Arnold Kling  

Giffen's Paradox of Health Care

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If you thought that Bush economics was an oxymoron before, wait until you read this morning's lead story in the Washington Post.


President Bush will propose that Americans be allowed to take tax deductions on more of their out-of pocket medical expenses, as part of an initiative the White House believes will rein in soaring health costs

Evidently, the Administration believes that health care is a Giffen good, so that if you subsidize it, total spending on it will decline.

The thinking is explained by John F. Cogan, R. Glenn Hubbard, and Daniel P. Kessler in this book.


Allowing out-of-pocket health-care spending to be tax deductible has two opposing effects on health care spending. First, expanding deductibility lowers the overall price of health care relative to other goods and services and, thereby, increases spending...Second, [it] induces people to shift to health plans with higher deductibles and coinsurance rates which, in turn, lowers spending.

In appendix D, the authors claim to prove, using three pages of equations, that the second effect is larger than the first. With hundreds of billions of dollars at stake, I sure hope they didn't, you know, forget a term or accidentally flip a sign or something.

Forgetting the equations, here is the intuition. If there were no tax distortions, I would pay for $500 of health care. With the current tax code, my employer might buy $1000 of health insurance for me, at an after-tax cost of $700. I have no incentive at the margin to conserve on health care spending, so I spend $800.

With the new tax code, I take $700 in take-home pay instead of health insurance, and I pay for health care out of pocket. Because the marginal cost of health services is no longer zero, I don't spend $800 on health care. However, because medical expenses are tax deductible, I buy $650 of health care services instead of the $500 I would buy if they were not deductible and I had no insurance. So health care spending does not drop to the no-distortion level of $500, but it still declines from the current level of $800.

I think that there are good reasons to doubt that the results would shake out this way. My guess is that people would sort themselves into tax clienteles in such a way as to increase total health care spending, not reduce it. People with high marginal tax rates would pay out of pocket, while people with low marginal tax rates would stick with employer-provided health insurance.

When your hope for reducing health care spending rests on a sort of Giffen's Paradox, you really are grasping at straws.


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TRACKBACKS (3 to date)
TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/436
The author at voluntaryXchange in a related article titled Giffen Goods Don't Exist - Or Do They?? writes:
    Arnold Kling points out that the Bush administration announced and the Washington Post reported on a plan to reduce health care expenditures by subsidizing them. That will be neat trick - sort of like George Carlin noting that if he [Tracked on January 27, 2006 5:51 AM]
COMMENTS (14 to date)
Dave Schuler writes:

As you point out that it would be effective in reducing the cost of health care is doubtful. But that it would be a middle class tax cut is incontrovertible. One trick pony.

Huggy writes:

Overspending by "health/tax-code nerds" would fund the health care for the indigent. Governments would be restrained from mandating by nerds exiting out based on cost.
Government managed systems don't scale up. That fact doesn't change no matter how strong your feelings are about the subject. They provide bad care at high cost. Don't mention France as an exception. The entire country of France is effectively privately managed.

David Thomson writes:

President Bush only has a vague understanding of economics. The only thing he clearly understands is tax cuts---and this is an important reason why our current economy is booming Unfortunately, the rest of his thinking is something of a muddled mess.

George W. Bush may go down in history as one of our greatest presidents solely due to his efforts to combat terrorism. Sadly, it will probably be someone else who will straighten out our long term economic woes.

daveg writes:

George W. Bush may go down in history as one of our greatest presidents solely due to his efforts to combat terrorism. Sadly, it will probably be someone else who will straighten out our long term economic woes.

Bush spent US lives, bodies and money invading a country on the basis of mistaken (or manufactured) information. Great president due to his efforts to combat terrorism? Puh-lease.

jult52 writes:

"If there were no tax distortions, I would pay for $500 of health care. With the current tax code, my employer might buy $1000 of health insurance for me, at an after-tax cost of $700. I have no incentive at the margin to conserve on health care spending, so I spend $800."

Can you explain why you picked these particular numbers?

aaron writes:

I think you will see people will buy more expensive, higher quality versions of the products they currently buy out of pocket.

People will probably buy nicer eyeglasses and contacts. Hypochondriac parents will spend on things that insurance doesn't cover, rather than spending on products that will enhance their childrens' quality of life.

Ann writes:

Why did you leave off the next 5 words from this quote?

"President Bush will propose that Americans be allowed to take tax deductions on more of their out-of pocket medical expenses, as part of an initiative the White House believes will rein in soaring health costs by shifting responsibility toward individuals"

Perhaps the key here is "as part of". Just a quick glance through the article that you linked to shows that there's much more to the plan than just increased tax decductibility.

I haven't followed this issue closely but think that Bush's idea for less healthcare consumption is to encourage people to buy catastrophic health insurance (a high deductible, but extensive coverage for serious illness), combined with tax-deductible health savings accounts that can be saved from one year to the next, if they're not used. This hopefully would make people less likely to demand lots of extra tests or unneeded minor care, since the money could instead be saved for later, while still providing coverage for the truly, seriously ill that need to consume large amounts of healthcare.

You may disagree with the proposals, but it's disingenuous to pretend that the entire plan is to discourage health care spending by subsidizing it.

aaron writes:

What Bush seems to understand best is tax cuts that benefit the healthcare industry. Does he expect social returns on the investment, or does he expect personal gain?

These ideas do seem like they should work, but I don't see them doing much of anything.

I do welcome the idea that I can recieve the cash and the tax break for my medical expenses rather than my employer getting the break to pay for an HMO that I may or may not use. I would be much more inclined to pay out of pocket for care, and only have catastrophic coverage.

I would like to pay for things out of pocket, but paying prices that have been inflated by the system for decades with after tax dollar doesn't make sense when the company pays the same prices with pre-tax dollars.

Matt writes:

I think that there are good reasons to doubt that the results would shake out this way. My guess is that people would sort themselves into tax clienteles in such a way as to increase total health care spending, not reduce it. People with high marginal tax rates would pay out of pocket, while people with low marginal tax rates would stick with employer-provided health insurance.


Gee, I'm sure Cogan, Hubbard, and Kessler are thinking "If only I we had known this sooner." Or maybe not.

Boonton writes:

The premise here seems to be that out of pocket health spending will somehow be more optimized than third party health spending. This is a bit of a hoot because not too long ago the HMO was supposed to be the solution to health costs.

As you may remember, the premise of the HMO was that low co-pays would make cost-effective routine healthcare (such as an annual physical) cheap for the patient while using its bargaining power to keep the doctors and hospitals from adding unnecessary work to the patient's tab.

The problem with catastrophic type policies is basically once you reach your deductible the healthcare provider can pad the bill as much as they want.

Here the HMO was supposed to serve another useful function, to counter the fact that the doctor has a conflict of interest with the patient. The more work a doctor recommends the more he gets paid & even with the ability of the internet to make knowledge cheap to aquire the patient is still at the mercy of the 'expert'. The HMO has the ability to hire its own experts as well as track thousands of case histories to develop its own knowledge base that could be used to optimize the care for the patient.

HMO's were not a failure, they did control costs for a while and many doctors will tell you they hate the rise of the HMO's because they made them spend less time with the patients and cut their income (translation, cut the cost of healthcare by getting more productivity out of the doctors).

A policy should be economically neutral between catastrophic type plans and HMO types with low co-pays.

Chris Bolts writes:
The premise here seems to be that out of pocket health spending will somehow be more optimized than third party health spending. This is a bit of a hoot because not too long ago the HMO was supposed to be the solution to health costs.

However, the HMO is still the third party spender and the individual still does not pay for his/her own healthcare.

Fact of the matter is, no type of solution on healthcare costs until people start having a hard discussion about who should be responsible for people's healthcare: the individual or some other third party.

Arnold Kling writes:

jult52,
I picked those numbers because I wanted the hypothetical insurance company to make money (it would be unrealistic otherwise), my spending to show a response to incentives, and the net result be the one that Cogan-Hubbard-Kessler derived, which is that I spend less on health care with the subsidy than without.

However, any resemblance of those numbers to the behavior of any real person, living or dead, is strictly coincidental.

pgl writes:

Negative income effect dominates substitution effect. QED! Brilliant! Although, David Altig is arguing that demand curves slope down and are elastic.

Marc writes:

I don't see the problem with making out of pocket medical expenses tax deductible.

To me, it essentially accomplishes the same thing as HSA'a? The only difference being a tax deduction allows the sick and unemployed to deduct medical expenses where an HSA's only extends that benefit only to the healthy and employed.

Am I missing something here? Of course if you're against HSA's also, then nevermind.

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