Taxing Our Health

Market Driven Health Care: Who Wins, Who Loses in the Transformation of America's Largest Service Industry, by Regina Herzlinger, Reading, Mass.: Addison-Wesley, 416 pages, $25.00

Even within the "free minds, free markets" crowd, just what constitutes a free market in health care is controversial (See "Medical Meddling," December 1996, and Letters, March 1997). Is managed care a product of the market, of government distortions of the market, or of some mixture? What would America's health care system look like if it were truly operating under a free market?

Regina Herzlinger, a chaired professor at the Harvard Business School, enters this fray with Market Driven Health Care: Who Wins, Who Loses in the Transformation of America's Largest Service Industry. Billed as an "indispensable guide for policy makers, practitioners, and anyone interested in the future of this vital and complex industry," Herzlinger's book provides less a road map of the rapidly changing health care market–which now includes government, indemnity insurance, various levels of managed care, and even medical savings accounts–than a vision of the way it ought to be. While her vision is compelling, she fails to do it justice.

Like a political speech, Market Driven Health Care too often lurches from one applause line to the next, issuing crowd pleasers such as "patients will not be patient" but shirking the responsibility of providing the tough analysis of how the world Herzlinger envisions will actually come about, given the current regulatory, legal, and political environment. In the end, she knocks the legs out from under her own argument for consumer-driven health care by calling on Congress to determine, and the IRS to enforce, how much insurance individuals purchase.

Herzlinger designed and teaches a Harvard course on creating new health care ventures. She has written on this subject for the Harvard Business Review, and her book is remarkably similar to a cogent article she wrote for The Public Interest in 1994. Her straightforward vision for the future of health care is based as much on the system that produces the McDonald's french fry as it is on the now ubiquitous eye care centers. In the future, America's health care industry will comprise a plethora of competing "focused factories," freestanding centers of excellence that deliver one product–be it complete cancer treatment, foot care, or asthma therapy–and deliver it well. Focused factories "could be established that specialize in any of the millions of high-volume procedures, such as births, cataract surgeries, and bypass operations," she writes. "Others could provide all the services required to care for the chronic diseases or conditions that account for the bulk of our health care costs, like asthma, diabetes, foot pain, and cancer."

The transformation will be spurred by "activist consumers," who are more time-sensitive than ever and demand convenience and quality. Just as time-pressed consumers forced a revolution in retailing, eschewing unwieldy department stores such as Montgomery Ward and Walgreens in favor of specialty superstores such as Staples, Home Depot, and Toys "R"Us, they will transform the health care industry from one organized around the needs of the producers to one centered on the needs of the consumers.

Herzlinger's new world is also one in which reliable information is abundant. Acknowledging that it is currently difficult for consumers to find out even the most basic information on the cost and quality of various health care providers, institutions, and insurers, Herzlinger describes an era in which such information is as easily available as information on cars from J.D. Power, stereos from Consumer Reports, and restaurants from the Zagat Survey.

Empowered consumers–people spending their own money–will drive these changes by deciding whether to get their foot corns removed at Sal's Sole Repair or Al's Ankles & Feet, two of the hundreds of focused factories excelling in the treatment of toes. "When consumers pay directly for health care, the services they receive are economical and convenient," Herzlinger writes.

True enough. But herein lies the crippling defect of Herzlinger's book: She never adequately explains how we move to a system in which the consumer spends his own money, rather than that of his employer or government, when he shows up at a hospital or focused factory.

She does a good job of describing–with both anecdotes and statistics–what is wrong with the current system. It is inconvenient because "most of the health care system is organized around the needs of its providers, doctors, and hospitals, not around the needs of consumers." And she nails the reason–Americans don't purchase their own health care. "When people pay for their health care services directly from their own pocket those services are invariably convenient and helpful information is readily available. When people pay only partly out of their own pockets, as is common in the United States, the services are inconvenient and consumer-oriented information is largely unavailable." But she fails to adequately explain how the system will evolve so that individuals pay for a larger proportion of their health care.

It's not that Herzlinger doesn't recognize serious barriers to the development of her consumer-driven focused-factory health delivery environment, it is that she doesn't pay these barriers the attention they deserve. Herzlinger places barriers in three categories: insufficient demand due to a third-party-payer system; insurers wanting to control cost more than provide convenience; and regulatory barriers.

Consider those pesky regulatory barriers. "Licensing requirements needlessly restrict managers' ability to select appropriate personnel, while various legal roadblocks against the union of medical and business skills are in place," readers are told. Herzlinger cites restrictions on the ability of physician assistants to prescribe medicine as one such example, and the list could certainly be longer. But after identifying this problem, she is content to slip back into the warm fuzzies of "everything will work itself out" rhetoric.

Her solution to this classic concentrated-benefit and diffuse-cost situation is that "Americans want convenience from their health care system" and "ultimately the public will get its way; as it should." In her defense, her writings–this book included–are part of a necessary campaign to educate policy makers and consumers on the diffuse cost barriers. Still, as with many other areas this book touches on, the informed reader will wish that she treated this issue with greater depth.

Herzlinger's whole vision rests on the premise that individuals, not government or employers, will someday pay for a significant amount of their own health care. It is unfortunate that she waits until the second to last chapter of her book to address this fundamental issue.

Health insurance is employment-based for a majority of privately insured Americans, as most REASON readers know, because it is tax-free compensation. As a result, there is an incentive to buy more health insurance (or health care) with those pre-tax dollars than employees would purchase if–like food, clothing, housing, or entertainment–the cost were coming from their net incomes. The tendency, then, is for the employer to purchase not just catastrophic insurance à la homeowner's or auto insurance but routine maintenance and first-dollar coverage. There are two ways to correct this distortion: let individuals buy their own health care with pre-tax dollars (as in medical savings accounts) or make health benefits taxable compensation.

Herzlinger chooses the former, advocating either tax-deductibility for individual health purchases or a version of medical savings accounts, which combine high-deductible indemnity insurance with a medical IRA from which an individual could pay for routine health care with pre-tax dollars. In a world replete with high taxes and targeted tax breaks, either of these options is preferable to the existing system, and both would do much to develop a consumer-driven market in health care. But Herzlinger, like many technocratically inclined experts, isn't satisfied with letting consumers spend their own money on health care and decide which insurance policy to purchase. She wants the government to dictate to individuals how much insurance they must buy.

Advocates of medical savings accounts are sure to burst a blood vessel in their foreheads if they make it to Herzlinger's penultimate chapter, "A Consumer Controlled Health Care System." Basing her argument on an implicitly developed theory of adverse selection, Herzlinger argues that "a government mandate that requires the purchase of health insurance is essential to the existence of affordable health insurance policies."

Continuing along this line of reasoning, she states that otherwise "many young people may choose a policy that covers them only in the unlikely event that they are accidentally injured or contract an infectious disease such as hepatitis," as if young people, or anyone else, would buy insurance for any other reason. (Imagine a Harvard Business School professor complaining that individuals would only buy fire insurance that covers them in the unlikely event that their house burns down!) In Herzlinger's world, if young people aren't forced to buy products they neither want nor need, then "other people will not be able to find affordable health insurance." To prevent such a catastrophe, she calls for the government to require individuals to buy a "specific kind of policy."

Herzlinger goes much further than requiring that individuals buy some insurance, so as not to be a burden to society in the event that they unexpectedly contract a disease or become incapacitated, which is a boilerplate public goods argument. She wants specific insurance policies. So much for her consumer-driven market.

It gets worse. Readers are informed that "the purpose of insurance is to protect people from financial ruin," which means that the government should require individuals to buy certain health insurance policies based on their income. "People who earn $50,000 a year probably could afford to pay about $500 out of pocket for health care, while those who earn $200,000 realistically could pay a much higher amount." While this may be true, it should be a non-issue. Who is Herzlinger–or any other academic, politician, or bureaucrat for that matter–to tell individuals how much health care they can afford?

The effect of her scheme, although she never recognizes it, perhaps because she may be in the $200,000-a-year neighborhood, would be to further price people of modest means out of the health market. Since premiums are inversely related to deductibles, in Herzlinger's world, those of us toiling for less than six figures, many of whom are healthy and young, would be forced to pay more for health insurance so that individuals who are older and worse insurance risks–but who earn more money–could spend less.

Here Herzlinger also conflates current income with wealth or resources. Young adults often enjoy a financial safety net–provided not by the government but by their families. As many middle- and upper-middle-class college graduates know, parents will often buy high-deductible indemnity plans for their children who are too old for the family policy but not yet covered by their own employer-provided insurance. It may be the case that the young adult couldn't afford the $3,000 in health expenses before the policy kicks in, but many parents can.

In the end, the only rationale Herzlinger leaves herself for requiring young, healthy adults to buy more insurance than they otherwise choose is the cross-subsidy it provides older individuals in the insurance market. Readers can form their own opinion as to whether this justifies a federal mandate on individual insurance purchases. And who would enforce her minimum requirement? "The IRS would require taxpayers to demonstrate that they have purchased a health insurance policy that covers all the health care expenses that they could not afford to pay personally," she writes.

From here, the arguments start to contradict themselves, and it becomes clear why Herzlinger left the most important, and substantive, chapter for last. On page 259, she tells us that "clearly the mandatory policy should cover costly long-term care expenses and even preventive health care, for those who cannot afford to pay for them directly" (as if they can then afford to pay for them indirectly through insurance premiums). But on the very next page, she tells us that her "consumer-controlled approach" (which by now is really an IRS-controlled approach) relies on the freedom of individuals to purchase the package of benefits that they want. "Limits that are placed on Americans' ability to shop for health care will seriously compromise their ability to make the health care system more efficient," she says.

REASON readers will appreciate certain aspects of the book. Herzlinger makes the case, mostly by indirect example, that health care, like life's other necessities of housing, clothing, food, and a decent beer, should be provided for a profit. She usefully quantifies the opportunity cost of waiting for health care, which she places at $3.5 billion a year just for physician visits and $2.5 billion for undertreated depression. Many health analysts, especially those enamored with government-funded or -provided health care, tend to ignore these costs because they don't show up on the accounting ledger. Herzlinger also does a good job of compiling examples of entrepreneurial innovations in health care, such as a chain of cancer treatment centers, the eye care centers, and home health systems, all of which allow individuals to better manage their own health.

But in the end, these kernels of truth are simply not worth the effort. Serious health analysts and the casual consumer alike will be better served by reading Herzlinger's more precise 18-page Public Interest article. She simply didn't add enough muscle to the bones of this skeleton, to use a Herzlinger-like analogy, to stretch it into a 400-plus-page book.

Michael W. Lynch ([e-mail]) is REASON's Washington editor.