Chapter 2

What's Wrong With the Present System
Michael Tanner

After nearly a year and a half of debate, tens of millions of lobbying dollars, and smothering media attention, the debate over President Bill Clinton's plan for health care reform finally died not with a bang, but a whimper. But there remain significant problems in the health care system in the United States that must be addressed.

Most important, health care continues to cost too much. In 1995, Americans spent nearly $1 trillion on health care, amounting to 14.2 percent of gross domestic product. That is a 7.4 percent increase in health spending over 1994.¹ Although recent trends indicate that the increase in health care costs is moderating, both the relative price of medical care and real health care expenditures per capita continue to increase at a rate higher than the average increase over the past 30 years.

At the same time, almost 40 million Americans still lack health insurance, and millions more worry that if they lose their jobs, they will lose their insurance. Although most Americans are uninsured for only a short time, a method must be found to enable more Americans to obtain and keep health coverage.

As bad as these problems are, however, they are merely symptoms of a much larger flaw in the health care system in the United States: the link between health care and a misguided tax policy.

Current federal and state tax laws exclude the cost of employer-provided health insurance from taxable wages. Therefore, the vast majority of Americans-those who receive health insurance through their employers-do not pay federal or state income taxes or Social Security taxes on the value of their policies. Moreover, the employer can deduct the full premium cost as a business expense. Employers do not even pay Social Security payroll taxes on these benefits. In short, the entire cost of employer-provided health insurance is financed with before-tax dollars.²

Those Americans not fortunate enough to receive employer-provided health insurance, however, face entirely different tax laws. Part-time workers, students, the unemployed, and others-including most employees of small businesses-receive little or no tax benefit for purchasing health insurance. (Until recently, individuals were able to deduct out-of-pocket medical expenses only if they itemized deductions and these expenses exceeded 7.5 percent of their adjusted gross income (AGI). Less than 5 percent of American taxpayers were eligible for this deduction.)³ Self-employed workers received a tax deduction for a portion of their premiums.

For everyone else, except for the 7.5 percent AGI deduction for which few people qualify, out-of-pocket spending on health care outside of insurance policies is at a tax disadvantage relative to out-of-pocket spending under health insurance policies.

The difference in tax treatment effectively doubles the cost of health insurance for people who must purchase it themselves. For example, the family of a self-employed person earning $35,000 per year, paying federal and state taxes with only a 30 percent deduction, and paying Social Security taxes must earn $7,075 to pay for a $4,000 health insurance policy. A person working for a small business that offers no health insurance would have to earn $8,214 to pay for that $4,000 policy.

As a result, Americans increasingly have been driven to pay for their health care through third-party insurers and to purchase that insurance, when possible, through 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.

There are many reasons that Americans spend so much on health care. They include:

• Demographics. The population of the United States is growing older rapidly. Because the elderly require more-and more costly-health care, the U.S. system must absorb costs that the other systems avoid.
• Lifestyle. The United States has much higher rates of such social problems as AIDS, drug abuse, teen pregnancy, and violent crime, all of which lead to increased health care costs. Costs also are affected by such lifestyle decisions as smoking, diet, and exercise.
• Significant U.S. investment in medical technology. This includes significant investment in both research and development.

Only recently, however, has serious attention been given to another major reason for rising health care costs in the United States: third-party payment.

 

How Third-Party Payment Increases Health Care Costs

Most Americans do not pay directly for most of their health care. The overwhelming majority have health insurance that pays the bills. On average, for every dollar of health care services purchased, a third party pays 76 cents.⁴ As a result, consumers have little incentive to question costs and every incentive to demand more services.

Compounding this problem is the fact that most Americans do not pay even directly for their health insurance. Nearly 85 percent of working Americans receive health insurance through their employers. By shielding consumers from the consequences of their health care purchasing decisions, the third-party payment system encourages excessive use of medical services and drives up health care costs.

The concept of "excessive" medical use has a very precise meaning in economic analysis. When the marginal value of the resources used in a medical treatment is greater than the marginal value provided to the patient by that medical treatment, the treatment is classified as "excessive." (It should be noted, however, that this economic concept does not require that the treatment be entirely without value.)

Under normal conditions, an individual will purchase treatment when the cost equals the actual value (determined most easily by the average price that all individuals are willing to pay) plus the individual's idiosyncratic value of the treatment.⁵ This idiosyncratic value may be positive or negative. Not all patients assign the same value to a given procedure. How they view it includes many factors, such as peace of mind, threshold for pain, concern over missing work, and so on. Also relevant are "physician-induced demand" (a physician's ability to talk a patient into having a procedure) and even a patient's reaction to advertising.

Thus, under optimal conditions, a treatment would be purchased if Va + Vi = C, in which Va is the average amount that individuals are willing to pay, Vi is the idiosyncratic value to the patient, and C is the cost of the treatment.

Most Americans, however, are insured for a substantial portion of treatment costs. Therefore, most patients are not dealing with the cost (C); rather, they are dealing with the perceived cost (I x C), in which I is the fraction of the total cost actually paid by the patient. A patient will tend to purchase treatment whenever Va + Vi > I x C. Therefore, whenever I x C < 1, there will be a tendency on the part of the patient to overconsume. As we have seen, the proportion of costs actually being paid by the purchaser has been declining rapidly. Thus, the value of I x C has been decreasing. It is no surprise, therefore, that patients have been overconsuming health care and driving up total health care spending.

To cite a practical example, assume a patient had a headache. If aspirin cost $1,000 per pill, the patient would be likely to decide to live with the pain. On the other hand, if it cost a penny per 1,000 pills, he might well treat not only the headache, but every other ache and pain as well. Now assume that every person had a magnetic resonance imaging (MRI) brain scan as part of his or her annual physical. Relatively little value would result: A handful of brain tumors might be caught earlier. But if insurance paid for an unlimited number of MRIs, thereby eliminating the cost to the patient, more patients might choose to have the procedure. Because MRIs cost nearly $1,000 each, health care costs would rise considerably.

Some of the most compelling evidence that third-party payments alter the use of medical resources comes from a study performed under the auspices of the RAND Corporation in the late 1970s.⁶ The study assigned families to four health insurance plans with differing coinsurance provisions and deductibles. Coinsurance is the percentage of medical bills paid out of pocket by the patient; the deductible measures the maximum dollar amount that a family must pay out of pocket before the plan will drop the coinsurance requirement and pick up the remaining medical bill. Some families had no coinsurance, meaning that the plan paid all of their medical bills, while others had to pay up to 95 percent of their medical bills until they reached a deductible of $1,000 in 1973 dollars (approximately $2,850 in today's dollars).

The RAND researchers observed how the different coinsurance rates influenced the use of medical resources by 2,500 families for three to five years. They concluded that "The data from the Health Insurance Experiment clearly show that the use of medical services responds to changes in the amount paid out-of-pocket."⁷ In particular, families with no coinsurance used 30 percent more hospital services (measured in dollars) and 67 percent more visits to doctors, drugs, and the like than did the group that paid 95 percent coinsurance. Overall, the total use of medical resources was 46 percent greater for the group with no coinsurance.

Even smaller coinsurance rates produced savings. The study found that an individual with a 50 percent co-payment spent 25 percent less on health care than an individual with no co-payment. It also found no measurable difference in health status observed between these groups during the course of the experiment.⁸

The RAND study essentially confirms earlier studies by Martin Feldstein and others.⁹ In addition, studies of specific health care services such as mental health¹⁰ and prescription drugs¹¹ have shown that consumers will make cost-conscious decisions.

There also is evidence that prices will be reduced in response to cost-sensitive purchasing by consumers. For example, a study by Joseph Newhouse and Charles Phelps found that a 10 percent increase in out-of-pocket expenditures resulted in a 2 percent reduction in the price of physician services.¹² Several additional studies also have found that increased third-party payment led to price increases.¹³

There are only three ways to limit health care spending. Government can do it, insurance companies can do it, or individual consumers can do it. Take the MRI example described above. Government can prevent people from having MRIs with their annual physicals either by directly prohibiting them or by limiting the number of MRI units available. Insurance companies can do it through managed care, with a "gatekeeper" to ration the availability of MRIs. The final alternative is for the individual consumer to do it for himself. But that will occur only when the cost to the consumer reflects the value.

If out-of-pocket health care payments and individually purchased health insurance received the same tax treatment as employer-provided insurance, people would be more inclined to purchase insurance with high deductibles. They would reserve insurance for the type of risk-based catastrophe for which it was intended and reduce reliance on third-party payment for routine, low-cost expenditures.

 

Job-Based Insurance and the Uninsured

A second serious problem with our current health care system is that insurance is linked so closely to employment. If you lose your job or change jobs, you are in danger of losing your insurance.

Of the estimated 40 million Americans without health insurance at any given time, half are uninsured for four months or less, and only 15 percent are uninsured for more than two years.¹⁴ Essentially, these are people who have lost their jobs and, therefore, their insurance.

Yet these people did not lose their homeowners insurance or their auto insurance. The reason they lost their health insurance is that it alone is linked to employment through the tax code. If the tax code did not give preference to health insurance purchased through an employer, people would be more inclined to purchase insurance individually, with employers acting as little more than brokers, or through nonemployer groups. In that case, the individual, not the employer, would own the health insurance policy, making it fully portable.

Moreover, the difference in tax treatment influences who receives insurance in the first place. Workers who must purchase their insurance with after-tax dollars are 24 times more likely to be uninsured than those who are eligible for tax-free employer-provided coverage.¹⁵ Significantly, the poor and minorities, who are less likely to have employer-provided insurance, are most likely to be left without access to health insurance.¹⁶ Thus, the perverse impact of our tax policies is to penalize those least able to afford health insurance.

The lesson is clear: Changing the tax treatment of insurance will help solve two of the most important problems facing the health care system in the United States. By encouraging Americans to move away from first-dollar third-party insurance, changing the tax code will help reduce health care costs. Moreover, it will break the link between insurance and employment, thereby helping to extend coverage to the uninsured.

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Notes


¹ Health Care Finance Administration, Health Care Finance Review, Vol. 16, No. 4 (Summer 1995), p. 235.

² Federal Tax Policy and the Uninsured: How U.S. Tax Laws Deny 10 Million Americans Access to Health Insurance (Washington, D.C.: Health Care Solutions for America, January 1992).

³ Internal Revenue Service, Statistics of Income Bulletin, Spring 1991, p. 1.

⁴ John Goodman and Gerald Musgrave, Patient Power: The Free-Market Solution to America's Health Crisis (Washington, D.C.: Cato Institute, 1993), p. 77.

⁵ David Dravone, "The Five W's of Utilization Review," in Robert Helms, ed., American Health Policy: Critical Issues for Reform (Washington, D.C.: AEI Press, 1993), p. 241.

⁶ Joseph Newhouse et al., "Some Interim Results from a Controlled Trial of Cost Sharing in Health Insurance," New England Journal of Medicine, Vol. 305, No. 25 (December 17, 1981), pp. 1501-1507.

⁷ Willard Manning et al., "Health Insurance and the Demand for Medical Care: Evidence from a Randomized Experiment," American Economic Review, Vol. 77 (June 1987), pp. 251-273.

⁸ Ibid.

⁹ See, for example, Martin Feldstein, "Econometric Studies of Health Economics," in D. Kendrick and M. Intrilligator, eds., Frontiers of Quantitative Economics (Amsterdam: North Holland Press, 1974); Richard Eichhorn and LuAnn Aday, The Utilization of Health Services: Indices and Correlates: A Research Bibliography, NTIS No. PB-211 720 (1972); and Avedis Donabedian, Benefits in Medical Care Programs (Cambridge, Mass.: Harvard University Press, 1974).

¹⁰ Richard Frank, "Pricing and Location of Physician Services in Mental Health," Economic Inquiry, Vol. 23, No. 4 (October 1985), pp. 115-133, and John Wallen, Paul Roddy, and Michael Fahs, "Cost Sharing, Mental Health Benefits, and Physical Complaints in Retired Miners and Their Families," a paper published by the American Public Health Association, 1982.

¹¹ Alan Liebowitz, Willard Manning, and Joseph Newhouse, "The Demand for Prescription Drugs as a Function of Cost-Sharing," Social Science and Medicine, Vol. 21, No. 10 (1985), pp. 1063-1069.

¹² Joseph Newhouse and Charles Phelps, "New Estimates of Price and Income Elasticities," in Robert Rosset, ed., The Role of Health Insurance in Health Sector Services (New York, N.Y.: National Bureau of Economic Research, 1976), pp. 261-320.

¹³ See, for example, Frank Sloan, "Effects of Health Insurance on Physician Fees," Journal of Human Resources, Vol. 17, No. 4 (Fall 1982), pp. 533-557.

¹⁴ Bureau of the Census, Current Population Reports, Series P70-37, and unpublished data.

¹⁵ Jill Foley, Uninsured in the United States: The Nonelderly Population Without Health Insurance (Washington, D.C.: Employee Benefits Research Institute, April 1991).

¹⁶ Ibid.