more attracti ve.
s PE C IAL T 0 PI C 9 The Economics Health Care 725
for wi th after-tax dollars. When employees arc provided wi th additi onal income rather than
heal th insurance benefi ts, the i ncome i s subj ect to both payroll and personal i ncome taxes.
Thi s makes the direct purchase of heal th insurance far more coslly than purchnse through
an empl oyer. For example, a lower-middle-i ncome famil y confronti ng a 15 percent federal
income tax and the 15.3 percent payroll tax would have to earn approxi matel y S 12,000 of
addi tional income in order to purchase an $8,400 heal th insurance policy. A family in the
28 percent federal tax bracket would have to earn approximately $1 4,000 more in order
to purchase the policy. When state and local income and payrol l taxes are present, these
ligures are still hi gher.
Thi s discriminatory tax treatment encourages empl oyees to demand and empl oyers
to provide l ow deducti ble, small co-payment health insurance poli cies. In essence, heal th
care expenses covered in thi s manner are tax deductible, whereas those paid for out of
pocket or through the direct purchase of health i nsurance are not:' As a result of thi s dis-
tortion. more heal th care bills are paid for by third-party insurers and fewer arc covered
directl y by the health care consumer or through high-deducti ble i nsurance pl ans. As we
will see i n a moment, thi s affects the effi ci ency of health care delivery.
The li nking of heal th insurance to employment also reduces employee mobi li ty and
increases the number of people without any health insurance coverage. When empl oyees
lose their j ob, they also l ose their heal th insurance. Because purchase of a pol icy wi th
after-tax doll ars is so expensive, many unemployed workers remain uncovered until they
are able to find a new j ob. Furthermore. the di scrimi natory tax treat ment of di rect purchase
poli cies reduces the competitiveness of the heal th insurance i ndustry. Unsurpri singl y. the
industry i s dominated by a relativel y small number of companies alTering pri maril y '' one
si ze fi ts all " group plans.
Third-Party Payments
and Health Care Inflation
Following the establi shment of the Medi care and Medicaid programs in the mid- 1960s, thi rd-
party payment of health care expenditures grew rapidly, whereas the share of medical bi ll s
paid directly by the consumer declined. As EXHIBIT 3 shows. 55.2 percent of t:he 1960 medi-
cal expendi tures were paid directl y by consumers. Third parties fi nanced only 44.8 percent
of the 1960 total. Through the years, the share paid out ol' pocket has declined, whereas that
fi nanced by third pani es has risen. By 2007, third-pany payments accounted for 86 percent
of the medical care purchases, 45.3 percent by the government, and 40.4 percent by pri vate
insurers. Onl y 14 percent of the medical bi lls in 2007 were paid for directl y by consumers.
Economi c theory indi cates that the growth of subsidies to health care consumers and
accompanyi ng expansi on in third-party payments will push pri ces upward. There are two
reasons why thi s will be the case. First. subsi dies li ke those provi ded by Medicare and
Medi cnid wi ll increase the demand for medi cal care. ln turn. the stronger demand will
lead to hi gher pri ces. Unfortunatel y, the supply of many heal th care servi ces is hi ghl y
inelasti c, parti cularl y i n the short run. I n the health care industry, the short run may be
quite lengthy. T his is perhaps most evi dent in the case of the servi ces of doctors. Training
for doctors is long and ri gorous, and therefore an increase in doctors' fees will not qui ckl y
increase the suppl y of practi ci ng physi ci ans and thereby reverse the upward movement
or pri ces. Thi s i s parti cul arl y true when medical schools, perhaps unduly infl uenced by
the A meri can Medical Associati on. are rel uctant to expand the si ze of their classes. Thus,
the increase i n demand generated by Medi care and Medi caid pushes the pri ces of health
care services upward.
'Outof pockct health c;uc expense:-. can onl y be dcduc lcd if the la.\paycr lilc:; an itcmizl:!d rcturn. E\-cn in I his ca:o, c, only health
care expenses in cxc.:c.ss of 7.5 of the taxpayer's nJjusted grnss income: arc
726 PART 6 Applying the Basics: Special Topics in cmwmic.1
EXHIBIT 3
Out -of-Pocket and Third-Party Payment s for Medical Car e. HJGO and 2007
In 1960, out-of-pocket medical care expenditures of consumers accounted for 55 percent of the total,
whereas priw1te insurance and government programs paid 45 percent of the medical bills. By 2007, the
out-of- pocket payments had fallen to only 14 percent of expenditures, whereas those covered by a third
party had risen to 86 percent of the total. Economic theory indicates that growth of third- party payments
will reduce the incentive to economize and lead to both higher prices and expenditure levels.
1960 2007
Source: http:/ / www.cms.hhs.gov. Here, medical care payments are defined as personal
health care expenditures.
Second, the growth of third-parry payments weakens the i ncenti ve of consumers to
economi ze and shop for low-cost services and for producers to provide the goods at a
low price. I n a normal market. consumers will shop around and patronize those suppliers
that provide the most value per dollar of expenditure. In turn. this shoppi ng by consumers
provides suppliers wi th a strong incentive to control their costs and offer their services at
att racti ve pri ces. But when someone else i s paying all or most of the bi ll , the incentive to
economize is eroded. Rather than search for value relative to cost, consumers wi ll auempt
to purchase f rom the "best available supplier. pretty much regardless or price.
Perhaps the following example will help explain why the substitution of thi rd-parry
payment s for out-of-pocket spending wi ll lead to higher pri ces. Suppose that the govern-
ment, insurance companies, or some other third party was willing to pay 90 percent of the
bill of customers purchasing hair-styling services. Think how the behavior of both poten-
tial consumers and suppliers i n the hair-styling busi ness would be al tered. Because some-
one else i s payi ng most of the bill. many consumers wi ll now get their hair styl ed more
often, search for the very best tyl ists even if they arc qui te expensi ve, and pat ronize those
providi ng extra servi ces (for example. shoulder massages, pleasant surroundi ngs, and val et
parking). The strong demand will make i t possi ble for hair styli sts to rai se their pri ces, and
many will begin providing the " ex tras'' desi gned to convi nce consumers that thei r services
are the best. All of these adj ustments wi ll drive the price of hair-styl i ng services upward
and cause the thi rd-party expenditures to soar.
Of course, health care is a more serious matter than hai r sryl ing and wasted health care
resources are thus a greater concern. Yet our simple example ill ustrates what happens when
someone else is paying the bill . Economic theory i ndicates that when a thi rd party i s paying
more and more of the bill , the demand for the service will i ncrease, the incent ive to econo-
mi ze wi ll decl ine. and both the pri ces and expenditures on the service wi ll rise rapidl y.
S P E C I A L T 0 P I C 9 The Economics of Health Care 727
2.5
2.0
a:
(.)
.9 1.5 -- - -
Ql
. ~
i
~
1.0
X
Ql
'0
E
0.5
Prescription Drugs
0
1960 1970 1980 1990 2000 2008
Year
Source: htpp:j jwww.bls.gov.
The evidence is consistenl with thi s view. EXHIBIT 4 shows the rati o of the medi cal care
pri ce index to the overall consumer price index. I r the prices of medical services increase
more than the prices of other consumer purchases. thi s rati o will ri se. Note that thi s has been
the case year after year. Since the passage of the Medicare and Medicaid programs i n 1965,
the prices of medical services have more than doubled rel ati ve to the general consumer price
index. Thus. during thi s lengthy time span. on average, the pri ces of health care services
rose at more than twice the rate of other consumer items. Furt hermore. lhere is no evidence
that the healt h care innarion is about to subside. In fact, the increase in medical prices
rel ati ve to the general index of consumer pri ces has accelerated since 1980. Moreover. the
prices of prescri plion drugs. whi ch rose less than the consumer price index during the 1960s
and 1970s. have al so i ncreased subslantiall y more than the CPI since 1980.
As prices continue to soar. third-party payees. including both insurance companies and
the government. will take steps to reslrai n expenditures. They may li mit the amount paid for
vari ous services. requi re consumers to patroni ze only certain providers. make it more dif-
fi cult to obtain permissi on for costl y procedures. impose delays, and the l ike. Thi s i s essen-
ti all y the rou1e taken by the 'managed-care movement'' of the 1990s. Regul atory controls
of thi s type. however, are difficult to implement successfull y because they often conlli ct
wi th the inreresr of both consumers and healt h care providers. As the experi ence with man-
aged care illustrates . thi s path wi ll tend to result in unhappy consumers and deci sions that.
with the benefit of hindsi ght. were clearly inappropriate and in some cases li fe-threatening.
Controll ing costs through rul es and regulati ons imposed by a third party i s an imperfect
substitute for competiti on and the choices of consumers spending their own money.
The Growth of the Elderly
Population and Health Care
What wi ll happen to the future demand for healt h care? EXHIBIT 5 provi des insi ght on
I his que. ti on. Between 2000 and 20 I 0. the number of Ameri cans age seventy and over
expanded by 2.4 milli on. But the growt h of 1he populati on in thi s age category will soar as
the baby boomers (l he genermi on born aft er Worl d War II ) begin reaching retirement age
in 20 I 0. During the two decades following 20 I 0. the age seventy and over popul ation of
the Uni ted States will expand by 23.7 million, a whopping increase of 80 percent.
EXHIBIT 4
l ~ a t i o of l l ealth Care
Price I ndexes Relative
l o t he Consumer
Price I ndex
The ratio of medical care prices
to the general/eve/ of consumer
prices more than doubled
between 1965 and 2008.
After declining relative to the
Consumer Price Index during
1960- 1980, prescription drug
prices have increased far more
rapidly than the CPI since 1980.
728 PART 6 Applying !he Basics: Special Topics in Economics
EXHI BIT 5
Growth in the U.S.
Populati on Age Seve nty
a nd Ove r. 2000-2040
Between 2000 and 2010, the
number of people over age sev-
e11ty increased by 2.4 million.
But, during the two decades
that follow, the aging of the
baby boom generation will push
this group upward by 23.7
million. This rapid growth will
place enormous pressure on the
Medicare program because the
medical expenses of people over
age seventy are exceedingly high.
70
<i>
c
60


50
0
,..._

>
40
0
en
c
ro
u
30
E
28.0
25.6
<{
0
20

.0
E
::J
10 z
0
I
2000 2010
Source: http:/ ; www.census.gov.
I
36.9
2020
Year
I
62.3
51.7
I
2030 2040
Thi s huge increase in elderly Ameri ca ns has enormous implicati ons for the health
care industry. Because health care expenses are much higher for people in their seven-
ties than in their sixties and younger. thi s growth of Americans age seventy and over will
increase the demand for both medical services and the share of those services financed by
third panies. This wi ll push both health care prices and expenditures upward. It wil l also
cause spending on Medicare and ot her health care programs to soar and necessi tate higher
taxes for thei r finance. Unless reform is undertaken, the health care inflation and spending
growth of recent decades will not onl y continue but also accelerate.
The Medicare Trustees est imate that Medicare's unfunded promises- projected
spending beyond revenues antici pated at current tax rates- are $38 trillion.
5
That fi gure is
more than three times the official national debt and nearl y fi ve ti mes the unfunded li ability
of the Social Securi ty system. Even more important. it is two and a half times the size of
the U.S. economy.
American Health Care
at a Crossroads
As we have shown. heahh care prices have ri sen rapidl y and spending is growi ng faster
than GOP. In recent decades. health care expenditures have consumed approximately one
additional percentage poi nt of GOP every four years. Moreover, as the baby boomers
move into thei r senior years, the demand for health care will accelerate. These trends have
moved the topic to the cent er stage or publ ic debate. Nonetheless, there seems to be little
200() Annual Utporl o{ the llorm/.\ 1hHtee. f of rite Fcchral Jfm;pilal 111 .\/lrmwe ancl Pt'dtral SuptJicmenUu)' Nkt!icaf
lnwnmcr Tnut f'wul. pp. 201-202.
SPECIAL T 0 P I C 9 The Economics of Health Care 729
understanding or the poor performance or the industry and why health care spending has
ri sen so rapidly.
Perverse Incentives and the Provision of Health Care
Some charge that market forces have fail ed i n health care and therefore government must
intervene. The truth i more nearly the opposite: Government imervention has generated
perverse incentive , which have caused the marker to fai l. In a normal market, consumers
pay for the service and choose from whom to buy. Sellers operate in an open market and
they are compensated by thei r customers. The competi ti on from rivals provides sellers
with a strong incenti ve to keep costs and prices low. Because their revenues are provided
from consumers. sellers have a strong incenti ve to serve their interests. I f they do not.
consumers will take their busi ness and money el sewhere.
Key rel at ionshi ps that make markets work have been eroded by heal th care policies
that have evolved over more than si x decades. The structure of the health care market
i s now permeated with perverse i ncentives-those that encourage people to engage i n
acti ons that impose costs on others and use resources ineffi cientl y. These incentives
cl ari fy the forces underl ying both the poor performance of the industry and the ri sing
heal th care costs. They al so provide i nsi ght with regard to what can be done to i mprove
outcomes.
There are four major reasons for the poor performance of the health care industry. We
will consider each of them.
First, the structure of government programs relies on third-party payment s that erode
the i ncenti ve to economize. Very l ill i e health care is purchased directl y by consumers.
Most i s paid for indirectly through taxes or insurance premiums. When someone else i s
paying the bill. the patient has lillie reason to conserve on the usc of the resource and the
provider has li ulc incenti ve to keep costs low.
Second. the huge tax advantage provi ded for the purchase of heal th insurance through
one's employer undermines competi tion and makes it very costl y for individual s or fami-
li es to purchase a heal th insurance poli cy that fi ts thei r preferences. Rather than allowing
consumers to choose. govcrnmem subsidies and regul ati ons push them int o standardi zed
and controlled group plans provided through employers. Moreover. under this system, i f
you l ose your j ob, you also lose your heal th insurance. Peopl e do not generall y buy auto,
li fe, or homeowner insurance through their employer. Why do so many buy health insur-
ance thi s way? Answer: The tax system subsidi zes them to do so and puni shes them with
higher personal costs i f they do not.
Third. state regul ations that force insurers operating in the state to cover numerous
i tems such as in vi tro fert ilization. drug rehabi litation. marri age counseling, acupuncture,
and massage therapy al so drive up costs and make it still more difficult for consumers to
purchase a pol icy that tits their preferences. I nterestingly. the pol i tical pressure for thi s
coverage docs not come from consumers but rather from suppli ers wanting taxpayers to
subsidi ze their operati on.
Fourth. regul ations prevent consumers from purchasing a heal th insurance plan
offered in another state. Thus. if you \VOuld like to purchase insurance that would provi de
you with inexpensi ve basic coverage at a l ow cost , but you happen to l ive i n a state that has
adopted many of the expensive mandates. you are out of luck. Essenti all y. the government
has organi zed the health insurance business into separate cartels that operate i n each of the
fifty stat es. You can buy most everything rnnging from groceri es and automobiles to life
and auto in. urance from providers in other slates, but not health insurance.
Controlling Health Care Spending
There are onl y two ways to control the growth of health care spending: ( l ) pri ce controls
and pol it ical rationing or (2) competiti on and market pri ces. Politici ans would l ike you to
think that healt h care can be provided " free'' to consumers without restricting their access.
730 PA R T 6 Applying the Basics: Special Topics in Econo111ics
Health savings nccounls
Special savings accounts that
individuals a nd families can
use for t he payment of medical
bill s a nd the purchase of a
catastrophic (high deductible)
hea lth insura nce plan.
whi le sti ll controlli ng costs. Thi s i s a myth, and the experi ence of both the Uni ted States
and countri es wi th government-run health care systems illustrates this point.
All countri es with government health care systems use price control s and pol iti -
cally imposed restri cti ons to control costs. But these non-price-all ocati on methods lead to
waiting li nes, lower quality heal th care service, and less innovation. Lengthy delays for
treatment are common under government -run health care systems. Some try to estimate
the number of " li fe years'' saved to determi ne the cost-effecti veness or a treatment and
decide who wi ll be approved and who will be denied the care. For example. under the
Briti sh heal th care system, a patient i s i neli gi ble for a treatment expected to extend lite by
si x months i f the care costs more than $22,000. Those who are denied care or lack confi-
dence in the allowed treatment have only the option to seek medical care in a coumry that
does not have a government-run system. Patients who can afford it often do so.
The heal th care industry i s l arge. complex. and di verse. Trade-oils will have to be
made. How much should be spent on physici ans and other medical personnel rel ati ve to
pharmaceuti cal products and new medical technologies such as CT scans and MRi s? How
should resources be all ocated to preventi on and detection rel ati ve to treatment? Is the li fe
of a person with a learning di sabi li ty wort h the same as that of a genius? Do we really want
to use the poli ti cal process to make choices li ke these? The performance of centralized
government pl anning has not been impressi ve. and there i s no reason to expect that i t will
work better in heal th care than other sectors of the economy.
It i s tempti ng to thi nk that more government spending and regulati ons wi ll 'tix" the
heal th care system. The results of pri or regulations provide reason for cauti on. Regulati ons
designed to fi x one problem have often generated unintended consequences that create
another. To date, these regul ati ons have pol iti cized the heal th care industry, restri cted com-
petiti on, and eroded the incenti ve to control costs and use resources wi sely.
How to Move toward
Consumer-Driven Health Care
lf the provi si on of health care is to become more efficient and cost-effect ive, greater
reliance must be pl aced on consumer choice and direct payment of medi cal expenses.
How can thi s be achieved? Several poli cy changes would be hel pful. but the foll owi ng six
alternat ives are particularl y important.
1. EQUALIZE THE TAX TREATMENT OF OUT-OF-POCKET MEDICAL EXPENSES AND THE
DIRECT PURCHASE OF HEALTH INSURANCE WITH THAT OF HEALTH INSURANCE PURCHASED
THROUGH AN EMPLOYER. Thi s could be achieved by ei ther making the health care benefits
provided through one's employer taxable or by making the paymem of out-of-pocket heal th
care expenditures and the purchase or personal health insurance fully tax deductible. Thi s
deductibil ity would not be of mut:h value to taxpayers wi th low incomes or those fi l ing
the shor1 tax forms. These taxpayers could be provided with a 30 percent tax credit, a tax
saving si milar to that of empl oyer-provided plans, for expenditures on the direct purchase
of medical insurance and out-of-pocket payment of medical bills. This would also make it
cheaper for people wi thout access to employer-provided i nsurance to purchase coverage and
pay medical bi ll s directly.
2. ALLOW THE RESIDENTS OF EACH STATE TO PURCHASE HEALTH CARE FROM OUT-OF-
STATE PROVIDERS. This would break up the government-protected cartels now operati ng
in each state and make the health insurance indust ry more competi tive. It would also
expand the options avail able to consumers and make it easier for them to purchase a plan
more consistent wi th thei r personal preferences.
3. ENCOURAGE HEALTH SAVINGS ACCOUNTS (HSAS) AND THE DIRECT PAYMENT OF
MEDICAL BILLS FROM THE ACCOUNTS. Beginni ng i n 2004, health smings accounts
were made more attracti ve. but not on an equal basis to i nsurance purchased through
one' s empl oyer. Approxi mately 250 mi lli on nonelderly Americans are now el igi ble for
SPECIAL T 0 PI C 9 The Econo111ic.1 of Health Care 731
these accounts. In 2009, HSAs all owed individual s with a hi gh-deductible insurance
pl an ($1. 150 or more) to make tax-deductible contributi ons of up to S3.000 per year
for a single person (or $5,950 for a marri ed couple) int o a savi ngs account to cover
future medi cal bill s. Empl oyers making contributi ons into their empl oyees' accounts
may take the contributions as a business expense. Indivi duals have a property right to
the account. and their ownership i s not dependent upon their employment. Funds can
be drawn from these account s for the direct payment of medical bi lls not covered by
the high-deductible pol i cies. Balances in the account s can earn interest tax-free and be
rol l ed over from year to year. Accumul ated bal ances can either be used in retirement or
passed on to heirs. Because the funds belong to the account holders, they will have a
strong incentive to search for sound alternat i ves and allocate their heal th care spendi ng
in an economi cal manner. Si nce the 2004 legi slation. more and more employers have
offered these accounts as an opt i on, and their use i s growing. In 2009. HSAs covered
8 milli on indi viduals. HSAs reduce the incidence of third- party payments. and with
time. as more health care consumers shop for value, medi cal suppliers will become more
cost-sensitive.
4. ENCOURAGE THE PURCHASE OF CATASTROPHIC HEALTH INSURANCE AND DISCOURAGE
THE PURCHASE OF POLICIES WITH FIRST-DOLLAR COVERAGE AND SMALL CO-PAYMENTS.
HSAs are desi gned to be used with a hi gh-deductibl e, modest co-payment insurance pl an
that can be purchased at an economical pri ce. Insurance works well when i t compensates
people for l osses resulting from unpredictabl e events outsi de of thei r control that sel dom
occur, but when they do. l arge losses are imposed on the unfortunate part i es. Under these
circumstances, the premiums of those experi encing littl e or no damage can be used to com-
pensate those experiencing large losses. Large medical expenses such as those resul ting
from a severe injury or a catastrophic illness like diabetes or cancer generall y fall i nto thi s
category. It makes sense to promote the purchase of health insurance providing protecti on
against large medical bill s from sources like these. Hi gh-deductible policies-lor example,
one that covers most medical expenses i n excess of $3.000 per year-are rel ati vely cheap.
I n 2009, such a poli cy coul d be purchased for an annual premium of approxi mately
$1,900. A system of tax credits could be uti lized to encourage all (or at least most) ci tizens
to purchase policies ol' thi s type.
In contrast, insurance works poorl y when the " losses" are widespread among the
insurees and when the acti ons of those insured inlluence the si ze of the benefi ts they
derive. Under these circumstances, many insurees wi ll do less to avoid acti ons that
increase the likelihood that events tri ggering compensation will occur; and. as a result.
insurance premiums will be costl y rel at i ve to the benefit s. Many heal th care costs, i nclud-
ing those resulting from routine i llnesses (for example, colds and tlu). common chi ldhood
diseases. mi nor i njuries, and the like. fall into thi s category. In varying degrees, most
everyone can expect to experi ence such medical problems, and there are several alterna-
ti ve ways of deal ing with them, some of which are far less costly than others. Predictably,
insurance will work poorly for medical costs of thi s type. Furthermore. policies requiri ng
only a small co-payment for routine medi cal expenses promote the third-party payment
system that rerards economizing behavior. Thus, it makes no sense for public pol icy to
encourage such schemes.
5. SHIFT MEDICARE AT LEAST PARTLY FROM A REIMBURSEMENT SERVICE TO A DEFINED-
BENEFIT PLAN. Under this approach, Medicare recipi ents would receive a speci fi c amount
each year for paying medical bills directl y and purchasi ng pri vate insurance. All Medicare
recipients would be requi red to purchase at least a carastrophic insurance plan. The funds
not used in one year coul d be roll ed over for use in subsequent years. This approach would
increase the freedom of Medi care reci pients to choose the combination of medical services
and method of payment that best fits their personal situation.
6. PLACE MORE EMPHASIS ON THE SUPPLY SIDE OF THE HEALTH CARE MARKET. Each year,
the government spends several hundred bi lli on dollars subsidizing demand and helping peo-
ple purchase medical servi ces . Very little is spent encouraging additional supply. However,
732 PART 6 Applying The Basics: Special Topics in Economics
without addi ti onal supply, demand subsidies merel y lead to hi gher pri ces and a reallocati on
of health care services among consumers. The subsidy reci pi ents. pri maril y the elderl y and
those wi th low incomes. obtain more medi cal care, and others receive less. Furthermore, the
primary beneliciaries of the demand-side subsidies are the health care suppliers. who receive
the higher prices for their servi ces. Suppl y-side programs woul d focus more on the training
of health care providers. For example, they might provide more aid for the growth and devel-
opment of medical school s--only one new medical school has been e tabli shed in the Uni ted
States during the last two decades. Aid to l ow-income students qual ified to attend medical
and nursing school s might also be expanded. In contrast with demand subsidies, programs
that expand the suppl y of medical personnel would make it easier to control future costs.
Health care currently costs so much because consumers directly pay for so little of
it. When consumers spend their own money, they will choose wisel y and their choices
will provide suppli ers with a strong incentive ro control costs and offer qual ity service. I f
we want to improve effi ciency and reduce the growth of health care spending. the current
system must be reformed. The si x proposals outlined here will lead to ( I ) more di rect pay-
ment (and less third-party payment) of health care expenses, (2) more competi ti on in the
health insurance industry. (3) lower cost of catastrophic insurance protecti on (but higher
cost for low deductibl e. high co- payment coverage). and (4) greater rel iance on expanding
supply of medi cal services rat her than stimul ati on of demand. These reforms wil l not sol ve
all of our health care problems. but economic analysis suggests they are a major move in
the right directi on.
Spending on health care has soared in recent
decades. 1\tl easured as a share of the economy, total
health care spending has ri sen from 5.2 percent
to the health care inflati on and soari ng expendi tures
of recent decades.
As the baby boom generati on grows older, the
number of people aged seventy and over ;viii
increase sharply between 2010 and 2030. Under
in 1960 to 9 . I percent i n 1980 and 16.2 percent
in 2007.
Following the enactment of Medicare and Medi caid
in the mi d- 1960s. the direct expenditures of health
care consumers graduall y declined and those of
thi rd-party payees expanded. The out-of-pocket
spending of consumers accounted for only
14 percent of heal th care spending in 2007,
down from 55 percent in 1960.
The growth of subsidi es to health care consumers
and greater rel iance on third-part y payments or
recent decades ( I ) increased the demand for
medical servi ces and (2) reduced the incenti ve of
both health care consumers and providers to
economize. Bot h or these factors have contributed
the current Medicare program, this will i ncrease the
demand for health care services and the share of
medical payments fi nanced by a third party. Unless
reform i s undertaken. thi s wil l mean both more
heal th care inflati on and substanti all y higher taxes
for the finance of Medicare.
Reforms that ( I ) place more emphasi s on direct
(rather than third-party) payment of medical bi ll s,
(2) increase competition in the health insurance
industry, (3) encourage catastrophic insurance pro-
tecti on (but not l ow clcductible, l ow co-payment
plans), and (4) expand the supply of health care
wil l help control ri sing heal th care expendi tures.
1. How does the substitution of thi rd-part y payments
by insurance companies and the government for the
out-of-pocket purchase of health care by consumers
i nfluence the demand and price of medi cal servi ces?
Explain.
*2. When an employer provides health insurance ben-
efits as pan of the compensat ion package. does this
represent a gift by empl oyers to their empl oyees?
Do employees earn these benefits? Why or why
not? Justi fy your response.
3. Do individuals have a ri ght to free heal th care? Do
they have a ri ght to force others to provide them
wi th free healt h care? Di scuss.
*4. How did the Medicare and Medicaid programs
inlluence the cost of medical services purchased
by Americans who were neither poor nor elderl y?
Expl ain.
5. Consider the six reform proposal s suggested by the
authors at the end of thi s feature. Indi cate why you
bel ieve each is either a good or a bad idea. Explain
your answers.
S P E C I A L T 0 P I c 9 The Economics of I-leal/It Care 733
*6. Do personal choices influence health care expen-
ditures? If health care is paid for by others or if
everyone is charged the same premium for health
care. how will thi s i nfluence the incent ive to make
healthy lifestyle choices?
7. Suppose the government establi shed a new program
that would use revenues from a payroll tax to finance
85 percent of the maintenance and repair cost of
automobiles incutTed by those who are employed.
How would thi s legislati on influence (a) the prices of
auto repair and mai ntenance services, (b) total spend-
i ng on these services. and (c) the cost of thi s program
in the years immediately ahead? Do you think this
program should be adopted? Why or why not?
*8. I f the government either provi de (or forces
insurers to provi de) insurance to persons wi th
preexi sting adverse health conditions, how will thi s
influence the incenti ve to purchase insurance when
you are healthy?
* Asteri sk denotes questi ons for whi ch answers arc gi ven
in Appendi x B.