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September 15,1994

eCONOMIC
COMMeNTORY
Federal Reserve Bank of Cleveland

The Economics of Health Care Reform
by Charles T. Carlstrom

l e w things are as important to Americans as good medical care. In 1992, we
spent about 14 percent of our national
output on health-related services, and by
the year 2000, mat share is expected to
reach nearly 19 percent.1 To some, these
numbers are frightening. To others, they
merely reflect the preferences of a
health-conscious and aging society. As
Congress and President Clinton iron out
the final details of a health care reform
package, it has become clear that the
scope and scale of the legislation are
destined to affect the course of American
lives for years to come.
Although the administration's original
proposal, entitled the Health Security
Act, did not have enough support to survive the legislative process intact, it is
likely to be a guidepost for the direction
health care reform will eventually take.
In fact, its basic elements — universal
coverage, mandatory participation in
regional health alliances, communitybased insurance premiums, employerpaid health insurance, and standby price
controls — are included to some degree
in all of the reform proposals currently
being discussed in Congress.
This Economic Commentary looks
specifically at the economics of health
care reform. Because the competing
plans are too numerous to discuss in
detail, I focus on the major elements of
the original Clinton plan to highlight how
this and similar legislation would deal
with the underlying economic issues
affecting the U.S. health care industry.

• Universal Coverage
President Clinton has vowed to veto any
reform package that does not provide for
universal coverage.2 Today, approximately 14 percent of Americans lack
health insurance (see figure 1). Of those
who are covered, 76 percent cany private insurance, while the remainder are
insured through government programs.
The two principal forms of government
insurance are Medicare and Medicaid,
which provide coverage for the aged and
the poor, respectively. The original intent
of these programs was to ensure that
every American would have access to
medical care. While each has succeeded
in greatly expanding the number of persons covered by insurance, universal
coverage has never been achieved.
Although many would contend that the
issues of universal coverage and health
care reform can be logically divorced
from one another, the President has argued that universal coverage is a necessary component of any cost-saving
package. One reason is that most of the
35 million people who lack health
insurance do receive medical treatment.
In fact, in 1994, the uninsured are
expected to consume more than $ 1,200
per capita in medical services — only
39 percent of which they will pay for
themselves. The remainder of the tab
will be picked up by taxpayers and private payers.3 These private payers frequently end up being everyone who
purchases medical care, since hospitals
write off as "unreimbursed costs" a
large share of the expenses incurred by
uninsured individuals. This practice in
turn helps to drive up medical prices.4

Although President Clinton's original
health care reform proposal was
roundly criticized in many quarters
and could not muster enough support
in Congress for passage, at least one
of its three basic provisions—universal coverage, mandatory participation
in regional health alliances, and community-rated insurance premiums—
appears in all of the major reform initiatives now being considered. Thus,
rather than trying to sort out the pros
and cons of a myriad of alternative
plans, this article uses the original
Clinton proposal to analyze how
Americans' pocketbooks—as well as
their health—are likely to be affected
by each of these three provisions.

There are other reasons why some insist
that universal coverage is a necessary
part of any reform package. Today, the
health insurance industry is based on
experience ratings. Premiums depend on
the expected cost of providing insurance
to an individual or subgroup and thus are
directly related to a person's age, sex,
and health status. Many argue that community ratings, wherein everyone residing in a given geographical area pays the
same premium, would be more equitable
as well as more efficient.
Experience ratings are considered inefficient because insurers spend a vast
amount of resources trying to ascertain an
individual's health status. Due to adverse
selection, this "waste" is probably necessary. Adverse selection refers to the
increased incentive for those with poor
health or chronic illnesses to purchase
health insurance under community-rated
plans. This forces insurance companies to
charge premiums that are not actuarially
fair for normal, healthy individuals. As a
result, healthy persons have a tendency to
forgo coverage.
Experience ratings are one way of
bringing these individuals back into the
system, since those with little risk of becoming ill are charged lower premiums
than the high-risk population. Unhealthy
persons are effectively excluded from
experience-rated plans, since insurance
companies generally refuse to cover
pre-existing conditions. For community
ratings to work, it is important that
those in excellent health continue to
purchase medical insurance. Mandatory
coverage, with subsidies for the poor
and unemployed, is one way of ensuring that outcome.5

• Employer-Provided
Health Insurance
Currently, most private health insurance
is provided through employers. In fact,
more than 91 percent of those with private coverage have some or all of their
premiums paid for either by their company or by the employer of their spouse
or parent (see figure 1). This has led to a

FIGURE 1 PRIMARY SOURCES OF HEALTH INSURANCE

Veterans Affairs
0.3%

SOURCE: Congressional Budget Office calculations based on the March 1992 Current Population Survey.

significant fraction of the population feeling locked into their current job because
they fear losing their health benefits.6
Critics of our present system argue mat
the reason employment and health insurance are linked so closely is the substantial tax break that exists for employerprovided medical benefits. Employees are
not taxed on fringe benefits such as health
insurance, while firms can deduct the cost
of providing these benefits on their corporate income taxes.
Despite the alleged inefficiencies of
employer-provided health insurance, the
President's plan (as well as several others) would keep and build upon that
facet of our current system. Job lock is
expected to be minimized by three
changes mat are shared by many reform
initiatives: universal coverage, standardizing the amount of insurance employers
must provide, and instituting community
ratings to eliminate rules against preexisting conditions.
The cornerstone of the original Clinton
plan is mandatory employer-provided
health insurance.7 All firms with fewer
than 5,000 employees would be required
to join a regional alliance that would
either purchase coverage directly or contract with private insurance companies.
In addition, the Medicaid program
would be dismantled, with beneficiaries
required to enroll in health plans through
a regional alliance. Since membership in

these alliances would be compulsory,
any adverse selection problems would
be eliminated. Supporters also believe
that the sheer size of the alliances would
give health insurance buyers the market
clout to demand lower premiums.
Firms with more than 5,000 full-time employees (as well as the U.S. Postal Service) could opt out of joining the regional
alliances and instead form their own corporate alliances. However, if at any time
in the future a company decided to join a
regional alliance, it would forever forfeit
its right to opt out of the system.
While this element of health care reform
is arguably the foundation of the Clinton
proposal, it is also the provision l«ast
likely to survive a congressional vote.
Senator Mitchell's plan, which minors
the President's in many ways, would
make enrollment in the health alliances
voluntary — a compromise that might
prove far less innocuous than it appears
at first glance. Allowing individuals and
firms to purchase insurance outside the
cooperatives would, in the words of a
recent New York Times editorial, "invite
the healthy to peel away and leave the
chronically ill." 8 This in turn would
endanger the move toward community
ratings. To minimize that risk, the
Mitchell plan restricts the ability of
insurance companies to discriminate
based on pre-existing conditions.

Another element of most of the reform
bills now being considered is a standardized benefits package of employerprovided insurance. Under the administration's proposal, regional alliances
would be responsible for purchasing
health insurance and for deciding which
insurance plans to buy and what medical
procedures to cover. Each alliance would
be required, however, to offer at least one
traditional fee-for-service plan. Under
Senator Mitchell's alternative, all firms
providing insurance for their workers
would be required to purchase a standard
package of benefits.9 The danger here is
that decisions regarding what types of
research and development are undertaken
would largely be made, at least indirectly,
by government agencies via the choice of
what drugs and procedures were covered.
• Job Lock and
Small-Firm Subsidies
A particularly contentious issue in the
ongoing health care debate is whether to
require firms to purchase coverage for
their employees. Opponents argue that
such a rule would be particularly punitive
for small firms. Therefore, virtually all of
the plans that contain employer mandates
provide for some type of government
subsidy for small companies. Under the
original Clinton proposal, small firms
with below-average annual wages would
have their "contributions" held to between 3.5 and 7.9 percent of payrolls, depending on employment and payroll size.
Unsubsidized employers within a regional alliance would be required to
contribute 80 percent of the average
total premium for all single workers
without children. For married couples
and individuals with children, this calculation is more complicated. Workers
in both small and large firms would be
responsible for paying 20 percent of
their own health insurance. Table 1 estimates total premiums for full-time
workers and employer contributions for
unsubsidized firms in 1994.

TABLE 1 ESTIMATED TOTAL PREMIUMS AND
UNSUBSIDIZED EMPLOYER SHARES
(per full-time worker in 1994)
Total
Premiums

Single person
Married couple
One-parent family
Two-parent family

Unsubsidized
Employer
Shares

$2,100
4,200
4,095
5,565

$1,680
2,315
3,033
3,033

SOURCE: "An Analysis of the Administration's Health Proposal,'' Congressional Budget Office study,
February 1994.

Although job lock as currently defined
may not be a problem under many of the
reform plans being considered, subsidies
such as those spelled out in the Health
Security Act could make it quite costly
for low-wage workers at fully subsidized
firms to move to an unsubsidized firm or
to one subsidized at a lower rate. Consider, for example, a worker in either a oneor two-parent family who earns $15,000
per year. If this individual obtains work
at a subsidized firm, management would
have to pick up between $525 and $1,185
of his health insurance premium each
year, depending on the subsidization rate.
An unsubsidized firm, by contrast, would
have to pay $3,033 per year. Thus, there
would be a cost advantage of between
$1,848 and $2,508 for this person to
work at the subsidized firm.
Although this advantage applies only to
companies hiring low-wage workers,
the savings are likely to passed on to
their employees. The Congressional
Budget Office estimates that a person
making less than $20,000 per year
would, on average, receive a pay cut of
more than 15 percent if he went to work
at an unsubsidized firm instead of a
subsidized one.10 Since subsidized
firms would tend to be smaller and less
apt to offer career advancement potential, the proposed reform raises questions about both job and social mobility
for low-wage workers.

This same reasoning implies that higherwage workers will find it costly to
switch from an unsubsidized to a subsidized firm. It also suggests that employers may sort workers according to salary.
For instance, consider a large corporation that has both high-wage executives
and a lower-wage cleaning staff. Management would have an incentive to hire
out all janitorial services to small subsidized firms or to spin off a small subsidiary that would qualify for subsidies.
Although some legal restrictions against
this type of sorting are included in the
Clinton legislation, it is not clear how
successful they would be.

• Cost Containment Provisions
Although cost containment was a major
impetus behind the call for health care
reform, most of the current proposals
address the problem in only one way:
direct government control of health
care prices. The President's initial plan
did include other less direct —- and,
supporters believe, very effective —
provisions for containing costs. First,
the large government cooperatives
would have significant market power
and presumably would be able to hold
down price increases. Second, since
the plan establishes community ratings,
the current costs of administering an
experience-rated system would be eliminated. Many also believe that the
administrative expenses of insuring one .
large group instead of many small ones
would be lower.

However, "standby" controls are in
place to supplement these measures if
necessary. Without further congressional
approval, the President's plan mandates
that by the year 2000, the per capita cost
of the standard benefit package cannot
increase by more than the yearly percentage rise in the Consumer Price
Index (CPI) plus the percentage rise in
real per capita GDP. That is, premiums
cannot be hiked more than the average
price rise for all goods and services,
except for a slight adjustment for real
output growth.
The danger with these controls — and
with price controls in general — is that
when price increases are artificially
limited, the private market must find
another way to allocate scarce resources.
For example, price controls on gasoline
in the 1970s produced shortages that resulted in long lines of motorists waiting
to fill their tanks. Rent controls in New
York City have led to a shortage of
apartments and to landlords letting the
quality of their properties deteriorate.
While economists are nearly unanimous
in their disdain for price controls, President Clinton is not alone among those
hoping to use them to slow the pace of
medical inflation. Senator Mitchell's
plan, for instance, calls for additional
taxes on insurance companies that boost
their prices beyond acceptable levels.
Such price controls are especially dangerous in the medical field because,
according to some, a primary reason
why medical inflation has consistently
exceeded CPI inflation is that the former is poorly measured.
One explanation for medical care prices
rising at a faster rate than the cost of
other goods and services is better and
more expensive technologies. For example, 35 years ago it was impossible to
keep a person with kidney failure alive.
Today, with dialysis and immunosuppressant drugs (which have led to vastly
improved transplant rates), the cost is
approximately $30,000 a year.

Adjusting price indexes to account for
better technologies not only is difficult
but is in some sense impossible, as illustrated by the above example. How do
you value technologies that previously
did not exist? Although the Bureau of
Labor Statistics incorporates a quality
adjustment in its CPI number, the inflation rate for medical care is almost certainly biased upward for the reasons
stated above. It is further skewed because changes in the number and type
of nurses who minister to patients and in
the availability of new equipment are
both generally ignored when the price
series for hospital rooms is computed.1'
All of this suggests that even with effective health care reform, the standby
price controls may have to be implemented to meet the President's objectives. If history is any guide, these controls may well have a deleterious impact
on medical care. Possible consequences
include reduced access to medical services, longer waiting times for both doctor visits and tests, restricted access to
high-cost medical technologies, and a
slowdown in die development of new
technologies.12
• Conclusion
The administration's healthreforminitiative—as well as most of the alternatives now being debated in Congress—
has been designed to minimize the differences between the old regime and the
new, at least during the initial phase-in.
The President's original proposal called
for a mandatory system that in many respects parallels what is now voluntarily
chosen by many large companies. Workers would choose their health insurance
coverage from a menu of two or three
different plans, and the bulk of the cost
would be paid for by employers, with
employees picking up the remainder via
payroll deduction. The major difference
from today's system is mat the "federal
law rather than the employer would
determine the benefits and the premiums."13 Decisions that used to be made
by the private market would instead be
made by the government.

The Clinton plan thus envisions the
government taking a more active role in
many facets of the health care delivery
system. Federal agencies would oversee
the regional alliances, which nearly
every firm would have to join. If these
measures still failed to control costs,
mandatory price controls on premium
increases would kick in.
But the administration's plan certainly
does not stand alone in this regard. Virtually all of the reform proposals now
being discussed assign a more active
role to the government. The unintended
consequences of such a course — if
experience with government intervention in other industries is any guide —
may be a bitter pill for Americans to
swallow. Given the magnitude of the
possible side effects, perhaps this new
approach to health care, like any new
drug, should have to be proven safe and
effective before being allowed into the
marketplace.

• Footnotes
1. See "Projections of National Health
Expenditures," Congressional Budget
Office (CBO) study, October 1992, p. ix;
and "Managed Competition and Its Potential to Reduce Health Spending," CBO
study, May 1993, p. ix.
2. There have been reports that the President
may soften his stance on universal coverage
in order to ensure that health care reform
passes this year.
3. See Economic Report of the President
1994, U.S. Government Printing Office,
p. 135.
4. I discuss the issue of unreimbursed costs
in more detail in "The Government's Role in
the Health Care Industry: Past, Present, and
Future," Federal Reserve Bank of Cleveland,
Economic Commentary, June 1,1994.
5. See footnote 3, Economic Report of the
President 1994, p. 139.
6. Studies indicate that between 10 and
30 percent of American workers feel tied to
their current job for this reason.
7. The compromise plan submitted by Senator George Mitchell would not force employers to provide health insurance until the year
2000, and men only if more than S percent of
the population still lacked coverage.

8. See "Mr. Moynihan's Gambit," New York
Times. June 13,1994. (Voluntary enrollment
in the regional health alliances was also
included in an earlier reform proposal submitted by Senator Daniel Patrick Moynihan.)
9. This provision of the Mitchell plan may
have an unintended side effect: Firms that
currently provide health insurance for their
workers may cease doing so if the cost of the
standard package is significantly higher than
what they had been paying.
10. See footnote 3, Economic Report of the
President 1994, p. (A.
11. See I.K. Ford and P. Strum, "CPI Revision Improves Pricing of Medical Care Services," Monthly Labor Review, vol. 111, no. 4
(April 1988), pp. 17-26.
12. Some believe that investment in new
medical technologies is excessive and that
such a slowdown would in fact be beneficial.
Since employer-provided health care plans
are not taxed, the government pays for
approximately 40 percent of each health dollar spent Along with such subsidies comes a
tremendous incentive to favor newer and
more expensive technologies that are only
marginally better than the old ones.
13. See footnote 3, Economic Report of the
President 1994, p. 48.

Charles T. Carlstmm is an economist at the Federal
Reserve Bank of Cleveland.
The views stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

1994:IIIQ Economic Review Now Available
Economic Review is published quarterly by the Federal Reserve Bank of Cleveland. Below we present a summary of each of the three
articles contained in the most recent issue. Copies are available through the Corporate Communications and Community Affairs Department. Call 1-800-543-3489, then key in 1-5-3 on your touch-tone phone to reach the publication request option. If you prefer to fax your
order, the number is 216/579-2477.

A Conference on
Federal Credit Allocation
by Joseph G. Haubrich and
James B. Thomson
In October 1993, the Federal Reserve
Bank of Cleveland and the Journal of
Money, Credit, and Banking sponsored a
conference that examined the costs,
causes, and consequences of credit allocation by the federal government The eight
presenters looked at the broad rationales
for government intervention in U.S. credit
markets, analyzed some issues related to
pensions and federal pension guarantees,
and discussed a number of specific programs and regulations, including credit
imperfections in housing markets, riskbased capital requirements for banks, and
community investment rules. This article
is an overview of those proceedings.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

Address Correction Requested:
Please send corrected mailing label to
the above address.
Material may be reprinted provided that
the source is credited. Please send copies
of reprinted materials to the editor.

Employment Creation and
Destruction: An Analytical Review
by Randall W. Eberts and
Edward B. Montgomery
The capacity of markets to create jobs is
typically measured by net employment
changes. However, net job flows veil the
dynamics underlying these aggregate figures. Recent studies have examined the
cyclical behavior of the four components
of net employment: jobs gained from
business openings and expansions and
jobs lost from business closings and contractions. This paper extends the inquiry
to examine whether similar patterns occur
across regions. The evidence indicates
that regional employment changes are
primarily associated with job creation,
whereas cyclical employment fluctuations
are associated with job destruction. Thus,
policymakers need to differentiate between programs that stimulate regional
job growth and those that help firms survive economic downturns.

A Monte Carlo Examination of
Bias Tests in Mortgage Lending
by Paul W.Bauer and
Brian A. Cromwell
Despite three years of data from the Home
Mortgage Disclosure Act (HMDA) indicating that the rejection rate for black
mortgage applicants is much higher than
for whites, most banks have received regulatory compliance ratings of satisfactory or
better. This result may stem from the
absence of several key individual characteristics in the HMDA data, which can
cause tests to find bias even when it does
not exist Here, the authors examine the
steps involved in determining whether a
bank discriminates against minorities and
construct a simulation model to gauge
how well some of these tests perform
when the degree of bias is known. They
find that for plausible levels of bias, the
sample size is critical, but that low levels
of bias can be difficult to detect even with
large sample sizes.

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