Rising Medical Care Expenditures Could be a Plus for the Economy

Faculty Fellow, RIETI

Rising medical care expenditures are a common problem for developed countries. In the United States, which spends the highest share of gross domestic product (GDP) on health among developed countries, President Barack Obama has embarked on health insurance reform, one of the biggest issues in his first year in office, in what may turn out to be a crucial test for his administration. Meanwhile, in Japan, medical care expenditures as a percentage of GDP increased sharply in the 1990s when the nation's economy was in the doldrums. The government has since implemented a series of measures to curb medical care expenditures but these measures have now been made the culprit for inducing what has been described as a collapse of medical services.

Are the rising medical care expenditures experienced by developed countries good or bad from an economics viewpoint? Findings from recent studies suggest that it has a generally positive impact on the economy. Even when medical costs rise, if the end result is that we can extend the number of years of good health (i.e. the length of time we can enjoy good health without nursing care) as a result of medical services, and the economic value of this exceeds the increase in medical costs, then our standard of living is said to have improved.

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According to a 1999 study conducted by Professor David Cutler of Harvard University and Dr. Elizabeth Richardson Vigdor of Duke University, while the per capita lifetime medical spending in the U.S. increased by about 25,000 dollars between 1970 and 1990, the economic value of an increase in the number of years of good health is estimated to have risen by 95,000 dollars, nearly four times the medical cost increase, during the same period of time. The number of years of good health is subject to various factors and it is difficult to determine how much of the increase in the number of years is attributable to medical services. However, it is certain that medical services have been a significant contributor. And it is generally perceived that the increase in medical care expenditures has had a positive impact.

These conclusions were supported by multiple ensuing studies. A joint study conducted by Associate Professor Tadashi Fukui of Kyoto Sangyo University and myself found that the economic value of an increase in the number of years of good health increased by nearly four times that of the increase in medical care expenditures during the period 1990-99. Meanwhile, in another study, Masaaki Kawagoe of the Cabinet Office has shown that the economic value of an increase in the number of years of good health increased by about 10 times that of the increase in the medical care expenditures during the period 1970-2005. It should be noted, however, that these studies focus on medical services as a whole. Thus, we cannot conclude that these services are free from wasteful practices.

According to a study by Professor Robert E. Hall and Professor Charles I. Jones of Stanford University in 2007, a country's medical spending measured as a share of GDP would increase when the national income increased in tandem with the overall economic growth, provided that individuals are able to decide how much to spend on health care. The purpose of medical services is to extend the number of years of good health. When national income increases, the economic value of being able to enjoy the benefits of an extended healthy life (i.e. the economic value per unit of time during which people benefit from the increased income), would increase equally. Even looking at the same medical service, an increase in the economic value of an extended healthy life for higher income earners justifies them spending a greater portion of their income on medical services.

It has long been a common belief that income growth is a major contributing factor to an increase in medical care expenditures. In his 1977 study, Professor Joseph P. Newhouse of Harvard University compared the levels of income and medical care expenditures in 13 developed countries, finding that a one percentage point rise in the income level results in a 1.2 percentage point increase in medical care expenditures. He thus showed that medical care as a consumer good would fit the definition of a luxury item, the demand for which grows faster than income growth. One major contribution of Hall and Jones (2007) is that they have gone beyond explaining such consumer preference for medical care to theoretically elucidate, based on the characteristics of medical services, the mechanism by which the medical care expenditures are determined.

Another major contribution made by Hall and Jones is that they incorporated into a standard model of economic growth the fact that the extension of a healthy life leads to an increase in economic welfare (i.e. the level of economic satisfaction among the entire population, of a country). This provided a viewpoint to see an increase in the number of years of good health as the fruit of economic growth, bringing both health economics and macroeconomics into the scope.

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GDP per capita, which is used as a measure of living standards, represents the value of annual national income per person and does not reflect the benefit of extended life in good health, which is derived in the form of continuing to enjoy the living standards over a longer period of time. Fundamentally, however, the level of living standards should be considered as a combined value of the "quality" of life (i.e. the level of annual income) and the "quantity" of life (i.e., the number of years of life in good health). During the 20th century, the average life expectancy increased dramatically, meaning that there was a significant increase in the quantity of life. The average life expectancy in the U.S. increased from 47 years in 1900 to 77 years in 2000. Japan saw an even sharper increase from 44 years at the beginning of the 20th century to 81 in 2000. In other words, the living standard measured in terms of annual national income surely increased as a result of economic growth during those years but, at the same time, the length of period in which people can enjoy that level of living standards also increased by about 60% in the U.S. and more than 80% in Japan.

In their joint study in 2005, Gary S. Becker and Tomas J. Philipson, both of whom are professors of the University of Chicago, and Rodrigo R. Soares, associate professor of Pontificia Universidade Catolica do Rio de Janeiro, pointed to the need to consider differences in the life expectancy in comparing the income levels of developed and developing countries. Because average life expectancies in developing countries are shorter than those in developed countries, the gap in the living standards between developing and developed countries would be greater than the gap in GDP per capita. Meanwhile, average life expectancies have increased more sharply in developing countries than in developed countries. This indicates that the extension of life in good health in developing countries has been equally or more important than income convergence as a contributing factor to the shrinking of the living standard gap between developing and developed countries.

In the U.S., the government's role in securing medical care services is limited to the provision of public health insurance for the elderly (Medicare) and medical aid for the poor (Medicaid). The remaining others, i.e. the active working population, are left to decide for themselves whether or not to purchase private insurance plans on their own. Hall and Jones' (2007) vision of a world in which health care spending decisions are left to individuals may reflect the situation in the U.S. today.

If so, the fact that the share of medical spending in GDP in the U.S. has continued to rise and is by far the highest in developed countries can be interpreted as a result of preferred choices made by individuals. Then, findings by Hall and Jones (2007) seem to support the claim that there is no need for government interference thus providing good grounds for opposing the health care reform proposed by President Obama. However, by making slight changes to the numerical assumptions in their simulation model, we can derive a conclusion suggesting that the current level of medical spending in the U.S. is not adequate. Thus, it is not appropriate to use their findings as grounds for denying the need for government interference.

If the provision of medical services is left to the market and health care spending decisions left to individuals, the gap between the rich and the poor would translate into a gap in medical services and ultimately a gap in life expectancy. Indeed, the gap in medical services is extremely huge in the U.S. In the country where the world's most advanced medical services are provided, a large number of people are left uninsured.

Other developed countries have a universal health insurance system or its equivalent to make medical services equally accessible to all citizens, whether rich or poor. The fact that medical spending in the U.S. is far higher than other developed countries suggests that government involvement works to reduce overall medical care costs. However, we cannot categorically conclude whether or not the level of U.S. medical spending, as determined by the market, can be perceived as adequate, or whether medical spending levels in other developed countries including Japan are more adequate than that of the U.S., because there is a strong likelihood of market failure for medical services.

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When decision-making for medical spending is built into a political process, the level of medical spending is determined by the power balance between those seeking to increase medical care expenditures and those trying to suppress such expenditures. The introduction of an intergenerational income transfer mechanism - such as one in which health insurance premiums paid by younger generations are used to cover the cost of medical care for the elderly - or a public financing system may create a "fiscal illusion." That is, people might feel as if someone else would be paying for their medical expenses and begin demanding a higher quality of medical care and disregard the costs involved. The medical industry, for its part, would also urge the government to increase medical care expenditures. On the other hand, the fiscal authority and companies which bear the employer's portion of insurance premiums would try to suppress medical spending as they see it as a cost.

It is certainly an important research theme to investigate and identify the political process through which medical care expenditures are determined. However, if we concentrate on doing just that, we would easily lose sight of a fundamental question: what is an ideal state of affairs for medical spending? In addition to guaranteeing equal access to medical services, a government needs to rationally evaluate the cost and benefit of such guaranteed medical services so as to provide what its people consider as a reasonable level of services. In doing so, the economic value of life, which has hitherto failed to attract sufficient attention, should be taken into consideration, and research findings on medical services' contribution to the extension of a healthy life fully utilized.

* Translated by RIETI.

>> Original text in Japanese

October 5, 2009 Nihon Keizai Shimbun

November 18, 2009

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