Brookings: Programs - Economic Studies

Supporting Broad-Based Economic Growth and Fiscal Responsibility Through Tax Reform

Adam Looney — Wed, 22 May 2013 02:30:00 -0400

Chairman Murray, Ranking Member Sessions, and Members of the Committee: Thank you for inviting me to share my views on the role of tax reform in supporting broad-based economic growth and fiscal responsibility.

The United States faces a daunting outlook for budget deficits, an increasingly challenging global economy for many American workers and businesses, and rising income inequality.

Improvements in tax policy could help address these challenges by making our tax system more fiscally sustainable, more efficient, and more fair. Indeed, any tax reform will be evaluated based on how it affects each of those three criteria.

But improving on all three dimensions simultaneously is increasingly difficult because of tradeoffs between competing goals of efficiency, revenues, and equity.

Today’s long-term budget outlook means that we’re likely to need higher tax revenues in the future. And rising inequality means that changes in policy will be increasingly scrutinized for how they affect the progressivity of the tax schedule. But a tax reform that devotes revenues to deficit reduction and retains our progressive system would have much more difficulty achieving other goals—such as lowering tax rates.

In my testimony today, I want to describe some of these tradeoffs and some potential paths forward.

Tax Reform and the Budget

Much of the energy surrounding tax reform focuses on the model of the Tax Reform Act of 1986. In that reform, tax rates were lowered substantially and the lost revenue was restored by cutting tax breaks, deductions, exclusions, and other so-called tax expenditures. That reform enhanced economic efficiency without increasing the deficit. In the 27 years since then, however, the economic context has changed, making such a reform harder to achieve.¹

First, we face a dire long-run budget outlook; most believe that putting the budget on a sustainable path will require contributions from both spending cuts and revenue increases. Many hope that tax reform can help produce those revenues.

This makes tax reform more difficult because revenues allocated to deficit reduction are revenues that cannot be used to reduce rates, and vice versa.

Moreover, raising revenues and cutting rates at the same time is a tall order. At first glance, the list of tax expenditures is projected to add up to $1.4 trillion in 2015.² But that figure dramatically overstates the revenue gains that are available from cutting expenditures.

Some expenditures, including obscure items like imputed rent, would be difficult to eliminate for practical or administrative reasons; others, like credits and deductions for working families with children are integral to combating poverty and encouraging employment. These categories account for roughly one quarter of all tax expenditures.³ An additional one-third of the tax expenditures arise from the preferential treatment of savings and investment. And the largest non-savings-related expenditures include those for health insurance, mortgage interest, state and local taxes, and charitable contributions. These, and many others, tend to serve substantive goals, remain on the books because they were too difficult to eliminate in 1986, and, as you well know, are backed by popular constituencies.

In addition to political difficulties, there are basic practical issues to consider. Certain tax expenditures exist for the purposes of simplifying the tax system, to reduce record keeping, or to minimize the filing burden on taxpayers. Eliminating those provisions or scaling back others could make the system more complicated and onerous.

Because of such considerations, the Congressional Research Service warns that “it may prove difficult to gain more than $100 billion to $150 billion” each year from reducing tax expenditures.⁴ And those estimates are based on a 35 percent top rate; if marginal tax rates were reduced, eliminating a dollar’s worth of deductions would raise proportionately less revenue. In other words, if eliminating a dollar of mortgage interest today raised 39 cents, under a top rate of 25 percent, it would raise only 25 cents—37 percent less.

To put these numbers in perspective, in order to be revenue-neutral, the tax plan included in House Budget Committee Chairman Ryan’s budget would require eliminating roughly $450 billion worth of tax expenditures each year just to balance out the individual income tax rate cuts targeted in his plan.⁵ The plans initially developed by the Domenici–Rivlin Task Force and the Bowles–Simpson Commission, which reduce rates and contribute to deficit reduction, likely require reductions in tax expenditures of a similar or larger magnitude.

The gap between the reductions in tax expenditures required by such plans and those that could be agreed upon illustrates the challenge of formulating a plan that achieves both lower rates and higher revenues.

Tax Reform in a Progressive System

A second consideration is the issue of rising income inequality and its relationship to the tax code. Earnings have risen dramatically at the top—by more than 250 percent over the past 30 years for households in the top one percent of the income distribution. At the same time, many households at the middle and bottom have experienced stagnating or even declining earnings. Changes in the tax system over the past 30 years have exacerbated these problems; the very people who have received the biggest income gains in the past three decades have also seen the largest tax cuts. A progressive tax code is perhaps the most significant and powerful tool available to counteract income inequality. Indeed, there are increasing calls for policymakers to use the tax code for that purpose.

Such concerns were much less salient the last time we did tax reform. In 1986, the phenomenon of rising inequality had yet to be fully discovered or understood, and the technical expertise to measure how the tax system affected inequality had yet to be developed.

Today not only are concerns about the progressivity of the tax schedule heighted, but so is our ability to measure how tax changes affect different groups. That raises the level of scrutiny directed to reform and also reveals a substantive tradeoff: that any changes in rates and tax expenditures must balance out within income groups in order to retain a progressive tax structure.

In a series of papers, colleagues at the Tax Policy Center and I analyzed these tradeoffs by examining a hypothetical reform with the stated goals of maintaining tax revenues, lowering marginal tax rates, while at the same time ensuring a progressive tax system.⁶ We took as an example a plan that lowered the top rate from 35 to 28 percent and continued the low rates that apply to savings and investment. These rate reductions are roughly the same levels specified in earlier plans from Bowles–Simpson and Domenici–Rivlin, but are substantially smaller than those specified in Chairman Ryan’s plan. We asked what it would take to achieve other goals of revenue and progressivity.

In that analysis, we estimated the revenue losses due to lower rates, and then tried to pay for those revenue losses by eliminating tax expenditures. We assumed that certain tax expenditures were off the table because of the administrative difficulty of closing certain breaks; others were off the table because they provided preferential treatment for savings and investment.

Overall, the available tax breaks were enough to offset revenue losses from lower rates. But this resulting tax schedule, we found, was less progressive. Even when we implemented the most progressive way of reducing the remaining tax breaks, there was simply not enough revenue from these breaks in the top brackets to offset the revenue losses from lower marginal tax rates.

This result—that this sort of base-broadening reform led to a less progressive tax system—was true even when we incorporated revenue feedback, not just according to the standard dynamic effects used by Tax Policy Center, Treasury, and the Joint Committee on Taxation, but also additional feedback effects from optimistic estimates of potential economic growth, drawn from theoretical models.

The implication is that such a tax reform must give up on at least one of its stated goals: either higher-income taxpayers would receive a tax cut and middle- and lower-income taxpayers a tax increase; the deficit would go up; preferences for savings and investment would have to be reduced; or marginal tax rates would need to be higher.

Prospects for Reform

Of course, these considerations don’t rule out tax reform; indeed, many experts have put forward plans that provide more incremental reforms that simultaneously achieve efficiency gains, higher revenues, and a more progressive tax system. But such plans require substantial compromises.

For instance, certain plans proposed by the Domenici–Rivlin Task Force and the Bowles–Simpson Commission achieve their distributional goals by eliminating preferential rates for capital gains and dividends and curtailing other savings and investment-related tax breaks.

A host of other incremental reforms propose improving the efficiency of the tax system not by reducing rates but by reducing inefficient or wasteful tax expenditures. For example, deductions and exemptions—like for mortgage interest, that currently provide tax savings of up to 39.6 percent—could be replaced with flat credits of, say, 15 percent, providing continued support for homeowners but in a less-costly and more progressive way.⁷ An overall limit on the value of tax expenditures at 2 percent of income would provide an across-the-board reduction in costly tax expenditures.⁸ The President’s Budget includes a provision to limit the amount that certain tax deductions and preferences can reduce tax liability by to 28 percent. And at a meeting convened by the Hamilton Project last February, a bipartisan group of tax experts presented proposals to reduce benefits from the mortgage interest deduction, subsidies for fossil fuels, preferences for retirement savings, and the overall value of deductions.⁹ A common thread is that all of these proposals enhance economic efficiency, raise revenues, and increase progressivity.

Beyond economic appeal, proponents of this approach hope for political appeal. To paraphrase Harvard Professor Martin Feldstein: if Republicans want to reduce the deficit by cutting spending and Democrats want to increase revenues, by focusing on tax expenditures we should find a middle ground.¹⁰

1. For a further discussion see: Greenstone, Michael, Dmitri Koustas, Karen Li, Adam Looney, and Leslie B. Samuels. “A Dozen Economic Facts About Tax Reform,” The Hamilton Project (May 2012).

2 Marron, Donald B. “How Large are Tax Expenditures? A 2012 Update,” Tax Notes (April 9, 2012): 235.

3. For a description of these expenditures, see Nguyen, Hang, James Nunns, Eric Toder, and Roberton Williams. “How Hard Is It to Cut Tax Preferences to Pay for Lower Tax Rates?” Tax Policy Center (July 10, 2012): Table 1.

4. Gravelle, Jane G. and Thomas L. Hungerford. “The Challenge of Individual Income Tax Reform: An Economic Analysis of Tax Base Broadening,” Congressional Research Service (March 22, 2012): 3.

5. Tax Policy Center Table T13-0110

6. Brown, Samuel, William Gale, and Adam Looney. “On the Distributional Effects of Base-Broadening Income Tax Reform,” Tax Policy Center (August 1, 2012); Brown, Samuel, William Gale, and Adam Looney. “TPC’s Analysis of Governor Romney’s Tax Proposals: A Follow-Up Discussion,” Tax Policy Center (November 7, 2012); Marron, Donald. “Understanding TPC’s Analysis of Governor Romney’s Tax Plan,” Tax Vox (August 8, 2012); and Nguyen et al. (2012).

7. Batchelder, Lily L., Fred T. Goldberg, Jr., and Peter R. Orszag. “Reforming Tax Incentives into Uniform Refundable Tax Credits,” The Brookings Institution Policy Brief 156 (August 2006).

8. Feldstein, Martin, Daniel Feenberg, and Maya MacGuineas. “Capping Individual Tax Expenditure Benefits,” NBER Working Paper 16921 (April 2011)

9. See Alan Viard, “Replacing the Home Mortgage Interest Deduction,” Joseph E. Aldy, “Eliminating Fossil Fuel Subsidies,” Karen Dynan, “Better Ways to Promote Saving through the Tax System,” and Diane Lim “Limiting Individual Income Tax Expenditures” in 15 Ways to Rethink the Federal Budget, The Hamilton Project (February 2013).

10. Feldstein, Martin. “A Simple Route to Major Deficit Reduction,” The Wall Street Journal (February 20, 2013).

Authors

Adam Looney

Image Source: Chris Maddaloni

Why Reform Medicare? The President's and Other Bipartisan Proposals to Reform Medicare

Alice M. Rivlin — Tue, 21 May 2013 09:00:00 -0400

Mr. Chairman Members of the Committee:
Why reform Medicare? The main reason for reforming Medicare is not that the program is the principal driver of future federal spending increases, although it is. The main reason is not that Medicare beneficiaries could be receiving much better coordinated and more effective care, although they could. The most important reason is that Medicare is big enough to move the whole American health delivery system away from fee-for-service reimbursement, which rewards volume of services, toward new delivery structures, which reward quality and value. Medicare can lead a revolution in health care delivery that will give all Americans better health care at sustainable cost.

As this Subcommittee knows very well, health care in the United States is expensive and getting more so. Moreover, quality is uneven and much care is duplicative, wasteful, and uncoordinated. For many decades, however, reformers focused less on cost containment and quality improvement than on closing growing gaps in health insurance coverage. Now that near-universal coverage has been assured by the Affordable Care Act, attention should shift to improving quality and value of health care delivery for all and containing cost growth.

I recently had the privilege of co-leading (with former Senators Daschle, Domenici, and Frist) the Bipartisan Policy Center’s team that produced, A Bipartisan Rx for Patient-Centered Care and System-wide Cost Containment, in April. We reached consensus on a comprehensive package of reforms that span the entire health care system, with a particular focus on the Medicare program and federal health-related tax policy.

We believe that, if enacted together, these reforms will improve health care quality for patients and families and lower overall spending growth across the entire health care system. While budget saving were not our primary objective, we believe our Medicare reforms would achieve roughly $300 billion in net savings over ten years (2014-2023), and over the second decade (2024-2033) would result in another almost $1 trillion in budgetary savings to the Medicare program. These savings estimates are net of the cost of fixing the dysfunctional Sustainable Growth Rate (SGR) physician payment formula.

Our bipartisan foursome were not mavericks working in isolation. The major themes of our report are featured in two other recent bipartisan reports—an update of the Simpson Bowles Commission recommendations and a report from the Bending the Curve project at the Engelberg Center at the Brookings Institution—and many aspects appear in the President’s budget proposals. These reports suggest a bipartisan convergence on the importance of using Medicare and tax reform to lead the transition of the health system away from fee-for-service reimbursement toward quality and value-based care.

Broadly the recommendations of the Bipartisan Policy Center report include:

Preserve the guaranteed health coverage promised in traditional Medicare while adding more choices and protections for beneficiaries, especially low-income beneficiaries.
Modernize the benefit package for Medicare.
- Cap beneficiary cost sharing at $5315 (catastrophic protection).
- Combine the deductible for Parts A and B ($500) and make coinsurance more predictable.
- Exempt physician visits from the deductible and preventive care from cost-sharing.
Limit Medicare supplemental coverage, which beneficiaries will have less incentive to buy if they have catastrophic. [Restrict first dollar coverage--Medigap must have deductible of $250 and can’t pay more than half coinsurance and deductibles—includes Tricare and FEHBP].
Protect low-income beneficiaries—help with all cost sharing (A,B,D) up to 150% FPL
Raise Part B premiums for higher income beneficiaries—[lower thresholds for increased premium to $60,000 for singles and $90,000 for couples and index.]
Create “Medicare Networks” an improved version of the Affordable Care Organization demonstrations in the ACA. Medicare Networks would be provider led and enrollment based and would enable better coordinated care. Beneficiaries would have incentives to join (lower premiums and lower cost-sharing in network) and providers would have incentives to join (higher updates and shared savings.) Reimbursement to Medicare Networks would increasingly reflect measures of quality and value.
Replace SGR with better designed structure and update with MEI. Costs offset some of the savings, but worth it to get rid of dysfunctional SGR.
Increase competition among health plans in MA by implementing a new competitive bidding structure where that would result in lower payments and helping beneficiaries navigate plan choice on a user-friendly website. Allow MA plans to share savings with beneficiaries. Improve risk adjustment in MA and supplement better risk adjustment with reinsurance. Well executed reform of MA could accomplish many of goals of premium support without establishing a whole new system.
Limit the tax-favored treatment of expensive health insurance products. Cap the exclusion of employer-paid benefits as a substitute for the “Cadillac Tax.”
Under our plan beneficiaries would have three choices: traditional FFS Medicare; Medicare Networks reimbursed for performance on measures of quality and value; and Medicare Advantage (MA). We would have a fall back cumulative limit on the increase in Medicare spending for each choice. Doubt would be necessary.

This will not be an easy set of reforms to enact or implement. It will require sustained effort at both the federal and state levels, as well as in the private sector. But there is no simple way to change our complex, fragmented health care system. We believe enactment and implementation of these reforms would not only improve care and save taxpayer dollars in Medicare; it would do the same for the whole health care delivery system.

Authors

Alice M. Rivlin

Publication: United States House of Representatives Committee on Ways and Means, Subcommittee on Health

Image Source: © Jim Young / Reuters

What Should the Supreme Court Do About Affirmative Action?

Henry J. Aaron — Mon, 20 May 2013 10:42:00 -0400

Author's note: the following review of the book Mismatch: How Affirmative Action Hurts Students Its Intended to Help and Why Universities Won’t Admit It by Richard H Sander and Stuart Taylor, Jr. was commissioned by Leon Wieseltier of the New Republic on September 10, 2012. It was submitted on January 30, 2013. No editorial comment having been received to date, I am posting it on the Brookings web site.

The Supreme Court decision in Brown versus Board of Education was a watershed event in several respects. It crowned a lengthy legal campaign to overthrow segregation in public schools. It rapidly widened into a multi-front campaign to assure that African Americans, other minorities, and women would not be excluded from any important aspect of American life. And it invoked social science in support of a fundamental reinterpretation of the Constitution.

Following Brown, it soon became clear that removing legal barriers was not enough to end the legacy of discrimination. Lyndon Johnson’s 1965 speech at Howard University stated bluntly that “We seek not just freedom of opportunity. We seek not just legal equity but human ability, not just equality as a right and a theory but equality as a fact and equality as a result.”

To counter the effects of past discrimination, Johnson said, it is necessary not just to remove barriers but also to offer help. Some assistance was procedural. Selective colleges, universities, and graduate schools began for the first time to recruit minorities actively and to mentor them. Other assistance was substantive, such as making race, sex, or national origin a ‘plus factor’ for jobs, contracts, and college admission. Programs of this sort immediately raised knotty conundrums for law, ethics, and social science. Were they constitutional? Were they fair? Did they work?

The legal problem was obvious. The 14^th amendment states: “No State shall...deny to any person within its jurisdiction the equal protection of the laws.” Title VI of the Civil Rights Act of 1964 prohibits discrimination on the basis of race, color, and national origin in programs and activities receiving federal financial assistance. Title VII of the Civil Rights Act flatly bars consideration of race in hiring and promotion decisions. Many universities are state chartered and supported. Private and public institutions of higher learning receive federal contracts. The constitution and civil rights laws make no exception for discrimination practiced to redress past injustices.

Ethical issues are also inescapable. Giving African Americans or Hispanics a special break does not increase the number of jobs or slots in university classes. Giving them an edge means pushing others back in the queue. Many of those ‘others’ never personally did anything wrong. If giving such edges to past or present victims of discrimination was accepted, how large an edge was it fair to give and for how long?

In its earliest phases, affirmative action clearly helped its intended beneficiaries. In 1933 when Harold Ickes and his two lieutenants, Clark Foreman and Robert Weaver—later the first black cabinet officer under president Johnson—required that blacks be hired to help build public housing, there could be little doubt that African Americans benefitted from their action. When Richard Nixon’s Secretary of Labor, George Shultz, commented about discrimination in the building industry: “We found a quota system; it was there; it was zero,” there could be no doubt that moving from zero would help those who had been excluded. The nation was so far from the goal of fair treatment of minorities and women that possible conflicts with other objectives seemed remote. But when selective colleges and universities began to admit minority students with comparatively weak academic credentials, many of whom got poor grades and dropped out at distressing rates, a new question arose...did race preferences, at least in higher education, really help those they were intended to help?

Research on the impact of preferential admissions in higher education and litigation over its constitutionality ran on parallel tracks.

The policy of boosting enrollments at selective universities and colleges from what came to be called ‘under-represented minorities’ developed rapidly during the 1960s and 1970s. It coincided with efforts by those institutions to become genuine meritocracies. Although prestigious undergraduate and graduate programs had always favored the academically talented, they also held many slots for the offspring of previous graduates and generous donors. Athletic or artistic skills helped too, of course. Discrimination in admissions was routine, primarily to hold down the numbers of bright kids with the “wrong” religion or cultural background.

Then in the 1960s and 1970s, the weight attached to good grades and high test scores on entrance exams soared. Bragging rights came to those colleges whose entering classes had the highest scores on college entrance examinations. Some slots were still held for the progeny of previous graduates, the well-connected, the financially generous, and the artistically talented or athletically skilled. But academic standards for admission rose at both the undergraduate and graduate level. In simple terms, the ‘good’ schools, more than ever before, became academically excellent.

As far back as the 1970s concern grew that the policy of giving an edge to African Americans, Hispanics, and other members of under-represented minorities, however well-intentioned, might be doing more harm than good. Giving applicants from these groups an edge in admissions necessarily meant that, on the average, they came with weaker academic credentials than did whites. To be sure, selective schools offered matriculants big advantages—enriched environments, good connections, and, to those who graduated, a valued credential. On the other hand, students without adequate preparation might find the work just too difficult. As a result, they might even learn less than they would at less selective institutions. They might suffer stigma or be marked as second-raters or shamed as beneficiaries of unearned advantages, as many critics of affirmative action claim and some supporters fear. The result would be low-academic performance, high drop-out rates, wasted time and money, and, in extreme cases, blighted lives. The risk of these adverse effects would be larger the greater the gap between the student’s preparation and the norm at the institution they attended. This, in brief, was known as the mismatch hypothesis.

Determining whether a mismatch effect actually exists is extremely difficult. Even if admissions were race blind and even if there were no mismatch effect whatsoever, African Americans and Hispanics admitted to selective colleges and universities would predictably have lower grades and graduate a lower rates than do whites. This expectation is in no manner racist. It follows directly from two indisputable facts. African Americans and Hispanics applying to college have lower test scores and high-school grades on the average than do whites; and test scores and grades both are predictive of academic performance.

A hypothetical example illustrates how these two facts will produce different success rates for various groups. Imagine that colleges use an academic index for selecting students. The index can take on three values: 1 (high), 2 (medium), or 3 (low). Those with a higher academic index do better on the average in college than those with a lower score. Imagine also that out of every 100 whites, 35 score 1, and 35 score 2, and that out of every 100 African Americans and Hispanics 10 score 1 and 50 score 2. Selective schools admit only those who score 1 or 2, and they do so in a race-blind manner. Half of whites but only one-sixth of African Americans and Hispanics score 1. Those who score 1 do better in college than those who score 2. It follows that whites will do better in college on the average than will African Americans or Hispanics. This conclusion would not follow if tests and grades under-predicted performance of minorities relative to that of whites. But repeated studies have shown that tests and grades do not under-predict performance of African Americans and Hispanics.

The observation that African Americans and Hispanics who enroll at selective universities have lower qualifications for admission than do whites should therefore come as no surprise. Affirmative action adds to the difference between test scores and grades of entering students. But gaps would exist even if there were no affirmative action, and whether or not mismatch exists.

So, the challenge...how can one tell from the observation that African Americans and Hispanics do less well in college than do whites at selective schools whether this gap results from mechanical reasons of the sort just described or from harm inflicted through mismatch?

Simply comparing grades and graduation rates of various groups is not enough. The undeniable fact that students from under-represented minorities get poorer grades and drop out more often than white students do proves nothing about whether affirmative action helps or hurts its intended beneficiaries. One could go further and measure whether students at selective institutions do better or worse than do students with similar test scores and grades at other colleges and universities.

That is just what Derek Bok and William Bowen, former presidents of Harvard and Princeton, respectively, did in their evocatively titled book, The Shape of the River. This study, published in 1998, drew on a rich data set developed with the support of the Mellon Foundation, which Bowen then headed. The survey reported on a large data set—College and Beyond—reporting the college experiences, graduation rates, and subsequent earnings of 93,660 students who graduated from thirty-four select universities and colleges in 1951, 1976, and 1989. Using statistical techniques that controlled for the expected influence of high-school grades, pre-college admission tests, race, and certain other characteristics, the authors found that African-American students who attended elite universities did as well as or better than African-American student who attended less elite institutions. The authors reported that they found no evidence to support the mismatch hypothesis.

The Bok-Bowen study was highly influential. The authors are highly respected. The survey was large. The information it contained was broad and detailed. Even so, the survey data were not ideally suited to test the effects of affirmative action. The earliest surveyed cohort attended college before affirmative action was much practiced and it is not clear to what extent that cohort drove the results. The data came mostly from highly selective institutions. Furthermore, because the data have not been freely available, few scholars could check the Bok-Bowen findings or do additional analysis. The importance of making data available so that other scholars may try to replicate results and identify errors hardly needs emphasis in light of recent controversies regarding the impact of government debt on economic growth.

Bowen and other co-authors revisited the question of how college affects students in 2009 with a new study, Crossing the Finish Line, based on an even larger survey. This study reported on the experiences of 124,522 freshmen who began college in 1999 at one of fifty-seven four-year public universities. These institutions were generally less selective than those included in the College and Beyond survey. Bowen reported some startling results. Regardless of the quality of the high schools that students attended, their grades predicted college performance far better than did standardized tests. The 2009 study also confirmed the major finding of The Shape of the River—that after controlling for high-school grades, test scores, race, and socio-economic status, students were more likely to graduate from more selective than from less selective universities. Once again, Bowen and his co-authors found no evidence to support the mismatch—what they called the ‘over-match’—hypothesis. Students are well-advised, they said, to enroll in the most selective institution that will accept them.

Critics questioned whether the Bok-Bowen studies provided support for affirmative action. Invoking considerations of fairness, Stephen and Abigail Thernstrom noted that high graduation rates from elite institutions reflected not only the high qualifications of enrollees, but the high expectations for graduation at them. Besides, they emphasized, giving a race- or ethnicity-based edge to some necessarily involves a race- or ethnicity-based handicap for others. One of those groups with a race-based handicap, they noted, are Asians, whose academic credentials on the average outshine those of whites and who suffered much discrimination in American history.

Others argued that ordinary survey data are inherently inadequate to test the mismatch hypothesis. No survey can measure all educationally-relevant student characteristics. Specifically, surveys cannot measure aspirations or mental toughness, which are relevant to educational outcome and may be correlated with the schools students attend. Many social scientists argue that the best way, and sometimes the only adequate way, to test the effect of an intervention is the randomized experiment. Such methods are routine in medical and agricultural research, but they are not normally available to those testing the effects of affirmative action. Students cannot be randomly assigned to colleges. And, even if they could be, the very act would color the results. Normally, analysts are stuck with survey data. They can do no more than control statistically for every influence they can measure and hope that omitted factors are not very important.

From the earliest years of affirmative action, those denied admission to schools that gave minorities a race-based or ethnicity-based edge have challenged the practice in court. In 1978, the Supreme Court ruled in The Regents of the University of California v. Bakke that the constitution barred the university from setting aside a fixed number of slots in its medical school class for under-represented minorities. But, universities could use race as a ‘plus’ factor in pursuit of ‘diversity,’ which, the Court said, is a legitimate educational goal. To this day, however, the Court has not defined exactly what diversity is or how one would know if it had been achieved.

Breaking with Bakke, the federal Circuit Court serving Louisiana, Texas, and Mississippi ruled in 1995 in Hopwood v. Texas that the University of Texas Law School could not use race as a factor in admissions. The case never got to the Supreme Court, however, because Texas dropped the challenged admissions practices.

Seven years later, the Supreme Court heard a pair of challenges to admission practices at the University of Michigan. For undergraduate admissions, Michigan used a point scale based on grades, test scores, and other factors. One hundred points assured admission. Under-represented minorities received 20 points automatically. In Gratz v. Bollinger, by a 5-4 margin, the Court reaffirmed that the pursuit of diversity is a legitimate goal, but it ruled that Michigan’s procedure was not ‘narrowly tailored,’ did not in general treat each applicant individually, resembled a quota system, which the Court had disallowed in Bakke, and was therefore unacceptable.

At the same time, also by a 5-4 vote, the Court upheld a race-conscious admission policy by the Michigan Law School. In Grutter v. Bollinger, the court said that the use of race was acceptable because the law school considered many factors and did so on an individual basis. The swing vote in both cases and author of the opinion of the Court was the now-retired Justice Sandra Day O’Connor, who has been succeeded by Justice Samuel Alito, widely thought to be less sympathetic than O’Connor to affirmative action.

The legal history is marked by chaotic disagreement. Not only has the court been divided, but the majorities have disagreed in the reasoning that has led to their judgments. For strong minded, independent jurists to reach a common position by different reasoning is not unusual. But the opinions reflect unresolvable internal conflicts. The Constitution guarantees equal protection, irrespective of race, national origin, sex, and age. Yet, American history is redolent of despicable violations of those principles. When, at last, Congress and private groups began to take steps to counter the legacy of discrimination, the highest court has been willing to curb, but not bar, these measures—at least, not yet.

While the idea that the best qualified people should get jobs, the best proposal should win the contract, and the best students should be admitted to selective colleges commands widespread support, few people adhere rigidly to the principles of meritocracy. They understand that in many cases no clear or reliable metrics exist for measuring merit. Furthermore, once one acknowledges that colleges and universities may legitimately consider factors other than test scores and grades in determining which applicants should be admitted, it is inevitable that some students refused admission will be better qualified on academic grounds than those admitted.

The point made in virtually every legal brief by a litigant complaining of discrimination because an African American or Hispanic with lower test scores or a weaker academic record was admitted reflects a profound confusion—such a result is inescapable once other criteria for admission are allowed to influence results. And because race, musical talent, athletic skills, and other non-academic characteristics predict academic performance less well than do grades and test scores, it is likely that those admitted because of such ‘non-academic’ qualifications will perform less well, on the average, than those admitted for purely academic reasons. Their grades are likely to be lower and they are likely to graduate at lower rates than those with stronger grades and test scores. Other influences, such as compensatory programs for the ill-prepared, easy grading (for athletes), or enrollment in ‘gut’ courses can partly or fully offset such tendencies. But the tendency is basic.

The issue of whether affirmative action in education is constitutional has returned to the Supreme Court docket. On February 21, 2012 the Supreme Court agreed to hear arguments in the case of Fisher v. Texas. Oral arguments took place on October 10, 2012. Outside interest in the case has been intense. The court received 90 ‘friend of the court’ (amicus curiae) briefs from interested parties, including social scientists.

Following the Hopwood decision, Texas adopted a simple policy of admitting applicants in the top 10 percent of Texas high-school graduating classes. Although the top-10-percent formula sacrifices some academic selectivity, it is a transparently reasonable admissions policy for a state-chartered institution dependent on state funds for part of its budget. It does not explicitly involve race or ethnic origin, but de facto residential segregation guarantees that this formula will result in the admission of more African Americans and Latinos than if admissions were based on test scores. Since its adoption, this formula has accounted for 60 to 80 percent of undergraduate admissions to the University of Texas. Following the Grutter decision, which sanctioned admission policies that considered race in a narrowly targeted, individual manner, Texas instituted what it called a “holistic” process to govern other admissions. The holistic admissions procedure uses both an academic index, based on test scores and grades, and a personal achievement index based on a wide range of other factors including two essays, family background, activities in the community and elsewhere, and race.

Ms. Fisher, a white Texas high school graduate, was in the 12^th percent of her class and therefore was not admitted on the 10 percent plan. Nor was she admitted through the alternative selection process. She was offered a place on a waiting list, which she refused. She challenged the constitutionality of the Texas admission policy, claiming that but for her race she would have been admitted and was thereby unconstitutionally denied equal protection under the law.

The briefs of the parties to the case focus on whether the use of race in the Texas formula does or does not qualify as ‘limited and individualized,’ as specified by Justice O’Connor in Grutter v. Bollinger. But the court may go further by limiting or overturning Grutter, and at least four justices are thought to be disposed to do so. Persuasive evidence that affirmative action harms those it is intended to help would buttress the ethical foundation for such a position. One of the amicus briefs, by UCLA law professor Richard Sander and legal journalist Stuart Taylor, argues just that. Their book, Mismatch: How Affirmative Action Hurts Students It’s Intended to Help, and Why Universities Won’t Admit It, is a lengthy and rich argument in support of this position. So significant is this indictment of affirmative action that another amicus brief, by a veritable Who’s Who of empirical social scientists is devoted to rebutting the Sander/Taylor brief. Social scientists submitted several other amicus briefs, some in support of Ms. Fisher’s appeal, some opposed.

Mismatch extends and elaborates an indictment of affirmative action first presented by Sander in 2004 in a Stanford Law Review article. That article provoked intense controversy, personal invective, and allegations of data suppression. Mismatch recounts this controversy in score-settling detail and is, thus, also a personal memoir and an expose of intellectual politics in the academy, as well as a layman’s guide to social science research on a tricky subject. Co-author Stuart Taylor comes to this tale with the background of having written Until Proven Innocent, a chilling and devastating expose of the way a rogue—and subsequently disbarred—district attorney railroaded Duke lacrosse players after a stripper falsely accused them of rape, and tells how Duke faculty members and administrators rushed to condemn the players despite abundant warning signs of prosecutorial abuse.

Sander and Taylor do not argue that affirmative action is inherently harmful to its intended beneficiaries, but rather that it is pushed to a damaging extreme. To make their case, they lay out a theory of how affirmative action, as practiced by the most select universities and colleges, ramifies through much of higher education. A few top universities are able to attract most of the academically able African Americans and Hispanics. Although the academic credentials of these students, on the average, are not as strong as those of their white or Asian classmates, these African-Americans and Hispanic students are mostly able to handle the academic challenges they face at these top schools. Sander and Taylor argue that is why Bok and Bowen found that most of the minority students they surveyed graduate and do well professionally.

But that is just part of the story. The selective institutions, Sander and Taylor argue, so seriously deplete the limited pool of academically well-qualified minorities that lower tier schools, also trying to meet affirmative action goals, admit applicants with credentials so weak that these students do less well than they would at still less selective institutions. Mismatch can be inferred as well, Sander and Taylor argue, from the finding that a larger proportion of students with a given SAT score major in the difficult STEM subjects (science, technology, engineering, and math) at less-selective than at more selective schools.

The reasoning is straightforward. First-level courses in these fields that serve as pre-requisites for upper division study weed out students who are comparatively weak at the institutions they are attending. Because affirmative action allows minority students to attend colleges where their academic preparation is comparatively weak, such students are more likely to get weeded out than they would be had they attended less-selective colleges and universities, where their academic preparation would have been more competitive.

The strongest evidence for the mismatch hypothesis comes not from data on undergraduate admissions but from information on law school graduates. The American Bar Association compiled data on thousands of law school graduates from a wide range of law schools—the Bar Passage Study (BPS). Because student grades and class rank depend, in part, on the average academic strength of classmates, students with a given academic index are more likely to get better grades at lower ranked law schools than they would at higher ranked law schools. Furthermore, African American and Hispanic students covered in the BPS were the beneficiaries of sizeable race- and ethnicity-based admission preferences at most law schools.

Based on data from the BPS, Sander and Taylor report two findings that, they argue, suggest mismatch. First, African American and Hispanic law school graduates with similar academic index scores (based on undergraduate performance) to those of whites passed the bar at lower rates than did whites. But if one controlled for both academic index and law school grade point average, there was no significant difference in passage rates of African Americans, Hispanics, and Whites. The reason why relative class standing influences bar passage, they argue, is that instruction and grading are geared to the median student in each school. Students who are weaker than average at a given school will find it hard to keep up, will learn less than they would if instruction was geared to their level of preparation, and will therefore pass the bar exam at lower rates than they would had they attended a school better tailored to for their academic skills. This finding implies that law school students should not follow the advice from Bok and Bowen gave to undergraduates—go to the most selective school that will admit you—but should instead be very careful not to over-reach.

Could both Bok/Bowen and Sander/Taylor be correct? The curricula at professional and graduate schools are notoriously austere. The environment in law school is ruthlessly meritocratic to an extent true of few undergraduate programs. If the conditions between undergraduate and graduate schools and among undergraduate programs are sufficiently different, affirmative action might help in some cases and hurt in others.

An intense intellectual battle followed Sander’s 2004 article and continues to this day. One exchange illustrates how hard the issues are analytically and how difficult it is to reach consensus. Two members of the Yale Law School faculty, Ian Ayres and Richard Brooks, noted that not all African Americans surveyed in the BPS accepted admission letters from the schools they had listed as their first choices. Some went to lower choice schools that were mostly less selective than the first choice schools. The students in the two groups were otherwise similar. If mismatch were a problem, they reasoned, students who went to first choice schools would be more likely to get low grades and less likely to pass the bar than those who went to less select schools. In an initial draft, Ayres and Brooks found no such differences and stated that the evidence provided no support for the mismatch hypothesis.

Sander reports that Ayres and Brooks shared their analysis with him and that he pointed out errors, which they then corrected. After the corrections were made, Sander and Taylor claim that the corrected results closely match what the mismatch hypothesis suggests—those students who did not go to their first-choice, relatively select law schools got better grades, graduated at a higher rate, and were more likely to pass the bar on their first try. But, they assert, Ayres and Brooks refused to modify the text of their initial draft. In addition, Ayres and Brooks are among the signers of the amicus brief by quantitative social scientists which is highly critical of the methods that Sander and Taylor use. This brief states flatly: “Sander’s research has major methodological flaws—misapplying basic principles of causal inference—that call into doubt his controversial conclusions about affirmative action....Sander’s research does not constitute credible evidence that affirmative action practices are harmful to minorities....”

Quite apart from the analytical case that Sander and Taylor make against affirmative action, Mismatch is an expose of politics and back-biting in the academy. It charges that those controlling what should be publicly available data refuse access to people who it is feared will come up with politically objectionable answers. It charges critics with refusals to admit demonstrable mistakes. Both Taylor’s earlier book on the Duke rape case and Mismatch report enough unreasoned and unreasonable behavior in the name of political correctness to make one gag. Most importantly, Mismatch charges universities and colleges with a stunning lack of candor regarding the extent of affirmative action and refusal to provide data with which analysts could evaluate its effects.

Although Mismatch indicts affirmative action in its current form, Sander and Taylor recommend that affirmative action be modified not ended. They note that minorities who are favored by affirmative action disproportionately come from favored socio-economic groups, children of professionals and others with higher education. They recommend that racial preferences be no larger than preferences based on financial need and socioeconomic status. The emergence of growing economic inequality heightens the appeal of class-based affirmative action. Precisely how such balancing of racial, socio-economic, and needs-based factors might be achieved is not explained in the book. Others have also urged class-based affirmative action as both fairer and politically more acceptable than race-based affirmative action—notably, Richard Kahlenberg who has taken that position for nearly two decades. Unfortunately, Sander and Taylor leave a key question unanswered—if current race-based affirmative action harms intended beneficiaries, why wouldn’t a mix of some race-based and some class-based affirmative action also do so?

Particularly troubling for a technically minded reader/reviewer is the absence from a book running to nearly 300 pages of any clear, technical presentation of the mismatch hypothesis. The authors say at the outset that in order to keep the book to a reasonable length, they are omitting ‘technical or elaborating material’ but that such details can be found at their website. At various other points in the book, readers are also advised that they can find further detail at the same web site. As I write this review and after personal contact with both authors, the website remains without such supporting material.

What conclusions should the Court and the public take from Mismatch and the cacophony of conflicting research on the effects of affirmative action? First, universities and colleges should provide qualified analysts access to data on admission practices. It is not credible that universities would suffer irreparable damage if their admission practices were publicized. Nor is it believable that minorities who benefit from racial preferences would wilt from the stigma if these practices were spelled out. The failure of colleges and universities to divulge data on the way affirmative action operates should not be tolerated. The best way to correct any over-use or misuse of affirmative action is not to ban it but to insist that its operation be illuminated with hard data and further analysis.

Second, on the major theme—the charge that affirmative action hurts its intended beneficiaries—I believe that judgment must still be withheld. Sander and Taylor present a powerful case that it does so in particular instances. But the character of college and university programs and their objectives is enormously varied. It is much more important to make sure that African Americans and Hispanics are well-represented among tomorrow’s public officials and business leaders and that they are well trained than it is to assure racial or ethnic diversity among tomorrow’s mathematicians and biomedical researchers. Meritocratic values have their place. So too do the values of inclusiveness. If there was ever a place where one size does not fit all, it is in the treatment of affirmative action within the academy.

Authors

Henry J. Aaron

Image Source: © Jose Luis Magaua / Reuters

Will Obamacare Implementation Really Be a "Train Wreck"?

S. Lawrence Kocot — Mon, 20 May 2013 00:00:00 -0400

Senate Finance Committee Chairman Max Baucus, an architect and supporter of the Affordable Care Act (ACA), recently caught the Administration's attention when he voiced his concerns about the implementation of the health exchanges—the centerpiece of Obamacare now scheduled to go live on October 1—saying that he sees "a huge train wreck coming."

President Obama responded to concerns about implementation, emphasizing that he is 110 percent committed to getting implementation done right, but he also cautioned that there will be mistakes and hiccups.

While the Administration is certainly not going to highlight major problems at this point in the implementation cycle, there are a few key indicators to watch over the next few months to assess how well implementation is progressing:

1. Affordability. Very simply, can individual and small group purchasers of health insurance in the new marketplaces afford the likely cost? A recent report by the Society of Actuaries indicates that we can expect to see per member per month costs of plans in the individual markets increase by as much as 32% under the ACA -- with many states seeing increases even higher. The Administration and some advocates claim that the actuaries' report is misleading or just plain wrong, and that any cost increases will be covered by ACA's generous subsidies that will cushion the blow for most of those eligible for the benefits.

The Qualified Health Plan approval process is still in progress, so we won't know the full extent of the cost increases until later this summer. However, with projected insurance plan costs for some states now available, we can already see that there will be significant variation across the states on average costs in the non-group market. Vermont and Rhode Island are projecting favorable rates to consumers; Washington is mixed depending upon enrollee characteristics; and Maryland costs are projected to rise by 25% on average next year - but with healthy young men seeing their insurance costs rise as much as 150%- contrary to the ACA's goals of providing affordable insurance.

If the Society of Actuaries is right, we can expect that the cost of this new health insurance may be hard to swallow for some consumers who will not be eligible for subsidies - some 1 million persons in 2014, according to CBO. And for the other 6 million expected enrollees eligible for subsidies in 2014, the cost to the federal government could be more than the projected $35 billion. If overall plan and subsidy costs are much higher than anticipated, legitimate questions may be raised about the sustainability of the program.

2. Availability. Even after we know more about the "rate shock" that is predicted to come later this summer, the question then becomes: will state marketplaces be operational by October? This gets to the heart of the "train wreck" comment, as the law requires that subsidies be administered through enrollment in the marketplaces. Sixteen states and the District of Columbia have agreed to run their own state marketplaces, while the remainder have surrendered many of the operational decisions or have deferred completely to the federal government to run theirs.

Even under the best of circumstances, the Centers for Medicare & Medicaid Services (CMS) would have difficulty pulling off the simultaneous operational roll-out of more than 30 federally facilitated/partnership marketplace exchanges (FFEs) at the same time. In order for the FFEs to work as planned, CMS needs a willing state partner that is committed to making it work through precise coordination of technology and business rules, which requires extensive operational planning and resource allocation, as well as close collaboration and constant communication.

Let's face it: not all partners in the states are even willing, much less committed, to providing the time and resources to make a federal marketplace successful in their state. What Baucus is hearing about the FFE progress in Montana is consistent with what many FFE states are reporting -- many of these FFEs are not ready yet and time is running out to get them there.

So what about the 17 state-run marketplaces? They have been given over $3.5 billion in federal grants since 2010 to be ready to enroll consumers in the new insurance benefits on October 1, 2013. While some of these states are clearly ahead of the pack in terms of readiness, despite their best intentions, it is likely that not all state-run marketplaces will be fully operational by the deadline. CMS may have to decide if and when to take responsibility for some of them, which could be viewed by opponents as an early admission of failure.

To be fair, establishing marketplaces in 50 states and D.C. is an ambitious undertaking. With unprecedented cooperation required across multiple federal agencies, states, and quasi-state bodies and agencies coordinating with state insurance commissions and plans, the requirements and deadlines for effective implementation are virtually impossible. Additionally, new data systems that have never been fully tested with live data can't be expected to perform without technical glitches and a period of correction.

3. Outreach. As has been reported, CMS did not get the nearly $1 billion they said they need for outreach and implementation of the marketplaces. While this seems like a lot of money, it is not nearly enough to accomplish the task, especially given the difficulties CMS will have with some of the consumers they are trying to enroll - low-income, less healthy, and "young invincible" consumers, many of whom have not had insurance before. As polls have shown, 78% of subsidy eligible Americans do not know this benefit will be available. Like all marketplace applicants, they will need to fill out a multi-page form and will need help to get educated about subsidies to make the insurance affordable. Experience has shown that the hardest benefits to sell are the ones that cost even a little to those who have the least. This explains why Secretary Kathleen Sebelius has been desperately trying to rally insurers and private organizations such as Enroll America to step up to supplement federal enrollment efforts; the private assistance will help, but it is not likely to be enough.

So, is this really the train wreck Senator Baucus sees? It probably depends on what type of railroad one was expecting. The implementation of Medicare Part D tells us that there are plenty of opportunities for things to go wrong with exchange implementation. No implementation is without challenges and this one will be particularly rough given the size and scope.

At the end of the day, however, the measure of implementation success is probably not the expense of the benefit nor whether technology works as intended; technical problems can eventually be fixed and in the short term, manual processes can hide a lot of sins. Rather, the real measure of success is how many people actually enroll in this new benefit and get the subsidy for which they qualify. If CMS can stay focused on these measures, the light at the end of the implementation tunnel may be much brighter than the light on the political train that continues to barrel down the tracks in their direction.

Authors

S. Lawrence Kocot

Publication: Real Clear Markets

Image Source: © Jessica Rinaldi / Reuters

CO2 Emission Permit Prices Plunge In Europe: What's Up?

Adele Morris — Fri, 17 May 2013 13:47:00 -0400

Recent headlines proclaim "deep trouble" in the European cap-and-trade system for greenhouse gases, evidenced by the decline in allowance spot prices from over $25 per metric ton of carbon dioxide in June 2008 to about $3 this month. Although many press articles have referred to an "oversupply" of emissions permits, suggesting some kind of intrinsic imbalance, the markets are clearing just fine. It's just that the price is lower than forecast.

Whether this represents trouble or not depends on what you think the goal of the program should be. If the goal is to ensure that emissions in the covered industrial sectors are no higher than the emissions caps, then the program has worked just fine. It just didn't have to work very hard since much of the decline in emissions relative to projections was driven by the multi-year economic crisis. A sputtering EU economy lowered industrial activity and consumer energy demand, and this drove down allowance demand and prices. This makes compliance easier for the remaining emitters just at the time business and consumers are suffering most. This counter-cyclical property might be seen by some as a feature, not a bug.

On the other hand, if you think the goal of climate policy should be to provide stable cost effective long-run incentives to lower emissions relative to what would otherwise occur, then the ETS price plunge is a cautionary tale. First, it illustrates the importance of the design details of the carbon market. The ETS law included no provision to restrict automatically the number of allowances when prices get low. Efforts to withhold allowances failed when, not surprisingly, coal-dependent states balked at the proposed stringency in an economic downturn.

Second, the price volatility shows that the ETS hasn't really fixed the market failure in which fossil energy prices don't reflect their full social costs, including environmental damages. Economists widely advocate a price signal on carbon that would include those external costs, as best we can estimate them, in fuel prices through a carbon tax or a cap-and-trade system. The ETS illustrates one key drawback of a poorly designed cap-and-trade system: fluctuating allowance prices and abatement incentives. Price volatility makes no sense if you're trying to internalize an external cost because there's no reason to think the social cost of carbon fluctuates over the short run, much less drops by 90 percent over five years.

Third, the ETS illustrates the potential for laxity in one carbon market to erode abatement incentives abroad. For example, the Australians plan to convert their carbon tax to an ETS-linked permit program in July 2015. The prospect of linkage to the ETS lowers the expected Australian carbon price well below the current tax of about $25 per ton of CO2. To be sure, low prices in the ETS just amplify the investment-depressing effect of the broader uncertainty around a policy so incompetent one wonders if they'll go through with it.

Finally, the ETS experience reveals the limitations of framing the environmental success of a climate policy solely in terms of emissions levels. Many environmentalists are more comfortable with an emissions cap than a carbon tax because the cap provides more environmental certainty. However, the lower-than-predicted ETS allowance price has made it unexpectedly easy for utilities to fire up coal-powered plants and delay investments in cleaner natural gas and renewables, and this could set back climate efforts in the EU for years.

The fits and starts of the EU carbon market suggest the potential advantage of an enduring and credible incentive to reduce emissions through a carbon tax. Even if the EU had set a tax at the lesser of the estimated damages from emissions and the public's willingness to pay, it would surely have been greater than the current ETS price, suggesting that the policy with the greater environmental certainty has foregone the opportunity for greater environmental benefits.

Policymakers should expect the unexpected and do what they can to establish a climate policy that is robust to changing economic conditions at home and abroad. Compared to the EU's current approach, a modest predictable tax would be more robust to shocks, solidify the payoffs of investments in new technologies and emissions reductions, cost less (especially if the revenue is used wisely), and ultimately do more to protect the planet.

Authors

Adele Morris

Publication: Real Clear Markets

Image Source: © Alessandro Garofalo / Reuters

Why Investors Should Brush Up on Their Political Science and Economics

Douglas J. Elliott — Fri, 17 May 2013 16:38:00 -0400

Newspapers have been reporting the possible misuse by hedge funds of confidential information about proposed government actions. Whatever the truth of these particular allegations, it is a sign of the intense interest that much of the “smart money” displays in the specifics of government policy.

This runs counter to the misconception, still held by many investors, that we will eventually return to the “good old days” when they can focus again on businesses and ignore governments. They believe that the current need to actively scrutinize the likely actions of the U.S. and other governments is a fluke resulting from the financial crisis and the ensuing severe recession. This seems very unlikely. Governments should always matter a great deal to investors: they establish the framework of laws and regulations that rule business transactions, set taxes, establish monetary policies, decide government spending levels, choose among infrastructure projects, etc.

A return to the norm

The truth is that the 20 or so years preceding the financial crisis was the aberration and we are returning to more normal conditions. In the U.S., we went through a couple of decades in which governments were relatively laissez faire, intervening less than usual in business operations and continuing a trend of deregulation.

Further, the Fed, in line with central banks in other advanced economies, began to believe that a “Great Moderation” had occurred in business cycle conditions as a result of better central bank operations based on an accumulation of understanding of monetary policy over the years. Financial markets operated fairly freely, as the government held the reins with a light hand.

Do not expect these conditions to recur anytime soon. In the short to medium term, the memory of the terrible economic and political damage from the financial crisis will certainly keep the level of government intervention in the U.S. at high levels. Further, the need to resolve our fiscal problems will involve major decisions about what the government does and how it pays for it. This will have knock-on effects throughout the economy, both by affecting general conditions and by hitting particular industries, such as defense contractors or hospitals. This will come on top of activist monetary policies at the Fed that will bring years of critical decisions about the level of purchases of bonds by the Fed, their eventual disposition as the inventories are worked down, and, of course, an eventual rise in interest rates that will need to be carefully managed.

World markets increasingly important

Beyond our shores, the global economy is increasingly influenced by emerging market countries that believe in much more active government policies and even state ownership of major businesses. These nations will also make key decisions about where to invest public funds, and where to encourage the investment of private money, as they continue to develop rapidly. The choices of their governments, and the reactions of our own, will have a major impact on U.S.-based companies and on our own stock markets and interest rates, as well as the value of the dollar in foreign currencies, and therefore our trade balances.

Europe, for its part, is going through a prolonged set of inter-related political crises that aggravate economic problems, in turn worsening the political difficulties. The impacts on businesses and the overall economy have had, and will have, substantial effects on America and the rest of the world. Europe is likely to remain in political turmoil for years, even if the potential short-term disasters are overcome. If things work out on the positive side, reshaping their joint political institutions will still take years and will have major effects on their economies and therefore ours.

Government actions matter

This pattern, where government decisions have determining effects on business choices and investor returns, is typical of preceding decades and even centuries. Sometimes this has been vividly demonstrated by decisions about war or the trade equivalent -- trade wars or competitive devaluations of exchange rates. Other times, the big impacts have come from tax and regulatory policies that differ greatly from that of neighbors and trading partners. Other times it has been massive infrastructure projects such as the creation of the transcontinental railroads and the federal give-aways of free land to homesteaders. Even the abolition of slavery had massive economic impacts. Government actions going forward may be less dramatic than these examples, but there is no doubt that what happens here and abroad will be profoundly influenced by political decisions and the implementation of these decisions by bureaucracies.

So, pay attention to politics here and around the world and the intersection of those politics with underlying economic issues. Government decisions may sometimes prove to be more important than the intricacies of business strategies in determining the fate of investments.

Authors

Douglas J. Elliott

Publication: Yahoo! Finance

Image Source: © Kevin Lamarque / Reuters

How Much Do Americans Care About Income Inequality? Part II

Scott Winship — Wed, 15 May 2013 16:00:00 -0400

Recently in this space, I criticized an op-ed that claimed to resolve a paradox related to inequality and public policy. Ilyana Kuziemko and Stefanie Stantcheva argued that while Americans are "deeply troubled about the current level of income inequality," support for government policy to reduce it is low. Based on a series of randomized experiments they conducted with Emmanuel Saez and Michael Norton, Kuziemko and Stantcheva speculated that rising inequality has eroded trust in government, resolving the paradox.

In my previous essay, I argued that there is little evidence to indicate that Americans are particularly concerned about inequality, so their lack of interest in having the government intervene should be unsurprising. Here I want to draw attention to a problem with the conclusion of Kuziemko and her colleagues that providing people with information about inequality reduced trust in government.

In their experiment, some survey respondents were provided information about their ranking in the income distribution and about inequality levels. Receiving this information produced a decline in expressed levels of trust in government. Kuziemko and her colleagues conclude that,"emphasizing the severity of a social or economic problem appears to undercut respondents' willingness to trust the government to fix it-the existence of the problem could act as evidence of the government's limited capacity to improve outcomes more generally." But the information in their survey did not simply emphasize the severity of inequality, it exaggerated economic hardship.

Respondents randomly selected to receive information about inequality first input their "annual household income" and were told the share of "US households" that earn less than their own "household." But the information the survey gave respondents made them feel richer than they were. I typed into the survey form the 2011 median household income according to the Census Bureau-$50,054. The survey should have told me that "my" household was richer than 50 percent of American households-that's what the median is. Instead, I was told I was richer than 66 percent of households.

In fact, what the information provided by the survey told the subject was the percentage of tax returns that have less gross income than the household income she reported. Tax returns are not households. Two roommates living together, a cohabiting couple, a married couple filing separate returns-all of these constitute one household but two tax returns. More to the point, a sixteen-year-old burger-flipper or a fulltime college student with a work-study job are also distinct tax returns even if they live at home. Furthermore, gross income on tax returns (AGI with adjustments put back in) is not "household income" as most people think of it. For example, non-taxable public transfers-including most Social Security benefits and all welfare benefits-are excluded. So are the tax-favored employee benefits commonly deducted from paychecks, such as health insurance premiums, retirement plan contributions, and flexible spending accounts.

The result of these differences between the income of households and the gross income of tax returns is that the median for the former is quite a bit bigger than the median for the latter (and the same is true for other parts of the income distribution, such as the "richest ten percent" or the"poorest third"). The survey tool reports that $33,800 is the median "household income"-one-third less than the actual median.

The respondent, then, "learned" that she was richer than she was, and if she correctly thought that her standard of living was average before responding, she learned that it was better than average. More people were doing worse than her than she thought, and fewer people were doing better than her. The next step in the survey drove that home by inviting her to move a slider to see how "households" with different income levels rank compared with other households. This step reinforced that Americans were poorer than they actually were.

Different subjects were shown additional screens subsequently. However, everyone randomized to receive the information about inequality proceeded through the rest of the survey-with its questions about policy preferences and trust in government-having been given this overly-negative data about how Americans are doing economically. The subjects randomized to bypass the informational screens were not primed in this way. The design of this experiment does not allow us to assess whether getting accurate information about the distribution of household income reduces trust in government. Instead, trust in government may be eroded by getting anxiety-provoking (and inaccurate) information.

Interestingly, Kuziemko and her colleagues report results from a separate experiment they conducted indicating that among below-median households, being primed with negative information about the state of the economy reduces opposition to inequality and support for redistribution and for progressive approaches to deficit reduction. It may be that attempting to convince middle class Americans that economic insecurity is more pervasive than it is will prove counterproductive to those who wish to help the truly insecure.

I have argued elsewhere that conventional accounts on the left do, in fact, systematically overstate both the extent of economic insecurity and the strength of the evidence that income inequality is harmful. It would be a regrettable irony if an excessive and distorted focus on inequality turns out to be more harmful to struggling families than income inequality itself.

Authors

Scott Winship

Publication: Real Clear Markets

Image Source: © Carlo Allegri / Reuters

The History of Cyclical Macroprudential Policy in the United States

Douglas J. Elliott, Greg Feldberg and Andreas Lehnert — Wed, 15 May 2013 00:00:00 -0400

Since the financial crisis of 2007-2009, policymakers have debated the need for a new toolkit of cyclical “macroprudential” policies to constrain the build-up of risks in financial markets, for example, by dampening creditfueled asset bubbles. These discussions tend to ignore America’s long and varied history with many of the instruments under consideration to smooth the credit cycle, presumably because of their sparse usage in the last three decades. We provide the first comprehensive survey and historic narrative of these efforts. The tools whose background and use we describe include underwriting standards, reserve requirements, deposit rate ceilings, credit growth limits, supervisory pressure, and other financial regulatory policy actions. The contemporary debates over these tools highlighted a variety of concerns, including “speculation,” undesirable rates of inflation, and high levels of consumer spending, among others. Ongoing statistical work suggests that macroprudential tightening lowers consumer debt but macroprudential easing does not increase it.

Downloads

The History of Cyclical Macroprudential Policy in the United States

Authors

Douglas J. Elliott
Greg Feldberg
Andreas Lehnert

Publication: Office of Financial Research, U.S. Department of the Treasury

Image Source: © Larry Downing / Reuters

Federal Tax Reform? Don't Bet The Rent Money On It

Bill Frenzel — Tue, 14 May 2013 11:52:00 -0400

In some years there are no budgets. This year we have been presented with thre dueling budgets, one from each house and one from the president. Neither house has picked conferees, and neither has any current inclination to do so. Each prefers to glare at the other until the next election day.

The “Grand Bargain” on the Federal budget this year is still possible, but it seems less and less likely. The prospect is for another year of small deals, recurring crises, and several continuing resolutions.

As hopes for the big fiscal fix recede, tax reform moves to center stage. Ideally, tax reform ought to be a part of a larger budget agreement. But, with that agreement now slipping out of reach for 2013, tax reform seems to some observers to be a more promising suspect.

Tax reform appeals to both parties for different reasons. Democrats need it for new spending to stimulate growth. Republicans want to use it for lowering tax rates for the same reason. Those differences may be irreconcilable, but members of Congress seem to want to give tax reform a try.

Perhaps the best reason for tax reform optimism lies in the fact that the chairmen of both tax-writing committees really want to do it. Dave Camp, chair of the House Ways & Means Committee, is now serving his last term as chair under caucus rules. Max Baucus, Camp’s Senate Finance Committee counterpart, is in a similar position. He is retiring from Congress after this term.

Both of these leaders are strongly motivated to produce a tax bill before they slide into history. Both are able veterans who know the tax code. They meet regularly. Both have held hearings on tax reform, and have given it much study over the past two years. In addition, Camp has the blessing of the House Republican leadership including Speaker Boehner, who has saved the precious number, HR 1, for a tax reform bill.

Some business interests, led by the U.S. Chamber of Commerce, want to see reform of the tax code, too. Many of them see advantages in potentially lower rates, and in reform of U.S. taxation of their foreign income. American business is by no means unified on this subject, but there clearly is plenty of interest.

There is, however, another side to the tax reform story. Historically, it is a rare event. The last successful effort was in 1986. Before that one has to backtrack to 1958 to identify a major tax reform enactment. In the 1986 version, both Congressional parties, (with Democrats in the majority) and the President, Ronald Reagan, strongly supported it. Even so, the process took two years. Nobody believes that the 1986 political consensus can be duplicated today.

In 1986, the American people polled strongly in favor of tax reform. Nowadays, they are not so sure. They saw the 1986 act substantially altered by amendment in the years immediately thereafter. Today, the public is not sure that tax reform will help them. And, even if it does help, they are pretty sure it will soon be amended beyond recognition. Trust in the government has all but faded away in the last three decades.

In the end, the biggest hurdle for tax reform will be to overcome the opposition of interests who are unwilling to part with their tax preferences peaceably. Unsurprisingly, many individuals and corporations just love their tax preferences. Some of them would be worse off with a system that abolished those preferences even if their basic tax rates were lowered.

This group is sophisticated. It knows how to make strategic political contributions, and it knows how to lobby successfully. It also knows how to maneuver in the current political environment where polarization is the rule, and in which members of Congress do not often trust one another. For these interests, the conditions on the playing field are just about perfect for defending their preferences.

Just as the country needs a Grand Bargain, it also needs tax reform. It would be wonderful if tax reform could be achieved this year. The two chairmen and many members will give the good old college try. But, if a budget compromise is not possible, it also seems unlikely that a good tax reform bill can be enacted. Cheer for tax reform; pray for it; just don’t bet the rent money on it.

Authors

Bill Frenzel

Publication: Forbes

Image Source: © Kevin Lamarque / Reuters

Advancing Reform: Medicare Physicians Payments

Kavita Patel — Tue, 14 May 2013 10:00:00 -0400

Chairman Baucus, Ranking Member Hatch and members of the Committee, thank you for this opportunity to highlight ways to advance physician payment reforms in Medicare. The Medicare program retains a strong commitment to provide care to approximately 50 million beneficiaries across the country; a key partner in the provision of this care are the 900,000 healthcare providers who see beneficiaries in medical offices, hospitals, skilled nursing facilities and other settings.[1] Each day, providers work hard to deliver the best care for their patients yet our current payment system falls short time and time again, with financing mechanisms that perpetuate fragmented care and volume over coordination and value. Fortunately, there are better ways to pay physicians that can enable them to improve care, enhance the patient experience and potentially achieve greater savings for the Medicare system overall. I am honored to present some solutions from my work at the Engelberg Center for Health Care Reform at the Brookings Institution and our Merkin Initiative on Clinical Leadership, as a Commissioner on the National Commission on Physician Payment Reform and perhaps most importantly, as a practicing internal medicine physician.[2]

Current Payment Policies in Medicare

Currently, Medicare pays physicians primarily by a fee-for-service (FFS) schedule that is informed by relative value units (RVUs). Relative value units are determined from the Resource Based Relative Value Scale (RBRVS) which defines the value of a service through a calculation of physician work, practice expense and practice liability.[3] A relative value unit is assigned to every medical service that physicians carry out during a clinical visit. [4] The RVU is then adjusted by geographic region (so a procedure performed in Miami, Florida is worth more than a procedure performed in Salem, Oregon). This value is then multiplied by a fixed conversion factor, which changes annually, to determine the amount of payment to the physician. As the number of billable service codes have grown over time, an extensive regulatory process was enacted to develop RVU weights and update them year over year.

Over time, the RVU updating system has placed an increasing importance, evidenced by RVU weights, on procedures, scans, and other technical services that fix certain ailments or problems. Emphasis on technologies and interventions have resulted in a marked disparity between reimbursement for specialties which emphasize procedures such as cardiology and gastroenterology and those that do not such as primary care, endocrinology or infectious diseases, thus exacerbating shortages and the hierarchical culture within medicine.

The 1997 Balanced Budget Act exacerbated the problem with the introduction of the sustainable growth rate or SGR. The SGR was intended to keep the growth in Medicare physician-related spending per beneficiary in line with growth in the nation’s gross domestic product (GDP). In the early years of the SGR, this worked fine, as spending growth was lower than the calculated GDP target and payment rates for physician services increased. But starting with the recession in 2002, spending growth per beneficiary began to exceed GDP growth. In 2002, payment rates were reduced accordingly, by 4.8 percent.

Every year since then, the scheduled SGR payment rate reductions have not taken full effect. Instead, because of concerns about access to care and the sufficiency of payments, Congress has headed off the full payment reductions on a short-term basis. Typically, this has involved offsetting at least some of the budgetary costs with payment reductions affecting other Medicare providers. As Figure 1 illustrates, actual updates as well as the SGR formula update still grow at rates far below input costs (MEI) and payment rates for other providers, thus exacerbating systemic flaws. In short, our system is broken.

Payment Reforms in the Affordable Care Act

The Affordable Care Act included over 100 policy changes in Medicare provider payments, many of which are currently being phased into the current delivery system and affect physicians directly. [5] These reforms include Medicare Accountable Care Organizations (ACOs), Value-based payment modifiers, the Bundled Payments for Care Improvement initiative as well a number of broader efforts for statewide level innovation, multipayer efforts to promote primary care and alignment of payments for Medicare-Medicaid beneficiaries (dual eligibles). These reforms are incredibly effective at encouraging providers to delivery high-quality, coordinated care at a lower cost and enable Medicare to pay for value. As Jonathan Blum, Acting Deputy Administrator and Director of the Center for Medicare recently pointed out in his testimony before this committee, “the Medicare program has been transformed from a passive payer of services into an active purchaser of high-quality, affordable care.” [6] While these reforms will offer a great deal of insight into how we can improve Medicare physician payment through authorities granted in the Patient Protection and Affordable Care Act, they are still largely based on a fee-for-service payment system. We must acknowledge the limitations in implementing payment reforms in the face of a dominant fee-for-service system. One early large-scale Medicare pilot implemented in oncology in 2006 serves as a good example: in conjunction with reductions in Part B drug payments, oncologists received an additional payment to report on whether the chemotherapy care provided by them adhered to certain evidence-based guidelines. This promoted comparisons to the published guidelines and also supported the development of evidence on how widely published guidelines were being followed in practice. [7] However this pilot did not make any changes in the underlying structure of fee-for-service payments and did not explicitly tie payments to measured improvements in performance, resulting in limited feasibility and adoption. In order to move away from our current system and build on the promise of ongoing efforts we must remove the SGR as a constant impediment to true systemic change.

Recommendations of the National Commission on Physician Payment Reform

In an effort to explore new ways that to pay for care that can yield better results for both payers and patients, the Society of General Internal Medicine convened the National Commission on Physician Payment Reform in 2012. Our commission, composed of a broad range of leadership and expertise spanning the public and private sectors, adopted twelve specific recommendations for reforming physician payment:

The SGR adjustment should be eliminated
The transition to an approach based on quality and value should start with the testing of new models of care over a 5-year time period and incorporating them into increasing numbers of practices, with the goal of broad adoption by the end of the decade.
Cost-savings should come from within the Medicare program as a whole. Medicare should where possible, avoid cutting just physician payments to offset the cost of SGR repeal, but should also look for savings from reductions in inappropriate utilization of Medicare services.
The Relative Value Scale Update Committee (RUC) should continue to make changes to become more representative of the medical profession as a whole and to make its decision-making more transparent. CMS has a statutory responsibility to ensure that the relative values it adopts are accurate and appropriate, and therefore it should develop alternative open, evidence-based, and expert processes beyond the recommendations of the RUC to validate the data and methods it uses to establish and update relative values.
For both Medicare and private insurers, annual updates should be increased for evaluation and management codes, which are currently undervalued, and updates for procedural diagnosis codes, which are generally overvalued and thus create incentives for overuse, should be frozen for a period of three years. During this time period, efforts should continue to improve the accuracy of relative values, which may result in some increases as well as some decreases in payments for specific services.
Fee-for-service contracts should always include a component of quality or outcome-based performance reimbursement.
Higher payment for facility-based services that can be performed in a lower cost setting should be eliminated. Additionally, the payment mechanism for physicians should be transparent, and should reimburse physicians roughly equally for equivalent services.
In practices having fewer than five providers, changes in fee-for-service reimbursement should encourage methods for the practices to form virtual relationships and thereby share resources to achieve higher quality care.
Over time, payers should largely eliminate stand-alone fee-for-service payment to physicians because of its inherent inefficiencies and problematic financial incentives.

10. Because fee-for-service will remain an important mode of payment into the future even as the nation shifts to fixed-payment models, future models of physician payment should include appropriate elements of each. Thus, it will be necessary to continue recalibrating fee-for-service payments, even as the nation migrates away from that method of paying physicians.

11. As the nation moves from a fee-for-service system to one that pays physicians through fixed payments, initial payment reforms should focus on areas where significant potential exists for cost savings and higher quality.

12. Measures should be put into place to safeguard access to high quality care, assess the adequacy of risk-adjustment indicators, and promote strong physician commitment to patients.

Moving Beyond the SGR

Eliminating the SGR is a principal recommendation of many expert reports, including our Commission’s Report, MEDPAC, The Brookings Institution, Simpson-Bowles and the Bipartisan Policy Center, but the question remains, repeal and replace with what? [8][9]^,[10]As stated above we (and other clinical groups and societies) recommend a five year transition to newer models of payment which move away from FFS as the dominant payer. But the devil is in the details, and proposals to move towards new models over a period of time leaves policymakers and physicians wondering what their practices will look like next month, next year and beyond. In moving from principle to practice, it is also important to acknowledge that while there will be no one payment model that applies to all physicians, payment models must be relevant to primary care physicians and specialists alike. Additionally, given the growing complexity of caring for Medicare beneficiaries, payment models should encourage collaborations between specialists and primary care physicians rather than focus on a model that is suited for one clinical specialty alone.

Short-Term Steps in Advancing Payment Reforms

To facilitate providers’ transition to alternatives to fee-for-service payments, CMS should harmonize current payment adjustments and quality improvement initiatives and apply those funds towards a care coordination payment which could give physicians more support for broader long-term reform pathways. Medicare has implemented quality reporting systems and payment adjustments for physicians, hospitals, and other providers. But these payments are generally administered as either a flat percentage or adjuster to all FFS payments. In contrast, shifting some existing FFS payments into a care coordination payment would give providers more support in moving toward condition-based, episodic payments, or global payments that allow for management of a population of payments that would otherwise be impossible in the current payment setting.

Table One highlights current efforts within the Medicare to increase value in care; each initiative is important but in isolation results in marginal financial gains and at times and each of these initiatives is limited in scope. For example, quality measures for the Physician Quality Reporting System (PQRS) have flexible annual submission options, with qualification through registries, electronic health records etc. However, the program has suffered from criticism that measures are not as relevant to specialists. And at best, providers will gain approximately an average of $1059 for participation per year, which some might say is not worth the effort, even in a penalty phase of the program. With the passage of the American Taxpayer Relief Act of 2013, a mechanism will be in place by 2014 for specialty specific efforts to satisfy CMS’ reporting requirements for PQRS, which will encourage higher specialist participation in quality improvement efforts and help align clinician-developed quality measures with CMS’ mandate to examine quality of patient care. Applying these measures to help physicians understand how registries can not only benefit their patients but lead to better predictability in a changing payment landscape will facilitate entry into pathways of reform.

Meaningful use measures are also quite detailed with important process metrics but physicians will likely also “perform to the measure” and may have difficulty going beyond unless there are linkages to payment reform. This is reflective of the sentiment that many providers express that they are constantly being asked to measure and perform, all while trying to see just as many patients in a day of work with little to no reward for doing less or changing workflows in order to reduce inappropriate utilization of resources. For example, proposed Stage 2 meaningful use measures include 17 core measures and six additional menu objectives from which a physician would choose at least three. This adds up to a total of 20 distinct actions that often involve all office staff. Rather than adding to these measures, CMS should consider how existing measure components could be applied to a payment update overall or a care coordination payment for the care of a patient with a chronic disease.

In the case of a care coordination payment, providers who opt to enter into a care coordination pathway in the first year can receive a lump sum of payment. This payment would be roughly equivalent to the potential bonus payments for all programs in table one. In return they would have to demonstrate that they are improving clinical practice and implementing outcomes-based clinical measures which are germane to their practice. In this example, a cardiologist would receive a population level care coordination payment derived from bonus payments and some FFS payments who does the following:

Participates in a care coordination pathway for chronic cardiac disease (atrial fibrillation, congestive heart failure, etc)
Subscribes to a cardiac specific registry (thus meeting PQRS requirements)
Implements patient engagement tools for electronic care coordination, medication reminders, therapeutic lab monitoring for anticoagulation (meeting requirements for meaningful use, value-based modifier program, e-prescribing)
Implements a significant practice transformation (potentially a new component which allows for a physician in a small, medium or large practice to individualize their approach to innovation)

The cardiologist would satisfy program requirements and would receive the maximum bonus payments.

Implementing this kind of approach involves potentially supporting CMS and additional entities to provide data on performance measures and quality improvement at more regular intervals along with technical assistance to understand how to translate incoming data into practice transformation. This process can begin in the year following a SGR repeal and can be supported through the assistance of existing clinical societies and quality improvement organizations. In this manner, assumption of clinical and performance risk becomes more commonplace for physicians. Simply put, physicians understand that they need to be held accountable for payment in a standard fashion, but want to feel that they can bring some degree of personalization into their practice in order to meet the needs of their populations.

Finally, I encourage CMS to continue implementing important changes through the Physician Fee Schedule including recent changes for care coordination.[11] These changes are an important acknowledgment that while we migrate from a payment system dominated by fee-for-service, we need to also enhance the existing system to be aligned with the expected outcomes of policy changes. Recent calls for evaluating the distribution of evaluation and management codes and determining the accuracy and appropriate valuation are also an important step in the short term.

Movement from The Short Term to Longer Term Sustainable Payment Reforms

As clinicians of all specialty types realize that there is a viable pathway to care for patients and work across silos. The appetite for a more attractive option is evidenced by the overwhelming response to applications for the CMMI Challenge Grants, BPCI initiative, Medicare Shared Savings Program and other efforts. Clearly, physicians want an alternative.

Through my work at the Brookings Institution’s Engelberg Center for Health Care Reform and the Richard Merkin Initiative on Clinical Leadership, we have been meeting with physicians in primary care and specialties as well as other healthcare stakeholders. With iterative feedback from clinicians in practice, we have proposed a longer term payment model that takes into account the currently uncompensated critical elements of patient care, the need for more flexibility in the way physicians are able to use their time and treatment resources in the best interest of their patients’ individual circumstances, and the need to implement care reforms in a way that recognizes the intense and growing cost pressures in our health care system.

Our model, outlined in Figure 2, would build on the short term payment advances above with incorporation of a payment for care coordination that is derived from the programs in Table One and identify additional opportunities to improve care and lower costs that are not reimbursed well in traditional fee-for-service payment systems. For example, a common procedure in the outpatient cardiac practice is the echocardiogram (echo), or ultrasound of the heart. This procedure is sometimes performed in place of preventive counseling or watchful monitoring of a patient in coordination with a primary care physician, in large part because a hospital-based outpatient cardiology practice receives up to $450 for an echo compared to $53 for a visit without the procedure. Imagine paying both the cardiologist and primary care physician a fixed payment of $400 that allows for longer term communication and conservative monitoring in return for reporting on clinical outcomes at a population level. The clinicians are take the financial risk involved in the clinical care of their patient using the investments previously made by clinically driven pathways, registries and care coordination solutions.

Column A represents total spending on health care and reflects the current state of physician payment: exclusive reliance on the FFS model for physician payments, with waste and inefficiency in the form of redundant and unnecessary care, breakdowns in coordination, escalation of preventable complications etc. This leaves the total cost of physician care high.

Column B illustrates total spending in our alternative payment model. First, a set of services currently reimbursed for a particular episode of care or part of chronic care management are bundled together into a single payment to physicians as a case management payment. For example in clinical oncology a case management payment would include after hours phone care for breast cancer or a palliative care counselor for patients with lung cancer. This enables clinicians to focus less on volume and more on tighter coordination among providers and settings for patients. In addition, we continue the aforementioned care coordination payment paid to physicians, which is built on concepts such as PQRS/ MU and actually increases the current level of physician payment relative to the fee-for-service baseline in Column A. Care coordination payments allow flexibility for physicians to invest in clinical practices and infrastructure through practice transformations that maximizes their ability to treat patients in clinically appropriate ways while not reducing their income due to reductions in billable procedures that would otherwise occur. The investments in clinical practice can include infrastructure/HIT investments or in the case of a small practice, an investment in a shared clinical social worker with other small practices with similar patient populations.

Continuous quality improvement resulting from adherence to clinician-driven process and outcomes measures and the increased flexibility in income will push physicians to decrease and ultimately eliminate the waste and inefficiencies that plague the current system. Overall physician payments increases, offset by reductions in total Medicare spending and system wide savings. Care coordination payments that enhance total physician income tied to quality measures would encourage physicians to collaborate and focus on elements of patient care that reduce cost and inefficiencies across the spectrum. In oncology, for example, we do not specify which metrics should be used in which case but comment that target metrics would change over time and as efficiency is maximized in certain areas of care (i.e. ED visit rates) bonus payments would not cease because of lack of room for improvement. Measures would have to be selected with flexibility to accommodate various provider circumstances and changes in the long term improved performance in certain areas.

Physicians who enter into broader accountable care arrangements in which there is a shared savings component will likely find that this model could lead to an increased proportion of shared savings beyond the 2% threshold; therefore our described model would not be mutually exclusive to ACO arrangements, but could enhance them given the decreased reliance on fee-for-service reimbursement.

Tools that Enable Financial, Clinical and Performance Risk

As I have mentioned earlier, physicians will need tools to better understand risk- these are not lessons we had in medical school or in clinical training. Financial metrics (such as those available to ACOs), performance metrics in the form of actionable and regular data feeds as well as peer-led initiatives should be considered essential components of a payment reform package.

Conclusion

Our nation is in a sustained period of constrained finances and while the cost to repeal the SGR has been decreased to $138 billion, finding the offsets and mechanism to pay for such a solution will not be easy. But it is essential that this Committee seize the opportunity to finally dispel the notion that we allow for a system that rewards the balkanization of our patients through a payment mechanism which promotes volume over value. I commend Senators Baucus and Hatch in their recent call for proposals and specific suggestions from the clinical community and look forward to working with the Committee to identify a tangible path forward. Thank you for this opportunity and I look forward to your questions and comments.

[1] Report to the Congress: Medicare Payment Policy. Medicare Payment Advisory Commission. http://www.medpac.gov/documents/Mar12_EntireReport.pdf

[2] Frist W, Schroeder S, et al. Report of The National Commission on Physician Payment Reform. The National Commission on Physician Payment Reform. http://physicianpaymentcommission.org/wp-content/uploads/2013/03/physician_payment_report.pdf

[3] The RBRVS has three components. Physician work accounts for the time, skill, physical effort, mental judgment and stress involved in providing a service and is approximately 48 percent of the relative value unit. Practice expense refers to the direct costs incurred by the physician and includes the cost of maintaining an office, staff and supplies and accounts for 48 percent. Professional liability insurance takes into account the malpractice insurance essential for maintaining a practice and is 4 percent of the calculation. Overview of the RBRVS. American Medical Association. http://www.ama-assn.org/ama/pub/physician-resources/solutions-managing-your-practice/coding-billing-insurance/medicare/the-resource-based-relative-value-scale/overview-of-rbrvs.page

^{^[4]}The Centers for Medicare and Medicaid Services (CMS) uses Current Procedural Terminology (CPT) codes to determine services that it will reimburse for Medicare enrollees and each CPT code has an assigned relative value unit.

[5] Policy Options to Sustain Medicare for the Future. January 2013. Kaiser Family Foundation. http://kaiserfamilyfoundation.files.wordpress.com/2013/02/8402.pdf

[6] Statement of Jonathan Blum on Delivery System Reform: Progress Report from CMS Before the Senate Finance Committee. 28 February 2013. Full transcript available at: http://www.finance.senate.gov/imo/media/doc/CMS%20Delivery%20System%20Reform%20Testimony%202.28.13%20(J.%20Blum).pdf

[7] Doherty J, Tanamor M, Feigert J, et al: Oncologists’ Experience in Reporting Cancer Staging and Guideline Adherence: Lessons from the 2006 Medicare Oncology Demonstration. J Oncol Pract. 6(2): 56–59. 2010.

[8] Antos J, Baicker K, McClellan M, et al. Bending the Curve: Person-Centered Health Care Reform. April 2013. Full report here: http://www.brookings.edu/research/reports/2013/04/person-centered-health-care-reform

[9] Bowles E, Simpson A, et al. A Bipartisan Path Forward to Securing America’s Future. Moment of Truth Project. April 2013. Full report available here: http://www.momentoftruthproject.org/sites/default/files/Full%20Plan%20of%20Securing%20America's%20Future.pdf

[10] Daschle T, Domenici P, Frist W, Rivlin A, et al. A Bipartisan Rx for Patient-Centered Care and System-Wide Cost Containment. Bipartisan Policy Center. April 2013. Full report available here: http://bipartisanpolicy.org/sites/default/files/BPC%20Cost%20Containment%20Report.PDF

[11] Bindman A, Blum J, Kronick R. Medicare's Transitional Care Payment — A Step toward the Medical Home.N Engl J Med 2013; 368:692-694

Authors

Kavita Patel

Publication: U.S. Senate Committee on Finance

Why We Still Think College Isn't for Everyone

Isabel V. Sawhill and Stephanie Owen — Mon, 13 May 2013 15:41:00 -0400

Is a college degree worth it? Not for everyone, according to our newly-released Center on Children and Families policy brief. The value of a college degree can vary dramatically, depending on factors such as field of study, type of college, graduation rate and future occupation. Here’s our final follow-up blog post, where we take a closer look at the conclusions we come to in the brief. (Read the first, second, and third parts here.)

Last week, the Center on Children and Families released a policy brief on making smarter decisions about higher education. We have welcomed the ensuing spirited debate from policymakers, students, colleges, and fellow researchers. The title of our policy brief, “Should Everyone Go To College,” is intentionally provocative and was chosen to start a conversation around the question. In favor of simplicity, we used the blanket term “college” to argue that a traditional four-year bachelor’s degree is not for everyone. We do think that some sort of postsecondary training is a good idea for almost everyone. This includes associate’s degrees, technical and vocational certification, apprenticeships, and worker training programs.

Some suggest that encouraging marginal students to pursue some of these non-academic paths creates a tracked system that keeps low-income and minority kids out of the upper echelons of our society. For that reason, vocational education has largely fallen out of favor in the United States, but gaps in academic performance between rich and poor and blacks and whites have persisted or, in the case of income, even grown. Closing these gaps has been one goal of the research done by the Center on Children and Families at Brookings, and we agree strongly that more needs to be done to prepare students to be college ready at the end of secondary school. But for the students we focus on in our brief—teenagers and young adults planning their educational and career paths—it is often too late to make up this lost ground.

The goal should be to help them make the choices that will turn out best for them given their individual strengths at the end of high school. For a student who has performed poorly in the classroom, the most bang-for-the-buck may come from a vocationally-oriented associate’s degree or career-specific technical training or from a period of work before returning to school with stronger motivation to learn what academic institutions teach. Think of the alternative: this student’s poor grades and possible ambivalence about classroom learning means he is likely to never finish his degree, and will have wasted time and money that could have been spent learning an employable skill. On the other hand, there are plenty of low-income students who are smart enough to succeed in college but who tend to choose schools that are beneath their ability and are more likely to drop out. The correlations of family background with college entry, persistence, and graduation have been rising, meaning it is especially important to help low-income students with the requisite abilities and preparation to enroll in a high-quality institution. Those individuals could benefit from better information about financial aid, graduation rates, and expected earnings.

Unfortunately, that information is not currently available: no one single comprehensive dataset containing information on earnings by school (let alone by major or program) exists. The Student Right to Know Before You Go Act, which we mention in our brief, has bipartisan support and would be an improvement on the status quo. The PayScale dataset we used for our brief has significant limitations, including questions about the reliability of its calculations and its representativeness.

Finally, some have rightly pointed out that our findings are descriptive, and should not necessarily be interpreted causally. It is likely true that smarter students self-select into engineering majors, so not every student will do better if she studies engineering rather than English. The same logic applies to more selective schools: part of why students at elite schools do better later on is that they are more talented before they ever enter college. Even so, careful economic research suggests that students do best when they attend the best school they can get in to, and that certain majors have real benefits.

Ultimately, higher education decisions are made by individual students and their families, and are based on their unique interests, strengths, and personal values, not only income and career prospects. Students need to have realistic expectations about what they’re likely to get out of pursuing higher education. Rigorous economic research has found that there is a sizeable proportion of people who experience a negative return to their education. That doesn’t mean they may not excel at other pursuits. It just means that one size doesn’t fit all high school students.

Authors

Isabel V. Sawhill
Stephanie Owen

Image Source: © Jessica Rinaldi / Reuters

The Affordable Care Act and Designing the District of Columbia's Health Benefits Exchange

Alice M. Rivlin — Mon, 13 May 2013 13:59:00 -0400

Before the Health Committee of the District of Columbia Council, Alice Rivlin encourages the Committee to implement the health benefits exchanges of the Affordable Care Act in order to provide universal affordable health care coverage. Explaining that the District has passed tests regarding Medicare and Medicaid, Rivlin describes the District's current health delivery system, explaining the landscape of health care carriers for groups and individuals and recommending that the health exchange become the sole venue for the purchase of individual and small business health insurance.

I am happy to testify on the bill before this Committee, “Better Prices, Better Quality, Better Choices for Health Coverage Amendment Act of 2013,” transmitted by Mayor Vincent C. Gray on behalf of the DC Health Benefit Exchange Authority. I strongly support the bill.

The federal Affordable Care Act (ACA), passed in 2010, is a major step toward an American health care system that covers almost everyone at sustainable cost. Implementation of the ACA is a long-sought opportunity to solve a disgraceful national problem—the fact that a large and growing share of the population cannot afford health insurance—as well as a chance to improve the quality and value of care delivered. As you know, the legislation was controversial at the national level, but the District welcomed it as an opportunity to realize our community’s goal of affordable health care coverage for all.

The District chose to comply with the ACA by creating its own health benefits exchange rather than letting the federal government do it. The District assembled a highly qualified Health Benefit Exchange Board, which recruited a strong professional staff and has implemented the ACA with energy and dispatch. Recently, the District’s exchange passed Phase Two testing with the Centers for Medicare and Medicaid Services. This indicates that the District is expected to be ready to enroll customers on October 1, 2013, and begin coverage on January 1, 2014. We should all be proud of the District for becoming a leader and role model in implementing the ACA, while some States have delayed and are behind schedule.

The exchange will require carriers to compete with one another by displaying qualified plans in transparent form in an electronic market place and allowing consumers to select the best plan for them. Some will receive federal income-tested subsidies to make plans more affordable. This is a win-win: DC residents will receive better health insurance at a lower cost and carriers will sell more insurance policies.

Designing the best exchange for the District has been challenging because DC’s health insurance market is small and highly concentrated. There are only four carriers one of which one controls more than three quarters of the individual and small group markets. The individual market is especially small—in part because of DC’s past success in reducing the number of uninsured residents through generous Medicaid eligibility and the creation of the Alliance. The individual market is estimated to fall below the 100,000 participants that the Urban Institute and others estimate to be the minimum size of the risk pool needed for an exchange to operate efficiently. In view of the small size and high concentration of the market, the DC Health Benefit Authority recommended, and the Council supported, merging the individual and small group markets after a transition period. Merging the markets recognizes that separate exchanges for the individual and small group markets would have too few carriers and too few enrollees to achieve the stability and efficiency that can be achieved in a merged market.

Now the Council is considering whether to make the exchange the sole venue for the purchase of individual and small business health insurance in the District. We believe that this measure will maximize competition, transparency, and the insurance choices available to consumers. Conversely, retaining a separate market outside the exchange will reduce the risk pool below critical size and invite carriers to attempt to attract younger, healthier individuals and employer groups outside the exchange, leaving higher risks in the exchange. In a small market with a dominant insurer, it is essential that the exchange risk pool be as inclusive as possible, both to stabilize the exchange—which is the only source of federal subsidies for District residents with modest incomes—and to maximize transparency and competition.

These design decisions are difficult, but, on balance, it seems wise to require that all DC individual and small business plans be purchased on the exchange with a single risk pool, to allow carriers to offer as many different plans as they want on the exchange, and to work hard to make the exchange as transparent and user friendly as possible. Moreover, the Board’s transition plan carefully balances the goal of full and speedy implementation with the needs of individuals and small business. The transition plan will allow small businesses to enter the health exchange over a two-year transition period, permitting small businesses to wait until the market settles should they feel the need.

Over the past couple of decades DC has gone from a city with a shamefully inadequate health system to a leader in provision of affordable health coverage and improving access to good quality care. We can all take pride in the steps DC has made to take advantage of the opportunity offered by the ACA to move to universal affordable coverage by acting quickly to implement it competently and expeditiously.

Thank you for the opportunity to speak today.

Authors

Alice M. Rivlin

Publication: The Health Committee of the DC Council

Image Source: © Joshua Roberts / Reuters

Helping Young People Make Better Higher Education Choices

Isabel V. Sawhill and Stephanie Owen — Fri, 10 May 2013 09:00:00 -0400

Is a college degree worth it? Not for everyone, according to our newly-released Center on Children and Families policy brief. The value of a college degree can vary dramatically, depending on factors such as field of study, type of college, graduation rate and future occupation. Here’s the last in a three-part blog post series, where we take a closer look at findings from the policy brief. (Read the first part and second part here.)

Even though we often talk about college as a monolith, the truth is that not all college degrees are created equal. There is huge variation in the return to a bachelor’s degree, depending on choice of major and occupation; school type and selectivity level; and likelihood of graduating. All of this suggests that it is a mistake to unilaterally tell young Americans that going to college—any college—is the best decision they can make. If they choose wisely and attend a school with high graduation rates, generous financial aid, and high expected earnings, they can greatly improve their lifetime prospects. The information needed to make a wise decision, however, can be difficult to find and hard to interpret.

We lay out a three-pronged approach that would help every young person make a smart investment in their future: better information, performance-based scholarships, and better alternatives to a traditional four-year degree.

Authors

Isabel V. Sawhill
Stephanie Owen

Image Source: Mike Segar / Reuters

For Some, College May Not Be a Smart Investment

Isabel V. Sawhill and Stephanie Owen — Thu, 09 May 2013 09:00:00 -0400

Is a college degree worth it? Not for everyone, according to our newly-released Center on Children and Families policy brief. The value of a college degree can vary dramatically, depending on factors such as field of study, type of college, graduation rate and future occupation. Here’s the second in a three-part blog post series, where we take a closer look at findings from the policy brief. (Read the first part here.)

For a young adult shopping for a college, the choices can be overwhelming. That shiny brochure can make College X look like a great place to spend four years. But what do you really get out of choosing one school over another? As it turns out, quite a bit. The return on investment (ROI) of a bachelor’s degree varies widely at different types of schools. For certain schools, according to the online salary information company PayScale, the ROI is actually negative.

But getting into college and choosing a school is only the beginning. College isn’t worth much unless you graduate. Part of what sets certain schools apart is how many of their incoming students actually come out with a degree.

Notice that there is a wide range of completion rates within each school selectivity category, particularly for the less selective colleges. Not every student can get into Harvard, where the likelihood of graduating is 97 percent, but students can choose to attend a school with a better track record within their ability level.

Authors

Isabel V. Sawhill
Stephanie Owen

Image Source: © Rebecca Cook / Reuters

Regulating Systemically Important Financial Institutions That Are Not Banks

Douglas J. Elliott — Thu, 09 May 2013 09:00:00 -0400

Certain financial institutions are so central to the American financial system that their failure could cause traumatic damage, both to financial markets and the larger economy. These institutions are often referred to as “systemically important financial institutions” or SIFIs. The Dodd-Frank Act, the comprehensive reform legislation signed into law during the summer of 2010, requires financial regulators belonging to the Financial Stability Oversight Council (FSOC)[1] to name those financial institutions that it believes are systemically important.[2] Such SIFIs are to be supervised more closely and potentially required to operate with greater safety margins, such as higher levels of capital, and to face further limitations on their activities.

Throughout Dodd-Frank the focus is principally on banks, particularly commercial banks, and the act effectively designates all commercial banking groups with $50 billion or more in assets as SIFIs. However, it requires regulators to consider whether other financial institutions are systemically important, leaving the decision about which non-bank financial institutions should receive that designation up to the FSOC, with advice from the Federal Reserve Board (Fed). The FSOC is in the process of determining what non-bank institutions it will designate as SIFIs, but it seems clear that several large life insurance groups and at least one large finance company (GE Capital) will be named. Eight “financial market utilities” have already been designated. (These are firms such as clearing houses that do the back office transactions that make many financial markets function.) Other financial institutions may be added as well, such as hedge funds or money market funds.

Dodd-Frank also authorizes the FSOC to designate certain types of activities as systemic regardless of what institution is conducting them, giving the regulators greater powers to control those activities. There is some potential for this to be invoked in regard to money market funds and that possibility has given the FSOC greater leverage in pushing for changes to the rules governing money market funds even if the systemic activities designation is never used. This paper will generally not discuss the activities clause, but will focus instead on the regulation of entire institutions designated as SIFIs.

Once a non-bank financial institution has been designated as a SIFI, very real questions arise as to how best to regulate these institutions. The Fed becomes the regulator for SIFI purposes, alongside the existing primary regulator. However, the Fed has little previous experience of overseeing some of these types of institutions, particularly insurers. Therefore, it needs to figure out how to evaluate their safety and how to coordinate with existing supervisors. Doubtless, the Fed will end up falling somewhere on a spectrum between simple reliance on existing regulatory paradigms and procedures and developing an entirely separate approach that may rely excessively on its prior experience as a banking supervisor.

The Fed should not simply defer to existing regulators and view non-bank SIFIs as safe if they say so. It has a legal obligation to form its own conclusions. Further, viewing the institutions systemically may provide a different perspective, perhaps pointing to systemic risks that would not be given adequate attention by traditional industry regulators who are not responsible for the safety of the financial system across the country or concerned about linkages to the rest of the world. This could be particularly true in insurance, which is regulated at the state level and therefore has not historically had any body whose primary responsibility was to look at national systemic risks. The National Association of Insurance Commissioners (NAIC) acts as a coordinator for the state insurance commissioners and works to ensure high standards across the country. However, these standards are aimed at ensuring the safety of individual institutions with little emphasis on the linkages between these institutions that could lead to systemic problems.

On the other hand, there is a real risk that the Fed will give insufficient deference to the extensive experience and knowledge residing with the existing regulators, particularly in regard to insurance, which has so many differences from banking. Decision-makers at the Fed would be only human if they relied excessively on the tools with which they were already familiar and if they were more comfortable starting from scratch in designing regulation and supervisory tools, instead of relying on the experience of others.

There are multiple dangers in taking an idiosyncratic Fed perspective that pays too little attention to existing regulatory approaches:

The Fed may simply get a decision wrong, out of an insufficient level of understanding of the new industry. It is one thing to study an industry intensively, it is another to have lived with it for many years, as the primary regulators have.

The Fed could be “right” from the point of view of reducing systemic risk, but the economic cost of eliminating or reducing a particular source of risk may far exceed the benefit. Dodd-Frank did not call for the elimination of systemic risk, but rather appropriate control over it. As with so many areas of life, absolute elimination of risk would require forbidding a great deal of beneficial activity. The bureaucratic peril here is that the Fed’s mandate from Dodd-Frank may bias the organization towards elimination or sharp reduction of systemic risk, with insufficient regard to the economic costs that would show up in day-to-day operations.

New Fed regulations could effectively force “relitigation” of a myriad of issues that have already been decided by the primary regulators. Sometimes there are multiple legitimate ways to approach an issue and it may be better to stay with the existing decision than to go through the industry upheaval of adopting to a new approach that simply has a different set of pros and cons, but may not be substantially better.

Lack of sufficient coordination with existing regulators could result in contradictory requirements that hamper operations. The Fed and the primary regulators will presumably manage to avoid outright contradictions, although there is definitely the possibility of temporary stand-offs as the two sides feel their way to a working arrangement. Beyond that, though, there is the risk that the approach of the Fed and of the primary regulators will be incompatible in practice, even if this is not obvious on the surface of the written regulations. One side or the other may believe it is possible to meet their requirements without infringing the rules issued by the other, but it may not in fact be feasible.

Pointing out these dangers of inappropriate regulation is not intended to argue against the designation of non-bank SIFIs, which I do favor and which is clearly the intent of Dodd-Frank. There are legitimately differing views on whether insurers, for example, are ever systemically significant, but I am among those who believe that a few very large life insurance groups likely do merit this designation. The key message of this paper, however, is that non-banks are not just funny looking banks, but operate in truly different industries, providing different services, and facing a different balance of risks and opportunities than do banks. Therefore it is very important that Fed regulation of non-bank SIFIs is tailored to each distinct industry and is managed with appropriate humility about the Fed’s level of understanding and with appropriate deference to primary regulators, while meeting the Fed’s obligations to develop their own independent judgments. This is a difficult balancing act, but not fundamentally different than the balancing acts that all regulators face between the risks of action and inaction. The bulk of this paper delves deeper into these issues in the context of life insurers.

The Fed is most definitely aware of the dangers and is intent on avoiding them. However, it is virtually certain that mistakes will be made in an area of this complexity where there are at least two sets of perspectives and experiences coming together, especially given the novel nature of the task of regulating systemic risk. One concerning point is that there is not a clear agreement yet on what systemic risk is and how it ought to be measured, adding still more uncertainty about how best to regulate it.

Systemic Risk

There is some disagreement about the best definition of systemic risk. A report by the International Monetary Fund and two global financial regulatory bodies defined systemic risk as:

“a risk of disruption to financial services that is (i) caused by an impairment of all or parts of the financial system and (ii) has the potential to have serious negative consequences for the real economy. Fundamental to the definition is the notion of negative externalities from a disruption or failure of a financial institution, market or instrument. All types of financial intermediaries, markets and infrastructure can potentially be systemically important to some degree.

Three key criteria that are helpful in identifying the systemic importance of markets and institutions are: size (the volume of financial services provided by the individual component of the financial system), substitutability (the extent to which other components of the system can provide the same services in the event of a failure) and interconnectedness (linkages with other components of the system).”[3]

Dodd-Frank defines systemic risk in terms of a situation in which “material financial distress at the [financial institution], or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the [financial institution], could pose a threat to the financial stability of the United States.”[4]

There is substantially more disagreement about how to measure the level of systemic risk in the aggregate. Breaking this down to the contribution from individual institutions is yet trickier still. As a further important complication, systemic risk arguably varies over time. An entity could be systemically significant under some circumstances and not others.

The FSOC’s evaluation process to decide which institutions to designate as SIFIs relies heavily on subjective judgments of the relative importance and inter-relationships of the relevant qualitative and quantitative factors. This is not a criticism. Objective, quantitative criteria will require both a detailed analytical model of how the financial system works that is well beyond the current state of research and considerably more and better quality data than currently exists. Many academics and official researchers are working to create those prerequisites, but it will be years before they can hope to succeed, if they ever fully do.

There are multiple ways in which a financial institution can be systemically important – by its size, the degree to which to which it is “interconnected” with other parties, or conceivably by its reputation and thus influence on financial markets. The central concern is that a SIFI’s failure would cause serious damage to the financial system, and thereby to the rest of the economy. The sources of that damage could be any one or more of the following, and perhaps others as well:

Counterparty and other credit risks. One of the most obvious concerns is that when a SIFI goes under it may impose substantial, if not crippling, losses on other financial institutions and parties who are owed money by the institution. This could cascade throughout the financial system with knock-on damage to the wider economy.

Contagion. Sometimes the principal damage from the collapse of a financial institution comes from serving as a “bad example” that causes the market to reassess which other organizations might wind up in the same difficulties.

Problems with deposit-taking activities. One of the key reasons that banks are regulated so highly in the first place is that consumers and businesses place deposits with them which they count upon to be readily available and riskless. There can be severe economic disruptions if depositors find their funds suddenly unavailable.

Maturity mismatches. Financial institutions often operate by “borrowing short and lending long”, since the interest rates on short-term borrowings are typically below the interest rates earned on longer-term loans and other assets. This strategy usually is exposed to the risk of a sudden liquidity freeze that makes it highly expensive or impossible to “roll over” short-term liabilities. Excessive maturity mismatches become a systemic problem if they are too widespread or concentrated at one or more SIFIs.

Market utility interruptions. Some institutions play a central role in the day-to-day functioning of financial markets, resulting in the potential for widespread damage if they fail.

Types of non-bank SIFIs

There are several major categories of non-banks that could be systemically important; the considerations that could lead to their designation are discussed briefly below. (A fuller review of the issues is available in the paper I wrote with Robert Litan, referenced in footnote 1, which focuses more on the issues surrounding designation of SIFIs.) The discussion excludes banks of all types and their close affiliates, which are effectively already designated as SIFI’s under Dodd-Frank.

Finance companies. Until the recent crisis, there were a number of major lenders to consumers and small businesses that financed themselves by issuing short to intermediate term debt in the wholesale financial markets, in contrast to commercial banks that raise their funds primarily with insured deposits. When financial markets froze, this finance company business model proved to be too risky, except in special circumstances, since it exposed the firms to the danger that they would be unable to “roll over” their debts. Borrowing short-term and lending long-term only works if the ability to borrow short-term is not interrupted for any extended period. The recent crisis showed once again that such liquidity freezes occur too frequently to be assumed away.

Smaller finance companies may not pose a systemic risk if they fail, since in a crisis the markets may still be willing to fund their larger competitors. However, when large finance companies are threatened with failure, they may indeed pose systemic risks. Because of the risks of the finance company business model that were revealed in the recent crisis, a number of the solvent finance companies that have survived have converted to bank status in order to have access to insured deposits even in difficult economic conditions.

Securities firms. Investment banks and brokerages can clearly create risks to the financial system, as demonstrated by Bear Stearns, Lehman, Merrill Lynch, and others in the recent financial crisis. However, the most important of these firms are affiliated with commercial banks and are therefore already considered SIFIs for that reason. It appears unlikely that any of the stand-alone securities firms based in the US will be designated as SIFIs, but one or more could expand over time to the point where they might be designated in the future. It is also possible that a large US subsidiary of a foreign securities firm could be designated as a SIFI.

Life insurers. Some life insurance entities are so large that their sheer size makes them obvious candidates for designation since other financial institutions will have major credit exposures to them. On the other hand, the types of activities they undertake tend not to be as risky for the system, especially since they are generally funded by quite long-term liabilities, such as life insurance policies and annuities that have substantial fees for early surrender. In general, the systemic risk created by a life insurer is likely to be considerably less per dollar of asset size than would be true for a bank, taking into account probabilities rather than just worst cases. However, each case must be examined on its own merits and regulators must watch out for the development of activities at one or more life insurance groups that might spawn greater systemic risk in the future. Life reinsurers, which provide wholesale insurance protection to life insurers, have greater risk per dollar of assets because they are interconnected with many other insurers and reinsurers. However, none of the US-based life reinsurers are of sufficient scale to be likely to be designated as SIFIs.

Property/casualty insurers. Insurers providing protection against accidents and lawsuits are important financial institutions and sometimes very large. However, the nature of traditional property/casualty insurance creates little risk for the financial system as a whole. The investments of these firms tend to be very conservative and liquid, since they could be needed quickly in the event of a natural catastrophe. As a result, the big risks to these insurers are on the claims side, which has little correlation with financial crises. (Financial crises do not spawn natural disasters and even extremely large hurricanes and earthquakes are too small to trigger a financial crisis.) There is no indication that any property/casualty insurers will be designated as a SIFI, with the exception of AIG. That firm will be designated for political and historical reasons more than anything else, although the stated rationale will doubtless refer to its life insurance business and activities outside of traditional insurance.

Hedge funds. These funds cover a very wide range of activities, most of which would not warrant SIFI designation. If any do, it would almost certainly be because they operated with quite significant amounts of financial leverage and were of considerable size (as was LTCM in the late 1990s before the Fed helped arrange a private sector reorganization). The combination of size and leverage could generate sufficiently large credit exposures for other SIFIs to merit inclusion of these funds or they might exacerbate other potential sources of risk, including contagion.

Other fund models. Two other important fund business models are venture capital (VC) and private equity (PE) funds. Neither would appear to create any significant systemic risk when they are run in a traditional manner. However, the legal structure could be used to operate more like a highly leveraged hedge fund, in which case there is at least the theoretical possibility of being a SIFI. In practice, it is unlikely that the FSOC will designate any of these funds as SIFIs for some years, if ever.

Mutual funds. These fund groups are an interesting case, since some of them are of very large size, yet they are essentially pass-through entities and seldom use very much in the way of leverage. The small amount of leverage employed means correspondingly less credit exposure to lenders. There may be significant credit exposures for trading counterparties, but the lack of leverage makes it hard for the funds to go broke and therefore fail to be able to meet their obligations. Given their importance in the financial system as a whole, regulators may wish to know what these funds are up to and thus possibly demand additional information beyond what they are required to submit now, but because of their pass-through nature they are likely to be small contributors to systemic risk. Here, too, it is unlikely that the FSOC will designate any mutual funds or their management companies as SIFIs anytime soon.

Money-market mutual funds. Consumers often use money market funds almost as if they were bank accounts, including writing checks against them in order to make day-to-day transactions or to easily withdraw cash from them. These funds are also large purchasers of commercial paper (CP) issued by both financial and non-financial corporations. In the midst of the recent financial crisis when the main alternative to CP financing -- bank loans -- was often unavailable, the continued viability of these funds was (and remains) especially important.

It was for both these reasons that the federal government felt compelled to guarantee money market funds in the recent crisis. The government feared that a potential major run on many, if not all, money market funds constituted a substantial risk to the financial system.

A number of changes have already been made to the regulation and operation of money market mutual funds in order to reduce their systemic risk, including a shortening of the maximum maturities of their investments and the creation of expanded disclosure. However, it remains an open issue as to whether one or more money market funds will be designated eventually as SIFIs.

Other institutional investors. There are numerous other categories of institutional investors whose members could theoretically be designated as SIFIs, but where this is unlikely to occur in practice. These include pension funds, endowments, and sovereign wealth funds, among others. In general, these share the characteristics of very low leverage, long-term funding, and the absence of a primary role as a financial intermediary. As a result, even the largest of these organizations is unlikely to represent sufficient system risk to be designated as a SIFI.

Financial market utilities. There are many entities that operate behind the scenes to implement financial transactions, such as stock and commodities exchanges, clearing houses for derivatives transactions, etc. Some of these, such as the largest clearing houses, will definitely present enough systemic risk to qualify as SIFIs, in part because of their combination of sheer size and their volume of counterparty credit risk, as well as their overall centrality to important markets. In fact, the FSOC has already designated eight financial market utilities as systemically important and may designate more.

Regulating SIFIs

Once SIFIs have been identified, it is almost certain that they will then be regulated differently from other financial institutions. An important underlying decision is whether the Fed’s regulation should focus solely on sources of systemic risk, holistically on the entirety of safety and soundness issues, or somewhere in between. Dodd-Frank does not clearly answer this question. On the one hand, federal regulation is imposed on non-bank SIFI’s precisely because of systemic risk issues, suggesting that such issues should be at the core of the Fed’s supervision. On the other hand, Dodd-Frank calls for heightened prudential standards for SIFI’s of all kinds, presumably on the theory that the failure of a SIFI, no matter what the cause, would have systemic repercussions.

Blending these two viewpoints, the Fed is almost certain to look at a wide range of prudential concerns, but perhaps with a sharper focus and tougher rules for those aspects that appear to increase systemic risks. For example, the Fed would be particularly inclined to be concerned about maturity mismatch and liquidity issues because they are significant safety and soundness issues in their own right while also bearing the potential to make the system as a whole riskier by triggering the equivalent of a “run on the bank”, with all the potential for contagion that would bring. On the other hand, operational issues that carry idiosyncratic risk may be given a lower priority and left largely to the primary regulators. For example, internal accounting weaknesses could help to sink a single entity, but might not have any larger systemic significance. Similarly, issues that are likely to arise at a time of wider financial crisis may garner more attention than items that are random or more likely to surface during good times, when any potential systemic problems would be easier to handle.

What can the Fed do as a supervisor? There are at least five ways additional regulation of SIFIs could occur:

Regulating at least certain non-bank SIFIs in a manner consistent with banks. One of the hardest questions in financial regulation is where to place the “perimeter of regulation.” In this case, the key question is which entities should face the heavy regulation that banks and their close affiliates do. (Banks also benefit from special privileges, such as access to deposit insurance and the Fed’s discount window, but regulation of other SIFIs may not bring such advantages in the current environment.) One of the concerns expressed in the Dodd-Frank debates was how to prevent some institutions from acting very similarly to banks, but retaining the advantage of lighter regulation. Dodd-Frank provides quite considerable powers that could be used to add many bank-like regulations (such as activity restrictions) for certain non-bank SIFIs.

If such a broad scope of regulation is applied, it is likely only to be for institutions regulators view as acting like banks. Finance companies could be caught in this net and it is theoretically possible that a large hedge fund that went after banking type business could also be brought in. This is unlikely to be an issue for most categories of non-bank SIFIs, such as insurance groups that do not already own deposit-taking institutions. That said, Dodd-Frank does provide that certain restrictions should apply to all SIFIs even though the specifics appear to have been designed primarily with banks in mind.

Information reporting. SIFIs will doubtless be mandated to provide a great deal of information, with particular emphasis on aggregate credit and counterparty exposures to other SIFIs and near-SIFIs. Other information requirements will likely include exposures to particular asset classes, capital levels, and the results of stress tests. It is also likely that many non-SIFIs will be subject to some additional reporting obligations as well, both to determine whether they qualify at some point as SIFIs themselves and also for the FSOC and its new agency in the Treasury, the Office of Financial Research, to better monitor overall system-wide financial risks.

Counterparty exposure limits. Dodd-Frank requires that banking groups limit their total exposure to individual counterparties. Non-bank SIFIs could be faced with similar requirements.

Activity limits. Banking groups are also limited by the “Volcker Rule” included within Dodd-Frank, which requires them to limit or eliminate certain types of proprietary trading and investment activity. Similarly, provisions pushed by Senator Lincoln created restrictions on the ability of banking entities to act as derivatives dealers. Non-bank SIFIs might be placed under similar restrictions on activities that are perceived as being particularly risky and not at the core their business models, or at least the business models policymakers view as being in the public interest.

Capital requirements. One of the most important ways that regulators can encourage safety at financial institutions is to require appropriate levels of capital as a margin for error against losses that might come through bad luck or errors. Banking groups already face substantial capital requirements that are being tightened significantly through the so-called Basel III process, coordinated by the Basel Committee on Banking Supervision. Insurers also have substantial capital requirements imposed by their regulators for similar reasons. Dodd-Frank specifically calls for SIFIs to face higher capital requirements than non-SIFIs, with the details to be determined by the regulators.

Capital requirements are such a universal, and important, element of the regulatory approach to banks that there is a strong likelihood that non-bank SIFIs will be subjected to similar requirements. This is most likely for SIFIs that perform a classic intermediation function and have large balance sheets, such as finance companies, which play a role fairly similar to banks. Some sort of capital regulation might also be extended to hedge funds, although these funds may be able to argue that their differences from banks justify an exemption from any capital regulation. Other asset managers, such as mutual funds or venture capital management companies, are the least likely to have this requirement, because their business models create little need for capital. As discussed below, capital requirements already exist for insurers and may be expanded or altered by the Fed in its role as a regulator of SIFIs.

Capital regulation is an extremely powerful tool to affect the behavior of financial institutions, since it very directly alters their ability to provide an adequate return to their shareholders. This is even more powerful since top managers in financial institutions almost invariably hold a considerable amount of their net worth in company stock. If this powerful tool is applied too widely, such as to funds managers that act as pass-through entities and not true intermediaries, it could substantially change the ability of otherwise valid business models to work. Ironically, adding an unreasonable burden to, say, mutual funds could push financial assets into the hands of financial intermediaries instead that present greater systemic risks.

Liquidity requirements. The recent financial crisis underlined the importance of liquidity, the ability to come up with cash, potentially on short notice, to cover deposit withdrawals, debt redemptions, and other needs. Banks will have quite extensive liquidity requirements going forward and the Fed will certainly consider appropriate liquidity requirements for other SIFIs.

Principles for regulating non-bank SIFIs

Some key principles should guide the Fed’s regulation of non-bank SIFIs.

Carefully balance the costs and benefits when designing regulation and supervision. This is important for all regulators and is so basic that it probably needs little further elaboration. However, it will be critical not to lose sight of this key principle. It will always be tempting for the Fed to add yet further constraints and safety margins on non-bank SIFIs, in its pursuit of systemic stability, particularly as the Fed will take the blame if a serious future crisis develops. However, safety margins come with costs and it would be harmful to the economy if those costs were excessive compared to what may be only a modest increase in stability from a given regulation. For example, equity capital is significantly more expensive, in practice if not always in theory, than other sources of funding. Requiring more capital therefore adds a cost that will have to be absorbed by some combination of customers, employees, stockholders, and others who deal with the firm[5]. Deciding what regulations to impose and choosing which firms they are imposed upon must be a balancing act between the improvements in safety and the economic costs of achieving the improvements.

Defer to primary regulators as appropriate while maintaining the ability to perform the Fed’s mission. The Fed will have to balance a second set of considerations, which is how to coordinate with primary regulators, such as the state insurance commissioners and the National Association of Insurance Commissioners, their coordinating body. The Fed should take advantage of the decades of experience and the specific expertise of the primary regulators. It should also avoid conflicts in regulations with those promulgated by the primary regulators, except where the Fed believes that an important principle is at stake. This should leave room for compromise on the many judgment calls that will exist on precisely how best to deal with a particular type of risk. At the same time, the Fed has a different mission from the primary regulators and cannot, and certainly will not, simply assume the primary regulators will take care of the job for them.

Do not impose excessively bank-like regulatory approaches. Many of the non-banks, particularly insurers, have quite different business models, and even purposes, from banks. It will be critical to take account of these when designing regulation and supervision. This is discussed in considerably more detail below in regard to the life insurance industry.

Avoid the dangers of a business “monoculture.” SIFIs are likely to be regulated in a common manner on many important dimensions. If this is carried too far, as it easily might be, institutions with quite different business models may be regulated in the same way[6]. For example, if capital regulations are applied to institutions for which capital levels are actually relatively immaterial, it may force them to hold considerably more capital and to make business decisions based on the effects on their actual capital relative to what is required. In essence, this kind of decision-making could force any non-bank SIFIs to act more like banks, even when their business models would not otherwise push them in that direction. This reduction in diversity could expose the system to greater risk from factors common to the regulatory approach. A useful analogy is the danger of a “monoculture” in crops. If the entire Midwest is planted with wheat, for example, then the dangers of contagion from a virus that attacks wheat become more severe than if multiple crops were grown. The same kind of risk may be created when otherwise different kinds of institutions are effectively forced to behave in a similar manner.

Support useful innovation. If SIFIs were to be regulated in an excessively uniform way, then it may become more difficult for organizations to develop innovative new approaches to business. In particular, if SIFI regulation and supervision entails any sort of ex ante or ex post approval of innovative products or ways of doing business, this prospect could be enough to keep the innovation from being introduced. At the same time, the greater regulatory costs of SIFI designation may also spur some organizations to use “financial engineering” to create new securities or transaction types that appear to pass risk on, without in fact fully doing so. Again, the SIV structures that were created during the boom period and contributed to the recent financial crisis are an example of this type of structure.

Try to minimize the inevitable uncertainty about future regulation and supervision. The cost of regulation does not come just from the actual regulatory choices of policymakers. The sweeping powers of the FSOC and Fed over SIFIs create considerable uncertainty for shareholders, creditors, and counterparties, which is likely to be priced into any transactions. Equity investors would demand higher expected returns to compensate for the greater risk and opacity of the business. Debt holders would similarly increase their demanded interest rates and some would switch to investing in other industries. Lenders and insurers may feel compelled to charge customers more to compensate for the greater uncertainty about the rules under which they will be operating. There is a limit to how much the Fed can do to alleviate these concerns as it is itself determining how best to operate in this new area, but transparency, clarity, and an appropriate level of deference to existing regulators should help.

Regulating Life Insurers as SIFIs

One of the trickier tasks for the Fed will be to determine how best to regulate groups that are centered around life insurers. Life insurers have a considerably different business model than the banking industry with which the Fed is familiar, yet they also have some important similarities as financial intermediaries. Some of the key points to consider are as follows:

The core task of an insurer is to take risk. The central economic role of an insurer is to pool risk. An isolated family can be devastated financially by the premature death of a breadwinner, but a thousand or a million families pooling their risks together can easily bear that random risk by spreading the cost of premature deaths over the entire group. Paying a thousand dollars a year for life insurance may be feasible for a family who could not have afforded to bear the full cost of a death on their own. For this reason, life insurers have often been founded as mutual aid organizations that eventually converted to a legal status as “mutual” insurers, owned by their policyholders. In many cases, these mutual eventually converted to stock form in order to gain the full benefits of market access. Pooling of risks has costs that raise the average expense level of dealing with the accidents and tragedies that befall us, but virtually all people and firms would rather pay a bit more on average to avoid the chance of financial catastrophe.

Banks also exist to take risks, particularly the risk that a loan will not be repaid, but their central historical economic role has been to channel funds from depositors to borrowers with worthy projects while providing liquidity to depositors and even borrowers. Risk is inherent in those roles, but it does not have the same centrality as risk-taking does for traditional insurance.

However, life insurers are also financial intermediaries, like banks. Much of what life insurers do is to provide attractive investments to their clients, generally with tax advantages. Even traditional whole life policies do this. A life policy that charges the same premium every year of one’s life effectively overcharges in the early years for the mortality risk, allowing a build-up of value that pays for undercharging in the later years. This build-up of value beyond what is needed for the mortality charges and other expenses accumulates as a cash value that can be withdrawn, or borrowed against at a fairly attractive interest rate. Economically, this is equivalent to buying a term life policy and investing the difference between this policy’s premiums and what a whole life policy would charge in order to build up cash value, which can be used to pay the rising premiums as one ages[7].

Beyond that, life insurers sell large amounts of annuity products that are generally used as tax-advantaged investment vehicles. The simplest form of an annuity is an immediate annuity, which pays out a fixed amount each year for as long as the annuitant lives. This provides valuable insurance against living too long and running out of money. Most annuities, though, are deferred annuities. For these one pays in advance, with the annuity payments starting some years in the future, such as at one’s expected retirement age. The initial investment builds up a cash value that can, and usually is, withdrawn prior to annuitization. Clients often buy these with the expectation of cashing them in, taking advantage of the tax deferral of income in the meantime. On these products, the insurer does take a risk that the contractually promised annuitization terms will prove too generous in the long run, but by far the larger portion of the insurer’s risk is from financial intermediation, the danger that it will not invest the funds in a manner that provides a high enough return to cover the increases in cash value plus its expenses.

Life insurers are usually also asset managers. Some life insurers manage client money without taking on investment risk, such as by running a family of mutual funds, just as banks manage trust accounts and often have their own mutual fund offerings. In addition, all of the life insurers that are likely to be SIFIs also do a large volume of business in “variable annuities” and “variable life insurance” products. In purest form, these are identical to traditional annuities and life insurance policies, except that the investment risk resides with the policyholder. (This is accomplished in part by keeping each policy in a “separate account” from a legal point of view.) Instead of building in a fixed rate of increase in cash values, there is a formula based on the performance of an agreed financial instrument or basket of investments. For example, a client who wants to own an insurance product, but desires the potentially higher returns of the stock market, would buy a variable product with a cash value that increases based on a stock market index or on the performance of what is effectively a dedicated mutual fund attached to the variable product.

In many ways, the safety and soundness risks of variable products are low, since investment risk vanishes for the insurer in the purest form of the product. The prudential risk is not zero, since the stream of future fees will generally depend on the underlying cash values and particularly bad performance of a variable fund could lead to lawsuits or certainly to redemption of the insurance products by withdrawing clients. However, the risk in the pure form is quite low.

The risk is somewhat increased by the practice of providing certain guarantees of the investment performance. For example, some deferred annuities carry a guarantee that if the owner dies before the start of the annuitization, their heirs will receive the original investment amount even if market performance has caused the cash value to be below that level. Other guarantees, potentially more costly, are sometimes provided.

The provision of guarantees complicates some regulatory decisions. In particular, there is the question as to whether to include the assets from variable products in simple ratios, such as the “leverage” ratio. This is a straightforward calculation in which the total capital of a financial firm (the value of its assets beyond those required to pay its obligations) is divided by the total amount of its assets. Although simple, this is a much-used and valuable indicator of the margin of error a financial firm has to cover any mistakes or accidents. Further, this ratio is enshrined in many regulatory requirements, often with mandatory effects. Given the high volumes of assets life insurers have in variable products, their inclusion can have a major impact on the ratios.

The obvious, and probably correct, answer is to count only a portion of separate account assets in these calculations, perhaps only a small fraction. However, adjusting asset values for the amount of risk they entail risks reducing the benefit of using a straight leverage ratio. Banking regulators already use a separate, and much more complex, set of measurements to determine a risk-weighted capital ratio. One of the main arguments for using a straight leverage ratio is to complement the risk-weighted one by providing a test that is much harder to “game” since there is minimal discretion in calculating the figures.

Life insurers take on much longer maturity obligations than banks do. Traditional life insurance is mostly issued with guaranteed terms for long periods, often up to the full lifetime of the insured party. There are some term life insurance policies without guaranteed renewability, but they represent a small fraction of a typical life insurer’s total assets and liabilities. In contrast, a typical bank loan is for a few years at a time. Even mortgages tend to roll over roughly every seven years on average, due to refinancings or home sales.

The long-term nature of the liabilities gives life insurers more time to respond to problems. Banks can fail very quickly if markets lose confidence in them. Life insurers are much more resilient in the short run, since much of their funding is from liabilities that are long term, giving them time to restore confidence or to find alternative funding. This is a critical difference, but not an absolute one. Sometimes banks fail because they have been slowly deteriorating over a long period and eventually a crisis arises which highlights their vulnerability; something similar could conceivably happen with life insurers. For their part, life insurers do have many obligations that can be redeemed over a shorter period, although there is often a significant penalty charged to customers for doing so, which reduces the net damage to the insurer. A bad enough scare could certainly create the equivalent of a bank run, since many customers would be willing to sacrifice 5-10% of their policy’s value in order to be sure of keeping the remainder. That said, there are at least two factors besides the penalties that might discourage a “run”. First, there is a system of statewide guaranty funds for insurance benefits, analogous to federal deposit insurance. This may reduce the propensity of policy owners to flee, although concerns about the ability of the guaranty funds to cover an insolvency of the size that a SIFI might bring would raise questions about this safety benefit. Second, some policy owners may no longer be able to replace the death benefits provided by their existing policy at a reasonable price, because they have aged, exited a job that provided group benefits, or have suffered from deteriorating health. If those death benefits were a significant factor in the decision to buy and hold that particular policy, then there would be a substantial disincentive to flee.

Long-term liabilities also mean life insurers need long-term assets. Life insurers make commitments that run for many years, meaning that they also need to own assets with long durations, otherwise they run re-pricing risk. That is, if they commit to provide a return of 5% for the next 30 years and invest the funds initially in an investment returning 7% for 5 years, they may find at the end of 5 years they can only earn 3% going forward, turning their 2 point positive spread into a 2 point negative one. Thus, the danger for life insurers is often that their investments are of shorter maturity than their liabilities, because financial markets are substantially shallower in the long end. This is the opposite problem from that of banks, which usually make loans and investments of 3 years or longer, but fund them quite substantially with liabilities that are well shorter than that, including deposits that can be cashed in on any given day without penalty.

The long maturity of insurance liabilities has important policy implications. Bank regulators worry a great deal about banks “borrowing short and lending long,” so they have devised rules to push banks towards shorter-term assets and longer-term liabilities. Using that same approach with life insurers could expose them to dangerously high levels of re-pricing risk. It would also lower their average returns, since longer-term investments tend to pay more, so insurers would have to raise their prices to make up for reduced investment income. The economy as a whole could also suffer in another way, since life insurers are one of the larger providers of long-term investment funds. This would be unfortunate, since many commentators have pointed out the need to increase the supply of such funds, especially with regard to the massive investments in U.S. infrastructure that are needed in the years ahead. (Life insurers are already significant funders of infrastructure projects in the US through their holdings of municipal bonds and sometimes through other investment vehicles.)

There are several factors that could have the insidious effect of pushing the Fed towards encouraging a perverse interest rate mismatch at life insurers. First, using market valuations for longer-term investments can substantially increase their volatility over shorter time horizons. Current GAAP accounting rules often use mark-to-market values and some market participants take the same approach whether or not the figures appear in the accounting statements. This provides incentives for the Fed to take the same approach. (State regulators decided years ago to avoid that level of volatility by not marking bonds to market and they have stayed with that decision.) Volatility in the results reported to markets or regulators, especially if they trigger regulatory pressures, could push managements to optimize their short-term situation at the expense of the long-term. In particular, it could push them to shun investments in long-term assets even though this provides both a better match with the maturity of their liabilities and higher rates of return.

Second, and related, the Fed may be concerned that such variations in market value may lead insurers to participate in “fire sales” to get out of market segments that are being hit badly in a market panic, exacerbating wider systemic problems. Third, as good bureaucrats, they may simply not want to have to answer questions as to why they allow insurers to hold such long assets, especially questions that would arise in the midst of a market crisis. It may be easier for them to apply an investment model closer to that of banks.

Life insurer failures, which are fairly uncommon, can be triggered by misjudging their obligations, not just their investments. Life insurers can fail because they have mispriced their promises through careless underwriting or faulty assumptions about death rates or health or accident risks. They can also experience a run of bad luck among their clients. These problems are more likely to occur in their related business lines that involve health risk, such as health insurance or long-term care insurance, than in traditional life products. However, it can certainly happen even in traditional long-term life insurance policies. They can also fail because of bad investments, just as banks can do. Many times, it is a combination that does an insurer in, when investment returns fail to keep up over the long term with insurance payouts that rise more steeply than expected.

For their part, virtually all bank failures revolve around asset problems – bad loans or bad investments – since their obligations are generally known with certainty. Some might dispute this characterization, arguing that bank runs result from deposits and other liabilities turning out to be much shorter-term in practice than expected. This is certainly true, but it is fairly rare for a bank run to occur unless it is triggered by losses on assets, especially since the advent of modern deposit guarantee systems.

Thus, there is a significant difference in the sources of failure for life insurers compared to banks.

Maintaining appropriate liability reserves is critical for life insurers. A consequence of the importance of the variations in the cost of future obligations is that regulators need to pay careful attention to the techniques used by insurers to set their reserve levels. These are the amounts set aside on an insurer’s books to reflect payments that must be made in the future for insurance claims of various kinds. If too little is set aside, then an insurer is operating with a much lower margin for error than will be shown on its books, since its true capital will be overstated. If too much is systematically set aside, then insurers will overcharge for their services in order to cover these inflated expectations of future payments. State insurance commissioners in the US pay considerable attention to reserves for future claims and have detailed rules about their calculation, given their importance.

Capital Requirements

For their long-term survival, all businesses need to have a positive net worth, that is, assets worth more than their liabilities. This is critically important for financial institutions and other confidence-sensitive businesses, since they must not only be able to survive, but it must be clear that they can do so. In the financial industry, net worth is referred to as “capital” and the concept can become a lot more complicated. For example, for some purposes the only portion of the financial institution’s balance sheet that may be considered as capital is the accounting value of its common stock, which means that preferred stock and some other non-liability items are treated as if they were liabilities for this measurement. For other purposes, some liability items may be treated as if they were common stock. There are good reasons for these different measurements, depending on the particular purpose of the calculation, but the details are unimportant for this paper. (Please see my primer on bank capital for a fuller description of capital at financial institutions http://www.brookings.edu/~/media/Research/Files/Papers/2010/1/29%20capital%20elliott/0129_capital_primer_elliott.PDF )

Bank capital requirements
Before considering the capital requirements that will be placed on life insurers, it is useful to consider the approach taken to banks. The Fed will be strongly influenced in its thinking about life insurance capital requirements by its experience with these bank capital rules. This is both because it is the Fed’s experience with capital requirements, and therefore permeates their thinking on the topic, and because the asset-related risks of life insurers have considerable similarity to the risks for banks. (Realized losses on securities or loans are the same whether held by a bank or by an insurer, although the ability to bear “paper losses” does vary due to differing funding structures.) As discussed in detail below, there are also many differences in how capital requirements should be considered for the two different types of financial institutions.

Formal capital requirements have been imposed on banks for decades, both here in the US and in most of the world, including all of the advanced economies. They are considered important enough that there are global agreements intended to ensure that all major economies meet at least certain standards for the capital of their internationally active banks. Generally the same or very similar rules are used in these countries for their more purely domestic banks as well. The rules are promulgated by the Basel Committee on Banking Supervision (Basel Committee), which reaches them based on a consensus among its members, consisting of the central banks or banking supervisory authorities of all of the most important banking centers and many other nations as well. The original Basel Accord was agreed in 1988 and very substantially revised and altered in 2004 with the resulting version known as Basel II. The global financial crisis has spurred another round of revisions that will sharply increase the total amount and quality of the capital banks are required to hold. The upcoming version is known as Basel III. (There were also important interim changes that have already taken effect known, perhaps predictably, as Basel 2.5.)

The heart of the Basel approach is a calculation of the ratio of capital to risk-weighted assets.

This was incorporated in the first accord and has been considerably expanded with each revision. The idea is that the amount of capital required should be based not just on the size of the bank in terms of assets, but on the total level of risk created by those assets. (Note that liability risk was almost completely absent from Basel I and II. Liquidity issues are being given prominence in Basel III, which goes beyond the capital required to look at maturity mismatches between assets and liabilities. However, there was seen to be no need to reflect the possibility that liabilities might vary in value, since this just is not a serious issue with banks, as opposed to insurers.)

Each asset type is multiplied by a risk weighting, which can range from zero to 1250% depending on its risk compared with a standard loan that receives a risk weighting of 100%. Government bonds of major countries are considered to have no risk and therefore have a zero risk weighting, although there has been serious pushback on this score by outside analysts, spurred in part by the sovereign debt crisis in Europe. Most mortgages have a 50% risk weighting. Very risky tranches of securitized products have risk weightings well north of 100%. There are a large number of other categories with their own explicit risk-weightings.

The total level of risk-weighted assets at a bank is calculated by multiplying the amount of each asset type held by the appropriate weighting and then adding them up. The average risk weighting for banks in the US is about 80%, while it is about half that in Europe and Asia, for a variety of reasons, including varying accounting rules which exaggerate the difference with the US.

The Basel II accord introduced an innovation that has been retained, the use of internal risk modeling by the more sophisticated banks. The core concept is that major banks have a strong economic interest in evaluating the riskiness of their loans and therefore have developed very detailed models, influenced by the latest thinking among financial economists. It was considered desirable to bring this more advanced thinking into the calculation of risk weightings, in part to encourage all banks to move to better risk models and for the major banks to expand and improve their use of such modeling. Therefore, banks can use their own calculations to determine the risk weightings for certain types of assets, subject to supervisory approval of their models.

Some observers expressed concern at the time about the fact that banks would have an economic incentive to bias their estimates of risk to the low side once the results of these internal models took on regulatory implications. These concerns have intensified in light of the under-estimation of risk in the run-up to the financial crisis, but have been handled in the Basel process by stricter rules about how models should be constructed, rather than by abolishing their use in the capital calculations.

Insurance capital requirements
For their part, US insurers have for many years been subject to their own risk-based capital (RBC) requirements, promulgated by the National Association of Insurance Commissioners and incorporated into law and/or regulation in each state. There are significant similarities to the Basel approach for banks, but the rules are both more and less complex for insurers and reflect the different characteristics of that industry.

The biggest difference with the banking rules is that NAIC RBC requirements take account of risk not just on the asset side, but also in regard to insurance risk (the liability side of the balance sheet), interest rate risk, and other business risks, including litigation. Risk weights are assigned for the different categories of assets, liabilities, and insurance products to reflect their varying risk levels. There are also downward adjustments to account for the interactions between the various sources of risk, recognizing that not all of these areas will necessarily go wrong at the same time and, if they do, they may not all go to their extreme states.

An underlying issue that will have to be resolved is what accounting system the Fed will use in regard to insurers. All insurers that have publicly traded securities report their results using Generally Accepted Accounting Principles (GAAP) as promulgated by the Financial Accounting Standards Board under delegated powers from the Securities and Exchange Commission. However, all US insurers also report to their regulators using a different set of accounting principles known as Statutory Accounting Principles (SAP). The two sets of accounting standards are identical in many aspects, but differ in a few key areas. A crucial difference is that, under SAP, fixed income securities such as bonds are shown at their amortized principal amount (essentially their face value with some appropriate adjustments) and not their market values, as under GAAP. Fixed income securities are a large part of the holdings of insurers and the two valuation methodologies can produce quite different results. In particular, market volatility affects the GAAP valuation of these fixed income assets while it has very little effect on the SAP valuation.

Another crucial difference is that GAAP operates under a “going concern” approach, whereas SAP uses a liquidation approach. Thus, items that would have little value in a liquidation are treated as worth only that much, whereas GAAP rules allow them to be held at the value that will be realized over time. A trivial, but illustrative, example is office furniture. SAP treats it as worth almost nothing since a liquidation would have a fire sale effect. GAAP treats it as worth what was paid for it, minus any depreciation, since it is presumed that its use in the business will justify over time the original purchase price. There are considerably larger items, such as spreading the benefit of up-front sales commissions over the life of the products sold, that make a real difference. SAP is virtually always more conservative in this manner.

There is a good argument for using the SAP approach for regulatory purposes. However, US banking regulators were badly burnt by using Regulatory Accounting Principles (RAP) for banks and savings and loans a couple of decades ago. By allowing non-GAAP rules, they opened themselves up to pressure to soften accounting rules when the savings and loans ran into problems. They switched after the S&L crisis to using GAAP and became allergic to the idea of allowing different accounting for regulatory purposes. It will be interesting to see if the Fed chooses to use different accounting than the insurance regulators do.

Choosing a Fed capital methodology for life insurers
The Fed will clearly focus on capital levels as a major part of its prudential oversight of life insurers. There are multiple methodological choices it could make, broadly including:

Acceptance of the NAIC capital calculations. The Fed could choose to defer to the state insurance commissioners on the capital calculations, in recognition of their role as primary regulators and their far longer experience in analyzing and regulating the industry.

Use of bank capital calculations for insurers. At the other extreme, the Fed could simply try to fit insurers into the bank formulas. This seems unlikely, at least taken to this level, since insurers are so obviously different than banks. It would also expose the Fed to accusations that it was ignoring major areas of risk at the insurers, relating to their liabilities and their pricing of their obligations.

Modification of the NAIC capital calculations. The Fed could accept the basic NAIC approach, but choose to modify parts with which it felt uncomfortable.

Creation of a hybrid NAIC/Basel approach. It is possible that the Fed would choose to use the Basel approach for calculations of risk-weightings for assets and combine that with the NAIC approach for the other categories, perhaps with some modification. This would allow them to argue that they are remaining consistent with the rules for banks, where applicable, while capturing the main elements of difference between life insurers and banks.

Whatever choice the Fed makes, with the exception of simply accepting the NAIC measurements, the devil will be in the details. Insurers are quite different from banks, so even using categories that seem identical between the two industries may be harder than it would first appear. Obviously, this difficulty would be exacerbated the closer the calculations are to those used for banks. A modified version of the NAIC rules would doubtless still require some complex choices, but would be considerably easier to apply to insurers than would be a totally new methodology for them.

What might the Fed do beyond capital standards?

One area of regulation analogous to capital requirements would be liquidity requirements. The Basel III rules, which will be implemented in the US, include quite detailed calculations to ensure that banks have the ability to generate the necessary cash to meet all of their obligations even in a period in which markets freeze up and liquidity vanishes. It is certainly possible that the Fed will apply similar tests to life insurers and other non-bank SIFIs. It is unclear at this point not only what the Fed might do, but how much effect such standards would have. For example, it is possible that life insurers would easily pass the Basel III liquidity tests, since such a high proportion of their liabilities have maturities over one year. However, there is the vexed issue that a large portion of these obligations could be brought forward if the holders were scared enough to pay the full contract penalties. The Fed might choose to make very conservative assumptions about the behavior of these liabilities in a severe crisis that hit the life insurance industry, even though there were relatively few such problems at the life insurers in the recent crisis. They might postulate a future crisis in which life insurers were more central to the problems and therefore suffered higher attrition of their policies. In practice, this would result in a requirement for life insurers to hold large levels of short-term, highly creditworthy liquid assets such as Treasury bills or deposits with solid banks and make it harder for life insurers to hold the long-term assets they need to match their long-term liabilities.

Beyond this, Dodd-Frank gives federal regulators a wide range of powers over SIFIs, including the ability to require the divestiture or cessation of activities that they believe create excessive levels of systemic risk. It would be surprising, however, if the Fed took such an action anytime soon. There is a fairly high hurdle for doing this and the Fed would be under even greater scrutiny in regard to life insurers, since it is not the primary regulator and is known not to have lengthy experience in analyzing them.

That said, the ability to impose tougher capital requirements than those of the primary regulators gives the Fed strong leverage to push for the cessation or modification of activities that it does not like. If, for example, it were to conclude that insurers were taking on too much risk with the guarantees they provide on variable products, it would be easy to discourage this through the risk-weighting procedures. For example, it might decide that any products with the type of guarantees it disliked would be treated for capital purposes as if they were not in separate accounts, with consequent higher capital charges and with inclusion in a straight leverage ratio calculation. There will also be any number of discretionary areas of supervision where the Fed could be more or less sympathetic to management requests depending on how comfortable it was that the company was operating in a sensible manner. It simply does not pay to annoy powerful regulators if one can help it, so there would be a natural tendency to listen to the Fed, even in circumstances where it may seem to be overstepping. Listening may not translate to acting, though, if the economic cost is too high.

One indicator of the Fed’s intentions in regard to detailed supervision will be the size of the staff it assigns to the life insurer SIFIs and whether, and to what extent, it places them on-site at the insurers. Obviously, it will need fewer staff members the more that it relies upon the primary regulators.

Conclusions

In the wake of the recent financial crisis, there is now much more attention paid by policymakers to the question of the overall level of risk in the financial system and the role of systemically important financial institutions in helping to create and spread that risk. This is clearly the case for non-bank financial institutions, especially life insurers. Life insurers are very important financial institutions and have been extensively regulated for centuries for that reason. However, relatively little attention was paid until recently to the ways in which individual insurers might affect the rest of the financial system. Dodd-Frank attempts to ensure that the possible systemic risk created by all the important non-bank financial institutions be considered.

Whatever one believes about the wisdom of designating some life insurers and other types of non-banks as systemically important, it is critical that the ensuing regulation by the Fed of any designated SIFIs be appropriate to their industries. Life insurers in particular are quite different animals from banks and so it is crucial that the Fed not instinctively treat them simply as funny looking banks and try to force them to be more like traditional banks. The most likely place that such a mistake could be made is in the area of capital requirements, where the Fed has extensive intellectual investments in their current approach to bank capital, buttressed by agreements with their peers in other nations. Applying bank capital standards inflexibly to life insurers would run the real risk of forcing them to act more like banks, even when this would actually increase their risk. For example, the long-term nature of life insurance liabilities necessitates the holding of long-term assets in order to reduce the risk that funding costs will shoot up when shorter-term assets are rolled over. Banks, on the other hand, have much shorter liabilities and therefore need to be careful not to lengthen their assets too far.

The Fed has promised to pay careful attention to the differences between banks and other financial institutions that are designated as SIFIs. It is crucial that they be rigorous in doing so.

[1] Members of the FSOC include the Treasury Secretary (chair), the Chairman of the Federal Reserve System, the Comptroller of the Currency, the Chairman of the Federal Deposit Insurance Corporation, the Chairman of the Securities and Exchange Commission, the Chairman of the Commodities Futures Trading Commission, the Director of the Bureau of Consumer Financial Protection, the Director of the Federal Finance Housing Agency, the Chairman of the National Credit Union Administration Board, a member with insurance expertise designated by the President and confirmed by the Senate, and various non-voting members (such as a representative of state bank regulators).

[2] There is some ambiguity in the legislation as to whether all systemically important financial institutions must be designated as such, or only those where the FSOC feels it is necessary to do so. Section 113(a)(1) uses the term “may” whereas Section 112(a)(12)(H) indicates a requirement.

[3] See the report to the G20 Finance Ministers and Governors by the IMF, BIS, and FSB, “Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations”, available at http://www.bis.org/publ/othp07.pdf

[4] See Section 113 of the Dodd-Frank Act.

[5] See, for example, the study by the Macroeconomic Assessment Group set up by the Basel Committee on Banking Supervision and the Financial Stability Board, “Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements (Final report)”, December 2010, http://bis.org/publ/othp12.pdf. This report references a large number of other studies on the effect of capital requirements on credit provision and on the real economy.

[6] Regulators are aware that there are significant differences between different types of institutions and will attempt to take this into account appropriately. However, there will also be bureaucratic and political pressures to use common approaches, even when these are not entirely sensible, in addition to a natural human tendency to use tools with which one is already comfortable.

[7] It would be necessary to have a guaranteed schedule of premium payments to create a true equivalence and there are other differences, such as in tax treatment.

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Regulating Systemically Important Financial Institutions That Are Not Banks

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Douglas J. Elliott

Bending the Cost Curve in Health Care the Right Way—Through Better, More Person-Centered Care

Mark B. McClellan — Thu, 09 May 2013 13:54:00 -0400

The United States spends about 17 percent of GDP annually on health care, a figure that is projected to grow substantially in the years ahead, despite the recent slowdown in health care spending growth. Rising costs mean insurance coverage keeps getting more difficult to afford. Those rising costs, plus the aging demographics of the nation, account for most of the spending side of our nation’s long-term fiscal challenges at both the federal and state level. They mean higher expenditures on Medicare and Medicaid, and the tax subsidies for employer-provided coverage and the new subsidies for private insurance in the individual marketplaces. At the same time, biomedical innovation using genomics, systems biology, information technology, and innovative and convenient ways to deliver care holds the potential for much more effective, personalized care – if we can afford to develop and use it. That’s not the case so far: patients often do not get treatments we know to be effective, innovative treatments and ways of delivering care are hindered by payments that are tied more to the site of services and what we’ve paid for in the past than the value of these treatments for particular patients, and we often pay more for complications than for the coordination of care and person-focused support that could help health care providers and patients get much better results for the money they spend. Something has to change, not just to make sure that healthcare costs can be contained, but also to make sure that the quality of health care gets better by providing better support for what patients need.

Our new report, “Person-Centered Health Care Reform: A Framework for Improving Care and Slowing Health Care Cost Growth” is a system-wide framework to address our cost problems by improving care – by leveraging the large and growing opportunities for more person-focused care. We have developed a set of proposals for saving $1 trillion over 20 years and improving care at the same time. Written in collaboration with leading experts from across the academic and political spectrum, our report proposes a framework for how to improve health care financing and regulation so that we can achieve better, higher-value care for each person. The report describes a specific series of steps to improvement the way care is delivered in each part of our health care system, including Medicare and Medicaid, the employer and individual insurance markets, antitrust enforcement and other regulatory reforms. Focusing on person-level quality of care as the fundamental strategy for addressing health care cost growth is in some ways new, but it builds on promising ideas and trends throughout our health care system. It is an idea whose time as come, and which we should start to adopt as our long-term approach to addressing the health care quality and cost problems now.

This report is the third in our “Bending the Curve” series. While building on the past reports, it also differs from our previous work in some very important ways. First, we have broadened our group of authors. Still with us is the core group of experts who participated in previous reports – people like Joe Antos from AEI, Mike Chernew and David Cutler from Harvard, Mark Pauly from University of Pennsylvania, Dana Goldman from USC, Steve Shortell from UC Berkeley, and others who have a tremendous amount of health policy expertise and experience. We’ve also benefitted from some new expert perspectives, including Kate Baicker from Harvard. And along with that expertise, our group now includes some other experts with extensive policy and political experience – including NGA director Dan Crippen, former Senate Majority Leader Tom Daschle, former CEA chair and Columbia dean Glenn Hubbard, former Utah Governor and former HHS Secretary Mike Leavitt, former HHS Secretary and University of Miami President Donna Shalala, and former budget directors Peter Orszag and Alice Rivlin. Together, this unique group sparked a new and welcome level of discussion about reform. In particular, as Mike Leavitt put it, if Republicans and Democrats were at the point where they had to reach an agreement on reforming care and addressing the challenge of rising costs, what would they agree on – and how could we make sure it would work?

As we worked to answer these very practical questions, we were forced to consider the full range of key technical and political issues involved in health reform. We reviewed the kinds of reforms that we have considered before to improve quality and lower costs, along with new evidence on how those reforms and others being implemented now are working (with different degrees of success) in the public and private sectors. We combined that with consideration of how best to move forward in a way that avoids the need for disruptive short-term payment cuts, provides the policy certainty needed to accelerate the trends toward the availability of much better, more personalized care, and addresses serious short-term weaknesses in in Medicare, including unstable physician payments and a lack of support for beneficiaries to save money when they get better care These considerations led to a plan that involves implementing reforms that are not disruptive in the short term while supporting better quality and coordination of care, leading to a large impact over time on supporting improvements in care that can sustain slower cost growth in the years ahead. Our conclusion is that enacting these health care reforms will not be easy, but we agree that this is the best path forward.

We do need to act now. If enacted, our framework is able to avoid the more aggressive steps that will almost certainly be needed in the years ahead to achieve more urgent reductions in federal spending, like cuts in payment rates as in sequestration, or restrictions in coverage for vulnerable populations and in access to new types of innovative care. And even more importantly, it will speed up the innovations in health care and biomedical technology that lead to better results and lower costs for patients. The bottom line is that the best way to control health care costs is to have health care policies now that do as much as possible to support better care for each patient.

We have a window of opportunity right now for implementing thoughtful health care financing and regulatory reforms that improve care today and promote much better, person-centered health care for the future. This is the best way for the country to achieve its overall deficit reduction targets. We should act now before the window closes, and we are left only with policy options that shift costs, reduce quality, and most importantly, diminish the ability of patients and health care providers to achieve better care and better health.

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Mark B. McClellan

Regulating Non-Bank Systemically Important Financial Institutions

Thu, 09 May 2013 09:00:00 -0400

Event Information

May 9, 2013
9:00 AM - 11:00 AM EDT

Saul/Zilkha Rooms
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

The Dodd-Frank Act requires federal regulators to name financial institutions that are “systemically important” (SIFIs). These institutions will be subject to greater scrutiny by regulators who will have the legal ability to impose additional regulations on them. How should authorities decide which financial institutions other than banks should be designated as SIFIs? Once designated, how should they be regulated? The analysis is particularly challenging for financial groups with life insurance units at their core, given their differences with banking.

On May 9, the Economic Studies program at Brookings reviewed the designation and regulation of non-bank SIFIs, with particular emphasis on life insurers. Panelists included experts from academia, as well as Martin Baily, senior fellow and director of the Initiative on Business and Public Policy at Brookings. Douglas Elliott, fellow in Economic Studies, served as moderator of the panel on the designation of SIFIs and also presented some views on the regulation of non-bank SIFIs once they have been designated.

Read Doug Elliott's paper, "Regulating Systemically Important Financial Institutions That Are Not Banks" »

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Regulating Non-Bank Systemically Important Financial Institutions

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A Bipartisan Case for Chained CPI

Martin Neil Baily and Glenn Hubbard — Thu, 09 May 2013 00:00:00 -0400

Over the last few days, politically driven critics have called on the president to abandon his support for changing the way the government indexes provisions in the budget to inflation by switching to “chained CPI.” Looking beyond politics, we’re here to say that these critics’ arguments are wrong on their merits.

As economists from opposite ends of the political spectrum, we would strongly urge the president and leaders in Congress to continue to support moving to chained CPI, which represents the most accurate available measure of inflation and cost-of-living increases. Switching to this more accurate measure of inflation represents the right technical, fiscal and retirement policy—and policymakers should not delay any further in making this improvement.

From a technical sense, the current CPI—or consumer price index—that is used to index many parts of the budget and tax code is widely understood to overstate inflation. This is because it fails to account for so-called “substitution bias,” in which consumers reallocate their purchases depending on the relative prices of similar goods. For example, if the price of apples goes up, consumers will buy more oranges. However, this behavior is not accounted for in standard CPI measurements.

The Bureau of Labor Statistics, which calculates the CPI, is very aware of this shortcoming, which is why it has developed and refined the chained CPI for more than a decade. The nonpartisan Congressional Budget Office states that the chained CPI “provides an unbiased estimate of changes in the cost of living from one month to the next.”

Some argue that using the chained CPI to index Social Security benefits is inappropriate because it does not reflect inflation for retirees, which critics suggest is higher than it is for working-age adults because of the elderly’s higher rate of spending on healthcare. However, the CBO has said that based on the available research, it is unclear whether the cost of living actually grows at a faster rate for the elderly than for younger people, and that the CPI-E —“E” for “experimental”—which was intended to provide a more accurate measure of inflation for seniors, has several methodological flaws that overstate inflation, including underestimating the rate of improvement in healthcare.

Beyond the technical case for the chained CPI, there is a strong fiscal case. Because current measures currently overstate inflation by about 0.25 percent per year, moving to a more accurate measure would result in real deficit reduction. Measuring inflation more accurately would generate savings from throughout government: about $390 billion in the first decade alone. Roughly one-third of those savings would come from slower growth in Social Security benefits, another third from revenue increases (as certain tax provisions such as the cutoff points of income tax brackets are indexed to inflation) and the remaining savings from a combination of other spending programs and lower interest payments on the debt. Given the very real need to begin to put our debt on a sustainable path, this would be a small but important contribution. The savings would be gradual, with only a small amount in the near term, thus protecting our fragile recovery from immediate austerity.

Finally, switching to chained CPI is the right retirement policy—or rather, a small piece of it. The Social Security program is on a path to exhaust its trust fund. Current projections indicate that this will occur in 2033, threatening cuts for all beneficiaries, including the very rich and the very poor, the very young and the very old, veterans, disabled workers and others. Improving the way we measure inflation won’t prevent the program’s looming insolvency, but it will eliminate a full fifth of the long-term funding gap.

To the extent that the overpayments under the current formula offset the shortcomings of our current retirement system for the lowest-income and most-elderly beneficiaries, a switch to chained CPI can and should be accompanied by targeted policy changes providing benefit enhancements designed to help the affected populations, rather than providing higher-than-justified inflation adjustments for all beneficiaries.

The federal government should not knowingly continue to measure inflation inaccurately, especially given the costs to the budget and to the Social Security program. Changes that cut Social Security benefits are a tough sell for Democrats, and changes that increase revenue are a tough sell for Republicans. But if they cannot even agree to a technical correction to those areas of the budget, how will they be able to make the hard choices to control our debt and reform our government over the long term?

Authors

Martin Neil Baily
Glenn Hubbard

Publication: The Hill

Innovative Technologies and Nonprescription Medications: Addressing Undertreated Diseases and Conditions through Technology Enabled Self-Care

Thu, 09 May 2013 09:00:00 -0400

Event Information

May 9, 2013
9:00 AM - 4:00 PM EDT

The Brookings Institution
1775 Massachusetts Ave., NW
Washington, DC

On May 9, the Engelberg Center for Health Care Reform convened an expert workshop “Innovative Technologies and Nonprescription Medications: Addressing Undertreated Diseases and Conditions through Technology Enabled Self-Care.”

Recognizing the public health impact of undertreatment of common diseases and conditions, the U.S. Food and Drug Administration is exploring how a regulatory expansion of the nonprescription drug class might increase access to important medications and treatments. This initiative is referred to as Nonprescription Safe Use Regulatory Expansion (NSURE).

At this meeting, a wide range of experts and stakeholders explored the use of technologies as a condition to the safe use of medications within a nonprescription setting, discussed perspectives on the role of technology to support the safe and effective use of nonprescription products, and explored the integration of innovative technologies into the health care delivery system.

Event Materials

Should Everyone Go To College?

Stephanie Owen and Isabel V. Sawhill — Wed, 08 May 2013 09:00:00 -0400

Summary

For the past few decades, it has been widely argued that a college degree is a prerequisite to entering the middle class in the United States. Study after study reminds us that higher education is one of the best investments we can make, and President Obama has called it “an economic imperative.” We all know that, on average, college graduates make significantly more money over their lifetimes than those with only a high school education. What gets less attention is the fact that not all college degrees or college graduates are equal. There is enormous variation in the so-called return to education depending on factors such as institution attended, field of study, whether a student graduates, and post-graduation occupation. While the average return to obtaining a college degree is clearly positive, we emphasize that it is not universally so. For certain schools, majors, occupations, and individuals, college may not be a smart investment. By telling all young people that they should go to college no matter what, we are actually doing some of them a disservice.

The Rate of Return on Education

One way to estimate the value of education is to look at the increase in earnings associated with an additional year of schooling. However, correlation is not causation, and getting at the true causal effect of education on earnings is not so easy. The main problem is one of selection: if the smartest, most motivated people are both more likely to go to college and more likely to be financially successful, then the observed difference in earnings by years of education doesn’t measure the true effect of college.

Researchers have attempted to get around this problem of causality by employing a number of clever techniques, including, for example, comparing identical twins with different levels of education. The best studies suggest that the return to an additional year of school is around 10 percent. If we apply this 10 percent rate to the median earnings of about $30,000 for a 25- to 34-year-old high school graduate working full time in 2010, this implies that a year of college increases earnings by $3,000, and four years increases them by $12,000. Notice that this amount is less than the raw differences in earnings between high school graduates and bachelor’s degree holders of $15,000, but it is in the same ballpark. Similarly, the raw difference between high school graduates and associate’s degree holders is about $7,000, but a return of 10% would predict the causal effect of those additional two years to be $6,000.

There are other factors to consider. The cost of college matters as well: the more someone has to pay to attend, the lower the net benefit of attending. Furthermore, we have to factor in the opportunity cost of college, measured as the foregone earnings a student gives up when he or she leaves or delays entering the workforce in order to attend school. Using average earnings for 18- and 19-year-olds and 20- and 21-year-olds with high school degrees (including those working part-time or not at all), Michael Greenstone and Adam Looney of Brookings’ Hamilton Project calculate an opportunity cost of $54,000 for a four-year degree. In this brief, we take a rather narrow view of the value of a college degree, focusing on the earnings premium. However, there are many non-monetary benefits of schooling which are harder to measure but no less important. Research suggests that additional education improves overall wellbeing by affecting things like job satisfaction, health, marriage, parenting, trust, and social interaction. Additionally, there are social benefits to education, such as reduced crime rates and higher political participation. We also do not want to dismiss personal preferences, and we acknowledge that many people derive value from their careers in ways that have nothing to do with money. While beyond the scope of this piece, we do want to point out that these noneconomic factors can change the cost-benefit calculus.

As noted above, the gap in annual earnings between young high school graduates and bachelor’s degree holders working full time is $15,000. What’s more, the earnings premium associated with a college degree grows over a lifetime. Hamilton Project research shows that 23- to 25-year-olds with bachelor’s degrees make $12,000 more than high school graduates but by age 50, the gap has grown to $46,500 (Figure 1). When we look at lifetime earnings—the sum of earnings over a career—the total premium is $570,000 for a bachelor’s degree and $170,000 for an associate’s degree. Compared to the average up-front cost of four years of college (tuition plus opportunity cost) of $102,000, the Hamilton Project is not alone in arguing that investing in college provides “a tremendous return.”

It is always possible to quibble over specific calculations, but it is hard to deny that, on average, the benefits of a college degree far outweigh the costs. The key phrase here is “on average.” The purpose of this brief is to highlight the reasons why, for a given individual, the benefits may not outweigh the costs. We emphasize that a 17- or 18-year-old deciding whether and where to go to college should carefully consider his or her own likely path of education and career before committing a considerable amount of time and money to that degree. With tuitions rising faster than family incomes, the typical college student is now more dependent than in the past on loans, creating serious risks for the individual student and perhaps for the system as a whole, should widespread defaults occur in the future. Federal student loans now total close to $1 trillion, larger than credit card debt or auto loans and second only to mortgage debt on household balance sheets.

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Should Everyone Go To College?

Authors

Stephanie Owen
Isabel V. Sawhill