Issues Every Plan to Reform Health Care Financing Must Confront

American Economic Association

Issues Every Plan to Reform Health Care Financing Must ConfrontAuthor(s): Henry J. AaronSource: The Journal of Economic Perspectives, Vol. 8, No. 3 (Summer, 1994), pp. 31-43Published by: American Economic AssociationStable URL: http://www.jstor.org/stable/2138216 .

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Journal of Economic Perspectives- Volume 8, Number 3-Summer 1994-Pages 31-43

Issues Every Plan to Reform Health Care Financing Must Confront

Henry J. Aaron

O n any reasonable scale of complexity, major reform of health care financing is the most intricate legislation with which Congress has attempted to grapple since World War II. Countless issues of eco-

nomic analysis, administration, and political balancing are responsible for the more than 1,300 pages of draft legislation President Clinton has submitted to Congress. If the Clinton proposal or any other of comparable reach is enacted, lengthy implementing legislation from 50 states and shelf-fulls of regulations will multiply the page-count.

Moreover, the institutions involved in insuring patients and delivering care are so complex, the financial stakes in reform are so large, and the pace of advance in medical science is so rapid, that the desired organization of delivery of care and scale of insured services is likely to change greatly over time. Hence, the health care reform debate of 1994 should be seen not as a crisis that national action will resolve, but as the start of a continuing political colloquy and periodic legislation that will persist for many years.

The goals of reform are widely acknowledged: assuring essentially all U.S. citizens and legal residents financial access to health care; to slow the growth of health care spending, which means reducing the tendency for insured patients and their care provider-agents to consume health care the marginal benefit of which falls well short of marginal social cost; and to sustain or improve the quality of care. My discussion will proceed under the assumption that removal of imperfections in the health insurance market and feasible subsidies will not suffice to achieve the first goal through voluntary actions of businesses and individuals. For that reason I believe and shall assume that some form of

* Henry J. Aaron is Director of Economic Studies, The Brookings Institution, Washington, D.C.



32 Journal of Economic Perspectives

mandate, on individuals or businesses, or some form of direct government provision will prove necessary to make certain that everyone is insured.

If a mandate is necessary, the object that people are to be required to buy must be defined and the entity required to do the buying must be named and its responsibilities specified. I shall focus on three particular questions related to such a mandate: the magnitude of redistribution that will arise from moving to community rating; the administrative issues in choosing between a mandate on employers to pay for insurance and a mandate on individuals; and the problems of paying subsidies under these two forms of mandates. In so doing, I shall neglect issues of considerable importance that will be addressed during the debates on health care reform, including the mechanisms for achieving cost control, and the ways in which quality of care can be sustained and improved. Before coming to these issues, I shall argue that the preference of economists for basing insurance premiums on the predicted loss experience of carefully differentiated groups is largely ill-considered and should be abandoned.

Should Experience Rating Be Abandoned?

Most current insurance is "experience rated," either through self- insurance or through medical underwriting.'

Self-insured companies typically pay actual claims plus a small administrative charge to an insurance company or other agent hired to process claims, which means that their insurance premiums (retrospectively) equal their actual loss experience. By excluding self-insured plans from state regulation, the Employee Retirement and Income Security Act of 1974 encouraged this practice. Roughly half of insured employees are covered by employers who self- insure.

By contrast, when other employers and all individuals buy insurance coverage, it is subject to medical underwriting, which simply means that the premiums (prospectively) are based on individual or group characteristics that are correlated with the use of health care, based on past experience. Those who make larger-than-expected claims can be subject to surcharges or even nonre- newal of coverage.

However, the widespread use of experience rating is relatively recent, whether through self-insurance or medical underwriting. Initially, most health insurance was "community rated," meaning that in a given community or metropolitan area, all members of each of a small number of family types paid the same premium. This arrangement proved unstable. New insurers sought out groups (or companies) with low expected costs, and then offered premiums below the community rate. Insurers using community rating found average costs of their remaining clients had risen, they raised premiums, and thereby created new opportunities for raiding. Only a few communities and companies

IAccording to the Employee Benefits Research Institute (1992), 65 percent of all employer plans are self-insured.



Henry J. Aaron 33

continue to engage in community rating, typically in noncompetitive insurance situations.

Few adherents of experience rating can be found outside the ranks of professional economists. Noneconomists see price variations as unfair- punishing the sick-and tend to downplay the incentive effects of price variations. Conversely, few advocates of community rating can be found inside the ranks of professional economists, except among some specialists in health care. However, I believe that noneconomists come closer to a valid judgment on experience rating than do economists. The practical question, I shall argue, is how much variation from community rating, if any, is desirable or necessary.

Presumably, the advantage of experience rating must be that the greater variations in price (as opposed to community rating) will affect behavior in some socially useful way. Three sorts of behavior are potentially relevant here: personal behavior that affects personal health or demand for health care services, business behavior that affects worker health, or choice of insurance by consumers.

Personal Behavior The potential for price differences to influence personal behavior depends

on how experience rating is achieved. If a person is part of a large group (like a business), individual incentives from experience rating are small. Wage and fringe benefits rarely vary based on individual use of medical services, but are set for the whole group of employees or for large subgroups, such as families with children.

In the case of groups with fewer than about ten members, a class that includes fewer than 20 percent of all employees and less than half of the privately insured, premium variation can affect individual incentives to some extent. Small groups are usually experience-rated through medical underwriting, and the premiums vary on the basis of a few characteristics: age, sex, place of residence, occupation, and medical history. Of these characteristics, the first and the last are the most important.

About 10 percent of the variation in the use of medical services is predictable given current techniques, if medical history is excluded from consideration (Newhouse, 1994). Thus, one statewide Blue Cross-Blue Shield plan sets a base premium for males over age 65 roughly seven times higher than premiums for men under age 24. The company sets a base fee for 24 industry groups, provides discounts of up to 10 percent for 16 industry groups, and imposes surcharges ranging to 30 percent, charging the highest cost companies a surcharge of 44 percent over the lowest cost companies.

Analysts who speak of the benefits of experience rating for individuals usually seem to be thinking about incentives to control use of medical services. Of course, the level of controllability varies considerably: use of mental health services is often somewhat controllable; use of cancer chemotherapy is much less so; use of cardiac intensive care after a coronary is largely involuntary. The potential for saving from higher deductibles and cost sharing is limited because




health care spending is so highly concentrated in a small number of high cost episodes-5 percent of the population accounts for 50 percent of outlays for acute care (Aaron, 1992).

Other controllable behaviors that affect health care include such activities as smoking, participation in risky sports, and eating habits. Some such behaviors, like heavy drinking or reckless driving, are beyond the observation of medical underwriting. In total, no more than 20 to 30 percent of the variance in the use of health services is predictable (Newhouse, 1994).

Even medical underwriting may provide incorrect incentives. Take health insurance discounts for nonsmokers, for example. First, the price signal is unlikely to reflect the separate effect of smoking on health expenditures during the contract period. In practice, smoking serves as a proxy for the many unobservable ways smokers differ from nonsmokers. Moreover, the appropri- ate extra health premium for smokers should reflect the lifetime effects of smoking, not the effects over the six-month or one-year period of a typical insurance contract. But since the deleterious health effects of smoking depend on the duration of past smoking, and diminish if smoking ceases in the future, it is not at all clear what the relevant price signal should be or how any refined rule could be administered. In short, the profit-maximizing signal may give individuals incorrect behavioral incentives.

In short, the value of incentives from medical underwriting are seriously compromised. When the price signals on controllable behaviors have any effect on individuals at all, they are almost always too high or too low (because other important variables are excluded), and may even be of the wrong sign. This is a classic case of market failure, because insurance contracts for all possible states of the world are not available.

The major sources of predictable interpersonal variations in health costs are characteristics over which individuals have little or no control: age and genetic endowments. Deciding how to distribute age-related variations in health insurance costs is purely a matter of distributional equity. As our capacity grows to identify genetic predispositions to a wide range of illnesses, it will be hard, I think, to defend the proposition that people born with a predictable tendency to develop, say, cancer should incur a negative "dowry" at birth equal to the high predictable medical costs they will incur, which is what basing health insurance on expected medical outlays would imply. Nor will it make sense to argue that those with a genetic predisposition to some form of rapid death should pay less for health insurance, because their lifetime medical costs are likely to be lower. In fact, most noneconomists and even many economists are likely to find these speculations more than a little bizarre.

Business Behavior Many illnesses and injuries are related to the workplace or, more com-

monly, to occupation. Prices of commodities that are dangerous to produce should reflect the costs generated by these dangers. Self-insurance and medical



Issues Every Plan to Reform Health Care Financing Must Confront 35

underwriting might achieve this goal. Community rating would defeat it and would sharply reduce the gain from business behavior that could improve health or reduce workers risks, such as investments in safe plant design or equipment and in worker training, and wellness programs. However, rules and regulations, including workers' compensation, may offer some similar incentives to improve workplace safety although these alternative techniques may be less accurate or more costly than reliance on accurate price signals.

Along with its positive effects on safety, experience rating also creates perverse business incentives. It encourages employers not to hire candidates with high predictable health care costs-the older, the disabled, the previously ill. This incentive is particularly strong with respect to low-wage workers, because health insurance costs do not vary with pay. Community rating avoids such perverse business incentives, and thus complements laws that prohibit discrimination based on age and disability.

Experience rating may also affect business organization. The rapid and unpredictable growth of health insurance costs has encouraged companies to reduce core work forces, by contracting with outside workers to whom they need not offer health benefits. Companies that do not offer health insurance probably tend to attract employees who place little value on health insurance relative to other forms of compensation of equal cost, although the actual extent of such "clientele" effects is unknown. The converse occurs with companies that provide health insurance as a fringe benefit of employment. The introduction of community rating will undo these effects.

Choice of Insurance Both experience-rating and community rating are consistent with a range

of insurance choices. Most of the health care reform plans calling for mandatory coverage that are now under serious political consideration would guaran- tee coverage for a specified package of services, and then allow people to purchase supplemental coverage. However, whether people would be permitted to buy private insurance that ensured greater access to the mandated services, and, if permitted, whether they would find such insurance attractive, is less clear.

In general, the mandatory plans under discussion do not contain high- and low-option plans that differ based on deductibles and cost sharing. They deny such choice, in part, because having plans with two levels of generosity raises serious problems of adverse selection (Stiglitz and Rothschild, 1976). At least one private plan found that the premium difference between high-option and low-option arrangements was greater than the difference between the deductibles.2 Despite this fact, some people continue to demand high-option

2This statement is based on personal conversation with Joseph Newhouse describing negotiations regarding the Harvard University health plan.




coverage, in apparent defiance of the laws of rational behavior. Thus, while some people (including perhaps most economists) might prefer less costly, high-deductible plans, proposals now under discussion preclude this option. The reasons for demanding more extensive insurance coverage in other dimen- sions-added services or higher maximum coverage-is easy to understand. Because the addition of services can be used by insurers to select among patients, variation among insurance plans increases the burden on risk rating.

Price differences can also affect the choice of provider or provider group. The essence of managed competition is that differences in prices charged by providers for given benefits should be clearly visible to households and re- flected in after-tax income. All of the major proposals for reform of health care financing, other than the so-called "single payer" options, embrace this princi- ple; and there is no good reason why a single-payer plan should exclude provider competition. For that reason, I shall not discuss it further.

Conclusions about Experience Rating On balance, experience rating through either self-insurance or medical

underwriting produces modest constructive incentives at best. In contrast to property and casualty insurance, most of the variation in predictable medical outlays is traceable to factors that neither individuals nor employers can control. Moreover, in the name of small potential efficiency gains, experience rating requires extensive administrative costs to keep track of who belongs in what group and creates perverse incentives not to hire the sick, the old, the handicapped-discriminatory behaviors that numerous laws and regulations have been enacted expressly to prohibit.

One aspect of experience rating might be retained: geographic variation. For example, the Clinton health plan, at least at the outset, would retain geographic variations in health spending by basing initial premiums within each regional health alliance on historical spending.3 Whether efforts should be made over time to reduce such inter-alliance variations raises additional questions that I shall not explore here.

Apart from such geographic variations, the common view on experience rating is mostly right: it penalizes the sick, through no particular fault of their own, and raises a host of disturbing equity concerns. Economists should stop displaying a regrettable instinct for the capillary by dwelling on imagined efficiencies from experience rating. I would urge them to turn to tasks that are genuinely important for efficiency in the delivery of health care: for example, designing partly-prospective payment systems that promote competition but discourage cream skimming by providers.

3I would also recommend that a move to community rating should be accompanied by heightened scrutiny over workplace safety and exploration of defensible variations in premiums among companies related to hazard-specific variations in medical outlays.



Henry J. Aaron 37

How Much Redistribution Will Community Rating Cause?

Most economists hold that the costs of health insurance will be borne by workers in the medium- to long-run, whether premiums are collected from employers or workers (Krueger, 1993; Gruber, 1993). This finding holds if the benefit is available only if the charge is paid. If the benefit is available as a matter of right, however, the charge should be regarded as a free-standing tax (Aaron and Bosworth, 1994). In either case, a mandate would raise employment costs for currently uninsured workers. With the passage of time, most of the cost would lead to reduced wages or other fringe benefits. In addition, the currently uninsured now receive free care, the cost of which is shifted to other payers and from there to premiums for the currently insured.

Such shifts are relatively modest, since roughly 85 percent of the U.S. population is insured. Far larger redistribution would result from community rating, a step that would level insurance costs at least within geographical areas.

In President Clinton's plan, community rating takes the form of charging employers one of three premiums (set in each health alliance) based on whether the worker is single, a single head of household, or married. Each state would form one or more nonoverlapping regional health alliances, among which the three premiums would differ based on historic spending patterns.

How these boundaries are drawn will affect premiums: for example, the premium charged a business in a town adjacent to a metropolitan area will depend on whether the town is included in the presumably high-cost metropolitan area or in some presumably low-cost suburban or rural alliance. For similar reasons, how alliance boundaries are drawn will influence whether companies with 5,000 or more workers will exercise the option under the Clinton plan to form their own health alliances, independent of the regional alliances. Since premiums would depend on how alliance boundaries are drawn, so will the subsidies paid to low-income households, who are eligible for aid if family income is below 150 percent of official poverty thresholds, and to businesses, who are eligible for subsidies if they employ fewer than 75 workers and pay average earnings below $24,000. Drawing boundaries among health alliances is likely to initiate political battles even more intense than those associated with Congressional redistricting.

How much the proposed community rating shifts costs among companies is impossible to measure accurately with currently available data. An examina- tion of current levels of health insurance payments among two-digit SIC industry groups permits rough estimates. Some illustrative data of this sort is presented in Table 1, for six industries with high health care costs and six with low costs.

Columns 2 and 3 present data on total employer contributions for health insurance per full-time-equivalent worker and as a percent of wages, respec- tively. The enormous differences among industries arise from four sources: variations in the proportion of active workers for whose insurance employers




Table I

Private Employer Health Insurance Costs by Industry, 1992

(billions of dollars) Total health insurance $171 Retirees 18 Current employees 153 Cost of uninsured workers 20

Current employer Adjusted employer Difference between contributions for contributions for current and

Industry health insurance health insurancea adjusted contibutions

($ per FTE) (% of wages) ($ per FTE) ($ per FTE) (% of wages)

High cost industies Mining

Metal mining 5,327 12.9 3,165 2,163 5.3 Coal mining 9,982 23.3 4,146 5,835 13.6

Manufacturing-Durable goods

Primary metal industries 5,108 14.3 2,593 2,515 7.0 Transport equipment 5,449 13.5 2,630 2,819 7.0

Manufacturing-Nondurable goods

Tobacco manufactures 7,653 17.3 2,869 4,785 10.8 Petroleum and coal products 6,800 14.2 2,776 4,024 8.4

Low cost industries Agriculture, forestries, and fishing

Farms 485 3.5 2,041 -1,555 -11.4 Transportation and public utilities

Local and interurban passenger transit 559 2.7 2,128 -1,569 -7.6

Retail trade 788 4.5 2,090 -1,303 -7.5 Finance, insurance, and real estate

Insurance agents, brokers, and service 1,216 3.4 2,126 - 910 -2.6 Real estate 716 2.8 2,091 -1,375 -5.3

Services Auto repair, services, and parking 754 3.6 2,110 -1,357 -6.5

Sources: Current and adjusted employer contributions computed by the author from unpublished data of the Bureau of Economic Analysis and Lewin-VHI. The industrial distribution of total employer payments is estimated for census years by the Bureau of Economic Analysis. These ratios have been held constant since the last census year, 1987, and applied to total employer contributions of each year. aAdjusted premium includes a 13 percent increase in average costs to cover uninsured workers and assumes uniform costs for non-retirees (community rating).




pay; variations in the range of benefits covered; variations in the cost of a given set of benefits based on riskiness of employment, age and demographics, and the location of the industry; and variations in the ratio of the number of retirees for whom employers provide benefits to the number of insured active workers.

Column 4 shows average costs per full-time equivalent worker under a system in which coverage is expanded to all workers and employers pay 80 percent of the national average insurance premium. The estimates in column 4 are based on the assumption that the cost for current employees is uniform across all plans nationally, and that the cost of providing insurance for the 26 percent of the private workforce that is currently uninsured would be half that of a currently insured worker.4 Columns 5 and 6 show the change in employer health care spending in dollars and as a percent of wages from current levels (column 2) to that shown in column 4.

These estimates are not intended as estimates of the Clinton plan. They take no account of the subsidies in that plan, the fact that regional variation would continue, and a number of other important factors.5 The interindustry redistribution shown in Table 1 exceeds that under the Clinton plan, which would leave geographical cost variation in place. However, because Table 1 reports pooled industry data, it likely understates redistribution among individual companies. In this symposium, David Cutler shows that demographic variations are far more important in explaining cross-company differences in costs than are plan variations.

Although inexact in various ways, the shifts in Table 1 demonstrate that the redistribution from a shift to community rating is large. The resulting adjust- ments may be concentrated in labor markets, with only secondary implications for prices or the reallocation of output among industries. Alternatively, an industry-wide increase in labor costs may initially be passed forward to consumers in the form of higher prices (Gordon, 1977). The increased real cost of labor would cause a shift to more capital-intensive production, and consumers would shift demand away from labor-intensive products with the largest price increases. As a result, workers end by bearing more of the burden than would

4The premiums for the total private economy exclude the costs of retiree benefits, which are then added back, on a very approximate basis, by two-digit industry. 5For example, some companies now offer benefits beyond those in the Clinton benefit package and payments beyond 80 percent of total insurance cost. While not required to continue offering such benefits, many companies almost certainly would do so. Also, the costs of retiree benefits would initially remain with companies (apart from the shifting inherent in a move away from experience rating) if, as seems likely, the Clinton proposal to relieve companies of the full cost of retiree benefits does not survive. Even if companies must pay premiums for retirees under the age of 65 and for benefits not covered by medicare for retirees over age 65, the Clinton plan relieves companies of much of the cost of retiree benefits, who are relatively old and therefore relatively costly, because of community rating. Finally, these estimates make no allowance for the effect on premiums of regional health alliances of averaging in the "medically needy," a group now receiving Medicaid that has relatively high costs and that would be part of the community-rated pool within each regional alliance (Lewin-VHI, 1994).




be conveyed as their share of consumption. The eventual effect may differ little from direct wage shifting, but the process of price shifting can result in a larger change in product prices and in the composition of output for a possibly lengthy transition. In reality, the adjustment process will vary widely in speed and character, because factor and product markets are imperfectly competitive and the extent of forward or backward shifting will depend on the market power companies enjoy in product and labor markets.

Most of the debate among economists regarding the effects of health care reform has proceeded at a highly aggregated level. Within the representative- company, representative-household framework, the effects of health insurance reform are small. But even if the sum of the effects is minor, these (largely offsetting) gains and losses deserve more analytical attention than they have received. However, disaggregated analysis requires more and better data than now are available.

Should Companies or Individuals Be Subject to an Insurance Mandate?

To achieve universal coverage, any reform of health care financing must rely on a mandate. Which approach is superior: an employer mandate or an individual mandate?6 The issues fall into three broad categories: administrative ease, the efficiency of subsidies, and transition.

Administrative Ease Under an employer mandate, the government enforces coverage by deal-

ing with companies for employees and with individuals who are not members of a family in which someone is employed.

The ease of administration for the employed depends in large measure on how premiums are set and on how coverage is determined. The task is easy if employers pay a payroll tax at the same rate wherever the company operates, and if employees and their dependents are thereby covered. Complexity increases as employer payments vary for different workers, for example on the basis of hours worked or of earnings. More difficult problems arise if payments vary based on the employment status of spouses-for example, if premiums are lower for one or both members of a couple when both husband and wife work,

6For example, Clinton's plan requires employers to sponsor insurance plans for all employees and pay 80 percent of the average cost of insurance in the health alliance or alliances to which the employer belongs. His plan also mandates that non-aged individuals who are self-employed or are out of the labor force must demonstrate that they have insurance. Senator Chafee's plan, in contrast, would require employers to sponsor coverage, but not to pay for it. The mandate to pay for coverage would fall on individuals. However, many employers would no doubt continue to pay for coverage, because Chafee would retain most of the tax advantages now enjoyed by employer- financed coverage.



Henry J. Aaron 41

than if only one is employed outside the home. Additional difficulties arise if, as under the Clinton plan, different members of the same nuclear family are employed in areas with different financing arrangements (that is, under different regional or corporate alliances). In that event, the source of coverage must be determined, and transfers of funds among financial agents must be managed.

The chief administrative advantage of the employer mandate is that the government must deal only with companies rather than the far larger number of individuals. This advantage is eroded to the extent that employees are directly eligible for subsidies based on income that require periodic filings to determine eligibility and subsidy amount. If the employee payment were identical for all workers, the requirement of individual payment would not add any serious administrative complexity for employees.

For the self-employed and the non-working, the difference between enforcing coverage under an employer mandate and doing so under an individual mandate loses most of its meaning. For any given pattern of charges, the government would have to rely on declarations accompanying tax returns, direct registration, or some other enforcement mechanism. As with all tax enforcement, the self-employed will pose more vexatious and costly problems than do the other-employed. All plans, other than those that would establish direct government insurance, rely on an individual mandate for people who are outside the labor force and who are not members of a family in which at least one persons works.

On balance, therefore, the difficulties of enforcing coverage under an employer mandate and an individual mandate seem quite similar, as long as both provide similar subsidies.

The Efficiency of Subsidies All systems of mandatory private coverage require explicit subsidies. An

individual mandate requires subsidies to low income households for whom the mandate would otherwise be unaffordable. Employer mandate plans typically call for two classes of subsidies-transitional subsidies to ease the transition for some companies that did not previously pay for coverage, and permanent subsidies to reduce the tendency for mandated premiums to raise employment costs of low wage workers disproportionately.

Permanent subsidies under an employer mandate face an inescapable dilemma. If subsidies are paid on behalf of low-wage workers wherever employed, some portion of subsidy is "wasted," since some low-wage workers are members of high income families. Payment of subsidies to low-wage companies doesn't solve that problem and creates incentives to reorganize businesses to segregate subsidy-eligible workers in companies without high-wage workers, whose presence will reduce subsidy payments.

The Clinton plan illustrates the latter problem. It requires all employers to pay 80 percent of the average cost of insurance for each of three family types,




but caps the payments in two ways. First, no company is forced to pay more than 7.9 percent of payroll for health insurance. This limit means that companies with costs above 7.9 percent of payroll are automatically eligible for subsidy. Second, companies with fewer than 75 workers are eligible for caps equal to a reduced percent of payroll. The lowest rate, 3.5 percent, applies to employers with fewer than 50 employees and earnings per worker under $12,000 annually.

This arrangement creates at least three odd interrelated incentives. First, companies with 75 or more workers have a strong incentive to contract out for services of low-wage workers that can be produced by companies employing fewer than 75 workers. Custodial services, mail rooms, and other low skill services are best purchased from separate small companies that are eligible for caps under 7.9 percent.

Second, a company with average health care premium costs under 7.9 percent of payroll must bear the full cost of health insurance for a new worker, even if that new worker earns only the minimum wage. Family benefits typically cost approximately $2.50 per hour. While recent research has caused many labor economists to reduce their estimates of the disemployment effects of increases in the minimum wage, a jump of about $2.60 per hour-or nearly a 50 percent increase-that is indexed vastly exceeds any historical change.7

Third, the caps on maximum payments create disincentives for some companies to hire high-wage workers. For example, consider a company that is subject to the 7.9 percent cap. If health insurance costs would average $3,000 per employee but for the cap, and if the company takes on an additional worker at a $100,000 salary, the company's health costs rise not by $3,000 but by $7,900.8

This odd incentive is entirely eliminated if the subsidy is based not on average company earnings or the number of employees, but is targeted on all low-wage workers. In this case, the number of recipients of subsidies rises dramatically. Perhaps more worrisome, any method of subsidizing low-wage workers by making payments to companies confronts companies with higher gross costs of raising wages for such workers-the cost of the wage increase itself plus the loss of subsidy.

None of these problems arises under an individual mandate, where the subsidies can be based on family income. Employer-based subsidies, as a

7This effect is responsible for the incentive to "buy rather than make" services produced by low-wage workers. 8A second example is somewhat more striking. Consider company Y with 24 employees earning an average of $12,000 annually. This company will be eligible for the cap of 3.5 percent of payroll on its health costs, holding them to only $10,800. If it wants to hire a supervisor at a salary of $90,000, the cap to which it is subject rises to 6.2 percent and its health charges rise by $13,356, a tax of nearly 15 percent. Too much should not be made of this last oddity which depends largely on the existence of notches in the subsidy formula of the Clinton plan. If the concessionary rate phased out gradually rather than in steps, the anomalies are drastically reduced.




practical matter, cannot be based on family income or even on family earnings, but rather must depend on earnings of each worker.

Transition The chief advantage of the employer mandate is that it keeps current

employer outlays flowing, thereby minimizing the adjustment costs of shifting to a new payment base. This advantage is both economic and political. The economic advantage is encapsulated in the old saw from public finance: an old tax is a good tax. The deeper truth in this saying is that current taxes are capitalized into values of assets. Undoing such taxes-or contractual distribu- tions of health insurance costs-will produce windfall gains and losses. As already indicated, these gains and losses may be considerable.

Designers of health care reforms have operated under the mistaken notion that employer-mandates and individual mandates cannot be joined. It is possible to combine the best features of each. Employers could be required to sponsor and pay for a portion of the health insurance of their employees. Subsidies could be provided on behalf of low-wage workers to minimize any disemployment effects. The amounts paid for health insurance could be included at year end on the W-2 forms each worker receives. The total amount that each household would be required to pay for health insurance could be based on family size and family income, less whatever has been paid by employers for whom family members worked during the year. If exclusion from personal income tax of most employer payments for health insurance are retained under a system where everyone must have health insurance, while individual payments must be made from after-tax income, the incentive for employers to sponsor and pay for health insurance would actually increase.

References

Aaron, Henry J., Serious and Unstable Condi- tion: Financing America's Health Care. Washing- ton, DC: Brookings Institution, 1992.

Aaron, Henry J., and Barry Bosworth, "Economic Issues in Reform of Health Care Financing," Brookings Papers on Economic Activ- ity: Microeconomics, forthcoming 1994.

Employee Benefits Research Institute, Data Book, Washington, DC, 1992.

Gordon, Robert J., "Can the Inflation of the 1970s be Explained?," Brookings Papers on Eco- nomic Activity, 1977, 1, 253-77.

Gruber, Jonathan, Testimony, Committee on Ways and Means, House of Representa- tives, 1993.

Krueger, Alan B., "Observations on Em- ployment-Based Government Mandates, With Particular References to Health Insurance," mimeo, Princeton University, 1993.

Lewin-VHI, Inc., The Financial Impact of the Health Security Act, 1994.

Newhouse, Joseph P., "Patients at Risk: Health Reform and Risk Adjustment," Health Affairs, Spring 1994, I, 13, 132-46.

Stiglitz, Joseph E., and Michael Roth- schild, "Equilibrium in Competitive Insur- ance Markets: An Essay on the Economics of Imperfect Information," Quarterly Journal of Economics, November 1976, 90, 629-49.



Documents

Issues Every Plan to Reform Health Care Financing Must Confront