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Commentary By David Gratzer

It Will Take An Injection of Capitalism To Free Ourselves

Health Pharmaceuticals

If the era of modern medicine began with a bang — the introduction of penicillin in 1941 — the era of modern American health insurance began with a whimper.

The biggest event to shape American health insurance occurred on Oct. 26, 1943, when the Internal Revenue Service issued what seemed at the time like a mundane tax ruling. For the first time, the IRS confirmed that employees were not required to pay tax on health insurance premiums paid on their behalf by their employers.

The ruling had its roots in the wage and price controls imposed by the administration of Franklin D. Roosevelt as part of the war effort. The effects of price control are well remembered — for instance, a black market for gasoline. But wage control also produced a side effect, as employers sought ways to provide employees with competitive salaries without violating federal mandates. Across America, employers found their answer in health benefits. The IRS ruling legitimized the practice, establishing the supremacy of third-party payership and the importance of employer-based coverage.

For employees, generous health benefits make sense, particularly for those in the higher tax brackets. Rather than seeing nearly 50 cents on the income dollar lost to taxes, they get a full dollar of health benefits. For employers, there is a clear advantage as well: It's cheaper to offer lavish health benefits than to raise wages. Both the employer and the employee gain by this arrangement. Before wage and price controls, employer-based health coverage was relatively rare. By 1987, a full 70 percent of employers offered health benefits.

But employers and employees aren't actually getting something for nothing. There is a group that supports the whole scheme: taxpayers. Making health benefits tax-free is, in fact, a massive tax subsidy. The so-called tax exclusion amounted to $188.4 billion in 2004.

Third-party payership

Because health insurance is all-encompassing — leaving Americans to pay, literally, just pennies on the health care dollar — we tend to miss the basic point of insurance.

Think of car insurance: People purchase it to cover them for accidents and other misadventures. They pay the premium every year in order to avoid a significantly larger expense, such as the cost of fixing a car after an accident, that they have a small chance of incurring.

As Lawrence Mirel, the insurance commissioner for the District of Columbia, explains, "An 'insurable event' — from traffic accidents to tornadoes — is something that, first, is very unlikely to happen; second, will come without warning; and third, is not something the person who is insured ever wants to happen."

Car insurance — ultimately an insurance against accidents — perfectly matches Mr. Mirel's definition. Contrast this with modern health insurance, in which a large amount of money is paid to cover virtually everything, from major crises, such as cancer, to such minor events as a yearly physical exam. Car insurance premiums aren't too pricey, especially when people purchase high-deductible plans, but the average family's health premium tops $9,000 a year.

What would car insurance cost if people insisted on plans that had low deductibles? Or policies that included not just major body work, but also oil changes and gas and a paint job every time your spouse tired of the car's color?

Absurdities of this kind are present in health care because health insurance is based on a model appropriate for the conditions of the early 1940s but not for today. Third-party payership reigns supreme.

Health care inflation

There is a straightforward, if profound, consequence to this situation: health care inflation.

Over the past 60 years, health expenditures have grown dramatically. Of course, most analysts suggest that the advancement of medicine has led to the cost explosion.

But is that the right conclusion to draw?

The late Nobel Prize-winning economist Milton Friedman thought health care ought to be cheaper. That it isn't cheaper suggested to him a major structural problem.

His health care hypothesis evolved out of a simple question: Why is it that in every other field where enormous technological strides have been made, total costs have fallen over time, but in health care they have increased?

Some would argue that medical care has grown more sophisticated over those years. But then, so has the production of food. Today, Americans spend a fraction of what they did a half-century ago on food — yet the U.S. agriculture industry feeds more people. In fact, in basically every other area of the economy, the pattern holds.

"It's the way we enhance productivity," Dr. Friedman noted.

So why is health care the exception?

The reason is simple: Americans do not pay directly for physicians or hospitals or other health providers. A third party makes the vast majority of payments in the United States. And as Dr. Friedman has observed, nobody spends somebody else's money as wisely as he spends his own.

It is true that workers see deductions for health premiums in paycheck after paycheck, but out-of-pocket expenses account for only 14 cents on every health dollar spent in the United States.

For decades, third-party payment has been the standard, so much so that practically every politician today emphasizes the importance of employer-based health coverage. Health economists time and again use the same phrase to describe America's bizarre arrangement for health financing: It's the "natural order" of affairs.

But there is little that is natural about the arrangement. Consider, for example, the way we pay for food or clothing or housing — all basic needs, just as health care is. But imagine how you would shop if you knew that you would have to pay only 14 cents on the dollar of your grocery bill.

Enter bureaucracy

With such a perverse incentive, it's only a matter of time before someone steps in and attempts to tame costs. Third-party payership, thus, inevitably leads to a bureaucratization of health care. There's an old expression: He who pays the piper calls the tune. With so little being spent directly by the person receiving health care, it is assuredly not the patient who is calling the tune.

Bureaucratization has two direct results. First, it undermines patient satisfaction. Despite the incredible advances in medicine, people are frustrated because bureaucrats ultimately decide what gets covered and under which conditions. And it's not just patients who are unhappy. Doctors as a whole are more dissatisfied than ever with the practice of medicine, even though their ability to help a patient is significantly greater than it was 30 years ago.

The second result is "bureaucratic displacement." Soon after the creation of the National Health Service in 1948, the British government was spending significantly more on health care, but the system didn't seem any better for it. A physician named Max Gammon sought to solve this policy riddle. After an extensive study in the 1960s, he remarked: "In a bureaucratic system, increase in expenditure will be matched by fall in production. Such systems will act rather like 'black holes' in the economic universe, simultaneously sucking in resources and shrinking in terms of 'emitted production.' "

His observation applies also to America's health care system today.

For example, several economists, including Dr. Friedman, have looked at the input and output of American hospitals. From 1946 to 1996, the number of hospital beds fell by more than 60 percent; the fraction of beds occupied, by more than 20 percent. In sharp contrast, input skyrocketed. Hospital personnel per occupied bed multiplied ninefold, while cost per patient day, adjusted for inflation, rose an astounding 40-fold.

According to Dr. Friedman: "Progress in medical science may well explain most of the decline in output; it does not explain much, if any, of the rise in input per unit of output. True, medical machines have become more complex. However, in other areas where there has been great technical progress — whether it be agriculture or telephones or steel or automobiles or aviation or, most recently, computers and the Internet — progress has led to a reduction, not an increase, in cost per unit of output. Why is medicine an exception? Gammon's law, not medical miracles, was clearly at work."

The wrong kind of competition

The health industry today appears to teem with competition: Drug companies spend billions of dollars in advertising, attempting to persuade people to choose one product over its competitors. Hospitals work feverishly to attract the interest and contracts of insurance companies. Insurance carriers market scores of products to employers, pitting one PPO (preferred provider organization) against another. Yet according to health care researchers Michael Porter and Elizabeth Olmsted Teisberg, the problem is that American health care lacks the right type of competition.

Competition, they suggest, should exist at the level of disease — that is, the prevention, diagnosis and management of particular illnesses. Instead, hospitals and health plans at present compete with one another, and the results are higher cost and lower availability.

America doesn't really have a market for health care, it seems, merely a market for health insurance (for third parties).

Everyone who goes to a grocery store regularly knows the price of milk. But what about the price of a visit to the family doctor or a simple blood test? Walk into a grocery store, and every item has a sticker indicating its price, but have you ever walked into a doctor's office and seen a list of prices? Has it even occurred to you to ask what a procedure or test will cost?

In a normal market, self-interest is useful. The baker, to use Adam Smith's example, isn't getting up at 4 in the morning because he wants your dinner party to be a success. By the same token, you aren't particularly concerned about your baker's mortgage when you buy a dozen rolls from him.

In a normal market, consumers seek good products at attractive prices offered by efficient suppliers. Likewise, producers are always concerned with delivering quality goods and services — and innovating to achieve that goal. The result: better products and services at lower prices.

But these normal market processes — based on productive self-interest, if you will — have been inverted in the world of health care.

Today we are surrounded by medical marvels that would have seemed miraculous 60 years ago, when our current health care system was created. In the coming years, we can expect more of the same.

Yet while the good is getting better, the bad is getting worse.

Health care stands at a crossroads. If we stay mired in an economic model from the World War II era, costs will continue to swell and government's role will keep growing, as will the rationing of health care. If, however, Americans unleash the market forces that have transformed the rest of their economy, health care will become cheaper, better and more accessible for everyone.

This piece originally appeared in The Dallas Morning News

This piece originally appeared in The Dallas Morning News