[Economic Report of the President (2004)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]


 
Chapter 10

Health Care and Insurance


The breadth and pace of innovation and change in the provision of
health care in the United States over the past few decades have
been no less than astounding. Technological progress in the form
of new medical knowledge, medicines, treatments, and medical devices
has allowed Americans and people worldwide to live longer, healthier
lives.

As new treatment options become available, it is not surprising that
the United States and other major industrialized countries continue
to shift more resources to health care. Research suggests that
between 50 and 75 percent of the growth rate in health expenditures
in the United States is attributable to technological progress in
health care goods and services. However, the increase in resources
devoted to health care has led to concern about its affordability,
both for families worried about tight budgets and for the Nation as
a whole. A strong reliance on market mechanisms will ensure that
incentives for innovation are maintained while providing high-quality
care in the most cost-efficient manner. Americans should have more
choices, more information, and more control over their health care
decisions.

Health insurance plays a central role in the workings of the U.S.
health care market. An understanding of the strengths and weaknesses
of health insurance as a payment mechanism for health care is
essential to the design of reforms that retain incentives for
innovation while reining in unnecessary expenditures.

This chapter discusses the roles of innovation, insurance, and reform
in the health care market. The key points in this chapter are:
 U.S. markets provide incentives to develop innovative
health care products and services that benefit both
Americans and the global community.
 Over reliance on health insurance as a payment mechanism
leads to an inefficient use of resources in providing
and utilizing health care.
 Reforms should provide consumers and health care
providers with more flexibility and information.


The U.S. Health Care System as an
Engine of Innovation

Innovation and new technology have changed the practice of medicine
over the past few decades. Diagnostic tools such as magnetic
resonance imaging and computed tomography scanning have made it
possible for doctors to see otherwise invisible problems. Innovations
such as balloon angioplasty treat conditions that previously
required extensive surgery. Minimally invasive surgical techniques
such as arthroscopy provide treatment options that lead to shorter
hospital stays and faster recoveries. Restorative surgeries such as
hip and knee replacements are now commonplace and provide patients
with improved mobility and thus improved quality of life. New
pharmaceuticals treat conditions that were previously intractable or
help to avoid more costly surgeries and lengthy hospital stays. The
list of advances is long and impressive.


The Value of Health Care Innovation

Innovation in health care goods and services, including advances in
scientific knowledge that have changed many people's day-to-day
behavior, has markedly improved the lives of Americans. Life
expectancy at birth in the United States increased from 68.2 years in
1950 to 77.2 years in 2001. Medical advances have also increased the
quality of life through innovations that improve mobility, sight, and
hearing.

Some might argue that these advances are not unique to the United
States and that Americans spend too much for health care relative
to other countries. The United States expends a higher fraction of
GDP on health care than does any other industrialized country.
According to an international comparison released in 2003, the United
States spent 13.9 percent of GDP on health care in 2001, while the
average among industrialized countries was 8.4 percent of GDP.
Measures of health outcomes such as longevity and infant mortality,
however, are not markedly different in the United States than in
other advanced economies that spend substantially less on health
care.

The argument that the U.S. health care system is overly costly
relative to other countries implicitly assumes that if two countries
spend different amounts for health care and get the same health
outcomes, then the higher-spending country must be inefficient and
wasteful. This argument is not correct in the case of health care for
two reasons that are related to the leading role of the United States
as a source of research and innovation.

First, in general terms, while all countries can benefit from
research and development expenditures made by a single country, only
the health expenditures in the innovating country will include the
costs of research and development. Health expenditures in
non-innovating countries will exclude the research and development
costs.

Second, free markets incorporate incentives for innovation that
generate products, services, and knowledge that potentially benefit
all countries. Markets naturally encourage and reward innovation.
Unfettered by government price controls or access restrictions,
innovative products, talented health care practitioners, and skilled
health care professionals are rewarded in the marketplace. This
leads to technological advances by encouraging talented people to
participate in the health care industry and by increasing investment
in new products and research. The financial rewards for innovation
will be reflected in U.S. health expenditures through a combination
of higher prices and wages, and higher usage than in other countries.
Once a product or service is developed through the combination of
talent and capital, however, it becomes available for use outside the
United States. Countries in which government regulation has
supplanted market forces will still have the opportunity to take
advantage of U.S. innovation without having to pay as much for it.

As an illustration of how U.S. health expenditures reflect the
incentives for innovation, consider products such as medical devices
and pharmaceuticals. The patent system exists to encourage innovation
for these types of products. The innovator's incentive in a
patent-based system is the opportunity to hold a monopoly on a
product for a limited period of time. Therefore, the innovator can
temporarily charge a higher price and earn more profits than he would
without patent protection. The higher consumer expenditures that can
result from monopoly pricing will be reflected in health care
expenditures.

Once the patent system has led to the development of a product, it is
available for use throughout the world, not just in the United States.
This leads to an opportunity for other countries with centralized
health agencies to negotiate a price close to production costs,
thereby paying lower prices than they would in a free market that
fully respected patent rights. What this implies is that other
countries can reap the benefits of U.S. innovations in health care
goods and services but pay only a fraction of the costs. It follows
that if the United States attempted to reduce health expenditures by
adopting cost-control policies found in other countries, innovation
would slow and both Americans and citizens of other countries would
be affected.


U.S. Leadership in Health Care Technology

Several pieces of evidence point toward the preeminence of the
United States in providing health care technology. First, since
1975, the Nobel Prize in medicine or physiology has been awarded
to more Americans than to researchers in all other countries
combined. Second, according to data collected through 1993, 15 of
the 19 marketed "biotech" drugs used for nondiagnostic purposes were
the product of U.S. companies alone. U.S. companies shared credit
with companies from other countries for two more of the 19 drugs. As
of 2002, eight of the world's ten top-selling drugs were produced by
companies headquartered in the United States.

A third example of U.S. leadership is that many important medical
innovations in the past 30 years arguably originated in the United
States. This evidence is based on a survey designed to determine the
relative importance of a variety of medical innovations developed
over approximately the last 30 years. Starting with a review of the
medical literature, researchers compiled a list of 30 major medical
innovations and then surveyed over 300 leading general internists in
the United States concerning the relative importance to their
patients of the innovations. Based on the survey, researchers ranked
the innovations in order of importance. The first and second columns
of Table 10-1 reflect the results for the top ten innovations.

The table also includes countries of origin, a category that was not
included in the original research. Assignment of country was based on
the



location where the first clinically viable form of the innovation
was developed or produced, or where research important to its
creation occurred. The United States dominates this chart as the
innovating country for these important medical developments. Of the
ten, eight include the United States as a key country. The United
Kingdom and Japan, the next closest sources, are associated with
just two of the innovations each.

Table 10-1 should not be misinterpreted. Scientific advances by
their nature are evolutionary, with recent advances building upon
prior discoveries. The process of identifying a single person or
team for progress that relies upon previous work is necessarily
subjective. Nevertheless, such judgments are regularly made in
selecting awards such as the Nobel Prize. But even taking into
account the unavoidable limitations of such a list, it does suggest
a dominant role for the United States in the development of new and
useful medical technologies.

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Box 10-1:  Price Regulation and the Introduction of New Drugs


A recent study suggests that pharmaceutical firms tend to avoid or
delay introducing new drugs in countries with price controls. In the
study, which includes data from 25 countries on 85 new chemical
entities introduced in the United States or the United Kingdom
between 1994 and 1998, the three countries that did not require
price approval before launch (the United States, Germany, and the
United Kingdom) introduced the most new drugs. Analysis controlling
for per capita income and other country and firm characteristics
shows that countries with lower expected prices or smaller expected
market size have fewer launches and longer launch delays. In the
European Union, where drugs can be approved through a centralized
procedure for use in the entire region, countries with price
controls still experience significant launch delays.

According to the study, the connection between price controls and
delayed access to drugs lies in the tendency for price controls to
"spill over" from one country to another. Firms have an incentive to
avoid or delay launching drugs in markets with price controls if
they fear that the low prices will "spill over" to other markets.
There are two main mechanisms by which price controls in one
country can affect pharmaceutical profits in another: parallel
trade and external referencing. With parallel trade, one country
can take advantage of regulated low prices in another country
through trade. With external referencing, countries can incorporate
external price controls into domestic prices through price-setting
formulas that depend on prices in other countries. Overall, the
study suggests that there is a tradeoff between low prices and
rapid access to new drugs.
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Insurance Reform as a Means of Providing
Health Care More Efficiently

While the U.S. health care market provides excellent incentives
for innovation, there are legitimate concerns about cost. Rising
health expenditures for families and firms can lead to difficult
decisions over how best to allocate limited budgets. Pressure on
government budgets continues to increase due to major health care
programs such as Medicare (health insurance primarily for the
elderly) and Medicaid (health insurance primarily for the poor).
Physicians and hospitals struggle with government regulations,
rising liability costs, and growing administrative burdens. To craft
adequate responses to such challenges, it is important to understand
the economic forces at work.

Technological progress in health care has been very beneficial, but
it has led to growth in health care expenditures as the new
technology has been applied to increase the length and to improve
the quality of life. Research suggests that between 50 and 75 percent
of the growth rate in health expenditures in the United States is
attributable to technological progress in health care goods and
services. Potential sources of the remaining 25 to 50 percent of the
growth rate include: higher demand for health care due to increasing
incomes and the aging of the U.S. population; the increased practice
of "defensive medicine" (that is, medical procedures with limited
therapeutic value that are performed by physicians to avoid
lawsuits); and increased use of health insurance plans as a payment
mechanism for health care.

There are various ways to reduce health care costs. Reducing the
incentive to practice defensive medicine has the potential to lower
the level of health care costs and is therefore an important
objective. Modifying the health insurance system offers an
especially attractive target for cost-saving reform because it would
affect both the level and the growth rate of health expenditures.
Reforms could be targeted to reduce administrative costs and the
incentive to overuse health insurance as a payment mechanism.
Understanding the strengths and the weaknesses of the health
insurance system is central to developing policies that will lead to
more cost-effective health care and to greater access to health care
for those underserved by the current market.


The Appropriate Use of Insurance

Insurance is an indispensable tool in modern economies. Individuals
insure automobiles against the possibility of an accident and homes
against the possibility of a fire. Life insurance provides financial
security to loved ones in case of an untimely demise. In each of
these examples, the basic principle is the same: for a fee--the
insurance premium--the insurer promises that some financial benefit
will be forthcoming if a well-defined event takes place such as a
car accident, a house fire, or a death.

Insurance is a valuable economic commodity. By giving up some income
in the form of a premium, a consumer can avoid the large decline in
wealth associated with an unfortunate event. Even if the event does
not occur, a consumer benefits from the reduced uncertainty provided
by insurance.

Insurance is generally not needed when there is little uncertainty or
when financial risks are small. For example, insurance policies
usually do not pay for items such as groceries, clothing, or
gasoline, although it would certainly be possible to create such
policies. Suppose, for example, that an individual could purchase a
clothing insurance policy with a "coinsurance" rate of 20 percent,
meaning that after paying the insurance premium, the holder of the
insurance policy would have to pay only 20 cents on the dollar for
all clothing purchases. An individual with such a policy would be
expected to spend substantially more on clothes--due to larger
quantity and higher quality purchases--with the 80 percent discount
than he would at the full price. However, the insurance company would
need to charge a high premium to cover expenses. The premium would
need to cover the 80 percent discount on the clothing that the
individual would have bought had he or she been paying full price.
Additionally, the premium would need to cover the insurer's expense
for clothes purchased because the individual buys clothes as if they
cost only 20 cents on the dollar. Few individuals would find such an
expensive policy cost-effective.


Moral Hazard

The clothing insurance example suggests an inherent inefficiency in
the use of insurance to pay for things that have little intrinsic
risk or uncertainty. It also illustrates the broader problem in
insurance markets known as moral hazard. Moral hazard refers to the
idea that policy holders will make different choices when they are
covered by an insurance policy than when they are not, but the
insurer cannot fully monitor or restrict their actions. In the
clothing example, moral hazard results in insured individuals
spending more on clothing than they would without insurance.

Optimal insurance contracts must balance the value that consumers
place on reducing their exposure to risk against the inefficiency
arising from moral hazard. In the absence of uncertainty, insurance
is wasteful because moral hazard will lead to excessive use and there
is no benefit to the consumer from risk-reduction. Inefficient use
of insurance will be reflected in an unnecessarily high cost for
insurance. Standard features of insurance contracts such as
coinsurance rates, copayments, and deductibles are attempts to
mitigate the moral hazard problem. Even so, inefficiencies of this
sort are pervasive in the U.S. health care system.


Adverse Selection

Another issue that arises in discussions of insurance markets is
adverse selection. Adverse selection occurs when an insurance policy
attracts certain types of people, and the insurer cannot identify
these people before they enroll. If the premium is based on the
average individual, but the policy disproportionately attracts those
who spend more than the average person (in the clothing example,
individuals with particularly expensive tastes in clothes), the
policy will lose money for the insurer. The policy will then either
increase in price or not last in the marketplace.

Adverse selection illustrates a problem that exists when the
consumer knows more about his or her characteristics than the
insurer. As a result there is a market inefficiency where, in the
extreme, some consumers do not purchase insurance because the only
policy available to them is priced for the most expensive consumers.
If insurers could distinguish among different types of consumers,
policies could be tailored to specific types and priced accordingly.
With better information, an efficiently functioning insurance market
would be able to provide insurance in a way that would maximize
individual consumer welfare.


Health Insurance in the United States

Health insurance in the United States has several unique features.
First, the employer portion of premiums for employer-provided health
insurance is generally exempt from income and payroll taxes. The
employee portion of premiums is similarly tax-exempt for the roughly
one-half of workers covered by tax-advantaged health plans. This
leads to the second, and unsurprising, feature, which is that most
health insurance is provided through employers. Over 60 percent of
all individuals in the United States have employer-provided health
insurance. The central role of employer provision makes health
insurance very different from other types of insurance, such as fire
and car insurance.

Third, health insurance policies in the United States also tend to
cover many events that have little uncertainty, such as routine
dental care, annual medical exams, and vaccinations. For these types
of predictable expenses, health insurance is more like prepaid
preventative care than true insurance. If automobile insurance were
structured like the typical health policy, it would cover annual
maintenance, tire replacement, and possibly even car washes.

Fourth, health insurance tends to cover relatively low-expense items,
such as an office visit to the doctor for a sore throat. Although
often unforeseeable, this expense would not have a major financial
impact on most people. To continue the analogy, it would be similar
to car insurance covering relatively small expenses such as replacing
worn brakes.

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Box 10-2:  Who are the Uninsured?


The U.S. Census Bureau estimates that in 2002, 242.4 million people
in the United States had health insurance for the entire year, while
the remaining 43.6 million people were uninsured.  Uninsurance
persists in the face of public programs such as Medicare, Medicaid,
and the State Children's Health Insurance Program. In general, these
programs provide health insurance to the elderly, the very poor, and
the children of the moderately poor, respectively.

The uninsured are a diverse and perpetually changing group. The
Congressional Budget Office claims that due to sampling techniques,
the U.S. Census Bureau estimate of 43.6 million (15.2 percent of
the population) more closely represents the number of people who are
uninsured at a point in time than the number of people who are
uninsured for an entire year. Just under half of all new spells of
uninsurance end within four months. The number of people who were
uninsured for all of 1998 (the most recent year for which
comparative survey data are available) is estimated to have been 21
million to 31 million (7.6 to 11.2 percent of the population).

Some individuals included in survey-based counts of the uninsured
may in fact have access to public coverage.  For instance, the
number of people who report having Medicaid is smaller than the
number determined to be enrolled based on the program's
administrative data. The reasons for this discrepancy are not well
understood.  People might fail to report this coverage because
of a possible stigma associated with being on Medicaid or because
the survey questions are confusing. In addition, some individuals
who are uninsured are eligible for Medicaid but have not enrolled.
These people are counted as uninsured in surveys, but they are
effectively insured because they can enroll in Medicaid should they
require medical treatment.

Others who lack insurance coverage possess economic or demographic
characteristics that suggest many of them may remain uninsured as a
matter of choice. For example, some have levels of household income
that are above the median for the population.  Over 32 percent of
uninsured individuals report a household income of $50,000 or more.
Others have access to employer-provided coverage but do not opt to
participate. Researchers believe that as many as one-quarter of
those without health insurance had coverage available through an
employer but declined the coverage. Still others may remain
uninsured because they are young and healthy and do not see the
need for insurance. In fact, more than two-fifths of uninsured
individuals are between the ages of 18 and 34.

Finally, many of the people included in domestic estimates of
uninsurance are citizens of other countries. Over 8.9 million of the
43.6 million people included in the U.S. Census Bureau estimate of
the uninsured are not U.S. citizens. This includes both legal
immigrants and foreign-born individuals with non-immigrant status,
such as students, diplomats, and undocumented individuals.
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A Brief History of Health Insurance in the
United States

The historical background of health insurance coverage in the United
States helps explain why health insurance is different from other
types of insurance. In the early twentieth century, health insurance
tended to cover wage loss rather than payment for medical services.
This insurance is comparable to present-day disability insurance or
workers' compensation. Limited health care coverage reflected the
small number of options available to the medical profession for
improving health--there were few costly treatments to insure against.

The first modern health insurance policy appears to have been started
in 1929 when a group of teachers contracted with Baylor University
Hospital. For an annual premium of $6, the policy guaranteed up to
three weeks of hospital coverage. Providing insurance through
employers, rather than to individuals, lowered administrative costs
for insurers. It also mitigated the problems from adverse selection
because the insured group was formed without regard to health status.

Employer-based coverage was encouraged by legal provisions during
World War II that allowed employers to compete for employees by
offering health benefits during a period of wage and price controls.
Separately, a 1943 administrative tax court ruled that some
employers' payments for group medical coverage on behalf of employees
were not taxable as employee income.

A consequence of exempting premiums paid on employer-provided
insurance is that tax receipts to the Federal government are lower
than they otherwise would be. It has been estimated that Federal tax
receipts in 2001 were about $120 billion lower as a result of the
tax exemption. Research suggests that the tax preference for
insurance induces people to buy more expansive health insurance--for
example, people buy policies that cover a broad array of health
services--and policies that have low deductibles and low coinsurance
rates, which lead to the associated inefficiencies from moral hazard.

To summarize, health insurance markets can be improved in at least
three ways. The first is to encourage contracts that focus on
large expenditures that are truly the result of unforeseen
circumstances. The second is to strengthen health insurance markets
outside the traditional employer-based group markets. The third is
to provide a more standardized tax treatment of all health care
expenditures.


Proposals for Modernizing the
Health Care Market

Health insurance reforms have the potential to increase the
cost-effectiveness of health care markets without sacrificing the
incentives that are essential to continued innovation. Reforms that
lead to more direct interaction between consumers and health care
providers, relying less on third-party payers such as insurance
companies, have the potential to increase the efficiency and
therefore the cost-effectiveness of health care markets. Coupled
with changes that provide consumers with more flexibility and
more information, such reforms would continue to provide the market
signals important for developing new and useful health care
innovations. The President has proposed several reforms that promise
to move the Nation in the direction of achieving these goals. Taken
together, these reforms will help preserve the innovative strengths
that have proven so valuable to Americans and will improve the
efficiency of the U.S. health care system.


Medicare Prescription Drug, Improvement,
and Modernization Act of 2003

The Medicare Prescription Drug, Improvement, and Modernization Act
of 2003, enacted in December, adds a prescription drug benefit to
the Medicare program. The new drug benefit will give more
Medicare beneficiaries access to prescription drug coverage and will
provide benefits for individuals with limited means and low incomes.
A prescription drug discount card will be available for
beneficiaries until the full drug benefit is available nationwide.

The Act also establishes another key element of the President's
health care agenda, Health Savings Accounts (HSAs). With an HSA,
individuals and their employers may contribute pretax dollars to
fund an account that can then be used to pay for medical expenses.
Once established, this money belongs to the individual and can
accumulate over time. The account remains with the individual if he
or she changes employers. With such accounts, there is an increased
incentive to purchase insurance that only covers events that are
truly random and large, and to pay for other expenses using an HSA.
Indeed, the law requires that such accounts be coupled with a
high-deductible insurance plan.

With less reliance on insurance for routine health expenses,
consumers would place a greater value on information about health
care options and providers. More prudent use of insurance would
also reduce "middle-man" costs of involving an insurance company in
what could otherwise be a simple transaction between the patient
and the caregiver.


Next Steps in Improving Health Care Markets

The passage of the Medicare bill was a major accomplishment, but
much remains to be done. A number of proposals on the President's
agenda for health care reform would lead to improvements in the
health care market.


Association Health Plans (AHPs)

The AHP proposal enables small businesses and associations to
purchase health insurance for employees and their families. These
plans offer small businesses and self-employed individuals the
potential for lower health insurance premiums resulting from
decreased administrative costs and increased bargaining power with
insurers and medical providers.


New Tax Deduction for Health Insurance Premiums

The President has proposed a new tax deduction for health insurance
premiums. Individuals who purchase a high-deductible insurance
policy coupled with an HSA would be able to deduct the value of the
insurance premium from their income taxes even if they do not itemize
their deductions. This would encourage the use of high-deductible
insurance by providing a tax benefit similar to that given to
employer-provided insurance.


Refundable Health Credit

Many workers do not have the option to obtain insurance through
their employment. The President has proposed a refundable health
credit that could be used to purchase insurance. This credit will
help expand health care access for low- and middle-income workers
who do not have good employer-based coverage options.


Reducing the Cost of Medical Care Through Liability Reform

Malpractice premiums are a significant cost for physicians and
hospitals. The President has proposed the national adoption of
standards to make the medical liability system more fair,
predictable, and timely. Adoption of these proposals would lower
the cost of providing health care (see the discussion of this
subject in Chapter 11, The Tort System). Similarly, fear of
litigation keeps health care providers from sharing vital
information on quality problems and medical errors. The President
has called for legislation to allay these fears and make it possible
for health professionals to share information to reduce errors
and complications.


Improving Efficiency Through the Use of Health Information
Technology

The use of information technology in health care holds the promise of
reducing medical errors, facilitating communication between care
providers and patients, and reducing administrative costs.
Computerized physician order entry, a type of technology that
allows physicians to write medication orders electronically, has been
shown to reduce significantly the rate of serious medication errors.
Intensive care telemedicine, a type of technology that allows
remote specialists to monitor patients continuously with
video-conferencing and computer-based data transmission tools, has
been found to decrease intensive care costs substantially in certain
settings. The President is proposing to double the funding (for a
total of $100 million) for the Department of Health and Human
Services to increase the use of these new technologies through
demonstration projects.


Conclusion

The U.S. health care system has provided tremendous benefits for both
American citizens and the global community. New knowledge, innovative
products, and life-saving medical procedures are the results of the
U.S. market for health care. The proposed policies will help preserve
the strengths of the U.S. market and will improve the efficiency and
affordability of health care.