Center for Business and Public Policy
at the University of Illinois, Urbana-Champaign

Last week Medicare actuary Richard Foster released a report on the cost of health reform.  The report estimates that total health costs will increase by about $311 billion over the next decade beyond what would have happened without the legislation.  Republicans are using the report to support their claim that health reform will increase the cost of health care.  This is true, but it isn’t news.

We’ve known all along that expanding coverage would increase the cost of health care in this country.  Insured people use more health care than the uninsured, and so there’s no way to avoid the fact that covering more people will result in higher total health care costs.  As the Medicare actuary, Mr. Foster’s prime interest is in the cost of health care, since Medicare pays a large chunk of those costs.

The main counterpoint to the new report is president Obama’s claim that health reform would lower the cost of health care for most families.  This, strangely enough, is also true.  Here, Obama is talking about the out-of-pocket cost that families pay for insurance, net of government subsidies.  And, health reform has substantial subsidies for poorer families.  According to a CBO report that came out last fall, net of subsidies, premiums are expected to fall for a majority of Americans.  Of course, these subsidies will be paid for in the form of higher taxes of one form or another (or reductions in, say, Medicare reimbursements).

So, coverage is going up, total expenditure on health care is going up, taxes are going up, and net premiums are, for many Americans, going down.  But, we knew that already.

Another interesting point in the Foster report is his explicit recognition that the budget figures for health reform and, in particular, the claim that it will reduce the deficit, depend on following through on the law’s provisions that cut Medicare reimbursements and increase taxes, and that it is not at all clear whether we will do so.  And, if we don’t, the numbers will look far worse than the CBO’s numbers from last year.

Again, this is true, but it isn’t news.  The CBO’s mandate is to score bills as they are written.  Congress has long taken advantage of this by putting outrageous provisions into bills that they know are unlikely to be enacted or by pushing costs out beyond the CBO’s 10-year study window.  We know this goes on.  We knew it when the CBO scored the bill last fall.  The only real difference between the CBO’s analysis and Foster’s is that while the CBO is prohibited from speculating about whether taxes will be increased, Mr. Foster is not.

So, while many people have pointed to Foster’s report as a signal that the costs of health reform are going to be substantially different than originally presented, a better interpretation is that Foster’s report examines the same basic set of facts from a different point of view.  However, you felt about health reform, there doesn’t seem to be much in the report that should change your mind.

While the Goldman Sachs testimony yesterday made all the political headlines yesterday, there was a second event occurring simultaneously that is much more important for our long-term economic security.  You see, despite all the rhetoric about financial regulatory reform, the Goldman Sachs hearings are really all about the past. 

The bigger story is about our future.  President Obama formally kicked-off of the “National Commission on Fiscal Responsibility.”

This Commission has the most difficult and important jobs in Washington – to figure out how to restore U.S. fiscal policy to something akin to a sustainable course.  It won’t be easy.  After 50+ years of total government spending comprising about 1/5 of the U.S. economy, the three entitlement programs - Medicare, Medicaid and Social Security - are projected – all by themselves – to exceed this share of the economy in the lifetime our today’s schoolchildren.  Throw in continued expenditures on all other functions of government – national defense, homeland security, environmental protection, education, the court system, and more – government spending is projected to consume an ever larger share of our economy.  This, in turn, has the potential to raise interest rates, crowd-out private investment, and thus reduce our rate of economic growth.

The President was careful not to take anything off the table yesterday.  That is important because this is not going to be an easy problem to solve.  At the end of the day, there are only two solutions to our fiscal problem. 

Solution 1: Raise more revenue.  In political terms, this means raising taxes.  I doubt that the Republican members of the Commission will be fond of this.

Solution 2: Cut spending.  In political terms, this means reducing the growth rate and/or level of benefits from “sacred cow” programs with vocal constituencies – such as seniors.  Democrats proved in 2005 that they are unwilling to cut benefits.  And many Republican members of the House sought to “solve” the problem through free lunch gimmickry, arguing that personal accounts (which I support, albeit for different reasons) would generate high enough returns that no benefit cuts would be needed. 

Where does that leave the Commission?  I see it most likely pursuing one of three possible outcomes.

Outcome 1:  The D’s and R’s on the Commission are unable to find enough common ground, and thus the Commission issues a final report that offers a series of options, each with proponents and dissenters.  In other words, partisanship.

Outcome 2: The Commission agrees they need to have at least some options that most members agree to.  And, caving to political pressure, they throw intellectual honesty out the window, and use a combination of both time-tested and brand new gimmicks to make it seem like the problem can be fixed without serious revenue increases or spending cuts.

Outcome 3:  The Commission takes a brave political stand by pointing out the extraordinarily difficult fiscal challenges ahead of us, proposes politically earth-shattering reforms, and then disbands and watches its proposals wither and die in the backrooms of Congressional committees.

Given the composition of the committee (see list here), I am optimistic that option 2 will be discarded.  But I think 1 and 3 are equally likely.

If there is hope for real reform coming out of this Commission, it will be because the Commission actually includes many sitting members of Congress who control the key committees.  In this important sense, this Commission has more in common with the 1983 Greenspan Commission, which led to politically difficult Social Security reforms being passed by Congress, than with the 2001 President’s Commission to Strengthen Social Security, which had no members of Congress and which saw its recommendations soundly ignored.

I hope my skepticism is mis-placed.  I sincerely hope this Commission comes up with good options, and that those in power listen.  If this happens, the long-term implications for “good” are far greater than 99% of all other economic news …

Last week I made a post about how shocks to university endowments affect university operations.   Here is a link to an article put out by the U of I News Bureau that offers another summary of that work … (click here)

In my last blog, entitled, “What Discount on a House Where a Murder Took Place?”, I asked for comments from readers who could suggest answers to the three questions posed.  You might want to click on that title to read the blog, but short versions of the questions were: (1) how much discount would YOU require to buy that $400,000 house in which an awful murder had taken place; (2) how much discount do you think the market price would actually reflect; and (3) can you explain any reason for the difference?

I’d like to thank several of you for submitting comments with your answers, and I must say that all of you are on the right track.  The first question has no right answer, as it depends on personal preferences, but I think MOST people would not want to live in such a house, and would therefore skip the house entirely or at least need a substantial discount.  I would guess that the average answer might be about 25% discount, or $100,000 off (which still means paying $300,000 for that house).

Therefore I was just a bit surprised, initially, when the new owner admitted to buying the house for only a small discount.  One problem is that the true discount is impossible to know, because we can’t determine exactly what price the house would have received if the murder had not taken place.  That’s why I’m vague about the actual discount, but my best guess is that the house would have sold for $400,000, so the price of $380,000 is only a 5% discount.

Anyway, that surprising answer got me to thinking, and I soon realized the same answer as in the comments on my blog.  The “average” person does not matter, because the “average” person does not buy the house!  It is the person who values the house the most who ends up buying it.  Another part of this answer is that people are different (“heterogeneity”).  Some would never buy the house, some would need a large discount, some would need little or no discount, and some might even like the idea of living in such a notorious house.

Think about an auction, with a thousand participants, but where only TWO of them were willing to pay extra to buy this murder house (a mere 0.2% of participants).  Those two would bid up the final price to more than $400,000.   Given that possibility, the actual buyer was lucky to get any discount at all!

Part of the reason for telling this story is that the same logic applies in other markets.  At least it explains why somebody bought that piece of art you thought was so ugly.  It also explains why investors in the top tax bracket get such a big break on tax-exempt bonds.   Consider the following example.

A taxable bond earning 10% would be a good investment for a tax-exempt institution, but not for someone in a 40% tax bracket for whom the NET return is only 6%.  That person would instead buy the tax-exempt bond earning 8%.  But that person earns 8% instead of 6%, so you might wonder why the municipality offers that high an interest rate.  The answer is heterogeneity.  The very first tax-exempt bond offering might get to pay a rate only slightly higher than 6%, and could get top-bracket taxpayers to buy it, but successive offerings have to pay higher and higher interest rates to get more people to buy.  If the equilibrium of supply and demand is at an 8% tax-exempt bond rate, it means that those bonds appeal to everybody in all brackets above a 20% tax rate.  The guy in the 20% tax bracket who is just barely indifferent is the “marginal” investor, and the market price is set at the margin. 

Yet I have to end with another house where gruesome murder took place.  Here is a link to a story on NPR that begins: “I bought Jeffrey Dahmer’s childhood home in Bath, Ohio. … Let that sink in for a second. … If your first reaction is “eeewwwww,” that’s perfectly understandable.  Dahmer was one of America’s most notorious serial killers; his rampage lasted from 1978 to 1991. He confessed to killing at least 17 young men. Many of these murders involved torture and cannibalism.”

Now THAT house got more of a discount!

Earlier this year, I made  a post (click here) in which I suggested that universities might wish to increase their spending out of endowments to help maintain, during an economic downturn, their investment in high-value projects (such as recruiting and retaining top faculty and staff).  Such an approach would be consistent with one possible view of endowments - that they are to serve as a buffer stock or an insurance policy against bad economic times.  Some of the comments I received - as well as a post (click here) by my colleague David Ikenberry - were less enamored of this idea. 

Now, I have research to indicate that most universities, in fact, do NOT behave this way.  Rather, it appears that when universities suffer negative shocks to their endowments, they actually reduce the rate of spending from their endowment beyond what would be implied by their own spending rules.  In essence, they do not use endowments to protect their universities from larger spending cuts.  Instead, they appear to act in a manner consistent with trying to preserve the value of the endowment for its own sake.

Our research goes on to show that following endowment shocks, universities respond by cutting staff - including maintenance workers and secretaries.  Less prestigious schools tend to reduce tenured and tenure track faculty (most likely by not replacing those who retire or leave), whereas more selective institutions tend to do more to  protect their tenure-system faculty.  The only group that is unaffected by the shock is “administrators.”

We also find that when an endowment invests more of its resources in alternative asset classes - things like private equity, hedge funds, timber, commodities, and the like - universities make even larger cuts following a negative endowment shock.  This could be for one of two possible reasons.  First, these alternative asset classes are more illiquid, and thus not easy to access during down markets.  Second, it may be that the reported value of these assets - which are much harder to value than, say, publicly traded stocks - are overstated, and the endowment knows it (or at least suspects it).

These results suggest that university faculty and staff have a clear stake in decisions about how endowments are invested and in the payout policies. 

If you would like to read more about this, I can refer you to the paper itself (click here) or to a write-up about the paper that appeared in “Inside Higher Ed” (click here).

As I tell my students, “I believe in markets, but I also believe in market failures.”  When the basic assumptions of perfect competition hold, markets do a great job at allocating resources efficiently.  The right goods are produced, and they find their way from the firms that produce them at the lowest cost to the consumers who place the highest value on them.  A well functioning market is a thing of beauty.

However, when the basic competitive assumptions do not hold, markets can work very poorly.  Without getting too long winded, it is reasonable to argue that industries such as health insurance and banking do not satisfy the competitive assumptions, and this provides a justification for government intervention.  For example, in health care the problems of adverse selection (the people who most strongly desire health insurance are the ones most likely to buy it) and moral hazard (when people don’t pay out-of-pocket for a service, they tend to use too much of it) are significant and serious reasons why unregulated markets may not be efficient, and introducing regulations to address these problems is the (economically) strongest argument in favor of reform.

Of course, the second part of what I tell my students is that “I believe in governments, but I also believe in government failure.”  Markets are complicated and difficult to actively manage in even the best circumstances.  Throw in the fact that governments themselves are filled with political and bureaucratic concerns that may prevent ideal regulations from being enacted, and it is easy to see why the cure is often worse than the disease.

Which brings me to my main point: government intervention should be motivated by the need to address a serious problem with markets and mindful of the fact that government has the potential to make things worse as well as better.

So, what could a group of six Democratic Senators possibly be thinking in introducing legislation aimed at preventing airlines from charging for carry-on baggage?  Where is the market failure here?  What is the great inefficiency that this legislation is supposed to address?

As Senator Schumer (D – NY) said “When you charge for a carry-on bag, it’s a slap for anyone who flies.”  Maybe.  But, people who choose low-cost airlines are saying that they prefer to be slapped rather than pay a few bucks more for a ticket.  If they don’t want to fly Spirit (the pioneer in charging for carry-ons), they can choose another airline, or another means of travel.  If people are wiling to choose Spirit despite the inconvenience of leaving their carry-on bag at home or paying to check it, then Spirit has actually done a good thing.  People just want low ticket prices.  Period.  And, Spirit is giving it to them.  That is a triumph of markets, not a failure.  Southwest in the U.S. and Ryanair in the UK/Europe have been very successful following a no-frills/low-price strategy.  The only thing preventing Spirit’s new pricing will do is prevent them from giving people what they really want: the lowest-cost seat on a plane.

On the other hand, if people choose alternate carriers, Spirit will quickly come to see the errors of its ways and remove the bag charges.  Or, if there really are benefits to the airline due to “lower[ing] some passengers’ costs, speed[ing] up boarding and lines at security checkpoints and reduce[ing] delays,” then Spirit could lower its prices even further in order to make up for the additional cost of paying for a carry-on.  Again, markets at work.

In my mind, to the extent that there is a problem here, it is that people do not know about and/or correctly anticipate the charges for things like checked bags, carry-on bags, etc.  So, if Senator Schumer and his colleagues want to do something to help here, they could think about regulation aimed at transparency in pricing.  For example, when you go to buy a ticket you could be told that “this airline charges $X for a checked bag, $Y for a carry-on, $Z for food, etc.”  This way, we could be confident that everybody was given the chance to learn about the airline’s pricing scheme.  As long as everybody knows that by choosing Spirit they save $17 on their ticket but will have to pay $45 if they choose to put a bag in the overhead bin, then we should trust market forces to bring about the right trade-off between the price of a seat for yourself and the price of a spot for your bag.

April 15 - tax filing day.  Undoubtedly, the newspapers will be full of the usual debate about whether the rich pay too much or too little in taxes. 

A Washington Post article (reprinted here) written by my fellow economists Rosanne Altshuler and Roberton Williams last week has received a fair amount of press coverage by pointing out that “about 45 percent of households will owe no federal income tax in 2010.”  This has led to the usual debates about whether this is “fair” or not.  But “fairness” is not a particularly well-defined notion, and your view of it probably depends a lot on whether you are one of those paying taxes, or one of those not. 

Rather than get into a debate about fairness, I want to make a point about economic efficiency, and a point about the interaction of politics and economic policy.  

The economic efficiency point is straight out of introductory public finance.  Most taxes have two impacts.  First, they redistribute resources in some way.  Second, they usually change relative prices and therefore distort economic decision-making.  These distortions in economic decision-making lead to real economic costs.  There are many names for it – the deadweight loss of taxation, including the excess burden of taxation, the efficiency cost of taxation, even the Harberger Triangle (named after the eminent economist who rigorously made this point). 

Whatever name you use, the point is simple: when you tax an activity, you not only raise revenue, but you also destroy some economic value along the way.  In other words, to raise a dollar of revenue, you may destroy another 25 or 30 cents of activity in the process of raising the dollar.  These excess burdens are not always easy to see with the naked eye because often it is in the form of something that did not happen – a transaction that never occurs, an hour of labor withheld from the market, an investment not made, and so forth.  Think of the “dog that did not bark in the night.”       

What is particularly important about this is that the size of this excess burden grows with the square of the tax rate.  That means, essentially, that if you double the tax rate, you significantly more than double the excess burden.  In short, each dollar of revenue gets a more expensive to collect.

As a result of this, most economists agree that the most efficient way to raise a given amount of revenue is to have a smaller tax rate applied to a larger tax base.  The Tax Reform Act of 1986 was a particularly good example of tax policy designed to do exactly that – including more sources of income in the tax base, removing special exclusions and exemptions, and then lowering the marginal tax rate.    

The fact that 45% of households face no income tax is one of many indications that we may have too narrow of a tax base, and therefore too high of a tax rate.  (There are many other examples, most of which are even more quantitatively important, including things like the exemption of home mortgage interest or health care insurance premia). When we leave one person untaxed, the tax burden on the remaining individuals must be higher.  And, importantly, the deadweight loss is higher. 

The second point I would make is that when nearly half of the population pays no income tax, what incentive does that half have to control government spending?  As we have learned over and over again in numerous contexts (including 3^rd party insurance payments), people are a lot more likely to spend money when the money they are spending is somebody else’s.  After all, who wouldn’t like more public spending if somebody else is going to foot the bill?  

So whatever your views about the “fairness” of who pays taxes, let’s be clear that it has real economic and political consequences.  

What passes for pension reform in Illinois came with lightening speed in late March. The bill (SB 1946) appeared suddenly and was approved by substantial bi-partisan majorities in barely two days and enthusiastically signed by Gov. Pat Quinn. After some preliminary actions on March 23, the Illinois House and Senate took 71 separate actions on March 24, leading to the final approval of the bill.                  

The bill was widely hailed in the editorial pages of newspapers in the state as well as the Wall Street Journal and by politicians as an important step toward addressing the state’s massive budget shortfall by dealing with the pension piece of the problem – the one that has come to symbolize the cause of and solution to the state’s fiscal woes.

Unfortunately, the pension reform process was seriously flawed on procedural grounds. In addition, the new legislation falls far short of effectively dealing with pension funding problems, not to mention the larger state budget issue. 

In a recent News-Gazette commentary, State Sen. Mike Frerichs, D-Champaign, heralded a new day of openness and transparency in the General Assembly. His Taxpayer Transparency Act (SB 3622), approved by the Senate, would “put an end to the practice of last-minute, secret budgets in Illinois.”   Further, it will mandate “that general revenue spending proposals must be available for public review for four days prior to the General Assembly taking a vote.” 

Overcome by this spirit of openness, the Senate passed pension legislation that few members, not to mention citizens, understood. By comparison, the recent national health care debate was a model of openness and propriety. In fact, two weeks after the legislation was approved, no one in Springfield could give a definitive answer to a number of key features of the bill. There were no significant hearings on the legislation, no real input from the state’s pension systems, and no competent actuarial study before the bill was approved. 

It is surprising how the editorial writers and commentators bought into the reform idea. In a Chicago Tribune commentary, Abner Mikva, an icon of Illinois politics, stated: “Gov. Quinn and the legislature deserve a lot of credit for a pension reform that is a substantial piece of any meaningful fiscal restraint program. More than a faint praise, they deserve a loud hurrah.” It is disappointing that the former distinguished judge, noted for his advocacy of proper and open procedures in politics, would be cheering what transpired in Springfield. 

The faulty process might be forgiven if the results effectively addressed the pension problem.  Instead, the new bill can be viewed as business as usual similar to the so-called reforms of 2003 and 2005, where purported savings to be realized far in the future became the excuse for reduced current funding efforts. 

The pension bill imposes a new dramatically lower second tier by severely limiting pension coverage and pension benefits for new employees. This will differentially impact public school teachers and public higher education employees who are not covered by social security. New retirement benefits will only be partially indexed for inflation, and these adjustments will not be compounded. The result is that a retiree would lose around 28 percent in purchasing power during a 20-year retirement with 3 percent inflation and 50 percent with 6 percent inflation. 

To save state funds, pension benefits for new employees will be based on a fraction of the social security earnings ceiling – currently $106,800 per year regardless of the actual employee’s salary. This too will only be partially adjusted for inflation, which will cause the earnings ceiling for a new employee working 30 years to fall to 64 percent of the social security ceiling with 3 percent inflation and to 42 percent with 6 percent inflation. 

These are only two of several punitive measures that will reduce future pension benefits. The fallacy of this approach is that it assumes that there will be no adjustment necessary in the hiring costs for new employees who are offered drastically reduced benefits compared to current employees. Can new, highly skilled employees be hired with such meager benefits? This can only be done by paying higher salaries to compensate for the lower benefits or through the establishment of supplementary retirement systems to make up for the deficiency. What the state saves in lower pension costs will be partially offset by higher wages and new supplementary benefit costs. 

Rather than using the new pension savings as a means of setting the state on a path to solvency, the new pension bill is used as an excuse for the state to continue its reckless ways by reducing scheduled pensions contributions. What is overlooked in this discussion is that the budget problems facing the state are really the result of excess spending over several decades where deficits have been partially funded by shorting the state’s pension systems. For example, had the state made timely payments (based on actuarial costs of slightly more than 10 percent of payrolls) to the State Universities Retirement System, SURS would be fully funded with assets of around 106 percent of liabilities rather than its actual level of around 50 percent. 

No reasonable observer can deny that pension reform as well as a careful evaluation of non-pension post-retirement benefits such as health insurance needs to be part of a general solution to the state fiscal mess. However, these changes must be accompanied by greater fiscal discipline as evidenced by spending austerity and enhanced revenues. Unfortunately, the General Assembly appears to view its version of pension reform as a substitute for such discipline.

 Giertz is professor of economics at the University of Illinois and an elected member of the State Universities Retirement System Board of Trustees. The views expressed here are his and not necessarily those of these institutions.

I almost forgot this one from the Boston Globe.  I’ve written in the past about how if you require insurers to accept all comers and charge the same price to everyone, regardless of their medical history, then you really need to accompany this with a mandate requiring everyone to buy insurance.  Otherwise, rational people will wait until they become sick and then buy insurance.  The way this type of gaming is enforced is through a “mandate,” which practially means that you pay a penalty if you don’t buy insurance.   Of course, the mandate is really only as mandatory as the size of the penalties, and one of my big complaints about the new health reform package is that the penalties to people who don’t buy insurance aren’t big enough.  Anyway, the Globe article discusses the appearance of gaming in Massachusetts, where people sign up for health insurance for relatively short periods and spend a lot of money while they are insured.