Code Red: Two Economists Examine the U.S. Healthcare System

March 22, 2012

Will Obamacare Drive Out Employer-Sponsored Insurance>? A Simple Test

Filed under: Uncategorized — David Dranove and Craig Garthwaite (from Oct 11, 2013) @ 11:55 am

Many opponents of Obamacare claim that large employers will drop employee health coverage in droves. The Wall Street Journal has made this argument a centerpiece of its opposition to the health exchanges. The argument has some face validity – employers that drop coverage can save about $10,000 per employee in insurance costs but only have to pay fines of $2000 per employee. What employer would not want to save $8000 per employee?

Supporters of Obamacare argue that if employers do not pay for insurance, they will have to increase wages. This will temper the incentives of employers to drop coverage. This follows from a classic model in labor economics that says that employers have to give workers a competitive wage/benefits bundle, and that the mix of wages and benefits is largely fungible. Thus, if benefits fall by $10,000, wages will increase by about the same amount. The theory is well accepted. While it has been difficult to construct empirical tests of this theory, the available evidence is largely supportive (though the evidence of 1:1 fungibility is less compelling than the evidence of some degree of fungibility.) This may explain why the Congressional Budget Office predicts that only a few million workers will lose their employer sponsored coverage and get pushed onto the exchange. Even so, the Wall Street Journal and others have dismissed this theory and evidence, arguing that employers who drop coverage will pocket the full savings and therefore than tens of millions of workers will be affected.

I want to propose a simple test of the naysayers’ position. The test relies on evidence that the Wall Street Journal and others should find unimpeachable –stock market valuations. This is a quick and dirty test but the results are so compelling that I think it is sufficient.

I rely on some basic labor market data. Consider that American firms pay workers about $60,000 annually in average compensation and benefits. Moreover, these labor expenses represent about two-thirds of the total cost of production. Now suppose that firms can reduce their wage/benefit package by $4000 by dropping $10,000 in insurance coverage, paying a $2000 fine, and increasing wages by just $4000. In other words, I am supposing that there is 0.5:1 fungibility between wages and benefits. (I get similar qualitative findings with any ratio that is substantially less than 1:1, as the naysayers are assuming.) This savings reduces total compensation costs by 6.7 percent and therefore reduce total production costs by 4.4 percent. In effect, this simple move would increase returns on sales by 4.4 percent! This would effectively double the average return on sales for U.S. manufacturing firms (which is currently about 5 percent) and represent an even bigger increase in retail and other industries.

If the naysayers are correct, then the passage of Obamacare should have had a remarkably powerful impact on the stock market. Share values should have doubled and then some! And the effect should have been immediate, as investors could have performed the same math as I have just done and seen the good times ahead. Of course this did not happen. I can only conclude that investors did not and do not expect large employers to reap a windfall from Obamacare. Large employers that drop coverage will have to increase compensation to workers to make up for the difference. Obamacare does not provide a free lunch to employers, and this is why the CBO and others expect such a small impact on employer-provided coverage.

What I find most remarkable is that the Wall Street Journal is a staunch believer in free markets, yet it conveniently ignores market mechanisms when it wants to make a political point.


  1. Very interesting approach. Except it is missing one key thing: the bonanza return for firms letting go of healthcare benefits is not available until Obamacare kicks in in 2014. So the bonanza was not available immediately upon passing of the law — it is more like a big dividend scheduled to paid out beginning in 2014. Stock prices do not immediately jump when the dividend is announced, instead they rise gradually to meet the date of the dividend. As a matter of fact, stock prices have been rising gradually as of late, so I could argue that the naysayers ARE correct, and companies WILL be dumping insurance in 2014.

    Whether you like the dividend analogy or not, there were/are just too many economic, political, taxing, and regulatory unknowns between 2010 and 2014 for the market to have reacted immediately in either direction.

    Comment by Eric Grebner — March 22, 2012 @ 12:32 pm

    • But the net present value of the benefit could be computed at the time the law was enacted. (The passage of the law was news, given the close vote.) Uncertainty about whether the law would be implemented as written would reduce the stock market premium.

      Comment by dranove — March 22, 2012 @ 12:34 pm

      • The discount rates used for the NPV would have to be very high because of all of the unknowns between 2010-2014. If one thinks in terms of the CAPM, on the date of passage, the expected future cashflows for each U.S. stock should have, as you argue, jumped. But the unsystematic risk of each stock would have had to simultaneously jump as well due to the 2010-2014 unknowns surrounding the law and the specific implications for the firm in question. I would further argue, that upon passage of the law, the systematic (market) risk, too, simultaneously jumped due to all of the unknown tax, regulatory, etc implications of the law and the unknown effects on the economy. So an NPV in 2010 of increased cashflows that begin in 2014, but with fairly drastic CAPM discount rates, is closer to a blip at the time.

        Or, if one thinks in simple pragmatic terms, no one upon passage of the law could really have any confidence what the outcomes would ultimately be in 2014.

        Again, if anything, I could use your interesting approach, but to argue the opposite conclusion. As we get closer and closer to 2014, stock prices are rising. This is partially because marketeers believe companies will drop insurance in 2014 to double their operating cashflows. The NPV of these cashflows is increasing quickly as 2014 gets closer, and as both the unsystematic risks and the systematic risks attributable to Obamacare become gradually lower.

        Comment by Eric Grebner — March 22, 2012 @ 1:34 pm

      • All good points but it is telling that the market fell when Obamacare passed. So directionally the market did not think this would be of much help to employers.

        Comment by dranove — March 22, 2012 @ 2:48 pm

  2. I agree with the reasoning of both Mr. Grebner’s and dranove’s comments that prices wouldn’t rise until later (2014) but that at least the NPV should be included now. However, the biggest reason why such a premium may not be included at all is because of the huge uncertainity surrounding Obamacare. Most people seem to believe it has good chance of being repealed, especially if Obama loses the next election.

    Also, if we believe the rich favor low taxes and thus subscribe to the republican party, and if we believe that Obamacare will actually increase share prices (by employers dropping coverage), then the rich should vote for Obama (since they own a large % of the stock market). Because lower taxes are most definitely not going to come from either party, given the total fiscal deficit, which over 100% of GDP now (not counting social security and other obligations). Yet we’re still seeing the 1% mostly favoring the republican party, something to think about.

    Finally, there is something to be said about not having to worry about buying coverage on your own or being skeptical of the “quality” of care with Obamacare in the first place. Top employers will be reluctant to take away benefits from employees in order to save due to Obamacare. This is because employees are typically almost-terrified of not having coverage, and until Obamacare is established and people hear good things about it, employees will continue to demand the “better” coverage that they perceive employers are providing. Also, don’t forget that the extra $4,000 paid to the employees would have payroll taxes associated with it, 15.3% total (after the payroll tax cuts expire), 7.65% for the employee and 7.65% for the employer, which is about a $300 hit each to the employer and employee.

    Comment by Y. Shaban (small-biz owner & Kellogg MBA Fall 2012 applicant) — March 22, 2012 @ 1:21 pm

  3. “Large employers that drop coverage will have to increase compensation to workers to make up for the difference.”

    This and then some. Healthcare coverage is deeply personal to employees. A company which drops health insurance as a way to quickly cut corners could lose credibility with their customers and their workforce, as denial of healthcare coverage is likely to be experienced as a physical attack–either out of callousness or incompetence. Good luck to an employer trying to regain credibility to its workforce by equivalent monetary compensation alone.

    Comment by Justin Gaines — March 30, 2012 @ 1:35 pm

    • Recent history suggests that it will not make a difference to consumers if a company drops healthcare coverage and lets its employees fall through to federal universal coverage. When companies over the last two decades gradually cut and dropped pensions, consumers didn’t care. Nobody switched airlines or cell phone manufacturers because they learned United or Motorola was eliminating pension programs for current and future workers. Why should consumers care? Consumers still want the best deals and their favorite products. Just look at Walmart, probably the most criticized firm in recent history with regards to employee compensation. We see Walmart consumers are commiserating all the way to the checkout counter with their savings, don’t we?

      Likewise, the vast majority of employees are not in a position to quit upon hearing they will have to move to federal universal coverage. We employees already put up with the annual increase in premiums and changes in programs and coverage and the vast majority of us do not have a new job to jump to right away.

      As with pensions, however, and many other perqs such as stock options — healthcare coverage decisions at large private-sector firms will be subject to talent supply and demand. Supply and demand applies to local markets — in this case, the local markets are industry segments and sub-segments. So the retail segment vs technology segment vs financial segment, etc, will each drop healthcare at its own rates. For example, the retail industry mostly employs those with less than a college degree. Unemployment amongst these non-college-grad employees is ~10%, so supply is high, and retail companies perhaps therefore do not have to continue to offer healthcare to attract a sufficient workforce. Technology, on the other hand, employs many college graduates. Unemployment amongst these college-grad employees is closer to 4% or 5%, and technology companies are currently doing well, so supply and demand would predict that technology companies will not be able to drop healthcare if they want to remain competitive within their industry for retaining and gaining talent.

      Pensions did not disappear over night. They first began disappearing with firms on the verge of or in bankruptcy who had to make tough choices. Once one or two major players in an industry dropped pensions, others eventually had to follow suit to “remain competitive” from a cost basis. Besides large firms having plenty of finance professionals watching the bottom line, they have human resources professionals monitoring what the competitive compensation packages are in the industry. At some point, human resources agrees with finance that offering pensions is no longer needed to maintain and gain talent. The “callousness” of this decision was sometimes tempered, for example, by firms increasing perqs with regards to their 401k program.

      If Obamacare holds, I see company-offered healthcare coverage going a similar route as company pensions. Small firms and many mid-sized firms (much more beholden to the immediate bottom line) will drop healthcare within the first year. I see large private-sector firms, on the other hand, not wanting to be the first in their industry to drop healthcare. The first large private-sector firms who do drop healthcare will be out of financial distress. Once the ice is broken within an industry, it will — as with pensions — then be a slippery slope (yeah, mixed metaphor intended) for other firms to follow over time. Did it take 15 years for all private sector, non-union firms to eliminate pensions? Did it take 10 years for all private sector, non-union firms to move manufacturing overseas? Will it take 5 years for all private-sector, non-union firms to drop healthcare?

      Comment by Eric Grebner — March 30, 2012 @ 2:54 pm

  4. I take no issue with the author’s argument. In addition, I concur with the line of reasoning that large employers (500+ employees) will hesitate to eliminate company sponsored group health benefits. Smaller employers (e.g., under 100 employees), I believe, will behave quite differently. The risk profile is entirely different for these employers. One chronically/seriously ill employee can affect the health plan economics for the group and the company. As a result, small employers willl be inclined to use Obamacare as cover, moving their employees onto the state exchanges or investing some portion of the $8,000 saved in employee stipends directed at buying their own health insurance.

    Comment by Roger Clark — April 5, 2012 @ 8:37 am

  5. David, your readers may also be interested in reviewing what President Obama has said on this topic.

    Obama’s statement at SEIU’s New Leadership Health Care Forum on March 24, 2007 —

    “As I indicated before, I think that we’re going to have to have some system where people can buy into a larger pool. Right now their pool typically is the employer, but there are other ways of doing it. I would like to — I would hope that we could set up a system that allows those who can go through their employer to access a federal system or a state pool of some sort. But I don’t think we’re going to be able to eliminate employer coverage immediately. There’s going to be potentially some transition process. I can envision a decade out or 15 years out or 20 years out where we’ve got a much more portable system. Employers still have the option of providing coverage, but many people may find that they get better coverage, or at least coverage that gives them more for health care dollars than they spend outside of their employer. And I think we’ve got to facilitate that and let individuals make that choice to transition out of employer coverage.

    Comment by Phil — April 6, 2012 @ 12:39 pm

  6. The price of the stocks indicated has started to increase steadily since yesterdays ruling. Maybe investors were just waiting it out.

    Comment by Carlos — June 29, 2012 @ 1:26 pm

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