Truth on the Market

After two years of nagging and increasingly worse hip and leg pain, I learned last August (at age forty) that I have a congenital hip deformity and need to have both hips replaced.  In planning for this surgery, I’ve witnessed first-hand a problem that is driving American health care costs through the roof and is exacerbated by the Affordable Care Act (ACA).  Allow me tell you a little about my recent health care decision-making, the difficulty it exemplifies, and how the ACA squandered an opportunity to make things better.

The first decision I confronted after my diagnosis was when to have surgery.  Because I’m a teacher, the timing of my diagnosis—three days before fall classes were to begin—was most inconvenient.  I knew I could have surgery in early December and be recovered enough to begin the spring semester in mid-January, but that seemed like a lot of hassle.  I ultimately decided to hold off on my surgery until this summer and treat the pain with cortisone injections (of which I’ve now had seven).

In addition to having to decide when to have surgery, I’ve had to select a procedure and decide on a surgeon.  Because I’m young and active, one doctor recommended hip resurfacing, a procedure in which the femoral head is not removed but is instead shaved down and capped with chrome.  Another, stressing problems that may arise from the metal-on-metal aspect of hip resurfacing, recommended a total hip replacement.  I decided to follow his advice.

In researching physicians (which involved several costly office visits), I paid close attention to how different surgeons do things.  Most utilize the traditional posterior approach and access the hip joint from behind, cutting through the buttocks.  In recent years, a minority have switched to an anterior approach in which the incision is on the front of the pelvic area and no muscle is cut.  That approach results in a faster recovery and less risk of dislocation, but it requires a unique table and a surgeon who has received specialized training. 

Surgeons also differ on what brand of artificial joints they use (some are better than others), whether they use stems that are cemented within the femur (uncemented stems become fixed as the bone grows into them), what size femoral heads they employ (bigger heads tend to be more stable, at least to a point), the amount of time they keep patients in the hospital (some send patients home the same day of the surgery, others keep them in the hospital for a few days of rehab), and whether they will replace both hips at once.  Not surprisingly, surgeons’ views on all these matters were quite important to me as I made my choice of doctor.    

In the end, then, I’ve had to decide:

• When to have this surgery (December or June);
• How many rounds of cortisone injections to get (they become less effective);
• Which procedure to have (hip resurfacing or a total hip replacement);
• Whether to go with a posterior or anterior approach;
• Which components to utilize (cemented or uncemented stems, larger or smaller femoral heads, which manufacturer)
• How long to stay in the hospital; and
• Whether to schedule two surgeries or have both hips replaced at once.

The amazing—and disturbing—thing is that I’ve made all these decisions without ever, a single time, considering the relative cost of the options before me.  Cortisone injections (which, according to my latest insurance statement, cost $790 a pop) have been effectively “free” for me ever since I met the measly annual deductible on my health insurance.  From my perspective, the only cost of another round has been the pain and inconvenience of getting the injections.  In deciding on procedures (resurfacing vs. replacement), approaches (anterior vs. posterior), components (cemented/uncemented, larger or smaller head, brand), surgeons, hospitals, length of hospital stay, and whether to do both hips at once, the price of different options has never been mentioned.  Indeed, I’m nearly certain the doctors I saw couldn’t have quoted me any kind of a price had I requested one.  But, of course, I never requested pricing information because I didn’t care about relative prices.  I didn’t care about relative prices because I have an insurance policy that will pay for whatever I select.  And the various providers I’ve been considering—doctors, hospitals, and equipment manufacturers—know that I’m not considering price in making this decision and am thus unlikely to be swayed by a discount.  They don’t compete on price because doing so won’t win them any business.

My experience exemplifies the problem inherent in any system of third-party health insurance:  The people making consumption decisions are paying with other people’s money, so they have little incentive to shop on price, and providers, aware of that fact, have little incentive to lower their prices in an attempt to win business. 

While the problem is to some degree intractable, it’s been exacerbated by generous health insurance policies that have transformed true “insurance” (protection against catastrophic and unforeseeable risks) into what is essentially pre-paid health care (i.e., coverage for even foreseeable and minor expenses like check-ups and antibiotics for strep throat).  As an increasing number of foreseeable and cheap services and products are covered by insurance—so that the person making the consumption decision doesn’t bear the cost of her choice—prices will rise.  Why, for example, would a doctor lower or constrain her charge for an annual check-up when she knows doing so won’t win her any additional business? 

Unfortunately, the Affordable Care Act not only failed to make a simple change that could have helped mitigate this problem, it also imposed mandates that will make the situation worse.

A Sin of Omission: Failure to Fix the Tax Code’s Perverse Encouragement of Overly Generous Insurance Policies

As explained above, consumers’ incentive to ignore (and providers’ consequent disincentive to compete on) the prices of medical services grows as insurance becomes more and more generous. When everything is covered, a consumer won’t give a hoot about price, and neither will the providers competing for the consumer’s business. The system works best, then, if insurance—at least for lots of folks—is somewhat “stingy” and requires insureds to make some significant out-of-pocket expenditures. If there’s a substantial group of consumers out there whose insurance covers only unforeseeable and catastrophic events, competition for their business on foreseeable and minor expenses will end up lowering health care costs for all. It’s crucial, then, that there be a substantial number of insureds with stingy insurance (i.e., high deductibles and co-pays, significant coverage limitations) and an incentive to shop on price.

Unfortunately, the federal tax code discourages this type of health insurance. Under current law, employer contributions to an employee’s health insurance, but not individuals’ own expenditures on such insurance, are not taxed. This creates an incentive for employers to replace salary, upon which their employees are taxed, with more generous health insurance benefits (i.e., low deductibles, low copayments, lots of costly coverages), which are tax-advantaged. Those generous benefits, in turn, discourage both price competition and thoughtful decisions about health care consumption.

That the tax code perversely encourages overly generous insurance policies is hardly controversial. Indeed, a National Public Radio survey of liberal and conservative economists recently identified eliminating the deductibility of employer contributions to health insurance as one of six policy proposals “that have broad agreement, at least among economists.” As the diverse group of economists explained, the fact that “[n]either employees nor employers pay taxes on workplace health insurance benefits … encourages fancier insurance coverage, driving up usage and, therefore, health costs overall.” Even ACA architect Christina Romer (former Chair of President Obama’s Council of Economic Advisers) recently argued that overly generous insurance plans “lead families to be less vigilant consumers of health care.”

So why didn’t ACA proponents, who know the terrible damage wrought by the tax code’s treatment of employer-provided health benefits include a fix to the problem in the ACA? In a word, politics. In the 2008 campaign, John McCain proposed to eliminate the tax deductibility of employer-provided health benefits so that employer-provided and individually purchased insurance policies would receive equivalent tax treatment. He then proposed to provide refundable tax credits for health insurance purchases. By eliminating the incentive for employers to pay (and employees to demand) a greater proportion of worker compensation in the form of tax-free insurance benefits, the McCain plan would have encouraged individuals to buy cheaper but stingier insurance policies – precisely the sorts of policies that both mitigate the moral hazard problem inherent in any system of third-party health insurance and encourage health care providers to engage in price competition. Unfortunately, McCain’s plan was easy to construe as a “tax increase,” and, in a startlingly disingenuous line of attack, then-candidate Obama went there. He launched television ads accusing McCain of proposing to raise taxes, and he gave lots of speeches where he said things like this:

I can make a firm pledge: under my plan, no family making less than $250,000 will see their taxes increase – not your income taxes, not your payroll taxes, not your capital gains taxes, not any of your taxes. My opponent can’t make that pledge, and here’s why: for the first time in American history, he wants to tax your health benefits. Apparently, Senator McCain doesn’t think it’s enough that your health premiums have doubled, he thinks you should have to pay taxes on them too. That’s a $3.6 trillion tax increase on middle class families. That will eventually leave tens of millions of you paying higher taxes. That’s his idea of change.

President Obama, of course, failed to abide by his “firm pledge.” But far more importantly, his strong and misleading rhetoric against McCain’s plan to level the playing field between employer-provided and individually purchased health insurance policies made it impossible, as a political matter, to make the change economists of all stripes believe would help lower health care costs. As Bob Woodward observed in another context, Mr. Obama’s politics carry a price. Sadly, we’re the ones who pay it.

Two Sins of Commission

In addition to squandering an opportunity to enhance price competition among health care providers, the ACA, when fully implemented, will dampen the nascent price competition that is just beginning to rein in medical inflation and destroy price competition on preventive medical services and products.

Reducing Existing Price Competition by Impairing the HSA/High-Deductible Policy Option. In recent years, the rate of medical inflation has slowed significantly, leveling off at about 3.9%, substantially below the 6.2 to 9.7% of most of the 2000s. Not surprisingly, ACA proponents attribute this decrease to the Act. But that’s implausible given that (1) the bulk of the ACA hasn’t yet been implemented, and (2) the slowdown in medical inflation began around 2002 and the rate had substantially moderated by 2005, well before the Act was passed. The sluggish economy is undoubtedly responsible for some of the slowdown in health care inflation, but macroeconomic woes can’t explain the pre-recession reduction.

So what else is going on? One thing is that a drastically increased number of health care consumers are now insured under high-deductible health plans (HDHPs), typically coupled with Health Savings Accounts (HSAs) in which insureds may sock away money tax-free for meeting deductibles and making minor health care expenditures. From 2005-2012, the number of Americans covered by these plans jumped from one million to 13.5 million. Consumers who are so insured are far more price sensitive, and providers, courting their business, are more likely to compete on price. Indeed, a recent Rand study estimates that families using these health care plans cut health care spending by a whopping 21%. It seems likely, then, that “stingier” insurance has played a significant role in reducing medical inflation. That’s the judgment of Harvard health care economist Michael Chernew, who recently wrote that “[r]ising out-of-pocket payments appear to have played a major role in this decline [in medical inflation], accounting for approximately 20% of the observed slowdown.”

Unfortunately, the ACA threatens to derail the HDHP/HSA revolution. The threat comes from two of the Act’s requirements. First, the statute requires that qualifying (“bronze” level) policies have an “actuarial value” of 60%, meaning that the policy must cover at least 60% of an insured’s medical expenses. That’s a problem for any high-deductible policy coupled with an HSA because, by definition, the portion of medical payments made out of the HSA are not made under the policy sold by the insurer. In a recent guidance bulletin, the Department of Health and Human Services announced that payments made from employer contributions to HSAs would count as insurance payments, but when consumers spend HSA money they contributed themselves, those payments won’t count toward the proportion of medical payments from insurance—even though the insureds are spending money they would have spent on insurance premiums had they purchased policies with lower deductibles. Because a significant proportion of medical payments made by an insured with a high-deductible policy and HSA won’t count toward the minimum 60% actuarial value, insurers will have to raise payments made under the policy by lowering the deductible and/or covering more services. This will both raise the price of the policy, making the HDHP/HSA option less desirable to insureds, and destroy the social value of the HDHP/HSA approach—i.e., the more thoughtful consumption decisions and enhanced price competition that result when individuals are paying for medical care with their own money.

The ACA’s “80/20 rule” also promises to impair the HDHP/HSA model. Under that rule, an insurer must spend at least 80% of collected premiums on health care reimbursements or refund the difference to its insureds. Because high-deductible health plans collect smaller premiums but face fixed administrative costs, they are particularly likely to run afoul of this rule. Consider this example from Robert Bloink and William Byrnes:

[I]f an insurance plan collects $500,000 a month in insurance premiums in Florida and the corresponding administrative costs are $100,000, then $400,000 a month—or 80 percent—of the premiums are paid in benefits and the plan remains within the limits of the 80/20 rule. A HDHP that collects monthly premiums of, say, $300,000 in Florida with the same administrative costs will violate the 80/20 rule because the administrative costs represent more than 20 percent of the $300,000 in premiums collected within the state. The insurer will then be required to refund the difference to Florida policyholders, eliminating much of the incentive for offering low premiums in the first place.

Thus, the ACA, by reducing the attractiveness of the successful HDHP/HSA model, impairs the very development that is most likely to reduce medical inflation in the long run.

Decimating Price Competition on Preventive Measures.  One of the most controversial provisions of the ACA is the requirement that insurers fully cover all preventive measures. The controversy has centered on HHS’s directive that contraception, including the so-called morning after pill, be included in employer-provided coverage. Employers who oppose contraception on religious grounds maintain that HHS’s requirement violates their constitutionally protected right to exercise their religion freely, and I agree. But there’s another huge problem with the ACA’s mandate: it will greatly dampen price competition among providers of preventive services and products, thereby driving up their cost.

If consumers pay nothing for a preventive service regardless of its price, they have little incentive to select relatively cost-effective services, and providers therefore have little incentive to compete on price. If a woman’s birth control is, from her perspective, “free,” then why would she shop around? And if no one’s shopping around, why would contraceptive manufacturers lower or constrain their prices?

ACA proponents insist that the adverse effect of eliminating price competition on preventive measures will be offset by down-the-road cost reductions resulting from better preventive care. But that seems unlikely. Insurers already have an incentive to adopt an optimal reimbursement policy that covers preventive measures when doing so lowers total expected costs. Their scads of actuaries spend all day trying to strike a cost-minimizing balance. The mere fact that a service may lower future costs, then, doesn’t mean it should be fully covered by insurance.

Automobile insurers understand this principle. As John Cochrane observes, they don’t raise premiums slightly and cover routine oil changes—even though regular oil changes prevent higher costs down the road—because they know that insurance coverage would destroy price competition among mechanics and drive up the price of oil changes. By the same token, the ACA’s mandate that insurers fully cover all preventive health services is sure to increase the price of those services in the future.

Conclusion

My recent hip saga has really opened my eyes about the way health care consumption decisions are made. If I had a little more skin the game, I probably would have made some different decisions. I almost certainly wouldn’t have incurred charges of $5,530 ($790 * 7) for nine months of pain relief. I probably would have dealt with the hassle of a “hectic” holiday season and had surgery in December, saving thousands of dollars in fees for palliative care. I might have made different decisions about procedures, doctors, hospitals, cities, components, and whether to do both hips at once—though I really don’t know, since I have absolutely no idea how the relative costs of all these options differ.

One thing I do know, though: Separating the consumer from the price signal is a sure-fire way to waste resources.  The sad thing is that policy makers were beginning to understand that problem and some practical ways to mitigate it. The HDHP/HAS revolution was generating improvements and shedding light on how to move forward.

Then the Affordable Care Act happened.

What a tragedy.

My recent essay, How the Supreme Court Doomed the ACA to Failure, is the cover article of the current issue of Regulation Magazine.  I’ve been over the essay’s basic points several times (e.g., here, here, and here), so I won’t belabor them now.  My basic assertions are:

• The Affordable Care Act (ACA) provisions mandating both ”guaranteed issue” (insurers must sell to everyone) and “community rating” (insurers can’t charge higher rates to high-risk insureds) create a perverse incentive for young, healthy people to forego purchasing costly health insurance until they need medical treatment, at which point they will be assured coverage (because of guaranteed issue) at rates not reflecting their infirmities (because of community rating).
• When young, healthy people drop out of the insurance pool, premiums — reflective of the average health care expenditures of the covered population — will rise, driving even more young, healthy people from the pool.  To prevent such “adverse selection,” the ACA needs to encourage the young and healthy into the insurance pool, and ensure that they remain covered.
• SCOTUS’s opinion upholding the ACA, however, rejected (quite properly) the Act’s mandate to carry insurance and instead read the ACA to impose a ”tax” on those who freely opt not to buy insurance.  That tax, though, is far too small to induce a great many young, healthy people to stay in the insurance pool — even after the ACA’s generous (i.e., expensive) subsidies are accounted for.  And the reasoning of SCOTUS’s majority opinion limits Congress’s ability to raise the no-insurance penalties to an effective level.  Thus, adverse selection is inevitable and will tend to drive up the cost of health insurance by “sickening” the pool of insureds and increasing the average number of claims per insured.
• Now, an increase in claims per insured would not necessarily raise health insurance premiums if the ACA actually reduced the underlying cost of medical services, the primary driver of health insurance premiums.  Sadly, though, it does no such thing.  The handful of provisions in the 1,000-page statute that are aimed at underlying medical costs, rather than health insurance, range from anemic to silly.  Some, such as the requirement that all preventive services be provided with no out-of-pocket expenditure (the requirement underlying the controversial “contraception mandate”), are sure to increase underlying medical costs.  After all, what incentive do providers have to compete on the price of preventive services if the individuals making the decision to purchase those services face no marginal cost when deciding whom to patronize?
• The fundamental problem with the ACA’s purported cost-saving provisions is that they ignore the primary driver of underlying medical costs: the near complete absence of price competition among health care providers, who know that most individuals making consumption decisions (those with a standard or better health insurance policy) have no “skin in the game,” get no benefit from selecting a cheaper provider, and thus will not tend to award business to providers who are less expensive.  This unfortunate result stems largely from the federal tax code, which perversely encourages employees to demand (and employers to provide) such generous health insurance benefits that insurance has now effectively become “pre-paid health care.”  The tax code achieves this result by making employer contributions to health plans tax free, while fully taxing any dollars paid instead as salary.  As that bastion of free-market ideology, NPR, has reported, economists across the ideological spectrum agree that tax subsidies for employer-provided health insurance drives up the underlying cost of health care.  So did President Obama and his team, as evidenced by this op-ed in which Council of Economic Advisers Chair Christina Romer explains how “[e]mployers['] … strong incentives to pay workers with more generous insurance policies” tends to “lead families to be less vigilant consumers of health care.”  Sadly, President Obama’s shamefully disingeuous 2008 attacks on John McCain’s proposed health care reforms took off the table any treatment of the perverse tax code provisions that largely underlie medical inflation.  Ah, the Price of Politics.
• So the ACA will drive up the costs of health insurance and underlying medical costs.  But isn’t its redeeming virtue the fact that it will drastically expand health insurance coverage?  Hardly.  First, SCOTUS’s opinion prevents the Feds from forcing states to expand their Medicaid rolls, one of the primary means by which the ACA was to increase health insurance coverage.  At this point, ten states (including biggies like Texas and Georgia) are not participating in the Medicaid expansion, five others (including New Jersey and Virginia) are leaning against participation, and fourteen others (including Florida, Michigan, Ohio, and Pennsylvania) are undecided.  The upshot is that in a great many populous states, individuals and families that are not Medicaid eligible but earn incomes less than 133% of federal poverty level will receive no subsidy to buy health insurance on an individual basis.  Moreover, the plain language of the ACA denies individual purchase subsidies to citizens of states that decline to set up a state insurance exchange.  As of January 4, 2013, 25 states had firmly decided not to set up their own exchanges, and several others were in limbo.
• The primary reason that the ACA will fail to expand insurance coverage, though, is that it encourages employers of low- to moderate-wage employees to drop health insurance benefits.  The media have largely lambasted employers for this move, but it’s actually in the interest of their employees.  The ACA, you see, provides generous subsidies to employees who cannot obtain qualifying health insurance from their employers at an affordable price.  Those subsidies are far, far larger than the implicit tax subsidy an employee receives for employer-provided health care (by virtue of the fact that compensation paid as health benefits is not taxed).  Employees thus have a strong incentive to demand — and employers to provide — a compensation package that consists of higher salary in exchange for no health insurance coverage.  In the Regulation article, I run the numbers to show how the ACA creates an incentive for employers to drop coverage and pay a higher salary but fails to incentivize moderately compensated employees to turn around and purchase health insurance.  The upshot is that coverage levels are likely to fall.

So this is where we are.  The grand promises of reduced health care costs and expanded coverage look ever less credible.  As the ACA implodes, watch for calls for a single-payer system.  We may start with a Public Option, but I’d be surprised if single-payer’s not where we end up at the end of the day.  On the bright side, maybe we can see something groovy like this at the next American Olympics!