Monday, January 22, 2007

Pecuniary Externalities

For what it's worth, I think Paul Krugman makes some good points about the problems inherent in using the tax code to encourage or discourage the purchase of health insurance in his column today (original here, reposted here). I obviously don't sign on to his characterizations of "Bush and his advisers," and he stops short of his usual call for a single-payer system, so there's no reason to get into that today.

Were it up to me, I'd completely eliminate the exclusion of health insurance premiums from taxable income. That levels the playing field between premiums and other expenses (as the Bush plan tries to do), but it does so without forcing the tax code to be the arbiter of whether something was a legitimate health expenditure or not. It also raises tens of billions of dollars in additional tax revenue that can then be directed to all the other things the government needs to pay for.

However, I found this statement (highlighted in bold) in Krugman's column to be odd:
While proposing this high-end tax break, Mr. Bush is also proposing a tax increase — not on the wealthy, but on workers who, he thinks, have too much health insurance. The tax code, he said, “unwisely encourages workers to choose overly expensive, gold-plated plans. The result is that insurance premiums rise, and many Americans cannot afford the coverage they need.”

Again, wow. No economic analysis I’m aware of says that when Peter chooses a good health plan, he raises Paul’s premiums. And look at the condescension. Will all those who think they have “gold plated” health coverage please raise their hands?
Is he kidding me? That is almost the definition of a pecuniary externality. Wikipedia describes it as follows:
A pecuniary externality is an externality which operates through prices rather than through real resource effects. For example, an influx of city-dwellers buying second homes in a rural area can drive up house prices, making it difficult for young people in the area to get onto the property ladder.

This is in contrast with real externalities which have a direct resource effect on a third party. For example, pollution from a factory directly harms the environment.

Both pecuniary and real externalities can be either positive or negative.

So in the President's defense, there's a very simple argument to be made here. When one person feels inclined, for whatever reason, to purchase more health care services, that puts upward pressure on the price of health care services (if the supply curve is not flat) and thus the cost to everyone else in the market. Normally, we don't pay any attention to this, because that is precisely the mechanism by which a competitive market achieves economic efficiency.

The President is referring to the pecuniary externality generated by a tax distortion in the treatment of health insurance, which interferes with a market achieiving economic efficiency and thus should concern us. It goes as follows. Premiums are fully excludable from income tax, but out-of-pocket expenses are not tax advantaged. That favors health insurance arrangements in which there are low deductibles and high premiums. Such arrangements can lead to higher utilization of health services, since the insured faces no financial cost at the margin once the low deductible has been met. (This is just a standard moral hazard argument.) Krugman may not believe that the relevant behavioral effects are large here, but he's on shaky ground with his "Wow ... no economic analysis ..." comment.

For more on pecuniary externalities, I came across this source.


bakho said...

OK. So they should revisit the flex account rules. Sorry. The spending account my employer runs is use it or lose it. I know a lot of people that overspend on these accounts because of use it or lose it. My wife and I disagree on how much to put in. She gets annoyed if we pay for health care without the tax break. I get annoyed if we have to buy something we don't need to drain the account.

For some reason I am not eligible for the HSA option. They write this legislation like HSA so mostly wealthy people get the advantage. So even if the HSA is written to roll over, many people are still being screwed by the non-rollover provisions of the flex health accounts.

Is it true that more people have flex accounts than HSAs?

bakho said...

"Were it up to me, I'd completely eliminate the exclusion of health insurance premiums from taxable income."

I bet your clerical staff disagrees and would vote with their feet. How much taxes would your secretary have to pay? A secretary making $10 /h would make $20,000 / y. Health benefits for a family of 4 can be worth $10,000. At 17% tax rate, the salary would drop by $1700. This would drop take home pay from about $15000 to $13,300, at least a 10% cut in take home pay.

Your university would probably have to cut their insurance benefits or give employees enough raise to pay the tax. People take jobs for less than $10/h because they pay benefits for the whole family.

Chuck said...

I have to side with Krugman. You are correct that, theoretically, so-called gold plated plans could have higher utilization and push up prices by increaing demand.

However, theoretically, so-called gold plated plans could reduce demand for health care services by providing greater access to preventive care that saves resources in the long run. Also, it is possible that so called gold plated plans do not have stringent cost containment (unlike HMOs; luxury lines tend to have higher margins) and thus might permit health care providers to lower prices for care provided through HMOs. Since Bush made the claim, it is incumbant on him to have support beyond self-serving speculation.

piglet said...

Your argument is missing the point.

"The tax code, he said, “unwisely encourages workers to choose overly expensive, gold-plated plans. The result is that insurance premiums rise, and many Americans cannot afford the coverage they need.”"

This statement of Bush has nothing to do with supply curves. What he says is that the very existence of "expensive, gold-plated plans" drives up the general cost of health insurance. But this shouldn't be the case *if those expensive plans are adequately priced*. Why should it bother me if somebody else choses an "overly expensive" insurance? It's like saying that because some people are eating at expensive upscale restaurants, the food prices generally are pushed up. If it were true, it would be a good argument for socialism. Maybe some member of the press corps should point this out to Dubya? ;-)

It is however conceivable that insurance companies are subsidizing the "gold-plated" plans in order to attract the weathiest customers. This would be a big concern and should of course be prevented by good regulation. But neither Bush nor Andrew are referring to that.

piglet said...

"Bush is discussing the interaction of two groups of consumers in a market. He is claiming that one group demands more than it would otherwise due to the tax code."

They are also *paying* more than they would otherwise, bringing more resources into the system. On what basis can you claim that this is bad for the others? It might as well be good for the others because they are profiting e.g. from expensive infrastructure that would not be affordable without the top payers. My point is not that "gold-plated" plans are necessarily a good thing but I register with some amusement that the argument being made here (by Bush and you) would, if carried out consistently,
result in a call for a more socialist health care system.

piglet said...

"Your restaurant argument, if applied on the same scale as the number of people with low-deductible, high-premium plans, would also be appropriate."

I wonder what scale you are talking about. In any case, are you seriously saying that the restaurant industry would be more efficient if there were only McDonald's type restaurants?

piglet said...

Andrew, you are not responding to my arguments and you don't even attempt to offer an argument based on real-world experience, rather than on abstract supply curve theory without any empirical backup. Alas, that is the typical modus operandi of many economists and that's why many educated people hesitate to call what you are doing "science".

"not all of which are desirable when the demand shifts are induced by tax-incentives that are not good public policy." That the tax-incentive in question - an incentive to buy insurance (not necessarily "gold-plated" insurance, just insurance) is "bad public policy" is a hypothesis which you do not prove and which does not follow from your argument. And frankly, it is highly implausible. Without the tax incentive, fewer people would have insurance, which has negative consequences for the whole society.

piglet said...

I trust you can read the mind of GWB, since he didn't make any of those assumptions explicitly.

"Do you believe that the tax code, particularly its lighter treatment of premiums compared to out of pocket costs, induces insurance companies and their customers to have insurance plans with high premiums and low out of pocket expenses?"

I don't "believe" anything. I am looking up the health plans offered by my insurance provider. There are two plans that I was asked to choose from: "Classic" and "Point of service". The second is 50% more expensive, and would allow me to consult out-of-network doctors. In that case, however, I would have to pay considerably higher deductibles and co-payments, in addition to the higher premiums. So, if that is what you call a "gold-plated" plan, then no, your argument doesn't hold.

Now I will assume that I have the choice between paying higher premiums and lower co-payments, or the reverse. I grant the logic of your argument, but still things are more complicated than you paint them. If I am young and healthy, I will opt for the lower premiums. If I anticipate making frequent use of health care services, I might opt for the lower co-payments. It might look as if I am "induced to demand more health care" but in reality, I am just trying to minimize my total cost. Btw I am a text book "homo oeconomicus", and I am about the only one I know. Many people don't make health care decisions in the same "rational" manner. This is something that you need to take into account. Health care isn't just another market where the same mechanisms operate as in any market. Krugman has made this point repeatedly, and it is important to bear in mind. To cite just one other example, high co-payments may be counter-productive because they induce people to abstain from preventive health services or to wait too long before consulting a doctor.

I appreciate your posts but I feel that they need more real-world connection.