Why Holding Health Cost Increases to the Rate of “Inflation” Forces Rationing–
And Why America Can Nevertheless Afford Unrationed Health Care
MEDICAL INFLATION. The rate of medical inflation has fairly consistently exceeded the rate of general inflation. Is this due to waste and inefficiency, as many believe? Not according to an influential study by noted economist William J. Baumol of New York University’s C.V. Starr Center for Applied Economics. In a 1993 issue of the scholarly economics journal Public Choice, Baumol laid out the technical evidence for his dramatic conclusions.
Baumol pointed out a basic difference between health care and other parts of the economy. Health care is not — and cannot be — run like an assembly line. It depends very heavily on people — doctors and other health care professionals.
THE HIGH PRODUCTIVITY OF MACHINES. Industries that rely heavily on machines for their output, such as manufacturers using assembly lines, are constantly making those machines more efficient. A factory that produced 1,000 automobiles one year might, at the same real cost, be able to produce 1,050 the next. What that means is that the factory could pay out more in wages, and sustain increases in the costs of materials, without having to pass all of those on to the consumer in price increases.
THE LOWER PRODUCTIVITY OF LABOR. The same is not as true for service industries that rely heavily on labor, like health care. A doctor can’t see four patients an hour in one year, six patients an hour the next year, then eight patients an hour the following year and still expect to provide the same quality of care.
PRODUCTIVITY AND INFLATION. As wages and other costs of production rise throughout the economy, the need to pass them on to consumers in the form of higher prices is partly offset by productivity increases. The lower the rate of productivity increase, the greater must be the price increase. This means that service industries such as health care, which cannot take as great advantage of productivity increases as can manufacturing industries, have inherent or structural rates of inflation naturally higher than the rate of general inflation in the economy (which is the average rate of price increase for the whole economy, including the low inflation machine-intensive sectors). This, in turn, causes a steady rise in the proportion of the Gross Domestic Product (GDP) devoted to health care.
PRICE CONTROLS AND RATIONING. Therefore, efforts by the government to limit growth in health care costs to the rate of general inflation, measured by such indices as the well-known Consumer Price Index, necessarily compel rationing. Such limits would mean that the money permitted to be spent for medical costs would not be allowed to keep up with the rate of medical inflation.
Suppose the government prohibited your salary from increasing more than 2% a year, even in years in which inflation rose by 4 or 5 %. Each year you would get less for your money than the year before, forcing you to cut back on what you used to be able to afford. The same would happen if the government effectively limited what those over 65 were permitted to spend on health insurance, prohibiting their expenditures from keeping pace with medical inflation. Inevitably, there would not be enough money to go around and needed treatment would be denied–meaning rationing.
WHY AMERICA CAN AFFORD ADEQUATE HEALTH CARE WITHOUT RATIONING
Since the rate of medical inflation inherently exceeds that of general inflation, it is natural to ask whether that means that in the long run America will no longer be able to afford the health care we take for granted today. After all, if medical costs rise indefinitely, outpacing the rate of general inflation, how can we possibly afford to pay them unless we institute rationing?
BAUMOL’S ANSWER. Baumol provides a startling answer to this question, but one that flows directly from the same analysis that demonstrated how the difference in productivity increases between machine-intensive and labor-intensive sectors of the economy mean health care cost increases must exceed the rate of general (or average) inflation.
Even though productivity increases are lower in labor-intensive industries than in machine-intensive ones, on average there still are some productivity increases in almost every sector of our economy each year, including the health care sector.
PRODUCTIVITY AND WAGE INCREASES. By definition, a productivity increase means that for a given amount of labor, more is produced. Productivity increases are reflected, over time, in per capita GDP increases that more than offset the price increases that occur for health care and other goods and services.
The pie chart accompanying this article shows our economy in 1960 and 1990, and what it would be in 2040 if 1) productivity continues to grow at its historic average rate and 2) resources continue to be allocated in the same proportions as historically. The proportion of the economy devoted to health care grows from 5% in 1960 through 12% in 1990 to 35% in 2040. But because of the growth in the economy from productivity increases, not only does the per person amount available for health care increase dramatically–so does that for everything else!
Neither the higher rate of health care cost increases nor the resultant increasing proportion of the economy devoted to health care diminishes our economy’s ability to obtain more and more of all other goods and services as a consequence of resources being diverted to health care; instead, it increases.
Thus, the perception that the American economy cannot afford health care costs rising faster than the general rate of inflation is dead wrong.
THE REAL PROBLEM. But there is a real problem related to the differential rate of productivity increase in health care, and hence the higher rate of medical inflation. As a society, America can clearly afford unrationed health care, because the per person share of GDP increases in a way that outpaces increasing costs. But what about those whose income is increasing at a below-average rate–or is not increasing at all? Such individuals will indeed find health care cost increases more and more unaffordable.
Because Medicaid and Medicare are essentially societal subsidies to many of those on low or relatively fixed incomes, the rising rate of health care expenditures is felt very keenly in the ballooning of Medicaid and Medicare as a percentage of governmental budgets.
The past and projected increases in Medicaid and Medicare costs, with their threat to make budget deficits quite uncontrollable, has motivated the current Congress to impose reductions in the rate of growth of Medicaid and Medicare.
WHAT WILL BE DONE?
In dealing with Medicare, there are three alternative ways to respond to the reality that medical inflation exceeds the rate of general inflation.
TAXES. One — which may be dismissed out of hand as politically unrealistic — is to raise taxes so as to allow Medicare actually to cover fully the rising costs of medical care for older people.
RATIONING. The second alternative is to impose limits on the rate of growth in Medicare, bringing it below the rate of medical inflation, while effectively forbidding Americans to make up the difference with their own funds. This would inevitably lead to rationing.
SUPPLEMENTS. The final alternative is that provided by current law by something called “private fee-for-service” Medicare plans. These permit older Americans voluntarily to add their own money to that provided by the government in order to obtain an unrationed health care plan.
This permits those who do choose to supplement the government Medicare contribution with their own additional funds to escape rationing–and it follows from Baumol’s analysis of the effect of productivity increases that the average American (not just those unusually well off) would be able to afford it.
But what about those who are not sharing in the benefits of the general increase in productivity? The non-tax, non-rationing way to deal with the need to provide adequate health care for those whose incomes are not sharing in the general productivity increases is to rely on a phenomenon known as private “cost-shifting.” As shown below, allowing those who wish to add some of their own funds in order to get the health care plan they want helps make “cost-shifting” possible and thus helps protect poor older Americans from rationing, too.
COST-SHIFTING. Cost-shifting is even now key to the way Medicare operates. Most Americans probably believe that Medicare now pays for the cost of providing medical treatment to those covered by it, primarily retirees. They are wrong.
In fact, the reimbursement rates to medical providers for treating those covered by Medicare are substantially below the real cost to the providers. Thus, essentially every doctor, every hospital, every clinic that gives medical treatment to someone over 65 in the United States loses money by doing so. Yet, at present, people on Medicare do get medical care.
How is this possible?
The answer is that when medical providers set the prices charged their privately insured patients, they build in enough of a profit margin to enable them to make up for the losses they experience when treating those covered by Medicare.
Thus, a good proportion of the cost of treating those over 65 is typically shifted to working individuals. Essentially, workers help subsidize medical care for their parents or grandparents through a portion of the health insurance premiums paid on their behalf.
It deserves emphasis that, because they are sharing in the rewards of productivity increases, privately insured patients–mainly workers whose employers buy their health insurance for them and their dependents–can by and large afford the extra costs. On average, such cost-shifting will not diminish workers’ standard of living, it will merely mean that although their material standard of living will continue to improve, it may improve more slowly than if their parents and grandparents were largely left to die without adequate treatment.
The same is true of cost-shifting within the age group eligible for Medicare. Senior citizens who choose to add their own funds in order to obtain unmanaged private fee-for-service plans will also be adding money to the pool that is in part available for cost-shifting to help subsidize treatment for those older Americans who cannot afford to supplement Medicare payments.
Thus, private cost-shifting is the rabbit out of the hat. In the absence of increased taxes and correspondingly higher rates of Medicare reimbursement, it is the mechanism by which the remarkable ever-increasing productivity of our economy can be translated into adequate (and, in fact, constantly improving) unrationed medical care throughout America.