|Briefing Paper No. 19||October 4, 1993|
by Brink Lindsey
Brink Lindsey is director of regulatory studies at the Cato Institute.
The crisis of soaring health care costs has one fundamental cause: people are usually spending someone else's money when they purchase health care services. The rise of third-party payment has created an incentive structure that makes runaway spending inevitable. Health insurance is now the equivalent of auto insurance that covers fill-ups and oil changes.
The Cato Institute's Patient Power plan for health care reform seeks to put control over spending back in the hands of individual patients. Under the Patient Power plan, people could make deposits to tax-free Medical Savings Accounts to finance routine medical expenses. Workers currently covered by employer-provided insurance could fund their MSAs by switching from low-deductible policies to high-deductible catastrophic policies and depositing the premium savings. Furthermore, the Patient Power plan would eliminate the arbitrary discrimination of today's tax system and allow all Americans, regardless of employment status, to claim tax benefits for purchasing catastrophic insurance and making deposits to Medical Savings Accounts.
Our present health care system is suffering from run-away prices and spending. For the past three decades, health care spending has been growing more than twice as fast as the overall economy; as a percentage of gross national product, it has risen from 6 percent in 1965 to 14 percent today. Meanwhile, the system is plagued not only by overspending, but also by underinclusion: at any given time about 35 million Americans do not have health insurance. That combination of ills appears to pose an intractable problem: any move to extend health insurance in its current form to those without coverage will only fuel demand for health care and push spending up even further.
Fortunately, there is a solution to the predicament. The key is recognizing exactly what is driving spending through the roof. While many conditions have contributed to the spending explosion, one stands out as the fundamental problem with the U.S. health care system today: the consumer, the patient, has been cut out of the decisionmaking loop. Of every health care dollar spent in this country, 76 cents are paid by someone other than the actual patient--by the government, insurers, or employers. Consequently, in most situations patients neither benefit when they spend wisely nor bear the consequences of spending foolishly. With those incentives, it is no surprise that costs are soaring.
To reform the system we need to change the incentives. We need policies that will allow people to choose whether and how to spend their own money on health care needs. That is the idea behind the Cato Institute's Patient Power plan. The plan is explained in detail in Patient Power: Solving America's Health Care Crisis by John C. Goodman, president of the National Center for Policy Analysis, and Gerald L. Musgrave, president of Economics America, Inc.
Under the Patient Power plan, people would be able to switch from their current low-deductible health insurance policies to high-deductible catastrophic policies and put the premium savings in tax-free Medical Savings Accounts (MSAs). Those accounts would be used to pay ordinary and routine medical expenses, and catastrophic insurance would still be available to cover any major expenses. Whatever money was left in MSAs at the end of the year would remain there and continue to earn interest--you would get to keep what you did not spend.
The Patient Power plan would give people a direct financial incentive to spend prudently on health care, because they would be spending their own money. Furthermore, Patient Power would extend the same tax advantages to all Americans, unlike the current system that discriminates against the unemployed, the self-employed, and employees of small businesses that do not offer health insurance. Ensuring tax fairness would go a long way toward making health care affordable for people who are now without health insurance.
The Patient Power plan is explicitly voluntary: it is not designed to compel universal coverage under some one-size-fits-all arrangement. The most basic element of a truly competitive health care system is to allow people the freedom of opting out of it--true Patient Power begins with that fundamental freedom of choice. Accordingly, the Patient Power plan strives to expand options, not foreclose them--to let people make up their own minds about what works best for them.
The Rise of Third-Party Payment
Before 1965 spending on health care was restrained by the fact that most payments were made out-of-pocket by patients. Since then Medicare and Medicaid have expanded government third-party insurance to more and more services for the elderly and the poor, and private health insurance has expanded for the working population. As Figure 1 shows, 95 percent of the money Americans now spend on hospitals is someone else's money at the time it is spent. Some 81 percent of all physicians' payments are now made with other people's money, as are 76 percent of all medical payments for all purposes.
Third-party payment is now so dominant that the term health insurance has become a misnomer. True insurance is supposed to protect people against losses from rare high-cost events. Today's health insurance, however, covers all kinds of routine expenses that are entirely under the patient's control; such coverage is less insurance than pre-payment of medical services. Auto insurance does not cover fill-ups and oil changes, but today's health insurance covers the equivalent.
Percentage of Personal Health Expenses Paid by Third Parties, 1965 and 1990
[Bar Graph Omitted]
Hospital Physician All Services 1965 - 83.2% 1965 - 38.4% 1965 - 48.4% 1990 - 95.0% 1990 - 81.3% 1990 - 76.7% Source: Patient Power, Figure 4.2, p.77.
As a result of the dramatic rise of third-party payment, the consumers of health care, the patients, no longer have much incentive to spend money wisely. When people pay only five cents on the dollar for hospitalization, they are unlikely to be very prudent consumers, and hospitals are under little pressure to offer good deals. Elementary economics teaches that as prices go down, demand increases, and the recent history of the U.S. health care system confirms that basic truth. Because of third-party payment, health care has become nearly free at the point of sale, triggering an explosion in spending.
Putting Patients Back in Control
The health care reform proposals favored by the Clinton administration do nothing to address the third-party payment problem that is the root of the health care crisis. In fact, the administration's plan for "managed competition" would worsen the problem by creating a new third-party payment system that would be universal in coverage. To try to keep costs down, managed competition would impose onerous new bureaucratic controls and limitations on patients' choices.
Not only would managed competition fail to control costs, it would also pose a serious threat to the continued quality of American medical care. Managed competition means greater bureaucratic rationing of health care--whether openly through price controls and expenditure limits (so-called global budgets) or less obviously through increased third-party control over what services are paid for. But whatever form it takes, bureaucratic rationing means lower quality care. Just look at what has happened in countries where government controls the health care purse strings. In Britain kidney dialysis is generally denied to patients older than 55, causing at least 1,500 people to die every year for lack of dialysis. In Sweden the wait for heart x-rays is more than 11 months. And surgeons in Canada report that, for patients in need of heart surgery, the danger of dying on the waiting list now exceeds the danger of dying on the operating table.
The Cato Institute's Patient Power plan rejects the bureaucratic approach of managed competition. Combatting artificially stimulated demand with top-down bureaucratic interference is a multiplication of mistakes. The result is higher costs and lower quality care. What we need instead is a system that controls demand at the source: the individual patient. The way to get individual patients to control demand is to give them a financial incentive to do so.
Supplying that financial incentive is what the Patient Power proposal for Medical Savings Accounts is all about. Under the Patient Power plan, people would be able to deposit up to a certain amount of money every year in tax-free MSAs. Most people would fund their accounts by switching from their current low-deductible health insurance policies to high-deductible catastrophic policies and depositing the premium savings. They would then be able to draw down their account balances to pay ordinary, routine medical expenses, such as doctor's office visits, prescription drugs, diagnostic tests, and minor procedures. Catastrophic insurance would still cover the big-ticket items.
Whatever money you did not spend during the year would remain in your MSA to build up tax-free interest over time. Most people would be able to accumulate substantial savings over their working lives, which they could use upon retirement for whatever medical or nonmedical purpose they chose. Patient Power is thus diametrically opposed to the Clinton administration's managed-competition approach. Managed competition seeks to reform the health care system by adding new layers of bureaucratic control and further restricting consumer choice. Patient Power does just the opposite: it seeks to strip away third-party-payment bureaucracy and expand consumer choice. That is why the Cato Institute calls its proposal Patient Power: the goal is to empower patients, not bureaucrats.
How Medical Savings Accounts Would Work
Figure 2 gives an indication of how Patient Power would operate in practice. In a city that has an average cost of living--say Cincinnati or Denver--employers pay roughly $4,500 a year to provide an employee and his family with health insurance coverage. The policy has a low deductible, typically from $100 to $250. By contrast, the premium for a catastrophic policy with a $3,000 deductible is only about $1,500 a year. Under the Patient Power plan, an employer could provide a catastrophic policy and then put the $3,000 in premium savings in the employee's MSA. The employer is out $4,500 either way; it makes no difference to him how the money is split up. But for the employee, the advantages of the switch are enormous: he actually gets more money in cash (tax-free, interest-bearing cash) than he loses in reduced insurance coverage--even during the first year. Over time, unused savings continue to build up with tax-free compound interest.
The vast majority of Americans would greatly benefit from the combination of less expensive high-deductible policies and Medical Savings Accounts. In any given year most Americans have no or very small medical expenses, and 94 percent have medical expenses under $3,000. Under such asystem, your maximum personal exposure every year is capped by your catastrophic policy; meanwhile, your savings to meet that possible exposure keep accumulating every year with interest. In other words, the deck is stacked in favor of your coming out ahead.
Typical Health Insurance Costs in a City with Average Cost of Living
[Bar Graph Omitted]
Current Low-Deductible System: Cost of Insurance to Employer - $4,500 Patient Power Plan (Catastophic Insurance plus MSA's): Cost of Insurance to Employer - $1,500 Premium Savings for MSA Deposit - $3,000 Source: Golden Rule Insurance Company.
Medical Savings Accounts would be of particular help to employees and their families when money was tight. Even today's low deductibles, particularly when combined with copayments, can create true hardship for those struggling to make ends meet. With MSAs, money would be available to pay the first dollar of medical costs--no deductibles, no co-payments. In addition, people who were between jobs could use their MSAs to buy insurance coverage. About half the people who are uninsured remain that way for four months or less; typically, they are between jobs that provide them with health insurance benefits. The accumulated savings in Medical Savings Accounts would be available to tide people over during such times.
Establishing Tax Fairness
If Medical Savings Accounts are as great as they sound, why have employers not made them available already? Why do employers not offer high-deductible policies and cash bonuses as an alternative to conventional low-deductible insurance?
The reason such arrangements are currently unattractive is that under existing tax laws, only the employer's spending on health care is fully tax-deductible. Today, all the money an employer spends on health insurance for employees is tax-deductible; furthermore, none of it is included in the employee's taxable income. By contrast, self-employed people can deduct, at best, only 25 percent of their health insurance expenses--and even that limited deduction is not a permanent part of the law; it is on-again, off-again from year to year depending on whether Congress reauthorizes it. And the unemployed and employees of small businesses that do not offer health insurance get no deduction at all when they try to purchase insurance on their own.
Thus, under current law, employers spend pretax dollars on health care; everyone else is forced to spend (for the most part) posttax dollars. The tax bias in favor of employer-provided health insurance is considerable. As Table 1 indicates, a dollar of pretax health insurance benefits can be worth almost two dollars of taxable salary. Accordingly, once filtered through the various tax collectors, the premium savings from switching to a high-deductible policy would shrink as much as 50 percent if they were given as cash to employees. And if employees tried to establish their own make-do Medical Savings Accounts with that posttax money, they would also have to pay taxes on the interest they earned. It is little wonder that employers and employees opt for the tax-favored benefit over the tax-discouraged one.
Relative Value of a Dollar of Employer-Provided Health Insurance Benefits
Federal Tax Value with No State Value with State Category and Local Income Tax and Local Income Tax FICA tax only $1.18 $1.24 FICA tax plus $1.43 $1.57 15% income tax FICA tax plus $1.76 $1.97 28% income tax  Includes employer's share of FICA taxes.  State and local income tax rate equals 4 percent.  State and local income tax rate equals 6 percent. Source: Patient Power, Table 9.2, p. 266
It should be noted that under the current system, some people covered by employer-provided insurance are able to earmark money to go into so-called flexible savings accounts, from which they can pay health expenses with pretax dollars. The problem with flexible spending accounts is that at the end of the year, any unspent money reverts to the employer. That "use it or lose it" approach obviously encourages wasteful spending--the opposite of what Medical Savings Accounts would do.
The bias in the tax system not only discourages self-insurance through medical savings, it also renders conventional health insurance unaffordable for many Americans. The self-employed, the unemployed, and employees of many small businesses must pay posttax dollars for their health insurance, and not surprisingly they rarely do. About 90 percent of Americans who have private health insurance get it through their employers. Those not lucky enough to qualify for tax advantages through their employers must fendfor themselves, and their numbers swell the ranks of the 35 million uninsured.
The present indefensible system came about, strangely enough, because of wage and price controls during World War II. Businesses tried to get around wage freezes by offering health insurance benefits to their employees. The Internal Revenue Service went along, granting them a tax deduction and excluding the fringe benefit from employees' income. The law of unintended consequences frequently haunts governmental intervention, and here is a textbook case. Thanks to wartime emergency measures taken 50 years ago, we now have a health insurance system in double crisis, plagued by both explosive overspending and underinclusiveness caused by discriminatory tax rules.
What we must do, and what the Patient Power plan proposes, is to end the current discriminatory tax treatment of health care spending and establish tax fairness for all Americans. That goal could be accomplished in one of two ways. Individuals not covered by employer-provided insurance could be granted the same tax deduction that employers are allowed to take. Or, alternatively, employer-provided health insurance could be included in the taxable income of employees, and then all Americans could be granted individual tax credits for health care expenses.
Whatever form the tax incentive takes, it should be structured to allow a direct tradeoff between lower deduct- ible third-party health insurance and self-insurance through depositing money in a Medical Savings Account. For example, the deduction or credit could be tied to the average cost of a low-deductible policy. The higher the deductibles of the policies people chose, the lower their premiums would be, and thus the more money (up to a certain limit, say $3,000 a year) they could deposit in tax-free MSAs. Such an arrangement would allow individuals to choose the mix they preferred of third-party insurance and personal savings.
Cost Savings through Patient Power
The Patient Power plan of Medical Savings Accounts and tax fairness would revolutionize the incentives operating in the health care sector. Roughly two-thirds of all health-insurance-claim dollars in this country fall in the under-$3,000-per-year category. Under the Patient Power plan, people would be spending their own money in this dominant sector of the health care market.
Because they could keep what they did not spend, people would have an incentive to spend wisely for health care. A RAND Corporation study found that people enjoying free health care spend about 50 percent more than those who pay 95 percent of their bills out-of-pocket (up to a $1,000 maximum). Furthermore, people with free care are 25 percent more likely to see a doctor and 33 percent more likely to enter a hospital. All that extra spending of other people's money, though, does not necessarily buy better results: the RAND study found no apparent differences in most health outcomes for the two groups.
It is important to realize that given the current state of medical technology, the amounts we could spend on health care are potentially limitless. We could probably spend half our gross national product on diagnostic tests alone. There are currently some 900 different blood tests that can be performed. Why not make all 900 part of an annual check-up? And consider what would happen if every person who chooses to medicate himself with nonprescription drugs decided instead to go to the doctor. To handle the explosion in demand, we would need 25 times the current number of primary care physicians.
Given that the demand for medical services is potentially infinite, health care spending must be limited one way or another. And normally, he who pays the piper gets to call the tune. Thus, under the current system, health care is increasingly rationed by the third-party payers--insurance companies and government bureaucrats. Their control over who gets what--up to and including who lives and who dies--would increase dramatically under managed competition. Patient Power offers the only viable alternative to bureaucratic rationing: individual choice, with people making their own personal tradeoffs between medical services and other needs.
With people spending their own money on health care, doctors, hospitals, and other service providers would be forced to compete on price, quality, and convenience to attract patients. Currently, such competition is stifled because, by and large, patients are not the real paying customers--government and insurers are. Accordingly, the "prices" on medical bills are not really market prices at all; they are simply a means of passing along costs to third-party payers. And information on quality--for example, mortality rates at hospitals--is not normally made available to patients.
By contrast, competition has been vigorous in those exceptional areas of the health care sector where third-party payment does not dominate. Consider cosmetic surgery, which is not covered by any private or public insurance policy. Patients pay with their own money, and they are treated accordingly. They are generally quoted a fixed price in advance, covering both medical services and hospital charges. They are given choices about the level of service (for example, surgery performed at the doctor's office or, for a higher price, on an outpatient basis at a hospital). For another example, consider America's $12-billion eye care industry, in which costs have been holding steady or even falling in recent years. The simple reason: unregulated price competition.
By eliminating the third-party paper shuffling associated with small-dollar-amount expenditures, Patient Power would dramatically reduce administrative costs. Such costs today are unusually high (the cost of marketing and administering private health insurance runs between 11 and 12 percent of premiums) because of the enormous number of small claims that unnecessarily clog the present system. The cost of processing many small claims actually exceeds the amount of the claims. By converting to high-deductible policies and letting people pay routine expenses directly out of their Medical Savings Accounts, all that excessive paperwork would be eliminated.
Enormous cost savings could be achieved if the combination of catastrophic insurance and Medical Savings Accounts were extended universally (including replacing Medicare and Medicaid). Total administrative savings are estimated (based on 1990 figures) to be as high as $33 billion a year; in addition, more prudent spending by patients would produce savings of up to an estimated $147 billion a year. After factoring in extra costs of $12 billion a year due to instituting tax fairness, net total cost savings come to $168 billion--or nearly one-fourth of total annual health care spending in this country. And that rough estimate does not include the savings gained from lower prices that would surely be a major benefit of the new competitive health care marketplace that Patient Power would help bring about.
The Cato Institute's Patient Power plan to reform health insurance has three main elements:
Notice the key word repeated in all three elements of the Patient Power plan: allow. The plan is voluntary; it does not force anyone to do anything. The purpose of Patient Power is to expand people's choices, not narrow them--to enable people to make their own decisions about tradeoffs between health care and other needs, not to create yet another bureaucracy to make those decisions for us.
Only by empowering patients can we tap the power of market incentives to transform our bloated, bureaucratized health care system. So-called reform packages based on further restricting patient choice move in precisely the wrong direction; not only would they be unable to control costs effectively, but they would also imperil the high quality of medical care that Americans currently enjoy. Managed competition is not the answer. Real competition is. The Patient Power plan, by enabling people to spend their own money on medical needs, would inject a whopping dose of real competition into our ailing health care system.
Twenty Questions and Answers about Medical Savings Accounts
Ten Advantages of Medical Savings Accounts
 John C. Goodman and Gerald L. Musgrave, Patient Power: Solving America's Health Care Crisis (Washington: Cato Institute, 1992).
 Robert Brook et al., The Effect of Coinsurance on the Health of Adults (Santa Monica, Calif.: RAND Corporation, 1984).
 This section is taken from Goodman and Musgrave, pp. 257-61.
 This section is taken from Goodman and Musgrave, pp. 249-51.
© 1993 The Cato Institute
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