1. 2. 3. There Aint No Such Thing as a Free Lunch 4. 12. 13. 14. 15. 16. 19. 16. 19. 16. 19. 16. 19. 16. 19. 16. 19. 16. 19. 20. 21. 22. 23.

There Aint No Such Thing as a Free Lunch

24. 25. 26. 30. 26. 30. 26. 30. 26. 30. 26. 30. 26. 30. 26. 30. 31. 32. There Aint No Such Thing as a Free Lunch

Saturday, December 15, 2012

What Should be Done about the Fiscal Cliff

Everybody in the media seems to be talking about the fiscal cliff- the likely impact of the expiration of the Bush tax cuts and the planned cuts in government spending that are part of Budget Control Act of 2011. People are right to be concerned about it. Much discussion about the fiscal cliff, and its likely consequences, however, is misleading. The media have emphasized how a tax increase or cut in government spending will reduce overall spending in the economy so that firms have to cut back production and lay workers off. We should be much more concerned about how the fiscal cliff affects investment and entrepreneurship than how it affects aggregate spending.  This is why allowing tax rates to rise, especially on the rich, will do more harm than good. 

Republicans and Democrats claim that they want to reduce the government deficit, which would require some combination of tax increases and government spending cuts. Many are convinced, however, that both the government and families need to spend more to bring the rate of unemployment down. If taxes are increased, households and businesses will reduce their spending. This reduction in private spending, especially if it is combined with a reduction in government spending, may cause a recession.

Although increasing taxes and cutting government spending may have negative short run effects, a more fundamental question is how can the US economy return to a faster long run rate of growth that will make it possible for the millions who are now unemployed to return to work. Contrary to popular belief, the primary reason for the poor performance of the US economy is not that Americans are spending too little. It is rather that businesses are not investing enough in capital equipment and are not willing to hire people because of uncertainty about the future of the economy.  Reducing government spending and borrowing, particularly if the spending cuts are permanent and not temporary, may actually give people greater confidence to invest and start businesses. 

The biggest problem with raising taxes is not that people will spend less.  Higher tax rates influence the incentive to work and invest.  If entrepreneurs and investors expect the government to take 40 cents or more out of every additional dollar they earn, many are going to be less inclined to take the extra risks associated with expanding their businesses and hiring more workers. If, however, the government were to increase its tax revenue by eliminating loopholes in the tax code, the incentive to work and invest would be affected much less than by an increase in tax rates. Certain provisions in the tax code, like the mortgage interest deduction, reward people for doing things that do not help and may actually hinder the long run growth of the economy.  Incentives are the key to a healthy economy, so tax increases are most harmful if they reduce incentives to work and invest, which happens when government requires workers and investors to pay a higher percentage of each dollar earned. 

Why can’t the two sides compromise for the sake of being fiscally responsible- combining moderate tax rate increases with spending cuts?    The debt of the federal government is so large that the token spending cuts being considered by politicians of both parties will do little to prevent government bankruptcy. If the federal government used accounting standards that businesses use, it would count all of its unfunded liabilities, which increase by $11 trillion a year and total more than $200 trillion, as part of the debt. The reported federal government debt excludes trillions of dollars of unfunded Medicare and Social Security benefits that workers expect to receive when they retire in exchange for the taxes they paid during their working years. If a compromise could be reached that involved cuts in promised Social Security and Medicare benefits large enough to make those programs sustainable, it might be worth considering.

A tradeoff exists between short term stimulus of the economy and long term growth. It may be that cutting government spending would slow the growth of the economy in the short run, but that is not a foregone conclusion.  The resulting reduction in government borrowing would mean that more of the money people save would be available to finance private investment.  Increased investment would lead to more and higher paying jobs.  

Continuing to postpone taking steps to drastically reduce government spending, though it may modestly help the economy in the short run, is not the answer. Raising tax rates, however, will do little to address the long run debt problem of the US government and may just make it easier to delay needed spending reductions.  Limiting the share of income taken in taxes and cutting government spending will encourage firms to invest in capital and hire more workers, especially if combined with steps to roll back some of the recent increases in regulation of health care and the financial system, which have contributed so much to uncertainty about the future.

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Sunday, September 18, 2011

To be sustainable, Universal Health Care requires rationing

Critics of the Patient Protection and Affordable Care Act (ACA) claim that it does not do enough to control costs, particularly costs of government health care entitlements. This criticism is not entirely justified. The Affordable Care Act includes several provisions for controlling health care costs. Those provisions to control costs will probably not be fully implemented because of a fundamental contradiction between the healthcare system many Americans want and economic reality.

One of the most important steps taken to control costs was the inclusion of a plan to create an Independent Payment Advisory Board (IPAB), which is to consist of fifteen full-time members appointed for staggered six-year terms. The IPAB must provide a report to Congress about how to hold Medicare spending within legislated limits. Congress is given a strict timetable within which it must consider the board’s recommendations and vote on them or come up with alternatives that achieve comparable savings.

If all low and moderate income Americans are going to enjoy access to subsidized health care as envisioned by the ACA, then the government needs an organization like the IPAB to control costs. Without such an organization or if Congress does not give it enough power, Medicare costs will continue to rise to unsustainable levels. A similar approach is needed to control Medicaid costs.

It is doubtful that politicians would give the IPAB enough power to control costs like many of its proponents intended. Politicians in both parties are calling for repealing or weakening the IPAB. This is because to be successful the board must make some tough choices to limit the most costly and least effective kinds of care. Most likely, this would require some method of rationing health care, although officially the IPAB is forbidden to make recommendations that would result in “rationing”, raise premiums or increase the share of health care costs borne by patients. Few Americans would tolerate having their freedom to consume as much health care as they want restricted by rationing.

Those who support “universal health care” without also recognizing the need to use some method to ration health care are living in a dream world. In practice, universal health care requires that no one is denied access to basic health care because he or she cannot afford to pay the cost of that care. This means that prices will not be used to ration care. Because health care is a scarce good, some other rationing criterion must be used instead of prices. In some countries, such as the United Kingdom, health care is rationed by having people wait their turns, with the result that some illnesses become untreatable before the patient can get the necessary treatment. For example, because of delays for colon cancer treatment in Britain, twenty percent of the cases considered curable at the time of diagnosis become incurable by the time of treatment.

Many Americans want the benefits of a free market system and the benefits of government subsidized “universal” health care at the same time. In a free market, anyone can consume as much health care as he or she is willing to pay for. When it subsidizes health care, government enables people to consume more health care than they are willing to pay for. Hence, health care costs continue to rise until government can no longer afford to pay it share. Even without health care reform, the cost of government health care entitlements including Medicare, Medicaid, and the Children’s Health Insurance Program are rising to unsustainable levels.

If the federal and state governments are going to continue to be able to meet their financial obligations, government spending must be brought under control. If current trends continue, the Congressional Budget Office estimates that by the middle of this century, spending for health care entitlements will be more than half of all spending by the federal government. Thus controlling government spending requires reducing government spending on health care. This means that politicians must either abandon the attempt to guarantee universal access to health care for Americans as exemplified by the ACA or grant an organization like the IPAB the powers necessary to control health care costs. This would most likely involve some method of rationing health care. Expanding access to health care without cost control will hasten the bankruptcy of the US government. If that happens, many fewer people will have access to health care than was the case even before Congress passed the ACA.

Unfortunately, Americans value their freedom too much too permit a government agency to have the power necessary to control health care costs. Thus if the ACA’s provisions to expand access to health care survive, the US government will likely face a sovereign debt crisis making it difficult for the government to afford providing even basic services without tax increases that would severely hinder incentives to invest and hire people.

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Tuesday, July 19, 2011

The Affordable Care Act will not achieve its goals

Many of the goals of health care reform seem laudable. Proponents of health care reform want health insurance to be available to all Americans with premiums unrelated to a person’s health status. In addition, they want to make health insurance affordable for everyone regardless of income or employment status. They hope to lower health care costs through better information and accountability. They also claim that the above goals can be achieved with small increases in government expenditures that can be offset by modest targeted tax increases. If these goals were attainable via the provisions of the Patient Protection and Affordable Care Act (PPACA), it might deserve our support.

Not only are many of the goals that led to the PPACA appealing, but economic principles played an important role in how it was designed. For example, the Obama administration decided to include an individual mandate as a way to overcome the economic problem of adverse selection. In short, if government requires insurance companies to provide insurance to those with existing health problems for the same price as those who are healthy, most healthy people will choose not to purchase such insurance, raising the cost substantially for those who do. By requiring healthy people to buy insurance, and prohibiting insurance companies from setting rates based on health status, Congress intended to force healthy consumers to share some of the costs of insuring those in poor health, so that premiums in the aggregate are high enough to cover costs.

In spite of the efforts that went into its design, the PPACA will do more harm than good. Although it might reduce the premiums paid for insurance for those who are presently unable to afford health insurance, it will not come close to accomplishing the other goals listed above.

Insurance could become affordable for most of the uninsured via the subsidies included in the PPACA, but the amount spent on subsidies would likely far exceed the government’s cost projections, adding considerably to government deficits. The reason for this is that the subsidies likely would go to many more than those who are now uninsured. Subsidies in the Affordable Care Act are sufficiently generous for low and middle income workers that many companies and workers would benefit if firms drop health insurance coverage and the firms paid the required fine of two to three thousand dollars per worker for not offering insurance. The insurance premiums that firms would save by not insuring each worker are two or three times as big as the fine and companies can pass part of the savings to workers in the form of higher wages. As a result, moderate and low income workers would have more income left over after paying subsidized health insurance premiums though government insurance exchanges than if their employers provided their health insurance.

Not only will the PPACA cost the government more than anticipated, it will likely make insurance less affordable for those who do not get substantial subsidies to buy insurance from government exchanges. This is because, in spite of the mandate, many healthy people will choose not to buy health insurance and pay the penalty, which is a function of income, but no higher than $2250 per family per year. Thus those who buy insurance will be sicker than average and many will wait until they get sick to purchase insurance. Premiums will rise to reflect the higher health care costs of those who purchase insurance, making insurance too costly for people with good health who do not qualify for government subsidies.

The problem with the PPACA is that in a world of scarcity a rationally devised formula developed and administered by government bureaucrats will not reduce costs and improve efficiency. Rather, costs of meeting health care needs will be more effectively controlled with decentralized decisionmaking in a market economy. In a market system, prices and quantities continuously adjust to coordinate supply and demand in light of the economic calculations of each market participant. The desire to consume alternative goods and services would constrain each consumer's demand for health care thereby limiting its market-clearing price. When government pays or mandates that insurance companies pay for health care, prices and quantities no longer reflect the economic calculation of each market participant. Instead of prices and the value of alternatives constraining their demand for health care as they would in a free market, consumers purchase health care with little regard to cost. The result is steadily increasing demand and prices for health care with more and more of the economy’s resources devoted to health care, and government expenditures rising unsustainably.

Since the PPACA will not achieve most of its goals and will increase the budget deficit much more than proponents have claimed, now is the time to redouble efforts to repeal it, either by the current Congress or after the next election.

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Wednesday, June 15, 2011

The Problem of Being Overinsured

One of the arguments for health care reform is that millions of Americans with employer provided health care are underinsured. Proponents of this view are saying that people are underinsured if they are paying too many of their health care costs out-of-pocket. A little reflection on what insurance is and is supposed to do suggests that the problem is really the opposite- many, if not most Americans are overinsured- they have too much health insurance coverage.

On what basis can I claim that Americans have too much health insurance? The purpose of insurance is to protect people from risk. Private companies offer affordable insurance against losses from automobile accidents, accidental death, fires, storms, and floods, among other things. These kinds of insurance arose in response people’s willingness to pay for a contract that will compensate them for losses due to a relatively low probability event over which the insured party has little or no control. Yet, unlike other kinds of insurance, most of what is covered by many health insurance plans does not fit this description. This is why so many people who do not have employer provided health insurance are either uninsured or purchase only catastrophic coverage.

The problem with many existing health insurance plans is that they cover the cost of routine treatment for illnesses, such as colds and flu that occur frequently or the cost of care for conditions, such as pregnancy, that are heavily dependent upon the choices of the person who is insured. Basic economics teaches that paying for routine treatment via a third party insurance company will raise the total cost of that treatment. This happens for two reasons. First the insurance company, as middleman between the consumer and the health care provider, has costs that must come out of what the consumer pays. Second, insurance that pays for routine care lowers the cost of each doctor visit to the consumer, thus increasing demand. Higher demand with a given supply means higher prices.

It does not matter whether consumers or employers pay health insurance premiums. The premiums are part of the cost of health care. Eliminating routine care from being covered by health insurance would mean premiums would decrease and employers could pass the savings along to their employees as higher wages. The average consumer would be better off as a result. If it were not for the tax deductibility of health insurance premiums, employers would not cover routine care and avoidable conditions as much as they do.

This is not to deny that many Americans do not have sufficient access to affordable health care nor that the inability of some to afford health insurance is something we should be concerned about. Although it does not make sense for insurance to cover the ordinary medical costs of child birth, treating chronic asthma, or flu symptoms, it may be a good idea to have insurance in case of complications resulting from childbirth or to cover hospitalization for pneumonia and other serious illnesses.

The best way to help those who cannot afford basic health insurance is not to require or subsidize the kind of comprehensive health insurance plans that most employers now offer. On the contrary, health care costs and the cost of health insurance that would cover life threatening illnesses and serious accidents would be considerably lower if the existing system of taxes, subsidies, and government regulations did not result in so many people being overinsured.

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Thursday, June 9, 2011

Controlling Health Care Costs when Government Pays

Government, as a purchaser of health care, has sought ways to control health care costs. One of the more effective approaches that helped bring Medicare costs down was the prospective payment system (PPS). Instead of paying hospitals for the services that they provide, under PPS, the government pays them per case. Medicare began offering a fixed payment for each patient admitted to a hospital based on a diagnosis related group (DRG) that the patient was assigned to.

Offering a fixed payment per patient has both advantages and disadvantages. A big advantage is that it offsets the incentive of doctors to provide additional services to patients when the marginal benefit is below the marginal cost. When the government or insurance companies pay doctors and hospitals for the services they provide, patients will usually agree to additional treatment recommended by their doctors, even if it is not cost effective. Many patients would not agree to additional treatment if they had to pay out of pocket. The prospective payment system has been quite effective at reducing the average length of hospital stays without any evident decline in the health of those treated.

One problem with paying a fixed payment for each case is that it fails to account for differences between patients within each treatment category. Each patient will receive the treatment that the government deems necessary for the average patient with a given health problem. Some patients may need more than the average while others need less. Offering a fixed payment also reduces the incentive of hospitals to compete on quality. Hospitals will have an incentive to pursue quality improvements that are accounted for by the government’s payment formula (such as changes that hasten patients’ rate of recovery). If they cannot charge the extra cost of a quality improvement to the government or an insurance company, hospitals will only pursue it if patients are willing to pay extra for it out-of-pocket.

When government or insurance companies pay for health care and limit their payments via a PPS system, covered patients need not get too few health services or inferior quality services provided they have the freedom to choose their doctor or hospital and to pay whatever PPS does not pay. In this case, patients could pay extra out-of pocket to get extra services or superior quality care if they value either more than the additional cost. By contrast, government payment will lead to some patients getting more health care or higher quality than they are willing to pay for. As long as a third party pays most of the cost of a procedure, some people will consume more health care than is consistent with their preferences. Although paternalistic arguments can be made for this approach, government lacks the information to account for all the factors that might justify giving priority to some patients over others in using scarce health care resources.

It is a good thing when government takes steps to limit health care costs as they have done with the PPS system, as long as patients are permitted to pay extra to consume more than the limited quantity or quality of service covered by the insurance or government program. There is, however, a fundamental problem with this approach, which is part of the reason why Medicare costs continue to rise so fast that Medicare appears to be financially unsustainable.

No matter how carefully a hospital is at diagnosing a patient when he is first admitted, hospitals often do not know ahead of time what sequence of treatments will be most effective for each particular patient. As a result, Medicare allows retrospective cost sharing based on treatment decisions hospitals make long after the initial diagnosis. It is often unclear whether a certain treatment is appropriate for a given patient. The more that Medicare allows retrospective cost sharing the greater the incentive of hospitals to err on the side of more intensive and costly treatment. As technology improves, hospitals also have an incentive to use more expensive treatments, if they can get reimbursed for the additional cost, regardless of how large or small the marginal benefit actually is.

Lacking a profitability constraint or even much of a budget constraint, government Medicare adminstrators have inadequate incentives to compare the marginal benefits of a more intensive treatment regimen with the marginal costs.

By contrast, if patients or their families were the ones paying for the treatment, they would have an incentive to make treatment decisions based on a comparison of anticipated marginal benefits with marginal costs. This would provide a much more powerful incentive to control costs than PPS provides, as it is currently administered by the government. The best way to control the costs of medical care for the elderly is to have patients and their families bear a greater share of the costs of medical care, since they are the ones most likely to make choices that will promote a cost efficient level of treatment.

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Thursday, May 19, 2011

The Case for and Against an Individual Mandate to Buy Health Insurance

A major concern with health care in the United States is that many of those who most need health care are unable to get health insurance- either because they would be charged higher premiums or not fully covered by employer plans, due to preexisting conditions. An important goal of health care reform was to make sure that all, regardless of the state of their health, could get affordable insurance coverage. Accomplishing this while maintaining some semblance of a private health insurance market is difficult.

In a free market, health insurance companies set premiums based on expected health care costs, and those costs will be much higher for people with poor health. While some employer plans continue to insure people whose health deteriorates, it is difficult for those with preexisting health problems to find a job or qualify for full health insurance coverage if they do.

If the government requires health insurance companies to cover everyone who applies without charging more for those with poor health, a problem known as adverse selection arises. Insurance companies will set a premium high enough to cover the average person who is likely to buy insurance from them. Given the choice, however, many people who are healthier than average will choose not to buy this insurance because they are unlikely to visit the doctor enough to justify the premiums they will have to pay. Almost everyone whose health is worse than average will perceive the premiums to be a bargain and will buy this insurance. The resulting below average health of those who choose to buy insurance will cause premiums to rise, making buying insurance worthwhile only for those in very poor health.

The problem described above can be overcome either by government providing health insurance for all at taxpayers’ expense or by mandating that everyone buy health insurance. The only way to sustain a private insurance market when companies are required to insure everyone without discriminating against those with preexisting health problems, is to mandate that everyone, especially those who are relatively healthy, must buy insurance.

Is it possible to have a system that does not discriminate by price based on preexisting conditions without some kind of individual mandate? The short answer is no. Hence the only way to guarantee affordable health insurance for everyone is to take away individual freedom. Although access to affordable health care may sound like a good reason for Americans to sacrifice some freedom, it is not. As I will discuss in future blogs, the argument that everyone should be able to purchase health insurance on the same terms is inherently flawed and does not hold up under careful scrutiny.

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Monday, January 10, 2011

Private Roads and Highways- Why not?

Since many states face a highway funding crisis, some state governments and the federal government are considering proposals to sell highways to private investors. This goes against the the conventional wisdom that roads should be built and maintained by government and funded by taxes. Conventional wisdom, taught in many introductory economics courses, is that roads are public goods. One definition says a good is public if the cost of excluding people who don't pay for using the good is unacceptably high. If someone builds a road with lots of access points it would be very costly to exclude people who do not pay for it from using the road.

When thinking about charging people to use roads and highways, most people think of tolls. Private firms can and do manage toll highways. Although tolls may work for a few limited access highways, the cost of collecting tolls from the driver of each passing vehicle would likely outweigh the benefits for most roads and streets, which have numerous access points that are close together. But this does not mean that it would be infeasible to privately operate such roads and streets. Tolls are not the only way to charge people for the benefits they get from roads. Residents and business owners could be charged a fee for access to the road or street on which their homes or businesses are located. They could also be required to purchase a license to drive on the roads within a given jurisdiction.

Modern electronic technology makes it possible to charge people for using roads and highways without costly delays associated with collecting tolls manually.Yet even without modern electronic technology, private roads and streets were much more common in the past than they are today. In Britain, roads and highways were built and maintained by monasteries during the Middle Ages. Guilds invested in the construction and maintenance of turnpikes as late as the eighteenth century. Approximately 10,000 miles of private turnpikes were built in the US during the early 19th century. Private investors abandoned most of these when competition from government subsidized canals and railroads reduced their ability to earn enough in tolls to cover expenses.

Most private turnpikes were not profitable for their investors. Investors were often local merchants who would profit from additional traffic attracted by turnpikes. Thus they were willing to invest even though revenues from tolls did not generate a decent return. Private streets were also common in some US cities during the 19th century. Private streets were not supported by tolls, but by an assessment on residents located along the streets.

The paucity of private roads cannot be taken as proof that such roads would not be built in the absence of government subsidies. Few private highways exist because they cannot compete with government subsidized highways. Given the choice between paying a toll to drive on a private highway driving on a government highway at no charge, most drivers would rather drive on government highways than private highways, even if private highways were better quality and had less congestion.The result is a very inefficient system of roads and highways that are more costly than necessary with serious congestion problems in many cities.

Without competition from free highways subsidized by the government, people would be willing to pay to use highways. If the system of roads were sold to private entrepreneurs, they would find creative ways to fund them, just as they did at various times in the past. Whether it be local community associations or merchant associations who collect a fee from their members in exchange for building and maintating roads, or corporations who limit access to expressways and charge toll, people will pay for the use of roads and highways because they value mobility. Furthermore, expressway congestion could be reduced or eliminated by charging drivers prices that vary to reflect the scarcity of highway space during different times of the day. The revenue earned could be used to expand highway capacity in the most heavily traveled routes, thereby enhancing mobility, which in turn promotes widespread employment and prosperity.

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