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Should Governments Subsidize Health Insurance?

Obamacare

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The Obama administration and the Democrats in Congress have made “reform” of the U.S. health insurance system one of their top priorities.   The stated goals of this reform are covering the uninsured and slowing the growth of health care costs.

Critics of ObamaCare focus on the negatives it might generate, especially higher taxes and rationing.  Many also question whether it will in fact bend the healthcare cost curve.  These concerns are well taken, but they are just the tip of the iceberg.  The ideal “reform” is not creation of a new government health insurance program but elimination of existing programs.  Here’s why.

The standard argument for subsidizing health insurance holds that applicants for insurance know whether they are healthy or unhealthy, but insurers cannot tell which applicants are which.  Under this “asymmetry of information,” insurers must offer the same premium to everyone, but then only the unhealthy want to purchase insurance.  This “adverse selection” of applicants means private insurance might not arise or might only serve a portion of the market.

To address this problem, government can force everyone to purchase insurance at the actually fair price.  Then no adverse selection occurs, and insurance programs balance financially.  This approach requires government to subsidize insurance because some people cannot afford it on their own.

The adverse selection story thus suggests that a mandate plus subsidies might enhance the efficiency of the health insurance market.  The reality, however, is different.

To begin, the assumption that consumers know their own health better than insurers is problematic.   Insurers can determine a consumer’s health by requiring standard medical exams, and with modern medical technology insurers can readily determine which health and other characteristics forecast future health expenditures.

Absent regulation or subsidy, therefore, private insurers would offer coverage to everyone, but they would set higher premiums for unhealthy applicants.  Many people view this as unfair, since it means those born “with bad genes” suffer financially, other things equal.

Yet subsidizing health insurance is not the only way to help people unlucky enough to have poor health.   Instead, policy can transfer enough cash to enable everyone to purchase health insurance.   The unhealthy would still be worse off than the healthy, since they would face higher prices for insurance, but the cash transfers would minimize the impact of bad health on their material well-being.

In adopting this approach, policy would be treating health status the same way it treats all other elements of luck (IQ , athletic ability, parent quality, country of birth, or race) that determine a person’s “effective income.”  This approach also recognizes that social insurance can moderate the impact of luck without huge costs, but if it tries to even out all differences in circumstance, it will destroy private effort and innovation.

Thus, reasonable social insurance does not require mandated or subsidized health insurance; it can consist entirely of cash transfers.  And the cash approach is superior because providing health insurance is disastrous for the efficiency of health care markets.

The crucial negative is that subsidizing insurance exacerbates moral hazard: the tendency for people to change their behavior once insured.  Moral hazard in the health care market has two sides.  Patients do not pay the full price of health care, so they demand more.  Doctors know patients do not pay the full price, so they recommend excessive tests and procedures (in part to protect themselves against malpractice liability).

The moral hazard created by insurance is inescapable, and subsidizing insurance makes it worse by encouraging consumers to purchase generous coverage.  Private insurance moderates moral hazard with co-pays, deductibles, coverage limitations, and contract features, but government programs often exclude these.

Subsidizing insurance also means that government must sets prices at which it reimburses health care providers. As technological progress raises medical costs, however, expenditure on these programs swells and puts pressure on government budgets.  Governments responding by setting lower prices at which they reimburse health care providers, which causes rationing, fraud, creative billing, and other non-productive behavior in the health care system.  The price controls also kill innovation.

As in medicine, the first rule of policy should be, “Do no harm.”   Redistributing income in the form of health insurance has no compelling justification and large costs.   This means that instead of expanding government health insurance, policymakers should phase out existing government programs like Medicare and Medicaid.

Policymakers could also improve the quality of the health care system by eliminating other pre-existing, counterproductive policies.   The three most obvious are barriers to entry in practicing medicine (e.g., professional licensure for doctors), the excessive development costs for new medicines created by the Food and Drug Administration, and the subsidy for purchase of private insurance implied by the exclusion of employer-paid health premiums from taxable income.

By reigning in existing bad policies – rather than creating new ones – policy makers could restore sanity to the federal budget and guarantee more affordable health care for all.

About Jeffrey Miron

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Jeffrey A. Miron is an Economics Senior Lecturer and the Director of Undergraduate Studies in the Department of Economics at Harvard University. He is also a Senior Fellow at the Cato Institute and author of ”Libertarianism, from A to Z”.

2 comments

  1. avatar

    I’ve been on this for years. What we have is more along the lines of corporatism, not free market nor socialism. This whole bill is a lobbyist steak feast, and the politicians, through inflationary taxation from the Federal Reserve, help fuel this debt piled heap of wrench. It is a shame to watch the end of America, amazing I was born in these times….

    Just imagine what humanity will look back and say 100,000 years down the road when the non aggression principle is finally realized. Great article!

  2. avatar

    The real issue for me here is the constitutionality of such a measure. We all know based on Nancy Pelosi’s “are you serious” statement that any objections based on constitutional grounds are irrelevant and footnotes in the debate. However I ask myself “what is so dire that even with such strong resistance, a draft must be passed?” We are truly living in evil and questionable times. The debt burden must be met at some point, should this measure pass in its entirety I am positive that future generations will burn for this disastrous government intrusion.

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