Health Care Costs Set To Soar

By Tomas Philipson

Nations around the globe are grappling with rising costs of health care. In the US, health care liabilities and the federal debt are on a trajectory that is difficult to sustain. As the figure below shows, the Congressional Budget Offices estimates that federal deficits under current law will continue to rise faster than tax revenue, mainly driven by health care liabilities.

So why is health care spending growing? The answer is simple: Providers charge more and we continue to blindly pay through secretive managed care contracts that contain annual escalator clauses, silly outliers based on outrageous charge master rates that no one ever pays, and  consumers who don’t care about health care costs because “insurance pays it all!”

Employing reference based pricing ( ), or variations such as Cost Plus Insurance ( ) or Medicare Benchmarking ( ), health care costs can be reduced, not increased.

Law makers, regardless of political inclinations, are therefore rightly concerned about how health care reforms will affect the growth in health care spending. But private and public reforms to curb spending growth in health care are not a new concern. In the 1980s, policymakers instituted hospital payment reforms in Medicare, in the 1980s and 1990s private and public managed care organizations grew quickly, in the 2000s disease management programs sought to control costs for high-cost and chronically ill patients, and lately consumer-oriented health care plans (such as through medical savings accounts) have been expanding. However, despite these repeated efforts to curb spending, the health care economy has grown, and is predicted to continue to grow, faster than the rest of the economy. The most recent incarnations of reforms, e.g. accountable care organizations and bundled payment reforms, raise the question of whether this time is different? In other words, are recent reforms significantly different from these more dramatic changes in the past to warrant more optimism in curbing spending growth?  According to a recent federal demonstration study, the Premier evaluation, the answer was negative as it found much of an impact of recent organizational reforms on spending growth.

If medical innovation drives spending growth, then to contain future spending we must alter innovation incentives. Medical innovators earn their returns worldwide and regardless of where that innovation takes place. Swedish or Swiss firms do not innovate to sell only to their own small populations.  Therefore, domestic or regional reforms may have limited impact on innovation incentives unless they also greatly affect innovation returns around the globe. The fact that world returns drive domestic spending growth has three important implications.

First, local reforms efforts in the US do not tell us a lot about how ACA will affect overall spending growth. Reform efforts in Massachusetts under Mitt Romney will have different effects on spending growth than national reforms such as the ACA. In other words, a single small state in the US does not affect world innovative returns much and thus is unlikely to affect innovation incentives. For the same reason, many of the demonstration programs under the ACA will not be informative about future spending growth because they often involve a small set of payers or providers not altering world returns.

Second, the Affordable Care Act may likely raise, rather than lower, world returns to innovation and thus push future public liabilities higher. Put simply, most innovators would love to have legislators impose mandates or increased access for their products as the ACA does for health care services and products. National US reforms such as ACA matter to world returns because world health care spending is highly concentrated in the US; about half of world health care spending occurs here, despite that US makes up only about one-fifth of the world economy. The CBO estimates that ACA will raise the proportion of the US population that is insured from about 85% to 93%, which means many more individuals will demand future medical innovations, making them more profitable to market.  As another example, the high copay rates of some parts of the Medicare drug program (the so called “donut-hole”) will be reduced, also raising innovation returns. Regardless of the magnitudes of these innovation effects, they put upward rather than downward pressure on future federal liabilities.  Recent evidence by USC economist Neeraj Sood and colleagues suggests that this was indeed the impact of the public expansion of the Medicare drug program in 2006; drug-classes whose demand rose more from the program saw greater R&D investments.

Lastly, depending on the future course of emerging economies, particularly China, national US reforms may have less impact on the future world returns than commonly recognized.  The future demand growth in the world’s middle-income population is certainly good news for medical product innovators. This future outward shift in demand drives current innovation today; the returns from the medical products patents filed this year are likely not realized until at least a decade from now, when world health care spending may be far less concentrated in the US.  It seems that the future course of world returns will likely be a horse race between the two offsetting forces of a growing demand in emerging markets and lower markups in developed countries facing fiscal imbalances.

The question thus remains whether the global returns that have driven past spending growth will be affected to a large degree by US local or national reforms. The bottom line is that it is not unreasonable to predict that returns from new medical innovations discovered today will be larger either due to the ACA or from future growth in world demand.