Victorian Premier, John Brumby, has led a new charge for comprehensive reform of our health system and, in particular, funding arrangements for health insurance and provision. His report, Next Steps in Australian Health Reform, is comprehensive and far-reaching. It raises issues well beyond those that can be dealt with in a short article like this.

So I am going to focus on one aspect: a call to move to activity-based funding for care in public hospitals. At present, it is argued that grants-based funding for public hospitals has led to a steady erosion of Commonwealth support. In contrast, the private system, with an array of support, is based on activities (effectively, procedures and usage) and so has kept up with inflationary pressures on health care costs.

This leads to various distortions. For instance, if you are privately insured you can access PBS drugs in private hospitals but not public ones. No wonder so many privately insured patients admitted to public hospitals for specialised care don’t admit their status. And when public hospitals treat a private patient they are paid a daily rate of about $277 compared to the rate of $728 for the same patients at private hospitals. And things like dental care are implicitly subsidised by the government for privately insured households but not for others.

As an economist reading about things like this, it is clear that someone is not getting the ultimate incentives right. This leads to poor outcomes for the system.

We need a non-distortionary set of funding arrangements. We need to start from the premise that the government is paying for a certain minimal level of health care for all Australians. The fact that that care might be undertaken in publicly owned or privately owned hospitals is surely immaterial. The important starting point is that the care is provided.

Following on from that minimal provision, one could imagine private hospitals providing extras in order to compete for business. They could do this by having lower costs and funding the extras that way or by requiring patients to pay more than the government reimbursement rate. That is, patients wanting more will have to pay for it out of their own pocket.

Of course, more could mean a lot more; especially say for a private room and a long stay. This is where private health insurance could step in. It would provide insurance for those extra expenses and so households who want more will pay for it over time through insurance premiums rather than at the time.

This ‘top up’ system would be transparent (with funding based on activity overall) and non-distortionary. And notice that I have not mentioned Medicare surcharge levies, private insurance rebates or anything like that. The government is funding a certain level of health care and the rest is up to others.

Of course, as is plainly apparent, we do not have this system. Instead, what we have is an ‘opt out’ system with band-aids all over the place to stop it from falling apart. In this system, the government provides hospital-based health care but only through the public system. If you want those extras, you need to take out private health insurance. But, as a first step, the providers of that insurance need to fund entire procedures in private hospitals. Not surprisingly, that is expensive and so it is hard to convince consumers in effect to pay twice for something they have already paid for and can access publicly. Only those who know they are going to need to use the system (the less healthy) would opt for the high private insurance fees.

Recognising this gave rise to the private health insurance rebate and Medicare surcharge levy. One is a carrot and the other is a stick to herd people with higher wealth out of the public system and into the private one. So rather than just fund procedures in private hospitals directly (as I argue above), they do so indirectly. And that has given rise to the wealth of distortions, anomalies and inefficiencies that perplexes John Brumby.

But the ‘opt out’ system, with its twin goals of universal health insurance coverage and savings on direct public expenditures on health care, creates another set of problems: poor public choices with regard to the quality of public health care.

To see this, consider what would happen if the quality of public care were improved? That is, waiting lists were shortened, hospitals upgraded and the like. In this case, the gulf between private and public hospitals in terms of quality would be reduced and consequently, fewer households would take up private health insurance. Rather, they would come back to the public system.

Improving the public system increases not only the average cost per household in that system but the total number of users as well. Thus, from a fiscal perspective, the cost of improving the public system is not simply those direct costs but the indirect costs as well. Not surprisingly, this ties the hands of even the most well-meaning politicians in their ability to improve public health care quality. This inertia manifests itself on a number of levels.

As an example, consider the issue of the choice of doctor. In public hospitals, there is no choice. In private ones, there nominally is. However, the degree of choice in the private world can be overstated. Issues of availability and timing often arise as well as the fact that some more specialist treatments take place only at the larger public hospitals. Further, it is a simple fact that most households do not have a good idea about the trade-offs involved in choosing one doctor over another and so the empowerment given by the choice is limited. Despite this, the choice of doctor is nevertheless heralded as a primary reason to take out private cover.

But these same concerns about the actual choice given also raise an important question: why isn’t there a similar choice in the public system? If that choice were available, individuals would have to face trade-offs in waiting for their choice to be available, the location of the specialist and their own lack of information about the options. Moreover, it is unclear that this would result in a significant burden on the administration of the public system. However, to broach the idea that some choice might be given to patients in public care is simply heresy. Its feasibility has never, to my knowledge, been seriously investigated within government. The reason is obvious: if public patients were given such a choice, there may be a significant migration away from the private health system.

Moreover, if the choice that might exist in private health care was seriously evaluated and turned out to be limited, then there might be a similar migration. I am not saying for sure that either of these issues is simple, but that from an economics perspective they are relevant. However, the possibility that the choice of doctor may not be a significant differentiator between the private and public systems is currently such a concern that not even an opportunistic politician in any party has proposed it. The potential for increased public costs appears to be too great.

Thus, the way the private health insurance system is currently being used – as a means of getting health care off the public accounts – is itself leading to poor choices regarding the quality of public health care. This clearly has widespread ramifications and is a reason why reform is desperately needed.