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Moral hazard is a term economists use to explain how insurance can change the behavior of someone once they are insured. Many economists argue that current tax policy regarding health insurance is unfair, encouraging some people to buy more health insurance than needed, while discouraging others from purchasing it at all.

Interview with Mark Pauly, Ph.D., Bendheim Professor; Professor of Health Care Systems, Business and Public Policy, Insurance and Risk Management, and Economics

Few economists are as well-versed as Mark Pauly when it comes to explaining the complexities of the health insurance market in the U.S. and how income, health, and employment status affect insurance coverage rates. A two-time chair of the University of Pennsylvania Wharton’s Health Care Systems Department and ERIU-funded researcher,    Pauly’s views on health care economics and how policymakers should address health insurance and quality gaps are regularly sought by Congress, the Executive Branch, and others.  Pauly’s 1968 article on the role that moral hazard plays in the purchase of health care has been described as the “single most influential article in the health economics literature.” Pauly spoke to ERIU about moral hazard and the effects on behavior, why changing current tax policy would help more people get health insurance, and whether individual mandates are a useful vehicle for getting people to buy health insurance.

Can you explain the role of moral hazard in medicine and whether fear of moral hazard is what drives various insurance policies?

PAULY: We know that people will use more medical care when they have generous insurance than when they don’t.  It is like ants at a picnic.  Health insurance has a much greater impact on the health care market than other kinds of insurance. When people have health insurance, they will naturally take advantage of it.  The problem is that they have more health insurance than they should because they get a tax break. 

So you believe this leads to “unhealthy” behavior?

PAULY: Moral hazard produces more wasteful behavior.  If you have insurance, you say, ‘run that MRI, the insurer will pay for it’ even though you would not be able to pony up the $800 on your own.  The economics of this are pretty straightforward.  If people pay less out of pocket they seek more health care.  When people pay more out of pocket, they use fewer medically necessary services as well as unnecessary services.

Should we abolish health insurance altogether?

PAULY:  No but we should at least turn off the incentive for people like me to have super generous coverage.  It’s hard to believe it would harm health in any serious way.

So what’s the solution to preventing someone from overusing medical care?  Most people don’t go seeking out an MRI unless it’s prescribed by their doctor.

PAULY: One way is to require them to pay more out of pocket costs or have higher deductibles, which makes people be more careful about the services they buy. Most studies conclude that if you remove the tax exclusion for health insurance, people would buy less generous coverage.  How much less generous though is hard to say. But at least turning off the incentive for people who don’t have serious problems to seek generous coverage would be a start. If people could no longer lower their taxes by taking a job that provides health insurance, people would buy less generous coverage. 

What about people with chronic medical problems?  How do we prevent the underuse of necessary care?

PAULY: It is true that abolishing the health insurance tax exclusion could have a negative health impact for a small fraction of the people.  For example, when people with high blood pressure have to pay more out of pocket, their blood pressure probably won’t be as well controlled.  But the ones who benefit from the tax exclusion are people like me, people who don’t have high blood pressure and can afford to pay more out of pocket.  

Do you think administrative costs cause people to be uninsured?

PAULY: It does cost insurers more to sell policies in the individual market than in the group market. The costs involved in processing claims and determining how much will be paid on each claim do have something to do with why many people remain without health insurance.  If you don’t have access to health insurance from a large employer, it will be a lot more expensive because you’ll have to pay more to cover administrative costs and that extra amount is substantial.  Insurance in the real world generally comes with an administrative cost above and beyond the expected benefits that a person might get.  If administrative costs are high enough and the event you are insuring against is not all that risky or costly, the efficient thing would be to not insure it.

You recommended to the President’s Advisory Panel on Federal Tax Reform to change tax incentives for health insurance by equalizing it for everyone and limiting how much can be provided tax free.  What’s the benefit of this change?  Is it fairer and more efficient?

PAULY: I favor abolishing the tax exclusion employers get for buying employee health coverage.  But at the least I suggest capping it and taking the savings and subsidizing those who need health insurance, which would be the people who are low income and at high risk. It’s not that it’s bad to subsidize health insurance but it’s inefficient and unjust and gives bigger subsidies to higher income than lower income people.  If you abolished it, it would increase taxes of people in my tax bracket but it would still be more efficient. 

So you think the current approach is poorly targeted?

PAULY: It is inequitable. Right now, employers can buy health insurance for workers with money that is essentially invisible to workers.  Workers have no idea what their bosses spend on health insurance and it’s not part of their income. The only people who don’t get a tax break are workers whose employers don’t provide health insurance at all.  It’s unfair.  Jobs that don’t include health benefits tend to be lower paid, part-time or temporary and are held by those who have the toughest time accessing care.  The tax code distorts the health system by failing to help those who need help and giving millions more an incentive to consume more health care than they really need, which drives up demand and prices for everyone.  Capping tax breaks or what I call ‘subsidies’ for health insurance is a much fairer approach because right now the exclusion makes expensive insurance look cheap.

What would a cap do to “righting” behavior triggered by moral hazard?

PAULY: If we abolish the tax exclusion, it might reduce health care spending on the order of 25 percent for the people who have private health insurance.

Do you pin much hope in the Administration acting on the Commission’s recommendations?

PAULY: I am hoping the Administration will pay attention to the recommendations.  What is and isn’t excludable can be divorced from the political question of how high or low tax rates should be.   I think capping the exclusion might have a chance but it has to be put in the context of overall tax reform.

Why are you such a devotee of tax credits?  They never seem to be set high enough to make a difference?

PAULY:  Tax credits are a vehicle. Obviously, there is a threshold below which credits have small effects.  I think credits need to be at a minimum of about $1,500 for individuals and $3,500 for family coverage.  But the most fundamental point is that tax credits provide a means to do something to help the uninsured.  It gives people the ability to afford health insurance.  These can be much more carefully targeted. If you abolish the exclusion, it generates enough money to provide a reasonable set of credits to people who need coverage.

Is there any connection between tax breaks and levels of growth of the uninsured?

PAULY: I don’t think we have nearly the kind of information on this we would like.  But there is a hypothesis that because my income is pretty good and still rising and I have this tax break and a new technology comes down the pike,  I say ‘I want my insurance to cover that’ and that becomes the standard of care.  For lower income people they can’t afford the extra premiums that are induced by my behavior.  At least turning off the incentive for me to over adopt expensive new technologies would have a spillover benefit.  Premiums for low income people would rise less rapidly.  The tax subsidy causes distortions to the purchase of health insurance and new technologies that negatively affect people with low income and can add to more uninsured.

How effective is a mandate on individuals to buy health insurance?

PAULY: Individual mandates can be much more precisely targeted and be fairer and more efficient than an employer mandate.  An individual mandate lets the credit or subsidy to a person to be dependent only on their circumstances, not where they work.  If it is enforced, it will prevent free riders. The best way to make people aware of the cost of care they receive is to have them pay for it individually. If I wanted to go close the health insurance coverage gap, I would go with mandatory purchase once you have a tax credit that makes it easy to enforce. 

You have been working on this issue of the uninsured and reforming health insurance for years.  Are you optimistic for change?

PAULY: Realistically, given the expected costs of Iraq and other burdens, I’m not betting on much in the current Administration.  A complete end to the tax exclusion isn’t going to happen anytime soon but I do envision support for a threshold in which only basic coverage would remain untaxed. This doesn’t have to be that revolutionary of a step but it would make the cost of health care a lot more transparent than it is now.

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Funded by The Robert Wood Johnson Foundation, ERIU is a five-year program shedding new light on the causes and consequences of lack of coverage, and the crucial role that health insurance plays in shaping the U.S. labor market.