June 12, 2009 | 6:39 pm
Posted by Albert Fuchs, M.D.
How Medical Insurance Was Broken
In the last post we learned the legitimate valuable role that insurance plays in collectivizing risk. In this post I will explain how that model broke for health insurance and how we are still suffering the consequences.
It seems incredible that our current difficulties with healthcare originated in the 1940s, but that is exactly the case. During World War II the federal government imposed wage and price controls. Because wages were kept below their market value, companies had a hard time attracting excellent applicants. So to circumvent the wage cap companies began offering increasingly generous fringe benefits. One of these benefits was health insurance. Employer-provided health insurance became so popular that Congress passed a law making it tax deductible. The wage and price controls were abolished after the war and are long forgotten, but the employer tax deduction for health insurance is with us over six decades later and has thoroughly disfigured the healthcare marketplace. Let me explain how.
Remember the example of Bob’s Insurance Company in the last post? Imagine, for example, a world in which employer-provided home insurance became tax deductible. Everyone would get their home insurance policy through their work. Let’s also agree, just to keep the numbers simple, that most employees pay about a quarter of their income in taxes. The homeowner’s policy in the last post cost $1.50 per year, but prior to the tax exemption law each family would have to generate $2 in income to pay 50 cents in tax (25%) and have $1.50 left over to pay as their insurance premium. After the tax exemption law passes, their boss can buy insurance for each employee for $1.50 pre-tax, leaving the $0.50 for additional salary or other benefits. But this also completely skews what insurance can and should be used for. In the last post we explained why insurance was a terrible deal for routine, frequent expenses. Now, imagine that having a gardening service cost $150 per month. Prior to the tax exemption, this would require $200 in pre-tax income (since a quarter, or $50 would go to taxes). But now, Bob has a strong incentive to sell a policy that pays for gardening. He can offer the policy for $175 per month, which the employer can deduct from the employee’s salary. Since employers can get the insurance with pre-tax dollars, it’s suddenly cheaper to hire a gardener through your job-offered home insurance than directly. Everyone wins in the short term: Bob can pay the gardener $150 and still make $25 in profit. The employee gets a gardener for $175 rather than $200, and the employer saves on payroll taxes.
See what’s happened? The tax deduction has made it cheaper to buy something through pre-tax insurance than to buy the same thing directly with post-tax wages. Suddenly the insurance company has been transformed from a protection against unpredictable and unaffordable disaster to a way to get routine services at a discount.
Obviously, in the real world the tax deduction was for health insurance not home insurance. Now we begin to understand why health insurance has become so dysfunctional, even though most other types of insurance (think of life, auto, home…) are relatively inexpensive and almost never used. The reason is that it became cheaper for all of us to get routine care through our employer-provided insurance rather than to pay for it ourselves.
But this had other destructive consequences. First of all, it ties our ability to obtain routine healthcare to our job. Unlike equally important goods and services, like food and housing, if one loses one’s job in this new system, one usually loses access to healthcare. In the old system healthcare was just like food and housing – your employer gave you a salary and you shopped for the quality and price that was right for you. If you lost your job you might have less money, but you were still in control of what you wanted to spend your money on. You could still afford a doctor’s visit. Even if you briefly lost your insurance, that wouldn’t have been as big a loss as it is today, since insurance only covered a disaster. Now, insurance is the key to the doctor’s waiting room.
This handcuffing of employees to their jobs would have been bad enough, but the tax deduction had other perverse incentives. For the employee, it made healthcare expenditures cheaper than general household expenses. Using the simple example of 25% taxes, $400 in income can be used to either buy $400 in additional health insurance or $300 in other household expenses (after paying $100 in taxes). So this scheme encourages more spending on healthcare and less on everything else. Of course, doctors and hospitals didn’t complain as this amounted to a huge (but hidden) tax subsidy of the healthcare industry.
But a bigger problem caused by the tax exemption was that suddenly routine care was “covered”. To individual patients/employees that meant that their employer was paying for their routine care by paying for their insurance and that their out-of-pocket expense for any specific item of care was very low. This encouraged over-utilization. Any economics student knows that when anything gets cheaper consumers will demand more of it. Routine care became cheaper to the patient, so patients wanted more. But remember what we learned in part I. Redistributing cost through insurance doesn’t make anything cheaper. It adds a layer of expense since the insurance company keeps some of the money as profit. But this additional expense isn’t paid by the patient at the time care is delivered. It’s siphoned out of his paycheck whether he goes to the doctor or not. Each visit is cheap to the patient, so there is no incentive to conserve; the only incentive is to consume.
Predictably, utilization of healthcare and prices for services exploded. In fact, since World War II healthcare has consistently risen in price more than the general inflation.
This led to efforts to control costs and utilization through increasingly complex bureaucracy. Managed care was born. Physicians had to comply with progressively more onerous rules about what was covered and what wasn’t. Increasingly physicians worked for a boss other than their patient who dictated the quality and the reimbursement for the care they delivered. Patients found themselves unable to demand quality and shop for a better price (like they could in every other marketplace) while the amount taken out of their paycheck for their insurance continued to climb.
To summarize, the employer tax-deduction for healthcare led directly (though unintentionally) to a system in which
This sounds horrific enough, but in 1965 we demonstrated that no marketplace is so terrible that we can’t make it worse. That will be the subject of next week’s post in part III. In two weeks the series will conclude with my suggestions of some ways out of this mess.
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