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Rising Health-Care Costs: Who's the Villain?

Our Health-Care System Disguises Costs to Individuals

APRIL 01, 1995 by CHARLES VAN EATON

Dr. Van Eaton is McCabe/UPS Professor of Economics at Hillsdale College, Hillsdale, Michigan.

Why is the level of health-care spending what it is? Why does the rate of growth in health-care spending tend to rise faster than spending on other things? Can anything be done to control the rate of growth, if not the level, of health-care costs, short of having government take control of what now constitutes almost 14 percent of our entire Gross Domestic Product? What can be done to decrease the number of persons who are without some form of private health-care insurance?

As the political debate about health care unfolded, it became clear that virtually no one in the federal establishment thought that trying to get answers to these questions made any difference in what the politicians were trying to do to move government even more heavily into the health-care-services production system than it is now.

It does make a difference. There are strong differences of opinion on why the level of U.S. health-care costs are what they are, why these costs have been rising faster than the cost of other goods and services, and what government can do both to reduce the level of costs and to arrest the rate of cost growth.

On one side is the view that if the level of spending on health care is the product of forces over which government can, at best, have little control, there is no reason to give government more control. However, if part of the reason health-care spending tends to rise faster than other streams of spending is the product of policies generated by government programs, and if the goal is to reduce this rate of spending growth, the obvious place to start would be to do away with those government policies which contribute to spending growth.

Those who believe that both the level and rate of growth in health-care spending are problems unique to the private-sector character of the American health-care-services production system see no solution which does not involve granting considerably more power to government.

Why are costs what they are and why do they tend to rise as fast as they do?

“Villain Theories”

On one side of the debate one hears what may be called “villain theories” of healthcare costs. These theories focus on the production side of services and conclude that both the level and rate of growth in costs are the product of greed on the part of insurers, pharmaceutical companies, hospitals, and physicians.[1] Until these parts of the health-care-services production and financing system are brought under control, this argument goes, nothing can be done to reduce health-care spending. Clearly, policies based on this approach must eventually come to rely on command over, and control of both producers and consumers of healthcare services.

Against the villain theory of health-care costs lies the view that the level of healthcare costs is a product of six factors, none of which involves villains of any stripe.

1. The level of health-care costs relative to Gross Domestic Product is higher in the United States than it is in other countries because the American health-care system has been so successful in treating conditions which, in past times, would have been untreatable.[2] Consequently, good medicine increases rather than reduces the proportion of people in our population who have illnesses requiring continued treatment.

Dr. Willard Gaylin argues that “There are more people wandering the streets of the cities of the United States with arteriosclerotic heart disease, diabetes, essential hypertension, and other expensive chronic diseases than there are in Iraq, Nigeria, or Colombia. Good medicine keeps sick people alive, thereby increasing the number of sick people in the population; patients who are killed by their diseases are no longer part of the population.”[3] (Put another way, while the dead are no longer a cost burden to the health-care system, survivors are.)

2. The technological superiority of the American health-care-services production system has resulted in an increase in the quantity of health-care services demanded. The technical diagnostic capacity to test for that additional one percent of information, which might provide answers to a medical puzzle, results in a demand for additional testing and additional treatment-at additional cost, of course. (If this reflects a basic American value-wrong in the view of some critics-which says “damn the costs, save lives and use expensive technology whenever necessary,” costs are bound to be higher than would otherwise be the case.) Consequently there are many who argue that American medical technology is a major reason for the high level of health-care costs.[4]

3. What is all too often overlooked when the level of American health-care spending is unfavorably compared to spending in other nations is that the United States, in many ways that are unfortunate, is not like other nations. Therefore comparing the level of health-care spending in the United States relative to spending in other nations is not particularly useful unless all those distinguishing factors are addressed and statistically held constant before cost comparisons are made.

For example, many Americans lead lifestyles that contribute to strong demand for health-care services. As former Secretary of Health and Human Services Louis W. Sullivan noted, “It cannot be overemphasized that the top ten causes of illness and premature death in our nation are significantly influenced by personal behavior and lifestyle choices.”[5] Comparing data collected in 1977 and 1983, researchers found more obesity, less exercise, more drinking, and less sleep in 1983 than in 1977.[6] Add to this those other factors which extend beyond health care per se while simultaneously imposing greater demands on the system-problems having to do with rates of drug usage, crime, family breakdown, rates of HIV infection, and low-birth-weight babies born to unwed mothers-and it is not surprising that health-care spending is as high as it is.[7] In addition, the United States has a broad underclass enmeshed in poverty. Because they are often uninsured, low-income people with health problems often enter the medical system trough emergency wards—the most costly part to the health-care production system—and often postpone treatment to the point that when treatment is given it is more costly.[8]

4. Despite having a persistent poverty segment, America is a high-income nation. A nation with high income is going to spend more on everything, especially health care, because health care is, to use economists’ jargon, highly income elastic. When income levels rise by some given percent, the demand for health care rises proportionately more.[9] It’s both as simple and as complicated as this: a rich nation spends more on health care simply because it is rich.[10]

5. If there are reasons to believe that Americans spend more on health care because, to an important extent, we are what we are, this only explains the level of health care spending, not the annual rate of growth in spending. (The issue of medical malpractice litigation, too, is one that affects the level of health-care costs.) Why have U.S. health-care costs been rising? Is the cost increase issue one that also requires a “villain” explanation?

What can government do to change these cost factors? Virtually nothing.

The rate of growth in American healthcare costs relative to the cost of other things Americans buy, New York University economist William Baumol argues, is due to the relative difficulty of expanding productivity in services production compared to goods production.[11] In Baumol’s view, there are no villains.

Baumol, long considered one of America’s foremost scholars in the field of productivity analysis, argues that “There is no advanced country in which complaints about rates of cost increase are not heard.” In fact, “in fourteen of eighteen countries in the years 1960 through 1990, health-care prices rose more rapidly than prices in general. The U.S. rate of increase was exceeded by that in seven countries-Australia, Austria, Canada, the Netherlands, New Zealand, Norway, and Switzerland. The universality and persistence of the problem suggests something which lies deeper than the particular administrative or institutional arrangements adopted in any single country.”

Those inclined to see the rise in healthcare costs in terms of villains who must be managed by direct government intervention into the health-care-services production system may be failing to grasp the nature of services production relative to goods production. Both data and theory compel serious observers to acknowledge that it is far more difficult to increase productivity in services such as health care, law, welfare programs, mail, police, sanitation, repairs, and the performing arts, compared to manufacturing, because in the latter the continual development of new tools and management techniques makes it possible to expand output with fewer units of labor input.

By contrast, services—particularly health-care services—all have a “hand-craft” attribute in their supply process. Consequently, when productivity rates differ across different sectors of an economy, say, manufacturing compared to health care, the money price of health care will rise relative to the money price of outputs in those sectors where productivity gains are real and substantial. Therefore, Baumol concludes, rising health-care costs are “an inevitable and ineradicable part of a developed economy and the attempt to do anything about it may be as foolhardy as it is impossible.”[12]

But even when services productivity is relatively stagnant, real services costs can be seen to be falling despite the rise in services’ dollar prices because there is in fact no service whose productivity is untouched by technical progress in other sectors. A general rise in productivity led by those sectors where productivity gains are easier to accomplish means, by definition, that it requires ever less labor time to acquire all things. “In an economy in which productivity is growing in almost every sector and declining in none (modern medical technology has certainly improved some aspects of medical-labor productivity, particularly the development of new tools and techniques which make it possible to do surgical procedures on an outpatient basis compared to an inpatient basis), it is a tautology that consumers can have more of every good and service: they simply have to transfer some of the gains from the sectors that are becoming more productive into the sector that’s becoming only a little moire productiv.”[13] Consequently, the rise in the dollar price of health-care services is not evidence of a system in despair, but only of a broad difference in relative productivity rates between services and goods.

But, Baumol rightly notes, “This happy conclusion is just a bit too simplistic…. it will not be easy to convince the layperson that, even though the prices of personal services appear to be rising at a phenomenal rate, in fact the costs of these services (in terms of their labor time equivalent) are really declining because of increases in labor productivity generally.”[14]

6. While Baumol’s argument as to why the dollar cost of health care has risen relative to the cost of other components of GDP is compelling, it is not, as he would be the first to acknowledge, the whole story. The rest of the story deals with the fact that health-care demand may now be the most heavily subsidized component of aggregate demand. Subsidizing demand for the output of a relative-productivity-lagging healthcare sector adds an additional source of pressure to increasing health-care costs.[15]

For example, even though the German insurance system is bankrupt despite premiums that come to 13 percent of payroll, after paying the tax, Germans “graze themselves to obesity on medical services because the price of care, as perceived by individuals, is essentially zero.”[16]

A new econometric model developed by Gary and Aldona Robbins of Fiscal Associates, Inc., which looks at how America finances health care, provides insight into why our current system for subsidizing health care distorts demand and adds costs that increase the probability that some people will be priced out of the market for affordable health insurance coverage. The Robbinses note the following:

•       Prices matter. People are not price sensitive in the market for health care as they are in the market for other goods and services because some third-party (Medicare or a private insurer) pays most of the cost of health services. For the same reason, health-care providers are less concerned about the costs of the services they supply because someone other than the patient will pay all or the major part of the bill.

•       Health spending has been rising because prices paid by patients have been falling. When we are using someone else’s money, we pay less attention to costs and thus spend more. Over the period 1960-1990 the share of personal income spent out-of-pocket on health care declined from 4 percent of total consumption expenditures to 3.6 percent. Over the same period the amount spent from all third-party sources has more than tripled-from 4 percent of consumption on all goods and services in 1960 to 13.3 percent in 1990. Clearly this increase reflects the fact that the demand for health-care services is the most heavily subsidized component of household spending.

•       Most Americans are overinsured. because of government policies. Through generous tax subsidies to employers, government “pays” up to one-half of the cost of employer-provided health insurance. A corporation that pays, say, 50 percent of its income in federal and state taxes combined would be able to “escape” half the cost of providing such insurance to its employees. Through Medicaid and Medicare, government directly pays medical bills for the poor and elderly.

•       Because it is easier to subsidize the demand for health care compared to the supply of health care, increases in demand result mainly in higher prices rather than in more services. On average, each additional dollar spent on health care buys only 43 cents more of real services but adds 57 cents more to prices.

•       The main cause of rising health-care spending is government. Direct government spending has increased from 24 percent of all health-care spending in 1960 to 42 percent in 1990. When tax policies are included–which means provisions in the tax code that make employer-provided health insurance tax-free while individuals who purchase their own insurance must do so with after-tax dollars–the government’s share of health spending has risen from 34 percent in 1960 to 53 percent in 1990.

•       Because of the third-party character of our health-care finance system, most people have no idea how much they are personally contributing to cover the costs. In 1992 national health spending was equal to $8,821 for every U.S. household, with most of this burden hidden from view.

•       Because of third-party insurance and government subsidies, the most costly services are often the cheapest to patients. On average, patients pay only 4.5 cents out of pocket for every dollar spent on hospitals, but 68 cents out of pocket for every dollar spent on pharmaceuticals. Thus, to patients, hospital therapy appears cheaper than drug therapy while for society as a whole the opposite may be true.

•       Because of government policy, many Americans are uninsured. In 1990, through the tax system, government may be said to have “spent” about $64 billion subsidizing private health insurance by encouraging employer-based health insurance which is deductible for business tax purposes. At the same time, people who purchase their own insurance are penalized. When state mandates require insurers to cover a wide range of “health services” (hair transplants in Minnesota, for example) and larger firms which self-insure are exempted from such mandates, larger firms are exempted from the cost-increasing effects of such mandates while smaller firms and individuals are not. Add the tax deductibility component and small firms and individuals are often priced out of the market.[17]

One must conclude that, however unintentionally, our current system of third-party-driven health-care finance has yielded an unusually perverse outcome: while it contributes to higher levels of health cost for the nation as a whole, it sends a signal to individuals which leads them to believe that health-care costs are cheap. Consequently, the direct effect of rising health-care costs are largely hidden from the majority of individual health-care consumers.

In short, if the word “crisis” has any place at all in the debate, it should not be applied to the health-care-services production system, it should be applied to how we finance the demand for health-care services because this system, which is based on having someone other than the health-care consumer pay the bill, robs individuals of a direct stake in health-care cost control.[18]

What should government be trying to do? It certainly should not be trying to impose a massive Medicare or Medicaid system on the whole country. Neither should it be moving to bring all Americans under the umbrella of employer-provided health insurance. These two systems, to the extent that they have contributed to disguising health-care costs to individuals, have been the single most critical factor in forcing health-care costs upward. Government should move the system away from its heavy reliance on third-party payments toward a system based on individual accountability for health-care spending. Is that the direction government will finally take? We shall see. []


1.   In Putting People First, President Clinton blamed greed for the growth in health-care costs. “What we need,” he said, “is leaders willing to take on insurance companies, the drug companies, and the health-care bureaucracies to bring healthcare costs down.” Princeton economist Dr. Uwe E. Reinhardt, a frequent speaker before The American Medical Association, believes that physicians earn too much relative to the quantity of real health-care services supplied to patients. See, “Why You’re Afraid of the Doctor,” The New York Times Book Review, April 20, 1990; and “Resource Allocation in Health Care: The Allocation of Lifestyles to Providers,” The Millbank Quarterly, Vol. 65, No. 2, 1987, pp. 153-176.

2.   Willard Gaylin, M.D., “Faulty Diagnosis: Why Clinton’s Health-Care Plan Won’t Cure What Ails Us,” Harper’s Magazine, October, 1993, pp. 57-64.

3.   Gaylin, p. 59.

4.   This is not a settled question. See, for example, Stuart H. Altman and Stanley S. Wallack, “Is Medical Technology the Culprit Behind Rising Health Care Costs? The Case for and Against,” in Medical Technology: The Culprit Behind Health Care Costs? (Washington, D.C.: U.S. Department of Health, Education, and Welfare, Public Health Service, 1977), pp. 24-38. Note: while medical technology may be expensive, these advances almost always lead to more cost-effective total cam and better quality of life. It is interesting that in no other industry is less technology considered progress.

5.   Alf Siewers, “Don’t Socialize U.S. Medicine, Sullivan Says,” Chicago Sun-Times, June 24, 1991.

6.   Leonard A. Sagan, The Health of Nations: True Causes of Sickness and Well-Being (New York: Basic Books, Inc. 1987).

7.   Nicholas Eberstadt, “Why Aire So Many Babies Dying?” The American Enterprise, September/October 1991, p. 38.

8.   Alain C. Enthoven and Richard Kronick, “A Consumer-Choice Health Plan for the 1990s,” New England Journal of Medicine, 320:29-31, January 5, 1989, p. 30.

9.   In cross-section studies of differences in health-care spending among nations, George J. Schieber and Jean-Pierre Poullier found that each 10 percent difference in per-capita Gross Domestic Product is associated with a 14 percent difference in per-capita health-care spending. Schieber and Poullier, “Overview of International Comparisons of Health Cam Expenditures,” Health Care Financing Review, Annual Supplement 1989, p. 72.

10.   Studies conducted by A. J. Culyer reveal that the significantly higher income level Americans enjoy accounts for 80 percent of the amount they spend on health care compared to other nations. See A. J. Culyer, “Cost Containment in Europe,” Health Care Financing Review, Annual Supplement 1989, p. 23.

11.   William J. Baumol, “Anatomy of an Illusion. Do Health Cam Costs Matter?” The New Republic, November 22, 1993, pp- 16-18.

12.   Ibid., p. 16.

13.   Ibid., p. 18.

14.   Op. cit., p. 18.

15.   Does the presence of subsidy really increase demand? According to a Brookings Institution study, as reported by David Kelley in Reason, January 1994, in 1964 before Medicaid went into effect, the non-poor saw physicians about 20 percent more frequently than the poor. By 1975, the poor were visiting physicians 18 percent more often than the non-poor, In 1963 among those with incomes under $2,000, there were only half as many surgical procedures as among those with incomes of $7,500 or more; by 1970 the rate for low-income people was 40 percent higher than for those with middle-class incomes.

16.   Wilfried Prewo, chief executive of the Chamber of Industry and Commerce in Hanover, Germany, “Germany is Not a Model,” Wall Street Journal, February 1, 1994.

17.   Gary Robbins, Aldona Robbins, and John Goodman, “How Our Health Care System Works,” National Center for Policy Analysis Policy Report No. 177, February 1993.

18.   Grace-Marie Arnett, president of Arnett & Co., a Washington, D.C., health-policy consulting firm, argues that “In virtually all developed countries, the concept of using health insurance as a protection against financial risk has been lost. Instead, health insurance has become a plan for pre-payment of routine medical expenses.” See “You Bet Your Life,” in National Review, May 24, 1993, pp. 30-34, In the same vein, Peter Samuel argues that “While America’s medical technology and professional expertise are unmatched, our health-care financing arrangements are collapsing.” See “Health Reform Politics,” in National Review, May 24, 1993, pp. 34-37.

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April 1995

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