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In addition to all of these indirect effects on inflation from medical cost increases, there is a final set of effects which is very important. Formal or informal cost-of-living adjustments affect the wages of many workers. On average, those workers covered by inflation-adjustment clauses receive a wage increase of about one-half of 1 percent for each l-percent increase in the price level. Thus, the massive inflation in medical costs in recent years has been translated into higher wages, higher costs to employers, and ultimately higher prices for a wide range of goods and services.

Senator NELSON. Are you saying that under the automatic inflation adjustment clauses, the workers are receiving only an adjustment of 50 percent of the increase in the cost of living?

Dr. SCHULTZE. On the average, that is right. That does not mean they do not get more informally. Some wage agreements have more than that in them, but if you average the agreements, they are about 50 percent.

If you look at the really good contracts, they tend to be two-thirds.

We cannot measure the complete impact of medical costs on prices. I tried to get my staff to give me a measure of these indirect impacts, but we do not really have the data to to it.

Let me suggest that in addition to the normal clearly recognizable impact of rising medical costs on inflation, there are these whole series of indirect impacts, which I could just summarize quickly: The impact on liability insurance; the impact on employer costs, and, therefore, in prices through the medicare payroll tax; the increased cost of fringe benefits for health insurance; and, finally, the second and third and fourth round effects of all of these, which get translated through cost-of-living allowances into still higher wages and still higher prices. While I cannot estimate for you the full impact, these indirect impacts are not insignificant, and hence when you have medical care costs rising more rapidly than the general price level, they are contributing, not just directly to inflation, but to a host of indirect ways to inflation. We sometimes forget how pervasive this is.

Let me turn for a moment to suggest some of the impacts on small business.

The effects of health-care inflation may hit small businesses harder than bigger firms. The burden of payroll taxes paid by smaller businesses tends to be greater than for larger firms because a lower percentage of workers in small firms have incomes above the wage base for the social security tax.

Moreover, since health insurance premiums generally are the same for all workers, regardless of their income, firms with lower-wage work forces must devote a larger percentage of their payrolls to healthcare premiums if they are to provide benefits equivalent to their larger competitors.

Thus, skyrocketing medical costs have a pervasive and far-reaching effect on the overall rate of inflation in our economy.

Dr. GALBRAITH. May I interrupt?
It is difficult to say that big business lacks the capacity to pass this
Dr. Schultze. What you have to do is balance the two things.

Dr. GALBRAITH. Surely General Motors can pass this on more easily than a small firm.

on.

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Dr. SCHULTZE. There are two parts, casual observation says you have two offsetting factors. First, if you look at wages of the union contracts, they are more likely to have good medical insurance than small business.

On the other hand, given the increase, small business is less likely to be able to pass it on. So I would say that it would, on balance, hurt small business more.

Senator NELSON. Small businesses are at the fighting edge of the competitive system. Is it not so, as suggested by Professor Galbraith, that arbitrarily, General Motors can say, “This is our addition,” and, since there is nobody in the marketplace to compete with them, they can pass it on?

Dr. Schultza. I fully agree. I simply say you have to balance that with everything else.

I think you are right, it does hurt small business more, but I cannot measure it.

Let me talk a little bit about the need for hospital cost control.

I do not think I have to convince the chairman, but I think it would be useful to get it into the record.

As I noted earlier, hospital expenses have become one of the most important contributors to health-care cost inflation.

The cost of an average day in the hospital has been rising twice as fast as other elements of health care. As a result, hospital costs today account for 40 percent of all health-care expenses, compared to only 30 percent in 1950. The structure of the hospital industry is a major factor underlying the escalation of hospital costs.

Nearly 60 percent of all hospital beds are located in publicly owned hospitals. Over 35 percent of all hospital beds are in nonprofit, privately run hospitals.

Senator NELSON. What percent?

Dr. Schultza. Slightly over 35. Fewer than 4 percent of all beds are in competitive, for-profit hospitals. Moreover, the shift to thirdparty payments has affected hospitals greatly. Patients today pay only about 6 percent of all hospital bills from their own pockets. In other words, neither patients, hospitals, nor doctors have much incentive to strive to hold down costs.

Senator NELSON. My staff tells me that in for-profit hospitals, the cost is rising more slowly than non-profits. Is that your impression?

Dr. SchultzE. Well, as an economist, you can expect that to happen. I have not seen that statistic, but you would expect that to happen.

And one has to balance the quality of care, type of patient, and geographic location.

As you know, in many areas, there are surplus hospital beds and unnecessary, expensive machinery that sits idle—while patients and the rest of us bear the cost.

The mechanisms for reimbursing hospitals also have contributed to the problem. Whether payments are made by individual insurance companies or by governments, hospitals generally are reimbursed according to their own costs.

As a consequence, reimbursement methods offer little incentive to hold down costs.

In effect, if I may interject in a slightly informal manner, it is a little bit like the situation of a group of professional people, doctors, who have an absolutely cost-plus laboratory at their own command,

and obviously, since they do not pay, and the patient does not pay, their professional interests, quite apart from income, are all in the direction of increasing steadily the complexity, the scientific technology, the duplication of equipment. It is an absolutely natural response of a large group of professional people, in an economic situation, in which anything they can do, which can legitimately be shown to be a cost, gets paid for

Fifty-five percent of hospital costs are paid for by the public now, 39 percent of that from the Federal Government, and the remainder from State and local governments.

Senator NELSON. You mean through Government institutions?

Dr. SCHULTZE. Either through medicare, medicaid, or support of municipal hospitals or public health hospitals.

Senator NELSON. What percent?
Dr. Schultze. Fifty-five percent.
Senator NELSON. And the rest is third party?

Dr. Schultza. Almost all of the rest, 37 percent of the remainder is third party payers.

Senator NELSON. And then there are uninsured individuals?

Dr. SCHULTZE. The remainder is a combination of uninsured individuals, plus individuals paying a part of the costs covered by insurance, and private charity.

It is a self-perpetuating mechanism which is understandable, and which one could expect with this kind of a system.

Direct control over hospital costs may be the only way to bring hospital costs back into line in the immediate future.

Mandatory programs run by State governments to control hospital costs appear to have had some success.

In 1976, the latest year for which data are available, hospital revenue increases in the six States with some form of mandatory controls rose 15.4 percent, compared to a national rate of 17.8 percent.

In a way it is kind of a commentary to say that 15.4 percent is not so good, but compared to 17.8 percent it does show some favorable performance.

On the other hand, voluntary programs at the State level appear to have had little ict on costs. In the three States with voluntary programs in effect in 1976, hospital revenues rose by 22 percent.

The Administration originally proposed, as a remedy for the serious inflation problem in the hospital industry, mandatory controls over hospital costs and revenues.

Proposals in the Congress would maintain mandatory controls as a threat, while giving hospitals the opportunity to bring their cost increases into line through voluntary efforts.

A mandatory program, in my view, has the better chance of success. But, in any event, it is clear that some form of hospital cost-containment program is essential to bringing down the overall rate of inflation.

Thank you, Mr. Chairman.
(The prepared statement of Dr. Schultze follows:]

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Good Afternoon.

I appreciate the opportunity to appear before this committee to discuss the urgent problem of inflation in

the health-care sector of the economy.

Over the past two decades, the American people have

devoted a progressively larger share of their income to acquiring more and better health care in part

because they wanted more and better health-care services

and in part because the costs of health care have risen

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Medical care has become the nation's second largest industry,

and one of the fastest growing.

However, the health-care

sector also has become one of the most persistent contributors

to our extremely difficult inflation problem.

From 1959 to 1966, the year Medicare was introduced,

the cost of medical care services as measured by the consumer

price index rose on average by about 3 percent a year, or

about 1-1/2 percentage points faster than the overall rate of inflation during the period. Since 1966, medical care costs have

exploded. Excluding the period of wage and price controls,

the price of medical care has risen on average by about 10.5

percent per year since 1966.

That is almost 5 percentage

points per year faster than the overall rate of inflation.

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