Unhealthy Subsidies

Arnold Kling has provided a succinct and accurate—as far as it goes—diagnosis of what’s wrong with health care in the United States. His distinction between health plans, public and private, that merely insulate consumers against the cost of health services and those that efficiently insure individuals against unpredictable and unbearable risks is right on the mark. Poorly designed health coverage has created expectations that are far too costly for the nation to honor any longer.

Regrettably, we have little experience in designing efficient health insurance. Any health coverage, after all, makes some things costless, or nearly so, to covered individuals, thus inviting them to over-consume those things and generally to be less cost-conscious than they otherwise would be. Indeed, economists have a name —“moral hazard” — for the natural tendency of consumers to spend more freely when they’re spending someone else’s money. Economists also understand that health insurance can be spectacularly inefficient unless it is specifically designed to counteract not only this tendency but also health care providers’ exploitation of it by prescribing tests and treatments without regard to cost. Kling’s essential point is that U.S. health plans do not seek to offer subsets of the consumer population coverage that balances the value to them of the financial protection provided against the added costs of moral hazard, including administrative costs incurred to curb insurance-induced spending. Thus, private and public financing plans generally have low deductibles, use only mild cost sharing to deter consumption, and impose only trivial contractual or legal limits on what will be paid for. With the resulting over-insurance hugely inflating demand for more and costly services over a long period of time, the supply side has responded predictably, by developing and deploying expensive clinical practices and technologies having negligible marginal value — what Kling calls “premium medicine.”

The Kling essay might have been clearer about precisely why U.S.-style health coverage, both public and private, has evolved into an entitlement program under which everyone expects nothing less than the very best that “modern medicine” has to offer. The subsidy for the purchase of health insurance created by excluding the cost of employer-sponsored coverage from employees’ taxable wages and income, although regularly remarked upon, is an even more fundamental problem than most observers seem to appreciate. Although the subsidy is widely criticized for disproportionately benefiting high-bracket taxpayers, that is not the real problem; indeed, the more than $200 billion in revenue that the subsidy costs the federal government each year is presumably recouped by taxing other income at higher marginal rates, so that higher-income individuals probably derive no net tax benefit at all. Instead, the true vices of the tax subsidy are three. First, it has caused taxpayers to prefer coverage that enables them to pay as many bills as possible with untaxed rather than after-tax dollars, thus accounting for the ubiquity of coverage that effectively insulates patients from the cost of the services they consume. U.S. health coverage has been primarily designed, not to provide optimal insurance against unpredictable risks, but to exploit a tax loophole that, because it affects payroll as well as income taxes, is lucrative for all earners.

The second vice of the tax subsidy is less widely recognized. By making employers responsible for designing or selecting health coverage and effectively hiding most of the cost of that coverage from employees, the tax subsidy has induced employees to believe that their health coverage is paid for mostly by their employer, not themselves. The irony here is that, unlike the insulation patients enjoy against the cost of care they receive, the insulation of employees against the cost of their health coverage is only apparent, not real. Economists are virtually unanimous in holding that, whatever their pay stubs may say, employees bear the full cost of their coverage in the form of reduced compensation of other kinds. Although employers and labor unions have happily claimed credit for the rich health benefits conferred on workers, their apparent beneficence has been financed by diverting dollars from the workers’ pay envelopes. Insulating employees from the truth about who pays for health coverage (now over $11,000 per year for the average family) has spawned the kind of coverage that Kling appropriately deplores.

The final — and, to my mind, most destructive — vice of the tax subsidy is its effect on the political economy of health care. With insured consumer-voters generally believing that someone other than themselves is paying for their health care, they see no reason not to approve regulatory and other public policies that raise the cost of that care and foreclose opportunities to economize. For example, consumers’ backlash against managed health care in the 1990s, though partly attributable to the ineptitude, dishonest marketing, and opportunism of managed-care organizations, resulted in large measure from consumer-voters’ failure to appreciate that MCOs were performing a useful service in keeping costs under some control. The surge in health care spending after employers and legislatures joined the public backlash by discouraging MCOs’ cost-containment efforts was an ironic consequence of public ignorance about who ultimately bears the cost of health care.

The tax subsidy thus introduces new “moral hazards” into health care decision-making. Not only are employers, union leaders, legislators, and courts happy to commit employee-voters’ money in ways that make themselves appear to care about health above all things, but their stake in not having to say “no” to more and better health care also coincides perfectly with the preferences of the politically powerful health care industry. For these reasons, the tax subsidy has survived through political thick and thin even though every policy wonk knows that it is a principal cause of wasteful spending on health services. Liberals, of course, resist proposals to fix this glaring defect in the incentive system that drives health care spending. Why fix incentives to encourage consumers to make more appropriate health care choices when big government stands ready to choose for them?

The preference of liberals for a single-payer health plan notwithstanding, something approaching their goal of universal health coverage could be achieved by ending the current tax subsidy and offering refundable tax credits of, say, $6000 to families that spend at least that amount in health plan premiums or contributions to a health savings account (HSA). Although citizens would be free to go uninsured, those who do so would forgo the tax credit, thus in effect contributing funds to maintain the public safety net. Because the tax credit would not be sufficient in itself to buy the kind of insulating coverage to which Kling objects, the market should quickly supply products qualifying, more or less, as “real” insurance. Consumers wanting conventional coverage would have to spend after-tax dollars to get it.

Kling’s ideas for new kinds of health insurance — in particular his notions that coverage should have a time horizon longer than one year and that cash indemnities might replace payments for costs incurred — deserve to be fleshed out and tested in the marketplace. But the market should also leave room for those consumers who are fearful of taking too much responsibility for their own health care to choose comprehensive coverage by health plans that act as their corporate agents in purchasing care and in making difficult choices. Some plans would presumably be integrated with health savings accounts in order to keep track of high deductibles and coinsurance and to ensure that patients have funds available to pay for care that they desire but which is not covered under the plan’s contract. Some corporate health plans would not be insurers at all but would actually provide care through participating physicians who ration care according to the plan’s protocols or clinical guidelines. Kling’s criticisms of overly broad insurance should not be taken to preclude consumers from enrolling in comprehensive, integrated health plans of the HMO variety. Plans like the admirable Kaiser-Permanente system, which can efficiently provide care tailored to the preferences of particular consumer groups, should be encouraged, not discouraged. Integration of physicians into such efficient plans and significant quality improvements could both be fostered simply by making HMO-type plans legally responsible for their providers’ torts.

There is still room, I believe, for policy measures that encourage private health plans to drop their role as enablers of the public’s addiction to “premium medicine” and to become, at long last, efficient insurers against predefined risks. Public programs could then be redesigned either to emulate the private sector’s new economizing methods or, better still (assuming that some daunting practical problems can be overcome), to facilitate their beneficiaries’ enrollment in private health plans that compete to give consumers good value for money, not just easy access to standard medical care. But even though market-based reforms are still feasible, the mouths of big-government enthusiasts are watering once again at the prospect of “health reform,” just as they did in the early Clinton years.

Also from This Issue

Lead Essay

  • Insulation vs. Insurance by Arnold Kling

    In this month’s lead essay, Cato Institute adjunct scholar Arnold Kling draws from his book, Crisis of Abundance, to argue that the health coverage most Americans enjoy is not insurance at all, but what he calls “insulation.” “The problem with insulation,” Kling argues, “is that it is not a sustainable form of health care finance… Insulation leads people to over-consume health care services. Americans make extravagant use of services that have high costs and low benefits.” Kling explains how real health insurance would work, and how it would help solve the crisis in health care, and explores how we could transistion to a system over time institutionally and culturally in order to resolve the inconsistent demand for insulation and affordable, effective care.

Response Essays

  • Abundance Is Insulated from a Crisis—For Now by Matthew Holt

    According to health care strategist Matthew Holt, Arnold Kling is correct that consumer insulation from the costs of “premium medicine” is partly responsible for the rising cost of health care, but Holt dissents from Kling’s solution. Holt examines what he takes to be the three main strategies for dealing with “the insulation and overuse of medical care in the U.S.”: a nationalized “single payer system; a system of “managed competition”; and “individual consumer control of spending at the point of service.” Holt argues that the latter two options face deep problems, and that a nationalized single-payer system “is the likeliest outcome in perhaps a decade or so,” even it is not politically feasible at present. “Kling has provided a decent analysis,” Holt argues, “but has proposed a solution that both ignores the political and cultural realities of the health care system, and probably wouldn’t even work in theory.”

  • Yes, We Need Real Insurance … Real Social Insurance by Jonathan Cohn

    Jonathan Cohn, a senior editor at the New Republic, agrees with Kling that our current health care system doesn’t function according to the widely understood principles of individual insurance, but he doubts we’d do better at fighting rising costs and maintaining quality if citizens with “real” insurance were free to take price into account in their choice of care. “We have precious little evidence to believe that people can distinguish good care from bad care,” Cohn writes. And the notion that consumer choices will improve over time is, according to Cohn, “a lovely idea, but one that seems highly dubious.” Cohn argues that we need a broader notion of insurance — social insurance — to shield people not only against unexpected illness and harm, but against “genetic and economic bad luck.” Cohn argues that many nations do just fine in managing the cost/quality tradeoffs inherent in a state-controlled system of universal coverage, and that Americans would be happy with such a system “if only they knew how those systems really worked.”

The Conversation