Envisioning a free market in health care.

• Author: Schansberg, D. Eric

Although President Obama and the Democratic Congress were able to pass landmark health legislation, their efforts to reform health care ran into predictable political roadblocks. In a severe recession, taxing business and labor is obviously not helpful to economic recovery. Moreover, an array of overreaching sales pitches--claims of additional coverage without additional costs or rationing--piqued the cynicism of the general public. Given historical spending and budget deficits, an expensive new federal program is difficult to swallow. Mandates and restrictions on health insurance can only exacerbate the problem of rapidly rising health care costs (Tanner 2010).

Perhaps most important, although many people express dismay with the health care system, they are generally content with their own health care and health insurance. They might be willing to help others get care or insurance, but become quite concerned if reform might include a dramatic change in their own status.

Need for Real Reform

One can speculate whether "Obamacare" will persist, particularly in light of recent constitutional challenges to the individual mandate, or whether economic and political markets will adjust significantly. The legislation imposes a burden on those with private insurance and will lead to higher costs for many taxpayers. Moreover, a sluggish economy--made more sluggish by Obamacare--will limit government spending initiatives, especially at the state and local levels. Given the current state of America's health care system, with extensive third-party payment and favorable tax treatment, there is need for real reform.

Santerre (2007) provides a "health misery index" from 1940-2006 that indicates the sum of "excess" medical inflation (above increases in the CPI) and estimates of the percentage of those without health insurance. The index declined consistently from 1940 to 1975: excess medical inflation was low and relatively stable, while the proportion of uninsured Americans decreased in all except two years--from 90.7 percent to 12.6 percent. The spread of private insurance was responsible for most of this decline prior to the creation of Medicaid and Medicare in 1964, when the proportion of uninsured was 27.9 percent. Since then, the spread of public insurance has been the most significant factor in decreasing the percentage of uninsured. Santerre's index bottomed out in 1980 at 13.1 before trending slightly upward to a high of 16.6 in 2006 (see Cutler and Gelber 2009).

Table I presents measures of excess medical inflation in medical care, physician services, dental services, and prescriptions. There was medical deflation until the growth of subsidized private insurance in the 1950s.

Such measures are admittedly simplistic, but they point to a few realities. First, it would be useful to have objective measures of health, health insurance, and health care. But such measures are difficult to find and subject to abuse. Second, there is causation between the short-run benefits and long-run costs of government involvement. Figure 1 illustrates that health care expenditures have risen steadily as third-party payments--through low-cost government health insurance as well as through employer-provided coverage exempt from taxes--have increased.

The status quo is suboptimal with respect to (1) access to health care and health insurance, (2) affordability to individuals and cost to taxpayers, (3) the unfortunate connection of health insurance to employment, and thus the problem of portability (Adams 2004), and (4) inequities in the available subsidies. If the status quo is unacceptable, then two basic choices remain: increase government involvement in health care or let the free market operate.

If one wants to increase the role of government, then to what extent and at what level? For example, should government operate health care facilities and set pay rates for doctors or empower poor people with the resources to acquire privately produced health services? Should government involvement be extended at the federal, state, or local levels? Given the observed challenges of implementing similar reforms at the state level--for example, in Massachusetts and Tennessee why would one be optimistic about expanding the role of the federal government?

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Government has become increasingly active in regulating and financing health care over the last 40 years--increasing health care spending from 25 percent to more than 50 percent of overall spending. This increased intervention has led to higher, not lower, health care costs. Moreover, the direct costs of past expansions of government intervention in health care have been grossly underestimated. For example, the Joint Economic Committee (2009) notes that the initial 1965 estimate of 1990 Medicare expenses was $12 billion when actual spending turned out to be $110 billion.

The tendency to underestimate the costs of government intervention introduces a serious problem for advocates of more government control of health care. Why would anyone trust the government to run a new health care program when it has already wasted so much money? Can anyone believe President Obama when he claims that his reform will save $500 billion in Medicare spending? More likely, we will experience higher costs, reduced services, longer waits, and lower quality.

Government intervention in health care has increased under both major political parties over the last 45 years. As we will see, there are compelling stories that increased intervention has caused more and more trouble in the provision of health care. In any ease, the government has clearly failed to control costs. Its hypothesized success at doing so in the future--aside from imposing significant rationing--is an article of blind faith.

So, what would it look like to have less government involvement in health care? Freer markets would mean far less subsidization and regulation of the transactions between insurers, providers, and consumers. The result would be more competition, more choice, and lower costs. This article covers a litany of policy reforms that would unleash the market from burdensome and costly regulation, and discusses best practices in the private sector. The key questions addressed are: How would a free-market system improve affordability, access, and quality? How would the market deal with vital issues like portability and pre-existing conditions? And how would the market improve incentives and outcomes?

Ending the Subsidy for Employer-Provided Health Insurance

In moving toward a free market in health care, the most important first step would be to end, or at least reduce, the subsidy for health insurance obtained by workers through their employers. Allowing employers to use pre-tax dollars to buy health insurance lowers the net price of coverage and thus increases the amount of coverage demanded by workers who do not have to pay taxes on their health benefits.

Ironically, the subsidy is itself the product of unforeseen consequences from earlier government intervention--namely, caps on wages during World War II. Unable to pay higher wages, firms shifted to fringe benefits as a form of higher compensation, including health insurance. (1) The subsidy is inequitable because it is unavailable to the self-employed, unemployed workers do not receive it, and those subject to higher marginal tax rates benefit the most. Moreover, by treating health insurance benefits as a "tax preference" item, the Treasury loses substantial revenue (Joint Committee on Taxation 2009).

The ideal, revenue-neutral solution would be to remove the distortionary subsidy for all workers and lower income or payroll taxes by the same amount. A second-best option would be to extend the same subsidy to all individuals and to separate it from employment. (2) But the question then becomes, how much insurance should be subsidized? If the current subsidy is extended to all individuals, that arrangement would dramatically increase existing distortions. Although more equitable, it would be even less efficient and would presumably cause even more trouble with access and affordability. One option would be to reduce or eliminate the subsidy for the wealthy, but that would only limit the damage done by such subsidies.

Given the political constraints and economic realities, the practical option may be to simply extend the existing subsidy for health insurance to everyone but only at a level to provide catastrophic insurance for substantial and unpredictable medical expenses. A variation on this theme would be to provide the subsidy on a means-tested basis, reducing it for those with higher incomes.

Emanuel and Fuchs (2005) propose a voucher system to accomplish something like this. The system would be universal (eventually extending even to Medicare recipients), allow freedom to choose insurance plans and purchase more insurance and services with post-tax dollars, eliminate Medicaid and employer-provided insurance, and rely on a private delivery system.

Would firms continue to provide health insurance as a part of compensation? Perhaps. Workers would no longer have a tax incentive to get their insurance through their employer. But the inertia of tradition, along with the presence of search costs, would still provide some impetus for employers to present workers with a menu of options. Moreover, the firm might still enjoy economies of scale--if subsets of employees could coalesce around a few types of insurance. (3)

In any case, with the removal of the subsidy for health care above catastrophic coverage, the incentive to obtain so much insurance would diminish. Thus, many people would reduce coverage to that level. Insurance companies could help individuals with catastrophic risk management--their traditional function. Firms could get out of the business of managing, rationing, and buying health care. We would delink insurance from employment, ending the...