1 Chapter 10 – Social Insurance II: Health Care Public Finance McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

2 What’s Special About Health Care? Health care costs are large and growing fast Number of reasons why First Welfare Theorem may be violated –Poor information (physician induced demand) –Adverse selection and moral hazard –Disease externalities

3 What’s Special About Health Care? In the context of health care, moral hazard can be analyzed in a conventional supply-and-demand framework. Health insurance changes the price of health care and creates deadweight loss.

Figure 10.1

5 What’s Special About Health Care? Without insurance, consume M 0 of health care services. Insurance in this example lowers the price of services to 20% of actual price. With insurance, consume M 1 of health care services. Deadweight loss equals abh.

6 The U.S. Health Care Market Patchwork of public and private insurance 13.2% of GDP Spending on hospitals is 32% of costs Spending on physician services is 22%

7 The U.S. Health Care Market: Private Insurance Virtually all (93%) of private insurance for the non-elderly is provided through the employer. –By-product of wage and price controls during World War II –Tax provisions subsidize employer contributions –Group market is less expensive than individual market

8 The U.S. Health Care Market: Private Insurance Link to employment potentially leads to “job lock” –When you leave your job, you also lose your health insurance –May be difficult to get new insurance if you have a “pre-existing” condition –Kennedy-Kassenbaum Act mandated that employers must include a new employee who previously had health insurance, even if he or she has pre-existing condition.

9 The U.S. Health Care Market: Private Insurance Group market –Possible that workers within a firm are fairly heterogeneous, so adverse selection is less of a concern –On the other hand, employees not randomly assigned An employer may shift-compensation toward wages, or shift employee’s onto spouse’s plan by offering a less generous package of benefits. More problematic at smaller firms.

10 The Role of Government Medicare Implicit subsidy for employer health insurance Medicaid

11 The Role of Government: Medicare Approximately 40 million enrollees Not means-tested Program divided into three parts: –Part A: Hospital insurance (HI) –Part B: Supplementary medical insurance (SMI) – optional, but 99% of elderly take it up –Part C: Medicare+Choice – optional, a managed care arrangement where elderly get certain additional benefits like prescription drug coverage and have restricted choice of providers

12 The Role of Government: Medicare Medicare does not cover: –Long-term institutional services like nursing homes –Prescription drugs, though new legislation was passed in 2003 that will phase-in coverage Medicare beneficiaries spent $87 billion on outpatient prescription drugs in 2002

13 The Role of Government: Medicare Medicare financing paid for by payroll tax on current workers Uncapped, totals 2.9% split evenly between employer and employee

14 The Role of Government: Medicare Medicare financing paid for by payroll tax on current workers Uncapped, totals 2.9% split evenly between employer and employee Medicare outlays have grown dramatically over time – raises concerns about its solvency

Table 10.1

16 Part D Source:

17 The Role of Government: Controlling the Costs of Medicare Medical Savings Accounts (MSAs) –Consumers have very weak incentives to control costs, the moral hazard issue. –MSAs are in effect a catastrophic insurance policy – provides payments for very expensive illnesses, but not the day-to-day health care needs. –Money in MSAs that is not used can be used for non- medical purposes. –Leads to adverse selection, where the low-risks opt into MSAs.

18 The Role of Government: Implicit Subsidy for Health Insurance Employer contributions for health care plans are not subject to taxation –If employer increases wages by $2,000, employee only keeps (1-t)x$2,000, where t=marginal tax rate –If employer provides health insurance worth $2,000, tax bill does not increase Provides incentive to substitute away from wages and towards fringe benefits like health insurance.

19 The Role of Government: Implicit Subsidy for Health Insurance Because of subsidy: –More firms provide employer-provided health insurance –Firms provide more generous health insurance

20 The Twin Issues: Access and Cost Access to health care –83% of non-elderly have some form of health care –17% of non-elderly (41 million people) are uninsured –Uninsured are diverse group Most are employed Less than half are poor Absence of health insurance different from absence of health care

21 The Twin Issues: Access and Cost Costs –Table 10.2 shows the rapid growth in health care over time –Table 10.3 and Figure 10.2 show that the U.S. has much higher levels of health care expenditure than other developed countries, but the rate of growth is not out of line

Table 10.2

Table 10.3

24 The Twin Issues: Access and Cost Why are costs growing? –The “graying” of America – older populations require more health care –Income growth – health care is a normal good –Third party payments – insurance coverage may have changed –Improvements in quality – treatments are very different (better and more expensive) than in previous decade

25 New Directions for Government’s Role in Health Care Individual mandates –States force their residents to purchase automobile insurance, so why not health insurance? –Heritage Foundation’s plan would have an individual mandate, replace the implicit tax subsidy to employer-provided health insurance with vouchers, and keep Medicare and Medicaid intact.

26 New Directions for Government’s Role in Health Care Individual mandates –Analogy with automobile insurance is tenuous. Automobile accidents clearly cause fiscal externalities – damages to other vehicles, passengers, and property. The consequences of getting sick are largely internalized. States remove the highest risks (e.g., those who have drunk driving convictions and those under age 16, etc.) from the insurance pool by restricting their ability to drive. The high health risks are not removed in any way.

27 New Directions for Government’s Role in Health Care Individual mandates –Enforcement of mandate is unclear –What happens if someone did not purchase insurance? –If someone chooses not to drive or own an automobile, there is no mandate that they buy insurance.

28 New Directions for Government’s Role in Health Care Single Payer –One provider of health insurance, funded by tax collections. –Eliminates adverse selection problem, and is used in many developed countries. –Analog in U.S. would be to extend Medicare. –Prices are not used in this case to ration health care, and often rationing is done by imposed constraints on the supply side (e.g., waiting lists for health care).

29 New Directions for Government’s Role in Health Care Single Payer –Also, denial of treatments for some patients In United Kingdom, patients over age 65 are generally not permitted kidney dialysis –Health care costs are growing at about the same rate in these countries as in the U.S.