The Economics of Health Care

Expenditures on Health Care

U.S. expenditures on health care have significantly increased from 5.2% of GDP in 1960 to 17.5% in 2014.
Medicare and Medicaid were established in the mid-1960s.
Medicare primarily covers hospitalization costs for the elderly.
Medicaid covers healthcare costs for individuals with low incomes.
Spending on both Medicare and Medicaid has increased substantially.
Medicare expenditures in 2014 were 13 times the expenditures in 1970, even after adjusting for inflation.
Real Medicaid spending in 2014 was 15 times its 1970 level.

Growth of Expenditures on Health Care (1960-2014)

Health-care expenditures have grown to become a larger share of the U.S. economy since 1960.
Health-Care Expenditures as a % of GDP (including both private and government):
- 1960: 5.0%
- 1970: 6.9%
- 1980: 8.9%
- 1990: 12.1%
- 2000: 17.3%
- 2010: 17.3%
- 2014: 17.5%

Real Expenditures on Medicare and Medicaid (1966-2014)

Real expenditures on both Medicare and Medicaid have increased significantly over the past several decades.

Socialized Health Care

In many countries, healthcare is socialized.
Hospitals and medical clinics are government-run and financed through taxes.
Doctors, nurses, and other medical personnel are government employees.
No country can afford unlimited free health care for all.
When price is not a primary factor, non-price factors like waiting lists and absence of expensive treatments emerge.
Wealthy patients in socialized medicine countries often seek treatment in other countries.

Structure of Health Care in the U.S.

Both private and government entities play important roles in the U.S. healthcare industry.
Physician services are typically provided privately.
Hospitals are often operated by local governments.
In 2014, 87.2% of U.S. healthcare spending was paid by a third party, either taxpayers or private insurance companies.
Medicare and Medicaid cover most of the healthcare costs for the elderly and those with low incomes.
Health insurance is highly important for the non-elderly population.
About two-thirds of the non-elderly population have health insurance through their employer.
The U.S. tax system favors health insurance purchased through employers because healthcare benefits are not considered income.
This system discriminates against direct payment of medical expenses and the out-of-pocket purchase of medical insurance.
This encourages employees to demand low-deductible, small co-payment health insurance policies, and discourages direct payment of medical bills and the purchase of high-deductible insurance plans.

Third-Party Payments and Health-Care Inflation

The tax system, Medicare, and Medicaid have all contributed to the growth of third-party payments.
In 2014, third-party payments accounted for 87.2% of medical-care purchases, up from 44.8% in 1960.
Out-of-pocket spending by consumers accounted for only 12.8% of health-care spending in 2014, down from 55.2% in 1960.

Out-of-Pocket vs. 3rd-Party Payments for Medical Care, 1960 and 2014

The share of medical expenses covered by a third party (insurance or government) and paid directly by the consumer for 1960 and 2014:
- 1960:
  - Out of pocket: 55.2%
  - Private health insurance: 22.7%
  - Public: 22.1%
- 2014:
  - Out of pocket: 12.8%
  - Private health insurance: 39.3%
  - Public: 47.9%

Subsidies, Third-Party Payments, and Health-Care Inflation

Economic theory suggests that the growth of subsidies to healthcare consumers and expansion in third-party payments will drive up the prices and expenditures of medical services.
Growth of subsidies, such as Medicare and Medicaid, will increase the demand for medical care.
Stronger demand will lead to higher prices, especially if supply is inelastic.
Growth of third-party payments reduces the incentive for both consumers and producers to economize.
Consumers have less incentive to economize because someone else is paying the bill.
Producers have less incentive to economize because consumers are insensitive to the prices charged.

Ratio of Health-Care Price Indexes to the Consumer Price Index (CPI), 1960-2015

Since 1960, the prices of medical services have risen more than twice as rapidly as the general price level, indicated by the Ratio of Health-Care Price Index to CPI.
Both subsidies and third-party payments have pushed healthcare prices upward.
Rising healthcare prices and expenditures are expected due to policies and the changing incentive structure over the past five decades.

The Growth of the Elderly Population and Health Care

As the baby boom generation ages, the elderly population of the U.S. will grow rapidly after 2015.
The growth of the elderly population between 2015 and 2035 will increase both subsidy levels and third-party payments, driving health-care prices and expenditures upward.
The U.S. population over 70 years old will increase significantly in the coming decades, making it difficult to control healthcare prices and spending.
Number of Americans Age 70 and Over (millions):
- 2000: 25.6
- 2010: 28.0
- 2020: 38.2
- 2030: 53.7
- 2040: 63.6

Reasons for Poor Performance of the Health Care Industry

Government programs promote third-party payment systems, eroding the incentive to economize.
Tax advantages for purchasing health insurance through employers undermine competition and increase costs for individuals to purchase suitable health plans.
State regulations increase costs by requiring insurers to cover numerous items.
Federal regulations reduce competition by preventing consumers from purchasing health insurance plans offered in other states.

Major Provisions of Affordable Care Act (ACA)

Individuals are required to purchase approved health insurance policies, with tax penalties for non-compliance.
In 2016, the tax penalty was 695, and up to three times this amount for families.
Employers with 50 or more employees must provide approved health insurance or pay a 2,000 annual fine per full-time equivalent employee.
This mandate does not apply to part-time employees (working less than 30 hours per week).
The act establishes health-care exchanges operated by state or federal governments, providing subsidies for health insurance purchases for those with incomes up to 400% of the poverty level.
Individuals with incomes of 133% of the poverty level will be covered by Medicaid.
The subsidy decreases by approximately 25% of additional earnings as income increases from 134% to 400% of the poverty level.
Insurers must cover children of policyholders up to age 26 and are prohibited from charging higher rates or rejecting individuals due to pre-existing health conditions.

Major Implications of the Affordable Care Act

The act is complex and may have unpredictable secondary effects; however, some effects are predictable:
- Part-time work will increase, as employers avoid the 2,000 penalty by not providing health insurance to employees working less than 30 hours per week.
- Many employers with a high proportion of middle- and low-income employees will drop their health insurance because subsidized exchange plans are more attractive to individuals with incomes less than 250% of the poverty level. This will increase the number of individuals receiving subsidies and drive up future costs.
The effective marginal tax rate for those making between 134% and 400% of the poverty level often increases to 50% or more when payroll and income taxes are combined with the phase-out of health insurance subsidies.
This reduces the incentive to develop skills and advance up the income ladder.
Growth will slow, income mobility will decline, and the size of the underground economy will increase.

Impact of Affordable Care Act (ACA) on Health-Care Costs

The third-party payment system increases healthcare prices; the ACA is expected to increase this share.
Mandating more comprehensive plans will increase the demand for health-care services and the cost of health insurance.
Increased administrative requirements of the ACA have caused some doctors to retire early, reducing the supply of health care services.
There is little reason to expect that the ACA will decrease either the price or cost of health-care services.

Health-Care Reform

There is pressure to modify and reform the ACA.
Economic analysis indicates the following reforms would improve performance and control the growth of health-care spending:
- Equalize the tax treatment of out-of-pocket medical expenses and the direct purchase of health insurance with that of health insurance purchased through the employer.
- Allow residents of each state to purchase health care from out-of-state providers.
- Encourage health savings accounts (HSAs) and direct payment of medical bills from such accounts.
- Encourage the purchase of catastrophic health insurance and discourage the purchase of policies with first-dollar coverage and small co-payments.
- Place more emphasis on the supply side of the health-care market.
These proposals may not solve all problems but are a major move in the right direction.

Questions for Thought

Why have the prices of medical services risen so much more than other prices during the last several decades?
Does it make any difference whether medical services are paid for directly by consumers or by a third party such as the government or an insurance company? Why or why not?
Low deductible health insurance coverage encourages health-care consumers to search for the best prices for medical services.
- Is this statement true or false?
If consumers do not have much incentive to shop for value per dollar of expenditures on medical services, producers will not have much incentive to keep prices low.
- Is this statement true or false?
Currently, health insurance purchased through an employer is tax deductible (it is not counted as taxable income), while the direct purchase of health insurance and payment of medical expenses are generally not. Do you think this is sound policy? Why or why not?
When an employer provides health insurance benefits as part of the compensation package, does this represent a gift by employers to their employees? Why or why not?