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Fix Health Care by Tackling “the Wedge”

by Arthur Laffer, Donna Arduin, and Wayne Winegarden
September 09, 2009

President Barack Obama has stated: “Soaring health care costs make our current course unsustainable.” And he’s right. The growth in per capita expenditures on health care has exceeded the growth in overall consumer prices every year for nearly the past 50 years. Such a trend cannot continue forever.

The President’s proposed reforms, however, do exactly the wrong thing. Increasing government subsidies for health insurance will increase what is the primary driver of excessive health care spending: the government health care wedge.


Bad Incentives

The health care wedge is one way of thinking about government involvement in the economy. The health care wedge represents an economic separation of effort from reward, or consumers (patients) from producers (health care providers). When the government or another third party spends money on health care, the patient does not. The patient is then separated from the transaction in the sense that the costs are no longer his or her concern. This health care wedge also separates patients from doctors in determining what type of care should be provided. Instead, health care decisions are made by government, by insurers, or by judges deciding medical malpractice liabilities.

The health care wedge diminishes consumers’ incentives to monitor costs. Consumers bear only a fraction of the costs from any additional health care service. On the supplier side, doctors and other medical providers receive no incentive to provide higher quality services for less cost. No positive benefit accrues to those who do so.

Costs do accrue, nevertheless. One of the most important disincentives for doctors to monitor costs is the tort liability threat. Rising tort liability costs have encouraged doctors to practice “defensive medicine”—ordering extra tests and performing extra procedures not because they are needed but in order to avoid a claim of medical malpractice. This “defensive medicine,” according to the American Medical Association, added between $99 billion and $179 billion in additional costs in 2005 alone.

 As a result, Medicare, Medicaid, and tax-favored, employer-based coverage blind both patient and doctor to the cost of care. Meanwhile, litigation risks incentivize doctors to run additional tests to limit their liability exposure. Government regulations and the third-party payer system are also diminishing the market incentives to implement best practices programs that would help eliminate waste, fraud, and abuse. Whether the payer is government or an insurance company, the process removes the competition and the patient feedback that drives innovation.

Take, as an example, programs to implement best practices, or comparative effectiveness research. Comparative effectiveness research evaluates different medical procedures and treatments for the purpose of educating doctors and patients about which treatments are effective and economical and which treatments are not. An oft-cited com-plaint of the current U.S. health care system—a complaint not without merit—concerns the lack of sound comparative effectiveness research.

The President has called for a government agency to provide comparative effectiveness research. He and others believe that comparative effectiveness research is difficult to keep out of the public domain. Thus, according to this theory, an organization’s incentive to invest in this research is diminished by the prospect that a competitor will free ride on their investment. Consequently, organizations will naturally under-invest in comparative effectiveness research, ac-cording to this argument.

But, as Michael Cannon of the Cato Institute points out, prepaid group plans have a large incentive to provide comparative effectiveness research to their members, because the benefits of the research can be effectively captured within their networks of doctors and facilities. However, complex government regulations discourage prepaid group plans. Further, declining out-of-pocket expenditures means that consumers do not bear the costs or reap the benefits of ensuring the most cost-effective practices; thus, their incentives to seek those benefits are accordingly lessened. Taken together, government interventions have deadened the incentives to create comparative effectiveness research.


Health Insurance Distorted

Government policies have also distorted private health insurance, which is another factor in the growth of the health care wedge. Most Americans do not have health insurance as the term is traditionally understood. Insurance is a tool for managing risk. In exchange for periodic payments from a customer, an insurance company provides protection against a large but uncertain potential cost.

Take disability insurance. A potential risk for many families is the possibility that the primary (or one of the dual-income earners) might meet with an accident that prevents him or her from working for a prolonged period of time. In such a case, a family could face potential financial ruin. To protect against this risk, many primary income earners will purchase a disability insurance policy. In return for annual (or quarterly or monthly) payments to the insurance company, the company will pay a pre-determined amount of money to the income earner should an unfortunate accident or disabling illness occur.

Health insurance does not work this way. As opposed to covering only true health risks (the costs associated with broken arms or major surgeries), health insurance pays the costs for routine health events that are not risks in the true sense of the word. An analogous situation would be for disability insurance plans to pay an individual’s disability claims for missing work due to a cold.

Imagine if another form of insurance, such as automobile insurance, worked like health insurance. As opposed to covering the costs from major automobile accidents, costs of routine maintenance such as oil changes and tune-ups would also be covered. Additionally, to ensure that car owners were all treated equally, insurance companies would be prohibited from charging different rates for specific drivers who cause more accidents or from charging different rates to groups with different driving habits—married women in their 50s, for instance, who might qualify for lower rates than single, 18-year-old males.

If indeed automobile insurance worked like health insurance, safe drivers would end up paying more for automobile insurance to subsidize the costs of unsafe drivers. Car consumers would also have no incentive to shop for the best deal when it came to changing the car’s oil, getting a tune-up, or performing any other routine maintenance service. The cost for routine maintenance services would be expected to increase. Additionally, because a car owner would not bear the costs resulting from improper maintenance, the incentive to properly maintain cars would decline. The number of major car repairs, and the cost of these repairs, would all increase as well.

Automobile insurance companies, trying to arrest the rising costs of car repairs and car maintenance, would begin to increase the number of rules and regulations. The result would be significant market distortions in the automobile insurance market, skyrocketing costs of repairs, and an increase in the number of major repairs. In short, both the automobile insurance market and the automobile repair market would become much more inefficient—to the point where people might even begin to wonder whether the automobile repair market is special, needing the government to mandate prices and repair schedules.


The Growing Health Care Wedge

Over the past five decades, the health care wedge has grown as government health care expenditures have been substituted for private health care expenditures and as private health insurance has shifted to plans offering first-dollar coverage.

In 1965, the private sector funded over 75 percent of total U.S. health expenditures. But the creation of Medicare in 1966 started to shift the balance of spending toward the public sector. The private share of national health expenditures fell to 70 percent in 1966, and 63 percent in 1967. Since 1967, the private sector has been slowly funding less and less of total national health expenditures. In 2007, less than 54 percent of total national health care expenditures were paid for by the private sector. Public expenditures (at the federal and state levels) now fund nearly one-half of total U.S. health care expenditures.

Concurrent with these trends, total out-of-pocket spending by patients has plummeted even faster as a share of total health expenditures. (See figure above.) Note that while total out-of-pocket expenditures have been declining as a share of total national health expenditures, they have nevertheless grown in total inflation-adjusted terms. Despite the government covering a growing share of total health care expenditures, individuals continue to pay more than ever before.

Taken together, these trends illustrate a complete reversal of the way health care is purchased in the United States. In 1960, the private sector funded over three-quarters of national health care expenditures, with individuals responsible for nearly one-half of these costs through out-of-pocket expenditures. Today, the private sector funds just a bit more than one-half of these expenditures, with only a little over $1 out of every $10 coming out of the consumer’s pocket.


Reforms Must Address the Health Care Wedge

Rising health care expenditures are limiting income gains and thereby hurting family budgets, raising tax costs, raising individuals’ dollar costs at a rate that is not sustainable, and damaging the U.S. economy. The economic costs from these inefficiencies are large. In a recent paper for the Cato Institute, Michael Cannon notes:

Examining Medicare records, researchers have found that per-beneficiary spending varies widely from one area of the country to the next. In some areas, Medicare spends twice as much per senior as it does in other areas. Researchers have also found that beneficiaries in high-spending areas do not start out sicker, do not end up healthier, and are no happier with the care they receive, than beneficiaries in low-spending areas. That suggests that a significant amount of Medicare spending pro-vides no discernible benefit to the program’s intended beneficiaries. Those researchers estimate that as much as 30 percent of total U.S. medical spending provides no discernible value. If so, then Americans spend more than $700 billion each year, or 5 percent of gross domestic product, on medical services of no discernible value.

On a per capita basis, $700 billion in waste, fraud, and abuse imposes a bill of over $2,300 per le-gal resident in the United States. The possibility that 30 percent of total health care spending is waste underscores the President’s contention that reform is needed. However, successful re-forms will directly address the root causes of the problems outlined above. The root cause is the adverse government policies that have diminished the incentives and ability for either doctors or patients to control costs and experiment with alternative, more effective ways to deliver health care.

The centerpiece of the Obama plan is the creation of a public health insurance option that supposedly would ensure that private insurance companies provide a fair product at a reasonable price. Such a solution assumes that the problem is ineffective pricing and services from health insurance companies. As shown, this diagnosis is wrong.

Creating another government insurance plan would not address the problem of rising health care costs, but it would further diminish consumer incentives to monitor those costs. In an analysis published in August for the Texas Public Policy Institute, we estimate that increasing public subsidies for health insurance by $1 trillion over the next decade would add at least 5 percentage points to health care inflation. Such a plan would also increase government expenditures by more than 5 percent per year by the end of the next decade and reduce gross domestic product by 5 percent cumulatively by 2019.

The guiding principle of beneficial health care reform should be that the current third-party/government-driven health care system needs to be changed, not enhanced. Rather than expanding the role of government in the health care market, Congress should implement patient-centered reforms that include the following features:

Individual ownership of insurance policies. The tax deduction that allows employers to own employees’ insurance should instead be given to the individual.

Expanded use of Health Savings Accounts (HSAs). HSAs empower individuals to monitor their health care costs and create incentives for individuals to use only those services that are necessary.

Interstate purchasing of health insurance. Policies in some states are more affordable because they include fewer bells and whistles; consumers should be empowered to decide which benefits they need and what prices they are willing to pay.

Fewer mandates on insurers to cover specific benefits. Empowering consumers to choose which benefits they need is effective only if insurers are able to fill these needs.

Simple vouchers for low-income individuals instead of Medicaid block grants to the states. An income-based, sliding scale voucher program would eliminate much of the massive bureaucracy needed to implement today’s complex and burdensome Medicaid system. It would also produce considerable cost savings.

Elimination of unnecessary scope-of-practice laws. Non-physician health care professionals should be allowed to practice to the extent of their education and training. Retail clinics have shown that increasing the provider pool safely increases competition and access to care—empowering patients to decide from whom they receive their care.

Reform of tort liability laws. Defensive medicine needlessly drives up medical costs and creates an adversarial relationship between doctors and patients.

By empowering patients and doctors to manage health care decisions, a patient-centered health care reform would directly address the distortions weakening our current health care system and would simultaneously control costs, increase health outcomes, and improve the overall efficiency of the health care system.


Dr. Laffer is chairman of Laffer Associates and co-author of
The End of Prosperity: How Higher Taxes Will Doom the Economy—If We Let It Happen (2008). Widely known as the “Father of Supply-Side Economics,” Laffer served as a member of President Ronald Reagan’s Economic Policy Advisory Board from 1981 to 1989. Ms. Arduin is a managing director at Arduin, Laffer & Moore Econometrics, which provides economic, fiscal, and policy advice to governors, legislatures, think tanks, and corporate clients throughout the country. She was a top budget advisor to then-governors John Engler (Mich.), George Pataki (N.Y.), and Jeb Bush (Fla.), and current governor Arnold Schwarzenegger (Calif.). Dr. Winegarden is a managing director at Arduin, Laffer & Moore Econometrics. This article is adapted from their longer paper, “The Prognosis for National Health Insurance,” published by the Texas Public Policy Foundation, August 2009.


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