Health care and higher education: Key drivers of long-term inflation

As inflation rates reach 40-year highs, discussions about elevated price levels have taken center stage and grabbed policymakers’ attention. There is a growing consensus that the Federal Reserve must step up and tighten monetary policy soon to cool the economy, hopefully without causing an economic hard landing.

But if we take a step back and consider the long-term drivers of inflation in two key areas – higher education and health care – it quickly becomes apparent that there are deeper challenges that must be addressed and require both market reforms and fiscal policy changes.

In 2020, U.S. health care spending reached an astounding 19.7 percent of GDP, rising from an already high level of 17.6 percent in 2019. Even prior to the pandemic, the U.S. was notorious for spending far more on health care than its peers while attaining worse outcomes on a variety of metrics (including life expectancy and avoidable deaths). The underlying problems associated with the U.S. health care system are well-documented.

There is a role for well-thought-out fiscal interventions to boost efficiency and competition in the health care sector. Reforming the U.S. patent system and making the federal government a more effective negotiator that can leverage its role as a large-scale purchaser to attain lower pharmaceutical drug prices are low hanging fruit that can be plucked with bipartisan support if the Big Pharma lobby can be kept at bay.

Boosting the supply of much needed health care workers is another priority. Overcoming high costs associated with training health professionals and reducing administrative burdens linked to the practice of medicine are also important from a cost control perspective. Reducing the current high levels of concentration in the hospital sector will boost competition and enhance productivity.

The economics of health care are somewhat complicated by the presence of externalities, market failures and asymmetric information problems (adverse selection and moral hazard). Standard supply-demand approaches and a laissez-faire attitude may not work in the health care context. It is time for U.S. policymakers on both sides of the aisle to engage in serious discussions aimed at reducing overall U.S. health care expenditures.

From a macroeconomic standpoint, the American economy is misallocating valuable resources on a massive scale. If the U.S. were to reduce its expenditures on health care to around 12 percent of GDP (the level typically observed in Germany), there would be considerably more resources to devote to more productive ventures such as early-childhood education, physical and digital infrastructure, and public research and development (R&D) funding.

Another concern relates to the long-term fiscal health of the U.S. As the population ages, a growing share of Americans are becoming eligible for Medicare. Even though the U.S. system is dominated by private health care providers and private insurance, total government spending on health care is actually about the same as the OECD average. U.S. government already spends (as a percentage of GDP) as much as its peers and yet covers a far smaller fraction of the population. 

According to a recent Brookings report, “34 percent of Americans received their health care via government insurance or direct public provision” in 2018, and health care “has doubled as a share of total government expenditures in the last three decades, from 11.9 percent in 1990 to 24.1 percent in 2018.”

Regarding the cost of higher education, there are four main explanations for the decades-long surge in college tuition and fees. One explanation, referred to as Bowen’s revenue theory of cost, suggests that higher educational institutions are willing to spend practically any amount of funds they can raise in pursuit of their primary objectives, which are educational excellence, prestige and influence.

Another explanation is based on Baumol’s cost disease. Baumol noted that unlike sectors that are inherently able to take advantage of technology-induced productivity growth, higher education, health care and a few other service industries, are typically characterized by low productivity. Since higher education and health care need to employ highly educated professionals (who could otherwise be employed in alternate high-productivity sectors), they still need to offer high pay to attract talent (resulting in a high wage-low productivity mix).

A third explanation is referred to as the Bennet Hypothesis. In a 1987 New York Times op-ed, then Secretary of Education William J. Bennett observed: “Increases in financial aid in recent years has enabled colleges and universities blithely to raise their tuition, confident that Federal Loan subsidies would help cushion the increase.” Essentially, a cost subsidy, in the form of federal loans/grants, pushes up demand for higher education faster than supply and raises costs. 

Finally, as with health care, the higher education sector suffers from asymmetric information. Given that a college education is an “experience good,” it is hard for students and parents to ascertain the quality of the educational service or the value of a degree at the outset. This causes institutions to compete for students by offering ever more extravagant amenities and facilities.

Collection and dissemination of information regarding median earnings of alumni (broken down by majors) and job/grad school placements would help shed light on institutional quality and limit the need for a costly construction arms race. Lessening policy distortions and offering alternate pathways for high school graduates to obtain skills-training may also limit college tuition inflation. 

Complex cost-side problems facing both the U.S. health care and higher education sectors require careful consideration. Throwing good money after bad is not the best answer — socializing the cost of core social goods will neither keep a lid on inflation nor put the U.S. on a firmer fiscal footing in the long run. 

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.