Don't Gut Part D

In an issue brief for the left-leaning Centre for Economic and Policy Research, economist Dean Baker resurrects the idea that Medicare should "negotiate" (read set) prices for drugs. After all, if other federal health insurance programs require mandatory "rebates" for prescription drugs - the Veterans Administration and Medicaid, for instance - why shouldn't Medicare?

Baker's analysis largely focuses on cross-country comparisons with several countries that set prices for prescription drugs - Canada, Denmark, Japan, the Netherlands, and the UK - all of whom spend significantly less per-capita on prescription drugs than the U.S. He concludes that that through "negotiation" with drug companies (cleverly, he never uses the less palatable "price controls") we could save anywhere between $309 and $726 billion over 10-years - savings which would accrue to the federal government, states, and to individuals.

To his credit, Baker at least tries to rebut the pharmaceutical industry's argument that price controls would stifle innovation. According to Baker, strong patent protections (which give companies monopoly pricing power over their products) lead to a more corrupt drug industry, which in turn leads to dangerous drugs being approved (like the recent Vioxx scandal). He offers a proposal by Nobel Laureate Joseph Stiglitz as an alternative - that clinical testing of drugs should be financed entirely by the government, which he thinks would nullify the pharmaceutical industry's argument that patents are required to recoup the high costs and enormous risks required to bring new medicines to market.

(This is a bad idea layered on top of another bad idea. A bad idea sandwich. This would put the government in the position of both paying for new medicines and funding the clinical trials to test them, creating a massive conflict of interest, since approving fewer new medicines would also lower government expenditures. And the process of choosing which medicines to take through clinical trials - ED drugs, HIV, cancer, diabetes - would become hopelessly politicized by Congress.)

Still, Baker's love of price controls is clearly popular with the White House. The president voiced support in his SOTU address for health care cuts similar to Simpson-Bowles (which also included Medicare Part D price controls), and claimed that paying drug companies market prices through Medicare Part D is tantamount to a subsidy.

For what it's worth, Baker's paper is correct (or at least strictly tautological) in its assessment: if the United States were Canada, or Denmark, or Japan, we would pay for drugs like Canada, Denmark, or Japan - and probably pay lower prices. But that's not the case.

The U.S. is different in more than just how we structure our health care system. The U.S. is different in its demographics, per-capita income, social attitudes, and income distribution. All of these are areas where the U.S. varies tremendously with its OECD competitors, and these are salient factors when it comes to evaluating at U.S. health spending.

With that in mind, it is worthwhile to address some of the faults in Baker's assessment.

Comparison of Per-Capita Spending

To compare other countries' spending with that of the United States', Baker looks at PPP (purchasing power parity) adjusted per-capita spending levels on prescription drugs. Certainly, this offers an interesting comparison of prescription drug spending across countries while holding constant purchasing power (essentially what one American dollar buys elsewhere - hint: it buys less health care but more of other goods). But this ignores potential differences elsewhere in the health system - for instance, it may be that higher prescription drug spending reduces spending in other categories (as the CBO has seemingly, though not explicitly, taken into account in their modeling efforts).

For instance, it turns out that the U.S. tends to spend significantly less than Denmark, Canada, or the Netherlands (Baker's OECD sample choice) on long-term care services for the elderly.


Source: OECD StatExtracts 2010;
Note: latest data for Japan was 2009; UK Data was unavailable

Does this necessarily mean that these other countries should work to reduce their spending on long-term care? Not really. Demographic needs and provision of healthcare should (and do) reflect country specific policy and political choices - not rote conformity with economic peers. One size really doesn't fit all.

But this argument probably won't assuage those concerned about pharmaceutical price-gouging - so let's look at the issue from a different perspective. We already know that the U.S. spends more on healthcare as a percent of GDP and per-capita than any other OECD country. But what about the share of total health spending represented by prescription drugs?


Source: OECD StatExtracts 2010;
Note: latest data for Japan was 2009; Netherlands & UK data on drug spending was unavailable

Here, America's spending on prescription drugs as a share of total health spending is lower than both Canada's (by 40%) and Japan's (by 80%). It's also about two-thirds higher than Denmark's. Again, per-capita costs only provide a crude comparison for health system comparison that doesn't take into account total spending, and the share of prescription drug costs as a burden on the health system as a whole. We might spend more on prescription drugs, but it's also far from the real sources or drivers of U.S. spending considered as a whole - well worth taking into account if you're really concerned about the drivers of U.S. health care spending (as opposed to just singling out a politically convenient industry).

The last aspect of these cross-country comparisons that Baker fails to address is the makeup of prescription drug spending. Who ultimately pays for the drugs? (Baker takes this into account when projecting U.S. savings, but assumes that the makeup would remain the same - probably an unrealistic assumption).


Source: OECD StatExtracts 2010;
Note: latest data for Japan was 2009; Netherlands and UK data on drug spending was unavailable;
U.S. data from CMS's National Health Expenditure Tables;
Japan's data does not sum to 100% due to rounding

In fact, when looking at who ultimately pays for prescription drugs, the relative share of spending varies significantly by payer. Likely, to imitate a country like Denmark, the U.S. government's share of spending on drugs would have to almost totally displace private insurance for prescription drugs. (President Obama or Baker might like this, but it's obviously a non-starter in Congress or for the American people.)

Without this shift, lowering prices for Medicare would just lead to a cost shift from public to private payers as drug makers tried to maintain their margins. In other words, employers and patients outside of Medicare would have to pay more, so that the government could pay less. There is no such thing as a free lunch, and so Baker's plan would be to leave someone else to pick up the check.    

Savings are Likely Exaggerated

Baker at least concedes that inflicting massive price cuts on drugs would hurt pharmaceutical innovation, and acknowledges that something would have to be done to offset the impact of the lost industry revenue. Implementing Joseph Stiglitz's proposal (aside from the bad features we mentioned earlier) would cost quite a bit of money and as such, that cost - at least tens of billions of dollars annually - should be deducted from any potential savings.

More on this point: A working paper by health economist Austin Frakt looks at potential savings from restricting Medicare's drug formulary to that of the Veteran's Administration (which is about 40 percent less generous, according to the authors). The results did find savings of about $14 billion if accounting for all Part D enrollees. But there is a significant loss of "consumer surplus" (the difference between what a person is willing to pay and what they do pay) to Medicare enrollees from reduced drug access - and because the authors assume that all drugs are valued equally between VA patients and Medicare beneficiaries (an important simplification), and the net savings are relatively small compared to the gross, these estimates are highly sensitive. In any case, Frakt et al's estimates are significantly less than those that Baker arrives at even over a decade. Certainly, the proposals are different - Frakt offers an operationally feasible proposal which would likely be a more realistic implementation of Baker's.

Finally, it is useful to look at the effects of price controls and restricted formularies on innovation (something that Frakt's paper doesn't explicitly address since it is cross-sectional in nature). In a 2005 report for the Manhattan Institute's Center for Medical Progress, Frank Lichtenberg, a Columbia University Economist, noted that after the VA tightened their drug formulary, VA patients' life expectancy may have declined because of reduced access to newer drugs for VA patients.

All in all, Baker's conclusion - that European-level price controls are compatible with saving money and sustaining innovation - is wildly optimistic.

Concluding Thoughts

Price controls have been shown to stifle innovation, and shifting to a European-based system would require numerous other changes to our health care system, and indeed, our economy as a whole, that would be innovation dampening.

Broadly speaking, European price controls are sustainable (at least in the short term) because the U.S. still allows something close to market pricing. As in the case of global defense spending, Europe can afford to pay much, much less, because the U.S. spends more - proving a global security umbrella.

 If the U.S. were to sharply reduce spending on prescription drugs, Europeans would have to pay much more, or global pharmaceutical innovation would decline sharply. If nothing else, access to new drugs would suffer tremendously as a 2011 essay in the Annals of Health Law notes:

The U.S. pharmaceutical industry has historically been characterized as the market-driven pharmaceutical system of the world...companies in the U.K. have endured profit controls...[this] has led to vast differences in the advancement of pharmaceutical innovation and to significant disparities in patient access to medicines.

Baker indulges in a favorite habit of the left - assuming that free lunches really are possible. In every other sector where governments have imposed price controls (food, housing, automobiles), supply, quality, and innovation dwindle sharply.

Pharmaceuticals may be an exception for the moment, because capital can still flow to jurisdictions (like the U.S.) where market-friendly rules still apply. Ironically, European price controls may benefit the U.S. by making America a destination for risk capital, and pharmaceutical R&D investment - along with the millions of jobs and the health benefits that come with enhanced innovation. Americans undoubtedly do pay more for drugs because Europeans pay less (economists call this third degree price discrimination) but the solution is to ask them to contribute more to global medical innovation, especially through bilateral trade agreements. The Europeans can free ride to some extent, but global medical innovation is lower than it would be if they were paying prices commensurate with their wealth level - and these losses are felt just as acutely by European patients suffering from Alzheimer's, cancer and other diseases.

America does need to rein in health care spending. The best idea in this regard may come from the bipartisan Simpson-Bowles Commission, which suggested capping federal health care spending growth at GDP +1%. (It also recommended Medicaid-level drug rebates for Medicare, but no plan is perfect). This would have the benefit of forcing providers and patients to shift towards the best mix of products and services. This might entail more use of pharmaceuticals, and thus more, not less drug spending but would also be welfare enhancing. Obamacare actually attempts something like this through its ACO model, and its selective productivity cuts to some Medicare providers. The problem is that policymakers insist on keeping their hands on the till, shifting the market to and fro based on the political winds of the moment.

It's a recipe for shipwreck, albeit a time honored one on the left. We can only hope that Washington has the foresight to recognize Baker's idea for what it is - a gross oversimplification that will only produce unwanted consequences. 

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