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What is Driving Rising Healthcare Costs?

Monday, May 18, 2009

Our healthcare system is in trouble today because we have consistently ignored market-oriented solutions and instead sought out policies based on public finance and top-down regulation.

On May 7, the Obama administration revealed that it seeks to set aside more than $630 billion over the next ten years to establish a separate fund to radically alter the U.S. healthcare industry. The White House claims that this sum will be raised without increasing the already titanic $7 trillion in cumulative budget deficits over the same time period (20102019). How will it do so? First, by “rebalancing the tax code so that the wealthiest pay more” (specifically, raising taxes on households with incomes over $250,000). Second, by “promoting efficiency and accountability, aligning incentives towards quality and better care,” and “encouraging shared responsibility.”

The initial tax hikes on the quarter-million-dollar club are projected to raise $318 billion over ten years (although they may not raise that much). But while the same document states that the details of this plan, to be hashed out with Congress, “must put the United States on a clear path to cover all Americans,” it concedes that “$630 billion is not sufficient to fully fund comprehensive reform.” Translation: hold onto your wallets. Middle-class Americans should be prepared for significant tax increases within a few years.

While it would be naïve to be surprised at President Obama’s aggressive healthcare agenda (this was a major plank in his campaign), the broader and much more interesting issue remains: what factors push up healthcare costs and what can be done to make healthcare more affordable?

The drivers of high healthcare costs are manifold, and include the perverse incentives associated with an insurance-based payment system, low labor-productivity growth in the provision of care, and the closely related issue of a constrained supply of healthcare providers. The expense of treating the uninsured or under-payments from Medicare and Medicaid is shifted onto private healthcare providers, as is the expense of litigating and/or settling malpractice lawsuits. While significant ink has been dedicated to all of these topics over the years, I will focus my attention on the first three.

The United States relies on a third-party payment system whereby individuals and employers purchase insurance that allows patients to receive healthcare services that are in turn paid for by insurance providers. For the elderly and disabled, the government assumes the role of the insurer, using funds from payroll taxes (rather than insurance premiums) from current workers to pay medical providers for care provided to those currently enrolled in Medicare, Medicaid, and other public healthcare programs.

Although the current system epitomizes the overuse or misuse of insurance, the Obama plan fails to recognize this, and instead seeks to expand the size and scope of this distorted system.

The current system overextends and perverts the use of insurance. The purpose of insurance, whether public or private, is to spread catastrophic risks over a large pool of individuals. Automobile insurance provides a great illustration of this. When was the last time you submitted a claim to your auto insurer asking to be reimbursed for an oil change or a tire rotation? Never. But that begs the question, why do you have auto insurance? For most of us, the answer is to cover the cost of a new car if we total our current one or to cover the expense (both property and medical) of the other party if we are involved in a multivehicle crash.

For the sake of argument, let’s assume that auto insurance did pay for routine maintenance. How would this affect your behavior? Most consumers are very price conscious and will only take their cars to repair shops they believe to be honest, and they are quick to question recommended repairs. If, on the other hand, auto insurance began to pay maintenance bills, I suspect that most drivers would select the most convenient shop, and would cease to be concerned with the price or the necessity of recommended repairs, because after all, it is being billed to the insurance company. We would end up with drivers unwilling to do any due diligence regarding the price or efficacy of auto repairs, and thus as a nation we would grossly overspend on them. With time, auto insurers would significantly increase premiums to cover these high repair costs, and would likely seek to screen out the owners of older cars that are more likely to need significant repairs. Soon, poorer Americans who simply want basic liabilitycoverage would find it difficult to afford the premiums and would become uninsured drivers.

Health insurance should not cover basic or routine medical services, but instead should cover major illnesses, surgeries, etc. Moreover, the government should require that healthcare providers charge all patients the same fees for out-of-pocket medical procedures (insurance companies and the government should be free to negotiate discounted prices for the services for which they directly pay, but these preferred rates would not apply to the services paid out-of-pocket by their members). This would bring normal, competitive market forces to bear on the provision of routine medical services. Insurance would then provide (as it is properly intended) coverage against significant and expensive maladies. This helps the poor in two ways. First, routine services would be much cheaper, and so the poor and uninsured would be able to afford (out-of-pocket) basic services. Second, the price of catastrophic medical insurance would be within reach of many more Americans. While high-deductible insurance plans already exist (in which the insured pays the first $1,500 to $2,000 in medical expenses and the insurer pays everything above this amount), what is really needed is for Medicare and Medicaid along with most employer-provided plans to adopt this high-deductible model. Although the current system epitomizes the overuse or misuse of insurance, the Obama plan fails to recognize this, and instead seeks to expand the size and scope of this distorted system.

Nearly half of all healthcare costs in 2007 were due to labor compensation; prescription drugs accounted for 10 percent and program administration 7 percent.

The second major driver of high healthcare costs is low growth in productivity in the healthcare industry. In labor-intensive professional industries such as law, education, and healthcare, the number of customers serviced in a given year, whether they be clients, students, or patients, changes very little over time (how many more students does a high school teacher instruct in 2009 compared to 1950?). By contrast, industrial products such as consumer electronics, automobiles, etc., are produced each year with greater efficiency (factory workers produce more radios, auto workers crank out more cars, and so forth), so despite rising wages in those industries, greater labor productivity helps to keep unit production costs down. Also, many of these products are manufactured overseas in markets with plentiful and cheap labor supplies. Because professional services cannot be so easily offshored, and because rising wages in these industries are not offset by higher productivity, their price tends to grow more quickly than inflation. The economist William Baumol discovered this phenomenon in the mid-1960s and coined the phrase “cost disease” to describe it. According to Bureau of Economic Analysis statistics, nearly half of all healthcare costs (48.1 percent) in 2007 were due to labor compensation.

The only effective means of combating this disease is to increase the supply of healthcare professionals to put downward pressure on wage growth. This can be done in a number of ways. As championed by the late Milton Friedman, the American Medical Association must cease restricting the supply of medical doctors. In addition, the United States needs to rely on offshoring with a twist: rather than sending Americans abroad seeking medical services, allow more foreign doctors to come to America to practice medicine. A medically trained and licensed doctor from a developed nation will provide much better care to a poor American than no doctor at all. Moreover, too many services that could easily be provided by nurses are instead provided by doctors, a practice that is exceedingly wasteful. Does the Obama plan address this issue? Not really. The stimulus bill provides $59 billion in healthcare spending, but less than 1 percent of that amount ($500 million) is allocated to train the next generation of doctors and nurses. The larger $630 billion overhaul fund only seeks $330 million (0.05 percent) to increase the size of the U.S. healthcare workforce. Instead of working with the American Medical Association to help address this supremely important issue, President Obama has focused his efforts on containing prescription drug costs and streamlining the paperwork involved in maintaining medical charts and processing medical billing. According to U.S. Department of Health and Human Services data, in 2007, prescription drugs accounted for 10 percent of all healthcare spending, while program administration represented only 7 percent. Clearly the president is focusing on the wrong problems.

Rather than sending Americans abroad seeking medical services, allow more foreign doctors to come to America to practice medicine.

Our healthcare system is in trouble today because we have consistently ignored market-oriented solutions and instead sought out policies based on public finance and top-down regulation. Historically, each crisis has brought its own government solution, which in time has given rise to new problems necessitating still more government intervention. This all began in 1944, when employers began offering health insurance and other benefits to attract prospective employees because government wage and price controls prevented the payment of higher cash wages. Thus government regulation had the unintended consequence of giving rise to the current system of employer-provided health benefits. In the mid-1960s, President Johnson’s “Great Society” gave us Medicare and Medicaid, which insured millions of senior citizens and in the process drove up the cost of medical care due in part to the third-party payment problems discussed above. In response to high prescription drug costs, President George W. Bush gave us an oddly designed Medicare prescription drug coverage benefit (Medicare Part D). Apart from being excessively complicated, the plan is a great example of the misuse of insurance—Medicare Part D should cover catastrophic drug expenses, not mundane drugs such as Viagra.

Fast forward to today and we are on the cusp of instituting nationalized healthcare despite the fact that the baby boom generation is beginning to retire and both Social Security and Medicare are staring down the barrel of insolvency. 

Dustin Chambers is assistant professor of economics at the Franklin P. Perdue School of Business.

FURTHER READING: The American Enterprise Institute’s Thomas P. Miller wrote “ What DO We Know About the Uninsured?” and “Obama Healthcare 2.0,” on how the president’s opening offer of healthcare at a teaser rate fails to deliver what we actually need, value, and can afford.

Image by Darren Wamboldt/Bergman Group.

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