Bengt Jönsson and Philip Musgrove
In a market economy prices serve three functions: they guide the allocation of resources, they ration scarce goods and services, and they finance the payment of compensation to the factors of production. When the market
provides these functions, the question of how to pay for a particular good or service does not arise: consumers buy the product in amounts that are determined by their wants and capacity to pay, and producers deliver those
amounts, with prices equilibrating demand and supply.
There are several reasons direct payment by consumers for health care is inefficient and unequitable, creating the need for government interventions and for alternative mechanisms to allocate resources and financing. This paper considers the financing mechanism—that is, the role of government financing of health care. Other issues related to government intervention, such as the optimal allocation of resources in the provision of health care, are discussed only if they directly relate to government financing.
In considering the alternatives for government financing of health care, we focus on three questions: Should government pay for health care? Does it matter which of two general models—social insurance and direct financing from general revenues—is used for public finance? Which taxes should be used to finance health care, and do the types and levels of taxes matter for coverage, benefits, and expenditures? Nearly all the available empirical evidence relevant to these issues is for OECD countries; thus the conclusions do not necessarily apply to developing countries. Wherever possible, the situation in developing countries is discussed separately.
Relations Between Finance and Provision of Health Care
There is no necessary connection between the way that health care is paid for and the way that it is delivered; in particular, public finance does not imply public provision. The arguments for and against public provision of health services are very different from those related to public and private financing (Jönsson 1996). It is common
Government Financing of Health Care 56
to distinguish three relations between funders and providers of health care: the reimbursement, contract, and integrated approaches (OECD 1995). These relations are largely independent of specific taxes and other sources of funds.
Under the reimbursement approach, providers receive retroactive payments for services supplied. These payments may be billed directly to insurers or to patients, who may be partly or entirely reimbursed by insurers. The
reimbursement approach, often coupled with fee−for−service payment arrangements, can be found in systems with multiple private and public insurers and multiple (usually private) suppliers, as in the United States. In low−
and middle−income countries it is rare for the reimbursement model to be combined with public finance. Chile is an exception, with part of government financing reimbursing private providers retroactively.
The contract approach involves an agreement between third−party payers (insurers) and health care providers aimed at greater control over total funding and its distribution. This approach tends to be found in social insurance systems with predominantly private (nonprofit) providers.
Bengt Jönsson is professor of health economics at the Stockholm School of Economics. Philip Musgrove is principal economist in the Human Development Department at the World Bank.
Prospective budgets are combined with per diem, case mix (diagnostic related group, or DRG), and fee−for−service payments. A variant of this system is used in Brazil, where budgets are set by the state or municipality and providers are paid under a DRG tariff (Lewis 1994). Preferred provider organizations in the United States also use the contractual approach.
In integrated health systems the same agency controls both the funding and the provision of health services.
Medical personnel are generally paid salaries, and budgets are the main instrument for allocating resources.
Integrated public systems are used in the Nordic countries and until recently were the model in the United
Kingdom, and are the common organizational form for ministries of health in developing countries. In many such countries the integrated approach is also used for social security systems, which have their own hospitals and clinics, although there are often also contractual relations with private providers. Health maintenance
organizations (HMOs)in the United States are examples of integrated private systems.
Most health care systems include elements of all three systems, just as most have a mix of models for public finance. There also have been significant changes over time. Italy and Spain's public health care systems have moved from a contract approach to an integrated system, while those of New Zealand and the United Kingdom have moved from an integrated system to a contract approach.
There may be a trend toward two types of relation between funders and providers (Jönsson 1996; van de Ven, Schut, and Rutten 1994). The first type involves a (near) public monopoly in health care funding, through taxes or compulsory social insurance contributions, and competitive contracts with private and public providers. Thus financing and provision may be separated, in what is sometimes referred to as a purchaser−provider split. The second type is an integrated model with competition between different integrated systems (HMOs).
In the first type consumers usually have no (or limited) choice of insurer, but do have a choice of provider. In the second type there is a choice of insurer, but once this choice is made the consumer is tied to the providers linked with that insurer. No health care system in the world offers a free choice of both insurer and provider to everyone in the population.
The role of government differs between these two organizational models. In the first type the government must raise most of the necessary funds, and then contract with the providers. In the second type the government must regulate competition between insurers, or third−party payers, and distribute the public subsidies needed to
Government Financing of Health Care 57
guarantee universal access to a certain level of health care. Determining the criteria and mechanisms for the distribution of risk−adjusted subsidies is a major problem (Newhouse 1994; van Vliet and van de Ven 1992).
Such subsidies are usually differentiated by the consumer's age and sex and by region, taking into account the income of the population served (which affects the demand for services) and the costs of providing care. This approach has been used in Chile for primary health care (which is a municipal responsibility) and is being implemented in Argentina and Colombia.
Insurance is central to any discussion of health care finance. And while there are markets for many kinds of insurance, health care insurance is peculiar because of the nature of the asset being protected—human health rather than nonhuman capital (Musgrove 1996). The introduction of insurance for health care, whether voluntary and private or publicly financed, has consequences not only for the distribution of payments for health care, but also for the allocation of resources to and within the health care system. By introducing a third party that collects revenue and pays providers, health care insurance changes the relation between consumers and providers of health care (unless, as in the integrated model, insurance and provision are combined in a single agency; figure 1). The crucial importance of insur−
Figure 1
Economic relations in the finance and delivery of health care
ance and the problems peculiar to it provide one of the rationales for public financing of care, and raise most of the issues discussed here about how best to pay for it.
Should the Government Pay for Health Care?
One major reason for public financing of health care is the provision of public goods, such as programs for medical research, health promotion, vector control, and food and water safety. Such public goods provide benefits that are shared by many people, regardless of whether they pay for them. Thus entirely private markets would yield an inefficient allocation of resources, and government financing (or some other nonmarket alternative) is needed to optimize allocation. The situation is essentially the same for goods with externalities (such as vaccinations), which can be produced and consumed privately but whose consequences—good or bad—affect other consumers regardless of whether they choose to consume those goods. For example, immunization of part of the population also protects the unimmunized.
However, most health care interventions produce private goods, with benefits limited to individual consumers.
Arguments favoring public finance of purely private personal health care expenditures differ from those for public goods, for two reasons. The first is the need to finance health care for the poor—that is, people who cannot afford what society considers an adequate amount of health care either out of pocket or by buying insurance. The second affects the entire population, and derives from imperfections in insurance markets that prevent them from
providing an efficient and equitable allocation of health care resources.
Should the Government Pay for Health Care? 58
The relative importance of these two domains—subsidies for the poor and insurance for people who can help finance it—depends on a country's level and distribution of income, and explains much of the difference in health care outcomes between rich and poor countries. Many governments have become the main insurer for personal health care, particularly in high−income countries, and this involvement becomes the quantitatively most important reason for governments to raise money for health care. Because of the complexity of the insurance market, and the fact that both efficiency and equity are involved, such intervention raises the questions mentioned earlier whether to establish public insurance, how to organize it, which sources to use to finance it, and with what decisions and consequences for coverage, benefits, and spending.
Financing of Individual (Personal) Health Care Expenditures
There are three ways to finance individual health care: private individual payments, private collective payments, and public finance.
Private individual payments. These payments are also called out−of−pocket costs. The problem with direct individual payments for health care is that medical expenses are sometimes so high that even people with higher than average incomes cannot afford them. This problem is aggravated by the fact that increased health care costs may coincide with reduced income due to the health problems. In such a situation personal savings may be inadequate and opportunities to borrow for investments in health are limited. Moreover, people with the lowest incomes, who often need care the most, will be excluded from much care if it is financed by direct payments.
This problem does not preclude direct individual payments for health care—which usually account for 10−50 percent of all payments—but it does call for protection against high costs. That means paying for health care collectively, and sharing the financial risk. (There are no general reasons for government to finance small amounts of medical expenditures. The social benefits are small—all but the very poor can afford some medical expenditure—and the social costs may be high.)
Private collective payments (insurance). Because many illnesses occur rarely and seemingly at random, health care expenditures are uncertain as well as possibly high. By pooling a large number of people, insurance reduces the variability of their incomes net of medical expenditure. Health expenditures may be highly variable for a given member of the pool, but average outlays can be predicted fairly well. Thus insurance reduces financial risk for consumers who are risk averse (that is, who have a diminishing marginal utility of wealth or income) and lowers health risks since
care is more accessible. Financial risk is usually not eliminated because coinsurance and deductibles are used to make the insured person share the costs (see Chollet and Lewis and Creese and Bennett in this volume). A policy may require that the insured pay the first $200 of health care costs out of pocket each year (deductible) and then pay 20 percent of all charges (coinsurance).
This cost sharing is one way to control moral hazard — the increased use of services and reduced precaution in taking care of one's health that results when risk pooling leads to reduced marginal costs for services. Moral hazard can manifest itself in two ways, one static and the other dynamic. People with health insurance tend to see doctors more often and to use costly treatments even if the benefits are small (Pauly 1968; Zeckhauser 1970).
Doctors also may change their behavior, particularly in fee−for−service systems. Since costs are not borne by the patient, it is easier for doctors to suggest more expensive treatments. The dynamic effect of moral hazard is the incentives it creates to introduce new medical technology for which there would be no market in the absence of insurance (Weisbrod 1991). Both problems derive from the inability of the insurer to monitor service providers and the insured.
Financing of Individual (Personal) Health Care Expenditures 59
Insurance firms incur costs for doing business such as processing claims and marketing. These are called loading costs, and they generally make competitive private insurance more costly to administer than uniform public insurance. Many of these costs arise because insurance companies have an incentive to exclude high−risk consumers or to at least identify them so that they can be charged more, but have trouble identifying which risk class people belong to. In the short run this situation of asymmetric information —consumers who know their risks better than the insurer does—may benefit high−risk people who, if they know they are likely to need medical care, will be eager to buy insurance. This tendency of the highest risks wanting the most insurance is called adverse selection. If insurance companies compensate for it by raising premiums, some low−risk persons may decide not to buy insurance. This can lead to a vicious circle in which only high−risk people remain.
There are several ways to reduce moral hazard and adverse selection, although there is no complete solution for competitive insurers in a situation where information is asymmetric and imperfect (Pauly 1974; Zeckhauser 1970;
Spence and Zeckhauser 1971; and Mirrlees 1971). The optimal insurance contract is a second−best, nonlinear solution with a mix of risk spreading and incentives such as a moderately high deductible and a diminishing coinsurance rate (Blomqvist forthcoming). An alternative is to include "bonus options" (Zweifel 1992) or rebates in the event that the insured does not submit any claims during the year, with the rebate increasing in subsequent years without a claim until a maximum is reached. This approach provides first−dollar coverage but still provides incentives to reduce moral hazard. Few insurance contracts have these features, but many include suboptimal provisions such as an annual ceiling on copayments. Integrating insurance with service provision is another alternative, and removes the incentive for providers to overtreat since they then bear the financial risk.
Public finance: government as insurer. Moral hazard is a problem in any insurance system, but adverse selection and the attempts of insurers to counter it by excluding potential consumers and adjusting premiums are peculiar to private insurance. This is perhaps the main argument in favor of public insurance, which can more easily be made universal and in effect force everyone to share the risks. Public insurance is also often justified by some related problems—of free riders, of excluded population groups, and of collective risks that are largely independent of individual risks.
In a voluntary insurance system people can choose not to insure. This is not a problem if the uninsured can be ignored when they need medical care but cannot pay for it. If they are taken care of anyway—that is, allowed to
"ride free"—the incentive to have insurance is reduced. It is difficult to judge how important this problem is. In Switzerland most families have insurance despite the fact that it is not compulsory in all cantons. Cultural tradition probably plays a large role; and if most people make an effort to take care of themselves, there is room for generosity to those who do not. It is often suggested that private insurance be made compulsory in order to avoid the free−rider problem. But doing so would raise another problem which sanction to use for people who do not comply—and in any case is infeasible for poor populations.
Exclusion is the opposite of the free−rider problem. People may want insurance but cannot buy it because of low income or high risk. One solution may be to give them a voucher
(subsidy) so they can buy private insurance. The practical problems of calculating and administering such subsidies may be considerable, making public insurance simpler—again, particularly in countries with large poor populations. The elderly, with high risks for illness and related expenditures, pose a particular problem, and some countries have created public insurance just for them. The need to prepare for health expenses in old age can be partly solved through a funded system in which each insured pays into a fund that covers future needs (in contrast to a pay−as−you−go system, where each person's contribution goes toward the current expenses of all members).
This approach also has its problems. Knowledge about the future incidence and prevalence of illness and potential treatments is limited. Thus it is difficult, if not impossible, to calculate the premiums that 20−year−olds should pay for health care that they will receive in fifty years. One solution to such collective risks is for the government
Financing of Individual (Personal) Health Care Expenditures 60
step in as a re−insurer. The problem with life−long insurance can be seen in countries where private insurance funds go bankrupt when their members become older, and have to be merged into funds with younger members.
(This problem also affects pay−as−you−go public insurance, even in middle−income countries, as the population ages.) An alternative is for voluntary insurance to be restricted to a certain age group, for example below 65. The government must then finance care for people over that age. But with increasing life expectancy and the
concentration of costly illness at advanced ages, this approach means that the government will end up paying for the bulk of health care.
It is important to distinguish between actuarially fair insurance, as provided through risk pooling, and government social insurance programs. Actuarially fair insurance is provided through markets in which buyers voluntarily pay for protection against infrequent high medical expenditures whose probabilities can be statistically determined, with premiums adjusted accordingly (see Chollet and Lewis in this volume). Social insurance programs are provided by government, often involve an income transfer between population groups for reasons unrelated to health, have a defined set of eligibility rules, and are partly or wholly financed through taxes or compulsory insurance premiums that need not be actuarially fair. These differences raise questions about the best combination of private and public insurance, and in particular how public finance for health care affects the private market.
Public finance: government subsidies but does not insure. It is also possible for governments to finance health care without acting as insurers, by subsidizing private insurance through the tax system. Employers often pay a significant portion of workers' health insurance premiums: in the United States, for example, about 80 percent of the premiums for private health insurance are paid by employers (Phelps 1986). If employers are allowed to deduct these costs from the income on which they pay corporate taxes but employees are not taxed on the value of the premium—that is, the cost of the insurance is not treated as income to either the company or the worker then the insurance is partly financed by a subsidy or "tax expenditure" equivalent to the tax that the government does not collect. The same situation occurs if individuals' private health insurance premiums are tax deductible, or if employers pay directly for health care (self−insurance). This kind of public subsidy is not used much outside the United States, and there are few estimates of its cost. But in Brazil in the early 1980s it appears to have accounted for $1 billion in health care spending, about a quarter of what the government spent (Lewis 1994).
Paying for health care with employment−related tax deductions can solve some of the problems of private insurance, in that adverse selection is limited by contracting in large groups rather than one person at a time, lowering administrative costs. However, this approach introduces two other problems. First, employees may not recognize that they are paying for their insurance, at least partly, through lower wages. This leads to higher than optimal insurance coverage (overinsurance) and thus higher health care expenditures. The consequences for total health care expenditures can be substantial. Phelps (1986) estimates that employer group health insurance premiums in the United States would be about 45 percent lower if the tax subsidy were not in effect, even though marginal tax rates are only 25−35 percent. There are also welfare losses due to employment choices and wage levels, which are affected by the subsidized excess insurance (Feldman and Dowd 1991; Feldstein 1973; Manning and others 1987). Second, the size of the subsidy increases with the marginal tax rate; if taxes are progressive, the higher subsidies go to people with higher incomes, which is inequitable.
Total Health Expenditures and Government Shares
Total and public financing of health care in different regions are shown in table 1. The public share of health care expenditures is at least 50 percent in every region except Asia. The share is highest in rich countries, which also have the highest total expenditures. Private financing dominates in low−income countries, and direct
out−of−pocket payments are more important than private insurance as a source of revenue.
A similar, though less clear, picture emerges for OECD countries (table 2). The countries with the lowest incomes also have the lowest shares of public finance. The United States is an exception, having the lowest share of public
Total Health Expenditures and Government Shares 61
finance of all OECD countries. By contrast, the government provides nearly all health care resources in Iceland, Norway, Sweden, and the United Kingdom.
Since annual public spending on health typically reaches $1,000−2,000 per capita in rich countries, the questions of how to organize and pay for care are highly relevant. In low−income countries the amounts at stake are much smaller, both absolutely—$10 per capita per year in many African countries, and less than $100 in most of Asia and Latin America—and as a share of income, but it is harder to raise revenue and a larger share of the population is too poor to afford any significant amount of private health care. A better way to compare rich and poor
countries may be to estimate subsistence income and compare total and public health spending with the remaining nonsubsistence or discretionary income. On this basis public efforts to finance health care in poor countries would probably look larger than in OECD countries, making issues of organization and sources of revenue just as important, if not more so.
Which Model for Public Finance?
AS noted earlier, there is a basic distinction between tax−based (directly financed) and insurance−based public health care systems. In tax−based systems general revenue taxes are the main source of finance, and the government usually acts as the main provider of health care. Insurance−based systems are financed mainly through payroll taxes, up to a ceiling on wages at which point the marginal tax rate becomes zero. The number of insurance agencies varies by country, from one in most Latin American systems, to several in Europe, to more than 200 in Argentina. Directly financed systems also provide the protection that characterizes insurance, but the insurance is implicit, and individuals need not be explicitly affiliated to receive benefits.
There is also considerable variation in the connection between finance and provision. Social security institutes operate their own clinics and hospitals in most Latin American countries, but contracting with private providers is the norm in Argentina, Brazil, and most of Europe. In most cases these institutes oversee nonprofit institutions and independent physicians. Different systems use different methods to reimburse providers for services; some−
Table 1
Global health care expenditures by region, 1990
Region
Share of world population (percent)
Total health expenditure (billions of U.S. dollars)
Health expenditure as
percentage of world total
Public health expenditure as
percentage of regional total
Share of GNP spent on health (percent)
Per capita health expenditure (U.S.
dollars)
OECD countries 15 1,483 87 60 9.2 1,860
Transition economies of
Europe 7 49 3 71 3.6 142
Developing countries 78 170 10 50 4.7 41
Latin America and the
Caribbean 8 47 3 60 4.0 105
Middle East and North
Africa 10 39 2 58 4.1 77
Other Asia and islands 13 42 2 39 4.5 61
Which Model for Public Finance? 62