A cure for the health care cost disease.

You may have heard that the U.S. is about to plummet off of a fiscal cliff. Policymakers may disagree about how to bring the nation's finances into balance, but one thing they don't disagree about are the forces pushing us towards the abyss: in a word, runaway health care spending.

As former Obama OMB and CBO director Peter Orszag quipped in 2010, "it is no exaggeration to say that the United States' standing in the world depends on its success in constraining this health care cost explosion; unless it does, the country will eventually face a severe fiscal crisis of crippling inability to invest in other areas."


What is true at the federal level is also true at the state level. State Medicaid expenditures account for almost a quarter of state budgets today, second only to education funding. Medicaid expenditures are also projected to rise faster than state revenues, increasingly crowding out funding for other critical state priorities. Addressing the shortfall may require sharp tax increases, painful budget cuts, or both.

You'll also get little opposition from either side of the aisle that America isn't getting the best value for our outsized health care spending, currently at 18% percent of GDP and rising. According to a 2011 article in JAMA, "in just 6 categories of waste, over treatment, failure of care coordination, failures of execution of care processes, administrative complexity, pricing failures, and fraud and abuse, the sum of the lowest available estimates exceeds 20% of total health care expenditures." The same report estimated annual loses from fraud and abuse in Medicare and Medicaid at up to $98 billion annually.

There are two basic arguments about how to tackle the problem of rising costs, and they split largely (but not entirely) on ideological lines.

One, approach, generally favored on the left (and largely embraced in the Affordable Care Act), is to attack the problem on the supply side by increasing government's role in setting prices and defining insurance packages, along with driving delivery system reforms. Supply side reforms include bundled payments for Medicare and Medicaid; Medicare's new Independent Payment Advisory Board (IPAB); price controls on reimbursements for health care goods and services (Medicare's DRG pricing system; ACA cuts to provider reimbursements); stringent rate reviews for insurance carriers; and even heavier-handed market controls like bans on physician-owned hospitals, and requiring state pre-approval for new health care related facilities through certificate of need laws.

The other approach, generally favored on the right, is to focus on improving the functioning of health care markets on the demand side. This means increasing consumers' "skin in the game" for routine health care costs through consumer-directed health plans (CDHPs) and Health Savings Accounts (HSAs); capping or eliminating the tax exclusion of employer-provided insurance and replacing it with a standard deduction or tax credit for health insurance; and shifting other public programs, like Medicare, towards a defined contribution approach where seniors would shop from a competing menu of health care plans with a defined level of public support. Proponents of more consumer involvement in health care also support efforts to improve transparency on provider prices and quality, so that consumers can seek out the most effective and efficient providers (or in the case of insurance, the most efficient networks).

Whatever you may think about the Affordable Care Act, our recent election guaranteed that it is going to be implemented, more or less. The choice before the country now is how that implementation will be structured, and how to make that implementation sustainable given the massive cost explosion that the ACA - whatever its other merits - has done little to address. As we've argued elsewhere, many of its key provisions will likely make the health care cost problem worse, because it heavily subsidizes consumption of traditional, first-dollar insurance for families making up to about $92,000 a year, or four times the Federal Poverty Level.

But implementation, and America's mounting fiscal woes, also provides an opportunity for genuine dialogue and compromise. We're beginning to detect a growing acknowledgement on the center-left that more consumer side reforms are needed and inevitable, particularly in the ACA and, on the right, that mitigating the ACA's worst flaws could turn out to be both good policy and good politics - especially for an electorate that is increasingly frustrated by Washington's inability to tackle America's most serious challenges.

That conversation should be helped by a thoughtful and balanced paper from Richard P. Nathan, a senior fellow at the Rockefeller Institute in New York. The paper, How to Rein in Health Care Costs: Empower Consumers, is a concise tour de force in health economics and public choice theory that makes the case for incorporating more consumer-driven insurance choices into both public and private insurance programs, including the ACA.

First, Nathan recognizes that we'll need "at least one more round" of health care reform to truly tackle the cost problem.

Taken together, Medicare and Medicaid account for 25 percent of federal spending; they are projected to account for one-third in 2021. Medicaid also accounts for a huge and growing share of state budgets, and in some states local budgets as well. Focusing on Medicare, Jonathan Gruber estimates that in order
"to put the program on a solid footing for the foreseeable future would require imposing a 15 percent payroll tax. Every person in America would have to pay 15 percent of their wages to the government, basically doubling the tax burden on American families. ...

An analysis by Eugene Steuerle of the Urban Institute shows the share that Medicare taxes and premiums cover "of the care provided to the average recipient ranges from 51 to 58 percent over time." Steuerle says "[for] the rest we borrow from China and elsewhere, and we use up ever-larger shares of income tax revenue, leaving ever-smaller shares for the government functions. Bottom line: without reform, current workers would continue to shunt many of their Medicare costs onto younger generations."

Nathan is right on the mark. And to paraphrase Stein's law, if something can't keep going on forever, it won't.

While broadly supportive of the ACA, Nathan is skeptical that supply side reforms can adequately grapple with the endemic cost problems in American health care:

Provider-value social engineering shouldn't be the main line strategy for dealing with the fiscal imperative of fast-rising health care costs. Politicians are good at giving social benefits but not so good at taking them away. Likewise, leaders in government public health care programs tend to come to their jobs with a concern about and belief in the programs they are responsible for. Government
does not have the necessary penetration -- nor the leverage commitment, or clout needed-- to reform the huge health care industry.

This is a variation on Mancur Olson's famous theory of collective action. In a nutshell, it's very hard for large groups of individuals to organize for broad social aims - even when that organization would produce large gains for society. On the other hand, small, highly motivated special interest groups have powerful incentives to organize and lobby government for wealth transfers. In the case of health care, this means that providers (hospitals, nursing homes, physicians, home health care workers, etc.), consumer groups (like the AARP), and public sector unions (like the SEIU) are well positioned to push for increases in health care spending, with politicians reaping the rewards from campaign contributions and energized voting blocks.

Although Democrats are more associated with the welfare state, both parties have facilitated the expansion of public funding for the medical-industrial complex from a mechanism to help the poor and disabled to get access to care, to an entitlement program for the middle class and older (and more affluent) consumers. Republicans, after all, created the Part D Medicare drug benefit, and Republican governors, like George Pataki, in New York, have worked hard to leverage federal dollars to support local state Medicaid providers.

Unsurpringly, when it comes to meaningful reforms of Medicare and Mediciad, the track record of the federal government has been mostly disappointing. (And when it comes to weeding out fraud and abuse in those programs, the record is downright disgraceful.)

While supply side reforms are necessary, Nathan believes, "in the long run creating and managing competition in the health care marketplace is the better approach for achieving health care cost control by mobilizing price-consciousness in a way that at the same time protects consumers from having to pay the high costs of catastrophic care."

Baumol's Disease

Nathan illustrates the tremendous challenges facing even the best intentioned and determined supply side reformers by discussing Baumol's Disease - i.e., the problem of rising salaries and costs in industries that are labor intensive but in which there is little productivity growth, like health care. He recounts a story of how then Senator Daniel Patrick Moynihan tried (unsuccessfully) to convince Hillary Clinton and her aides working on health care reform in 1993 to take the problem of cost escalation in public health care programs seriously. Moynihan later told reporters working on a book recounting the collapse of the Clinton plan that:

Here I have it, sir, handing over charts and statistical analyses. Data. Documents for you. Medicaid doubled in eight years of the Reagan administration, then doubled again in four years of the Bush administration...Assuming geometric progression, sir, what day is the day on which we reach the point when Medicaid doubles in one day?"

Supply side health care reforms, in the long run, inevitably wreck themselves on the twin rocks of interest group politics (because powerful interest groups are always pressing for program expansion) and large informational asymmetries (because regulators and policymakers are critically dependent on pricing information supplied by the very industries that they are trying to regulate into efficiency). Nathan sums up the problem beautifully:

Within the health industry, temptations for game playing sometimes defy imagination, and very probably exceed the capability of government agencies to provide full and in-depth oversight and enforcement. Up-coding of services, ordering more tests (some of them in self-owned facilities), excessive consulting, and overly frequent appointments-- all add to the argument against government social engineering as the major strategy for cost constraint.

The Cure

Consumer driven health care plans cut the Gordian knot of Baumol's disease by sharply reducing the ability of policymakers and lobbyists to direct allocations of health care resources. (Indeed, David Kessler makes the case for Medicare reform precisely on these lines in a recent National Affairs article.)

In CDHPs, consumers shop for the types of care they are willing to pay for out of pocket or with savings from HSAs. Providers must adapt and become more efficient, or go out of business. Insurers continue to provide coverage against catastrophic expenses, which is really what you want - but because insurers would prefer that you not become catastrophically ill, they also focus more on prevention and chronic disease management, and on triaging the relatively small number of very complex cases to the most efficient providers. CDHP's thus have the capacity to promote both supply and demand side reforms.

Nathan buttresses his arguments about the utility of consumer driven care by noting how many private sector companies have shifted to CDHPs, and how government programs - like Medicare Advantage (also called Part C), the Federal Employees Health Benefit Program (FEHBP) and Medicare Part D already operate in a consumer-directed fashion, in a managed but otherwise fairly competitive marketplace.

The ACA contains elements of these arrangements, particularly through their state insurance exchanges, but nascent ACA regulations are unduly hostile to CDHPs, and are already undermining their ability to compete on state exchanges.

Still, surveying the scale of current public and private experiments in managed, but consumer-directed competition, Nathan is cautiously optimistic:

The marketplace is doing its job. Insurance companies are making changes in their policies and practices to win market share. Governments are doing similar things to manage competition as a way to rein in their spending on employee benefits.

To repeat (even though it should be evident), one can view these kinds of developments in varied ways. Program advocates can be expected to be unhappy. On the other hand, faced with growing concern about public debt and deficits other observers can view health policy changes like those discussed in this paper as unavoidable, but necessary.

A Word of Caution

Nathan offers a number of recommendations for encouraging the uptake of consumer driven insurance policies, both through the reform of the employer provided insurance market, Medicare, and Medicaid, and the ACA. They are all worth considering.

The caveat I would offer is that it is vitally important to encourage the widest possible competition among insurers and competing health care networks available to consumers. Not only HSAs offered by traditional insurers, but concierge style health plans offered by physicians' groups, tiered network plans, Accountable Care Organizations, and any other innovative insurance designs that meet minimum actuarial values should be available to consumers.

Having one market - at either the federal or the state level - will likely reduce the rapid competition and experimentation that is needed in consumer driven insurance markets. It is probably better to arbitrage competition between both state exchanges and a federal option to prevent providers or interest groups from capturing either.

The productivity revolution driven by Moore's Law in other areas of the economy is rapidly enabling computers to help doctors make faster and more accurate diagnostic decisions - and should eventually enable primary care physicians and even nurses to take over duties once relegated to expensive specialists. Other technologies like gene therapy offer the prospect of sharply reducing the labor and cost involved in treating even complex diseases like cancer. Accelerating the substitution of labor for technology can and surely will be enhanced by increasing consumer's role in health care markets.

Moving Forward

A first step in increasing the availability of CDHPs would be revising the ACA's insurance market regulations that effectively penalize CDHPs. Next, policymakers should target federal subsidies at lower-cost consumer directed plans in both exchanges and in the employer market (ideally, this would be achieved by harmonizing the tax exclusion for employer-provided insurance with exchange subsidies through a universal tax credit or deduction).

Reform of public programs should folllow. For Medicaid, every state could be offered a capped allotment along the lines of the successful Rhode Island experiment, encouraging states to incorporate more patient incentives and consumer directed plans for the vast majority of relatively healthy Medicaid enrollees, as suggested in a recent paper by my colleague Russell Sykes.

Medicare reform similarly can begin creating a level playing field for competition between insurers and Medicare fee-for-service, an idea that has supporters on both sides of the aisle.

The argument against these reforms, as Nathan recognizes, is not that they wouldn't work. They certainly would - along the way reducing employment and resources flowing to the health care sector, or at least the inefficient parts of it. Expect providers and affected interested groups to howl in protest.

Of course, those resources could flow back to the private economy, or could be used to leverage critical public sector infrastructure investments in other sectors - creating new constiuencies for more consumer directed reforms.

Nathan's paper gently reminds policymakers that the health care system is addicted to taxpayer spending and policy micromanaging in ways that make American health care far less efficient and far more expensive.

Encouraging the widespread uptake of consumer directed health plans is one way of curing Baumol's disease that would allow both the left and the right to get what they want - for the left, universal coverage, for the right, more consumer-directed health care. And for everyone else, lower costs and greater value for their health care dollars.

Is there a constituency for this win-win-win scenario? We shall see.

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