The incentive structure of our present health care system is fundamentally flawed, and the legislation signed by President Obama will exacerbate the problem. It will increase what we spend on health care, or lead to rationing, or both. Perhaps most important, it will undermine the self-reliance and character of the American people.
The only prudent response to Obamacare is to repeal it, and then move on to real reform. Fortunately, a simple, market-based, incremental, bottom-up approach to reforming our health care system is possible. Unfortunately, nobody in Congress has yet proposed it. Someone should. A bill of less than 100 pages would suffice to address the three big problems: surging cost, uncertainty about maintaining insurance coverage, and the uninsured.
Bending the cost curve—for real
President Obama claims we’re “bending the cost curve,” but it is hard to see how medical costs will be reduced with a massive new entitlement, a few minor pilot programs, and future cuts in Medicare at which Congress will surely balk when the time comes.
The only way in which Obamacare, or a revision of it, will be able to control costs is through some kind of rationing. Nobody likes rationing, but one cannot avoid it if one believes that ultimately people should not have to pay for their health care. For those who think people can and should take care of their own necessities, however, there is a better way of getting control of costs. Instead of establishing a bureaucracy above consumers and/or producers to dictate what they may consume and/or produce, we should strengthen the link between consumers and the cost of what they consume.
The rational way to control health care costs can be summarized in one phrase: Level the playing field. If all health care expenditures are put on a level playing field with regard to taxation, the market will naturally begin to control costs, as it does in other sectors of our economy.
Health care differs from other products Americans consume, including necessities like food and shelter, in the degree to which consumers are shielded from paying for what they consume. It does not take peculiar insight into human psychology to suspect that people are more careful about the cost of what they consume when they pay for it themselves.
Of course people often cannot pay for health care they need. Likewise, people often cannot pay for a new house if the one in which they live burns down. That is why we have insurance. Health insurance, however, works in a peculiar way, unlike any other form of insurance. Instead of protecting us when we face potentially catastrophic costs, health insurance policies usually cover most or all health care costs. They do not simply insure against catastrophe, but also pay routine expenses which we could easily anticipate and budget for. It is as if we filed a claim on our homeowner’s insurance every time we needed to paint a room, or even change a light bulb.
This approach creates huge administrative costs—not just in money but also in time, the hours and hours consumers and especially providers spend in dealing with insurance companies. (If you think this situation is bad now, wait until the government is your insurer!) Moreover, and perhaps more important, shielding the consumer from the cost of what he consumes means that people shop less intelligently and frugally than they could.
My family of four paid $5,063 in health care costs in 2008. That includes everything: dental, prescription drugs, yoga classes (for lower back pain), and our health insurance policy, which was $2,380 for the year. Our policy has a very high deductible ($10,000), so for the most part we pay our costs out of pocket. We approach insurance as insurance—protection against catastrophe—not as an expensive and bureaucratic middleman whom we hire to pay our bills. This encourages us to consume carefully. My wife and I try to avoid unnecessary procedures and visits to the doctor. We shop around and choose our providers, and they are happy to serve us, since we pay what they ask and they don’t have to haggle with our insurance company. All four of us are in good health, and my own quality of life is enhanced by confronting very little health care-related paperwork.
Amazingly, Obamacare will probably make it impossible to purchase the sort of policy my family has, through its requirement that insurance policies maintain a minimum “actuarial value” of 60 percent. This means that insurance must cover at least 60 percent of the total medical expenses incurred by a “standard population” with such a policy. At this point nobody knows exactly what a “standard population” is or how the phrase will be interpreted, but our policy probably will not come close to meeting this requirement, since most of the time people with such a policy pay their medical expenses out of pocket, and their insurance covers them only when something bad happens. Under Obamacare my family will therefore be forced to spend much more on insurance, and with less of what we spend on health care coming out of our own pockets, we will have less incentive to shop frugally than we do now. This is one of many ways in which Obamacare will indeed “bend the cost curve,” but in the wrong direction.
Of course many people cannot afford $10,000 in out-of-pocket expenses. Most Americans, however, can afford $1,000 or $500. Even deductibles at this level would cause a huge reduction in administrative expense and more intelligent consumption of health care. Some people do have policies with deductibles in this range, but more common are policies with partial co-payments up to a certain amount, which do not produce the same incentive to limit spending. We all tend to feel we should take advantage of something if we don’t have to pay the full price for it.
The current system encourages us to feel that we shouldn’t have to pay for our health care, that our insurer or employer or the government should do so. This elaborate cost-shifting is hugely inefficient, and if we take into account its indirect effects (notably lower wages), we are much worse off because of it. But this raises an obvious question. If having a high-deductible policy where one pays most expenses out of pocket enables people to spend less for equivalent or better care, why don’t more people do it? Why has the market produced the system we now have? The answer is the preferential tax treatment given to employer-provided health care. Employers pay their employees’ health care costs with pre-tax dollars, so employers and employees have an incentive to agree upon complete coverage through employer-provided insurance rather than higher wages on which employees must pay taxes.
One policy change our country needs, therefore, is to end the preferential tax treatment given to employer-provided health care. In 2008 John McCain proposed one way of doing this: by eliminating the deductibility of employer-based health plans. This proposal did not exactly catch fire with the electorate. Another way of doing it would be the opposite: by extending deductibility to all health care purchases—of health insurance, the services of licensed practitioners, and medical products, whether by corporations for their employees or by individuals for themselves and their families. This would be much fairer than the current system to people whose employers don’t offer insurance, and it would give them an incentive to buy insurance on their own.
Once all health care costs are on a level playing field with regard to taxes—deductible from both income and payroll taxes—people will no longer have an incentive to buy, or to seek from their employers, insurance policies that cover every routine procedure or trip to the doctor. They will start to shop around, both for cheaper insurance and for providers who offer good value and whom they trust. Every consumer of health care will have a personal interest in controlling costs.
How would this work? For the most part, the current system would remain in place. The only immediate change from health care providers’ point of view is that every year at tax time they would send their patients a summary of all expenses the patients had paid out of pocket. This would enable taxpayers to determine the deduction they should claim in calculating their taxable income. People would be reimbursed for any income, Social Security, or Medicare taxes paid in excess of what they owe once their health care costs are taken into account, and they would be reimbursed for the employer’s portion of the excess payroll taxes they have paid as well as their own share. Thus a couple with an income of $90,000 who paid $8,000 for health insurance premiums and out-of-pocket health care expenses would owe income and payroll taxes on $82,000, not $90,000. Any payroll taxes withheld on that $8,000 would be reimbursed as part of their federal tax return.
Employer-established health savings accounts (HSAs) resemble the approach proposed here, and could work well in tandem with it. Regrettably, individually established HSAs do not currently provide deductibility with regard to payroll taxes. As a result, someone who exchanges his employer-provided coverage for higher wages, buys an inexpensive high-deductible policy, and sets up an HSA to pay insurance premiums and out-of-pocket medical expenses may well end up losing money overall because of higher payroll taxes even if he spends significantly less on health care.
One might wonder how expanding the deductibility of medical expenses can reduce overall medical spending. After all, making consumption of something tax-deductible generally increases the amount of it consumed. To be sure, expanding deductibility will increase health care spending by those who are currently uninsured, but probably by only a modest amount. With less income, uninsured people are less sensitive than other Americans to tax breaks. But to the extent that this approach does increase health care spending by the uninsured, at least outside of emergency rooms, that is probably a good thing.
The critical question is, how will this approach affect health care spending by the majority who currently have insurance? I believe it will reduce such spending through the incentive it will provide people (and their employers) to move from employer-provided complete coverage into inexpensive high-deductible policies. The clearest evidence for this comes from employer-established HSAs. In Indiana, for example, Governor Mitch Daniels established for state employees an HSA option with an inexpensive high-deductible insurance policy in 2006. Since then total health care costs have declined 35 percent from the level incurred under the old plan, savings that have been shared by the state and its employees. These savings have arisen above all because people shop prudently when spending their own money. For example, Indiana state employees on the HSA plan are much more likely to request generic drugs to fill their prescriptions; this produces substantial savings with no diminution in the quality of care.
Imagine that instead of individuals deducting their mortgage interest, only employers could do so on behalf of their employees. Employers would then offer as a benefit to pay their employees’ mortgage interest. People would still be constrained by the cost of housing and other factors, but the fact that the mortgage interest was paid by employers would encourage people to consume as much mortgage interest as their employers offered. This would produce more overall spending on housing than the current system, where mortgage interest is deductible, but the employee himself pays for it. If the approach proposed here resembles the deductibility of mortgage interest, the current health care payment system resembles having employers pay mortgage interest.
Portability the natural way
People want “portability,” meaning they want to keep their health coverage if they change jobs or lose their jobs. Congress has addressed this issue—notably in 1996—but a few people continue to fall through the cracks, and many more are afraid they might. This is not surprising; as long as employers provide health care, there will inevitably be a conflict of interest between employees who want to be covered and employers and insurers who want to avoid the huge expense of covering people who come to them with “preexisting conditions.”
Democrats hope to solve this problem by compelling insurers to write policies for all applicants, including those with preexisting conditions. That sounds humane, but as many have noted, it creates an incentive for people to buy insurance only after they develop a serious ailment. It is one thing to require that insurance companies retain customers who develop health problems; this is the essence of insurance protection. It is quite another to require (as Obamacare does beginning in 2014) that insurance companies take on new customers who already have costly health problems, which will force premiums up for everyone else. Obamacare imposes penalties on people without insurance, but this seems unlikely to solve the problem; the incentive to game the system is too great.
The rational response to the portability issue is not to impose unfair and costly new rules, but simply to eliminate the tax incentive for people to get health care through their employers. Once the playing field is level with regard to taxation, the desire for portable coverage and control will lead people to buy their own policies, instead of seeking employer-provided insurance in exchange for lower wages. Another factor leading in this direction will be people’s awareness that they can spend less on health care, and increase their net income, by buying insurance policies with low premiums and high deductibles. Removing the tax incentive for people to get health care through their employer is the way both to reduce costs and to foster portability of coverage.
In light of how frequently Americans change jobs, it is bizarre that most of us get our health insurance through our employers. Obamacare will mandate, rather than replace, this inherently irrational system, by penalizing employers of 50 or more people who do not provide health insurance to their employees. It is hard to imagine a surer way to diminish freedom, efficiency, the responsibility of America’s citizens, and the number of jobs our economy creates.
Our aim instead should be a system where people buy their own policies as young adults and maintain those policies throughout their adult lives, at least until they become eligible for Medicare. Their employers should have nothing to do with it—or no more than providing an HSA contribution which the employee controls and through which the employee himself buys insurance. The portability of health insurance will then be a matter of course, as is the portability of car insurance or life insurance. This will not be achieved overnight (and in the meantime state high-risk pools will continue to address the problem of pre-existing conditions), but eliminating the tax advantage of employer-provided coverage will gradually move people in this direction.
Of course there will still be some people who don’t seek insurance until they develop a costly medical condition. Once insurance is separated from employment, however, people in this situation will clearly have behaved irresponsibly. While we are not going to let such people perish without medical care, we should by all means let them spend their own money rather than subsidizing them by requiring insurance companies to write affordable policies for them. If a person in this situation is forced to spend all his assets and turn to Medicaid, so be it. Such a person is in the same situation as somebody who had no home insurance when his house burned down.
There is one rare situation that perhaps requires a different approach. A small number of young adults already have preexisting conditions. We as a society might subsidize insurance coverage for such people by requiring that insurance companies write affordable policies for any applicant under 21 years of age. This would force up the cost of health insurance for all purchasers and might have other unforeseen consequences, but it would not undermine insurance as we know it, as Obamacare will starting in 2014.
The true problem of the uninsured
The third problem that must be addressed is that of the uninsured. This problem, unlike the other two, will not largely be solved simply by leveling the playing field with regard to taxation. A level playing field will lead some people who are currently uninsured to buy insurance—those whose employers don’t provide it but who can afford a cheap, high-deductible policy on their own. It won’t significantly change the situation of the majority of people who can’t or don’t buy insurance.
But are such people truly uninsured? Any person in the United States who urgently needs medical care can be taken to the emergency room of a nearby hospital. It is against the law for a hospital to refuse treatment in such a case. And most U.S. citizens who cannot otherwise afford medical care are eligible for Medicaid.
These are not enviable situations, but they are a form of last-resort insurance. To put it another way, we have effectively legislated a guarantee of emergency health care for those who truly cannot pay. Forgoing health insurance is unwise for those who have assets to protect, such as their homes. For those who do not, however, and for whom health insurance is forbiddingly expensive, it is not obviously foolish to take their chances with the de facto insurance that our society provides. Even many young people from middle-class families postpone buying health insurance.
Megan McArdle noted in the March issue of the Atlantic Monthly that academic researchers have found “no significantly elevated risk of death among the uninsured.” I don’t think this is surprising (though McArdle professed herself surprised); nonetheless, one rarely hears any commentator, liberal or conservative, acknowledge that for many people, and not just the very poor, it may make sense to forgo health insurance. We avoid acknowledging this partly because of an uneasy awareness that if we don’t urge and prod people to buy insurance, they might not do so, and our health care system might go broke.
Indeed it might, but our reluctance to discuss the matter does little good. We face a problem of incentives that has the potential to spiral out of control. The cost of the social insurance we effectively provide through laws that forbid hospitals to turn people away is borne by taxpayers and those with health insurance. When the cost of that social insurance rises, it makes health insurance more expensive, so fewer people buy it. This in turn makes health insurance still more expensive, since more people are relying on the social insurance but fewer are paying for it. A vicious cycle can arise, and perhaps already has to some extent.
This is the true problem of the uninsured, and it will not be solved by moralistic prodding. It also will not be fully solved by subsidizing the purchase of expensive insurance plans by those on the lower half of the income scale, as Obamacare does. Given the social insurance we provide to those in need, what health insurance ultimately offers is not so much health care as asset protection, and many people on the lower half of the income scale do not have assets.
A better and much cheaper way to address the problem of the uninsured is to reward everybody whose purchase of health insurance helps pay for the social insurance our country provides. We could do this by replacing part of the standard deduction we currently receive on our income tax with a $1,000 per person deduction for those with certified health insurance policies. (It is critical that this deduction be established at a flat rate per insured person. If it varies with the cost of the taxpayer’s insurance policy, it will re--create the current system’s incentive to buy expensive and wasteful policies.) From a strictly financial point of view, this is the same as taxing those who have no health insurance; it seems more liberal, however, in the sense of liberality or generosity, and more American, to reward people who pay for the social insurance our country provides than to penalize people who don’t. After all, someone with assets who wishes to self-insure doesn’t benefit from that social insurance—the hospital will treat him in an emergency, but sue him later if he doesn’t pay the bill.
A uniform tax deduction per insured person would substantially reduce the number of uninsured people without creating new mandates or entitlements that change the meaning of being an American (and not for the better).
How does this idea differ from other market-oriented proposals? The heart of the plan put forth by John McCain in 2008 was the elimination of employer deductibility of health care costs, to be replaced with a $5,000 credit or voucher per family ($2,500 per individual) to be used for the purchase of health insurance. McCain called it a “tax credit,” but also indicated that it would be given to those who owe no taxes, so “voucher” seems a more fitting term.
This plan seems unsound and unconservative. Although it uses market mechanisms, it has the federal government pay for everybody’s health insurance. Thus, on the critical question of who is ultimately responsible for health care, the McCain plan answers: the federal government. (It is actually clearer on this point than Obama-care.) The conservative answer to that question is: People are responsible for their own health care. To be sure, we as a society help those in need. That is a humanitarian measure, however—a gift, not a right—and there should be a mild stigma attached to it. We don’t want anyone to die for lack of medical care, but neither do we want people to lose the sense that it is better for them to take care of themselves. That would be morally devastating for all of us.
Americans expect people who can take care of themselves to do so. That is part of what it means to be a citizen of a country in which we rule ourselves as adults, rather than look to the state to watch over us like children. Liberals tend to see equality as the basis for social comity—and there is some truth to that. Even more important, however, is mutual respect, which is undermined rather than fostered if the government taxes some in order to take care of others who are capable of taking care of themselves. In their eagerness to take care of others, liberals tend to lose sight of the degree to which happiness depends upon self-respect.
The McCain plan is also inefficient. It would eliminate any incentive to buy inexpensive insurance. If families are given up to $5,000 to spend on insurance, they will have no reason to spend less. By contrast, if people are spending their own money and saving what they don’t spend, the market can do better than $5,000 in insurance costs per family. (It has for my family.)
Congressman Paul Ryan has put forth a multipronged proposal which includes state exchanges to help people shop for health insurance, medical panels to reduce the burden lawsuits impose on medical practitioners, and measures to encourage preventing illness before treatment is necessary. Regrettably, however, the proposal’s central feature is a “tax credit” or voucher system that resembles the McCain plan. Ryan stands out for the clarity and cogency with which he criticized Obamacare over the past year, and he has emerged as the leading thinker in Congress on a wide range of fiscal issues. I hope he will reconsider and redesign his health care proposal.
Congresswoman Michele Bachmann has proposed a bill that would allow all out-of-pocket medical expenses to be deducted, not just those exceeding 7.5 percent of income (or, under Obamacare, 10 percent of income). This is a good idea, but it affects only income taxes, not payroll taxes. Similarly, Glenn Hubbard, chairman of the Council of Economic Advisers under President George W. Bush, and two coauthors proposed in the Wall Street Journal that we make all health care spending tax-deductible, but they did not specify whether this would apply to payroll taxes.
Conservatives may be wary of adding a deduction to payroll taxes when Medicare and Social Security are in dire financial straits. That is understandable; since most people pay most of their taxes in payroll taxes, however, it is impossible to level the playing field between employer-provided coverage and individually purchased health care if nothing is done about payroll taxes. Only leveling the playing field will allow the natural incentive to emerge for people to take control of their own health care costs, buy inexpensive insurance policies, and pay routine expenses out of pocket. Only such a system will lead people to shop intelligently and spend less, so that health care will consume a smaller share of the national economic pie.
My very rough estimate is that total deductibility of health care costs will decrease federal tax revenues by about $14 billion, with half of this figure coming out of payroll taxes. This seems a small price to pay for “bending the cost curve” without rationing and without a reduction in quality. In terms of the deficits confronting Medicare and Social Security, $7 billion is less than a drop in the bucket, and it might help us address the crisis facing Medicare if we first manage to “bend the cost curve” for health care costs apart from Medicare.
Here’s how that $14 billion estimate was reached. In 2007, according to the Census Bureau, 8.9 percent of Americans were covered by insurance policies purchased privately, while 59.3 percent were covered by employer-provided policies. The deduction for employer-provided health care cost the federal government $246 billion. Thus the cost to the government of insurance deductibility for Americans who buy their own policies could be estimated at 8.9 percent divided by 59.3 percent times $246 billion, or $37 billion. However, people who buy their own insurance generally purchase much less expensive policies than those whose employers provide insurance for them; and they have lower incomes. If allowed to deduct the cost of their insurance, therefore, they will deduct much less, and they will deduct from incomes that are taxed at a lower level. Thus the cost to the government of allowing complete deductibility of health insurance purchases will be roughly half of $37 billion, or $19 billion. Self-employed Americans are already able to deduct the cost of health insurance in calculating their income tax (but not their payroll tax). This deduction currently costs the federal government $5 billion, so the additional cost to the government of allowing complete deductibility of health insurance will be in the neighborhood of $14 billion ($19 billion minus $5 billion).
The approach proposed here will also allow people to deduct health care expenses that are not covered by insurance. In doing so, however, it will give people an incentive to buy inexpensive high-deductible policies and pay routine expenses out of pocket. From the point of view of tax receipts, the growth in deductions for out-of-pocket expenses and the decline in deductions for less expensive insurance policies will offset each other. People who move from employer-provided comprehensive insurance to inexpensive high-deductible insurance, moreover, will generally see their taxable incomes rise, benefiting both themselves and the tax collector. Taken together, these factors probably will not add to the $14 billion figure mentioned above. These are rough estimates, however; the Congressional Budget Office could offer more precise ones.
The core of the change proposed here is to level the playing field between employer-provided and individually purchased health care, and between health insurance and other health care expenses. Both of these steps are necessary; neither one alone will do much good. And we must level the playing field with regard to both income and payroll taxes. Addressing income taxes alone is inadequate. Complete deductibility of all health care expenses will “bend the cost curve” and foster portability, and a separate, additional tax deduction for people with health insurance will reduce the number of people who are uninsured.
This is a much simpler and more modest proposal than Obamacare. It does not involve new bureaucracies, or fundamentally new rules for insurance companies, or a mandate to purchase insurance, or a huge and costly new entitlement that diminishes individual responsibility. The proposal could, and should, be presented in a bill short enough for interested citizens to read. One might object that it would not immediately transform our health care system—but that is surely an advantage. Incremental change will work much more smoothly than top-down radical change and will have many fewer unintended consequences.
This approach will initially leave our current health care system in place, altering only the incentives people face. Employers and employees will start to look differently at the huge sums they spend on health care. Employers will begin to offer a variety of coverage options, including limited coverage or no coverage in exchange for higher wages. Employees will realize that they can get cheaper care, over which they have more control, and which is portable, if they buy it themselves. People will start to shop around, as they do in every other area of life, and figure out what sort of coverage works best for them.
This will have a beneficial effect not only on our national finances, but also on our national character. Self-reliant as we Americans are in many areas of life, we tend to act like children when it comes to health care, as if somebody else should be paying for us. Surely the chief reason for this is that somebody else is usually paying for us. The approach proposed here will put the matter in our own hands, where it belongs.
Peter J. Hansen is president of Hansen Capital Management, Inc., in Lexington, Virginia.