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

Hollywood is abuzz today with the news of the 2010 Academy Award nominations.  If there were a category for “Most Frightening,” surely the newly released 2011 federal budget would be the odds-on favorite.  Released yesterday, the budget contains some difficult-to-swallow news about the difficult choices ahead of us.  

 Let me just highlight some of the more frightening numbers – all of which can be found in the proposed budget.  

• Even with the President’s proposed tax increases and spending cuts, the projected single-year deficit never falls below $706 billion (that, in year 2014).  Indeed, it starts with a projected FY 2011 deficit of $1.566 trillion, and ends in 2020 with a $1 trillion deficit.
• The debt held by the public is projected to roughly double over the next decade, from $9.3 trillion in 2010 to $18.57 trillion by 2020.
• Of course, the economy is growing over this time (at least we all hope), so more meaningful numbers are relative to GDP.
  • The 2011 deficit is projected to be 8.3% of GDP
  • The debt held by the public will rise from 63.6% of GDP to 77.2% of GDP over the next decade.

 Of course, this may be a best-case scenario (in terms of deficits) because it assumes the President gets what he wants, including (as reported in today’s Wall Street Journal):

• $175 billion rise in personal income taxes
• $117 billion rise in corporate income taxes

 I’ve written previously about why deficits matter, primarily because they serve as a drag on long-term economic growth.  President Obama’s very talented budget director Peter Orszag understands this as well as anyone.

 But as bad as things look over the next few years, we need to recognize that the really long-term budget forecasts are far worse.  

 It is no secret that the biggest drivers of increased government spending over the long-run are the “Big Three” (meaning entitlements, not the auto-makers).  Growth in spending on Medicare, Medicaid and Social Security are projected to outpace overall economic growth for as far as the eye can see.  Unless these programs undergo structural change to rein in costs, the implications for our economy are enormous.

Consider this: for most of the last 50 years, government spending has stood around 20% of GDP (yes, it is higher now, but I am taking a longer-term view).  According to the Congressional Budget Office, by the year 2035 (about the time today’s newborn children are starting their own households, when today’s college graduates are in their middle ages, and when today’s middle-agers are set to retire), spending on Medicare, Medicaid and Social Security will be 16% of GDP all by themselves.  By 2080 (when today’s newborns are retiring), these programs will comprise nearly a quarter of GDP – a higher fraction than ALL government spending today.  So unless we change these programs, the rest of the government would need to cease operation, tax rates will have to skyrocket, or we are going to watch our debt grow to unprecedented levels relative to GDP.

The main drivers of these trends are rising per capita health care costs and population aging.  We have so far been woefully unsuccessful at dealing with the first, and we may not want to do anything about the second (after all, most of us like living longer).

In short, as bad as the short-term budget outlook is, the longer-term budget outlook is even worse. 

Sorry to be so pessimistic … but sometimes the facts speak for themselves.

The CBO released a report this week that attempts to estimate the effect of the new Senate health care bill on insurance premiums.  The report is potentially important because supporters of the bill argue that it will lower health insurance premiums, while opponents argue that it will increase them.  In fact, not only do the two sides differ on what the bill will do, they differ on what the CBO says the bill will do.  From the New York Times:

“’The C.B.O. has rendered a fundamental judgment that this will reduce the deficit and reduce people’s premium costs,’ said Rahm Emanuel, the White House chief of staff,”

and yet …

“’The analysis by the Congressional Budget Office confirms our worst fears,’ Mr. Grassley [R, Iowa] said. ‘Millions of people who are expecting lower costs as a result of health reform will end up paying more in the form of higher premiums. For large and small employers that have been struggling for years with skyrocketing health insurance premiums, C.B.O. concludes this bill will do little, if anything, to provide relief.’”

So, I went and check out the report, which you can download here.  It’s actually quite an interesting read.

As background, what is the Senate plan supposed to do?  Among other things, the bill prohibits insurers from charging individuals higher prices based on their health status.  This is a laudable policy goal.  But, it must battle against a phenomenon called adverse selection.  Adverse selection refers to the fact that if you offer an insurance policy for, say, $5000, the only people who will be wiling to buy it are those who expect to have relatively high insurance costs.  So, someone who thinks they will only incur $500 dollars worth of medical expenses will be less likely to buy the policy than someone who expects $20,000 worth of expenses.  Currently, insurers address this problem by charging a low price to the person who expects $500 in expenses and a high price to the person who expects $20,000.  However, the new bill prevents this practice.  Suppose the insurer responds by charging a single premium of $3000.  This will attract all of the people who expect high costs and few of the people who expect low costs.  The result is that the average cost of those who buy insurance may be much higher than the average cost in the population as a whole.

If the insurer can’t make money charging $3000, it may raise its price.  But, doing so only discourages healthy people from buying insurance even more.  The result is that the insurer may find that it is able to offer a policy only at a very high price, or maybe not at all.  So, mandating uniform prices may not, by itself, be a sustainable policy.

The Senate bill addresses this by also mandating that most people buy insurance.  Since most people without insurance do not have the option of buying it through their employers, this means that they will have to buy insurance from the non-group (individual) markets.  Some of the new purchasers of insurance will be those who are sick and could not buy insurance in the private market before.  Others will be those who are healthy and chose not to buy insurance before.  Whether the net effect increases or decreases premiums will depend on whether the new entrants to the insurance pool tend to fall more in the former camp or the latter.

A third goal of the Senate bill is to encourage competition in the private insurance market.  Through the creation of insurance exchanges that facilitate shopping for good plans and possibly the addition of a government option, the bill seeks to encourage private insurers to offer high-quality plans at low prices in order to attract new customers.

A final goal of the bill is to ensure that all insurance products offer a certain, minimum level of coverage.  In effect, the bill requires many policies currently being offered in the individual market to cover more services than they do currently.  In particular,  individual-market plans that participate in the insurance exchange will be required to offer benefits that cover at least 60 percent of typical health expenses, and they would have to cover additional services that are not typically covered by individual policies today, including “maternity care, prescription drugs, and mental health and substance abuse treatment.”  Since these services are not covered by many plans now, this requirement will increase premiums.

So, to summarize:  the new bill should be expected to change premiums by (i) changing the services that are covered by a typical individual-market policy, (ii) encouraging competition, and (iii) changing the group of people who choose insurance.  These three mechanisms operate fairly independently. In other words, covering more services would increase premiums even holding the level of competition and pool of risks constant; increasing competition would lower premiums even holding services and the risk pool constant; and changing the risk pool would affect premiums even holding the services offered and level of competition constant.  Further, since the large group market is already fairly competitive, has no risk rating, and takes all employees, we expect the effects to be concentrated in the individual market.

The CBO’s findings are summarized in the table below, which I copied from the report.

The first column of numbers represents the effect of the Senate bill on per-person premiums in the nongroup market.  Covering additional services is expected to increase premiums by 27 to 30 percent.  This is not surprising and should not be controversial.  If you want to cover more services, then it is going to cost more.  People are paying more, but they’re also getting more.  The next two rows in the first column show that the bill is expected to have beneficial effect on prices due to increased competition, lowering premiums by 7 to 10 percent, and increasing the size of the pool of those buying insurance will reduce premiums by another 7 to 10 percent.  So, the overall increase in premiums in the non-group market is estimated to be somewhere in the range of 10 to 13 percent.  The second and third columns show that the bill is expected to have negligible effects on the small group and large group markets.

So, who’s right, the Democrats or the Republicans?  Well, there’s a grain of truth in what both sides are saying.  The bill will increase premiums for those in the nongroup market.  But, this increase is due exclusively to giving them more generous policies than they currently purchase.  Holding fixed the level of benefits, the bill lowers the cost of insurance, which means the bill is achieving its goals.  So, it seems to me the debate should be centered on which services we want to mandate.   If it is worthwhile to cover services like maternity care and substance abuse treatment, then it might make sense to mandate that all policies cover such services and to incur the extra cost of covering them.  (Although we might also ask, if the market wants these services to be covered, why does the market not currently cover them?) The current debate, however, is focused rather superficially on whether the bill increases or decreases premiums, which misses the point that the product is changing as well.

Incidentally, let me mention the Democrats’ other point, which is that even though the bill increases premiums in the nongroup market overall, many people in this market will be eligible for government subsidies to help offset the additional cost.  So, while total premium will go up, total out of pocket cost (premium net of the subsidy) will go down for the majority of people in the nongroup market.  However, this point is a bit disingenuous as well, since these subsidies are coming from taxpayers somewhere.  So, while these individuals may be paying less for their premiums, the cost of the whole system is certainly increasing.

Last week I suggested that the road to improving health may be to keep people basically “in good health” for longer, and that one way to do this might be increased focus on preventive care through early- and late- middle age.  However, it is a stretch to go from “preventive care improves health” to “preventive care reduces the cost of health care.”  And, the latter point is one that more often comes up in the context of health reform.

The logic behind preventive care is straightforward.  By increasing screening you identify diseases at an earlier stage.  And, if diseases are identified before they become serious, they can be treated and/or managed at a lower overall cost than if the diseases are identified only later once they do become serious.

Sounds good.  So, what’s the problem?  The problem is that screening costs money.  And, you will screen many, many people in order to identify a small number who can benefit from early treatment.  Even though screening is relatively cheap, and the benefits for the small number of people are large, the sheer number of screens that must be done to convey this benefit to a small number of people can often make early screening for a population very costly relative to the benefit derived from it.

This leaves several possibilities with regard to preventive care.  One: the preventive measure lowers overall cost.  Two: the preventive measure increases cost, but the medical benefits associated with it justify the increased cost.  Three: the preventive measure increases overall cost without commensurate medical benefits.  There is widespread agreement that we should adopt measures of the first kind and avoid measures of the third kind.  In the frenzy to reduce the overall cost of the health care system, measures of the second kind are often overlooked.  If, compared to how we currently spend medical dollars, a particular treatment (whether it is preventive or not) has a ratio of health benefit to cost that is significantly larger than typical treatments in our current arsenal, then we should do more of the new treatment and less of the current ones.  Although we are understandably reluctant to increase the cost of care, the necessity of improving the quality of our health care implies that we should make changes of this sort whenever we identify them.

Enter a 2008 study entitled “Does Preventive Care Save Mondy? Health Economics and the Presidential Candidates,” by Joshua Cohen, Peter Neumann and Milton Weinstein that appeared in the New England Journal of Medicine that looks at the costs and benefits of preventive care.  The study finds that, in general, blanket statements about how preventive care can reduce cost are not justified.  Taken as a whole, there is a distribution of cost/effectiveness ratios for preventive care that looks a lot like the distribution of treatments for existing conditions.  In other words, preventive care in general is not superior to waiting for conditions to emerge and treating them only then.

While preventive care in general does not appear to be cost-saving, some particular treatments, such as flu vaccinations for toddlers and colonoscopies for men aged 60 – 64 do appear to reduce overall costs.  Other preventive measures, such as screening newborns for certain enzyme deficiencies and high-intensity programs to prevent former smokers from relapsing, have very high cost/effectiveness ratios (i.e., they are the second type of program above) and should probably be encouraged.

So, can preventive care save our health care system?  The short answer is no.  In a letter in response to an inquiry by the House Subcommittee on Health, the Congressional Budget Office argues that, “for most preventive services, expanded utilization leads to higher, not lower, medical spending overall.”  A particularly compelling example is the following:

[A] recent study conducted by researchers from the American Diabetes Association, the American Heart Association, and the American Cancer Society estimated the effects of achieving widespread use of several highly recommended preventive measures aimed at cardiovascular disease—such as monitoring blood pressure levels for diabetics and cholesterol levels for individuals at high risk of heart disease and using medications to reduce those levels.4 The researchers found that those steps would substantially reduce the projected number of heart attacks and strokes that occurred but would also increase total spending on medical care because the ultimate savings would offset only about 10 percent of the costs of the preventive services, on average. Of particular note, that study sought to capture both the costs and benefits of providing preventive care over a 30-year period.

So much for the silver bullet.

A member of Congress who wants to spend additional money often has to say what tax will be raised to pay for it.  Somebody else who wants a particular tax cut for their favorite lobbyist may have to say what other tax will be raised.  As a general principle, this kind of “budget neutrality” is often a good idea.  In all likelihood, the Tax Reform Act of 1986 only succeeded because it was revenue neutral.  It broadened the tax base and lowered tax rates, to fix the tax system without changing the amount collected.

But how is revenue neutrality calculated?  Politicians on both sides of the aisle call upon the non-partisan Congressional Budget Office (CBO) as the arbiter of budget balance.  If important policy choices must pass the CBO’s litmus test, then we need to understand what test is being administered.  According to its website, the “CBO’s [cost estimate] statement must also include an assessment of what funding is authorized in the bill to cover the costs of the mandates and, for intergovernmental mandates, an estimate of the appropriations needed to fund such authorizations for up to 10 years after the mandate is effective” (http://www.cbo.gov/CEBackground.shtml).  This CBO test has a few major problems that could limit the benefits from a policy, or even prevent enactment of a good policy.

First of all, not every act of Congress must be revenue neutral.  But policymakers may want the restriction of revenue neutrality, in order to “prove” they are fiscally responsible.  Recently, President Obama in his health care policy speech to a joint session of Congress promised that he “will not sign a plan that adds one dime to our deficits — either now or in the future.”  Thus, one general problem is: who decides which projects must be revenue neutral?

Second, of course, a project may generate revenue or cost savings after ten years.  President Obama’s health care reform has initial start up costs, but it may “bend” the long-run cost curve for federal expenditures on Medicare and Medicaid, so that cost savings accrue and accumulate over more than ten years.  In general, the CBO’s ten-year balance sheet could say that a policy adds to the debt over ten years, even though it may save taxpayer dollars in the long-run.  On Wednesday, September 16, 2009, the CBO released its official cost estimate for the Senate Finance Committee’s draft health care bill, stating that it would have a “net reduction in federal budget deficits of $49 billion over the 2010–2019 period” (http://cboblog.cbo.gov/?p=354).  However, an additional, unofficial estimate by the CBO concluded that the “the added revenues and cost savings are projected to grow more rapidly than the cost of the coverage expansion”, meaning that over a longer time horizon that the bill further reduces the deficits.

To be clear, the federal debt is a real concern.  Running massive deficits that pile up year after year is unsustainable and irresponsible.  But a strict CBO ten-year cost estimate test may not be the best way to evaluate a potential policy change.

A third problem is that any such test must be somewhat arbitrary, regarding what is counted as “revenue”.  Does it just count actual dollars flowing into government coffers?  What about features of a policy that reduce future outflows?  Some pieces of additional spending in proposed health care reforms are intended to improve future heath and thus to avoid the need for some future medical expenses.  The CBO would count current “preventive care” spending as a cost, but it may not count the fact that this current spending could reduce the need for Medicare and Medicaid to pay for some future medical procedures.

Fourth, and most importantly, even if NOT revenue-neutral, SOME policies are still valuable, important, and worthwhile.  A project may have generalized benefit to everybody in society that exceeds the actual social cost, meaning that it passes a benefit-cost test, even though it requires government spending and is not “revenue neutral”.

Any revenue-neutrality test is a way for policymakers to “tie themselves to the mast” and prevent them from pork spending of the most egregious sort.  Maybe that’s good and worthwhile.  But it may also mean we can’t have some other worthwhile policies either.