The health care system is facing serious problems. These problems, which impose significant hardships on many individuals, need correction. Correcting the problems with the current health care system begins with an understanding of incentives to invest one's money one way or another. Incentives drive all economic behavior-including behavior in the health care industry. The cost and quality of health care goods and services respond to the interaction of consumers (patients) and suppliers (doctors and medical product suppliers).

The health care wedge is one way of thinking about government involvement in the economy. When the government or a third party spends money on health care the patient is not. The patient is then separated from the transaction in the sense that the costs are no longer his concern. This separation-how far the supplier and consumer are separated from one another-is what the economic wedge is measuring. The wedge measures the deadweight loss from this separation in higher costs that do not improve efficiency.

In the case of health care, the wedge also separates patients from doctors in determining what type of care should be provided. Decisions are made by government, insurers, and judges deciding medical malpractice liabilities. The government, lawyer, and third party wedge in our current health care system causes higher costs and diminished efficiency.

One of the most basic axioms of economics examines changes in behavior when prices change. When the price of a product increases, consumers have an incentive to consume less while suppliers simultaneously have an incentive to produce more. When prices are obscured by government interference in the marketplace, neither consumers nor suppliers have the necessary knowledge to properly allocate society's scarce resources.

An economic wedge occurs any time government policies separate effort from reward or consumers from producers. When government, lawyers, or third party insurance is responsible for paying the bills, consumers have no incentive to control costs. It is intrinsically an economic variable that operates at the margin where incentives come into play and decisions are made. Economic wedges inevitably change economic incentives, oftentimes leading to undesirable outcomes. The burden of government on the growth of the private sector economy illustrates the costs associated with economic wedges.

Government spending relative to the size of the private sector economy (the government expenditure wedge) is a proxy for the total burden of government activities on the economy. Figure 1 tracks the growth in the government expenditure wedge between 1951 and 2007 (the latest full data set available). As of 2007, total government expenditures were $4.4 trillion. Net domestic business output (corporate and non-corporate income adjusted for depreciation) for 2007 was $9.5 trillion. The resulting government expenditure wedge for 2007 was 46.1 percent.

The vertical black lines in Figure 1 represent the years in which changes in the path of the government expenditure wedge are evident. For instance, total government expenditures between 1951 and 1965 ranged from relatively flat to more expansive. Beginning in 1966, there is a change in the rate of expenditure growth that continued until 1983. The growth in government expenditures then slowed until 1989. A renewed, but short-lived, pick-up in government expenditures occurred between 1989 and 1993. The trend toward lower government expenditures then resumed until 2001. Since then, total government expenditures have risen.

Table 1 (next page) illustrates the negative impact that a high and/or growing government expenditure wedge has on private sector activity, as well as the positive impact of a lower and/or declining expenditure wedge. Taking each period separately:

• Between 1950 and 1965, the government expenditure wedge was relatively low (32.4 percent) and grew slightly (+5.5 percentage points). Private sector expansion was a robust 3.6 percent per year during this period.
• Between 1965 and 1983, the government expenditure wedge grew quickly, rising 16.6 percentage points to 49 percent. Growth in the private sector slowed to 2.5 percent per year.
• Between 1983 and 1988, growth in the private sector accelerated to 5.1 percent per year as the government expenditure wedge fell 3.3 points back down to 45.7 percent.
• The brief reversal in the government expenditure wedge between 1988 and 1992 led to a 5.2 percentage point rise in the wedge to 50.9 percent. Growth in the private sector economy slowed again to 1 percent per year.
• ;Between 1992 and 2000, the government expenditure wedge fell 9.2 percentage points to 41.7 percent. Growth in the private sector economy accelerated again to 4.5 percent per year.
• Finally, between 2000 and 2007, the growth in the government expenditure wedge started growing again (by 4.5 percentage points to 46.1 percent) and the growth rate in the private sector cooled to 2 percent.

Taken together, Figure 1 and Table 1 illustrate the consequences from the overall government wedge on total economic growth. By separating effort from reward, a large or growing government wedge diminishes the incentive to work, save, and produce; less work, savings, and production results. Such basic fundamentals of economics are not repealed at the health care industry's doorstep.

In order to correctly diagnose the current problems in the health care industry, one must first understand the incentives driving the people and organizations participating in the health care market. Understanding the incentives pinpoints the current weaknesses of the U.S. health care industry, and provides the basis for developing a methodology to assess the impacts from proposed reforms on the problems in particular and the health care industry overall.

Our current third party payer system creates a wedge that separates consumers from suppliers. Larger wedges create larger gaps between consumers and suppliers and lead to greater market inefficiencies and a larger number of adverse incentives. Many of the problems with our current health care system stem from the adverse incentives created by the wedge between consumers and suppliers.

On the consumer side of the market, the wedge diminishes consumers' incentives to monitor costs. Consumers bear only a fraction of the costs from any additional health care service. On the supplier side, doctors and other medical providers receive no incentive to provide higher quality services for less cost. No positive benefit accrues to those who do so.  

Costs do, nevertheless. One of the most important disincentives for doctors to monitor costs is the tort liability threat. According to the American Medical Association, defensive medicine in response to rising tort liability costs added $99 billion to $179 billion in additional costs in 2005 alone.¹²  

As a result, Medicare, Medicaid, and tax-favored, employer-based coverage blind both patient and doctor to the cost of care. Meanwhile, litigation risks incentivize doctors to run additional tests to limit their liability exposure. Government regulations and the third party payer system are also diminishing the market incentives to implement best practices programs that would help eliminate waste, fraud, and abuse. Whether the payer is government or an insurance company, the process removes competition and patient feedback that drives innovation. 

Take, as an example, programs to implement best practices, or comparative effectiveness research. Comparative effectiveness research evaluates different medical procedures and treatments for the purpose of educating doctors and patients about which treatments are effective and economical; and which treatments are not. An oft-cited complaint of the current U.S. health care system-a complaint not without merit-concerns the lack of sound comparative effectiveness research.

Cannon (2009) illustrates that removing government-created obstructions is a more effective policy reform to create comparative effectiveness research than the creation of a new government agency-an important principle supported by the President.

The President's principles call for a government agency to provide comparative effectiveness research, claiming a market failure has occurred. According to this theory, once comparative effectiveness research is known, it is difficult to keep out of the public domain. Organizations' incentives to invest in this research are diminished by the prospect of competitors benefiting from their private research at no cost to themselves. Consequently, organizations will naturally under-invest in comparative effectiveness research, according to this theory.

Cannon (2009) illustrates that the current lack of comparative effectiveness research represents the failure, not of the market, but of government.¹³ For instance, prepaid group plans (PGPs) have a large incentive to provide comparative effectiveness research to their members, because the benefits of the research can be effectively captured within their networks of doctors and facilities. However, government regulations and the complex web of state regulations discourage PGPs. On the demand side, the declining amount of out-of-pocket expenditures by consumers reduces their demand for comparative effectiveness research. Because consumers do not bear the costs or reap the benefit of ensuring the most cost-effective practices, their incentives to seek those benefits are accordingly lessened. Taken together, government interventions have deadened the incentives to create comparative effectiveness research.

Cannon explains that, by definition, government agencies are subject to political influence. The record of government agencies from the Federal Reserve Bank, to the Securities & Exchange Commission, to the National Center for Health Care Technology shows that political influence has created periodic conflicts in which the agencies' mission and/or independence came under extreme pressure. Because more effective means exist to create this valuable research, the best way to create effective comparative effectiveness research isn't to commission it from government but, rather, to remove the government obstructions preventing its creation.

¹⁰ Author calculations based on Bureau of Economic Analysis data.

¹¹ Ibid.

¹² American Medical Association (2008) Medical Liability Reform - NOW!: A compendium of facts supporting medical liability reform and debunking arguments against reform (February 5, 2008) http://www.ama-ssn.org/ama1/pub/upload/mm/-1/mlrnow.pdf.

¹³ Cannon, Michael F. (2009) A Better Way to Generate and Use Comparative-Effectiveness Research Cato Institute: Policy Analysis, February 6, 2009.