Health and Taxes

One of the longest-lived debates in the world is whether it is worth having a state-funded health sector or not. Those who prefer the latter (e.g. the US), believe that it does not make sense for the state to pay for the health of its citizens because they will be more heavily burdened by tax, and a larger amount of their taxes will be spent in health, when there might be better use for their hard-earned money. The countries who favour the former though, do not believe that this is the case. Have a look at the following graph on total per capita expenditure on healthcare, obtained from OECD data for 2011(measured in dollars, PPP):

The United States appears to have the largest per capita expenditure on the health sector, nearly double of what other developed countries are spending. In addition, even though these are per capita numbers the reader should remember that these do not reflect the whole population of the country, just like they do in most European ones. The reason is that not everybody is covered by insurance in the US and thus the amounts registered are those which belong to people under insurance schemes (and some others who both have enough money and are willing to spend it to get back to health). While he above graph shows total expenditure in health, the two below show how much is spent by the private sector and how much by the public on health:

In the public expenditure, the US only lags behind Norway and Netherlands (where 85% of health expenditure is by the public sector), but in the private health expenditure it surpasses its closest country (Switzerland) by more than 2.5 times, leading again to higher overall spending on health. The questions here are two:

1. Why is spending so high in the US?

2. How much extra taxes would it take to cover everyone?

The first question is rather easy, although at times it appears to elude most of the proponents of the private-funded health system. Imagine now that you have an insurance policy under a certain company and you get sick. The doctor (and the hospital in general) who examines you, knows whether you have insurance or not. The problem here is that almost any amount the hospital asks, the insurance company is willing to pay (obviously up to some specific amount over which the insurance company will deny to pay as it will consider it to be very large). This is actually profit-maximizing behaviour from the part of the healthcare providers, meaning that nobody could actually condemn the hospital for acting this way under the circumstances. Thus, they ask for higher prices than they possibly could had there been no insurance cover for everyone since its not the consumer who will pay the money (he does, indirectly though). How about those who do not have cover you might ask? Well, the hospital is "forced" to charge the same price for them as well, for the simple reason that if they charged them less then those who had cover might find it more profitable to lose cover, save the premium, and then pay the lower price at the hospital.

What's present here is free market with many frictions which are actually not allowing it to function smoothly. Insurance companies are distorting incentives and "forcing" hospitals to increase their fees, thus increasing the overall cost. When hospitals are public and healthcare is free, then prices in the private sector also fall. The reason is again simple: there exists a competitor and the competitor is a perfect substitute. For example, an oncologist working having a private practice would face the direct competition of a colleague working in the public sector. The two services are almost inseparable, meaning that the patient is indifferent as to who gets him better (so long as he gets better). Yet, if his competition is not charging anything, the only way for the private MD to charge high amounts of money is to make sure that he is providing a higher quality of service. Yet, the charge is somewhat capped: he cannot ask for as much as he wants, since everyone will shift to the public sector if he does. As you may easily see here, it is an issue of paying for extra quality; quality which is not debatable as people would not be paying all that money for a private doctor if he wasn't worth it (For those who do not think that this price change really happens have a look at this interesting article from the NYT comparing prices in the US and Belgium).

Moving on to the question on how much it would cost the US to move to state-funded healthcare, the answer is that it wouldn't cost as much as most people think. Let's say that it ends ups costing 20% more than it does to Norway (even though this is a hugely inflated amount), at $6802 per person. Then, deduct the amount already spent on healthcare by the state, currently at $4066, leaving us with $2736 per person. That's too much taxation a person might add. Is it really? Every person in the US spent $4441 on healthcare in 2011, i.e. more than 60% than the $2736 of taxation in the extreme case. 

Readers might wonder how the reduction in cost will occur if the US shifts from private healthcare to public healthcare. As already mentioned this is simple supply and demand, with competition forcing prices down. At the moment, hospitals are acting like cartels, meaning that they have a strong incentive to hold prices up and nobody is willing to leave that situation. If more hospitals are funded by the state, then competition in prices is increased, forcing prices down. There will be some variation in prices, obviously; yet, this will reflect differences in the quality of healthcare or other local factors (e.g. higher prices in New York than Nebraska). Even more, the consumer will be more assured that higher prices actually mean higher quality.

If the case is so simple then why aren't things changing in the US? The answer is two-fold: first there are those whose interests are being hurt (doctors, private hospitals, insurance companies) and do not wish for the situation to change. Second, people do not enjoy change. The reason is that we learn to adjust to the current situation, whatever that might be, and we are afraid to change, even if it is for the better. All it takes in most of the times is a shift in mentality; not an easy task though.

A History of Stagflation and Recent Experiences

When a person is asked what is the worst economic conditions one can think of the most common answer is, of course, high unemployment. We all know what unemployment means: people have no jobs, consequently no money to live by and the welfare of an entire nation is at stake. It just takes a look at the current situation in South Europe, especially in Greece and Spain, to understand that high unemployment can have devastating consequences. What makes life slightly easier for the unemployed is the fact that prices tend to fall when unemployment rises, as the Philips Curve claims. Yet, when a nation has to deal with high inflation and high unemployment simultaneously it faces a situation called stagflation.

The 1970's were such a period; in the UK, a recession caused the unemployment rate to rise by approximately 83% in the 1970-1979 period as it took about 14 quarters for the UK GDP to recover to it's pre-recession levels, with the overall output decrease at 4%, or about 1.5% in real terms if one uses the Bank of England data. Yet, even though the rise in unemployment was tremendous, the maximum value reached in the 1960's was just 4.2%. Yes, that is just 4.2% of the labour force and no it is not a typo. In comparison, only Austria had an unemployment rate of less than 5% in June 2013. Then why complain about growth?

The difference here was inflation. Inflation rose by an astonishing 200% in the 1970's, with annual rates reaching 24%. The starting value of inflation was not really that low either: in 1969, inflation was more than 5% while it rose to 24% in 1975. On average, the yearly inflation rate in the 1970's was 12.5% higher than any other period in the UK's history.

What is odd is that the term stagflation was not coined in the 1970's as one would expect. It was in fact first uttered in 1965 by a British politician, Iain Macleod, who warned about the situation "We now have the worst of both worlds—not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of “stagflation” situation. And history, in modern terms, is indeed being made."

This, however, was a rather strange conclusion: inflation in the 1960-1965 period was 3%, the unemployment rate was 1.5% and GDP grew on average 3.1% in real terms. Neither was the situation bad during the previous decade: in the 1950's output grew by 2.31% in real terms, unemployment was 1.24% and inflation was 4.3%, something which can be attributed to high growth during the years after the war (indeed if one excludes 1950-1953 the average inflation was 3%). Thus, what made 1965 different?

My guess is nothing. In fact, stagflation in the UK would not appear until the 1970's and the only pertinent issue was the level of inflation at a moderately high 4% in the 1965-1970 period. Yet, in no way did high inflation cause a stagnant economy. The next graph indicates the annual real GDP growth for the UK.

In the 1960's only once was real growth low, and this was at 1%, not something which would cause distress and something that South Europe economies would crave for at the moment. Inflation was indeed an issue; one which was due to policy (high government spending in periods of full employment). Yet, policy alone would not have created such an issue if oil prices had not skyrocketed in 1973-1974. To day, this has been the largest increase in oil prices, causing a major supply shock inflation which caused inflation to rise. The two major shocks in the decade, in 1973-1974 (252%) and in 1978-1979 (125%) were the main causes of recession. In total, oil prices increased by 1504% (that is 15-fold) in the 1970's.

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This, compared with a much greater dependency on oil than we currently have, caused the shock which came to be remembered as stagflation. The initial conditions had also been favourable: increased government spending in times of almost full employment caused higher than normal inflation and set the background for an even larger increase in inflation when the oil shock hit the world economy. Emphasis here should be made to the following point: as with hyperinflation, policy alone could not have caused stagflation; The oil shock was necessary for the situation to unfold and we would have not witnessed this part of history if it wasn't for it.

How about the politician's quote then? What triggered his comment if inflation was not higher than before and growth was still good? There are only two possible explanations: either he could see 7-8 years into the future or he was comparing with what had happened before and highly exaggerated. The first explanation is rather strange given that if he could do that he would have have made himself a very rich man, while the latter is more plausible if one looks at the data. According to the data mentioned above, inflation was higher by 1% and unemployment by 0.25% then the previous decade; strangely, GDP was growing by more during the time of his statement. It appears that the whole issue has been one of comparison between what the economy was doing and what the economy did. As politicians are more prone to dramatize situations than most people are, a subtle change in the economy (although percentage-wise the increase in unemployment was 20%) would spark just such a comment, especially if one thinks that Macleod was a Conservative while government was led by the Labour Party which had won a narrow victory in 1964. 

I wouldn't dare suggest that a period which satisfied the name and definition of stagflation never existed. Yet, the definition preceded the actual situation by more than 7 years, with no data or developments supporting the initial claim, which makes us wonder whether the statement had nothing more behind it than mere political agendas, since indicators just slightly deteriorated during the 1960's (with real GDP actually increasing). In addition, even though the recession was quite real, stagflation would not have justified its name had there not been a dramatic increase in oil prices.

Concluding, even though a resurrection of those who promote that stagflation would be an issue in the near future, I would just note that inflation both in the US as well as the EU and UK is falling and unemployment is much more stable (although higher) than it was a year (or more) ago. In addition, oil dependency has decreased over the years as alternative sources of energy emerged: solar, nuclear, geothermal and most importantly gas. Although I would not go as far as to declare that stagflation cannot occur, it would take a much more severe shock than the one in the 70's for it to take place.

Note: All data for the UK, including Oil Prices were extracted by the Bank of England's Three Centuries of Data file (.xls)