January 2006

Fixing the Health Care System

America’s health care system leads the world in producing medical breakthroughs, yet it is error-prone, expensive, and inefficient. On January 20, AEI convened a panel of three experts to discuss how our $2 trillion health care system can be fixed without destroying its strengths. The panelists looked at how shifts in the tax code affect the uninsured, how Medicare policy determines the quality of private medicine, and how national and state insurance laws keep many from buying health coverage, among other major issues. AEI’s R. Glenn Hubbard specifically examined policies proposed in his new book, Healthy, Wealthy, and Wise: Five Steps to a Better Health Care System (AEI Press, November 2005; coauthored with John F. Cogan and Daniel P. Kessler) that could save Americans $60 billion a year and provide insurance to as many as 20 million more people.

John Breaux
Advisory Panel on Federal Tax Reform

Connie Mack and I addressed the problems of America’s tax code as chair and co-chair, respectively, of the President’s Advisory Panel on Federal Tax Reform. The panel attempted to solve a revenue problem posed by the ability of companies to deduct without limit contributions to their employees’ health plans.

Health care is the largest single tax expenditure in the tax code. In 2002 the public spent $1.5 trillion, or $5,400 per person, on health care; moreover, there have been increases each subsequent year. The tax benefits associated with health care will cost approximately $141 billion or 12 percent of all federal income tax revenue in 2006.

There are several different types of tax benefits offered to employees with health care expenditures. First is compensation in the form of employer contributed premiums. These contributions are excluded from the employee’s taxable income. Secondly, employee-paid premiums are shielded from income and payroll taxes through cafeteria plans, which allow employees to put pre-tax money into benefits of their choosing. Thirdly, many employers now offer flexible spending accounts that are funded by untaxed dollars and can be used to pay for uninsured medical costs. Fourth, medical expenditures above a certain level can be excluded from taxable income as itemized deductions. Finally, the introduction of the health savings account (HSA) has given taxpayers another way to use pre-tax dollars to pay for medical expenses.

Most tax benefits related to health care help higher-income households more than lower-income households. Higher-income people are also more likely to have health insurance. Families that earn over $100,000 annually receive 27 percent of the tax benefits for health spending. This tax benefit is a problem because it favors only part of our population and gives people an incentive to spend more money on health expenditures than in the absence of such tax treatment.

Limiting the value of the tax exclusion addresses both fiscal and policy problems. The cap would increase revenue for the federal government and get people to understand how much medical care costs. Employers would continue to be able to deduct health expenditures for their employees. The panel suggests a limit on the amount an employee would receive tax-free to $11,500 for families and $5,000 for individuals. These dollar figures represent the national average spent on health care per person and the projected amount spent on health insurance in 2006.

Connecting people with the cost of insurance and medical costs will cause people to choose more self-managed plans, to enlist more competitive providers, and to utilize more preventative care. The problems of America’s health care system are not going to be fixed by spending more money. Rather the solutions lie in upgrading delivery systems, augmenting the involvement of recipients, and increasing the use of health information.

R. Glenn Hubbard
AEI and Columbia University

Though I am not a health economist --and neither are my coauthors--we decided to focus on health care as the primary domestic policy subject for two main reasons. The first is the enormous public anxiety attributable to health care. The concern is not only about the number of uninsured; rather, people are also worried about the rising costs and future affordability of care and insurance. We can deal with that anxiety either by using more market-related solutions or by expanding current government programs in health care. These two routes will be the heart of the discussion over the next few years.

The second reason is that health is the largest budget issue facing the country. The long-term problems are in the entitlement programs, and though Social Security is indeed a fiscal issue, Medicare and Medicaid are the primary targets for reform. Without addressing health markets, it is difficult to make effective structural adjustments to these entitlement programs.

Our book is not pro-government spending or anti-government spending. Though we champion patient-centered medicine and market reforms, we also talk about some government expansions in health care. We do not claim to have a silver bullet to solve all of America’s health care woes. Our proposal is intended to be a packaged, unified prescription.

We talk about the good, the bad, and the ugly aspects of America’s health care system. The good is innovation. While creating a package of reforms, we do not want to diminish the incentives for health care innovation. The bad is the enormous waste in the American system. The misuse, underuse, and overuse of therapies and treatments have been identified by the Institute of Medicine (IOM). We know from studies of Medicare that large variations in regional spending are not matched by variation in outcomes--a situation suggesting significant waste. The ugly encompasses both the rising rates of uninsurance as well as the exorbitant costs of health care. Though both Social Security and Medicare face budget problems with an increasingly aging society, rising relative prices of health care further disrupt Medicare’s ability to be fiscally sound.

Many in Washington focus on the cost of health care as the issue to be addressed. As economists, we prefer to focus on the value of the care we are receiving. Because the right signals for value from the other five-sixths of the economy come from private markets, we focus on the same mechanisms in the health care market. Both sides of the political spectrum argue that health care markets do not work due to a variety of information problems; however, asymmetrical information and incentive problems exist throughout the private economy.
 
What is impeding the ability of private markets to generate the value signals depended upon by the rest of the economy? There are a set of public policies which have consequences, intended or not, that significantly distort markets, raise costs and spending, and reduce coverage.

The first such policy is the tax preference for health care. More than merely a subsidy for health care in general, the code is a subsidy for a particular mechanism--employer-provided insurance. This subsidy has led to the flourishing of a market better described as prepaid health care than what economists traditionally name as insurance--coverage for unexpected and unaffordable costs.
 
The simplest way to fix the tax code is to repeal the employer exclusion, which is politically unpalatable. Our solution is to offer a uniform tax subsidy, conditional on having at least catastrophic insurance, regardless of whether one’s employer pays for health care, one buys it in another market, or one pays out of pocket. Our plan increases affordability and patient control.
 
Poorer individuals would receive a refundable tax credit. The chronically ill would receive a government subsidy for their care. Chronic illness is not an insurable event--it is a very high, predictable level of spending. Our proposal is for the government to subsidize 75 percent of the insured costs of the 1 percent of chronically ill patients with the highest medical expenses. The less-than-100 percent subsidy would provide incentives for private insurers to contain costs. The proposal also includes means testing so that we would not create another Medicare-esque, open-ended entitlement.

The second policy addressed by our package is the insurance system. To achieve our goal of patient-centered medicine, we must bring the individual and small group markets to a level playing field. Currently, purchasing one’s insurance individually or through a small group puts one in the province of state regulations, which add substantially to the cost of insurance. The Congressional Budget Office (CBO) estimates between 5 percent to 15 percent inflation due to these regulations. Creating a federal, mandate-free insurance market will expose the states to market forces and will avoid the imposition of regulations on state insurance markets.

The third policy centers on health information. Consumers have much less information about health transactions than in other parts of the economy. We offer a number of suggestions, all of which are familiar: best practices guidelines, report cards, aggressive use of the Medicare program to get quality information, pay for performance, and litigation reform. Litigation reform would facilitate health outcome information sharing without risk of exposure litigation.

Enhancing competition and malpractice reform comprise the fourth and fifth areas of change. A cap on noneconomic damages can eliminate much of the 7 percent increase in the cost of insurance from malpractice litigation.
 
These five reforms are the essential ingredients to allow private markets to help patient centered medicine. These reforms would cut health care spending by between $60 and $70 billion per year. The proposals would also cut the number of the uninsured, ranging from 6 to 20 million new people newly covered by insurance. Our policies favor low-income households. Such households often have large out-of-pocket health expenses, so they would be the major beneficiaries of the new tax subsidy and the refundable tax credits.

Rising anxiety and fiscal pressures have made health care reform the primary domestic policy. Answering these woes by increasing government intervention would reduce incentives for technological advancement. The alternative is to make the private markets function correctly. Though there is no silver bullet, making health care markets resemble the other five-sixths of the economy is where we would begin.

Douglas Holtz-Eakin
Council on Foreign Relations

If one continues to do business as usual in Medicare and Medicaid, the costs of those programs will rise from 4 percent of gross domestic product (GDP) to 28 percent of GDP--larger than the current size of the entire federal government. Even assuming deus ex machina events will stem some of that expansion, the programs will still triple to 11 or 12 percent of GDP.

One of the desirable pieces of the authors’ plan is the disentanglement of care decisions (the actual production and usage of health care) from financing decisions. The present system has care and financing heavily intermixed, clouding our ability to decide what we want to produce, how much it will cost, and how much we value it. It is crucial that people evaluate the benefit of different therapies.
 
A second strength of the authors’ proposals is the set of incentives that surround technology. Incentives to evaluate an innovation’s benefits and costs can slow the increase in health costs. Such incentives can promote technologies that save on costs or produce better outcomes and can discard the ones that do neither.

There are some problems with the authors’ plan, the first of which is its bundled structure. The last time we had an all-or-nothing plan on the table, health care reform lay stagnant for ten years. More incremental and non-packaged approaches would better address the urgency of the problem.

Second, if all health care expenditures are deductible, we must be prepared to face the enforcement costs such a policy inherently entails. Taxing all health expenses would not only avoid enforcement issues but also represents a better tax policy to inhibit the growth of expenditures. Additionally, such tax revenue can pay for the transition from employer-sponsored health insurance to different pooling systems. If individuals are to remain insured regardless of a change in company or in state, they must become the main purchasers of health insurance. The revenue raised by eliminating health tax preferences is needed to fund the growing federal government.

It may be worthwhile to refashion Medicare and Medicaid because they are such a large part of the cost equation. Medicare Part D brings competitive advantage from the private sector into the Medicare program. The question remains how to make it work most efficiently.

My ideas for Medicaid reform are relatively simple. Because states have management responsibility and budget constraints for Medicaid, the greatest step to incremental reform is to let states struggle with the problems delivering Medicaid benefits and to allow them to reap the benefits of their innovations. Shifting long-term care to the Medicare program would also make sense.
 
Given the different areas and costs involved in reform, more means testing should be built into the Medicare program. Having created the infrastructure to make markets work, no individuals are more capable of taking advantage of that infrastructure than high-income people, regardless of their age. To discipline the health care markets, incentivized wealthy people must demand care at a reasonable price from the doctors, hospitals, and prescription drug companies. This discipline is desirable for budgetary and efficiency reasons.

Finally, the United States’ public health care programs are not adequately prepared for a transition to an economy populated by a much greater fraction of people in their retirement age. Mechanisms to pre-fund the costs of retirement income, healthcare, and long-term care will ensure our ability to provide for the needs of the elderly and to give our children the standard of living to which we have become accustomed.

AEI research assistant Jonathan Stricks prepared this summary.