Monday, February 28, 2011

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.


Benjamin Cole said...

Either we go private, as Scott Grannis says, or we have to go top down, like Great Britian or France.

It is galling that other nations devote much less of GDP to healthcare, but get about the same results. We are talking 7 percent in some Euro nations vs double that in the US.

There are, however, moral issues involved. Many on the political right believe people should be "kept alive" at any cost, for as long as possible--remember the Terri Schiavo case? A Republican Congress actually held a special session on the Schiavo case, and Bush jr. cancelled a vaction (!) to return to DC.

The American public does not want to be told to pay or pull the plug-despite the fact that we have an aging population, and that many people are kept alive even when they are both aged and terminally ill.
Some cite figures to the effect that most health care dollars are spent on patients who are both terminally ill and aged.

This is a touchy issue, and the party fault lines--as so often is the case--do not break exactly the way one thinks they should. Sensible limits on care for the aged and terminally ill has been re-defineind as "death panels."

As for complete privitization, unless insurers are able to set limits--ie, have private-sector death panels--then insurance will only cost more and more in coming years.

There are solutions, but not ones that are particularly comfortable, for any of us.

mmanagedaccounts said...

Scott Grannis, sometime back in the early 1990s I saw a chart on the WSJ editoral page on the cost of healthcare in the U.S. going back into the 1940s. According to that chart, the cost of healthcare began to accelerate in 1965 and thereafter. Any of you remember having seen that chart? Any of you can provide data on healthcare costs pre-Medicare/Medicaid versus rising costs post-1965?

W.E. Heasley said...

Mr. Grannis:

Most excellent post! Excellent point!

Insurance theory and the risk management matrix produce an axiom that insurance should only be an option deployed when faced with low frequency/high severity risk. All other points on the risk management matrix are less efficient and/or inefficient for the deployment of insurance (inefficient use of premium dollars).

Enter the politico and exit the axiom. Politico intervention through the mechanism of government via tax policy and other government intervention [example 5,262,074 of: if markets fail, governments fail too] has created a non-market market within health-care and associated health-care insurance.

The socialized medicine scheme aka ObamaCare follows in lockstep of failure to adhere to the axiom of low frequency and high severity within the theory of insurance. Low frequency and high severity risks are the intersection points in the risk management matrix where the insurance mechanism is most efficient and qualifies for deployment. ObamaCare is the exact opposite in that it mandates a position of insuring low frequency/low severity risk.

By-the-way, insuring low frequency/low severity risk is a component of the phenomena “over utilization” which is cost driver.

Plastic Money888 said...

It's not health care its insurance.
There is no need to pull the plug-on an aging population. Since when does business complain for having to many clients. The problem is that as the article mentions only 12% is paid directly. Who needs all this stupid insurance. Why are we insured for the common cold? Medical Issuance should never be a subscription for all medical payments. "Insurance" is a price we paid to protect our self for something that even if not likely to happen would cause is serious financial problems. If not don't guy it since it will only cost you mere. You are basically asking some one to charge you for paying your bills. You never know the cost. If only 50% to 60% of of the US population would save just a few dollars per months instead of paying exorbitant premiums in five years they would have the money to cover most minor interventions and take an equivalent and cumulative deductible. The least the Government should do is not tax any money that responsible persons saved for this purpose. This would encourage responsibility and stop this cost spiral.

As we have it to day every politicians are focusing on Insuring every one. As if centralizing insurance will lower cost it will not. When we go to a doctor do we ask how much it will cost ? "No"
The reaction is I have insurance I may as well use it. So its a carte Blanche and then we wonder why premiums go up. Imagine doing your groceries with a insurance card, We would be out of Angus beef in a week and prices would hit the roof. When we insure our homes its for Fire or catastrophe not in case a window breaks so what is it with health insurance? Consult your doctor for this and that and show your cards .......... Its insane. Eat well,do exercise every day avoid as much medication as possible and only purchase catastrophic health insurance. Unless you are chronically you will save big time . hill

NormanB said...

The health care answer: Health Savings Accounts. Everyone gets an insurance stipend to buy HSA's. What they don't use they keep for their retirement. We'll all be out buying our meds at COSTCO-WALMART, seeing nurse practictioners at CVS, Googling form cheap blood tests, using those CPAP masks until they disintegrate, etc. We citizens will bring prices down. The Government cannot do it, period.

Rick said...

The same point can be made for education costs.

Anonymous said...

Good point about education, Rick.

Unknown said...
This comment has been removed by the author.
Unknown said...

Insurance should be used for catastrophic events. However, high deductible health plans did not take off, until lately, because the brokers make less money and thus steered companies away from them. The truth is that the economy has forced employers to move to high deductible health plans and the brokers have had to provide them. High deductible health plans combined with other innovation healthcare solutions like WhiteGlove House Call Health's offering lowers the employers premiums (or reserves) and lowers and caps the consumers out-of-pocket costs.

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