Why Is There So Much Waste in U.S. Healthcare?

Despite the acrimony over health care legislation, bipartisan analysts agree that much of what we spend does little to improve our health. New treatments for prostate cancer, for instance, are no better than older, less expensive ones.

Likewise, thousands of Americans receive back surgery that is no more effective than a placebo. Up to one third of US health spending may be wasted. President Obama is correct to talk about "bending the cost curve." But what makes health care so susceptible to waste?

One answer is incentives. Common sense says we should purchase treatments only so long as their benefits exceed the cost. If a medical procedure costs $1,000 but gives the patient $2,000 worth of improved health, that's a good deal.

While patients once had reason to care whether a test, treatment or medication was worth the cost, with today's low out-of-pocket costs there is much less incentive.

If the health benefit of the procedure is only $500, it probably doesn't make sense. But government policies skew these incentives, such that neither employers who purchase health coverage nor patients who use it have much reason to balance benefits against costs.

Health insurance provided by employers is exempt from federal income taxes, state income taxes, and Social Security and Medicare payroll taxes. A dollar of wages, by contrast, is subject to federal income taxes of around 25 percent, state income taxes of around 5 percent, and payroll taxes of 15 percent, leaving only around 55 cents in employees' pocketbooks.

Employers who are looking out for their employees will shift compensation toward health insurance and away from wages--precisely the pattern we've seen in recent years.

But how does this encourage waste? The more we spend on health care, the harder it is to ensure that each dollar of spending delivers a dollar's worth of benefits--economists call this "diminishing returns."

Yet, the tax subsidy means it makes sense to purchase even very wasteful health plans, since otherwise employees receive only the after-tax value in wages--around 55 cents on the dollar. While Americans view the health coverage tax exemption as relief from high costs, it is actually one of the reasons for high costs.

But that's only half the story. The tax deduction for health coverage applies to insurance premiums but not to deductibles or copayments paid by individuals. The tax exemption is greatest when health plans have high premiums and low copayments.

Not coincidentally, the share of health expenses paid out of pocket has dropped, from over half in the 1960s to around 13 percent today. While patients once had reason to care whether a test, treatment or medication was worth the cost, with today's low out-of-pocket costs there is much less incentive.

In sum, the tax code encourages employers to overspend on health coverage and patients to overuse it. MIT professor Jonathan Gruber, an influential Obama advisor, flatly states that "no health expert today would ever set up a health system with such an enormous tax subsidy to a particular form of insurance coverage."

Clearly, there are other sources of waste in health care and other ways we can make medicine more efficient. But federal tax incentives worth hundreds of billions of dollars each year push the health care cost curve in the wrong direction. Without improving incentives to balance costs and benefits, no reform plan can hope to provide quality affordable health coverage.

Unfortunately, current health legislation doesn't get the incentives right. Unions are fighting plans to make so-called "Cadillac" health plans subject to income taxes, while most congressional Democrats wish to further insulate Americans from balancing the costs and benefits of treatments. In the end, someone must make these choices. If it is not individuals, it will be the government.

Andrew G. Biggs is a resident scholar at AEI.

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