The Effect of Health Care Cost Growth on the U.S. Economy. 3.2 Effect on Employers

09/01/2007

In the U.S., the private sector bears a large part of the burden of rapidly rising health care costs because about three-fifths of all Americans have employer-sponsored health insurance. The popularity of employer provided insurance in the US partly stems from the fact that employer contributions to health insurance premiums are exempt from income and payroll taxes. Higher health insurance premiums may erode profits. In fact, some employers now view increasing premiums for health insurance as important to their profitability as rising energy costs and broader economic trends (Business Roundtable, 2004). For example, according to the chairman of Associated Industries of Massachusetts, where virtually all members provide health benefits, health care costs have been the number one concern over the past 15 years (Wroe, 2007). Similarly, a recent survey by the National Federation of Independent Business (NFIB) shows that rising cost of health care is the top health care concern of the nation's small businesses, but small business owners do not support sweeping health care reforms (BNA, 2007).

To preserve profits, firms faced with rising health care premiums may cut employment, reduce health benefits, raise prices, and reduce other expenses, including investments that may enhance future productivity. There is some research on the effects of rising health care costs on employment and benefits. However, we found very little research on how health care costs affect profits, revenues, output, or competitiveness of U.S. employers. Below, we summarize some of the main findings from the literature on the effect of health care cost growth on employers or private businesses.

Health care cost growth has no effect on employers if workers bear incidence of the costs. The traditional economic model of wage-benefit tradeoff implies that workers bear most of the burden of health care costs as long as workers value health insurance at its cost (Summers, 1989). There is some evidence that increase in the cost of fringe benefits results in a decrease in wages with no effect on employment (Gruber 1994). In this standard model, health care cost growth would result in a one-for-one decrease in wages with little or no effect on employer profits, output, employment, and employee cost sharing. However, recent evidence suggests that rising employee costs are prompting employers to reduce benefits, change health care providers, and move to high deductible, consumer-driven health plans4. Recent reports also suggest that employers are showing greater interest in cost-containment measures such as adopting workplace wellness programs, and offering financial incentives to workers to pay closer attention to their health (Butler, 2007; Shea, 2007; Race, 2007).

If employers bear some incidence of health care costs, then cost growth will lead to higher prices and lower output, less employment, and lower profits. The standard economic view, as described above, runs contrary to the general perception that employers bear a significant fraction of health care costs. Under this popular view, health care cost growth is likely to lead to higher prices and lower output, less employment, and lower profits.

Sommers (2005) and Baicker and Chandra (2005) offer potential explanations to reconcile the opposing views of the economic model and the view expressed by employers about the effect of health care costs. Sommers (2005) shows that an economic model where nominal wages do not decline in response to rising employment costs (a situation known as ‘sticky wages’) predicts that rapid health care inflation will lead to (1) lower profits, (2) higher prices, (3) lower output, and  (4) higher employee contributions. These effects are more pronounced for employers facing low general inflation and a high benefit to wage ratio.

Baicker and Chandra (2005) suggest that institutional constraints such as minimum wage laws and IRS non-discriminatory provisions might limit firms’ ability to offset increases in health care costs by lowering wages or reducing benefits. They exploit variation in medical malpractice payments across states to estimate the causal effect of health insurance premiums on labor market outcomes. They estimate that a 10% increase in health insurance premiums reduces the probability of being employed by 1.6%, reduces hours worked by 1%, and increases the probability of part-time work by 1.9%. For workers covered by health insurance, this increase in premiums leads to a 2.3% reduction in wages. They find no effect on the employee cost of health insurance. 

Cutler and Madrian (1998) show that when health insurance costs increase, firms have an incentive to reduce employment but increase hours worked per employee. They estimate that increases in health insurance costs in the 1980s led to a 3% increase in hours worked for those with employer provided health insurance relative to those without insurance. They argue that health insurance being a fixed cost, employers substitute greater hours per employee for the number of workers when insurance costs rise. However, Baicker and Chandra’s (2005) findings suggest that employers might also substitute full time workers by part time workers (without benefits), which results in a reduction in hours of work. The exact mechanism chosen by an employer would of course depend on a range of factors including the legal or institutional environment within which a firm operates.

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