Economics of Health Care Reform Stuart Butler, PhD, Washington, D.C.

Several economic points require consideration when assessing the current cost of health care in the United States and the potential savings from pro- posed reforms. Most savings projections are based on assumptions and estimates that cannot he accu- rate under the best of circumstances, and the error in the final results is greatly compounded by even small errors in the initial estimates. Experience with health care programs worldwide, including our own Medicare program, has shown that final costs are usually much larger--often several times larger- than initial estimates. It is even more difficult to predict the behavior of the population under a sys- tem that does not yet exist, and it is not clear whether a system such as the Jackson Hole Plan will actually produce savings. The effect our political system will have on any health system enacted through legislation must also be considered. The political process itself frequently results in more benefits rather than fewer, more regulation rather than less, and the shifting of costs to other sectors of the economy to minimize costs in the health sec- tor. When presented with projections and predic- tions in health care planning, we must critically ex- amine the initial assumptions, knowing that errors in these assumptions will magnify errors in the final results.

From the Heritage Foundation, Washington, D.C. Requests for reprints should be addressed to Stuart Butler,

PhD, Heritage Foundation, 214 Massachusetts Avenue, Washing- ton, DC. 20005.

Presented at the Meeting on National Health Care Reform, Newark, New Jersey, April 30-May 1,1993.

T he experts say that one of the key objectives of health care reform must be to reduce the amount of

money spent on health care in the United States. Since about 70% of Americans think not enough money is spent, that has rather important implications in terms of the way the political system might operate. When the various proposals are examined, nobody really knows what the final costs or savings of any of them will be.

Trying to make predictions about the economics of health care planning is enormously tricky, and those who do make predictions are usually scrupulous in putting in a footnote the assumptions underscoring their particular economic analysis. Since not everybody will agree with those assumptions, they make a big difference. John Sheils [I] says, in a footnote to an analysis of a managed competition proposal, “The estimates presented here are highly sensitive to assumptions about consumer behavior, reimbursement level and the overall effective- ness of managed competition.” In other words, there could be a huge difference in numbers, depending on fairly small changes in the assumptions in the analysis.

Table I is a somewhat A la carte summary analysis of various proposals, or elements of proposals, that are being discussed in the debate on health care reform. It shows what a change in one key element might lead to in terms of savings or cost increases in the health system. Although some of the numbers may be shaky depending on the details of the assumptions made, it breaks down elements common to certain reforms and gives an idea of what impact they might have.

In the debate over reform very often the “silver bullet approach” is mentioned, with experts saying, “there is one key thing-just fix it, then there will be enormous savings throughout the health care system.” But when examined, some proposals lead to rather less dramatic results than proponents would like you to believe [2]. With respect to defensive medicine, Lewin [I] feels that eliminating defensive medicine would save approximately $15 billion over 5 years, about $3 billion a year net savings from malpractice reform-not a lot of money.

One proposal being discussed concerning health insurance reform would group employees at small firms in a health care area and allow them to find insurance with a larger group. Here, in the context of overall health care expenditures, Lewin [I] estimates that small market reform could save about $25 billion over 5 years, or about $5 billion a year on average. So again, the savings from taking that approach are not all that great.

On the other hand, some fairly serious cost reduc- tions may be obtained by some tax measures under consideration, such as denying tax benefits for certain types of medical expenditures or putting a cap on the amount of tax deductible benefits for medical care. Taxation of medical benefits would also discourage

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TABLE I Summary of Health Care Cost Containment Reform Options*

($ in Billions)

Options

Baseline national health expenditures

Total Public Sector Private Sector Systemwide impact Federal State Employers Individuals/Families

5 Years IO Years 5Years IO Years 5 Years 10 Years 5 Years IO Years 5 Years 10 Years

53904.50 +5,+58.90 +,9+4.40 53069.60 869.20 2,262.50 I,97146 4,967.50 1,149.50 2.959.30

Insurance reforms

Small market reforms group Pre-empt state-mandated

benefits

-25.20’ -63.00 0.00 0.00 0.00 0.00 -21.40 -53.50 -3.80 -9.50

-7.50 -18.60 0.00 0.00 0.00 0.00 -6.40 -16.00 -1.10 -2.80

Medicare

Gradually eliminate dispropor- 0.00 0.00 -9.50 -33.40 0.00 0.00 7.10 25.10 2.40 8.40 tionate share adjust

Reduce teaching adjustment 0.00 0.00 -10.90 -30.00 0.00 0.00 8.10 22.50 2.80 7.50 from 7.7% to 3%

Freeze PPS rates for 1 year 0.00 0.00 -15.20 -39.70 0.00 0.00 11.40 29.80 3.80 9.90

Subtotal: provider options o.oo- 0.00 -35.60-103.10 o.oo---- 0.00 --zXl- 77.40 9.00- 25.80

Increase SMI coinsurance to 0.00 0.00 -21.10 -56.10 0.00 0.00 0.00 0.00 21.10 56.10 25%

Increase SMI premiums to 30% 0.00 0.00 -30.10 -125.00 0.00 0.00 0.00 0.00 30.10 125.00 for physician services

Increase and index SMI deduct- 0.00 0.60 -9.30 -37.50 0.00 0.00 0.00 0.00 9.30 37.50 ibles for physician Subtotal: beneficiary options o.oo- 0.00

------_ -60.50 -216.60 0.00 0.00 0.00 0.00 60.50 218.60

Taxation of benefits Tax expenditure cap: Tax the

insurance value of employer- paid health benefits

Monthly premium greater than -45.30 - 164.40 -97.00 -352.30 -13.60 -49.30 -51.80 - 187.90 117.10 425.10 $165/individual and $400/

family

Full amount with tax credit for -94.50 -282.20 -221.40 -662.50 -31.00 -92.70 -94.00 -279.90 251.90 752.90 individual and some employer contribution

Tax insurance value of Medicare benefits

Tax those above income 0.00 0.00 -30.50 -106.80 -4.30 -14.90 0.00 0.00 34.80 -121.70 threshold

Tax all beneficiaries 0.00 0.00 -54.60 -172.10 -7.60 -24.10 0.00 0.00 62.20 196.20

l Committee for a Responsible Federal Budget: Health Care Reform Project--April 1993.

tNegative amounts are savings from baseline expenditures.

people from over-insuring, as they tend to do when employer benefits are tax free, and would produce fairly significant savings in that area.

Taxing medical benefits is not something that most Americans find acceptable, however. While running for the Senate in Pennsylvania, Mr. Thomberg wanted to tax health benefits and was beaten by Harris Wofford. The changes that might yield truly significant amounts of tax money tend to run counter to what Americans will accept and therefore to what the political process is likely to deliver. When examining how certain proposals stack up economically and what their impact would be, bear in mind that (1) initial assumptions can vary widely and greatly influence a proposal’s likely outcome, and (2) the political system will place enormous con- straints on any plan, and what looks like an elegant and

effective plan on paper may be very different when it is implemented,

How fairly minor changes in initial assumptions can alter final outcomes can be illustrated by comparing different organizations that looked at the same element of change in reform yet developed very different plans. Some people allude to the savings of the Canadian system-with everybody in the same system, without needless duplication and paperwork, an enormous amount of money could be saved. “Enormous” is a soft word, however, and the savings from such a system projected by different organizations are very different. The Congressional Budget Office, for example, which is the body within Congress that evaluates all major bills put forward, estimates that a single-payer-type system would lead to administrative cost reductions of about

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238 THE AMERICAN JOURNAL OF SURGERY VOLUME 167 FEBRUARY 1994

$22 billion per year. The Bush administration’s Depart- ment of Health and Human Services projected $50 billion per year in savings. The General Accounting Office estimated that the potential savings of such a system would be between $60 and $100 billion a year. The difference between the lowest projection and the highest is $80 billion per year.

When such discrepancies are factored into the differ- ent proposals, the range of options and the range of numbers is enormous. In the malpractice area alone, the estimated savings from reforms range from nothing, according to the Congressional Budget Office, to around $21 to $22 billion a year, according to the Bush administration.

Nobody really knows what the cost differences are going to be in the final plans for a reformed system. I looked at the Medicare and Medicaid cost estimates made when the legislation was passed: The federal government estimates of the cost of Medicare over 15 to 20 years bore almost no relation to the real cost-it should be no surprise that the actual expenses were several times higher than the confident predictions at the time. So don’t believe any confident predictions, whether they are made by the Clinton administration, the Republicans in Congress, the American Medical Association, or whomever, because there are too many elements that can influence and change those projections.

When one looks at the likely economic impact of any particular proposal-whether it be the single-payer plan proposal or managed competition or the Heritage Foun- dation proposal-it is important to bear in mind how different assumptions and other factors will influence the final result. Another very real consideration is the way in which the political system itself will influence a particular plan and cause it to evolve as it goes through the process.

I mentioned already the inaccurate projections made for Medicare, back in 1965. One political factor that was not taken into account-one that came back to bite over the years-was the influence of the American Medical Association in making rules for setting fees on Medi- care. Lyndon Johnson was a person who wanted to get things done, without worrying about the details of a particular proposal. With Medicare, Lyndon Johnson’s charge was to get it passed and to let the details take care of themselves. One of those details was the Medi- care fee structure. The American Medical Association worked with the Department of Health to pnt into place a “usual and customary” system of fees that gradually expanded as the years went by-and that fee system has been one of the driving forces in the continual expansion of Medicare costs over the years. So not taking all the details fully into account can cause serious problems in terms of cost, even to the point of defeating the goal of the original proposal,

One of the snags in designing a health care plan, said Dr. Paul Ellwood, is that it is a bit like designing an airplane: You must have all the parts for it to work; if you decide there is something you don’t like, such as a

wing, YOU cannot take it off. He makes the same argument for the managed competition proposal. Unless all the elements are there, not only does the cost analysis get terribly out of kilter but also the system will not work to deliver the reforms and the savings that people want and that were intended by the originators of the plan.

Narrowed down to economics, how the political process deals with particular elements of particular proposals is crucial to the final cost. For example, if you examine managed competition-a concept that every- one is in favor of but everyone has different ideas of what it means-one of the key ideas of the theoretical model is that all Americans would receive a standard benefits package through their place of employment (or some- where else), and that it would be the only benefits entitled to tax relief. Ellwood analyzed that model to determine what elements it should contain, what would make good sense from both a medical point of view and an economic point of view. That analysis enabled projec- tions to be made about the final cost.

That theory of managed competition soon developed political difficulties. If a plan contains a standardized benefit package, and if people want a service outside the standard package, they must pay for that service with their own dollars without a tax deduction. Providers in the health care area, therefore, very much want to be in that benefits package-and the difficulties become appar- ent. Chiropractors are flooding Congress and the Admin- istration with form letters from their patients saying that chiropractic service is highly cost effective and must be in the benefits package. The mental health organizations are doing the same, and so is everybody else. Everyone makes a good case. And when the hearings take place on Capitol Hill, it is obvious what will happen: people will be there, suffering from a particular malady that re- quires a particular service. Others will confront their Congressmen and say, “Do you want to deny me this, do you want to in some cases literally condemn me by not providing this service?” And you know what Congress will do. One of the problems with managed care is that having a standardized benefits package will lead inevita- bly to enormous political pressure to expand that pack- age, and thus the total cost of that particular proposal also will expand.

We are already beginning to see that happening, not just by the flood of paper but also by what has happened to the Clinton administration proposal since the elec- tion. During the election period it was said that if we took all the waste out of the system, we could give people all the health care they need, and it really wouldn’t cost anything more-it could be paid for out of the $60, $70, or $80 billion that would be saved in administrative costs and waste in duplication. But when the Administration took office, pressure was applied to include other things in the benefits package such as mental health care and long-term care. Long-term care represents serious money. The cost projections of the proposal have been steadily going up since the Administration took office. Although the numbers are soft, estimates of $80, $90,

and $100 billion a year are now routinely discussed in Washington-for a proposal that was going to pay for itself during the campaign.

Political assumptions about a plan and the way the political process deals with a proposal are crucial to the final results. That goes for managed competition, it goes for some of the tax changes we support, and it goes for other proposals also. Taxation of benefits-eliminating those tax-free fringe benefits-would be a feasible way to get the money to pay for expanding health care access to other people. Politically, however, trying to put that into place is a serious problem. Most of the sophisticated tax proposals that have been put forward are designed to change the tax treatment of benefits in a way that encourages people to shop around for medical care.

A second way to evaluate the broad economic impli- cations of a particular proposal is to examine its impact on jobs and employment-a factor with political costs as well as real economic costs. An old adage in Washington is that “one person’s waste is another person’s job.” When you talk about substantial reductions in health costs or in insurance costs, you are talking about jobs, about affecting people’s daily lives. Regardless of what kind of model is under consideration or which of the various proposals is being examined, they all have major implications for jobs and employment.

A proposal that tries to substantially reduce the total cost of medical care in this country will significantly impact employment, particularly in the health sector. Health care is one of the fastest growing industries in the country, an area in the service sector where some of the best jobs are being created. Curbing the expansion of that sector or detracting from it would have enormous implications for employment and unemployment costs. So far no major, sophisticated analysis has been made of the potential impact of these particular proposals on jobs. The first one is due soon from the National Federation of Independent Business, which represents smaller firms, for whom the impact on jobs and employ- ment could be severe.

The economics of jobs also has important implica- tions for any form of mandate on employers to either provide insurance or pay some form of tax for a national health system. For example, the “pay or play” proposal would in its explicit form require employers either to provide a minimum set of benefits or to pay a tax for the equivalent benefits to be provided by a public program. The Clinton administration seems to be considering a standard payroll tax on all employers to pay for so-called accountable health plans. These proposals, whether for taxes or for required benefits, will have an enormous impact on the cost of labor in particular industries and on particular firms. Both employment effects and politi- cal effects are likely to be substantial.

In the November 1992 election, California had a ballot initiative to require all employers in the state to provide a basic benefits package for all workers and all dependents. It was not pay or play; rather, it was play or else. That initiative was defeated 2 to 1, not because

Californians didn’t want to have health benefits but because of an analysis that showed the job impact. Essentially, the analysis showed that smaller firms that generally do not provide health benefits for employees would be required to provide a standardized benefits package. If they were employing, as is typical of smaller firms, people who are paid close to the minimum wage or are fairly low paid, they would of course have said, “If I have to hire somebody for $7 to $10 thousand in wages and then have to add on $3, $4, or $5 thousand in medical benefits on top of it, I am just not going to hire that person or I am going to fire somebody I currently have employed.” Clearly, the job impact of that type of proposal could be very severe.

Any payroll tax could be a significant factor in a person’s employment, but the extent to which it is would differ depending on the design. For example, a payroll tax method of paying for health care, whether it be managed competition or a Canadian type of system, would tend to have less impact on employment opportu- nities for lower-wage employees than would a straight requirement that all employers provide a particular package of benefits. By applying, for example, a 5% or 6% payroll tax to all employees to pay for a general benefits package, the amount of money actually being paid out on the low-wage employees is small compared with the amount paid on high-wage earners. On the other hand, with required health insurance, the actual costs are typically not that different for either end of the wage scale-meaning a higher relative cost for hiring a low-paid person compared with a high-paid one. A plan’s impact on jobs obviously depends very much on the design of that particular proposal.

Finally, behavioral assumptions-how people will behave, how they will react to particular proposals- have enormous implications for the cost and the eco- nomic impact of any particular type of proposal. The different arrangements involve significantly different assumptions that lead to very different conclusions about how people will actually react to the plans. Whether people are allowed to make choices about what they want or whether they are required to accept a plan or given economic incentives to go with a particular proposal will greatly influence their behavior. For ex- ample, a tax change favoring heavily managed care will have some impact, but if that change is not in place, then the behavioral assumptions about the end results could be very different and the economic implications could be hugely different.

Behavioral assumptions are so crucial, and yet it is very difficult to make any solid predictions about what will happen with major reform in the health care system. We do have data on how people react to modest changes, however. The Rand Corporation has done an analysis of what happens in a free system treating a condition. If you put into place a copayment plan or charge a specific dollar amount to visit a doctor, you can make fairly accurate assumptions about how people will react. In other words, if the changes introduced are

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fairly small, we can make some predictions about how it will alter behavior.

With a major reform of the health care system, such as a move into managed competition or an all-payer system, it is geometrically more difficult to predict how behavior will change. The reason: when analyzing behav- ioral assumptions about fundamental reforms of the health care system, the range of possible error increases very rapidly and significantly, and makes it extremely difficult to assess what the final result will be.

The final item to examine in the economics of health care reform is the hidden economic cost. The hidden economic impact of health reform is very relevant to a genuinely full analysis of the total cost.

I lived in Great Britain for 30 years and am familiar with an all-payer system. The health budget under such a system and the expenditures and resources allocation in the medical field have enormous economic conse- quences elsewhere in the system but those consequences are not typically included when costs are analyzed. Look, for example, at the issues of queues in the British system: At any time, about 1.25% of all Britains are waiting to go into the hospital, because the hospital system is trying to ration its resources efficiently and keep its costs down. They are not waiting for serious procedures in most cases, and they do not always wait a long time; nevertheless, there is a waiting cost. If you are unable to work because you are waiting to go into the hospital, there is an economic cost both for you person- ally and for your employer. Those costs are not taken into account, and they don’t appear in the hospital’s budget. But an economist would say that the hospital is very inefficient and that waiting represents economic costs that far outweigh the savings gained by the hospital.

When looking at the health care reform picture, the hidden costs must be taken into account, particularly in areas of health care in which some kind of rationing or waiting list is an integral part. Unless the resulting hidden economic costs are also considered, you will not see a true picture of the total costs. That is why an alternative system like that of Britain, which spends only 5% to 6% of its Gross National Product on health care,

appears to offer tremendous potential savings-but that is because there are costs associated with the system that do not appear in the figures.

In this country, there has been a great deal of discussion about price controls, at least as a temporary measure-price controls on pharmaceuticals or perhaps a freeze on physicians’ fees similar to the Medicare system-to bring down the cost during the transition, if not permanently. Assuming that price controls work, even though their record is dismal, the hidden effects of a price control system must be brought to light. For example, price controls on technology, whether on pharmaceutical development or on other types of tech- nology, slow down investment in those sectors. That means there are long-term hidden costs: If the number of new drugs created is reduced because of a disinclina- tion to invest money in a price-controlled sector, that represents enormous costs that are hidden, but they are there.

Considering the various proposals put forth, there- fore, I think it is extremely important to be skeptical about the cost projections presented. Do not be too impressed by flow- charts and analyses that look sophis- ticated; because what you should really look at are the assumptions behind those projections-assumptions that will affect the numbers. Do the assumptions seem reasonable? If they do, then you may have a proposal that makes some sense. But if the assumptions about the medical side, or the consumer side, or the political side of health care reform do not seem reasonable or probable, do not believe that “they really won’t make much difference.” Because all the analyses show the exact opposite: A modest change, a small variation in those initial assumptions will lead to dramatic changes in how the numbers add up in the end.

REFERENCES 1. Sheils JP, Lewin LS, Haught RA. Data watch potential public expenditures under managed competition. Health AfT (Suppl) 1993. 2. Butler SM. Contradictions in the Clinton health plan. Back- grounder 1993; 924: 1-17.

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