Why are health care costs rising?

Health expenditures ($2.3 trillion now) as a share of GDP have more than tripled over the last half century. It has been argued that this is primarily a consequence of rising real per capita income, which more than doubled over the same period. Further, the rapid technological advances in recent years have dramatically enabled extending life spans of those with chronic diseases and treating hitherto fatal conditions. A US Congressional Budget Office (CBO) study in 2007 found that "the most important factor contributing to the growth of healthcare spending in recent decades has been the emergence, adoption, and wide diffusion of new medical technologies and services".



Do rising incomes lead people to demand more health care and therefore greater expenditures on health care? If not, what are the reasons for the steep rise in health care expenditures? This post will scan the literature to examine the various explanations for the rising health care costs.

Greg Mankiw links to two articles by Robert Fogel and James V DeLong, both of whom claim that the rising health care costs are a reflection of the changes in the incomes of Americans and the dramatic improvements in health care technologies and treatments over the years. Both of them are inclined to the view that the increased costs, on the balance, does deliver increased value in terms of treatments, saving and extending lives. Alluding to this, Prof Fogel writes,

"Medical interventions have not only contributed to the decline in prevalence rates of chronic conditions but also to the reduction in their severity. Advances in both surgical and drug therapies have significantly reduced the rate at which chronic conditions turn into disabilities that severely impair functioning. Such interventions have been especially effective in genitourinary, circulatory, digestive, and musculoskeletal conditions. However, many of the surgical procedures are quite expensive, and the cost of the new and more effective drugs is increasing sharply, mainly because of the large investments in developing these drugs."

He also draws attention to the steep increase in health care costs with age and its increasing relevance in view of the increasing life expectancy and the ability of modern medicine to prolong lives of people with chronic illness. The age specific relevance of health care assumes significance since the "severity of the conditions increases or because the cost of preventing further deterioration (or even partially reversing deterioration) increases with age".



The graphic below of health care costs of all persons above the age of 65 shows that five years before the year of death, annual health costs is the same as all annual Medicare costs per capita. But in the second year before death, the cost has risen by about 60 percent, and in the year of death the annual cost exceeds the average by more than four times. Indeed, expenditure on persons during their last two years of life account for 40 percent of all Medicare expenditures. He therefore writes that the "healthcare costs may continue to increase even if the age of onset of chronic diseases is delayed, because the proportion of a cohort living to late ages will increase. Moreover, the cost of keeping disabilities under control may rise because more effective drugs and procedures may be more expensive than the current set."



Pointing to the long-term income elasticity of the demand for healthcare of 1.6 (for every 1 percent increase in a family’s income, the family wants to increase its expenditures on healthcare by 1.6 percent), Prof Fogel writes,

"Expenditures on healthcare are driven by demand, which is spurred by income and by advances in biotechnology that make health interventions increasingly effective. Just as electricity and manufacturing were the industries that stimulated the growth of the rest of the economy at the beginning of the 20th century, healthcare is the growth industry of the 21st century. It is a leading sector, which means that expenditures on healthcare will pull forward a wide array of other industries including manufacturing, education, financial services, communications, and construction."

James DeLong writes that "the state of healthcare technology has improved to the point where it is delivering steadily increasing value for the money, and that as people meet more basic wants of food and shelter they move up the chain of desires and spend more on other things". He feels that the proposed health care reforms, by focussing on cutting costs, will only stifle innovation and harm the long term interests of the country and its future generations.

About those who are sceptical with the positive co-relationship claim, Mankiw again links to the works of Daron Acemoglu and Amy Finkelstein. Amy Finkelstein has, in the context of Medicare, traced the dramatic rise in health care's share of GDP to the spread of health insurance. She writes,

"I estimate that the impact of Medicare on hospital spending is over six times larger than what the evidence from individual-level changes in health insurance would have predicted. This disproportionately larger effect may arise if market-wide changes in demand alter the incentives of hospitals to incur the fixed costs of entering the market or of adopting new practice styles... A back of the envelope calculation based on the estimated impact of Medicare suggests that the overall spread of health insurance between 1950 and 1990 may be able to explain about half of the increase in real per capita health spending over this time period."

Amy Finkelstein, Daron Acemoglu and Matt Notowidigdo have a paper which looked at the relationship between income and health care spending, whose findings suggest that "rising income cannot explain much of the rising share of GDP devoted to health spending (In other words, we do not find evidence of an elasticity of health spending with respect to income that is greater than one)". We think that the "assumed" relationship that health-care share of GDP should rise automatically as incomes rise is on much shakier grounds than most people realize." Examining the local-area incomes, time-series variation in global oil prices, and the variations in oil reserves across different areas of the South of US between 1970 and 1990, they write,

"Our central estimate is an income elasticity of 0.7, with an elasticity of 1.1 as the upper end of the 95 percent confidence interval. Point estimates from alternative specifications fall on both sides of our central estimate, but are almost always less than 1. We also present evidence suggesting that there are unlikely to be substantial national or global general equilibrium effects of rising income on health spending, for example through induced innovation. Our overall reading of the evidence is that rising income is unlikely to be a major driver of the rising health share of GDP."

Mankiw also raises the possibility that health care spending has increased due to an expansion in the range of products available to the consumer due to exogenous (not driven primarily by the incentives determined by the health insurance system) technological change. He writes, "As doctors figure out new and better ways to prolong and enhance life, we may rationally choose to buy these products. It might be tempting to view this effect as a large income elasticity, for the technological change raises real incomes as well as healthcare spending."

Another reason for the rising health care costs may be the ubiquituous junk food industry and the "medical costs of (that) diet". It is claimed that higher spending for obese patients is mainly attributable to treatment for diabetes and hypertension. It has been estimated that Americans are spending $147 billion to treat obesity, $116 billion to treat diabetes, and hundreds of billions more to treat cardiovascular disease and the many types of cancer that have been linked to the so-called Western diet.

One recent study estimated that 30 percent of the increase in health care spending over the past 20 years could be attributed to the soaring rate of obesity, a condition that now accounts for nearly a tenth of all spending on health care. Calling for reforms to the American food system, Michael Pollan writes,

"There’s lots of money to be made selling fast food and then treating the diseases that fast food causes. One of the leading products of the American food industry has become patients for the American health care industry... the health care industry finds it more profitable to treat chronic diseases than to prevent them. There’s more money in amputating the limbs of diabetics than in counseling them on diet and exercise."

Any health insurance reform that promises universal health insurance, obligates insurers to take everyone at the same rates, provide a standard level of coverage and keep people on their rolls regardless of their pre-existing health conditions, would go a long way towards remedying the distortions in incentives between health insurers and the food industry. The former will soon realize that their profits lie in keeping the health care costs on their customers to a minimum, which in turn implies, among other things, greater attention to hitherto marginalized preventive care. Health insurers will have a strong incentive to reduce the chronic diseases and various health care risks associated with diet and lifestyle. This will rally the powerful health care industry to join the chorus against the agribusiness and food industry and the need for reforming the food system.