To fix health-care costs, begin with prices

Sector’s inefficiency results from government’s policies

By Geoffrey Lawrence
  • Thursday, January 21, 2010

The level of confusion in Washington over how to fix American health care is astounding. Congressional leaders and the Obama administration appear to believe that rapidly rising health-care costs demonstrate that markets can't deliver quality medical services to consumers. The solution, they contend, is to insert greater government involvement into the delivery and financing of medical services.

Meanwhile, the Republican opposition calls this a "government takeover of health care" while simultaneously criticizing Democrats' proposed cuts to Medicare. Both sides fundamentally misunderstand the problem. Government already controls the health-care industry, and that is precisely why it is so inefficient.

About half of all medical spending in the United States is financed directly by federal or state governments. Yet even decisions in the remaining "private sector" half are heavily influenced by federal Medicare, Medicaid and tax policy, making that sector just as inefficient. Federal tax deductions favoring employer-provided comprehensive group insurance over individual insurance have generated a maze of bureaucracies that now effectively control the medical decisions of individuals — whether patients or doctors.

This is not a market. A market results when individuals decide how to spend their own resources. They look at prices — implicit in which are the relative scarcities and efficiencies of alternative procedures and providers — and make their choices accordingly. Under this dynamic, the competitive marketplace, over time, delivers ever greater value for ever lower costs. The reason the current American health-care system cannot control costs is because individuals not spending their own money are not sensitive to prices. As a result, both government and private-insurance bureaucracies resort to rationing as the only alternative way of controlling costs.

Competitive markets that are responsive to individuals' choices are largely nonexistent in the health-care industry, because of the peculiar combination of financing and regulation that has removed market discipline. Federal tax deductions for employer-provided insurance have encouraged individuals to look for comprehensive policies that will finance all medical procedures — even for those that are routine.

Insurance is intended to safeguard against calamity. Many scheduled or routine procedures do not constitute calamity and, as such, are not necessarily financed most efficiently through an insurance policy. Yet, because the federal tax code has encouraged individuals to seek the most comprehensive employer-provided insurance plans available by making those benefits non-taxable, individual patients and doctors have no direct stake in deciding which medical procedures would be the best use of health-care dollars.

The resulting moral-hazard problem erodes market discipline and encourages over-consumption of unnecessary treatments. Without the market discipline normally imposed by judicious consumers, price competition also breaks down and prices no longer convey the appropriate information about relative scarcity and efficiency. Indeed, knowledgeable critics from both the right and the left acknowledge that it is primarily a government-led distortion of the price structure in health care that has led to an escalating national cost curve.

The solution to the nation's health-care crisis lies in correcting the incentive structures and re-establishing some form of market discipline in the industry. That will come when policymakers realize that the best decisions over which medical procedures would benefit an individual patient are made by that patient, advised by a doctor. Moreover, when incentives for deciding how best to spend resources — always necessarily limited — are returned to patients, large insurance bureaucracies become unnecessary.

More than any other vehicle, health savings accounts (HSAs) combined with catastrophic insurance coverage are returning control over health-care decisions to patients. HSAs cut out the bureaucratic middlemen by giving the patient a non-taxable individual spending account from which he and his doctor can make decisions over planned medical procedures. Catastrophic coverage, on the other hand, insures against the unforeseen.

The competition resulting from the dynamics of consumer demand also imposes market discipline upon medical-service providers, ensuring that their offerings meet the needs of patients. When patients and doctors control health-care finances, any need for bureaucratic rationing evaporates.

Given the high energy of the health-care-reform effort, it's curious that the concept of pricing is so absent from the debate. Only a meaningful price structure can contain the cost curve, and that can only be accomplished by granting patients and doctors more direct control over the use of health-care dollars. HSAs have gone a long way toward establishing that control. Yet, not only have policymakers failed to recognize this, but the proposed health-care "reform" bills could potentially eliminate HSAs altogether.

What would come in their place? Mandates for comprehensive insurance policies, a greater degree of moral hazard and, inevitably, more rationing.

If policymakers want to fix costs, they have to begin with prices.

Geoffrey Lawrence is a fiscal policy analyst at the Nevada Policy Research Institute.

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