Aldo Ponce

Dennis Heffley

William Lott

English

Research Papers in Economics

8 THE CONNECTICUT ECONOMY WINTER 2007
BY DENNIS HEFFLEY, WILLIAM LOTT AND
ALDO PONCE
Working harder with little to show for
it?  If so, you have plenty of company.
Earlier this year, the Federal
Reserve’s  Survey of Consumer
Finances reported that the average
real income of American families fell
2.3 percent between 2001 and 2004.
When incomes fail to keep up with
inflation, households either must dig
into savings or cut their consumption
of goods and services: fewer bags of
groceries, smaller apartments, maca-
roni and cheese instead of a meal
out.  So, are workers really becoming
less productive?  Are they being com-
pensated less for their efforts?  Or are
they just being paid differently?  And
do rising health care costs have any-
thing to do with these patterns?  
COMPENSATION LAGS
PRODUCTIVITY
Firms compensate their workers
with money wages or salaries (earn-
ings) and with employee benefits-
health insurance, life insurance, retire-
ment plans, etc.  The earnings/benefit
mix of total compensation is affected
by a combination of public policies
(e.g., income tax exemptions for most
fringe benefits), employee preferences
for benefits versus money income, and
employer decisions about how to
structure compensation packages to
best attract and retain qualified work-
ers.  But regardless of the mix, we
might expect total compensation,
adjusted for inflation, to closely track
worker  output.  In the graph (below
left), U.S. data for the last 45 years
show that real compensation (earnings
plus fringes) per hour worked has
grown less rapidly than hourly output,
as measured by real GDP per hour
worked in the non-farm sector. 
We’ve normalized each series in
the diagram—hourly output, real
hourly compensation, and real hourly
earnings—to a value of 1.0 in 1960.
This allows us to readily see the rate of
growth in each variable.  The top two
lines show that hourly output in 2005
was more than 2.6 times its 1960 level-
an average annual growth rate of
2.17%.  Hourly real compensation
grew more slowly (1.44% annually),
but still managed to nearly double
between 1960 and 2005.  The extent
to which real compensation has failed
to keep pace with output may itself be
an interesting story, but the focus here
is on the other gap—between compen-
sation and earnings—since this gap
reflects the growing role of fringe ben-
efits in the rewards to workers. 
REAL EARNINGS LANGUISH
Surprisingly, hourly real earnings
in 2005 were only slightly higher than
they were in 1960.  After a period of
reasonable growth (1960-1972), real
earnings per hour fell throughout the
remainder of the 1970s, stabilized dur-
ing the mid-1980s, fell a bit more in
the late 1980s and early 1990s, and
only began to grow again in the late
1990s.  This strikingly lackluster per-
formance seems to support widespread
The Painful Burden of
Health Care Costs
While the hourly rewards
to workers have barely
kept up with inflation, the
benefits component has
grown more rapidly.
0.0
0.5
1.0
1.5
2.0
2.5
3.0
2
0
0
4
2
0
0
0
1
9
9
6
1
9
9
2
1
9
8
8
1
9
8
4
1
9
8
0
1
9
7
6
1
9
7
2
1
9
6
8
1
9
6
4
1
9
6
0
Hourly Output
Hourly Real Compensation
Hourly Real Earnings
I
n
d
e
x
 
V
a
l
u
e
 
(
1
9
6
0
=
1
.
0
)
HOURLY OUTPUT OUTPACES REAL
COMPENSATION AND REAL
EARNINGS, 1960-2005
Source: The Connecticut Economy based on data from the Economic
Report of the President 2006, and the Bureau of Labor Statistics.WINTER 2007  THE CONNECTICUT ECONOMY 9
concerns about wage stagnation and
the diminished prospects of the aver-
age American worker.
Or does it?  While the hourly mon-
etary rewards to workers have barely
kept up with inflation, the benefits
component has grown more rapidly.
In fact, given the poor wage perform-
ance, it appears that fringe benefits
account for nearly all of the growth in
hourly real compensation over the last
45 years.
THE SHIFT TO FRINGES
So what has caused such a large
shift from money earnings to fringe
benefits?  Part of the reason is that
most fringes are not counted as taxable
income to workers, while employers
can deduct their total compensation
costs for hired labor from taxable
income.   But another likely explana-
tion is the rising costs to employers of
providing health insurance to their
employees—presumably driven by the
benefit payments made by insurers to
cover growing health care costs.  The
graph above shows that payments by
private insurers have indeed grown,
both per capita and as a percentage of
U.S. personal health care spending.
Payments by private insurers
amounted to just $28 per person in
1960, less than 22% of the $129 in
personal health care expenditures per
capita from all sources.  By 2004, per
capita health care expenditures had
increased more than 41-fold, to
$5,309 per person-an average annual
growth of 8.8% over the 44-year peri-
od.  Of this amount, $1,917, or just
over 36%, was paid by private insurers.
So private insurers’ role as a payer of
health care charges has grown, and the
bulk of the insurance is provided
through work, as part of the compen-
sation package.
If anything, the above figures
understate the magnitude of the prob-
lem facing firms and why their health-
insurance costs might crowd out
wages.  Many employers offer family
coverage, so each worker often brings
along one or more dependents.  On a
per worker basis, payments by private
insurers rose from $92 in 1960 to
$4,287 in 2004, or 9.1% annually.
Furthermore, even these figures only
reflect payments by insurers, not what
they charge employers for such cover-
age.  A recent report from Mercer
Health & Benefits, LLC, puts that fig-
ure at $7,523 per worker nationally,
and $7,992 in Connecticut (see
Hartford Courant, November 20,
2006, p. 2).  
Any way you slice it, health care
costs are pushing up premiums and
forcing employers to adjust.  Judging
by the first graph, it looks like one of
those adjustments has been limiting
average wage gains to little more than
cost-of-living provisions.  While work-
ers may not relish this outcome, many
employees seem willing to forego high-
er wages to preserve insurance benefits.
News accounts have pointed to the
By 2004, per capita
spending on health care
had increased more 
than 41-fold, to 
$5,309 per person
0%
10%
20%
30%
40%
$0
$500
$1,000
$1,500
$2,000
$2,500
2
0
0
4
2
0
0
0
1
9
9
6
1
9
9
2
1
9
8
8
1
9
8
4
1
9
8
0
1
9
7
6
1
9
7
2
1
9
6
8
1
9
6
4
1
9
6
0
Percent of Total Payments
Dollars Per Person
PAYMENTS BY PRIVATE INSURERS:
FRACTION OF TOTAL PAYMENTS 
AND DOLLARS PER PERSON,
1960-2004
Source: The Connecticut Economy based on data from the  Centers
for Medicare and Medicaid Services (CMS) and population data from
the Economic Report of the President 2006. 10 THE CONNECTICUT ECONOMY WINTER 2007
problem of “job lock”—reluctance to
switch jobs for fear of losing health
insurance.   
OTHER SOURCES OF PAIN?
Workers have also complained of
reductions in health insurance cover-
age and higher out-of-pocket pay-
ments, but the evidence here is mixed.
The graph below shows that out-of-
pocket payments for health care have
indeed risen, from $71 per capita in
1960 to $802 in 2004.  That’s more
than an 11-fold increase, yet the $71 in
1960 was equivalent to $453 in 2004,
so the inflation-adjusted increase in
out-of-pocket payments was much
smaller.  Moreover, the graph also
shows that, despite complaints about
“reduced coverage,” the percentage of
personal health care spending paid
out-of-pocket (the average “coinsur-
ance rate”) has fallen sharply, from
55.2% to 15.1%.  So, currently, only
about one of every seven dollars of all
personal health care spending—on
physician and dental services, hospital
care, drugs, etc.—is paid directly by
consumers.  The other six bucks come
from private and public insurance. 
For any individual, more complete
coverage is hardly a source of pain, yet
collectively this may indeed be the
major ailment.  Standard models of
insured health care markets predict
that increased coverage—a lower coin-
surance rate—increases demand and
makes consumers less sensitive to the
gross price of health care.  This, in
turn, boosts gross health care prices,
increases the quantity of care delivered,
and expands total health care spend-
ing.     
Another way that we all bear the
rising cost of health care is through
taxes used to finance public insurance
programs—Medicare for the elderly
and Medicaid for the poor.  Both pro-
grams were introduced in the mid-
1960s.  Payments by public insurance
programs rose from $28 per capita in
1960 to $2,356 in 2004, more than
doubling the public sector’s share of
personal health care spending, from
21.4% in 1960 to 44.4% in 2004.
The expansion, by the way, does not
reflect the more recent introduction of
Medicare drug coverage.  
NO EASY REMEDIES
There seems to be no shortage of
blame for the growing gap between
workers’ output and their rewards:
overpaid managers, higher corporate
profits, tax-happy bureaucrats, compe-
tition from illegal immigrants, weaker
unions—all have been cited as reasons
for wage stagnation and the sagging
real income of American workers.
Such factors might explain the output-
compensation gap, but they fail to
explain why the mix of compensation
has shifted away from wages toward
fringe benefits.  The growth in health
insurance coverage provides an expla-
nation, but it also poses a dilemma.
The degree of health insurance
coverage, private and public, has
expanded substantially since 1960, as
evidenced by the declining percentage
of charges paid out-of-pocket.  This
has boosted gross health care prices,
increased consumption, and greatly
expanded total spending.  In turn,
health insurance premiums have
soared, causing a painful shift of com-
pensation from wages to fringe benefits
to preserve coverage.  Faced with high-
er health care prices, however, some
workers have pushed for even more
complete coverage, which simply
aggravates the market-level effects.
So what’s the answer?  There are
no easy ones.  Managed care has shown
little capacity to solve the problem,
and may have even contributed to it
(The Connecticut Economy, Fall 2004).
Price controls on health care are politi-
cally tempting, but force markets to
adjust in undesirable ways, including
longer waits, “informal payments”
(bribes), and lower-quality care.
Removing health insurance from the
workplace also has been suggested, but
won’t happen as long as health insur-
ance remains an untaxed form of com-
pensation.  The best hope may lie in
structuring health insurance to reward
more healthful lifestyles and prudent
health care choices, but to have an
impact the rewards need to accrue to
the individual, not just the insurer or
employer.  Given the lack of growth in
real wages, the typical worker might
welcome such rewards.
0%
10%
20%
30%
40%
50%
60%
$0
$100
$200
$300
$400
$500
$600
$700
$800
$900
Percent Paid 
Out-of-Pocket
Dollars Per Person
2
0
0
4
2
0
0
0
1
9
9
6
1
9
9
2
1
9
8
8
1
9
8
4
1
9
8
0
1
9
7
6
1
9
7
2
1
9
6
8
1
9
6
4
1
9
6
0
OUT-OF-POCKET HEALTH CARE
SPENDING: ON THE RISE OR NOT?
Source: The Connecticut Economy based on data from the  Centers
for Medicare and Medicaid Services (CMS) and population data from
the Economic Report of the President 2006. 
William Lott is an associate professor and Aldo
Ponce is a graduate student in the Department of
Economics.  

The Painful Burden of Health Care Costs

http://cteconomy.uconn.edu/articles/DH_W2007.pdf

The Painful Burden of Health Care Costs

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