Economics, Entitlements

Have Rising Health Costs Driven Income Inequality?

In a recent response to a blog post where rising income inequality came up, I speculated that one cause could be increasing health costs. The reasons, I said, were that a) employer costs for health coverage are effectively deducted from workers’ salaries; b) relatively fixed health coverage costs are larger relative to low-wage workers’ salaries than high-wage workers’; and c) health costs are rising faster than total compensation. These together mean that salaries will rise more slowly for low-wage workers than high-wage workers, even if overall compensation (inclusive of benefits) rose at the same rate for both.

I did some simple calculations that confirmed the intuition. After some additional digging I also came across an interesting 2008 article from the benefits consulting firm Watson-Wyatt that takes the same approach and generates similar results, albeit in far greater detail. To simplify greatly, here’s how I thought about it:

Imagine two workers: high paid and low paid. High paid receives total compensation of $100,000, of which $5,000 goes to pay for health coverage. Assuming no other benefits, his salary would be $95,000. Low paid receives total compensation of $25,000, which minus $5,000 employer health coverage costs leaves him with $20,000 in salary. The ratio of high to low’s compensation would be 4-to-1 and of their salaries 4.75-to-1. Assume that both workers increase their productivity by 1 percent annually and their total compensation also rises at that rate. But now imagine that health costs rose at 4 percent annually and these rising costs were deducted from their salaries. While the ratio of high to low’s compensation would remain the same at 4-to-1, the ratio of high to low’s salaries would rise every year—to 4.87-to-1 after 5 years and 5.06-to-1 after 10 years.

In their more carefully calibrated model, which relied on data from the Bureau of Labor Statistics, the Social Security Administration, and other sources, Watson-Wyatt found that the overall picture fit quite well:

Our simple model/analysis appears to accurately reflect recent labor-market conditions (including trends in compensation, wages and inequality) and the cost of health care. The analysis suggests that growing wage inequality and the average worker’s stagnating wages can be explained by the rising cost of health care and its disproportionate effects on average workers.

This isn’t to say that rising health costs are the sole driver of income inequality. After all, wages have stagnated for many low earners who don’t receive employer health coverage, while pay for extremely high earners has risen faster than average compensation in the economy. Nevertheless, it appears that rising health costs could explain a good chunk of the wage stagnation we’ve seen toward the middle of the earnings distribution, among people who do receive health coverage but aren’t super-high earners.

If rising health costs guaranteed rising health value, then the measured increase in income inequality would literally be nothing to worry about. For instance, if instead of rising health contributions driving the effect it was rising employer pension contributions, it really wouldn’t be a big deal—less salary today, more benefits in retirement.

But the concern is that rising health outlays aren’t producing value at the margin. Of this I’m not totally sure. This isn’t to say there isn’t a ton of waste in the U.S. healthcare system; I’m confident there is. But much of it could be due to the third-party payer, all-you-can-eat restaurant model we follow, in which fixed costs (premiums) are high but marginal costs (co-pays) are low. This set-up is almost guaranteed to produce waste, but it’s not necessarily guaranteed to produce rising costs. It could be that the level of U.S. health spending is driven upward by the waste-inducing payment structures, but that the growth of health spending is driven by factors such as aging, new technologies, and so forth.

The conclusions from all this aren’t clear: the increase in income inequality could be more benign than we’d originally thought, but if there’s a lot of waste in U.S. health outlays then low earners are still seeing a greater share of their compensation thrown away than high earners simply because health coverage is a larger share of their overall pay.

What we’d really like is better individual-level data on total compensation, inclusive of benefits, rather than simply income. But often we focus on what we can measure (income) rather than what’s truly important (compensation).

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