Month: April 2010

The End of Government Subsidized Medical Innovation

Most Americans don’t realize it, but America’s status as the world’s primary source of medical innovation is heavily government-subsidized. During the healthcare reform debate, many pointed out that America spends over 17% of its GDP on health care, far higher than any other nation, and almost double the average for OECD nations. This high rate of spending on health care has fostered the growth of high technology health care, from pharmaceuticals to biotech, medical devices, imaging equipment and even surgical robots. What would happen if the government were no longer able to spend at such a rate?

Imagine for a moment that America had a purely free-market health care system, with no Medicare, Medicaid, and without tax breaks for health care. The government currently pays for 62% of all health care spending, and without this support, our healthcare system would be much smaller. If a free-market approach to healthcare brought spending down to the OECD average, the US would spend $1.2 Trillion (48%) less on healthcare than it does today [1]. Without Medicare to pay for costly end-of-life care, it’s doubtful that $200,000 per year chemotherapy drugs would find a market, or that anyone would pay full price for replacements on hips implants. In short, a free market health care system would deliver less health care technology to America – though it would still deliver technology that proved itself worthy and affordable to patients.

Of course in the real world government-subsidized innovation isn’t going away – or is it? America’s long term budget problems are driven chiefly by health care spending, as acknowledged by the trustees of Medicare. The Soviet Union eventually went bankrupt by spending 40% of its GDP on defense. The United States is on track to spend 40% of its GDP on healthcare by 2050 [2], with much of that on high tech gadgetry with low marginal benefit, and with virtually all of that money coming from taxpayers. This is obviously not sustainable.

The newly enacted healthcare reform law begins cutting Medicare in earnest, but deeper cuts will be needed to prevent Medicare’s insolvency. These cuts will inevitably mean less spending, and less revenue opportunities for big pharma, biotech, and medical equipment companies. While many other countries already have highly regulated healthcare markets with lower profit margins, pharmaceutical and medical equipment companies have been able to achieve consistent growth by tapping the US market and US taxpayers. Regardless of how healthcare reform plays out, America’s huge and growing debt mean that this situation will come to an end. The golden age of subsidized medical innovation is drawing to a close.

[1] CMS estimates that 2009 health care expenditures were $2.5 Trillion, or 17.3% of GDP. If this were reduced to 8.9%, the OECD average, health care expenditures would be $1.29 Trillion, almost half of what they are today. While we don’t know exactly what US health care spending would be without government subsidies and programs, we do know that government spending and subsidies would drop by roughly $1.3 Trillion ($1.1 Trillion in direct spending plus $200 Billion in subsidies), leaving a number very similar to the OECD average.

[2] See Figure 4 of this CBO Report for long term health care spending projections.

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What Happens When The US Can Borrow No More?

In a previous post, I noted that the US can handle a debt load up to about $20 Trillion, even in the absence of rapid economic growth. Unfortunately, we appear to be rapidly headed past that figure, with the White House’s official projection showing that total debt will pass $20 Trillion by 2016 [1], and will rise above $25 Trillion by the end of the decade!

The growth of the federal debt is thus unsustainable, as even politicians now acknowledge. Eventually, bond markets will be unable to consume the volume of debt that America needs to issue in order to continue spending. What happens at that point, when the US can no longer borrow to fund current spending?

Here are the options for 2015, using the assumption that real GDP growth and inflation will both average 2% through 2015, with a resulting budget deficit of $1,014 Billion [2]:

  1. Cut Spending: Spending cuts of $475B will be needed to reduce the budget deficit below 3% in 2015. A 3% budget deficit is generally viewed as sustainable by economists [3]. Budget cuts this size would necessarily have to include cuts to Defense, Medicare, or Social Security, as they together make up 2/3 of the Federal budget.
  2. Raise Taxes: As with spending cuts, $475B in taxes would be needed to drop the deficit below 3% in 2015. Taxes would have to be raised to 21% of GDP to close the gap, the highest total tax burden since at least 1975.
  3. Monetize Debt: Since the start of financial crisis, the Federal Reserve has been purchasing US treasuries in order to keep interest rates down and to inject cash into the economy. The Fed could also bail out government finances by buying the $475B in excess Treasury issuance in 2015, but this is the equivalent of printing money. Such an approach will create inflation, and is unsustainable in the long term.

The federal government is likely to attempt a combination of all three approaches in order to minimize the pain on any one interest group. Inflation will likely rise above its recent norm of 2% as the Federal Reserve quietly injects money into the economy. The federal government’s total tax burden will likely rise to at least 20% of GDP, and spending cuts in the hundreds of billions will be required. The sacred cows of Medicare, Defense, and Social Security will be cut, since there’s little to cut outside these programs. The future looks increasingly to hold higher taxes and less government services, a penance decades in the making.

[1] See table S-14 for the OMB’s debt projections.

[2] The OMB uses rosy economic growth projections (table S-13) of over 4% for most of the years between now and 2015. I use a more conservative 2% for real economic growth and 2% for inflation, for 4% total nominal GDP growth (vs. 5.6% used by the OMB). Using 4%, I estimate GDP at $18 Trillion in 2015, whereas the OMB projects $19.4 Trillion. My lower GDP estimate also lowers projected government revenue proportionally, so that my budget deficit estimate for 2015 is $1014 Billion (versus $752 Billion OMB estimate).

[3] Why is a 3% budget deficit acceptable? Long term real economic growth in the US is around 3.75%, so a 3% budget deficit will over time cause the overall debt to grow more slowly than the economy. As the debt-to-GDP ratio shrinks, interest payments on the debt become easier and easier to pay via the growing tax base.

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The End Of Employer-Based Health Care?

The employer penalties in the health care law are low enough that many businesses will drop health coverage. This is a blessing in disguise, as it will lower costs in the long run.

The fiery rhetoric on both sides of the health care debate obscured the details of the actual reform bill. Now that it has become law, policy analysts and journalists have been combing through the bill and issuing predictions on whether it will raise or lower premiums, help or hurt businesses, and generally bring or not bring the Apocalypse. The bill will definitely change how health care is paid for in the United States, but perhaps not in the ways many expect. The following analysis shows that it’s possible that the new law will end the system of employer-based health care entirely!

The Kaiser Foundation has produced a nice summary of the law, including employer requirements:

  • Employers with less than 50 employees face no penalties.
  • Employers with more than 50 employees that provide no health care coverage must pay a tax of $2000 per employee (with the first 30 employees being exempt)
  • Employers with more than 50 employees that do provide care may have to pay a tax 0f up to $2000 per employee if  their employees use the new health care exchange subsidies.

Given these requirements, what are an employer’s options?

  1. Drop Employee Coverage: A company drops its health care plan, paying the $2k per head tax and leaving employees to buy their own plans. The company will save $10,000 per employee on average given the average cost of health insurance [1], and will also save by eliminating benefits administration expenses. The company could give each employee a $9000 raise and still increase profit by $500 or more per employee [2]. Employees will be mad about the loss of benefits, but not too mad as they can get coverage on the exchange using their new income and potentially subsidies.
  2. Keep Employee Coverage: The company will face the administrative burden of supplying vouchers to some employees who would like to opt out, of complying with minimum benefits requirements, and will potentially still have to pay $2000 in fines per employee if its health care plan is deemed insufficient. The company’s use of benefits as a recruiting tool will be diminished once benefits can be obtained on the health care exchange.

Looking at the alternatives, why wouldn’t a company drop its health care plan? Particularly for employers with middle-income employees (who may qualify for federal subsidies), it makes more sense to drop health care coverage and raise wages than it does to continue the status quo. While the employer-based health care tax deduction still exists, for many families its appeal will be neutralized by subsidies available in the new health care exchanges. And since all Americans will be guaranteed access to insurance starting in 2014, benefits will no longer be the employment draw that they are today.

The health care reform bill will thus reduce the share of employer-based healthcare in the US market. This is an excellent change for a couple of reasons: first, it breaks the link between employment and health care, providing more stability to all Americans; and second, it slowly weans Americans off the employer health care tax deduction, which contributes significantly to health care cost inflation. Ironically, the bill’s writers did not intend it to be the demise of employer-based health care. But if this trend does accelerate, the bill may be successful in controlling health care costs. [3]

[1] The average employer contribution for a family insurance plan was $9860 in 2009, according to Kaiser Foundation research. With health care inflation averaging above 4% in recent years, this will rise to roughly $12,000 by 2014. If an employer chooses to pay the $2000 penalty rather than buy insurance for an employee, it can thus save $10,000.

[2] An employer could cancel insurance, saving $10,000 per employee, and then give each employee a $9000 raise. Payroll taxes (7.65%) would add another $688 to this sum, leaving a net profit of $312 per employee if an employer took this approach. Benefits administration expenses would also be eliminated, however, and these savings could be significant. Eliminating a single $40,000 salary HR position at a 200 person company would save another $200 per employee, for instance. So a net profit of over $500 per employee is quite possible – the actual profitability of the move would depend on how much of the health care savings the company chose to pass on in the form of higher wages for its employees.

[3] Why will the shift from employer to direct purchased health care coverage lower costs? First, when you spend your own money, you are more likely to be judicious about it. Second, when tax deductions are replaced with tax credits, the cost inflation effect will drop, since a deduction rises with every additional dollar spent, while a credit does not.

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