Executive Summary Treating Our Ills and Killing Our Prospects

By Steven A. Nyce Towers Watson and Sylvester J. Schieber June 29, 2011

Sylvester Schiebers contributions to this paper were supported by the Coalition for Affordable Health Coverage. The authors are indebted to Michael Slover of Towers Watson for his contributions to the statistical analyses included in parts of the paper and to Susan Farris of Towers Watson for her editorial help in preparing the final draft. All of the conclusions and opinions stated herein are those of the authors and do not necessarily represent those of the Coalition for Affordable Health Coverage, Towers Watson or any of their associates.

Executive Summary
Most of us are aware that health costs have been rising more rapidly than those in most other aspects of our lives and that they seem to have accelerated in recent years. There is also widespread sentiment that the rewards for increasing worker productivity in the United States in recent times have not raised all boats and that middle-class workers are increasingly being left behind with their rewards growing more slowly than productivity levels. Both of these perceptions are widely reported but they are seldom linked. For most workers, the majority of the health expenses they incur each yearand the health cost inflation that goes with themare hidden from the naked eye because they are financed through compensation packages, seemingly paid for by employers who actually consider them part of the cost of hiring workers. Of course, the costs of hiring workers have to be covered by their productivity or the employer cannot continue to offer them jobs. These health benefits costs have gotten so large in recent years and have been growing so fast that they now are contributing to the noticeable slowdown in workers pay and income growth. Robert Gordon has been studying the issue of growing inequality in income and pay in the United States and has raised a cautionary note regarding the conclusions that have been drawn in this regard. Gordon argues that productivity and income growth rates are computed on an inconsistent basis and when income is measured on a per capita basis as productivity is and both are converted into constant dollars using the GDP price deflator rather than separate deflators, the difference in the rates of growth in income and productivity are minimal. Despite this conclusion, Gordons analysis shows that from 2000 to 2007, output per hour was growing at a rate of 1.39 percent per year but mean income per person of working age grew hardly at all over that period. He suggested that further research was required to ascertain what was happening to this disappearing income.i A substantial part of the answer to Gordons puzzle is that tracking of aggregate compensation is based on the National Income and Product Accounts (NIPA) which includes cash pay for employed workers plus employer contributions for benefits provided to them as part of their total remuneration. The benefit costs include the employers share of payroll taxes for Social Security, Medicare and unemployment insurance plus employer contributions for retirement health benefit plans that they sponsor for their workers. In 2000 under the NIPA annual data series, benefits costs absorbed by employers were 10.6 percent their total compensation costs, rose to 12.5 percent by 2007 and to 13.7 percent by 2009.ii For the most part, the economic literature and the Census data series on the distribution of earnings and income ignore this element of compensation paid to workers and its distribution across the earnings spectrum. The benefits are sizeable enough that they have the potential to skew any analytical results that ignore them. The reason that compensation grew more rapidly in the latter period while pay fell behind was because of higher growth rates in the parts of compensation that do not show up in the regular paycheck. These are benefits costs that employers incur in behalf of workers. The benefit costs include the employers share of payroll taxes for Social Security, Medicare and unemployment insurance plus employer contributions for retirement health benefit plans that they sponsor for their workers. During the 1990s, hourly pay grew at around 1 percent per year 2

across most of the earnings spectrum. Pay growth in the period from 2000 through 2009 has been closer to 0.5 percent per year across the middle parts of the earnings distribution but has lagged behind the 1990s at all earnings levels (See Figure 5). The story with total compensation is somewhat different. During the 1990s, total compensation was also growing at a rate of around 1 percent per year over nearly 90 percent of the earnings spectrum. From the 40th to the 90th percentiles of the distribution, however, compensation growth during the 2000 to 2009 period actually exceeded what had been achieved during the 1990s. When benefit costs grow more rapidly than the compensation budget, wage growth is reduced. The growing share of compensation diverted to benefits, shown in Executive Summary Table 1, explains some of the public consternation about what has been happening to disposable earnings. While the major elements of this current discussion focus on health care issues, the results in the table are driven by more than just health care costs over the time spans reflected. During the 1980s, increases in the payroll tax acted as a drag on workers cash rewards as we implemented the changes to the Social Security Act that were adopted in 1977 and 1983 in response to the financing crisis that faced us in the late 1970s and early 1980s. During the most recent decade, employer contributions to employer-sponsored retirement plans have increased dramatically. The largest share of these latter increases has been directed toward defined benefit plans. While these plans have been curtailed in recent years, there is a tail of liabilities that still must be met from these plans that were much more prominent during the 1980s and early 1990s. These added contributions have arisen, in part, because contribution levels were reduced in the 1980s in response to regulatory changes that reduced employer contributions to the plans and to the booming financial markets in the 1990s. The funding problems that have plagued these plans since the beginning of the current century have required the dramatic increase in contributions because the aging of the baby boomers is making the liabilities more immediate, because falling interest rates have accentuated them and because the turmoil in the financial markets had reduced the value of asset trusts in many cases. The sluggish growth in workers disposable income in recent years has been attributed to a variety of things including changing reward structures in the corporate world and tax policy as the focus of many commentaries. Those factors may have played some role in developments but growing benefit costs were likely a much larger reason for the unsatisfactory results many people have had at the pay window in recent years. The underlying factors that have affected the nonwage components of compensation over the past three decades have not played themselves out so these forces will play a continuing role in the rewards picture for the future. In addition to the effects that growing health benefits costs have been having on workers pay and income, there is also evidence that they have been affecting labor markets as well. It is through a job that most workers acquire their health insurance in modern America. Health benefits have become totally engrained in the decisions of workers about all aspects of their workforce choices from what job to take, when or if to leave a position and whether or not to work at all. Single mothers are more likely to take full-time employment to qualify for health benefits than married mothers who can qualify under their husbands insurance. People receiving disability benefits are reluctant to go back to work because they will lose valuable health insurance coverage once they demonstrate they can provide for themselves. Workers unhappy in their current jobs and older workers wanting to find a bridge job as entry into retirement are trapped often in existing jobs with insurance coverage. These benefits cause 3

distortions in labor supply decisions that must ultimately affect the overall efficiency of our economy. Executive Summary Table 1: Share of Compensation Gains Provided in the Form of More Expensive Benefits Paid by Employers for Full-Year Workers by Earnings Decile and for Selected Periods*
Earnings decile 1 2 3 4 5 6 7 8 9 10 1980-1990* 100.0% 100.0% 90.8% 54.1% 63.9% 43.0% 48.6% 36.8% 29.7% 21.4% 1990-2000 30.4% 23.1% 25.0% 21.3% 17.8% 18.8% 12.4% 9.6% 7.8% 6.8% 2000-2009 35.2% 47.7% 52.3% 60.8% 55.7% 55.3% 54.8% 50.3% 45.0% 37.7%

Source: Updated results of projections presented in Steven A. Nyce and Sylvester J. Schieber, Health Care Inflation, Must Workers Bear the Brunt, Milken Institute Review (Second Quarter 2010), pp. 46-57.
*

Total benefit cost increases in the 1980s for the first and second earnings decile exceeded 100 percent of compensation growth. In both cases, benefit costs increased significantly but total compensation growth was in the negligible first decile and negative in the second.

In Executive Summary Table 2, the isolated effects of health benefits costs increases on compensation are shown for the analysis period. Empirical analyses, by their nature, consider the implications of things like health cost across broad groups of the population. For example, the heart of the analysis developed here is looking at the effects of health benefit cost inflation on the levels of pay realized by the full-time workers by earnings levels. The earnings splits that we have chosen are deciles. When we show in Executive Summary Table 2 that health benefits cost increases have absorbed 23.6 percent of the added compensation reward paid to workers in the bottom earnings decile in the period 2000 through 2009, our result includes all workers in that decile even though many of them do not actually participate in a plan. Because of declining coverage of workers, which has tended to be concentrated at lower earnings levels, the rates at which increasing health costs have crowded dollars out of the paycheck has been dampened. For many of these people, however, the loss of employerprovided health insurance has meant larger out-of-pocket expenditures for health consumption out from their disposable income. It is a classic case of damned if you do or damned if you dont, in that either way, other consumption is adversely affected. It is important to remember that the primary purpose of the analysis is to understand how health inflation is affecting the general rewards for broad groups of the workforce. When an 4

employer is considering the addition or retention of a worker, however, the focus is more narrowly focused on what that worker will cost in comparison to the expected value that he or she will bring to the organization. The marginal costs of workers in the various earnings deciles who actually take health insurance are quite different than the average of all workers in the deciles. Executive Summary Table 2: Share of Compensation Gains Provided in the Form of More Expensive Health Benefits Paid by Employers for Full-Year Workers by Earnings Decile and for Selected Periods*
Earnings decile 1 2 3 4 5 6 7 8 9 10 1980-1990* 285.8% 100.0% 106.9% 57.2% 74.4% 45.2% 55.5% 38.7% 21.4% 12.1% 1990-2000 26.8% 20.8% 23.6% 21.0% 19.8% 22.5% 15.5% 12.1% 9.1% 2.9% 2000-2009 23.6% 30.4% 30.1% 36.5% 28.9% 26.7% 25.8% 20.1% 15.0% 9.1%

Source: Updated results of projections presented in Steven A. Nyce and Sylvester J. Schieber, Health Care Inflation, Must Workers Bear the Brunt, Milken Institute Review (Second Quarter 2010), pp. 46-57.
*

Health benefit cost increases in the 1980s for the second earnings decile exceeded 100 percent of compensation growth. Benefit costs increased significantly but total compensation growth was negative in the second decile.

Executive Summary Table 3 shows how health benefits care costs have risen relative to wages between 1980 and 2009 for workers who actually enrolled in the health benefit plans offered by their own employers. In 1980, employers costs for those who enrolled in their programs cost single-digits relative to wages for all decile groups except the lowest with the median enrolled employee costing about 6 percent of pay. Over the next three decades, those costs have grown more than threefold relative to wages and reaching more than a third of individuals wages among the lowest decile groups. In fact, for the lowest decile group they have nearly eclipsed half of an employees take home pay in 2009. Likewise, these costs have been growing at much faster pace for the lowest paid highlighting the greater impact that compounding has on the lower pay groups. For example, health benefit costs relative to wages for the second decile were twice those of workers in the ninth decile in 1980, which by 2009 has risen to more than three times. Because of that, health benefits have the potential to make certain workers uneconomical in some cases.

Executive Summary Table 3: Health Benefit Costs as a Share of Wages for Full-Time, FullYear Workers Receiving Health Care Benefits through Their Own Employer
1980 1 2 3 4 5 6 7 8 9 10 15.4% 9.5% 8.0% 7.2% 6.3% 5.8% 5.4% 4.9% 4.3% 3.2% 1990 30.9% 18.7% 15.3% 13.3% 11.6% 9.9% 9.2% 8.2% 6.9% 4.9% 2000 38.1% 22.9% 18.6% 16.0% 14.0% 12.1% 10.8% 9.2% 7.8% 4.7% 2009 49.5% 30.9% 25.5% 22.3% 19.4% 16.8% 14.8% 12.5% 10.2% 6.3%

Source: Developed by the authors. On the labor demand side, the idea that employers treat health benefits as part of the compensation bundle suggests that increasing health premiums for their benefit plans would merely be adjusted by reducing other aspects of the total package. But workers cash pay tends to be sticky downwardit is difficult to reduce pay without causing a variety of disruptions among workers. If employers are forced to absorb health cost increases that exceed the added productivity that workers bring to the table, it is likely they will curtail employment in some cases. Katherine Baicker and Amitabh Chandra have also developed an empirical analysis of effects of rising health benefits costs on labor demand and estimate that a 10 percent increase in health insurance premiums reduces the aggregate probability of employment by 1.6 percent and total hours worked by 1 percent.iii To put these results into context, taking the excessive rates of growth in employers health benefit costs over the past decade compared to productivity growth, health costs have increased an excess of 20 percent. Extrapolating Baicker and Chandras results, this suggests that growing health benefit costs have added 2 percent to the unemployment rate over the period. No one knows for certain what the implications of the 2010 health reform law will be for U.S. workers in terms of their future health costsor even how they will acquire their health insurance coverage in the future. The analysis of what has occurred over the past three decades suggests that a considerable share of the disappointment with the rewards that many workers have received in recent years is due to the voracious appetite that health benefits have brought to bear on their productivity rewards. The extension of the trends on health benefit cost growth that have persisted for decades now suggests that if we cannot bring excessive health care inflation under control, workers prosperity is going to be increasingly threatened. A full-time worker in the second earnings decile in 2009 earned around $25,000 in total compensation on average. If his or her productivity goes up by the rate of growth that the Social Security actuaries estimate, by 2019 this worker will be earning around $36,600 in total compensation but nearly 75 percent of the difference from 2009 will have been consumed by rising health benefit costs. If the worker is being provided family coverage, the cost of health benefits will grow to consume all of 6

the added productivity contribution. Do we really think that health cost reform is going to restrain health inflation? Even Peter Orszag, who was the Director of the Office of Management and Budget and a major architect of the health reform package, and Ezekiel J. Emanuel who was a special advisor to the White House and OMB during the reform development suggest that under the new reform model, total health expenditures in the United States in 2030 will only be 0.50 percent less as a share of GDP than under prior law.iv One of the goals of health reform is to broadly expand the coverage of the population under health insurance programs. In a scenario where we assume that future health costs grow at the rate they have been growing since the turn of the century and where we assume that all workers take up health insurance in the context of employer-sponsored plans, our results are sobering. In this case, not only is recent health inflation eating away at cash wages in the compensation package, but expanded coverage will eat away further at aggregate rewards other than health benefits paid to workers. Because the expansion in coverage would be so much more dramatic in the lower ends of the earnings distribution, the growth in the rate of compensation absorption is more dramatic for lower earners. Once again, the results portend that we are at risk of health inflation stealing from our productivity rewards at rates that will leave little for other aspects of the compensation package. The stark result of the sort of scenario presented in Executive Summary Table 4 is that employers simply cannot offer many workers the benefits implied and pay them a wage that might grow over time beyond that and remain competitive in a global economy. The potential subsidization of health insurance under the health care reform law for workers who acquire it outside their employers suggests the economics of offering coverage will change significantly. Many employers, particularly in low-wage industries, will likely eliminate their plans and let workers fend for themselves in the new health exchange marketplace. At the margin, this sort of outcome may work and may even be desirable but we cannot avoid the fact that we are facing a national marketplace here. The mere shifting of health insurance costs from employers compensation packages to a mix of public subsidy and workers contributions out of their remaining disposable wages will not reduce national costs unless we bring excessive inflation under control. If health reform does not reduce the rate of growth in our costs, we must ask who is going to pay the bill? It is important to keep in mind that our projections have not included the bill for additional public subsidies under the new health reform law for workers not receiving employersponsored health care benefits. Nor do they include the potential response that policymakers will ultimately bring to bear on the underfunding of Social Security and Medicare that now persists which we have concluded in a separate analysis will be substantial.v The Congressional Budget Office projects that the cost of federal entitlement programs will rise from 10 percent of GDP in 2010 to 16 percent of GDP by 2030. Ultimately these costs will have to be absorbed by the productivity of our economysuggesting that at least two-thirds of the bill will come out of workers pockets one way of the other if costs are distributed in accordance with the way our national output is distributed. The workers costs to cover these federal expenditures may not come out of their compensation but they will still be extracted from their paychecks in the form of higher taxes. The potential of these costs hanging over our heads with seemingly little inclination on the part of policymakers to address them suggests that we have extremely little margin for any added subtractions from future workers compensation if we wish to pass on to 7

them the American Dream that each generation is given a chance to better itself compared to those that have come before. Executive Summary Table 4: Share of Compensation Gains Provided in the Form of More Expensive Health Benefits Assuming Expanded Coverage Under PPACA is Paid by Employers Where Health Cost Inflation Rates Persist at Current Rates
Projection Periods Earnings decile All 1 2 3 4 5 6 7 8 9 10 --------------------------------------------------------2009 to 2015 to 2009 to 2015 2030 2030 ---------------------------------------------45.2% 41.9% 42.8% 272.7% 136.8% 94.5% 71.2% 58.5% 47.1% 40.6% 32.2% 26.3% 16.4% 134.4% 87.5% 73.2% 65.0% 57.3% 51.4% 45.6% 38.9% 32.2% 20.3% 169.5% 100.0% 78.6% 66.6% 57.6% 50.3% 44.3% 37.2% 30.7% 19.3%

Source: Developed by the authors as described in the text.

Robert J. Gordon, Misperceptions about the Magnitude and Timing of Changes in American Income Inequality, (Cambridge, MA: National Bureau of Economic Research, 2009), NBER Working Paper 15331, Table 1. Computed from U.S. Department of Commerce, Bureau of Economic Analysis, National Income and Product Accounts found at: http://www.bea.gov/national/nipaweb/index.asp. Katherine Baicker and Amitabh Chandra, The Labor Market Effects of rising Health Insurance Premiums, NBER Working Paper No. 11160(Cambridge, MA: National Bureau of Economic Research, 2005). Peter R. Orszag and Ezekiel J. Emanuel, Health Care Reform and Cost Control, New England Journal of Medicine (June 16, 2010), found at: http://healthpolicyandreform.nejm.org/?p=3564. Steven A. Nyce and Sylvester J. Schieber, Health Care Inflation, Must Workers Bear the Brunt? The Milken Institute Review (Second quarter 2010), pp. 46-57.
v iv iii ii