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The Making of the American Health Care System

Posted Sep 03 2009 4:00am

The USS Arizona (BB-39) burning after the Japa... Image via Wikipedia

A colleague gave this to me to post anonymously.

October 26, 1943: Healthcare’s Pearl Harbor

Unlike that actual Pearl Harbor attack on Dec. 7, 1941, the health care Pearl Harbor which occurred two years later did not make headlines, was not addressed by President Roosevelt in a joint session of Congress and did not result in massive death and destruction. Indeed, there were probably only a small handful of people who were even aware that some happened on October 26 that affected health care.

But like Pearl Harbor, the events of October 26, 1943, were cataclysmic. They changed, fundamentally, irrevocably and for the worse, the trajectory of the health care system for the next 66 years (and counting). To understand the events of that day we have to back up a few years to beginning of WW II. Within months of our entry into WW II the size or our armed forces swelled from a few hundred thousand to many millions, eventually peaking at 16 million men and women in uniform. Almost all of these 16 million were taken from the existing workforce. This resulted in very severe manpower shortages in industry. As well, the Defense Department (known then as the War Department) consumed huge quantities of natural resources (rubber, iron, coal, gas, etc.). These manpower and resource shortages necessitated the implementation of wage and price controls for the duration of the war.

Private sector industries were desperate for workers but were prohibited from offering high wages to attract them. They were permitted to offer some benefits, health insurance among them, without violating the wage and price rules. It’s worth recalling the state of health insurance (and health care itself) at this time in history. Health insurance in 1941 was an anomaly. Both the Kaiser system and the Blue Cross systems were developed in the 1930s, but these touched very few lives. Overall, more than 95% of the population was uninsured. In 1941 health care expenditures accounted for less than 2.5% of GDP as compared to 17.6% of GDP today. But this data point doesn’t even begin to describe the minimal state of health care at the time. Today we spend $8,300 per capita on health care. In 1941 we spent, in 2009 dollars, $325 per capita on health care. (I spent twice that much last week in one dental appointment.) As compared to the health care industrial complex of today, the health care system was a cottage industry in 1941.

In any case, the wartime health insurance benefit did become a popular and effective means of attracting workers. And then came October 26, 1943. On that date the question was answered: Are employer-based health insurance benefits taxable as income? Until that day there was no answer to this question. Mostly companies offering health insurance did not report this as income, but some did. All these companies wanted a clarification from the IRS.

It is not recorded whether there was any political debate on this question. Were there advocates (perhaps the insurance companies) of tax-free health insurance? We don’t know. Were there opponents of such (perhaps budget-conscious Congressmen)? We have no idea. Were there any discussions of the possible implications of this ruling on our health care system? It’s very unlikely. Certainly given the state of our health care system at that time no one would have thought to utter the phrase, “We have to get our health care spending under control.” This would have been nonsensical. If there was any active consideration of this policy it surely would have been something like, “Health insurance? More people having health insurance is a good thing. Let’s leave it alone.” Or something like that. So, on October 26, 1943, a person, panel, of committee who to this day is unknown and un-named, ruled that employer-provided health insurance is not taxable income. And the rest is history. (In 1954 an act of Congress finally ratified and made permanent this IRS ruling.) Before detailing the mostly deleterious effects of this event, lets’ quickly recount the trajectory of the health care system over the next few generations.

As millions of servicemen and women were demobilized and returned to the civilian workforce the concept of the health insurance benefit had reached a critical mass. In the heavily unionized industries the addition of a health insurance benefit became one the most sought-after benefits of collective bargaining. And in the professional and managerial classes the offering of a health insurance benefit continued to be useful recruiting tool. In 1941 there were fewer than 5 million people in the US who had some sort of medical/hospital insurance. By 1950 that had grown to over 100 million, most of this based on employer-provided insurance. (Interestingly, individually purchased health insurance also increased rapidly during this period and peaked in about 1970 and thereafter steadily shrank as a mode of health insurance purchase.)
Along with this revolution in health care funding came a revolution in health care itself. In 1941 Sulfa drugs were just being introduced. Penicillin and other antibiotics were still several years away from practical use. Insulin to treat diabetes had been in regular use for several at this point and you did have a good chance of surviving appendicitis surgery and basic obstetrical care was probably doing some good as well. And if you had a serious cut or laceration could stitch you up and hopefully avoid infection. But that was about it. Even with the best health insurance plan in existence it would still have been very difficult to find much to spend health care dollars on. And then everything changed. Without belaboring the point there was an explosion of health care technology: New antibiotics, new steroids, new psychoactive drugs, heart surgery, transplant surgery, chemotherapy, radiation therapy (not entirely new), CT, MRI, PET scans, Gamma knives, stents, implants, new hips, news knees, new lenses, cochlear implants…the list goes on and on. (It is another story whether or not all of these advances are in fact advances, but that’s a different story.)

All of this increased health care purchasing power and expansion of medical technology obviously dramatically increased the demand for services and it quickly became clear that our health care infrastructure was inadequate to service this demand. Multiple pieces of legislation were enacted to correct this. Most notably the Hill-Burton act of 1946 provided funding for the construction of new hospital facilities. The goal was to achieve a density of 4.5 hospital beds per 1,000 in all locales of the country. Many other pieces of legislation during this post-war period subsidized and expanded the health care infra-structure including a dramatic expansion of the health care workforce.
Thus there were three forces that drove health care from being a cottage industry to being a Mega-industry:
  • Increased health care purchasing power
  • Increased health care technology
  • Expanded health care infra-structure
Collectively these three forces have produced a 25-fold increase in per-capita health care spending since WW II. The principle engine that drives this explosion of health care spending is employer-based health insurance.

Which brings us finally to the issue of why the October 26, 1943 tax ruling has been so damaging to our health care system
1. It has tied health insurance to employment.
One thing that everyone hates about our health care system is that for most people the only practical way to secure health insurance is through one’s employer. The tax advantage offered by this mode of insurance makes other options impractical or unavailable. And so our health insurance is only as secure as our job and we end up making career decisions based on the effect if will have on our health insurance status. All of this is a stupid, inefficient and arbitrary way to organize both our health care system and our workforce.

2. It has subsidized the purchase of health insurance.
In 1943 the idea of subsidizing the purchase of health insurance probably seemed like a pretty good idea. It could hardly be said at the time that we were over-insured. But over the decades those of us who do have employer-based health insurance are typically over-insured. When it is possible to buy $1 dollars worth of insurance for $0.75 (which is the effect of the tax subsidy) we will rationally choose to buy more health insurance that would otherwise be the case. When health insurance was still in its formative years (1945-1965) most insured people had what as called “major medical” insurance, that is, catastrophic insurance. But over time this has become the exception rather than the rule and the insurance subsidy has resulting increasingly lavish and comprehensive insurance policies. The idea of insuring against large and unforeseen health care expenditures has been replaced by the idea of insuring against routine and predictable health care costs.

3. It has separated the purchaser (patient) and seller (doctor, hospital) from the cost implications of health care.
In 1965 a threshold was passed: more than half of all health care expenditures were paid by third parties. Prior to the health insurance revolution most health care was paid for as you would pay for anything else—out of pocket. And since 1965 the percentage paid by third parties has continued to rise and has now leveled-off at about 80%. No other sector of our economy is characterized by such a triad (buyer, seller, payer). In this triad the buyer is essentially indifferent to cost and provides no brake on utilization or price. The seller is of course is incentivized to increase price utilization and finds little resistance from the buyer. And the payer tries vainly, and to no one’s satisfaction, to apply some brakes to the system. The buyer’s indifference to cost is further manifested by their indifference to the cost of health insurance itself. The perception on the part of the employee is that their company’s health benefit is “free” or most free depending upon their contribution. In fact the cost of employer provided health care is 100% paid for by employees in the form of lower wages. But this fact is not visible and in fact believed by most even when they are apprised of this fact. (It must be noted that economists have extensively studied this question and there is no disagreement on this issue.) Being indifferent to the cost of insurance employees are only interested in expanding the benefit as much as possible in the mistaken belief that it is free to them and this of course further exacerbates the problem of over-insurance.

4. It has artificially increased the demand for health care services.
In 2009 over 100 million advanced imaging studies (CT/MRI) will be performed in the US. One in four Americans will have an imaging study of some sort, some of them, multiple studies. No, not all of them are unnecessary. I imagine there are several million people who will benefit from these studies. But most of these 75 million imagees (is that a word?) will not benefit and the fact that they will not is entirely understood and predictable. This excess (and the excesses of every other procedure, device, drug that is a part of our health care system) is only possible through the artificially pumped-pumped up demand created by subsidized employer sponsored health insurance.

5. It has crowed out other forms of health insurance.
If one is employed and if one’s employer offers a health insurance benefit, it would be economically irrational to forgo this benefit and attempt to buy an individual policy with after-tax dollars. There is no possibility of getting as much for your money as you would with your employer’s plan. And so no one acts in this manner and thus the individual and small group insurance market is atrophied and inefficient. To be sure, without the tax incentive, employer-based health insurance would still be a viable option. We do, after all, sometimes get life insurance and disability insurance through our employers without the inducement of tax subsidies. And employer-based health insurance is an effective way to pool risk. But an efficient and effective insurance market needs more than just one viable and practical option.

6. It has ultimately resulted in a positive feedback loop of cost escalation.
And so, for the past 67 years we have been caught in an ever accelerating positive feedback loop of health care cost increases. As medical technology and infrastructure expand the need to fund this expansion drives up the cost and the need for health insurance. An anxious public is frightened to death at the prospect of paying for the scan, the surgery, the drugs and this public makes clear to the employers that their health insurance benefit must keep pace with these costs. The employers oblige as best they can and continue to fund premiums which tend to increase at about twice the rate of underlying inflation. And the next round of technology and price increases is thus funded and the process continues. Thus, we spend 17.6% of our incomes on health care, soon to break the 20% barrier.

It would be a vast oversimplification and simply wrong to suggest that all of our health care woes are caused by tax-subsidized, employer-based health insurance. But it is not wrong or an oversimplification to suggest that this is the single biggest factor driving the inefficiencies of our system. And it is, frankly, an easy problem to fix. But it appears that we won’t get this fix. Instead we are being to treated 1000+ page health legislation which will not become law in any case. Let me offer a 39-word health care reform bill that just might do the trick:
The Commissioner of the IRS shall revise the tax code such that from 2010 to 2015 the portion of employer-based health insurance benefits that is treated as taxable income shall increase in a linear fashion from 0% to 100%.
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