A large part of the welfare state, in both the United States and other wealthy countries, is devoted to paying for health care. In most wealthy countries, the government pays between 70% and 80% of all medical costs. The private sector plays a larger role in the U.S. health care system. Yet even in America, as of 2013 the government pays almost half of all health care costs; furthermore, it indirectly subsidizes private health insurance through the federal tax code.

Figure 18-5 shows who paid for U.S. health care in 2012. Only 14% of health care consumption spending (that is, all spending on health care except investment in health care buildings and facilities) was expenses “out of pocket”—that is, paid directly by individuals. Most health care spending, 77%, was paid for by some kind of insurance. Of this 77%, considerably less than half was private insurance; the rest was some kind of government insurance, mainly Medicare and Medicaid. To understand why, we need to examine the special economics of health care.

In 2012, U.S. personal health care expenses were $8,915 per person—17.2% of gross domestic product. This did not, however, mean that the typical American spent nearly $9,000 on medical treatment. In fact, in any given year half the population incurs only minor medical expenses. But a small percentage of the population faces huge medical bills, with 10% of the population typically accounting for almost two-thirds of medical costs.

Is it possible to predict who will have high medical costs? To a limited extent, yes: there are broad patterns to illness. For example, the elderly are more likely to need expensive surgery and/or drugs than the young. But the fact is that anyone can suddenly find himself or herself needing very expensive medical treatment, costing many thousands of dollars in a very short time—far beyond what most families can easily afford. Yet nobody wants to be unable to afford such treatment if it becomes necessary.

Private Health Insurance Market economies have an answer to this problem: health insurance. Under private health insurance, each member of a large pool of individuals agrees to pay a fixed amount annually (called a premium) into a common fund that is managed by a private company, which then pays most of the medical expenses of the pool’s members. Although members must pay fees even in years in which they don’t have large medical expenses, they benefit from the reduction in risk: if they do turn out to have high medical costs, the pool will take care of those expenses.

There are, however, inherent problems with the market for private health insurance. These problems arise from the fact that medical expenses, although basically unpredictable, aren’t completely unpredictable. That is, people often have some idea whether or not they are likely to face large medical bills over the next few years. This creates a serious problem for private health insurance companies.

Suppose that an insurance company offers a “one-size-fits-all” health care policy, under which customers pay an annual premium equal to the average American’s annual medical expenses, plus a bit more to cover the company’s operating expenses and a normal rate of profit. In return, the insurance company pays the policyholder’s medical bills, whatever they are.

If all potential customers had an equal risk of incurring high medical expenses for the year, this might be a workable business proposition. In reality, however, people often have very different risks of facing high medical expenses—and, crucially, they often know this ahead of time. This reality would quickly undermine any attempt by an insurance company to offer one-size-fits-all health insurance. The policy would be a bad deal for healthy people, who don’t face a significant risk of high medical bills: on average, they would pay much more in insurance premiums than the cost of their actual medical bills. But it would be a very good deal for people with chronic, costly conditions, who would on average pay less in premiums than the cost of their care.

As a result, some healthy people are likely to take their chances and go without insurance. This would make the insurance company’s average customer less healthy than the average American. This raises the medical bills the company will have to pay and raises the company’s costs per customer. That is, the insurance company would face a problem called adverse selection, which is discussed in detail in Chapter 20. Because of adverse selection, a company that offers health insurance to everyone at a price reflecting average medical costs of the general population, and that gives people the freedom to decline coverage, would find itself losing a lot of money.

The insurance company could respond by charging more—raising its premium to reflect the higher-than-average medical bills of its customers. But this would drive off even more healthy people, leaving the company with an even sicker, higher-cost clientele, forcing it to raise the premium even more, driving off even more healthy people, and so on. This phenomenon is known as the adverse selection death spiral, which ultimately leads the health insurance company to fail.

This description of the problems with health insurance might lead you to believe that private health insurance can’t work. In fact, however, most Americans are covered by private health insurance. Insurance companies are able, to some extent, to overcome the problem of adverse selection two ways: by carefully screening people who apply for coverage and through employment-based health insurance. With screening, people who are likely to have high medical expenses are charged higher-than-average premiums—or in many cases, insurance companies refuse to cover them at all. The problem that screening creates is that those people who need health insurance the most are more likely to be denied coverage or charged an unaffordable price. This is yet another reason behind the support for passage of the ACA, which expanded coverage to everyone regardless of their health history. The next section explains how employment-based health insurance, a unique feature of the American workplace, also allows private health insurance to work.

Employment-Based Health Insurance One way insurers have overcome adverse selection is by selling insurance indirectly, to peoples’ employers rather than to individuals. The big advantage of employment-based health insurance— insurance that a company provides to its employees—is that these employees are likely to contain a representative mix of healthy and less healthy people, rather than a group of people who want insurance because they expect to pay high medical bills. This is especially true if the employer is a large company with thousands or tens of thousands of workers. Employers require their employees to participate in the company health insurance plan because allowing employees to opt out (which healthier ones will be tempted to do) raises the cost of providing insurance for everyone else.

There’s another reason employment-based insurance is widespread in the United States: it gets special, favorable tax treatment. Workers pay taxes on their paychecks, but workers who receive health insurance from their employers don’t pay taxes on the value of the benefit. So employment-based health insurance is, in effect, subsidized by the U.S. tax system. Economists estimate the value of this subsidy at about $150 billion each year.

In spite of this subsidy, however, many working Americans don’t receive employment-based health insurance. Those who aren’t covered include most older Americans, because relatively few employers offer workers insurance that continues after they retire; the many workers whose employers don’t offer coverage (especially part-time workers); and the unemployed.

Table 18-6 shows the breakdown of health insurance coverage across the U.S. population in 2013. A majority of Americans, nearly 170 million people, received health insurance through their employers. The majority of those who didn’t have private insurance were covered by two government programs, Medicare and Medicaid. (The numbers don’t add up because some people have more than one form of coverage. For example, many recipients of Medicare also have supplemental coverage either through Medicaid or private policies.)

Medicare, financed by payroll taxes, is available to all Americans 65 and older, regardless of their income and wealth. It began in 1966 as a program to cover the cost of hospitalization but has since been expanded to cover a number of other medical expenses. You can get an idea of how much difference Medicare makes to the finances of elderly Americans by comparing the median income per person of Americans 65 and older—$21,238—with average annual Medicare payments per recipient, which were more than $10,000 in 2013. As with health care spending in general, however, the average can be misleading: in a given year, about 7% of Medicare recipients account for 50% of the costs.

At the beginning of 2006, there was a major expansion of Medicare to cover the cost of prescription drugs. At the time Medicare was created, drugs played a relatively minor role in medicine and were rarely a major expense for patients. Today, however, many health problems, especially among the elderly, are treated with expensive drugs that must be taken for years on end, placing severe strains on some people’s finances. As a result, a new Medicare program, known as Part D, was created to help pay these expenses.

Unlike Medicare, Medicaid is a means-tested program, paid for with federal and state government revenues. There’s no simple way to summarize the criteria for eligibility because it is partly paid for by state governments and each state sets its own rules. Of the nearly 51 million Americans covered by Medicaid in 2013, 26 million were children under 18 and many of the rest were parents of children under 18. Most of the cost of Medicaid, however, is accounted for by a small number of older Americans, especially those needing long-term care.

Nearly 14 million Americans receive health insurance as a consequence of military service. Unlike Medicare and Medicaid, which pay medical bills but don’t deliver health care directly, the Veterans Health Administration, which has more than 8 million clients, runs hospitals and clinics around the country.

The U.S. health care system, then, offers a mix of private insurance, mainly from employers, and public insurance of various forms. Most Americans have health insurance either from private insurance companies or through various forms of government insurance. Yet in 2012, before the implementation of the Affordable Care Act, almost 48 million, or 15.4% of the population, had no health insurance at all. What accounted for the high number of uninsured? And why was it such a severe problem that it spurred the passage of the Affordable Care Act?

Before the passage of the ACA, the Kaiser Family Foundation, an independent nonpartisan group that studies health care issues, offered a succinct summary of who was uninsured in America: “The uninsured are largely low-income adult workers for whom coverage is unaffordable or unavailable.” The reason the uninsured were primarily adults is that Medicaid, supplemented by SCHIP (which provides health care for children in families that are above the poverty threshold but still have relatively low income), covers many, though not all, low-income children but is much less likely to provide coverage to adults, especially if they didn’t have children.

Low-income workers tended to be uninsured for two reasons: they were less likely than workers with higher income to have jobs that provided health insurance benefits, and they were less likely to be able to afford to directly purchase health insurance themselves. Finally, before the ACA, insurance companies frequently refused to cover people, regardless of their income, if they had a preexisting medical condition or something in their medical history suggesting that they were likely to need expensive medical treatment at some future date. As a result, a significant number of Americans with incomes that most would consider middle class could not get insurance.

It’s important to realize that lack of insurance was not simply due to poverty. Before the ACA, most of the uninsured had incomes above the poverty threshold, and 35% had incomes more than twice the poverty threshold. We should also note that some of the uninsured were people who could afford insurance but preferred to save money and take their chances.

Like poverty, lack of health insurance has severe consequences, both medical and financial. On the medical side, the uninsured frequently have limited access to health care. Figure 18-6 summarizes some of the common problems associated with access to care, all of which are much worse for the uninsured than for the insured. On the monetary side, those who are uninsured often face serious financial problems when illness strikes. In many cases those without insurance are five times more likely than those with health insurance to be contacted by collection agencies, deplete their savings paying for medical expenses, or not pay altogether.

Health care is one area in which the United States is very different from other wealthy countries, including both European nations and Canada. In fact, we’re distinctive in three ways. First, we rely much more on private health insurance than any other wealthy country. Second, we spend much more on health care per person. Third, we were the only wealthy nation in which large numbers of people lacked health insurance until the ACA started to change that.

Table 18-7 compares the United States with three other wealthy countries: Canada, France, and Britain. The United States is the only one of the four countries that relies on private health insurance to cover most people; as a result, it’s the only one in which private spending on health care is (slightly) larger than public spending on health care. (This will not change under the ACA as most health insurance will continue to be provided by private insurers.)

Canada has a single-payer system: a health care system in which the government acts as the principal payer of medical bills funded through taxes. For comparison, Medicare is essentially a single-payer system for older Americans—and the Canadian system is, in fact, called Medicare. The British system is like the American Veterans Health Administration, extended to everyone: a government agency, the British National Health Service, employs health care workers and runs hospitals and clinics that are available free of charge to the public. France is somewhere in between the Canadian and British systems. In France, the government acts as a single-payer, providing health insurance to everyone, and French citizens can receive treatment from private doctors and hospitals. But they also have the choice of receiving care from a sizable health care system run directly by the French government.

Canada, Britain, and France provide health insurance to all their citizens; the United States does not. Yet all three spend much less on health care per person than we do. Many Americans assume this must mean that foreign health care is inferior in quality. But many health care experts disagree with the claim that the health care systems of other wealthy countries deliver poor-quality care. As they point out, Britain, Canada, and France generally match or exceed the United States in terms of many measures of health care provision, such as the number of doctors, nurses, and hospital beds per 100,000 people. It’s true that U.S. medical care includes more advanced technology in some areas and many more expensive surgical procedures. U.S. patients also have shorter waiting times for elective surgery than patients in Canada or Britain. France, however, also has very short waiting times.

Surveys of patients seem to suggest that there are no significant differences in the quality of care received by patients in Canada, Europe, and the United States. And as Table 18-7 shows, the United States does considerably worse than other advanced countries in terms of basic measures such as life expectancy and infant mortality, although our poor performance on these measures may have causes other than the quality of medical care—notably our relatively high levels of poverty and income inequality.

So why does the United States spend so much more on health care than other wealthy countries? Some of the disparity is the result of higher doctors’ salaries, but most studies suggest that this is a secondary factor. One possibility is that Americans are getting better care than their counterparts abroad, but in ways that don’t show up in either surveys of patient experiences or statistics on health performance.

However, the most likely explanation is that the U.S. system suffers from serious inefficiencies that other countries manage to avoid. Critics of the U.S. system emphasize the fact that our system’s reliance on private insurance companies makes it highly fragmented, as individual insurance companies each expend resources on overhead and on such activities as marketing and trying to identify and weed out high-risk patients, leads to high operating costs. On average, the operating costs of private health insurers consume 14% of the premiums clients pay, leaving only 86% to spend on providing health care.

By contrast, Medicare spends only 3% of its funds on operating costs, leaving 97% to spend on health care. A study by the McKinsey Global Institute found that the United States spends almost six times as much per person on health care administration as other wealthy countries. Americans also pay higher prices for prescription drugs because, in other countries, government agencies bargain with pharmaceutical companies to get lower drug prices.

However one rates the past performance of the U.S. health care system, by 2009 it was clearly in trouble, on two fronts.

First, a growing number of working-age Americans were uninsured. Coverage of children improved between 1999 and 2009, largely thanks to an expansion of a government program associated with Medicaid, the Children’s Health Insurance Program, and seniors were covered by Medicare. But as Figure 18-7 shows, the percentage of working age Americans (considered to be those between the ages of 18 and 64) without insurance was on a clear upward trend even before the severe economic downturn of 2007–2009.

Lying behind the growing number of uninsured, in turn, were sharply rising premiums for health insurance, reflecting rapid growth in overall health care costs. Figure 18-8 shows overall U.S. spending on health care as a percentage of GDP, a measure of the nation’s total income, since the 1960s. As you can see, health spending has tripled as a share of income since 1965; this increase in spending explains why health insurance has become more expensive. Similar trends can be observed in other countries.

Why was health spending rising? The consensus of health experts is that it’s a result of medical progress. As medical science progresses, conditions that could not be treated in the past become treatable—but often only at great expense. Both private insurers and government programs feel compelled to cover the new procedures—but this means higher costs, which either have to be passed on in the form of higher insurance premiums or require larger commitments of taxpayer funds.

The combination of a rising number of uninsured and rising costs led to many calls for health care reform in the United States. And so in 2010 Congress passed the Affordable Care Act (ACA) which took full effect in 2014. It was the largest expansion of the American welfare state since the creation of Medicare and Medicaid in 1965. It had two major objectives: covering the uninsured and cost control. Let’s look at each in turn.

Covering the Uninsured On the coverage side, the ACA closely follows a model that has been successfully used in Massachusetts since 2006 (introduced under Republican governor at the time, Mitt Romney). To understand the logic of both the Massachusetts plan and the ACA, consider the problem facing one major category of uninsured Americans: the many people who seek coverage in the individual insurance market but are turned down because they have preexisting medical conditions, which insurance companies fear could lead to large future expenses. (Insurance companies were known to deny coverage for even minor ailments, like allergies or a rash you had in college.) How could insurance be made available to such people?

One answer would be regulations requiring that insurance companies offer the same policies to everyone, regardless of medical history—a rule known as “community rating.” In fact, a number of states have such a rule. But community rating tends to lead to an adverse selection death spiral: Healthy individuals don’t buy insurance until or unless they get sick, and because only people with health problems are getting coverage, insurance becomes very expensive.

To make community rating work, it’s necessary to supplement it with other policies. Both the Massachusetts reform and the ACA add two key features. First is the requirement that everyone purchase health insurance—known as the individual mandate. This prevents an adverse selection death spiral. Second, government subsidies make the required insurance affordable for lower- and lower-middle income families.

It’s important to realize that this system is like a three-legged stool: all three components must be present in order for it to work. Take away community rating, and those with preexisting conditions won’t get coverage. Take away the individual mandate, and community rating will produce an adverse selection death spiral. And you can’t require that people buy insurance without providing subsidies to those with lower incomes.

Will this arrangement, once fully implemented, succeed in covering more or less everyone? The Massachusetts precedent is encouraging on that front: by 2012, more than 96% of the state’s residents had health insurance and virtually all children were covered. Since the ACA is very similar in structure, it ought to produce similar results.

Cost Control But will the ACA control costs? In itself, the expansion of coverage will raise health care spending, although not by as much as you might think. The uninsured are by and large relatively young, and the young have relatively low health care costs. (The elderly are already covered by Medicare.) The question is whether the reform can succeed in “bending the curve”—reducing the rate of growth of health costs over time.

The ACA’s promise to control costs starts from the premise that the U.S. medical system, as currently constituted, has skewed incentives that waste resources. Because most care is paid for by insurance, neither doctors nor patients have an incentive to worry about costs. In fact, because health care providers are generally paid for each procedure they perform, there’s a financial incentive to provide additional care—do more tests and, in some cases, perform more operations—even when there are little or no medical benefits.

The bill attempts to correct these skewed incentives in a variety of ways, from stricter oversight of reimbursements, to linking payments to a procedure’s medical value, to paying health care providers for improved health outcomes rather than the number of procedures, and by limiting the tax deductibility of employment-based plans. Even supporters of the reform admit that nobody knows how well any one of these measures will work, but they point out that ACA incorporates virtually every idea for cost control that has been proposed by health care economists and that some of these ideas are likely to be highly successful.

The ACA’s launch As you might gather, the ACA sets up an insurance system considerably more complex than other government programs like Medicare and Medicaid, which simply provide insurance directly. The ACA sets up special online marketplaces, the “exchanges,” in which insurance companies offer policies from which individuals must choose. To figure out how much these policies really cost, it’s necessary to calculate the subsidy you receive, which depends on your income as well as the premium. Making all of that work is a difficult programming problem. And sure enough, when healthcare.gov, the federally run online exchange, started up in October 2013, the system crashed repeatedly. For the next two months few people managed to sign up.

This was, however, a problem with the software, not the fundamental structure of the law, and by the beginning of 2014 it was largely solved. There was a huge surge of people signing up as the deadline for 2014 coverage approached, and by the time that deadline arrived more than 8 million people had signed up via the exchanges, while millions more had either purchased directly from insurers or been covered by an expansion of Medicaid.

How many of those signing up were newly insured? At first there were warnings that many of the policies being bought through the exchanges might simply be replacing existing coverage. By the summer of 2014, however, multiple independent surveys showed a sharp drop in the percentage of respondents without insurance. At this point it seems likely that the ACA will, indeed, manage to cover many though not all uninsured Americans. Whether it will also succeed in reducing the rate of cost growth remains to be seen, although by 2014 there were early signs that the rate of growth of health care costs was indeed falling.