As part of its effort to manage the economy during World War II the government passed the Stabilization Act of 1942 that imposed price and wage controls but authorized employers to offer health insurance as a fringe benefit exempt from wage controls. Employee provided health insurance was granted tax preferences in 1943 by an administrative tax court ruling, and in 1954 by changes to the Internal Revenue Code; health insurance payments were made tax deductible for the employer and tax exempt for the employee. Copayments remained fully taxable creating an economic incentive to have as many dollars of health care services paid through the employer provided plan. To avoid taxes, routine health payments and insurance against catastrophic health events were covered by the same policy. Health care users no longer observed nor cared to observe the full cost of medical treatment because that cost was largely independent of their out of pocket cost or insurance cost. Payment to providers is made by the insurance company. Economists frequently refer to this arrangement as third party payment. The price of group insurance was based on the medical cost of the group, and because one employee's efforts to limit health care expenditures had virtually no impact on the overall medical care purchased by the group, no employee had incentive to economize. Because they would be paid by the group, health care providers had incentive to provide the best quality care regardless of price. Price became less important as a rationing mechanism and the health care more subject to rising cost.1,2
Abstracting away from problems caused by government tax policy, and with due apologies for goofy numbers, a well functioning market for health care would look something like Figure 1. The demand curve shows the amount of health care that consumers are willing to purchase at each price, and the supply curve shows the amount of health care that providers are willing to sell at eat price. The point at which the curves cross (E) is call equilibrium and it occurs at the price which the quantity that buyers wish to purchase is exactly equal to the amount producers are willing to sell. There is no waste. In this market, the equilibrium in which the equilibrium price is $48 per unit of health care and the equilibrium quantity of health care is 24 units. Total medical expenditures are $1,152 ($48*24) and are depicted as the yellow area in the graph.
For the purpose of this analysis, I divided the market evenly into two types of households, low income and high income. I have assumed that the only difference in demand between the two is income and that given the same level of income, demand would be identical. This results in demand curves that converge at a zero price per unit. Neither household is completely priced out of the market, but the market price of $48 per unit results in a much lower demand by low income households (6 units) than my high income households (18 units). Low income households spent $288 for health care and high income families, $864. Although the low income families buy health care at the margin, they may be priced out of some procedures or insurance markets or may believe that they can force others to pay for their healthcare (see "Democrats Ask, Can Health Care Bill Be Saved?" and "She Chose").
One proposal that is often mentioned is to allow people to buy health care regardless of the cost. This proposal is untenable. Again, the numbers are fanciful, but the direction of their movement is not. At a zero price (point A on the Demand curve), 48 units of health care are demanded, more than 2.67 times more than upper income households would but for themselves if confronted directly by price. At a zero price, no health care would be provided. The price needed to induce health care providers to produce 48 units of health care is $96 per unit (point B on the Supply curve). Taxpayers from both low and high income households would be obligated to pay $4,608, 4 times the bill that households paid under market conditions.
The market uses prices to ration goods. Some have suggested that government established committees could better allocate health care resources. One solution might be to provide low income households with the amount of health care they would have purchased under market conditions if they had the same income as high income households. This changes the shape of the demand curve causing more health care to be purchased at each price. At eqhe Health care providers must be paid $2,048 to produce that level of care. Assuming that low income households pay only $288, their original expenditure for health care, the remainder must come from high income families who are clearly much worse off. Under market conditions, they paid $864, under government provision, they must pay $1,760. The increase in their tax obligation is the same as a reduction in income. Under market conditions, high income families would respond to the reduction of income by lowering health care purchases, but they are forced to buy more health care for themselves than they would freely choose.
Alternatively, the government could choose to provide the market quantity of 24 units of health care and divide it evenly between low and high income households with both receiving 12 units of health care. The total health care bill would remain at $1,152 and might be divided as it was under market conditions with low income households paying $288 and high income households, $864. Again, high income households are worse off. Their health care expenditures are the same but they can only use 12 units of health care as opposed to 18.
An easier and simpler approach would be to eliminate the tax advantage of employer provided plans.3 The government would be better off receiving more in taxes. If health care providers do not respond to changing market incentives, low income families would be no worse off but high income families would be worse off due to the higher tax bill. But people respond to incentives, even health care providers. Under existing incentives, they provide high quality care regardless of cost, but under the new incentives, they would provide the highest quality care per dollar of consumer expenditure. The quality of care would continue to improve but, with health care providers and consumers both more concerned about costs, at a much less explosive rate of cost growth. It is the only scenario in which the government, health care providers, and all consumers could be made better off.
1. The high intensity use of labor is a second reason for the rising cost of health care. See "Baumol, Cost Disease, and Health Care."
2. See "Rationing Health Care" for a more descriptive analysis of how the third party payment system distorts market incentives.
3. Alternatively, the government could extend the same tax benefits to private purchasers of health care that are now enjoyed by those who are covered through employer provided plans. The improved incentives would be the same for buyers and sellers of health care but government deficits would grow.
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