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Will lower health-care costs mean higher wages?

As we went over yesterday, the theory of the excise tax is that employers will buy less costly health-care plans and put the money they save into wages. Most of you had one question in response to that, which was well expressed in the first comment to the post: "I'm confused," wrote Reader44. "Instead of increasing wages, why won't employers just take that dollar not spent on health care and increase dividends?"

Earlier in the day, I'd been talking to MIT economist Jon Gruber about this issue. "There are a few things economists believe in our souls so strongly that we have a hard time actually explaining them," he said. "One is that free trade is good and another is that health-care costs come out of wages." To put it another way: Economists are pretty united on this point. A firm's compensation for its workers is pretty static, and if relatively more goes to health-care costs, relatively less will go to wages, and vice-versa. But this isn't just a matter of theory. The following graph charts the percent growth in the median household income versus the percent growth in health-care costs since 1990. The correlation is striking:

do_lower_health-care_costs_mean_higher_wages_(2).png

The correlation between the two data sets is -0.8, which is incredibly high for this sort of thing. To give you an idea, I also ran the correlation between GDP growth and median wages over the period: It was 0.7, which is to say that there was a weaker connection between economic growth and median wages than between health-care costs and median wages.

There is, in other words, very good evidence that employers pass health-care savings onto employees. A Rand study by Dana Goldman, Neeraj Sood and Arleen Leibowitz examined a particular firm's response to a period of premium increases and found that "about two-thirds of the premium increase is financed out of cash wages and the remaining one-thirds is financed by a reduction in benefits." Another study by Katherine Baicker and Amitabh Chandra found that a 10 percent increase in premiums "results in an offsetting decrease in wages of 2.3 percent," which is fairly impressive given that income is much higher than health-care premiums.

There's good reason to think that if health-care costs can be tamed, wages will rise. But one of the big problems in health-care reform is that workers don't understand this connection. They think of health-care coverage as a "benefit," rather than a form of compensation engaged in a fairly zero-sum competition against their wages. But more on that later.

By Ezra Klein  |  October 21, 2009; 9:00 AM ET
Categories:  Health Economics , Health Reform  
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Comments

The problem with this analysis is it only takes into effect historic data. When health care reform goes into effect over the next several years, whatever form it takes, it will make radical changes in our economy. It will have a leveling effect on income distribution. The rich (corporations and the oligarchs that control them) will suffer loss of income. Income for others will increase. Regardless. But there's no proof that the excise tax will directly increase wages. In fact, it's likely that corporations will take those savings to increase their profits.

How do I know? Well, I believe it in my soul so strongly that I can't explain it.

Posted by: NealB1 | October 21, 2009 9:30 AM | Report abuse

This was something I always thought about. If I am covered under my spouses plan, and if I opt out of their plan, shouldn't they pay me the money that they saved by not having to pay my premiums?

Which also then lead me to believe that if we went to a single payor system, paid for with taxes, would not employers end up bettor off than they are now? Wouldn't they actually have more resources to spend on things like more workers, or higher salaries. Wouldn't we also see an increase in peoples wellness and productivity as they would not have to worry about health care, or about costs and thus be able to focus more on work?

Posted by: JesseOfner | October 21, 2009 9:37 AM | Report abuse

i wonder what impact too the fact that the reforms will tax you almost immediately (at a time when the economy is still struggling mightily) and the benefits of cost reduction (I can't believe i just wrote "cost reduction" with a straight face) will be years down the line.

Its going to hurt a lot more before it even starts to get better. Or i shouldn't say better. Its going to hurt a lot more before it starts hurting less than it was before.

Oh and you need another colored line there Ezra. Add in unemployment there. How was unemployment during the time when costs came down in the 90's? If it wasn't as high as it is now then that has to factor in too. Employers will raise wages to the point where they have to and only to that point. Type of industry factors in there too. If the ratio of job applicants to jobs is high then I would expect that wages wouldn't go up as high as you'd hope.

Posted by: visionbrkr | October 21, 2009 9:43 AM | Report abuse

Every company I've ever worked for has told me that the company contribution toward health care (as well as contributions to SS, retirement plans, etc.) is part of my "total compensation".

Posted by: tl_houston | October 21, 2009 9:44 AM | Report abuse

Shouldn't it be more surprising that the health care spending to wages correlation is not -1? The results above suggest that firms are not indifferent between paying wages and paying for health care. In fact, they cannot completely crowd out wages with health care spending.

Posted by: apumich | October 21, 2009 9:50 AM | Report abuse

Not really. As one of the studies I mention suggests, some of that costs gets moved back into health-care benefits in terms of higher cost sharing, tighter networks, etc.

Posted by: Ezra Klein | October 21, 2009 9:57 AM | Report abuse

tl_houston,

that's becoming more and more common but can backfire on employers. I have a law firm client of ours who did that years ago and we suggested it to them again (after their costs just went up 20% this year) and they said employees still bash them on their "hidden paycheck". This is also a company that pays 100% of premium cost even though we recommend them not to do that and at least have employees pay a small portion of the cost on a pre-tax basis. Many employers still think they're being generous and giving their employees something but when in reality they're on shielding them from as Ezra puts it the "true cost of healthcare".

Posted by: visionbrkr | October 21, 2009 10:05 AM | Report abuse

Hi, Ezra,

This is indeed an interesting graph. And the correlation is certainly not surprising. However, you have to ask what is the chicken and what the egg. For example, when the cost escalation accelerated again after a period of slower growth in the mid-'90s due to managed care advent, the easiest thing for the employer was to take it out of the wages. A more interesting graph would also include productivity/profit, and that would show that, contrary to all the boo-hooing by corporate voices, healthcare costs did nothing to impede that growth. So, what I am saying is that wages are behaviorally low-hanging fruit for companies. And if everyone is doing it, the employees have no leverage. I agree with NealB1 below that this past behavior may not be predictive of how companies will allocate savings if healthcare costs are contained. In fact it is my guess that these savings will reflect minimally in wages (after all real wages have remained essentially the same for over 30 years even as productivity has grown exponentially), and are much more likely to go into the profit margin.

Posted by: murzee | October 21, 2009 10:16 AM | Report abuse

I think we should expect this relationship would be significantly affected by the unemployment rate and the company's confidence in the future.

I suspect that in an environment like the one we have now, with massive unemployment and general hysteria about our economic future, you are far less likely to see healthcare savings being plowed into wage increases than you were in 1995-1999. Investing in your employees is something you do when you are confident. I suppose the test of this would be to analyze state-specific numbers (or some other regional number) to see if states with different unemployment rates & healthcare inflation rates from 1992-present looked like the general national model. (I'm sure you'll do this in your copious free time.)

And are these nominal or real wage/cost increases? If we're using nominal, there's a strong chance we're not disentangling general economic conditions' impact on wages from healthcare-specific ones.

And all that said, I think the general economic benefit of health reform has been dramatically underestimated. It will certainly exert an upward push on wages--just not the massive push most economists believe it will have. And in everything from job lock to entrepreneurship to the economic stimulus that comes from more cash in employees' pockets, we'll see a significant benefit--those, especially, have been underestimated.

As we reshape our relationship with the health benefit, it'll be all to the good for the economy.

Posted by: theorajones1 | October 21, 2009 10:23 AM | Report abuse


Baby. Baby you know I love you but this, "There is, in other words, very good evidence that employers pass health-care savings onto employees..." is followed by two examples of employers passing costs, not passing savings. Do we have any studies showing a drop in insurance costs followed by bigger-than-usual raises for the staff?

Have the airlines' extra baggage fees disappeared now that gas prices are down?

Again, I'm optimistic, but all this presupposes a lot on the part of employers. It could be a one way street yo.

Posted by: ThomasEN | October 21, 2009 10:41 AM | Report abuse

This is all just wishful thinking.

Posted by: obrier2 | October 21, 2009 10:50 AM | Report abuse

--"There's good reason to think that if health-care costs can be tamed, wages will rise."--

There's also good reason to think that if pigs can fly, everyone will quit eating hot dogs.

Throwing more of health care into the government maw is not going to tame health care costs. Period.

Posted by: msoja | October 21, 2009 10:51 AM | Report abuse

I hope you realize that your simple correlation here doesn't say much:

1) You don't really have a random sample, since factors causing changes in a variable often cause change in that variable several consecutive years. Because you don't really have random draws in your data set, your result is more like noting a correlation across three or four randomly-drawn data points, which is not a very powerful statement; it could occur essentially by random chance. Also, I'm not sure why you cut off the analysis at 1990.

2) The existence of some effect doesn't necessarily say anything about the effect size. You'd really need to run a multiple regression over many more years of data to be able to say anything meaningful about the relative contributions of GDP and health care costs to wages.

Of course, I do believe you and Gruber, and I appreciate your trying to use some statistics -- something one essentially never sees in mainstream news -- but it's always important to be careful about how you use statistics.

Posted by: davestickler | October 21, 2009 10:54 AM | Report abuse

I second (third? fourth?) the concern about the effects of high unemployment on this relationship. I think the technical objections in running this correlation are valid, but well those objections would be equally valid for the (GDP,wages) correlation so I think it's ok let it go among friends.

I'm definitely amused that I'm in a conversation with a professor over in the econ building (about 1000 feet away) via a writer for the Washington Post (about 400 miles away). Oh the powers of the Interweb.

Posted by: reader44 | October 21, 2009 11:25 AM | Report abuse

I think Ezra chose this epoch because it demonstrates the rise and fall of HMOs. At least that's the context where I've seen this data before.

There is reason to believe the same may hold true if health care reform were to lower premiums. But as davestickler pointed out there may be other confounding variables.

Posted by: bmull | October 21, 2009 11:28 AM | Report abuse

This is the best argument ever for removing healthcare benefits from employment and having employees purchase thier own healthcare.

Posted by: kingstu01 | October 21, 2009 12:07 PM | Report abuse

A correlation in one direction does not prove a correlation in another. There is no evidence that a decline in employers' medical insurance costs will be passed on to employees in a wage increase. Indeed, CBO's and your assumption of an $83-billion increase in tax revenues from ObamaCare is highly dubious. It really all depends upon the specific industry's supply-and-demand situation for labor, few except government workers likely to increase and that's where most union members are. So actually there will be increased levies upon taxpayers to pay for government workers, while most other employers pocket the savings. Seehttp://maggiesfarm.anotherdotcom.com/archives/12635-CBOs-83-Billion-Assumption-Is-Dubious-UPDATED.html

Posted by: bnksd1 | October 21, 2009 12:20 PM | Report abuse

Like other people on this thread, I think this correlation doesn't take into account unemployment rates or economic growth as factors that influence whether labor cost savings get passed on to wages.

Posted by: StevenAttewell | October 21, 2009 12:56 PM | Report abuse

Some posters are saying that, because we have high unemployment, savings on health care wouldn't be passed along to employees as wage increases. There's a bit of truth to that, but it's not 100% accurate.

Econ 101:

In the long run, employee compensation is going to approach an equilibrium value where supply and demand for labor at that wage rate are roughly equal. But, right now, there's excess supply of labor relative to demand at current real wage rates, which indicates that wages will fall as we work our way back to equilibrium. But, since companies are locked into contracts with employees, they aren't able to reduce cash wages instantaneously, even though they could hire the same workers on the open market at lower levels of compensation.

So, because of the current state of the labor market, the effect of reducing health care costs right now would not likely be offset with wage increases for existing workers.

However, new hires would, in fact, get better wages if health care costs drop. That's because they're being hired at around the new equilibrium wage rate. If it's cheaper to provide health insurance, then demand for labor increases at every level of take-home wages, which increases the equilibrium value of the take-home wage.

And, of course, in the long run, as unemployment gets back under control, there will be an unambiguous increase in take-home wages resulting from any decrease in health care costs.

Posted by: davestickler | October 21, 2009 1:42 PM | Report abuse

Will the raise that I get compensate for the higher out of pocket that I have to pay with the new consumer driven health plan?

Will the raise that I get compensate me for the increase in anxiety caused as I contemplate my new higher out of pocket?

Only if I am young and feckless.

You have already heard from nine out of ten Economists on health policy. See here for a brief summary of the views of the tenth economist:

http://wonksanonymous.com/2009/10/19/why-the-blog-has-been-sparse.aspx

Posted by: WonksAnonymous | October 21, 2009 4:38 PM | Report abuse

Actually, I think workers don't so much think health care is a cost-free benefit as that it SHOULD be. That is, they look at their employers as a bunch of greedy skinflints who are squeezing them any way that can. Is this false?

Posted by: janinsanfran | October 21, 2009 4:58 PM | Report abuse

It seems to me that 1. ECON XXX is often not very accurate due to bad assumptions about behavior;

2. while it is highly unlikely all or even most of the employer savings will be passed on as salary, some of it will. Just like Wal*Mart passes on some of the savings they get from having their wares made overseas;

3. the savings passed on are not likely to be distributed equally (for sure by amount and probably by percentage) and most will go to the managers and executives rather than the workers.

Posted by: williamcross1 | October 21, 2009 7:57 PM | Report abuse

Jonathan Gruber's a good economist. And yes, there is a strong correlation between pay and coverage. But keep one thing in mind: employers are only passing these costs on to employees when the employer continues to offer coverage. Between 2000 and 2008, the number of small employers (less than 500 employees) that offer health insurance fell from 68% to 60% and its continuing to trend down. Here's a question: do employers who drop coverage increase wages by as much as that coverage was costing them? (Unlikely). Of the 46 million people who are uninsured, 20 million work for small employers. And that number is growing. So while it might be the case that reducing health care costs would be a zero sum game for employers who offer coverage, expanding coverage to the uninsured will end up a net positive for the country as a whole.

Posted by: tritrate | October 21, 2009 8:57 PM | Report abuse

That's a great idea to answer the question by looking at the correlation. But I had a few questions. First, how did you calculate the -0.8 correlation? I tried recalculating the correlation by eyeballing the points, and I could only obtain ~ -0.5 to -0.6 correlation. Second, I was wondering why you chose to compare the percent growth rather than the absolute value? Thanks!

Posted by: wahbahdoo | October 26, 2009 1:47 AM | Report abuse

Let me try to explain why economists deeply believe that higher health care costs imply lower wages.

Reader44 asked the right question
"I'm confused Instead of increasing wages, why won't employers just take that dollar not spent on health care and increase dividends?" Consider another question, "Why don't firms just cut wages and increase dividends ?"

The answers are similar. They are also complicated.

In the simplest economic models, all workers are always on the verge of quitting. If firms cut their wages, they quit. If firms reduce the generosity of their health insurance and don't raise wages to compensate, they quit.

In the real world most people aren't on the verge of quitting. The best explanation of why firms don't cut wages (the answer given by managers of firms when they are asked) is that it is terrible for "morale." They believe that it will anger workers and that this will be bad for the firm.

In any case, whatever prevents firms from just cutting wages, should prevent them from reducing the generosity of health insurance without compensation.

Sadly while firms almost never cut nominal (dollar) wages, they do allow real wages to decline with inflation. They also reduce the generosity of health insurance without raising wages. But the tradeoff between firms desire to give workers less and firms' desire not to anger workers should not be changed by the excise tax.

Note all those shoulds. Even the not so simplistic models tend to include the assumption that everyone understands the tradeoffs. It means the fact that people don't see things this way, should make us worry that things aren't this way. Fortunately the data strongly suggest that the theory works (this time (for once)).


Posted by: rjw88 | October 27, 2009 9:45 PM | Report abuse

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