The big problem with healthcare? It's not a market

I've showed this chart before, but this version includes recently-released data as of 2009.

Markets function well when they are free of outside intervention, when transactions costs are low, and when both parties to transactions have good information on which to base their buy/sell decisions. That is most certainly not the case for the healthcare market, and that's why it's a mess.

Thanks to a distortion introduced to our tax code in the early days of WWII, only employers can deduct the cost of healthcare insurance. To circumvent war-time wage and price controls which were preventing employers from attracting badly-needed workers, the government agreed to allow companies to give workers tax-free health insurance; companies could deduct the cost of the insurance, and it wasn't considered income to the workers. Workers thus received an important tax-free benefit which has since grown enormously in size and importance.

This significant feature of the tax code has finally taken us to its logical conclusion: whereas consumer paid for most of their own healthcare prior to 1940, they now get almost all of their healthcare paid for by someone else, since this is highly tax-efficient.  Along the way, of course, politicians have created a baker's dozen of federal and state programs designed to pay other people's healthcare costs.

The system as it stands today works best for employees when the insurance offered by employers and government agencies covers as much healthcare as possible, thus maximizing the tax benefit. That's the reason why low-deductible policies with prescription drug coverage are so popular. If employees were paying for their own healthcare, many would undoubtedly choose higher-deductible policies.

As the chart shows, consumers now pay only 12% of total healthcare costs out-of-pocket. The rest is paid by private health insurance companies (32%), medicare (20%), medicaid (15%) and other private and government programs. The 12% that is still paid out of pocket consists mostly of payments by individuals not covered by employer policies or government programs (whether voluntarily or not), and co-pays and deductibles by individuals that are covered.

It stands to reason that when people don't pay the bill for the services they receive, they are very unlikely to take price into consideration when making a healthcare decision. Why shop around if everything is paid for by someone else? And when politicians set the reimbursement rates for medicare, there is a huge potential for error and fraud. And when insurance companies and government agencies pay most of the bills, even for small things like a vial of 30 pills, back-office costs begin to add up. Furthermore, those who aren't employed by a company that offers healthcare insurance face an immediate "tax wedge" since they must pay for their own insurance with pre-tax dollars, thus inflating the cost relative to someone who is covered by an employer. That extra cost figures importantly in many people's decision to not buy insurance. Add it all up and you have every reason to think that the market for healthcare is not going to be a well-functioning or efficient market. It's not really a market at all, and that's why it's such a mess.

The biggest single way to fix the healthcare market would therefore be to change the tax code. Either let everyone or no one deduct the cost of healthcare insurance. If there were no tax-efficiency reasons for employers to offer healthcare insurance, most would eventually drop the program (it's a headache) and just let employees decide how to spend the money. (Think of the parallel between this and the big shift away from defined-benefit plans in favor of defined-contribution plans) That would put consumers back in charge and I would bet any amount of money that all sorts of healthcare innovations would be unleashed—as healthcare insurers and providers were forced to compete directly for customers—that would eventually result in a more efficient, less-costly, and more satisfying healthcare experience for everyone.

As a corollary, a good portion of the money that is currently being spent by government agencies on healthcare could be turned over to consumers in the form of a voucher. We need to let consumers make the decisions about how to spend the money, not bureaucrats.

UPDATE: For a thorough analysis and review of what's necessary to fix healthcare, see John Cochrane's essay "After the ACA: Freeing the market for healthcare." It's very long, but also very excellent. A must-read for anyone.