November 5, 2006 | Volume 3, Issue 2
Health Care Costs: Do We Need a Cure?
U.S. health care spending is high and rising rapidly. The U.S. spent $1.9 trillion on health care, or $6,280 per person, in 2004. Health spending rose 7.9 percent in 2004, and the health spending share of GDP grew 0.1 percentage point, to 16.0 percent in 2004, making health care the largest industry in the U.S. economy (Center for Medicare and Medicaid Services, 2006). Spending on health care is rising faster than the overall growth in the economy. We now spend more on health care than on food, clothing, computer hardware and software, or national defense. Not surprisingly, health insurance premiums are also increasing, along with concerns about the burden of mounting health care costs on individuals and society (Freudenheim, 2006; Kaiser Family Foundation, 2006).
Health care costs are indeed very high and growing rapidly. But, so what? From one perspective, this is not a problem at all, but a good thing. How so? Let’s use simple economic reasoning to frame our thinking. When should we be spending an increasing share of income on something? The answer is that we should spend more when that good is increasing in value. When should we spend a large share of income on a good or service? We should when that good generates a lot of value.
It is certainly the case that there have been major advances in medical technology. We are much better at treating heart disease, cancer, and other life threatening conditions. The mortality rate from heart disease fell by over 40 percent from 1980 to 2002, and the death rate from cancer fell by 7 percent over the same period. Another important indicator of health is the infant mortality rate, which fell by 47 percent from 1980–2002. Overall, life expectancy at birth in the United States has increased by 10 years since 1950 (78 vs. 68 years), 5 years since 1980, and by 2 years since only 1995.
In addition, there have been major advances in treating conditions that are not life threatening, but have a major impact on quality of life. Problems of severe mental illness, such as schizophrenia and depression, can be treated very effectively with modern medications, so much so that many patients can live normal, productive lives. Orthopedic problems can now be treated so that patients with severe problems recover nearly complete functioning. Degraded knee or hip joints can be replaced with artificial ones, and patients can resume active lives. Cataracts can now be removed and replaced with an artificial lens in a quick, simple outpatient procedure using only a topical anesthetic and without the use of stitches. Recovery is fast and vision can even be improved beyond what it was before the onset of cataracts. Many surgical procedures that once required large openings can now be done with laparoscopes, which only require small incisions. As a consequence recovery times are substantially shorter, as is the risk of infection.
These advances are extraordinary. While the values of non life-threatening advances have not yet been estimated, economists have estimated the value of increased life expectancy. Economists Kevin Murphy and Robert Topel (2005) have valued the increases in life expectancy between 1970 and 2000 at about $3.2 trillion per year, an amount equal to about one-half of average annual national income over the period. David Cutler and Mark McClellan (2001) estimate that every dollar spent on the treatment of heart disease has generated 7 dollars worth of value to society, and every dollar spent on treating low birthweight infants has generated 6 dollars worth of value for us.
What this tells us is that advances in medical technology have generated a lot of value. As a consequence, it is no surprise that we are spending more on health care. In fact, there is strong evidence to indicate that increases in health spending have been substantially outweighed by the value of increased life expectancy.
So growth in health spending appears to have been “worth it” on average. This leaves us with 2 questions. Has the growth in health spending been worth it on the margin? And what about the level of health spending—are we spending too much in absolute terms?
The question about whether the growth in spending has been worth it on the margin is a question about whether the last dollar of this increased spending generated at least a dollar’s worth of value. Economists agree that the growth in health spending has been driven by advances in medical technology, so this is a question about whether the additional spending on these innovations has generated at least as much additional value to society. The answer to this is unclear. We do not have direct evidence on this question, however some theory suggests that we may actually have too little innovation, due to imperfections in the health care system (Lakdawalla and Sood, 2005)
There is a reason to worry about growing spending on health care, however, and that is its effect on the federal budget. Approximately one-half of all U.S. health care spending is financed by the government, most of it through the federal Medicare and Medicaid programs. High Medicare and Medicaid costs must be financed through budget deficits, higher taxes, or cuts in federal programs. Our large and growing federal budget deficit is, at present, largely financed by foreign investors. However, it seems unlikely that this can continue indefinitely without serious adverse effects on the economy. Continuing increases in government spending on health care are therefore not likely sustainable without serious macroeconomic consequences.
What about the level of health care costs—are we spending too much? Here the answer is probably “yes.” We’d probably be better off if we spent a few dollars less on health care and allocated resources to some other uses (addressing global warming, improving national security, providing better education for low-income areas, etc.), or reallocated the current level of health care spending from some current uses to other types of care that are higher valued. The reason is that our health care system is subject to quite a few distortions. The design of insurance policies (both private and public), market power, policies for paying doctors and hospitals, asymmetric information, and government subsidies and regulations are all present in health care markets and combine to distort the functioning of the health care system. As a result, some of our health care spending is inefficient.
It is worth pointing out that there are distributional aspects associated with health care spending. The burden of increased private health care spending is borne nearly entirely by workers, not health insurers or employers. Research evidence shows that a dollar increase in health insurance costs for employers is paid for by workers, either by one dollar of pay they don’t get, or by a reduction in health benefits, including no insurance (Baicker and Chandra, 2005; Goldman, Sood, and Leibowitz, 2005). The number of people in the U.S. without any health insurance at all stood at 46.6 million, or 15.9% of the population, in 2005. This number has been increased by 6 million people since 2000 (Census Bureau, 2005).
So what is to be done? While there are some good reasons to worry about health care spending, it must be recognized that a great deal of this spending has generated value. We are living longer and living better, and that’s worth a great deal. Nonetheless, we need to find a way to rationally restrain health care costs. This will be a difficult task.
There are two problems associated with accomplishing this task. The first problem is the usual one: “no pain, no gain.” While we are probably spending too much on health care, most of that spending is generating value for those who are using and providing it. These individuals are unlikely to readily agree to policies that deprive them of care that they find privately beneficial. The second problem is finding a way to reduce spending on things that are generating little additional benefit relative to cost, without reducing spending on things that are highly beneficial. In particular, it is important to avoid reducing spending on beneficial innovations.
This will be a key challenge for health care policy. Reducing health care spending will be difficult, and the temptation will be to reduce health care spending across the board. This is a temptation to be avoided. Cutting spending unilaterally will decrease the good with the bad, and will constrain valuable innovations. Policymakers will need to take care to ensure that the cure isn’t worse than the disease.
References
Baicker, Katherine and Amitabh Chandra, “The Labor Market Effects Of Rising Health Insurance Premiums,” Working Paper No. 11160, National Bureau of Economic Research, Cambridge, MA, February, 2005.
Census Bureau, “Income, Poverty, and Health Insurance Coverage in the United States: 2005,” Table C-1, US. Department of Commerce, Washington, D.C. August 2005. http://www.census.gov/prod/2006pubs/p60–231.pdf.
Center for Medicare and Medicaid Services, “National Health Expenditure Data” U.S. Department of Health and Human Services, Washington, D.C. 2006, http://www.cms.hhs.gov/NationalHealthExpendData/02_NationalHealthAccountsHistorical.asp.
Cutler, David and Mark McClellan, “Is Technological Change in Medicine Worth It?” Health Affairs, Vol. 20, No. 5, pp. 11–29, September/October 2001.
Freudenheim, Milt, “Health Care Costs Rise Twice as Much as Inflation,” New York Times, September 27, 2006.
Goldman, Dana, Neeraj Sood, and Arleen Leibowitz, “Wage and benefit changes in response to rising health insurance costs” Working Paper No. 11063, National Bureau of Economic Research, Cambridge, MA, January, 2005.
Kaiser Family Foundation, “Employer Health Benefits: 2006 Annual Survey,” Henry J. Kaiser Family Foundation, Menlo Park, CA, 2006.
Lakdawalla, Darius and Neeraj Sood, “Insurance and Innovation in Health Care Markets,” Working Paper No. 11602, National Bureau of Economic Research, Cambridge, MA, September, 2005.
Murphy, Kevin and Robert Topel, “The Value of Health and Longevity,” Working Paper No. 11405, National Bureau of Economic Research, Cambridge, MA, June, 2005.