Give Consumers Control to Keep Costs Down

As policymakers in Washington deliberate over the next fiscal cliff, it would be irresponsible to ignore the need to rein in federal healthcare spending, which as of 2011 has hit $744 billion, or $2,392 per-capita; roughly 28 percent of total national healthcare spending. The remainder of the $2.7 trillion in health spending is made up of state and local spending (which itself depends to a large degree on federal spending) -- $470 billion (17.4 percent of the total) - and private spending -- $1.4 trillion (about 55 percent of the total). Altogether, government spending is just under half of total national health spending.

While the U.S. certainly gets good value for our spending by some measures, much of the growth in spending can be tied to the lack of a true market for healthcare, meaning few or weak price signals to the consumers of medical goods and services (a 2001 essay by Milton Friedman elaborates at some length on this topic).

The discussion on U.S. healthcare spending, unfortunately, often starts and ends with two charts:

oecd_nhe.png Thumbnail image for oecd_nhe_gdp.png

In the first chart, we see that the United States leads the OECD in per-capita health spending; in and of itself this doesn't tell you much. The U.S. is undoubtedly an outlier in many categories that measure domestic consumption. However, the second chart takes into account GDP per-capita (per person) as well, clearly showing the United States as an outlier.

This is a bit more concerning. Why does the U.S. spend so much more, and what does it get (if anything) for its spending.

According to the New York Times editorial board, we don't get anything of value for our added spending.

The contention then turns to the idea that a single-payer, or universal healthcare system is the route that the U.S. needs to take to control health care costs without much consideration for some of the actual reasons for the U.S.'s high levels of spending.

Scratch just a millimeter or two beneath the surface, and there are two factors that can account for more than half of the variation in OECD countries' per-capita health spending over the past decade: differences in per-capita GDP as well as out-of-pocket spending as a share of total national health spending.

Per-Capita GDP

That GDP is strongly correlated with health spending is a given - the chart presented earlier illustrates the highly correlated relationship between levels of GDP per-capita and health spending per-capita. In brief, richer countries spend more on health care. No surprise there. No one would seriously say that a poor country (like Rwanda) has a better health care system than France, just because it spends less on health care.

 While the U.S. may be an outlier in terms of OECD health care spending, it isn't completely removed from a possible trend, particularly if we drop the assumption that it would be a perfectly linear relationship (after all, differences in demographics often do not follow a linear trend).

However, even if we keep the rather rigid assumption of linearity, growth in per-capita GDP explains a significant amount of the growth in U.S. per-capita health spending.


Source: OECD StatExtracts Database

The chart above shows the tightly correlated relationship between GDP per-capita and health spending per-capita within the United States over the past 10 years, with the only real exception due to the recession. In fact, the above correlation explains over 90 percent of the change in per-capita health spending over the past decade. Of course, the above shouldn't be taken to imply causation (for a number of reasons, but largely because incomes can rise in response to inflation, as can medical costs, which in turn impact healthcare spending - put simply, there may be an endogenous relationship between the two variables), but does indicate (as the latest national health expenditure numbers do) that the rate of growth of healthcare spending may not be as out of control as it seems.

Out of Pocket Payments

While per-capita GDP may be strongly correlated with per-capita health spending, the explanation isn't entirely satisfactory. The fact is that in cross-national comparisons the United States is still an outlier - and while per-capita GDP may explain some 90 percent of the change within the United States, it explains a little less than half of the variation between OECD countries, over time.

The rather rich data available from the OECD, however, offers another interesting variable to investigate - Out of Pocket Payments (OOP) as a percent of total health spending. It should be noted that OOP refers to spending on actual healthcare goods and services (including deductibles and copayments), and does not include premiums to insurance companies (since those premiums are later used to pay claims). Theory tells us that consumer behavior tracks price sensitivity. If you have to pay more out of pocket for something, all other things being equal you'll buy less of it than if a third party pays a part of the cost.  In other words, people who have to cover more of their own bills, become more cost-conscious. Think of it as the open bar theory: If someone else is paying for your drinks, you don't buy Budweiser you buy Johnnie Walker Black.

The same holds for health care consumption. In fact, 10 years of data tells us that countries that have been more successful in controlling their health spending are indeed those with higher levels of OOP.


Although the trend may not be quite as clean (owing partly to the fact that these observations are over 10 years) OOP has an undeniably strong correlation with per-capita health spending.  

And in this metric the U.S. stands out rather ingloriously with one of the lowest levels of OOP in the OECD, coming in at 11 percent for 2011 and projected to fall even further as the ACA is implemented.

Now there may be (and probably are) diminishing returns from high levels of OOP, as an overly heavy financial burden incentivizes people to forgo cost-effective care. However, a well implemented system that creates a cost-conscious consumer (such as the health care system of Switzerland, which has an OOP of about 25 percent), can hold down costs without the need for onerous price controls that stifle innovation.

Back to the Fiscal Cliff

Proponents of single-payer health care ignore the fact that there is really no such thing as "free" health care. There's no magic pixie dust that makes health care more efficient when the government pays for it versus private employers. If the price to consumers is zero they will still drive up health care spending compared to other goods and services. And if the underlying costs of medical goods and services is increasing, so too will the price paid by consumers.  What governments can do is set uniform public health care budgets (including through the use of price controls) and - wait for it - increase OOP for consumers.

So what does this mean for fiscal cliff discussions?

The President has seemingly declared government health care spending off-limits. Instead, he wants to balance the budget through revenue increases. But if you're concerned about health care spending (and back in 2009, when he was fighting to pass Obamacare, the president said it was his highest priority) shifting more revenue to health care spending is the exact opposite of what you want to do.

If you really want to slow health care spending, you have to find ways to drive efficiency across the system, and this has to start with consumers. Medicare Part D, for instance, contains means-tested premiums that have helped drive consumers to generics and control costs. HSAs have been among the few insurance plan designs to hold costs down, without hurting quality (at least that we can see).

Other reforms could pare down subsidies in the ACA to 300 percent of FPL to make them a more realistic means test; better tax incentives could be implemented to encourage greater adoption of high-deductible health plans; private health insurance exchanges could be allowed to compete with the ACA exchanges (by allowing ACA subsidy dollars to be spent on those exchanges). Many options exist for putting more control of spending in the hands of consumers - and a system of appropriate means-testing can ensure that vulnerable populations like the low-income and the disabled are protected.

This isn't going anywhere with the White House, which continues to insist that 30% of all U.S. health care spending is wasted, but that health care entitlements can't be cut. And that we need more revenue to pay for them. 

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