The corporate moral-hazard problem.

The search for better economic policy.
Dec. 8 2005 4:20 PM

It's Not Your Grandpa's Moral Hazard Anymore

The problem goes corporate.

To the despair of almost every informed economist, by New Year's Day, Medicare recipients who want coverage for 2006 will have chosen a prescription drug plan. Even the former chairman of the president's Council of Economic Advisers, R. Glenn Hubbard, says that the costs of the prescription drug benefit are unsustainable in the long term, and perhaps even in the next five years. Meanwhile, a health-care program that many economists love, the Flexible Savings Account *, is also approaching a New Year's deadline. By Jan. 1, anyone with an FSA—a tax-free spending account for health care—must spend the money he or she has accumulated in that account or else lose it.

Most economists feel differently about the Medicare drug benefit and FSAs (called Health Savings Accounts in another form) because the two policies represent opposing views of the health market. The FSAs were designed to address what economists call the moral-hazard problem—that if you subsidize people's expenses for something, they will increase the amount they want to spend on it. To contain costs in health care, economists generally argue, we should raise the direct costs that people pay for medicine so they'll feel that they are spending their own money and have more incentive to be frugal. The Medicare benefit, on the other hand, tends to ignore economics and instead embodies a political idea about the social compact: that as a society we should subsidize the expenses of the elderly. A natural fear of that benefit is that the more drugs people can get for free, the more drugs they will take—regardless of how much they really need them—and as a result, spending will spiral out of control. In other words, FSAs were meant to solve the problems created by programs like the Medicare drug benefit.

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While the budget analysts panic, though, health economists have begun to disagree over how important moral hazard really is in influencing people's decisions about when to go to the doctor. Older surveys, like the RAND Health Insurance Experiment in the 1970s and 1980s, suggested that patients who don't pay out-of-pocket expenses sought care much more frequently than patients who have to make co-payments—but alas were not any healthier despite the added expense. Those studies have greatly influenced experts' opinions about the merits of big subsidies like the new Medicare benefit. Some newer studies, however, have downgraded the importance of moral hazard for the choices that individual patients make. A good example is a study by David Grabowski at Harvard and Jon Gruber at MIT. The two economists found that the Medicaid payment rates had no impact on the share of people who went into nursing homes. That means there was no evidence of a moral-hazard problem in this massive segment of the health-care market (it accounted for 7 percent of all health-care spending in the United States in 2000). The traditional economics view would hold that if patient choices aren't driven by moral hazard, then we might not have to worry that subsidies like the Medicare drug benefit will impose huge costs.

Unfortunately, the moral-hazard problem isn't gone. It has merely morphed into something more pernicious. The last decade has seen a dramatic consolidation of ownership in much of the health-care industry. Increasingly, it is the few companies left standing, rather than the patients, that are the source of the rapid escalation of health-care costs. With regard to the Medicare prescription drug benefit, the new fear isn't that costs will skyrocket as grandpa goes on a Lipitor buying spree. It's that Medicare spending will skyrocket because Pfizer jacks up Lipitor's price. The moral-hazard problem is more and more about corporations rather than individuals.

The evidence shows that companies are particularly likely to raise prices when the government is footing the bill. Economists Mark Duggan at the University of Maryland and Fiona Scott Morton at Yale studied the prices of the top 200 drugs in the United States from 1997 to 2002. They found that drug makers gamed the government procurement rules that forbid companies from billing Medicaid more for a drug than they bill private consumers. When private-sector demand for a drug is small compared with the demand of Medicaid patients (as is the case, for example, with antipsychotics), drug companies massively inflate the price of the drug for private buyers. Sure, they lose some business from that part of the market. But they more than make up for that loss by being able to bill the government at a vastly higher price for the Medicaid patients. Similarly, as the Wall Street Journal reported last week, some drug makers are donating money to charities that help patients make their co-pays for expensive drugs. The donations help ensure that the patients will be able to keep taking the drugs—and also keep the official prices high when the bill goes out to insurance companies.

As the moral-hazard problem for medical expenses becomes a corporate rather than individual matter, the solution that economists currently favor—Flexible Savings Accounts—will fail to rein in costs. The FSAs won't fix things because they change the incentives of individuals, not companies. Indeed, as more people get FSAs, we may very well see the companies raise prices even further to capture the tax-free savings in people's accounts. That would be exactly analogous to what has happened with "529" college savings programs. In 2001, Congress passed a tax break for college savings accounts. As I wrote three years ago, the plans were "supposed to be an enormous federal tax subsidy for education." But the small number of financial firms that are approved to manage the 529 accounts have basically captured that subsidy by raising their investment fees to levels well above those in the regular investment market.

So, as Jan. 1 approaches, we should certainly worry about the potential escalation in drug spending from the new Medicare benefit. But don't think the problem can be solved by forcing Medicare recipients to pay into Flexible Savings Accounts. It's not your grandpa's moral hazard anymore.

Correction, Dec. 9, 2005:Throughout, the original version of the article referred to Health Savings Accounts. In fact, the Jan. 1 deadline applies to Flexible Savings Accounts. Health Savings Accounts, another type of tax-preferred account for medical spending, do not have a time limit. (Return to corrected sentence.)

Austan Goolsbee is an economics professor at the University of Chicago Graduate School of Business and a senior research fellow at the American Bar Foundation.