The Problems With and Solutions to American Healthcare

When it comes to healthcare, economics tells us that we can do better. Distributive justice demands from us that we do better. A judicious combination of market forces, regulation, and transfers can provide us with more efficient healthcare for all, at a cheaper price.

Healthcare is a crucial thread in the tapestry of social conditions that allows us, either individually or as communities, to fulfill our goals in life and attend to matters of ultimate concern. It stands to reason that the common good requires the best healthcare possible.

Note that I chose the word healthcare, not health insurance. A distinction between these two terms is the basis of a sound analysis of the topic. The goal of healthcare is patient-centered, high-quality, innovative care for all. Health insurance is a means to achieve this goal. As I argue below, an efficient and fair healthcare system will consist of parts that involve health insurance (coverage against large, unforeseen events) and parts that do not.

The goal of healthcare is patient-centered, high-quality, innovative care for all. Health insurance is a means to achieve this goal. An efficient and fair healthcare system will consist of parts that involve health insurance (coverage against large, unforeseen events) and parts that do not.

Confusion about the ends of healthcare has often led us astray. For example, sometimes cost containment seems to be an end in itself. Even worse, on occasion, positions that reflect personal values are presented as self-evident healthcare imperatives that government regulation should impose. When Aristotle stated that we deliberate not about ends but about means, he quickly added, “For a doctor does not deliberate whether he shall heal.” Unfortunately, in the modern world, what Aristotle thought was beyond dispute is no longer a safe bet.

Health Expenditures: High and Growing

If it seems that we talk more than ever about healthcare, it is because health expenditures are high and growing fast. Every year, the Organization for Economic Cooperation and Development (OECD), a group of representatives from democratic market economies, compiles key indicators of health across its members and when possible, for key emerging economies. From 2000 to 2018, the rate of growth on health expenditure per capita was around 3.1 percent.

The figures for the United States are striking. In 2018, the nation spent, $10,586 per capita on health. As a share of gross domestic product, health expenditure is 16.9 percent: one-sixth of all the goods and services produced in a year by the U.S. economy. Of the $10,586, the government spends roughly half, and families and firms spend the other half. The U.S. spends more on healthcare per capita and as a fraction of gross domestic product than any other OECD country.

The OECD data also tell us that health expenditure is uniformly high among rich countries. This is despite the different ways in which health systems are organized. Why do we spend so much on healthcare? And why is expenditure growing so fast? Many economists emphasize four reasons:

  1. Technological Progress. As medical technology improves, we develop better treatments. However, these treatments are often increasingly costly.
  2. Aging. Health expenditure is linked with age. Most eighteen-year-olds are healthy. Except for checkups and perhaps glasses and the occasional prescription, they do not spend much on health. But even the healthiest ninety-year-olds require a fair amount of medical attention. Thanks to better medical knowledge, better behavior, and higher income, life expectancy has increased dramatically.
  3. Economic Growth. As we become richer, we demand more health services. As our material needs are easier to meet, thanks to economic growth, our demand for other goods increases. Few things are more precious for a wealthy person than an extra year of life.
  4. The Cost Disease. There are many goods and services for which technological improvements do not easily translate into higher productivity. However, as the general level of productivity in the economy increases, the opportunity cost of healthcare providers’ time has grown as well. This phenomenon is called by economists the “cost disease.”

While the first three causes raise challenges for societies, they are also reasons to celebrate human ingenuity. More problematic is the cost disease. However, there is no consensus about how important it is in practical terms: technologies, such as the internet, allow for a better use of a doctor’s time.

Interestingly, the growth in health expenditures in the U.S. has slowed down in the last few years. The consequences of such a slowdown, if maintained, are considerable. For example, the sustainability of the federal budget hinges on the growth rate of Medicare and Medicaid. While there are some reasons to be optimistic, one must remain cautious.

The Market in Health Services

I have argued that healthcare is expensive and likely to get more so over time. Our next task is to ask how we can provide it to all in a way that is both efficient and fair. The intelligent case for markets has never been that they are flawless, a proposition so obviously untrue that it is not even worth discussing. The case for markets is that they usually work better than feasible alternatives.

Note that I italicized three words: usually, better, and feasible. The word usually tells us that sometimes markets fail. The word better reminds us that, even when markets do not work well, the alternatives may be worse. The final word, feasible, emphasizes that one should not judge market behaviors against an idealized public service staffed by angels.

Do markets for healthcare work like other markets? There is no widespread consensus among economists. Why this divergence of opinion? The answer comes from a seminal article by Kenneth Arrow, who pointed out that markets for healthcare suffer from a few peculiarities. I highlight four of them here.

First, the demand for healthcare is irregular and unpredictable. Except for the very rich, a healthcare system exclusively based on one’s wealth implies too much risk-bearing. We need a mechanism for sharing these risks.

Unfortunately, insurance markets are plagued by what economists call moral hazard and adverse selection. Moral hazard means that I change my behavior when I know I am covered by insurance. Moral hazard does not require that everyone start misbehaving, only that some people will be a bit less careful. Adverse selection means that I will only enroll in insurance when, in my assessment, the probable benefits I will get out of it are higher than the costs. While this behavior is rational at an individual level, it presents problems for a society. The high-services plans only pool bad risks, raising their costs and hence their prices. A higher price will induce even more people not to take up good insurance, making the pool of risks worse and worse.

Second, healthcare is a market where information is highly asymmetric between the seller and the buyer. In addition, the buyer often cannot test or value the product. It is much harder for me to assess the quality of an oncological treatment or to decide which of the different treatment options I “prefer.” Markets work better when the difference in information between seller and buyer is small, than when it is large. Oftentimes, in other markets, this problem is solved through reputation, established either by repeated interaction with the seller or through social knowledge, such as online reviews.

That leads us to the third peculiarity of the market: purchases of health services are often urgent and not repeated.

Fourth and finally, many improvements in medical technologies are derived from research that has little immediate “market value.” Without public subsidies for research, technological innovation is bound to slow to a crawl.

My assessment of the theoretical arguments, and my reading of the empirical data, are that, when all considerations have been weighed, a carefully designed market for healthcare that includes vouchers for basic insurance, plus public subsidies for research and development in basic medical sciences, is the best way to organize our health system. But before I can outline how such a market would work, I need to discuss how healthcare is, right now, not working well in the U.S.

Healthcare in the United States: Problems

I have already pointed out that the U.S. spends considerably more on healthcare than does any other country—we do not get a good return on our investment. First, let us consider the investment in terms of outcomes. In 2011, life expectancy at birth in the U.S. was 78.7 years, lower than the average of the OECD (80.1 years) and more than four years below the leader (82.8 years). Part of the difference comes from a high homicide rate, a high traffic accident rate, a high suicide rate, and rampant obesity. While all of these statistics are deplorable, they are largely beyond the scope of the healthcare system. However, part of the difference is from a healthcare system that falls short for many. While in most cases, the U.S. does better than the average OECD country, it never reaches the top of the table, and often it is outclassed by countries that spend much less on healthcare.

Second, consider fairness. In 2009, 26.2 percent of the poorest Americans visited their dentist, while 56.9 percent of the richest ones did. In France, 63.9 percent of the poorest French visited their dentist, and 82.3 percent of the richest ones did. The U.S. ranked second in terms of inequality in access to dental care in a sample of sixteen OECD countries. Obviously, not everything is bleak—some of the leading hospitals in the world are in the U.S., and U.S. universities, clinics, and firms are world leaders in medical innovation.

Cost Control, Competition, and Efficiency

Why is the U.S. not getting a good return for its money? Because a number of misguided policies undercut cost control, competition, and efficiency.

In 1954, a new IRS code solidified and extended the ruling stating that employer-paid health insurance would be tax-free. This tax-deductibility generates important distortions:

  1. It changes the relative prices of goods and services. Once you add up my federal, state, and local income tax, my marginal income tax rate is close to 50 percent: all the goods I pay for with pretax money are effectively half as cheap as the goods I pay for after tax. Thus, I bias my consumption toward pretax goods, even when it is not socially efficient to do so.
  2. It induces individuals to purchase low-deductible, low-copay insurance instead of more efficient high-deductible, high-copay plans.
  3. It triggers the inclusion in health insurance of goods and services that do not have an insurance component—for example, toothpaste coverage.

The tax-deductibility of employer-paid health insurance means that most employees would not get their health insurance through the individual market but through their employer. This choice has several important drawbacks: it reduces individuals’ insurance options, it limits labor mobility and entrepreneurship, and it increases the risk associated with unemployment.

Since most healthcare is paid through third parties, the prices of medical services reflect negotiation tactics, complicated contractual arrangements, sharing of profits across different providers, and other factors that have little to do with the marginal cost of service. Individuals cannot purchase goods directly at a reasonable price, and this limits the incentives for cost control. The cross effects among all of these different arrangements are nearly impossible to understand, making the consequences of reform unpredictable.

Since most healthcare is paid through third parties, the prices of medical services reflect negotiation tactics, complicated contractual arrangement, sharing of profits across different providers, and other factors that have little to do with the marginal cost of service. Individuals cannot purchase goods directly at a reasonable price, and this limits the incentives for cost control.

 

Several important restrictions to the supply of healthcare raise prices and lower service. The most salient is the limited number of medical doctors. There are 2.5 practicing doctors in the U.S. per 1000 people. The average in the OECD is 3.2. American medical schools could train a substantially larger number of students without a significant reduction in quality.

Healthcare in The United States: Current Reforms

Not surprisingly, the problems of the U.S. healthcare system have led to major reform—the Patient Protection and Affordable Care Act (PPACA) of 2010. The PPACA is not totally without merit. It imposes an excise tax on high-cost health plans that compensates for some of the worst consequences of the tax deductions; it creates health exchanges that are supposed to increase competition; and it advances the idea that cost must be controlled and adverse selection in the insurance market reduced. However, the PPACA has failed at addressing important problems and will probably exacerbate many others, increasing the danger of a move to a single-payer, government-run healthcare system in the middle run.

While I will not try to analyze the shortcomings of the reform, I will note the following:

  1. The cost-control measures in the PPACA are insufficient, because the underlying problem of misaligned incentives has not changed.
  2. The phasing out of private insurance subsidies will generate effective marginal taxes as high as 80 percent for some families.
  3. Additional regulation will create the demand for additional regulation.
  4. The dependence of some healthcare regulation on the size of a firm’s workforce will create distortions in the size distribution of firms and in their growth.

Healthcare in the United States: Proposals

Given the problems with the PPACA, what can we do, if given control of the presidency and both houses of Congress, about healthcare system in the United States? Among the main proposals, I would highlight the following twelve ideas:

  1. The elimination of the tax-deductibility of health insurance and the move toward a system of individual portable insurance for unforeseeable contingencies plus health savings accounts (HSAs).
  2. The introduction of vouchers for the purchase of health insurance. The federal government would define a minimum health-insurance package that includes catastrophic coverage, high deductibles, transferability, and guaranteed renewal. Health-insurance companies would be certified to offer such a package at an actuarially fair price and at the national level. The federal government would offer a voucher to each individual to purchase such insurance.
  3. Enhancing the role of HSAs, which should be the normal way to pay for preventive and routine healthcare.
  4. The voucher system plus additional credits to top off the HSAs of lower-income households as a substitute for Medicaid and similar programs.
  5. More cost-control measures added to Medicare, including higher (means-tested) co-payments. Also, Medicare should move, when appropriate, toward result-based payment.
  6. The deregulation of insurance markets to increase competition and technology adoption.
  7. The enforcement of antitrust regulation for all participants in the market, while allowing for mergers of hospitals when economies of scale are at stake.
  8. Increasing the number of medical doctors.
  9. The modification of malpractice regulation to return to a system that ensures liability but prevents abuse.
  10. The acceleration of the adoption of new technologies that save costs, through a number of regulatory changes.
  11. The distribution of information among patients about healthcare options, treatments, and the quality of providers.
  12. A redesign of the support for basic research and development to maximize its impact in the long run.

This long list of proposals must be completed with a note of humility. Designing a better and fairer health system is a daunting challenge. When faced with this challenge, I cannot help but remember what F. A. Hayek wrote: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” Even though I am more sanguine than was Hayek about our prospects for reform, I know we may err and have to adjust our policies along the way. Or simply, as society and technology change, we may need to let institutions respond.

Economics tells us that we can do better. Distributive justice demands from us that we do better. A judicious combination of market forces, regulation, and transfers can provide us with more efficient healthcare for all, at a cheaper price.

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