Controlling Health Care Costs when Government Pays

Government, as a purchaser of health care, has sought ways to control health care costs. One of the more effective approaches that helped bring Medicare costs down was the prospective payment system (PPS). Instead of paying hospitals for the services that they provide, under PPS, the government pays them per case. Medicare began offering a fixed payment for each patient admitted to a hospital based on a diagnosis related group (DRG) that the patient was assigned to.

Offering a fixed payment per patient has both advantages and disadvantages. A big advantage is that it offsets the incentive of doctors to provide additional services to patients when the marginal benefit is below the marginal cost. When the government or insurance companies pay doctors and hospitals for the services they provide, patients will usually agree to additional treatment recommended by their doctors, even if it is not cost effective. Many patients would not agree to additional treatment if they had to pay out of pocket. The prospective payment system has been quite effective at reducing the average length of hospital stays without any evident decline in the health of those treated.

One problem with paying a fixed payment for each case is that it fails to account for differences between patients within each treatment category. Each patient will receive the treatment that the government deems necessary for the average patient with a given health problem. Some patients may need more than the average while others need less. Offering a fixed payment also reduces the incentive of hospitals to compete on quality. Hospitals will have an incentive to pursue quality improvements that are accounted for by the government’s payment formula (such as changes that hasten patients’ rate of recovery). If they cannot charge the extra cost of a quality improvement to the government or an insurance company, hospitals will only pursue it if patients are willing to pay extra for it out-of-pocket.

When government or insurance companies pay for health care and limit their payments via a PPS system, covered patients need not get too few health services or inferior quality services provided they have the freedom to choose their doctor or hospital and to pay whatever PPS does not pay. In this case, patients could pay extra out-of pocket to get extra services or superior quality care if they value either more than the additional cost. By contrast, government payment will lead to some patients getting more health care or higher quality than they are willing to pay for. As long as a third party pays most of the cost of a procedure, some people will consume more health care than is consistent with their preferences. Although paternalistic arguments can be made for this approach, government lacks the information to account for all the factors that might justify giving priority to some patients over others in using scarce health care resources.

It is a good thing when government takes steps to limit health care costs as they have done with the PPS system, as long as patients are permitted to pay extra to consume more than the limited quantity or quality of service covered by the insurance or government program. There is, however, a fundamental problem with this approach, which is part of the reason why Medicare costs continue to rise so fast that Medicare appears to be financially unsustainable.

No matter how carefully a hospital is at diagnosing a patient when he is first admitted, hospitals often do not know ahead of time what sequence of treatments will be most effective for each particular patient. As a result, Medicare allows retrospective cost sharing based on treatment decisions hospitals make long after the initial diagnosis. It is often unclear whether a certain treatment is appropriate for a given patient. The more that Medicare allows retrospective cost sharing the greater the incentive of hospitals to err on the side of more intensive and costly treatment. As technology improves, hospitals also have an incentive to use more expensive treatments, if they can get reimbursed for the additional cost, regardless of how large or small the marginal benefit actually is.

Lacking a profitability constraint or even much of a budget constraint, government Medicare adminstrators have inadequate incentives to compare the marginal benefits of a more intensive treatment regimen with the marginal costs.

By contrast, if patients or their families were the ones paying for the treatment, they would have an incentive to make treatment decisions based on a comparison of anticipated marginal benefits with marginal costs. This would provide a much more powerful incentive to control costs than PPS provides, as it is currently administered by the government. The best way to control the costs of medical care for the elderly is to have patients and their families bear a greater share of the costs of medical care, since they are the ones most likely to make choices that will promote a cost efficient level of treatment.

The Case for and Against an Individual Mandate to Buy Health Insurance

A major concern with health care in the United States is that many of those who most need health care are unable to get health insurance- either because they would be charged higher premiums or not fully covered by employer plans, due to preexisting conditions. An important goal of health care reform was to make sure that all, regardless of the state of their health, could get affordable insurance coverage. Accomplishing this while maintaining some semblance of a private health insurance market is difficult.

In a free market, health insurance companies set premiums based on expected health care costs, and those costs will be much higher for people with poor health. While some employer plans continue to insure people whose health deteriorates, it is difficult for those with preexisting health problems to find a job or qualify for full health insurance coverage if they do.

If the government requires health insurance companies to cover everyone who applies without charging more for those with poor health, a problem known as adverse selection arises. Insurance companies will set a premium high enough to cover the average person who is likely to buy insurance from them. Given the choice, however, many people who are healthier than average will choose not to buy this insurance because they are unlikely to visit the doctor enough to justify the premiums they will have to pay. Almost everyone whose health is worse than average will perceive the premiums to be a bargain and will buy this insurance. The resulting below average health of those who choose to buy insurance will cause premiums to rise, making buying insurance worthwhile only for those in very poor health.

The problem described above can be overcome either by government providing health insurance for all at taxpayers’ expense or by mandating that everyone buy health insurance. The only way to sustain a private insurance market when companies are required to insure everyone without discriminating against those with preexisting health problems, is to mandate that everyone, especially those who are relatively healthy, must buy insurance.

Is it possible to have a system that does not discriminate by price based on preexisting conditions without some kind of individual mandate? The short answer is no. Hence the only way to guarantee affordable health insurance for everyone is to take away individual freedom. Although access to affordable health care may sound like a good reason for Americans to sacrifice some freedom, it is not. As I will discuss in future blogs, the argument that everyone should be able to purchase health insurance on the same terms is inherently flawed and does not hold up under careful scrutiny.

Private Roads and Highways- Why not?

Since many states face a highway funding crisis, some state governments and the federal government are considering proposals to sell highways to private investors. This goes against the the conventional wisdom that roads should be built and maintained by government and funded by taxes. Conventional wisdom, taught in many introductory economics courses, is that roads are public goods. One definition says a good is public if the cost of excluding people who don’t pay for using the good is unacceptably high. If someone builds a road with lots of access points it would be very costly to exclude people who do not pay for it from using the road.

When thinking about charging people to use roads and highways, most people think of tolls. Private firms can and do manage toll highways. Although tolls may work for a few limited access highways, the cost of collecting tolls from the driver of each passing vehicle would likely outweigh the benefits for most roads and streets, which have numerous access points that are close together. But this does not mean that it would be infeasible to privately operate such roads and streets. Tolls are not the only way to charge people for the benefits they get from roads. Residents and business owners could be charged a fee for access to the road or street on which their homes or businesses are located. They could also be required to purchase a license to drive on the roads within a given jurisdiction.

Modern electronic technology makes it possible to charge people for using roads and highways without costly delays associated with collecting tolls manually.Yet even without modern electronic technology, private roads and streets were much more common in the past than they are today. In Britain, roads and highways were built and maintained by monasteries during the Middle Ages. Guilds invested in the construction and maintenance of turnpikes as late as the eighteenth century. Approximately 10,000 miles of private turnpikes were built in the US during the early 19th century. Private investors abandoned most of these when competition from government subsidized canals and railroads reduced their ability to earn enough in tolls to cover expenses.

Most private turnpikes were not profitable for their investors. Investors were often local merchants who would profit from additional traffic attracted by turnpikes. Thus they were willing to invest even though revenues from tolls did not generate a decent return. Private streets were also common in some US cities during the 19th century. Private streets were not supported by tolls, but by an assessment on residents located along the streets.

The paucity of private roads cannot be taken as proof that such roads would not be built in the absence of government subsidies. Few private highways exist because they cannot compete with government subsidized highways. Given the choice between paying a toll to drive on a private highway driving on a government highway at no charge, most drivers would rather drive on government highways than private highways, even if private highways were better quality and had less congestion.The result is a very inefficient system of roads and highways that are more costly than necessary with serious congestion problems in many cities.

Without competition from free highways subsidized by the government, people would be willing to pay to use highways. If the system of roads were sold to private entrepreneurs, they would find creative ways to fund them, just as they did at various times in the past. Whether it be local community associations or merchant associations who collect a fee from their members in exchange for building and maintating roads, or corporations who limit access to expressways and charge toll, people will pay for the use of roads and highways because they value mobility. Furthermore, expressway congestion could be reduced or eliminated by charging drivers prices that vary to reflect the scarcity of highway space during different times of the day. The revenue earned could be used to expand highway capacity in the most heavily traveled routes, thereby enhancing mobility, which in turn promotes widespread employment and prosperity.

There ain’t no such thing as a free lunch (or free healthcare)!

A few days ago, I received an email from the daughter of our Congresswoman. In the email she explained that because of Health Care Reform, which her mother supported, she no longer had to pay a $25 co pay for each prenatal appointment. This will save a family “that lives paycheck to paycheck” over $500 per year. Such savings makes healthcare reform sound like a wonderful gift until you stop to reflect- who pays the $25 that the consumer no longer has to pay each time she visits the doctor? The answer: for those who have health insurance, the elimination of copayments will mean higher premiums. In other words, paychecks will become smaller as insurance rates rise to cover this new government mandate.

Proponents of this new rule emphasize that if people do not have to pay for preventative care, they are less likely to require more expensive hospitalization or treatment in the future. Thus, mandating no copayments on preventative care may reduce health care expenditures in the long run. This line of argument is fundamentally flawed. It assumes that the government knows or can find out how much preventative health care each person needs and mandate insurance companies to pay for the required number of visits. How many doctor visits are covered as preventative will be a political decision, and self-interested medical professionals will undoubtedly play an important role in that decision. Thus we should not be surprised if the government mandates more free preventative care than would be cost effective for most patients.

We live in a world of scarcity. Money spent on health care cannot be spent on something else. If the insurance company provides a certain number of free doctor visits, each person covered by insurance will pay for the number of times the average person visits the doctor, regardless of how often he visits the doctor. One person’s visit to the doctor has an imperceptible impact on the per capita cost of health care borne by a large insurance company. Thus the monetary cost to each patient of a visit to the doctor for “preventative care” is effectively zero. The quantity of health care demanded will be greater at a zero price than at a $25 price. Since almost everyone will demand more health care at the zero price, insurance premiums will rise for everyone, and because more health care is being consumed, the total cost of health care will be greater than if everyone had to pay a $25 (or higher) copayment.

If you are covered by a typical health insurance plan which requires you to pay part of the cost of each doctor visit, Congress has not saved you money by passing health care reform. Instead they have mandated that you spend more than you might choose to spend on so-called preventative health care. If you don’t pay for it up front with a copayment, you will pay for it through higher premiums. The only way to keep people’s premiums from rising is if the “free” care is taxpayer funded, and then someone still pays for it.

Instead of Obama Care, which takes away our freedom, what we need is health care reform that gives the consumer more freedom to decide how much health care to purchase with his own money.

Why the Bush tax cuts should not be allowed to expire

Because I am concerned about fiscal responsibility, I am hesitant to advocate keeping taxes low. Nevertheless, as my colleague Shawn Ritenour emphasized in his blog, restoring fiscal responsibility while also promoting a prosperous economy requires cutting government spending, not raising taxes.

Raising taxes from the current level would have harmful consequences in any case, but those consequences are exacerbated by the fact that we are in a severe recession (some say depression). The main problem with raising tax rates is not that it will lead to a reduction in consumption and demand. If anything it will lead to increased consumption, though by government agencies and recipients of government transfer payments instead of the people who earned the money through their labor.

The more serious problem for the economy is how taxes influence production. When a greater share of each dollar earned is taxed away, it reduces the incentive to earn, whether through working additional hours, hiring more workers, or investing in capital. This problem is more serious for those in higher tax brackets, who are more likely to own businesses and have discretionary time and money that they could invest producing more goods and services. It is not spending that leads to economic prosperity, but greater production of what people value, which depends on entrepreneurs having confidence about the future direction of the economy and an expectation of being rewarded for taking risks. This is the key to an economic recovery that will restore prosperity while preserving freedom.

It is doubtful that raising tax rates on individuals with incomes over $200,000 ($250,000 for married couples), as proposed by the president, would lead to a reduction in tax revenue, but it will not lead to a very big increase. Thus if the big spenders currently in control of Congress really care about fiscal responsibility they will let the lower tax rates on the middle class expire as well. This would lead to an increase in revenue that is at least two or three times as large as from increasing taxes only on the those earning more than $200,000, who make up less than 5 percent of households.

Raising taxes on the middle class may actually have a less harmful effect on economic growth and prosperity in the long run than raising taxes on the wealthy, since work and investment by the middle class is likely less responsive to tax rates than that of the wealthy. Nevertheless, uncertainty about which tax rates will be allowed to increase and which will not also hinders economic recovery. Even if the president and Congress say they do not intend to raise taxes on the middle class, their unwillingness to bring spending under control leaves many of us expecting that Congress might raise those taxes out of fiscal necessity. This uncertainty discourages entrepreneurs from investing in capital to expand production of goods and services demanded by the middle class.

A clear commitment on the part of Congress and the administration to extend the Bush tax cuts across the board would remove some of the uncertainty and lead to greater investment and job creation. While such a commitment is not sufficient to address the looming fiscal problems faced by our government, it would be a step in the right direction.

Restricting Trade with China will not hasten Economic Recovery

With the unemployment rate stuck at 9.5 percent, some economists, such as Richard Posner, maintain that we are experiencing a depression. Clearly we have not experienced much economic recovery, and the future does not look promising. Why has the US economy been recovering so slowly? Some economists, such as Paul Krugman, place part of the blame on China and other countries that are running large trade surpluses with the US. The US trade deficit soared to $49.9 billion in June and $26.2 billion of this deficit was with China. We also ran a $3 billion trade deficit with Germany in June, and Germany’s trade surplus rose 30 percent compared to 2009.

By undervaluing its currency, the Yuan, China is effectively taxing imports and subsidizing exports. This contributes to the US importing much more from China than it exports to China. Krugman says that this policy benefits China while hurting the US. He argues that the US should threaten to impose sanctions on China if it does not allow the Yuan to rise in value. This may result in a trade war between China and the US. Krugman believes that if conflict results in reduced trade between the US and China, Americans could actually benefit. He argues that because we are in such a severe recession, if the government restricts trade, more will be spent on goods produced in the US, more jobs will be created and we will be better off. This view of trade policy, of which most economists are critical, is known as mercantilism.

Krugman’s assessment of Chinese exchange rate policy is backwards. Rather than benefitting China, it makes Chinese residents worse off while benefitting Americans. For a detailed explanation of this, read the article on China’s currency manipulation by Jonathan Catalan in Mises Daily ( In short, by holding the value of its currency down, the Chinese government is reducing the number of dollars received by its exporters for each item that they sell. This in turn, raises prices and reduces the purchasing power of the Chinese currency for all Chinese residents. Americans, on the other hand, benefit from being able to buy Chinese goods at a lower dollar price than otherwise.

Mercantilism and Keynesianism have much in common and represent a faulty understanding of how an economy works. The large US trade deficit is not the cause of high unemployment in the US. Trade deficits mean that instead of buying US goods with the dollars they obtain from trade, foreign citizens or their governments are purchasing US financial assets. The Chinese government uses the dollars it accumulates from trade surpluses to buy US government securities. This increases the supply of savings in the US, which, by reducing interest rates, should lead to more investment. Krugman argues from the paradox of thrift, that in a time of mass unemployment, if anyone (including the Chinese government) tries to save more, demand and investment fall because there is excess capacity in the economy.

Reduced trade with China would result in lower standards of living for Americans and would not lead to a net increase in jobs in the US. If the Chinese government responded to the threat of trade sanctions by raising the value of its currency, would that hasten the economic recovery? Not necessarily, because in order to raise the value of the yuan, the Chinese government must sell US government securities, which would lead to higher interest rates in the US and less capital investment. The reduction in investment would offset the increase in exports. The Federal Reserve could keep interest rates from rising and investment from falling by increasing the money supply. This, however, would lead to more price inflation.

It would be a good thing for the Chinese people, if the Chinese government allowed their currency to appreciate. It might even result in a small short term reduction in unemployment in the US as the Chinese buy cheaper American goods and Americans buy fewer Chinese goods. It would also make it harder for the US government to fund its deficits and would not cure the fundamental problem that is hindering economic recovery in the US- uncertainty about the rules and tax policy that will determine the profitability of investment projects. A return to full employment and prosperity requires a stable market economy where entrepreneurs have the confidence to invest in anticipation of future profits. This is more likely if instead of taking over health care and a greater share of the economy, government reduces its role, ending bailouts and unsustainable government spending.

Why voters oppose higher fuel taxes

Most voters do not like taxes and tax increases. One of the few taxes that was generally accepted and even welcomed when it was first enacted was the tax on gasoline. Unlike most other taxes, Americans recognized that paying this tax would result in improved roads and highways, which they valued. More recently, however, state legislatures and the US Congress have experienced widespread public opposition when they consider increases in gasoline taxes, in spite of growing concern about deteriorating bridges and highways.

Recent strong opposition to fuel tax increases does not mean that Americans are less willing than before to pay taxes in order to have better roads. What it does reflect is voters’ opposition to money paid in fuel taxes being used for purposes other than highway spending. In recent years almost 20 percent of money paid into the Federal Highway Trust Fund (FHTF) has been spent on mass transit. In addition, FHTF money is being spent on recreational trails, historic preservation, and scenic easements. Besides the FHTF money allocated for nonhighway purposes, a growing share is used for earmarks, which reflect political priorities of individual members of Congress rather than the priorities of highway users who pay gasoline taxes. Many drivers do not want to pay higher fuel taxes when less than 75 percent of the money paid in federal fuel taxes is used to maintain and improve streets, highways, and bridges.

Is the answer then a return to the good old days when fuel tax revenue was used in a (relatively) responsible manner? That may no longer be possible. The federal government and many state governments are now controlled by a ruling class that has little respect for the preferences of the general public. Instead, they seek to impose their enlightened ideas of how society should be organized. Hence, they may continue to seek to use fuel and other taxes to subsidize public transit and otherwise promote greater density and less automobile use, even if this is contrary to the wishes of the general public.

Widespread opposition to increases in fuel taxes at the federal or state level thus reflects a fundamental distrust of government. This distrust is based on evidence that the ruling class has its own agenda, which is inconsistent with the preferences of the general public. Given their smaller size, state governments may be more accountable to the voting public, and thus more likely to spend fuel taxes wisely. Recent failure to pass an increase in fuel taxes by the Pennsylvania legislature, however, suggests that voters are not yet ready to trust the Commonwealth to make good use of additional fuel tax revenue. If the federal and state governments can no longer be trusted to spend tax money wisely, a better approach may be to develop innovative local approaches to funding transportation.

An Example of Wasteful Transit Spending in Pennsylvania.

Anyone who wants to understand how the political process leads to wasteful spending on public transportation need look no further than the North Shore Connector, a 1.2 mile extension of the light rail line in Pittsburgh. Senators John McCain and Tom Coburn recently criticized this project as one of the three most offensive uses of federal stimulus funds. Recent attempts by the Pittsburgh Post-Gazette and the Port Authority of Allegheny County (PAAC) to defend this project against the Senators’ criticism reflect economic fallacies and also illustrate the process by which interest groups seek to profit from federal and state government money at the expense of taxpayers as a whole.

Defenders of the project point out that its construction provides thousands of jobs while supporting economic development on Pittsburgh’s North Shore. They ignore, however, the opportunity cost. A comparable number of jobs would have been created if the money had been spent elsewhere and much larger benefits would have resulted if the $529 million spent on the North Shore Connector were invested in a private sector project that consumers were willing to pay for.

Consumers will not be willing to pay even close to the more than six dollar per ride cost that would be required to cover the annual interest on the money invested in this project, not counting the operating cost and depreciation. The money spent on this project could be used to buy a brand new $40,000 SUV for each one of the 11,500 riders per day that are expected to use the North Shore Connector.

If it had not been for $62.5 million of economic stimulus funds, construction of the Connector would likely have been halted due to cost overruns. Not only has the cost increased from an original estimate of $363 million to $528.8 million, as noted by the Allegheny Institute (, but the project was scaled back in size, as PAAC dropped a planned spur to the Convention Center from the project. The PAAC website does not mention the most recent increase in costs, listing the project as costing $435 million to construct.

Why is so much money being spent on this project? Because about 80 percent of the cost was borne by the Federal Government and one sixth came from the Commonwealth of Pennsylvania, leaving only 3.33% of the cost to be paid by local taxpayers. Thus many Pittsburgh residents are strong supporters of the project. Supporters believe that if the money is not spent in Pittsburgh, it will be spent in some other city. When Uncle Sam pays for it, the cost is divided among the entire US population while the benefits accrue to a much smaller number of local transit agency employees, construction workers, and city residents who expect to use the service. It is not worth the effort of individual taxpayers to oppose this project politically because it costs only a few dollars per taxpayer, while the benefits to local groups are large enough that they are more likely to reelect their representatives in Harrisburg and Washington if projects like this are funded. When this and numerous other projects that benefit interest groups get added to the federal and state budgets, we end up with enormous government debt, which may soon be unsustainable.

Which Party will Promote Fiscal Responsibility?

Martin Wolf , writing for the Financial Times ( argues that if Republicans return to power, the accumulation of unsustainable government debt will continue. Wolf maintains that Republicans still promote “supply-side economics”, espousing the view that cutting taxes could balance the budget. He also points out that Bush-era tax and spending policy led to today’s extremely high deficits.

I think Wolf is onto something. Republicans are more concerned about cutting (or at least not raising) taxes than they are about fiscal responsibility. Few Republicans in Congress or the Senate are willing to propose serious spending cuts that would be necessary to bring the budget into balance (or even substantially reduce projected deficits). How many Republicans would consider cutting Medicare spending, for example? Rising Medicare costs as the baby boomers retire will be much larger than any recent economic stimulus spending.

Wolf argues further that Democrats are relatively fiscally responsible. Their support of tax increases does suggest that many of them care about fiscal responsibility. Nevertheless, just as the supply-siders exaggerate the incentive effects of tax cuts, those who believe that government can increase spending, as it will with health care reform and other progressive policy changes, and pay for it with tax increases, underestimate or ignore the negative incentive effects of tax increases.

Not only is it unlikely that the proposed tax increases will do much to bring down deficits, but it is doubtful that a big enough tax increase to make a dent in the deficit will succeed politically. And this is as it ought to be. Americans value freedom, but we cannot have the freedom to spend our money the way we want if government programs are absorbing a growing share of our income. Nevertheless, Democratic politicians play an important role in reminding Americans that tax increases will be necessary if the government is going to continue to spend as much as it has been spending recently.

The kind of fiscal responsibility that will preserve our freedom does not involve increasing taxes, particularly on the highest income groups who play such an important role in investment and entrepreneurial job creation. It does, however, require a commitment to make serious cuts in spending, including in some areas that are dear to many conservatives and Republicans, like national defense and Medicare. Keeping taxes low or reducing them without cutting spending is a recipe for a fiscal disaster that will eventually cripple the ability of government to perform even its necessary functions.