Wealth of Nations October 2005

The Slippery Economics Of Health Care

Is it really true that health care costs put American industry at an international disadvantage, as General Motors and other companies say?

General Motors announced this week that it had struck a deal with the United Auto Workers union to cut $3 billion a year from its spending on health benefits for retirees. Even this huge sum may be too little to secure GM's future. The company has plenty of things to worry about besides its spending on health: high gas prices and falling demand for its most profitable lines, to name two. Still, without the new agreement, the company's prospects would have been even worse.

GM is not alone. Many American businesses complain that they are being crushed by health care costs. Competitors abroad, they emphasize, are spared this burden, so America Inc. is at a grave disadvantage. It is not a new complaint, but the persistent trade deficit and the perilous finances of iconic industrial giants like GM give it a new edge.

Is it really true, though, that corporate health costs put American industry at an international disadvantage, as GM and many other companies say? The idea seems plausible, but it is more slippery than you might think.

In principle, as far as current workers are concerned, health benefits are just another form of pay. If companies pay each of their workers $1,000 a year in health benefits (and suppose, for the sake of argument, that the workers would have wished to buy them in any case), then it ought to be possible to pay them $1,000 a year less in wages and other forms of compensation, and still be about as successful as before in recruiting and retaining employees. Total pay is the same in each case.

To judge international competitiveness, labor costs must be seen as a whole and must be measured relative to productivity. Overall, American workers are productive enough to be competitive at prevailing rates of total compensation; otherwise, the rate of unemployment would be much higher. (What about the trade deficit? Doesn't that prove that lack of competitiveness is a problem? No. The deficit has little to do with competitiveness. Mainly, it reflects the strength of demand in the United States relative to the strength of demand in Europe and Asia.)

Now, it is true that several things complicate the GM picture. One is "legacy costs"—benefits due to workers who have retired. GM made expensive long-range promises to its retirees, on pensions as well as on health care, which the firm can no longer afford and wants to undo. Whether those promises were ever prudent is doubtful, and the company's provision for its future liabilities was evidently inadequate. A good rule is not to make promises you cannot keep. A related complication is labor relations. GM may be shrewd to complain about health care costs rather than wages or labor costs more broadly, even if they all amount to the same thing, so long as the UAW is more willing (and it probably is) to swallow a cut in health benefits than a cut in wages or jobs.

And politics comes in as well, of course. GM and other manufacturers may believe (and they are probably right about this also) that if they complain long enough and loudly enough about health and pension costs, the government will give them some kind of relief at taxpayers' expense. Complaining about high wages—even though, again, the issue is no different in principle—would be less likely to attract additional tax breaks or other forms of subsidy.

They crucial word in that last sentence, though, is "additional"—because the deals that businesses and their workers come to over wages, benefits, and hours on the job are already twisted badly out of shape by tax policy. If it were not for tax policy, and the big incentive that it gives employers to pay their workers in tax-sheltered benefits rather than in cash, GM would most likely not be providing health benefits in the first place.

This is the most important complication of all. The tax preference for employer-provided health care has a big unintended consequence: It makes health care more expensive.

How? By pushing decisions about health care—about the trade-off between costs and benefits—away from the actual consumers of health care. As a result, end users have little reason to economize. Managed care and insurance-policy deductibles mitigate the problem but do not resolve it. At the margin, with somebody else (apparently) paying the insurance premium, patients get additional health services at a fraction of the cost. So far as economic pressures are concerned, demand is unconstrained.

To be sure, there are other, non-economic, constraints: People do not demand surgery or chemotherapy for the fun of it. But they may very well demand the most expensive drugs, the most expensive procedures, the most expensive ancillary services, with no regard at all for the balance between efficacy and cost—a balance that they would certainly strike if they were paying out of their own pockets. In the aggregate, users still pay for those services—through either taxes or lower wages, or both. At the margin, they behave as though they don't. The result, predictably, is rapid inflation in the cost of care.

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