Mr. Chairman, I thank you for inviting me to testify today on seniors' access to prescription drug benefits. I am an economist who has devoted considerable attention to health care markets and the pharmaceutical industry. Most of what I wish to say today is drawn from my recently published book, Prices, Markets and the Pharmaceutical Revolution (AEI Press). That book is available from the publisher, AEI Press, and is also downloadable from the American Enterprise Institute website (http://www.aei.org/shopAEI).

Pharmaceutical Costs in Perspective

Outpatient expenditures on prescription drugs (with inflation taken into account) almost doubled between 1990 and 1998, and increased an additional 12.3 percent in 1998.(1) The elderly have consistently accounted for about 30 percent of those expenditures (Medicare Current Beneficiary Survey, HCFA). Pharmaceuticals are also claiming an increasing share of the U.S. health care budget. This is a relatively recent phenomenon, however. Prescription costs as a proportion of health care expenditures actually declined for many years after 1960, with the trend reversing in the early 1980s. Even today, the share of spending on pharmaceuticals is far below the levels of the early 1960s, despite climbing from 4.9 percent of health care costs in 1985 to 7.2 percent in 1997 (see Figure 1).

 Figure 1

Prescription Drugs as a Percentage of U.S.
National Health Expenditures, 1960-1997

Source: HCFA 1999

Other advanced economies have also seen rapid increases in pharmaceuticals expenditures.(2) In fact, the 7 percent of health care costs allocated to prescription drugs in the United States today is barely half the corresponding proportions in Canada (12.5%) or Germany (12.5%) and even further below the levels in France (16.7%), the United Kingdom (17.3%), and Japan (20.0%) (OECD Health Data 1998).

Why Pharmaceutical Expenditures Have Been Increasing

Increased drug expenditures are partly offset by reduced expenditures on other forms of health care. The medical literature is full of studies documenting health cost savings from drug therapies for ulcers, schizophrenia, depression, congestive heart failure, asthma, strokes, migraine headaches, kidney disease, AIDS, and other illnesses and conditions.(3) Nonetheless, expanded uses of pharmaceuticals tend to increase total health care expenditures for the simple reason that they lengthen lives and treat conditions that formerly were not treated at all.

Price increases are not the main reason for increased pharmaceutical expenditures. Prescription drug prices between 1993 and 1998 increased at less than 4 percent annually, only slightly above the general inflation rate and far below the rate at which prescription drug expenditures increased (see Figure 2).

 Figure 2

Prescription Drug Price Increases versus Total Expenditures Growth

Sources: Expenditures Increases from HCFA 1999;
Price Increases from Bureau of Labor Statistics, CPI, All Urban Consumers,
Prescription Drugs and Medical Supplies.

Surveys have accordingly found that higher prices for existing drugs account for less than one-fourth of expenditure increases. The bulk of the increases come from increased volume and, especially, a shift toward more expensive drugs, which are usually newer on the market.(4) Even this modest role for price increases is exaggerated because measurements of pharmaceutical price changes are upwardly biased, as pharmaceutical price indices fail to adjust for the higher quality of new drugs and the increased benefits from new uses for old drugs (see Triplett 1999, especially chapter 3 by Frank, Berndt and Busch).

Physicians are prescribing more pharmaceuticals primarily because there are so many valuable new drug therapies. New drugs are treating conditions that formerly were undertreated or even underdiagnosed (see Calfee 2000a for citations and additional material). Such conditions include high blood pressure, elevated blood cholesterol, obesity, diabetes, depression and other mental illnesses, and osteoporosis. Many of the new treatments are especially important for the elderly. The dramatic reduction in mortality from heart disease in the past 30 years, for example, is almost certainly due primarily to improved medical treatments including "clot-busters" and other innovative drug therapies.(5) We have also seen great progress in reducing pain and suffering, as a result of better pain relievers, drugs with fewer debilitating side-effects, pills that replace injections, and treatments for migraines and osteoporosis. Examples include the "Cox-2 inhibitors" for treating arthritis pain, and newer anti-depressants. So-called "lifestyle" therapies such as those for mild obesity, mild depression, allergies, hair loss and impotence are also of enormous value to consumers. Finally, such remarkable developments as improved hypertension treatments and the statin class of cholesterol-reducing drugs are saving lives by preventing heart attacks.

All this is flowing from what is widely regarded as a revolution in pharmaceutical research and development. This revolution is very much market-driven. Its power comes from combining scientific research and faster FDA regulation with burgeoning market institutions that include managed care with its disease management techniques and massive data sets, a revamped clinical trials industry, the computer revolution, venture capital for biotechnology, flexible labor markets, and innovations in advertising and marketing research.

This research revolution is still in its early stages, as scientists rush to decode the human genome and open up new research areas. A crucial task in constructing a pharmaceutical benefit for Medicare is to permit this revolution to continue uninterrupted.

The greatest threat to further progress would be controls over prices. The profit motive is what has brought us the new drugs that physicians and patients want to use. The expectation that the government will control the prices of new drugs--an HHS-dictated price for a breast cancer cure, for example--would force firms to constrain their research investments, causing many of our most talented scientists and entrepreneurs to turn to the many other areas in the U.S. economy that offer handsome returns for intelligence and hard work. Price controls would be a powerful disincentive for pursuing the expensive and risky explorations necessary to solve such stubbornly resistant problems as devising preventatives and cures for Alzheimers, diabetes, osteoporosis, arthritis, heart disease, and cancer (cf. Calfee 1999).

Price controls would also introduce overwhelming complexity into health care, create vested interests for those parties that benefit from controls (there are always some who do), and inhibit the market adjustments necessary for a dynamic research enterprise. And once in place, price controls are extremely difficult to dismantle. Advanced nations with pervasive pharmaceutical price controls, such as Japan, have for decades denied innovative drugs to their citizens (Thomas 1994).

Potential Dangers in a Poorly Conceived Medicare Drug Benefit

Medicare is predominantly a fee-for-service arrangement. History shows that Medicare's fee-for-service reimbursement mechanism leads to pervasive price controls--despite the fact that the original proponents of Medicare vociferously promised that the system would never lead to price controls for physicians, hospitals and other essential components of health care for the elderly (Hoff 1998). This history also demonstrates that an arrangement in which medical technology and services can be purchased only at Medicare prices leads to endless disputes, much gaming of the system, and highly arbitrary and unpredictable prices that are often dominated by political considerations.

If a drug benefit is simply folded into an unreformed fee-for-service Medicare system, price controls over pharmaceuticals would be inevitable. That is one reason why many informed parties have advocated reforming Medicare to bring it closer to a competitive private market before adding a drug benefit. A majority of the Breaux-Thomas Bipartisan Commission on Medicare Reform, for example, proposed to reform Medicare by bringing it more in line with the methods developed by private enterprise, and encouraging drug benefit plans similar to those in private health insurance rather being part of the obsolete fee-for-service arrangement now prevailing in Medicare (National Bipartisan Commission 1999).

This does not mean that it is impossible to add a useful drug benefit to Medicare. But it is essential to avoid the error of constructing a benefit plan that would do more harm than good, by curtailing the very research enterprise that has made prescription drugs essential to health care for the elderly.

Essential Elements in a Well-Designed Medicare Drug Benefit Plan

Two crucial questions immediately arise in any Medicare reform. The first, of course, is whether the plan would permit or encourage price controls on pharmaceuticals. The adverse consequences of price controls are so great that leaving pharmaceuticals out of Medicare altogether would be preferable to constructing a drug benefit that controlled prices. A Medicare drug plan would therefore have to be designed so as not to invite the progressive implementation of price controls, a fate that has met all other health care activities funded by Medicare. The Breaux-Thomas recommendations, which would provide defined contributions for health care plans but would not specify prices, presumably would not involve price controls. But what factors would enter the process for approving health care plans? The theoretical power to specify prices can easily evolve into a mechanism for price controls.

A second, equally important question about any Medicare reform is whether the elderly would be free to purchase medical services, including pharmaceuticals, outside their plan's limits. If they could, market incentives would continue to yield pharmaceutical advances. But if Medicare patients could not purchase pharmaceuticals outside the system--just as they now cannot purchase nonreimbursed medical care except under onerous conditions--the effect would be to create de facto price controls (Hoff 1998).

A Medicare drug benefit should also respect the basic economics of insurance. One of those principles is that insurance should not cover events that involve little or no financial risk. Here we must note the emerging role of pharmaceuticals for the elderly. Many people today can expect to lead relatively healthy and enjoyable lives through their eighties and perhaps into their nineties. In doing so, they will almost certainly make liberal use of pharmaceuticals, which are now attacking the most common illnesses and disabilities of old age and very old age. It makes sense for consumers to prepare for a lengthy retirement that includes pharmaceuticals along with recreation, travel, special living arrangements, good dining, and all the other products and services that are already finding huge new markets among the elderly. There is no individual or social benefit to selecting one component of these expected expenses -- pharmaceuticals -- and processing it through an insurance system, with its attendant administrative costs and debates over "health" compared with "lifestyle" products.

A related principle from the economics of insurance concerns financial limits. Deductibles should be substantial. Passing all pharmaceutical purchases through insurance, instead of only those exceeding, say, $500-1,000 per year, would create unnecessary administrative costs and would remove incentives for reasonably careful use of pharmaceuticals. Conversely, insurance should provide coverage for catastrophic costs, with limits on out-of-pocket expenses. Co-payments are essential to maintain a link (albeit an imperfect one) between what drugs cost and what they are worth to consumers. All of this can be means tested so as to provide a safety net for the impoverished elderly (Pauly 1999).

Private insurance is invariably more efficient and less susceptible to political manipulation than is insurance provided by the government. It would also permit the introduction of competing plans at varied prices, which is essential to avoid forcing Medicare beneficiaries to pay for plans that offer either far less or far more than what beneficiaries are willing to pay for. A voucher system, which is essentially what the Breaux-Thomas Commission recommended, would therefore be far superior to an insurance plan run directly by Medicare. The special problems of bringing pharmaceuticals into the Medicare fold--along with the simple fact that doing so involves new legislation and a new administrative mechanism--suggest that something akin to Breaux-Thomas might be adopted for pharmaceuticals even if the rest of Medicare were left untouched. That action would, among other things, provide important new evidence to inform the larger debate over Medicare reform.

Even such a modest system would be far from foolproof. It would be difficult to solve the problem of adverse selection (i.e., the tendency for those most in need of expensive treatments to choose the most generous insurance plan, thus driving up costs and causing the less-sick to choose leaner plans, which raises costs yet more). Adverse selection can cause premiums to climb so high that insurance plans for sicker participants provide little financial benefit. Also, a catastrophe benefit could raise difficult problems in deciding which new therapies (offered with the expectation of full government coverage) would be worth their cost. Nonetheless, a market-oriented Medicare reform could permit the pharmaceutical revolution to continue (cf. Calfee 2000b).

Problems with the Clinton Medicare Drug Benefit Proposal

The President described in July 1999 a new Medicare drug benefit proposal, which was slightly altered in January 2000 (see Office of the President 1999). Unfortunately, the President's plan would create many of the very problems that a Medicare drug benefit should avoid. The plan would pay for half of purchases up to an annual limit, starting at $2,000 in 2002 and increasing to $5,000 in 2008. There would be no deductible. Annual premiums, set to provide a 50% subsidy, were estimated to start at $288 in 2002 and reach $528 by 2008. (The White House recently indicated that these numbers were being adjusted upward, but the essential features of the plan remain in place.) Prices would be negotiated by regional purchasing monopolies, administered by a single pharmaceutical benefit manager selected by HCFA. These prices would apply to purchases by Medicare beneficiaries even after the benefit limits had been exceeded, thus extending the HCFA-negotiated prices to non-Medicare reimbursed prescription drug purchases. This would amount to price controls.

The White House estimated that total spending on prescription drugs for the elderly in its plan, including the patients' share, would start at $30 billion annually in year 2002 and increase by 5 percent per year to roughly $31.5 billion in 2003, $33 billion in 2003 and so on. But prescription drug expenses for the elderly are already running at about $33-35 billion, and are expected to increase to a minimum of $45 to $50 billion by year 2002, with further increases likely. The Clinton plan would therefore cut pharmaceutical expenditures for the elderly by over one-third in 2002, and even more in later years. This illustrates the central role that price and expenditure controls are expected to play in this plan.

The President's plan would also create the inefficiencies that invariably arise when there is no deductible, as even the most routine prescription drug purchases would go through the Medicare bureaucracy. The plan would also prohibit competing formularies or other competitive tools. Such an enforced uniformity would work to the disadvantage of most Medicare beneficiaries.

Other Proposals

I have not reviewed the details of other leading Medicare drug benefit proposals. I note, however, that the majority recommendations of the Breaux-Thomas Bipartisan Commission would avoid most of the problems with the White House plan. In particular, the Breaux-Thomas approach (the details of which would be set by a special board) would presumably involve deductibles, an avoidance of price controls, and competing plans with varied formularies. Much the same appears to be true of the Snowe-Wyden proposal (S. 1480).

Such plans at least offer hope for a Medicare drug benefit that would permit the pharmaceutical research revolution to continue, bringing yet more life-saving and life-improving therapies whose nature we can now only imagine.

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John E. Calfee is a resident scholar at AEI.