ECONOMIC ANALYSIS: The link between taxes and high health care costs

“Things that can’t go on forever don’t.” If those famous words of the otherwise obscure Nixon-era economic adviser Herbert Stein apply to anything, it is health care spending. Most of us recognize that health care is expensive, breaking the budgets of many households, pressuring businesses and even challenging the spending capacity of giant federal programs like Medicare and Medicaid. What is less clear is why this is so, and what can, or should, be done about it.

We spent more than $33 billion on health care in Indiana in 2004, the most recent year for which data are available. For the past four years, spending on health care statewide has grown at an annual rate of 8.2 percent, nearly twice as fast as the 4.2-percent average growth in the entire state economy.

It’s not all bad news-we are getting something for all that money, after all. Roughly half the increase in costs is due to increased use of health care goods and services. In fact, with our older, more affluent population, it would be a shock if we didn’t spend a bigger portion of our budgets-individually and collectively-taking care of our ourselves.

But half of the higher spending tab is due to higher prices-for everything from drugs to hospital care. In an otherwise tame inflation environment, health care prices stand out as an area of the economy where sticker shock still prevails.

This is distressing, but to economists, at least, it is unsurprising. A number of aspects of health care policy in this country feed the fires of health care spending growth, and indirectly support the ability of health care providers to push through high price hikes, beyond what might be possible in the rest of the economy. Some of these might surprise you.

The tax system might seem like a strange place to start when analyzing health care spending growth. But taxes do more than simply present us with bills to pay. They also can change our behavior. And in the case of health care spending, they encourage us to spend more on health care goods and services, even in the face of higher prices. Here is how it works:

When we buy food, purchase a car, or go to the movies, we pay for those things with what economists call after-tax dollars. Depending on exactly what income tax bracket you are in, you might need to earn $1.30 or more to have a dollar available for spending after paying Uncle Sam. And that includes most of your out-of-pocket spending on medical care-for over-the-counter drugs, co-pays and deductibles for private insurance-as well.

But that’s not the case for health care spending that is covered by an employerprovided health care plan. The premiums paid by employers on our behalf are not treated as taxable income, unlike the wage money your employer pays you in cash. That makes health care premiums cheaper than ordinary goods and services, since we need only $1 of income to pay for a dollar’s worth of health insurance coverage, but we need more than that to pay for a buck’s worth of most other things.

That sleight of hand in the tax code has had enormous implications. First off, we tend to buy more of things that are cheaper. So we buy more health insurance coverage. That’s why health insurance plans long ago pushed into things no ordinary insurance plan elsewhere would pay for, such as routine doctor visits. It’s cheaper, on an after-tax basis, to have the plan pay for such things than paying for them ourselves.

But doing so has blurred the connection between price and product. With a thirdparty insurance provider paying the bill, we may not even know the price of what we’re using. And our rising premiums reflect the costs of what all of us consume, instead of the consumption choices we make individually.

What’s the fix? That must wait until next week.

Barkey is a research economist at Ball State University. His column appears weekly. He can be reached by e-mail at

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