How Government Screws Up the Health Care System

How Government Screws Up the Health Care System. Professor Dwight Lee has an excellent column in Investor's Business Daily explaining how government subsidies increase the total cost of health care by reducing the out-of-pocket cost for consumers:

Government expansion of the medical system has increased health care costs because it has ignored the distinction between marginal and average costs of health care. ...Government expansion in medical insurance, while claiming to reduce costs, has consistently increased the average cost of health care by reducing its marginal cost. The marginal cost has been lowered with a combination of government subsidies and low-deductible health insurance, leaving direct payment for additional insurance an ever smaller percentage of the total cost. As the marginal cost for medical insurance declined, individuals quite rationally gave less thought to cost and consumed more medical care. Of course, this drove up the average cost of medical insurance, most of which was being paid for with increasing taxes and premiums. But people recognized that their extra consumption had no noticeable effect on their taxes or insurance premiums. They also knew that any savings in taxes and premiums resulting from shopping more carefully would be captured almost entirely by others. So while people complained as average costs increased, they continued making their medical decisions in response to lower marginal costs. Politicians respond to public complaints about increasing medical costs, but they invariably do so by trying to disguise the costs with more subsidies and convince voters that any costs not covered by reductions in waste and fraud will be paid with higher taxes on the rich. The medical plan receiving the most attention in Congress is no exception.

Professor Lee specifically shows how the government's tax preference for employer-provided care has distorted the health care market - especially for insurance. Unfortunately, he notes, the President's plan makes a bad situation even worse:

The right reason for taxing the value of health insurance is that leaving it untaxed motivates people to pay for medical care with before-tax dollars by purchasing low-deductible policies through their employers. While this makes sense for each employee, it guarantees higher average medical cost for everyone by reducing the marginal cost paid by most Americans — those with employer-provided health insurance. Taxing health insurance would eliminate the tax advantage of low-deductible policies. The shift to high-deductible policies, with lower premiums, would confront people with higher marginal medical costs and motivate more cost-conscious medical decisions. This would reduce the average cost of health care and lead to further reductions in insurance premiums without government mandates and rationing. Unfortunately, Obama's sudden interest in taxing employer-provided health insurance is motivated by the desire to finance the large increase in subsidies central to his medical plan. By lowering the marginal cost of medical insurance, these subsidies would offset the cost-reducing effect of taxing employer-provided health insurance. If Obama really wants to lower costs in ways consistent with consumer choice, and also stimulate economic activity, he should recommend taxing health insurance and using the revenues to reduce marginal tax rates. This would result in two marginal changes that would generate improvement in economic productivity. First, higher marginal costs for medical insurance would reduce the average cost. Second, higher marginal returns to creating wealth would increase prosperity.