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Health Care, Michael A. Morrisey
18 paragraphs found.

Federal and state governments are a major health care spender. Together they account for 46 percent of national health care expenditures; nearly three-quarters of this is attributable to Medicare and Medicaid. Private health insurance pays for more than 35 percent of spending, and out-of-pocket consumer expenditures account for another 14 percent.1


Traditional national income accounts substantially understate the role of government spending in the health care sector. Most Americans under age sixty-five receive their health insurance through their employers. This form of employee compensation is not subject to income or payroll taxes, and as a result, the tax code subsidizes employer purchase of employee health insurance. The Joint Economic Committee of the U.S. Congress estimated that in 2002, the federal tax revenue forgone as a result of this tax “subsidy” equaled $137 billion.2


Risk and Insurance

Risk of illness and the attendant cost of care lead to the demand for health insurance. Conventional economics argues that the probability of purchasing health insurance will be greater when the consumer is particularly risk averse, when the potential loss is large, when the probability of loss is neither too large nor too small, and when incomes are lower. The previously mentioned tax incentive for the purchase of health insurance increases the chances that health insurance will be purchased. Indeed, the presence of a progressive income tax system implies that higher income consumers will buy even more insurance.


The 2002 Current Population Survey reports that nearly 83 percent of the under-age-sixty-five population in the United States had health insurance. More than three-quarters of these people had coverage through an employer, fewer than 10 percent purchased coverage on their own, and the remainder had coverage through a government program. Virtually all of those aged sixty-five and older had coverage through Medicare. Nonetheless, approximately 43.3 million Americans did not have health insurance in 2002.3


The key effect of health insurance is to lower the out-of-pocket price of health services. Consumers purchase goods and services up to the point where the marginal benefit of the item is just equal to the value of the resources given up. In the absence of insurance a consumer may pay sixty dollars for a physician visit. With insurance the consumer is responsible for paying only a small portion of the bill, perhaps only a ten-dollar copay. Thus, health insurance gives consumers an incentive to use health services that have only a very small benefit even if the full cost of the service (the sum of what the consumer and the insurer must pay) is much greater. This overuse of medical care in response to an artificially low price is an example of “moral hazard” (see insurance).


Strong evidence of the moral hazard from health insurance comes from the RAND Health Insurance Experiment, which randomly assigned families to health insurance plans with various coinsurance and deductible amounts. Over the course of the study, those required to pay none of the bill used 37 percent more physician services than those who paid 25 percent of the bill. Those with “free care” used 67 percent more than those who paid virtually all of the bill. Prescription drugs were about as price sensitive as physician services. Hospital services were less price sensitive, but ambulatory mental health services were substantially more responsive to lower prices than were physician visits.4


Taxes and Employer-Sponsored Health Insurance

There are three reasons why most people under age sixtyfive get their health insurance through an employer. First, employed people, on average, are healthier than those who are unemployed; therefore, they have fewer insurance claims. Second, the sales and administrative costs of group policies are lower. Third, health insurance premiums paid by an employer are not taxed. Thus, employers and their employees have a strong incentive to substitute broader and deeper health insurance coverage for money wages. Someone in the 27 percent federal income tax bracket, paying 5 percent state income tax and 7.65 percent in Social Security and Medicare taxes, would find that an extra dollar of employer-sponsored health insurance effectively costs him less than sixty-one cents.


Workers, not employers, ultimately pay for the net-of-taxes cost of employer-sponsored health insurance. Employees are essentially paid the value of what they produce. Compensation can take many forms: money wages, vacation days, pensions, and health insurance coverage. If health insurance is added to the compensation bundle or if the health insurance becomes more expensive, something else must be removed from the bundle. Perhaps the pension plan is reduced; perhaps a wage increase is smaller than it otherwise would have been.


A recent study demonstrates the effects of rising insurance premiums on wages and other benefits in a large firm. This firm provided employees with wages and “benefits credits” that they could spend on health insurance, pensions, vacation days, and so on. Workers could trade wages for additional benefits credits, and vice versa. Health insurance premiums on all plans increased each year. When all health insurance premiums increased, the workers switched to relatively less expensive health plans, took fewer other benefits, and reduced their take-home pay. A 10 percent increase in health insurance premiums led to increased insurance expenditures of only 5.2 percent because many workers shifted to relatively cheaper health plans offered by the employer. The bulk of these higher expenditures (71 percent) was paid for with lower take-home pay; 29 percent by giving up some other benefits.6 Thus, if insurance premiums increased, on average, by $200, the typical worker spent $104 more on coverage and paid for this by reducing take-home pay by $74 and giving up $30 in other benefits.


These so-called compensating wage differentials, reductions in wages due to higher nonwage benefits, have important policy implications. They imply, for example, that a governmental requirement that all employers provide health insurance will result in lower wages for the affected workers.


Growth and Effects of Managed Care

The health care industry has undergone fundamental changes since 1990 as a result, in large part, of the growth of managed care. As recently as 1993, 49 percent of insured workers had coverage through a conventional insurance plan; in 2002 only 5 percent did so. The rest were in health maintenance organizations (HMOs), preferred provider organizations (PPOs), or other forms of managed care. Unlike conventional insurance plans, managed care plans provide coverage only for care received from a selected set of providers in a community. The basic idea with managed care is to limit the moral hazard that comes from overuse of health care, thus keeping insurance premiums lower than otherwise and potentially making the insured person, his employer, and the insurance company better off. An HMO typically provides coverage only if the care is delivered by a member of its hospital, physician, or pharmacy panel. PPOs allow subscribers to use nonpanel providers, but only if the subscriber pays a higher out-of-pocket price. Conventional plans allow subscribers to use any licensed provider in the community, usually for the same out-of-pocket price.


Selective contracting arguably led to the slower rate of increase in health insurance premiums through the mid-1990s. Since that time insurance premiums have increased more rapidly. Health economists believe that this change is a result of consumers’ unwillingness to accept the limited provider choice that comes with selective contracting, as well as from the reduction in competition that has resulted from consolidation in the health care industry.


Government-Provided Health Insurance

Medicare is a federal tax-subsidy program that provides health insurance for some forty million persons aged sixtyfive and older in the United States. Medicare Part A, which provides hospital and limited nursing home care, is funded by payroll taxes imposed on both employees and employers. Part B covers physician services. Beneficiaries pay 25 percent of these costs through a monthly premium; the other 75 percent of Part B costs is paid from general tax revenues. Part C, now called “Medicare-Advantage,” allows beneficiaries to join Medicare-managed care plans. These plans are paid from Part A and Part B revenues. Part D is the new Medicare prescription drug program enacted in 2003 but not fully implemented until 2006.


Some state governments limit the extent to which managed care plans may selectively contract with providers. All state governments have imposed laws governing the content of insurance packages and the factors that may be used to determine insurance rates. While these may enhance quality, they do impose costs that raise the price of health insurance and increase the number of uninsured. In testimony before the Joint Economic Committee of the Congress, one analyst reported the annual net cost of regulation in the health care industry to be $128 billion.10


Industry Outlook

The industry is faced with rising health care costs and an increasing number of uninsured. In the private sector the cost increases have led to an interest in consumer-directed health care. The idea is to provide health insurance payments only for expenditures in excess of a high deductible. The expectation is that consumers who must pay the full price for most health services will buy such services only when the expected benefits are at least equal to the full costs. Others see the reemergence of more aggressive selective contracting by managed care firms as a way to keep costs under control. The government is expected to be more aggressive in promoting competition among providers as well.


The retirement of the baby boom generation will put more pressure on Medicare. Indeed, the Medicare trustees reported in 2004 that the costs of the Medicare program will exceed those of Social Security by 2024. Medicare Part A—hospital coverage—is estimated to be unable to cover its expenses starting in 2019.15 Interestingly, the 5 percent of Medicare fee-for-service beneficiaries who die each year account for one-fourth of all Medicare inpatient expenditures.16 Tax increases, benefit reductions, and/or wholesale reform of the program will have to occur. The number of uninsured will increase if health insurance continues to be more expensive. Some have proposed expansions of existing public programs; others have proposed “refundable” tax credits as a means of subsidizing targeted groups.17 Still others argue for reductions in regulations and a greater reliance on consumer-directed health plans as a means of lowering costs and expanding insurance coverage (see health insurance).


In addition to forgone benefits, government health care systems have hidden costs. Any insurance system, public or private, must raise revenues, pay providers, control moral hazard, and bear some nondiversifiable risk. In a private insurance market such as that in the United States, the costs of performing these functions can be measured by insurance overhead costs of premium collection, claims administration, and return on capital. Public monopoly insurers must also perform these functions, but their costs tend to be hidden and do not appear in health expenditure accounts. Tax financing entails deadweight costs that have been estimated at more than seventeen cents per dollar raised—far higher than the 1 percent of premiums required by private insurers to collect premiums.


Further Reading

Dranove, David. The Economic Evolution of American Health Care: From Marcus Welby to Managed Care. Princeton: Princeton University Press, 2000.
Morrisey, Michael A. “Competition in Hospital and Health Insurance Markets: A Review and Research Agenda.” Health Services Research 36, no. 1, pt. 2 (2001): 191-221.
Morrisey, Michael A. Cost Shifting in Health Care: Separating Evidence from Rhetoric. Washington, D.C.: AEI Press, 1994.
Pauly, Mark V. Health Benefits at Work: An Economic and Political Analysis of Employment-Based Health Insurance. Ann Arbor: University of Michigan Press, 2000.
Pauly, Mark V., and John S. Hoff. Responsible Tax Credits for Health Insurance. Washington, D.C.: AEI Press, 2002.