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

Apologies for our recent hiatus from blogging.  One of us (Garthwaite) was conducting some field research in health care related to the birth of his second child.  We will now return to our semi-regular blogging schedule.

As the ACA insurance expansion begins to fully take hold, attention is returning to the seemingly ever growing cost of care in the United States.  Many voices are chiming in about the need to pay greater attention to the rising prices paid for medical services and pharmaceuticals. Last week we held Kellogg’s annual MacEachern Symposium. Featured speaker Amitabh Chandra put rising prices atop the list of reasons for healthcare cost growth. And a recent Bloomberg View editorial has called for price regulation of medical services (we should note that Chandra’s focus on prices was not a similar call for price regulation).

The central topic of this year’s MacEachern Symposium was the rising prices of specialty pharmaceutics, the poster child for which is Sovaldi, which is Gilead’s cure for hepatitis C and carries a price tag of about $84,000 for a course of treatment. These high prices have attracted a great deal of attention and led many to call for regulators to lower them by any means necessary. For example, President Obama has recently called for Medicare to be allowed to use its monopsony power to “bargain” down the price of pharmaceuticals.

It is dangerous to introduce new regulations to solve a problem without fully understanding the cause of the problem. At the most basic level, these prices are high because we grant 20 year patents to innovating firms to provide an incentive for them to make large risky investments in research and development.  If one factors in the very low probability that any patent turns into a marketable drug, the cost per new drug may be $2 billion or higher. Given the length of the regulatory process, the effective patent length results in about 12-13 years of time where the innovating firm can sort of act as a monopolist and set a profit maximizing price.  We say “sort of” because patents cannot prevent competition from different drugs that target the same diseases a feature that blunts the monopolists pricing power. As a case in point, Sovaldi already faces competition from newer drugs such as Harvoni (also developed by Gilead) and Viekira Pak (developed by Abbvie), and prices have fallen considerably.  And once patents run out, generic manufacturers can enter the market with an effectively perfect substitute for the product resulting in price decreases of approximately 70 percent.

It must also be pointed out that Gilead and the other makers of high priced drugs could never achieve such high volumes at such high prices if drugs weren’t covered so generously by health insurance.  Without insurance, very few Americans could afford the cost of Sovaldi, let alone the six figure price tags of many new cancer drugs. As a result, expansions of insurance such as those under the ACA and the creation of Medicare Part D, while laudable as goals, are part of the cause of high prices.

Taking these facts together, we note that if you want to lower drug prices you should be looking at either the current structure of the patent system or the design of the federally subsidized insurance system – both of which serve as distortions in the market. This is likely the reason for President Obama’s misguided focus on increasing Medicare’s monopsony power for drugs.  We discuss below why this would a problem and why instead, we think the President should focus on a particular feature of Part D that is likely driving higher prices for certain types of drugs.

Peter Bach of Memorial Sloan Kettering noted at the Maceachern Symposium, Medicare Part D has six “protected classes” of drugs where insurers were forced to offer coverage for every available product.  These categories are anti-cancer; anti-psychotic; anti-convulsant, anti-depressants, anti-psychotic, immuno-suppressant, and HIV and AIDS drugs. These protected classes all but assure that innovators can charge whatever they want to all insurers, not just those in part D, because private insurers that fail to follow Medicare’s lead can be sued for inadequate coverage.  A suit that would be hard to win when the poorly funded social insurance program offers coverage for the service.

With these facts in mind, we note that President Obama is upset about the monopoly prices caused by patents and his solution is to increase the market power of social insurers.  It might seem that increasing the clout of purchasers will make the drug market more competitive, but this is decidedly not the case.  The answer to having “too much” market power by one participant should not be to attempt to increase the market power of the other participants.

Instead, the President should think about doing things that increase competition among the drug makers.  First, he could think about implementing patent reform.  If what we desire is that pharmaceutical firms earn less money while their drugs are under patent then perhaps we should consider addressing the route of that alleged “problem.” Perhaps patents are too long and that should be fixed?  Or we could imagine systems that have been proposed wherein the breadth of the patent being a function of the value that the drug brings to market.  There are many reforms that we could look at if we think that the market imperfections created by patents are providing too many rents to innovating firms.

After considering patent reform, he could look into reforming the existing rules of Part D that bind that hands of insurance companies participating in that program.   If insurers can’t threaten to remove a drug from its formulary it’s very hard to effectively negotiate price discounts. And these discounts can be quite substantial.  Consider the case of Gilead’s Sovaldi.  While this drug was originally priced at $84,000, this was only the case while it was the only oral treatment that cured hepatitis C.  Less than a year later, Abbvie released Viekira Pak.  Initially, this drug was priced similar to Sovaldi.  However, as a result of competition between these products they are each now selling at a reported 40 percent discount.  Express Scripts, the nation’s largest pharmacy benefit manager, achieved this discount by removing Sovaldi from its formulary for the vast majority of its patients.  However, if Express Scripts wanted to attempt the same strategy with its equally expensive oncology products they would not be able to since CMS requires them to provide coverage for all of these products.  The best they could accomplish is to put different products on different cost sharing tiers – a far less threatening action given the cost of these drugs.

Removing protected class status would actually introduce more competition into drug pricing for Medicare.  Some people may argue that removing the drugs protected class status would deny needed pharmaceuticals to individuals, particularly those who might not respond to one therapeutic substitute compared to another.  In fact, a recent attempt by the Center for Medicare and Medicaid services to remove some of these protected classes was roundly criticized. However, it is important to realize that any attempt to lower the returns of pharmaceutical companies will, at the margin, decrease new drugs from entering the market.  Our recent research shows that many of the new drugs that are developed in response to small changes in expected returns are the very same me-too products and therapeutic substitutes that were individuals are worried about lacking coverage if the protected classes go away. While we note that our proposed solution of removing protected classes also involves lowering expected returns, we would hope that policies that remove inefficiencies in the market are superior to those that introduce even greater inefficiencies.

Last week we wrote that it was well past time to end the employer mandate in the Affordable Care Act.  In light of some commentary this week, we thought it best to revisit this issue in more detail.  It seems that most of the support for the employer mandate comes from a misguided understanding of why employers are currently the primary source of private health insurance.  It is explicitly not because of a sense of “responsibility” to the employee, at least not any more responsibility than they feel when they pay employee wages for their work.

Here is a basic summary of how labor markets work, based on decades of very widely accepted academic research and practical experience. Employees receive compensation from their employers in return for their work product.  In other words, employers aren’t running charities for their workers, but neither are workers volunteering their time at firms.  Each expects something from the other. Some employee compensation comes in the form of cash wages and some in the form of fringe benefits such as health insurance, pensions, free coffee, parking, etc.  Either explicitly or implicitly, employers and employees negotiate these compensation packages with employers attempting to craft the least expensive package that the employee will accept.  Firms know they can offer employees tax free income in the form of health insurance and they exploit this feature of the tax code to the benefit of both employees and employers.  And for a variety of reasons, prior to the exchanges, it was often much easier for employers to purchase insurance than it was for employees to buy it on their own.  As a result, many Americans get insurance from their employer.  As an added “benefit” of this system, the whole country likely spends more on health insurance than we otherwise would and the federal government provides more tax benefits to the rich than to the poor.

It should be clear from this point that employers are not “giving” their employees health insurance.  We know this because when health insurance gets more expensive, wages don’t grow as quickly.  This is because employers are only interested in the cost of the total compensation package, and if health costs go up, wages must go down.

Failing to understand these basic economic points leads to poor arguments and harmful policies.  For example, in a recent Viewpoint in the Journal of the American Medical Association, John McDonough and Eli Adashi make an impassioned plea in favor of keeping the Section 1513 of the ACA also known as the “Shared Responsibility for Employers.”

Congress’ decision to call the requirement of employers to provide health insurance or pay a fine as a “shared responsibility of employers” is a master stroke of propaganda to which we must tip our hats.  However, we must see through this cute turn of phrase and realize that this section of the ACA simply enshrines some of the worst aspects of our current health insurance system and actively works against many of the actual goals of the ACA.  Unfortunately, McDonough and Adashi have their blinders on.  They state, “[t]he core value undergirding the shared responsibility principle is the realization that all of the major stakeholders of the health care system must contribute something if comprehensive health care reform is to be accomplished. Stated differently, making the ACA work requires a measure of  responsibility from consumers, hospitals, physicians, insurance companies, drug makers, medical device makers, home health agencies, labor, and—because of section 1513—large employers.”  This argument amounts to a bit of a tautology.  Large employers are a stakeholder in the health care system because we mandate them to be a part of it [under section 1513] and because we mandate that they offer insurance they are a stakeholder in the health care system.  McDonough and Adashi never ask the more fundamental question:  Why should employers even be part of the health care system to begin with?  If we are trying to implement health reform, shouldn’t we be looking to end those aspects of the system the create large distortions?

They then go all in by stating that the shared responsibility is a “public good especially for employers who might otherwise be inclined to shift the cost of employer sponsored health insurance onto the federal government and thereby the taxpayers.”  Much like calling the employer mandate a “shared responsibility,” saying that this is also a public good is at best a misapplication of the term. In economics we define a public good as having two characteristics:  you cannot stop another person from using it and its value doesn’t decrease when another person does use it.  Clean air and national defense are quintessential public goods.  But health insurance?  (This is hardly the first time that JAMA has published egregiously incorrect economic arguments.  We note in passing that the American Economic Review has the good sense not to publish medical studies.)

Then there is this question of “shifting the cost” of ESI onto the government.  This notion ignores that the burden of ESI already falls on the government because these benefits are exempt from incomes taxes.  According to the White House Office of Management and Budget, in 2012 this cost the federal government approximately $170 billion.  Given the progressive nature of the United States Income Tax Code, this tax break is exceptionally regressive with an estimated five sixths of the benefits of the exemption flowing to the top half of the income distribution.  If employers stop offering health insurance, the competitive market for labor will force them to increase wages.  Because health insurance costs are roughly independent of wages, the resulting wage increase will be larger, in percentage terms, for lower income workers.  At the same time, federal tax receipts will increase and, given the progressive nature of the tax code, more of this money will come from richer Americans than from poorer Americans.  And if Congress could ever get its act together on tax reform, this could be part of a grand bargain resulting in lower overall marginal income tax rates.  This is what happens when you eliminate massive inefficiencies – everyone wins.  (Well, the bloated health sector would lose, as individuals might purchase less generous health insurance.  But isn’t the point of ongoing health policy to relieve us of this bloat?)

Firms that stop offering ESI could shift costs to the federal government to the extent that lower income individuals would now qualify for subsidies on the ACA exchanges.  We find it perplexing that ending the horizontal inequity of the ACA (i.e. the individuals with similar assets, income, and family structure face meaningfully different tax liability based on whether they get insurance from an employer vs. the exchange) would be seen as a negative.  Certainly this aspect of the ACA should be seen as a bug and not a feature.

We should also note that removing the employer mandate is not the same as ending employer provided health insurance. As noted health economist Mark Pauly has said many times, employees may value the services of their employers as a knowledge broker for insurance. In addition, firms with a high percentage of relatively well compensated employees may find it is economically advantageous to give up the subsidies on the exchange in order to retain their tax free insurance (though this seems to be more of an argument in favor of ending the tax exemption).  All we are asking for by ending the mandate is allowing the exchanges to compete on a more even footing with ESI.  Even if we do not eliminate the perversions of the current tax code, ending the mandate would benefit many employees and create a thicker and healthier market for the exchanges which should improve both the options and pricing.

The New Year always brings many changes.  In addition to soon to be broken resolutions, this particular year ushered in strict mandates requiring employers with more than 100 full-time employees to either provide health insurance to those employees or pay fines of between $2000 and $3,000.  We’ve seen many firms publicly respond to this by cutting benefits to part-time workers.  Despite the criticism that often accompanies these decisions, in many, if not all, of these cases this move benefits employees. Without the offer of employer-provided insurance they get access to the ACA exchanges.

Part of the criticism stems from the implicit belief that firms “give” benefits to their employees out of some form of philanthropy.  These benefits are just a tax-preferred (though not really for low-income employees) form of compensation, and research shows that increases in benefit costs result in lower wages for employees.  The firms that have cut benefits will either increase wages or lose a lot of employees. (If they cut benefits, do not raise wages, and do not lose workers, then they must not have been profit maximizing to begin with; we highly doubt that firms like WalMart would have knowingly forsaken an opportunity to maximize profits.)

As the employer mandate has been phased in since the passage of the ACA, we have seen an increasing focus on the artificial distinction between full and part time employees.  Firms are only responsible for fines based on how many full-time employees don’t have access to insurance and a compilation of anecdotal evidence suggests that employers have responded by placing strict caps on the number of hours their employees can work.  Suggestive evidence of this being a widespread phenomenon can be seen in this analysis of CPS data, which shows an increase in the number of part-time hours working below 30 hours per week.  While there are many things that could be causing this shift, the timing strongly suggests that hand of the ACA employer mandate at work.

Most recently, news emerged that Staples has threatened to fire any part time employee that works more than 25 hours per week.  To be fair, Staples executives claim that this is simply a reiteration of a long-standing rule though the timing suggests that stricter enforcement of this regulation is likely related to the large fines that Staples would face for part-time employees that cross the artificial 30 hour barrier.  In a recent interview, President Obama was none too pleased about this announcement:

“I haven’t looked at Staples stock lately or what the compensation of the CEO is, but I suspect that they could well afford to treat their workers favorably and give them some basic financial security. It’s one thing when you’ve got a mom-and-pop store who can’t afford to provide paid sick leave or health insurance or minimum wage to workers — even though a large percentage of those small businesses do it because they know it’s the right thing to do. But when I hear large corporations that make billions of dollars in profits trying to blame our interest in providing health insurance as an excuse for cutting back workers’ wages, shame on them.”

Shame on you Mr. President. First, Staples is only doing this because of your policies.  And who can blame them for reacting like this. Staples isn’t earning “billions” in profits per year. They are competing in a world of online commerce where their competitors don’t have the same large retail workforce (though much of their business appears to be shifting out of the retail setting as they shutter hundreds of stores.) Finally, it should be noted that recent research finds that these larger employers are already offering higher wages than “mom and pop” stores.

These points aside, the President’s statement is either disingenuous or belies a willful ignorance of how and why private employers provide benefits to their employees. Benefits are not something that private firms owe to their employees, instead they are part of a compensation package that is determined in the marketplace.  These benefits are provided by employers because of the combination of a historical accident of post-WWII price controls, the tax-preferred status of these benefits, and the benefits of risk pooling in the employer setting in a world where people don’t have to purchase insurance.  Most economists believe that this employer sponsored insured (ESI) is inherently inefficient, and recent research by Garthwaite and his co-authors shows that is distorts the labor supply decisions of many Americans.

In this setting, what we are actually talking about is not just the provision of benefits but limits on how many hours employees can work because of a new explicit mandate in the ACA.  This is just further evidence that the employer mandate is causing far more harm in the labor market than good.

While we have been critical of many aspects of the ACA, one facet we clearly support is that it represents the first realistic opportunity to move away from the distortions of ESI.  By forcing people to purchase insurance and imposing an increasingly binding tax on “high dollar” benefits, the ACA limits the main benefits of ESI.  However, it then includes a counter-productive mandate that forces employers to offer benefits and distorts the number of hours that employees work.

Rather than lecturing CEOs that are acting in the fiduciary interest of their shareholders, the President should show the courage to end the employer mandate.  It will surely not be popular among many of his most liberal supporters, but it ultimately will make the ACA more effective.

In our ongoing attempts to reform the ACA to better address the growth of health spending, rather than simply expanding insurance, the focus is turning to prices.  Some aspects of the ACA offer promising attempts to control hospital prices.  For example, as we have blogged about before, the emergence of narrow network plans allow insurers to more effectively negotiate with hospitals by providing a credible threat the high priced hospitals will be excluded from insurance plans.

However, we are also seeing the re-emergence of some truly terrible ideas.  In a recent interview with Vox, President Obama was asked about whether private insurers should be allowed to negotiate prices as a group.  He said, “I think that moving in the direction where consumers and others can have more power in the marketplace, particularly when it comes to drugs, makes a lot of sense.”

As the writers at Vox point out, it sounds a lot like the President is talking about the return of all payer rate setting. We have been down this road before. All payer rate setting had faddish appeal in the 1970s, with New York and seven other states trying it on for size. After research (including Dranove’s) showed that rate setting barely put a dent in double digit hospital price inflation, all of the guinea pig states except for Maryland abandoned the dubious policy.  Instead of centralization, states in the 1980s opted to deregulate insurance, which opened the door to selective contracting.  Prices plummeted, which is what we would expect once market forces were unleased.  And recent research shows that in recent years, even with the growth of provider market power, hospital prices in Maryland have grown faster than in surrounding states.   It is worth noting that private insurers agreed to all-payer rate setting in the 1970s due to concerns about cost-shifting.  If all payer rate setting is reincarnated, it will not be the first time that we have introduced a cure that was worse than the disease.

However, even if rate setting did drive down prices, this would hardly be evidence that it was succeeding.  After all, monopsony is every bit the antitrust problem as monopoly.  When today’s competitive payers try to drive a hard bargain they end up with narrow networks; they would drive harder bargains still but there is a limit to how small those networks can be – a limit circumscribed by market forces.  A single monopsony payer can force such a hard bargain that providers will be forced to cut staff, hours, training, or even close – and the monopsony payer will suffer none of the consequences.  This isn’t idle speculation… New York’s rate setting program was accompanied by some inner city hospital closures.  A rate setting commission would have to perform quite the balancing act, assuring that the right hospitals are open in the right locations, offering the right services at the right quality.  President Obama might trust government to thread that needle, but we surely do not (and frankly the course of human history with respect to central planning is on our side).

Advocates of allowing collusion among payers cite the need to counteract provider market power.  We feel their pain; Dranove has played a leading role in antitrust cases that target provider mergers.  But we are reminded of our parents telling us that two wrongs don’t make a right.  Allowing both sides of the market to have monopolies does not mean that we will get to an efficient solution.  As our colleague Marty Gaynor said, “If your bike gets a flat tire, do you let the air out of the other one?”  In this case we fear that rate setting which combines government agencies and private insurers into one collusive bargaining unit means we will deflate both tires and then throw the bike off a bridge.

Barring a Republican landslide in 2016, it looks like the Affordable Care Act (ACA) is here to stay.  By and large, we think that is a good thing.  While there are many things in the ACA that we would like to see changed, the law has provided needed coverage for millions of Americans that found themselves (for a variety of reasons) shut out of the health insurance market.

That being said, since its passage the ACA has evolved and the rule makers in CMS continue to tinker around the edges.  We are especially encouraged by CMS’ willingness to relax some of the restrictions on insurance design, but remain concerned about some of the rules governing employers and the definition of what is “insurance.”  In the next few blogs we will examine some of the best, and worst, of the ongoing ACA saga.

We start with one of CMS’s best moves—encouraging reference pricing.  The term reference pricing was first used in conjunction with European central government pricing of pharmaceuticals.  Germany and other countries place drugs into therapeutic categories (such as statins or antipsychotics) and announce a “reference price” which insurers (either public or, in Germany, quasi-public) that insurers will reimburse for the drug.  Patients may purchase more expensive drugs, but they were financially responsible for all costs above the references price.  Research shows that reference pricing helps reduce drug spending both by encouraging price reductions (towards the reference price) and reducing purchases of higher priced drugs within a reference category.  Other research has found suggestive evidence of similar results for reference pricing for medical services.

While the ACA does little to govern pricing in the pharma market, the concept of reference pricing can and should be extended other medical products and services.  In particular, insurers can establish reference prices for bundled episodes of illness such as joint replacement surgery.  Under the original ACA rules set forth by CMS, insurers were free to establish a fixed price for bundled episodes.  They could even require enrollees to pay the full difference between the provider’s price and the reference price.  But there was a catch. It wasn’t clear if any spending above the reference price would count to the enrollees by enrollees out of pocket limits (currently $6,600 for individual plans and $13,200 for family plans).  Obviously, allowing the out of pocket limit to bind on reference pricing would limit the effectiveness of this cost control measure.

A simple example may help. Consider knee replacement surgery for a patient who already paid $2,000 in medical costs this year.  An insurer might set a reference price of $15,000.  Then providers can charge any amount over $19,600 and the out of pocket cost to the patient would be capped at $4,600.  And if the patient had any other medical expenses that year, the out of pocket cost would be capped even lower.  This would hardly discipline providers whose prices are well above $19.600.   Considering that one study suggests there will be substantial differences between prices charged by the top and median quintile providers of bundled services, such kind of market discipline is sorely needed.

Last year the Department of Labor (DOL) solved this problem, issuing a new rule so that payments above the reference price do not count towards the out of pocket limit in large group and self-insured plans.  So now the formula for reference pricing under the ACA resembles the successful formula for reference pricing in Europe.  We would actually prefer the that the regulators go a step forward and say that spending above the reference price also cannot be counted towards the individual’s annual deductible.

But even this new rule will only go so far to introduce market discipline.  Insurers must be willing to bundle payments and this won’t happen in any big way until there are more “bundlers” – organizations capable of accepting bundled payments.  Providers need not integrate to do this; indeed, the organizational problem of paying and incentivizing individual providers (be they doctors, technicians, nurses, or therapists) remains regardless of how the bundler is organized.  But someone has to be the bundler.

More pragmatically, there are only so many conditions that lend themselves to bundling.  The study of price variation that we mentioned earlier covered most of the high priced conditions for which bundling is popular – joint replacements, CABG surgery, and back surgery.  Unfortunately, these represent just a small fraction of total health spending.  It is difficult if not impossible to delineate the boundaries of chronic care for diabetes, cancer, asthma, and many other high cost conditions.  One solution is to capitate providers, but many providers and their patients will object to this complete reversal of economics.  Shared savings under ACA is the half-hearted version of capitation.   But there is a way to incentivize patients to be more cost conscious.

The key is to recognize that deductibles might be a good way to get healthy people to pay attention to prices, but the U.S. health spending crisis is not driven by profligate healthy people. It is driven by the 18 percent of us, mainly with chronic conditions, who spend 80 percent of our health dollars. But patients with chronic conditions routinely blow through their deductibles.  So the increased reliance on first dollar deductibles seems woefully misplaced. CMS can and should allow insurers to creatively redesign cost sharing so as to increase the price sensitivity of chronically ill patients, without increasing overall financial risk.

For example, consider a typical plan with, say, a first dollar deductible of $5000, and a coinsurance rate of 10%. A diabetes patient will spend $5000 in just a few months, and the savvy diabetes patient will realize that the marginal price of all spending throughout the year is just 10 percent of the full price. This hardly encourages price sensitivity. Here is an alternative plan that the ACA should allow. Insurance covers the first $20,000 of medical bills.  Beyond that, the patient pays 33 percent of the next $20,000, up to their $6600 out of pocket limit.   (Of course, the exact thresholds would depend on the predicted medical needs of the patient.)  The patient faces less financial risk than previously, yet is faces higher marginal prices. It is a win-win. The point is that it is always possible in this way to encourage patients to be more responsible without increasing their total out of pocket burden.

Admittedly, this plan may force CMS to redouble its efforts to limit insurer cream skimming.  For certain this plan won’t do such a good job of encouraging price sensitivity among the healthy. But that is a feature and not a bug of our proposal. Instead of imposing costs on the low spending individuals who are not causing the run-up in health spending, we prefer to follow the advice of great sage Willie Sutton and concentrate our efforts on “where the money is” not where it isn’t.

To date, we’ve consciously chosen not to blog about the recent controversy surrounding our colleague Jon Gruber.  This is not because we lack opinions on the issue, but mainly because as economists we didn’t think we had anything of value to contribute to the discussion, which was largely about scoring political points.  However, recent attempts to stop grant support for Jon’s academic research have drawn our attention and we think it is important to highlight some important issues.  Beyond being the “architect of the ACA,” Jon is one of the most prolific and influential economists in academia.  His academic research is exactly what we should be supporting with grants regardless of any regrettable comments he made.

Since these videos emerged online, Jon has been subject to a wide range of attacks on both his personal character and his intellect (though we note that in a battle of the brains between David Axelrod and Jon Gruber, we’re taking Gruber every day and twice on Sunday).  We are not naïve, and understand that some of this is just part of the overly political nature of the debate over the ACA, in which the videos of Jon’s various comments are just another pawn.  Academics who choose to become involved in the political process must play by a different set of rules – and in the age of social media these rules are different even from what they were 10 years ago.  Though we would also note that the clutching of pearls by various members of each political party about the content of Jon’s statements does make use think we are watching the audition tapes for Casablanca’s Captain Renault.

We should note from the outset, that any casual reader of this blog realizes that we sincerely disagree with Jon on many political issues, particularly those related to the design and implementation of the ACA.  In addition, neither of us was pleased with the manner in which the ACA was debated, designed, or passed.  That being said, in the past couple of days, Republican lawmakers sent a letter to the National Institutes of Health asking them to review one of Gruber’s recent grants.  This is simply a bridge too far, going well beyond the bounds of reasonable and fair outcomes from this kerfuffle.

Perhaps a little context will make clear why this is the case.

Throughout his career Jon has written on a wide variety of topics ranging from the crowd-out of public health insurance, supplier induced demand and the effect of health insurance as precautionary savings (and these are just his health care papers).  In more recent years, Jon has focused a lot of his work on understanding the decision making of enrollees in Medicare Part D (i.e. the prescription drug benefit available to seniors as of 2005).

As we all know, choosing the right health insurance plan is really hard.  Consumers have to consider premiums, deductibles, copayments, coverage limits, networks…it is extremely challenging.  (To be fair, making the right choice for purchasing a variety of good is hard but insurance is just far more complicated).   We know from personal experience how hard this can be.  A few years ago, our employer offered a menu of health plans and learned, after the fact, that the cost sharing provisions assured that one of the options was worse for all employees, regardless of their health needs.  Even so, this was one of the most popular choices, and one of us made the mistake of choosing this plan!  I don’t think we are being presumptuous to say that if consumers with PhDs have a hard time making sense of plan options, others are also likely to struggle.  Indeed, Jon’s research (with various coauthors) confirms that seniors have potentially been making systematic errors with their initial plan selections.  For example, in peer reviewed work he has shown that seniors appear to use premiums rather than out of pocket costs when choosing their insurance plans, even though this decision rule often leads to worse financial decisions.

Jon’s  work is important for understanding how to shape the options available to seniors under Medicare Part D.  But it also suggests that all consumers may face challenges when choosing plans in the ACA exchanges and helps explain some of the rules governing plan offerings, such as the classification into “medal” categories that greatly facilitate comparison shopping.  In addition, several private companies are now providing information to consumers trying to sort through their plan offerings.  Jon’s research, which has been instrumental in these important developments, represents the very type of work that the NIH should be funding.  Thanks to his work, we have made important progress in designing exchanges that promote efficient choices of insurance plans.

Beyond this particular topic it’s important that we avoid the blatant politicization of the grant making process.  While we understand how some people could be offended by the comments that Jon made, and we remain unimpressed with the debate over the ACA, this shouldn’t spill over to the academic side of this conversation. Even throughout this entire process, no one has questioned the quality of Jon’s work or analysis.  He is one of the best economists of his generation and someone whose research should be supported. Ultimately, we all need to realize that stopping support for Jon’s research in order to score political points is, well, just plain stupid.

In the classic 1972 film The Candidate, Robert Redford portrays Senate candidate Bill McKay, who wins a surprising victory over the incumbent Crocker Jarmon. In the final scene, a stunned McKay escapes the victory party with his campaign adviser Marvin Lucas  in tow.   The movie ends with McKay asking “Marvin…What do we do now?”

Buoyed by their recent election gains, Congressional Republicans must be asking themselves the same question. Part of their answer is sure to be a renewed attack on the Affordable Care Act (ACA). Understanding that outright repeal is impossible for the foreseeable future, Republicans appear to be targeting (at least) two perceived flaws of the ACA: individuals cannot always keep their doctors, and individuals cannot always keep their health plans. We are hardly the biggest supporters of the ACA, as many prior blogs will show. But we think choosing these targets is not just a waste of effort but actually counterproductive to good health policy.

For the past three decades, Americans with private health insurance have gotten used to the idea that they do not have unfettered choice of doctors. In fact, Americans have time and again voted with their wallets for plans with networks. The majority is enrolled in PPOs, and most of the rest are in even more restrictive HMOs. Even in the exchanges, where individuals are not bound by their employers’ offerings, the plans with the broadest networks have lost out to narrower network plans that offer lower premiums in exchange for less choice. Like all goods, access is costly, and most Americans would rather sacrifice some access to save money. This doesn’t mean they won’t complain about it after the fact! In economics we call this a “revealed preference” and we believe that these revealed preferences are far more accurate than what people say they want. Put simply, if Americans prized access as much as Republicans seem to believe then why do they continually opt to save money by enrolling in limited access plans?

Given we know that Americans prefer money in their pocket over choice, any Republican effort to force all plans to broaden their networks will only serve to drive up health spending without a commensurate benefit. Republican lawmakers should keep in mind that we already have one prominent plan that promises nearly unfettered access – fee-for-service Medicare – which is a close as this country has to a single payer model. Is this what the Republicans really want?

Turning to the issue of plan turnover, we suppose this started when President Obama promised Americans that they could keep their health plans. We suppose Republicans were right to turn this into a campaign issue, but as a practical matter, it is not worth fighting. Yes, the ACA imposes minimum benefits standards and has encouraged some employers to drop coverage. In addition, some of the insurance plans offered in individual markets before didn’t meet these minimum standards and can no longer be sold. As a result, some individuals have been forced to switch plans.

While we have taken issue with some aspects of the benefits standards, we see no virtue in some sort of stasis in private insurance plan enrollments. Americans may value their relationships with their health care providers, but it seems unlikely that they would be equally loyal to their insurers. More to the point, it is high time that we weaned ourselves away from employer-sponsored coverage and therefore we should seize the opportunity provided by the ACA. By tweaking exchanges and the Medicaid program, as we describe below, Americans can take control of their insurance purchases, find coverage that better meets their needs, in a competitive market that encourages innovation without excessive regulatory oversight. Indeed, any new legislation that promises Americans can keep their existing coverage is likely to limit market competition; this hardly seems in keeping with the best of what Republicans claim to offer.

So if the Republicans’ current attacks on the ACA are misguided, what should they try to do? In the rest of this blog we summarize a few areas for reform. In subsequent blogs we will provide a more detailed blueprint for ACA reform.

Eliminate the employer mandate. There is no need to perpetuate employer sponsored coverage, which is an artifact of World War II wage controls and has persisted primarily because we lacked a well-functioning individual insurance market. One of the greatest benefits of the ACA is that it has created a well-functioning individual market, eliminating the primary reason the employer provided market has survived for so long.

Permit and encourage greater flexibility in health plan design. One of the greatest problems with the ACA is that it greatly limits innovation in plan design. For example, we would like to see a greater use of the lessons from the Value Based Insurance Design initiative. We understand that some of this is already being considered by CMS rule makers – a sharp push from Congress could make this a reality.

Encourage greater innovation in Medicaid. An exceptionally large number of the individuals who gained coverage through the ACA are enrolled in Medicaid. As a result, nearly 70 million Americans are now covered through this program. While many states have used managed care programs to serve this population, these systems have so far shown limited innovation. In exchange for agreeing to the ACA Medicaid expansion some states such as Arkansas and Indiana have implemented unique expansions that leverage the private market. We think that Republican lawmakers should encourage additional waivers that allow states that have not yet expanded Medicaid (or even those who already have) to adopt similar systems.

Last Thursday was a watershed day for the Kellogg School of Management and Northwestern University.  For the first time in 60 years, a sitting President spoke at NU, as President Obama spoke before an audience packed largely with Kellogg students and faculty.  As this is election season, it was no surprise that he spoke at length on a variety of issues and defended the Democratic record.  We are not experts on every matter of public policy and therefore will not examine every aspect of the speech.  But we have more than passing knowledge of health policy, and the President did spend some time discussing the ACA. He also mentioned many times that he was simply giving the audience “the facts” and that they could not be disputed. Given this speech occurred at our University, we feel obligated to take a look at what he said and do some basic “fact” checking.

Here is the relevant excerpt from his speech:

“Today, we’ve seen a dramatic slowdown in the rising cost of health care. If your family gets your health care through your employer, premiums are rising at a rate tied for the lowest on record. What this means for the economy is staggering. If we hadn’t taken this on, and premiums had kept growing at the rate they did in the last decade, the average premium for family coverage today would be $1,800 higher than they are. That’s $1,800 you don’t have to pay out of our pocket or see vanish from your paycheck. That’s like a $1,800 tax cut. And because the insurance marketplaces we created encourage insurers to compete for your business, in many of the cities that have announced next year’s premiums, something important is happening – premiums are actually falling. One expert said it’s like ‘defying the law of physics.’ But we’re getting it done. That’s progress we can be proud of.”

There is no reasonable interpretation of this section other than the President is claiming that 100 percent of the recent slowdown in private sector health spending is attributable to the ACA.  Unfortunately, this claim does not stand up to basic scrutiny.  This issue has been extensively researched by both ourselves and a number of other economists. Conclusions drawn from studies of prior recessions suggest that the ACA could be responsible for more than half of the current slowdown in health spending.  More significantly, the most recent published work, which focused on differences across geographic areas during the most recent recession, suggests that the ACA is responsible for at most a small fraction of the slowdown in private health spending.  We happen to know a lot about this research because we (along with colleague Chris Ody) are the authors of the aforementioned study.   We blogged about it last month, and you can find the full study here, in the policy journal Health Affairs.  We have also shared this evidence with staff in several Federal agencies, so our findings are not unknown in DC.

We will be generous to the President and assume that these findings somehow did not make it onto his radar screen, or that of his speechwriters, or even more unlikely even his economic advisers.*  As a result, the President has, at best, grossly exaggerated the impact of the ACA when the best available evidence is that the ACA may not have had any impact at all!  We find it at least a little ironic that the President has (perhaps unknowingly) misrepresented the facts on a subject that was extensively researched by faculty at his host institution.

While we are on the subject of the accomplishments of the ACA, the President has in other venues reminded his audiences that the ACA has reduced the ranks of the uninsured by 10 million.  What he fails to mention is that a very large portion of those individuals (perhaps even a large majority) were simply added to the Medicaid rolls of various states. Considering that roughly half of the states chose to sit out the expansion, this is a remarkable figure.  While it is a good thing that we are able to provide these people with health coverage, the ACA was billed as a way to utilize the marketplace to expand private health insurance coverage by bringing some order to the individual marketplace. This is a policy goal that dates back to Stanford Professor Alain Enthoven’s 1978 Consumer Choice Health Plan, and was shared by President Clinton as well as many Republicans.  We may ultimately get to this point, but we certainly are not there today. Given this fact, why not call the ACA what it is – a massive expansion of the Medicaid entitlement, coupled with an as yet modest program to help some individuals find subsidized private health insurance?   We are rather partial to Professor Enthoven’s plan and hope the exchanges grow, but we are a long way from fulfilling his vision.  Let’s not pretend otherwise.

*We are reminded of an episode of the great British comedy, Yes Minister, where the Minister for Administrative Affairs Jim Hacker learns, to his chagrin, that he would have been better off politically if he had remained unaware of the facts.  Perhaps it is best for the President if he can continue, with conviction, to spin this tale about the ACA.

We have all seen the doomsday predictions.  Health expenditures in the United States are a large and ever growing component of GDP.  Nothing can seem to stop this perpetual growth, and eventually these expenditures could account for over 20 percent of government spending and have ruinous effects on both state and federal budgets. This was part of the motivation for the 2009 Affordable Care Act (ACA).

But before the ACA was even drafted, something important was happening to the rate of growth medical spending – it was slowing!  From 2000 – 2007, health spending grew at 6.6 percent per year, well above inflation and a source of concern.  However, over the next four years this rate of growth slowed to an annual rate of “just” 3.3 percent.  We should note that even slower growth of a large number is a cause for concern.

The source of this slower growth has caused great debate.  Theories have ranged from a slower adoption and development of new costly technologies, to a number of blockbuster drugs coming off patent, to early effects of the ACA, and finally the effects of the “Great Recession.”

In a new study published in Health Affairs, we (along with our co-author Christopher Ody) examine the role of the economy in the slowdown in health spending.  In a research partnership with the newly established Health Care Cost Institute (HCCI) we obtained data on the health expenditures of a large sample of privately insured individuals.  We aggregate these data to the CBSA level and then examine how the effect of the 2008 economic downturn affects health spending in these areas.  We find that absent the recession, the rate of growth in health expenditures would have been 70 percent higher.  This is similar to some previous studies, and quite higher than others.

An advantage of our study over the existing literature is our ability to exploit regional variation during this downturn.  Previous efforts have primarily used evidence from past recessions on the relationship between aggregate economic activity and health spending to predict the role of the recession in the past few years.  However, there are many reasons to think that this recession might be different.  For example, it has been a longer and deeper recession than those in recent decades.  In addition, it was caused primarily by a shock to the financial system and results in large losses in housing wealth.  A second advantage of our study is that we examine individuals that retain private insurance. Therefore, our results show that the downturn in spending from the economy was not caused simply by individual losing employer provided health insurance.

Exploiting regional variation also allows us to control for other coterminous factors that might be affected health spending.  A fair question is what is the appropriate measure of economic activity in this setting?  The generally used measure in this literature is Gross Domestic Product (GDP).  For two reasons, this measure won’t work for our research question. The first is practical.  We don’t have good measures of this type of economic activity at the local (i.e. CBSA) level.  The second is more conceptual.  It is not clear that GDP reflects the economic conditions facing the average American.  This is particular true following the most recent recessions which have been marked by “jobless” recoveries where employment growth lags aggregate economic activity.

For these reasons, we measure the impact of the 2008 economic downturn using the change in the CBSAs employment-population ratio.  Looking just at the raw correlations, we find that every one percentage point decrease in the employment to population ratio resulted in a 0.84 percentage point decrease in medical spending in that CBSA.

While it is important to understand the past, the obvious question is: What does this mean for the future of health spending.  Our results suggest that if all other things remain equal, as the economy improves we should see a return to the previous rate of growth in health spending.  But are all things remaining equal?  Of course not!

First, we have implemented the ACA.  While we think it is naively optimistic to think this caused an immediate change in health spending in 2009, it is quite possible that in the future the incentives and programs created by this law could coordinate care in a way that leads to lower spending.  On the other hand, it is also fair to note that an increase in the number of insured individuals might actually raise health spending.  Just today, the Wall Street Journal reports large increases in utilization by the newly insured – including an increased used of the emergency room.  This utilization increase might offset the benefits of more coordination.

Second, one mechanism that likely drives a portion of our main results is a decrease in the generosity of cost-sharing for employer provided plans.  It is possible that this shift was greater in areas the suffered a larger macroeconomic shock as employers used less generous health insurance as a means of lowering compensation and absorbing the financial shock.  However, if this were the case it is quite possible that future employment negotiations may increase the cost sharing in these plans in the future.  Such a shift may take some time as these contracts are typically negotiated on at least at most an annual basis.  Therefore, we are not sure whether this will remain a permanent feature of the market.

Our results show that attempts to claim the slowdown in health spending primarily resulted from changes in government policy have little merit.  Importantly, we find this change among a group of insured individuals. This means that we are not simply finding that individuals losing insurance following job loss spend less on health services.  Instead, our results show that the depth and breadth of the downturn (and likely the decline in housing wealth) affected even the health spending of those who retained insurance.

However, it is also important to note that we find that among our sample of privately insured individuals approximately 30 percent of the decline in the growth in health spending resulted from factors other than the local economy. Given what we spend on health care services each year, this point is nothing to gloss over.  It is important to think carefully about what might or might not be in that 30 percent.  For example, this could result from factors such as a lower rate of technology adoption or the lack of new blockbuster drugs (though if this was the cause it seems like Sovaldi alone might end this channel).  But it also could be that economic trends that were not well correlated with the local economy, such as changes in the stock market, could explain a large portion of this effect.  Given this fact, we might want to keep our proverbial champagne on ice for even the 30 percent decline going forward.

The Affordable Care Act is premised, at least in part, on the notion that competition can be harnessed to reduce healthcare costs and improve quality. This explains why insurance in the individual market has not been nationalized. Instead, consumers go to an online exchange where they customers can easily (at least in theory) compare plans offered by different firms. Unleashing competitive forces should result in lower premiums for these plans. And why not? Over the past two decades, competition has been one of the few success stories in the U.S. health economy. For example, when competition intensified in the 1990s, healthcare costs moderated. When competition weakened in the wake of provider mergers and the backlash to the narrow networks that were essential to cost containment, healthcare costs rose.

When most people think about the benefits of competition, they tend to think about prices. Monopolies charge high prices; competitors charge low prices. There is nothing wrong with this perspective, but it misses a more fundamental point. In the long run, the greatest benefit of competition is that it has the potential to fuel innovation. This is as true, in theory, for health insurers as it is for telecommunications and consumer electronics. It hasn’t always been true in practice; for several decades after the IRS made employer-sponsored health insurance tax deductible, insurers tended to offer the same costly indemnity products. But consumers eventually demanded lower premiums, and insurers responded with managed care. After the backlash, insurers developed high deductible health plans and value based insurance design. Insurers are now moving towards reference pricing. These plans offer consumers reimbursement up to a pre-specified level for treatments that can be easily broken into a treatment episode such as hip replacements or MRIs. Patients have the choice of any provider, but they bear the cost of choosing a more expensive facility.

High deductibles and reference pricing are fine, but do not always work in practice. Chronically ill patients quickly exhaust their deductibles, and reference pricing does not work well for chronic diseases. In order to complement these tactics, some insurers are once again offering narrow network plans. We commented in earlier blog posts that the ACA would catalyze the return of these narrow networks and also warned that this might fuel another backlash. Unfortunately, a recent New York Times article shows, the backlash is well underway.

Make no mistake, restrictive networks are essential to cost containment. Through narrow networks, insurers can negotiate lower prices. More importantly, they can direct enrollees to providers who have lower overall costs and higher quality. Dranove has written two books about this. Don’t take his word for it. The independent Robert Wood Johnson Foundation has published two comprehensive studies showing that the competition triggered by networks has been successful in reducing costs and improving quality.

By definition, some providers are excluded from narrow networks, and this is where the trouble begins. Excluded providers who have lost out in the cauldron of competition always complain the loudest. In sports, there are pejoratives to describe such complaining losers, and it is the rare referee who is moved by their complaints. In healthcare, they are called an interest group, and when providers complain they have the ear of legislators. We should have no sympathy for them.

What about patients? Some patients knowingly choose health plans with narrow networks in order to save money, and should not be surprised to find that some of their favorite providers are excluded. Others may be in the dark about their networks. The solution isn’t to regulate narrow networks out of existence; it is to shine some light on network structure.

Another concern may be that low income enrollees who cannot afford broader networks might be at a disadvantage. But if we want to provide big enough subsidies so that all enrollees have broad networks, we will have to either (a) raise taxes further, or (b) limit the number of uninsured we can enroll. Neither choice seems better than the status quo.

Now, this does not mean that we think there is no place for regulation of narrow network plans. We don’t think that the newly formed ACA exchanges, or any market, should be the proverbial Wild West. For example, if we want consumers to make educated choices across insurance plans, then they require timely and accurate information about which providers are in which networks. We would think this would be more than feasible, though healthcare.gov was somehow unable to provide this information to many of the initial enrollees. We understand that providers go in and out of networks all the time and it would be burdensome for insurers to inform enrollees of all network changes in real time. But insurers could provide regular updates. We also wonder if insurers have the capability of identifying, through billing records, when a particular patient’s provider has gone out of network, and sending that patient an immediate update. In these situations, patients should be allowed to change their choice of plans outside of the open enrolment period in the same way they might be able to if they had another qualifying event such as the birth of a child. These small steps should prevent some of the worst case scenarios described in the New York Times article.

In addition, narrow network plans are only effective if there are multiple high quality providers offering services in an area. Given the recent wave of provider consolidations, it is critical that anti-trust authorities carefully monitor these mergers. After all, competition can only work in truly competitive markets.

But what we must avoid is mandating broader access. This would spell the end of market-based health reform. If insurers cannot exclude some providers, then providers have little incentive to lower prices and become more efficient. In the wake of the last managed care backlash, patients equated access to quality and virtually all insurers decided they needed to include in their networks virtually all providers. The result was double digit price growth that ended a decade of pricing tranquility. In the new post Great Recession economic reality, enrollees must have a low price alternative to high cost, broad network plans.

Many states have already attempted to mandate minimum access through Any Willing Provider laws. These laws require insurers who have come to terms with a specific provider to accept all providers who agree to those same terms. This may sound fair, but the economic implications of AWP for patients are anything but fair. Under AWP, no providers need negotiate with insurers or accede to an insurer’s request for discounts. Providers can bide their time, knowing that they can always force their way into the network. Having lost all their leverage, insurers can no longer demand discounts, and prices invariably rise. Research confirms this dim dynamic.

The push for broad access seems to be especially strong in sparsely populated states such as Montana. But proposals to assure access, which often take the form “At least X% of enrollees must live within Y miles of a provider” do more to drive up costs than any other rules we can imagine, because they grant effective monopoly rights to rural providers. Insurers facing such rules have two options (a) accede to the pricing demands of the local monopolies, or (b) drop coverage in areas where providers have been granted local monopolies. Montanans may as well have nationalized healthcare.

Health policy makers love to talk about the need to reduce costs, improve quality, and expand access – and like to talk themselves into believing that through government intervention they can achieve all three. They would do well to heed the economist’s “golden rule”: There is no free lunch.