“Two simple observations are key to explaining both the high level of spending on medical care and the dissatisfaction with that spending. The first is that most payments to physicians or hospitals or other caregivers for medical care are made not by the patient but by a third party—an insurance company or employer or governmental body. The second is that nobody spends somebody else’s money as wisely or as frugally as he spends his own. These statements apply equally to other OECD countries. They do not by themselves explain why the United States spends so much more than other countries.
No third party is involved when we shop at a supermarket. We pay the supermarket clerk directly: the same for gasoline for our car, clothes for our back, and so on down the line. Why, by contrast, are most medical payments made by third parties? The answer for the United States begins with the fact that medical care expenditures are exempt from the income tax if, and only if, medical care is provided by the employer. If an employee pays directly for medical care, the expenditure comes out of the employee’s after-tax income. If the employer pays for the employee’s medical care, the expenditure is treated as a tax-deductible expense for the employer and is not included as part of the employee’s income subject to income tax. That strong incentive explains why most consumers get their medical care through their employers or their spouses’ or their parents’ employer. In the next place, the enactment of Medicare and Medicaid in 1965 made the government a third-party payer for persons and medical care covered by those measures.
We are headed toward completely socialized medicine—and, if we take indirect tax subsidies into account, we’re already halfway there.
We have become so accustomed to employer-provided medical care that we regard it as part of the natural order. Yet it is thoroughly illogical. Why single out medical care? Food is more essential to life than medical care. Why not exempt the cost of food from taxes if provided by the employer? Why not return to the much-reviled company store when workers were in effect paid in kind rather than in cash?
The revival of the company store for medicine has less to do with logic than pure chance. It is a wonderful example of how one bad government policy leads to another. During World War II, the government financed much wartime spending by printing money while, at the same time, imposing wage and price controls. The resulting repressed inflation produced shortages of many goods and services, including labor. Firms competing to acquire labor at government-controlled wages started to offer medical care as a fringe benefit. That benefit proved particularly attractive to workers and spread rapidly.
Initially, employers did not report the value of the fringe benefit to the Internal Revenue Service as part of their workers’ wages. It took some time before the IRS realized what was going on. When it did, it issued regulations requiring employers to include the value of medical care as part of reported employees’ wages. By this time, workers had become accustomed to the tax exemption of that particular fringe benefit and made a big fuss. Congress responded by legislating that medical care provided by employers should be tax-exempt.”
Milton Friedman, “How to Cure Health Care”, Hoover Digest (2001).
http://www.hoover.org/publications/digest/3459466.html
Milton Friedman (1912-2006) was for many years Professor of Economics at the University of Chicago. In the academic arena, Friedman was best known for his theoretical and empirical research on consumption, monetary theory and history, and the complexity of fiscal policy. He received the Nobel Memorial Prize in Economics in 1976. In the political arena, he was best known for his advocacy for minimizing the role of government in favor of the private sector.
Friedman here makes two main points: First, that third party payment for health care services separates payment for health care services from the person who receives the service, and in doing so encourages the overuse of health care services; and Second, along the same lines, employer-provided health care insurance receives a tax subsidy, and by doing so it subsidizes the cost of health care, further leading to its overuse. Given these conditions, it should not be surprising that the demand for health care in the U.S. is high and the share of the health care industry in the economy is large.
Needless to say, the health care proposals now being discussed in Congress further extend the third party payment system far beyond its present scope and subsidize health care for many more millions of Americans. For this reason, one cannot expect these plans will limit either the share of health care in the economy or the continued rise in health care costs.
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