Truth on the Market

As his Council of Economic Advisers made clear in its recent health care report, President Obama sees two primary goals for his health care reform efforts: to slow the growth of health care costs and to expand coverage of health insurance. It’s pretty clear, though, which of these goals is steering the ship. While the President’s proposals include a few modest measures ostensibly aimed at reducing costs (digitizing medical records, collecting and disseminating data on treatment-effectiveness, etc.), the primary focus is on increasing insurance coverage. That’s unfortunate, for relentless pursuit of coverage expansion is almost certain to undermine the goal of cost containment.

To see why this is so, consider two facts the Obama administration keeps emphasizing: (1) that prices for health care services are spiraling upward faster than the rate of inflation, and (2) that health care expenditures, but not health care outcomes, inexplicably differ greatly across regions. Both of these facts are bizarre, and both suggest that an expansion of insurance coverage may actually impede efforts to slow the growth of health care costs.

In an innovative and competitive economy like ours, the normal tendency — absent a large increase in demand relative to supply, which we haven’t witnessed — is for the quality- and inflation-adjusted prices of goods and services to fall. The real prices for most health care services, by contrast, seem to spiral upward. That’s odd. So are the CEA’s observations that “utilization of specific procedures and per capita health care spending vary enormously by geographic region,” that “in many cases these variations are not associated with any substantial differences in health outcomes,” and that “[l]arge variation remains even after adjusting for differences in the age, sex, and race of enrollees across states.” Why would residents of Texas and Massachusetts spend so much more than residents of New Mexico and Maine to achieve the same health outcome?

Both anomalies — upward spiraling health care costs and substantial regional variations in outcome-adjusted spending — can be explained by the lack of price competition in the health care industry. When most consumers buy health care, somebody else, a private or public insurer, makes the direct payment. Consumers therefore have little incentive to shop around for favorable prices. And health care providers, aware of consumers’ price insensitivity, have little incentive to compete on price and to streamline their operations in a manner that reduces their costs (and consequently their prices). Providers are also likely to over-sell high margin services, which price-insensitive consumers are likely to buy, and to coordinate with local competitors on both prices and norms of treatment — e.g., the degree to which non-essential services (tests, etc.) are routinely provided. Such coordination is easy in an environment in which there is little price competition.

To get a sense of health care consumers’ price insensitivity, consider the results of a 2005 Harris Interactive poll of 2,000 adults covered under employer-provided health plans. That poll found that “63 percent of respondents who themselves or a close family member received treatment for a serious health issue in the past two years[] did not know the cost until after the treatment was received and 10 percent revealed they never found out the cost.” The survey also found that while two-thirds of consumers spend more than eight hours researching the purchase of an automobile, fewer than four in ten spend that amount of time researching a doctor (38%) or a health insurance plan (34%). It should not be surprising, then, that the average survey participant could predict the price of a Honda Accord within $300 but was off by a whopping $8,100 when it came to estimating the price of a four-day hospital stay.

These survey results make perfect sense. If someone else is footing the bill (directly, at least) for your medical care and you aren’t rewarded for selecting a lower-priced provider or for foregoing unnecessary service, you won’t spend the time and effort required to select a cost-effective provider and you won’t decline services of marginal value. Health care providers, well-aware of insured customers’ shopping tendencies, have little incentive to compete on price and plenty of motivation to adopt input-intensive treatment norms.

Things change drastically when customers have to foot the direct bill for medical treatment. Consider, for example, the price of LASIK eye surgery, which insurance generally does not cover. When LASIK was approved by the FDA in 1999, the price for the procedure averaged about $2,100 per eye. By 2005, the average price had fallen 20 percent to $1,687. By contrast, overall annual health expenditures per person in the United States rose from $4,400 to nearly $6,300 (a 43 percent increase) from 1999 to 2004. What accounts for this difference in price trends? Most likely, the vigorous price competition resulting from the fact that LASIK consumers shop around because they must pay out-of-pocket.

The lesson for health care reformers is that if we want to stop the upward spiral of health care costs — the real source of America’s purported health care crisis — we need to find ways to motivate providers to compete on price. Expanding insurance coverage won’t help here; such expansion will instead result in even less price-comparison among consumers and will encourage providers to raise prices and over-sell unnecessary or marginally useful medical services.

A better policy would encourage a system in which consumers pay more directly for at least a portion of their health care consumption so that providers have an incentive to win customers by offering the most cost-effective services. Increasing deductibles and co-payments would help on this front. Current policy, though, discourages high deductible and high co-payment insurance policies. Right now, employer contributions to health insurance – but not individuals’ own expenditures on such insurance – are not taxed. This creates an incentive for employers to provide very generous health insurance benefits (i.e., low deductibles, low co-pays, lots of costly bells and whistles) as a tax-advantaged element of their employees’ compensation.

Legislation proposed by Sen. Tom Coburn and Rep. Paul Ryan confronts this unfortunate incentive head-on and would increase the ranks of the insured while creating strong incentives to control costs. The central feature of the Coburn/Ryan legislation is the elimination of the employer insurance deduction and the creation of a refundable tax credit for individual insurance purchases. As John Goodman explains:

Under the Coburn bill, no longer would employers be able to buy insurance with pretax dollars. These payments would be taxable to the employee, just like wages. However, every individual would get a $2,300 credit (and every family would get $5,700) to be applied dollar-for-dollar against taxes owed.

The Coburn bill does not raise taxes, nor does it lower them. Instead, it takes the existing system of tax subsidies and treats everyone alike, regardless of income or job status. All health insurance would be sold on a level playing field under the tax law, regardless of how it is purchased. The impact would be enormous. For the first time, low- and moderate-income families would get just as much tax relief as the very rich when they purchase health insurance.

The Coburn bill would also encourage all Americans to control costs. The tax credit would subsidize the core insurance that everyone should have. It would not subsidize bells and whistles (marriage counseling, acupuncture, etc.) as the current system does. Since employees and their employers will be paying for additional coverage with after-tax dollars, everyone will have an incentive to compare the value of extra health benefits to the value of other things money can buy. When patients eliminate health-care waste, they will get to keep every dollar they save.

This plan, or some version of it, would go a long way toward accomplishing President Obama’s twin goals of cost containment and coverage expansion. And unlike his own plan and the leading Democratic proposals, it won’t drive the deficit (further) into the stratosphere. Unfortunately, though, Mr. Obama would have a hard time embracing this sort of approach, given his barely true attacks on Sen. McCain’s health care proposals during the presidential campaign.

This is when we could really use a flip-flopper.