Limits of Tolling as an Answer to Highway Funding Problems

Making users pay directly for the highways they use is an idea whose time has come. One aspect of this is recent efforts to impose tolls on selected portions of interstate highways. Tolling express lanes on congested highways, such as the Capital Beltway around Washington, DC, has been a very effective way to earn revenue while providing lanes that are almost always free of congestion. By providing a source of revenue to finance construction of additional lanes, this arrangement can reduce overall congestion. General and widespread tolling of interstate highways, however, will not work well unless drivers get superior service in exchange for the tolls they pay or can be required, through some means, such as mileage based user fees, to pay for the miles they travel on competing highways.

Mileage based used fees are preferable to tolls on selected highways. With mileage based user fees, technology such as GPS could be used to record miles driven by each car. Drivers would pay directly for the miles they drive, whether those miles were on Interstate highways, arterial highways, or local roads and streets.  Prices could vary depending upon the highway and time of day with drivers paying more for premium services, such as congestion free express lanes or bridges across major rivers.

Implementing a system of mileage based user fees would require that vehicles be equipped with a device that would record mileage driven including some information about location of each mile, even if just the state. Tolling interstate highways could be part of a transition to direct user fees until a system of mileage based user fees could be implemented. But carrying out a transition to tolls would be difficult politically. Many drivers oppose tolls for interstate highways because they already pay for the construction and maintenance of those highways via fuel taxes.  Another problem with tolls, is that drivers could avoid them by using a parallel road or highway that does not have limited access. This will increase maintenance costs, the number of accidents and the amount of congestion on those parallel roads and highways.

With existing technology, it is easy to collect tolls for limited access highways, but much more difficult to charge direct user fees for other roads and highways. Yet interstate highways have a dedicated source of funding that, depending on the state, may not be available to fund local streets and roads.  States often give priority to interstate highways over local streets and roads in decisions about allocating revenue from federal fuel taxes. When drivers use alternate routes to avoid tolls on limited access highways, they may be using roads funded by cash strapped local governments through property taxes rather than by fuel taxes.

It is best to limit tolls to those highways for which comparable un-tolled alternate routes do not exist for most drivers.  Furthermore, it is inequitable to impose tolls on some interstate highways, but not others, as a source of additional revenue to fund all highways or transit within a given jurisdiction.  Beginning in 2007, the state of Pennsylvania tried to toll interstate 80 and use the revenue to fund other highways and public transportation in the state.  Local citizen groups objected strongly, and the Federal Highway Administration rejected the proposal on three separate occasions.

As a long-term solution to highway funding problems, mileage based user fees are equitable and offer the promise of more efficient funding and management of highways, particularly if the fees can be used to cover the cost of the particular roads and highways for which they are collected. As an intermediate step on the way to mileage based user fees, tolls are problematic because they can only be used on selected highways, leading to traffic diversion and an inequitable distribution of the costs of funding highways.  Tolls can and should be used selectively to allocate space on congested highways. But rather than trying to impose tolls on rural interstate highways, it may be better for the federal and state governments to continue using fuel taxes, while promoting a gradual replacement of fuel taxes with mileage based user fees.

Do we need a massive influx of federal money to fix infrastructure?

One dramatic example to illustrate the seriousness of the infrastructure crisis in the US is the recent problem with lead in the water supply of the city of Flint, Michigan. According to one estimate, fixing the entire water infrastructure in Flint so that everyone could get safe drinking water from their faucets would cost about $1.5 billion or approximately fourteen thousand dollars per resident.  Combining this with the needs of other cities and with work that needs to be done on transportation and other infrastructure, it is easy to see how Trump’s proposal to invest a trillion dollars in infrastructure could be justified.  Spending huge amounts from the federal government budget, however, is not an efficient or cost effective way to respond to infrastructure problems.

The prospects of solving infrastructure problems in a much more cost effective way can also be illustrated by considering the case of providing clean drinking water for the residents of Flint. This illustration is based on an article by Charles Marohn, recently posted on the Strong Towns website.

Marohn points out that “the primary function of the water system in your city is not — as is widely believed — to provide you safe drinking water.” The existing system in most cities including Flint, made up of eight-inch water pipes, was designed to provide enough water for fire-fighting. If the only purpose was to provide water for household needs like drinking and bathing, much smaller pipes would suffice. This is the approach used by rural water systems in some small towns and agricultural areas where clean well-water is not readily available. These smaller pipes make it possible to provide safe drinking water at a lower cost per resident than with conventional urban water systems.

Instead of replacing the entire water system in Flint, where many pipes may be able to last 20 years or longer, the city could build a less expensive parallel system of small pipes. The existing system of lead pipes could be left in place for fire-fighting purposes only. This is but one example of how innovative and unconventional approaches could be used to fix infrastructure for a lower cost.

In many cases, entrepreneurs could devise private innovative solutions that are much more cost effective for replacing and repairing infrastructure. When a pot of federal money is available, cities and towns focus their efforts on getting as large a share of that money as possible, not on finding low cost ways to fix their problems. If instead, cities had to pay most of the costs of fixing infrastructure themselves, they would have a much bigger incentive to find the most cost effective way to do so.

 

 

The Federal Reserve and Interest rate increases in 2016

Since 2008, it has been very hard to find a bank that pays any interest on savings accounts. This state of affairs can be blamed on Federal Reserve monetary policy, which  kept short term interest rates close to zero for seven years. After talking about raising interest rates throughout most of 2015, the Federal Open Market Committee finally raised the target level for the Federal funds rate by ¼ point on December 16. Many now expect the Federal Reserve to gradually raise interest rates so that by the end of 2016 the federal funds rate is close to 2 percent.

If the federal funds rate continues to rise, other interest rates will likely follow. Rising interest rates are good for those of us who have money to save, but will discourage people from borrowing money to invest, which is important for economic growth. Higher interest rates in the US also cause the foreign exchange value of the dollar to rise. Given the fragile state of the world economy, this could hasten the coming of a recession to the United States.

Some economists have criticized the Federal Reserve for its quantitative easing, the policy of buying government bonds and mortgage backed securities, which expanded the monetary base by more than five-fold between 2008 and 2014.  Quantitative easing played a major role in holding down interest rates during that time period. It does not follow, however, that the Federal Reserve can improve the economy by now pursuing policy that would raise interest rates toward levels that commonly prevailed before the financial crisis of 2008. Interest rates are low today, not because of current Federal Reserve monetary policy, but because most of the nations of the world are on the brink of a recession.

All interest rates are market determined. Interest rates depend on the supply and demand for loanable funds, which the Federal Reserve alters by buying and selling US government securities or mortgage backed securities. By expanding the monetary base, the Federal Reserve put downward pressure on interest rates. In the past year however, the Federal Reserve has not increased the monetary base. A stable monetary base and money supply should keep inflation rates close to zero, which is a good thing for anyone who is trying to save money.

The federal funds rate, which is the rate banks charge for lending reserves to each other, has been largely irrelevant since 2008, because almost all banks have excess reserves and thus do not need to borrow from banks. Nevertheless, it does move with changes in the interest rate the Federal Reserve pays on excess reserves. Since banks must decide how much of their reserve balances to lend, the rate paid on excess reserves will have an effect on the interest rates banks charge for business and consumer loans.

To further increase the federal funds rate in 2016, the Federal Reserve would have to pay a correspondingly higher interest rate on excess reserves, which would likely discourage banks from lending money. For example, to raise the Federal funds rate to 1 percent, they would need to double the rate they pay on excess reserves, and their interest costs would more than double if banks increased their excess reserves in response to the higher interest rate. Holding more excess reserves is a less risky way for banks to earn interest than lending the money to a business or buying Treasury bills.

Most other central banks, including the European Central Bank, the Bank of Japan and the Chinese central bank have been increasing the supply of their currencies. This is why the dollar has been rising relative to the value of other currencies and the inflation rate in the US has been close to zero. As long as the Federal Reserve continues its policy of maintaining a stable monetary base, inflation should remain low. With recession looming in many parts of the world and many leading indicators pointing to a recession in the US, no good reason exists for the Federal Reserve to further raise interest rates. The Federal Reserve wants to prevent a recession and has indicated that it would like to see the rate of inflation increase so it is closer to the stated target of 2 percent per year.

Since little or no benefit can come to the Federal Reserve from raising the federal funds rate further, and the costs are substantial both in terms of increased likelihood of recession and reduced net income to return to the Treasury, do not be surprised if the federal funds rate remains stable or even falls in 2016. Although this means Americans will not earn much on their savings accounts, the Fed will at least be doing its part to delay the onset of the next recession.

Renewable Energy Mandates: A costly burden for the poor

Replacing fossil fuels with renewable energy to reduce carbon dioxide (CO2) emissions sounds like a good idea. It is certainly popular with government officials; twenty nine states, the District of Columbia, and Puerto Rico mandate use of renewable sources to generate electricity.

But with the high cost of these mandates and their impact on millions of low-income families struggling to make ends meet, state governments need to rethink their policy.

A recent study by the Manhattan Institute noted that these mandates have already increased electricity rates substantially in many states and will continue to do so. The mandates are called renewable portfolio standards (RPS) and require utilities to generate a specified minimum amount of electricity—ranging from 10 percent in Michigan to 40 in Hawaii—from wind, solar, biomass, hydroelectric, and geothermal sources. California’s standard requires that one-third of electricity in that state is generated from renewable sources by 2020.

The mandates have already had an impact in the states that have passed them. States with an RPS have seen bigger rate increases. Coal-dependent RPS states have seen residential rates increase by an average of 54.2 percent between 2001 and 2010, more than twice the increase in coal-dependent states without one. In Ontario, which is further along in this than most US states, the government has projected that electricity rates will increase by 46 percent over the next five years. The Manhattan Institute estimates that obtaining 20 percent of electricity from wind energy would lead to a 48 percent increase over the current price in coal-dependent regions of the US.

Besides the rising cost of electricity to consumers that will result from renewable energy mandates, the federal government is losing billions on subsidies and loan guarantees to companies, like Solyndra, that have gone or will likely soon go bankrupt. State and local governments, too, face expenses and loss of tax revenue from efforts to favor renewable energy. With unsustainable levels of debt, governments cannot afford to continue these policies.

Renewable energy costs considerably more than conventional. On-shore wind power, which is the least expensive renewable source widely available, costs more than natural gas even in the best locations, and is expected to cost an average of about fifty percent more by 2016. Instead of using more expensive renewable sources, gradually increasing the use of natural gas and using less coal can reduce the amount of CO2 generated per megawatt hour while lowering generating costs.

The biggest alleged advantage of renewable energy sources is that they will reduce CO2 emissions, but the case for bearing high costs to reduce CO2 emissions is weak. Besides the fact that it is not clear whether or how much increased CO2 emissions have raised global temperatures, or will in the future, the relatively modest reduction that can be achieved by renewable energy mandates will have little impact on atmospheric levels of CO2 and, more important, will reduce future temperatures by only an inconsequential few hundredths of a degree.

It’s time for voters to wake up to the underhandedness of their elected officials’ pursuing CO2 reductions indirectly in spite of public opposition, rather than openly debating whether that is a desirable goal. Cap and trade failed in Congress; RPS is just a sneaky way of slipping it past the public.

If the benefits of reducing CO2 are large enough, the costs of doing so should be openly discussed. Good stewardship requires not only finding a cost-effective way to achieve desirable goals, but also choosing a method that limits the size of any resulting increase in electricity rates for those who already have difficulty paying their utility bills. They are the ones who, as pointed out in The Cost of Good Intentions: The Ethics and Economics of the War on Conventional Energy, a major study by The Cornwall Alliance for the Stewardship of Creation, will be most hurt.

By imposing CO2 reductions on electric utilities, the government is effectively imposing a regressive tax in the form of higher utility rates. Low-income people spend a much higher share of their income on electricity than do high-income people. With the economy growing slowly and a recession looming in the not too distant future, now is not the time to impose higher energy costs on low income Americans.

How markets could provide affordable health insurance

A major problem with our health care system is that it costs much more to insure people with major health problems than it does to insure the majority who are in reasonably good health. Over the years, governments have used a variety of regulations and subsidies to make it easier for sicker members of the population to afford health insurance. These government regulations and subsidies, however, incentivize people to spend more on health care, raising the average cost of health insurance for everyone. Without the various government regulations and subsidies, markets could provide affordable health insurance for almost everyone by making it possible for people to insure against changes in their health status.
One way that the cost of health insurance is kept down for sicker people is through employer sponsored health insurance plans. Although these plans arose in response to wage controls during World War II, they have grown in importance because of tax deductions and a variety of regulations that have been implemented since then. If the tax deduction was not limited to group health insurance plans offered by employers, many of the healthiest workers would buy their own low cost health insurance in exchange for a higher wage from their employers, who would save the cost of premiums on those workers. If health insurance were not tax deductible, many people would choose less generous coverage for lower premiums than what employers now pay.
Employer sponsored insurance (ESI) works fairly well for those working for large corporations. One drawback is that it discourages workers from changing jobs, particularly if they develop a health condition that will increase the likelihood that they will incur major healthcare expenses. To keep premiums from rising for ESI plans before the Affordable Care Act prohibited them from doing so, health insurers often chose not to cover pre-existing conditions of newly hired workers.
Small companies that provide ESI have an incentive to hire only healthy workers if regulations do not permit insurance companies to exclude pre-existing conditions from the coverage they offer. A small firm also has an incentive to find an excuse to lay off a worker who develops costly health problems while employed, since insurers are likely to raise premiums for firms whose workers incur higher health costs.
Because all of the existing subsidies and regulations are not enough to keep those with chronic health problems from facing premiums that are much higher than average, the Affordable Care Act (ACA) requires insurance companies to provide full coverage for everyone who applies, regardless of health status, and it prohibits companies from varying premiums except based on age or whether the insured smokes. It includes an individual mandate so that healthy people will not opt out of buying insurance. The greater the percentage of healthy people paying premiums, the lower will be the premiums for everyone, including those with chronic illnesses.
Insurance companies will do everything possible to avoid providing insurance to people with chronic health conditions, if they expect to spend more on their care than the premiums they are permitted to charge. The ACA had to devise a complicated system of cross subsidies to get insurance companies to cover those with chronic health conditions at the same prices as everyone else. Government may be able to force insurance companies to provide affordable coverage to high risk people, but without adequate incentives, don’t be surprised if the insurance pays for care from a very limited network of health care providers, severely limiting the options of high risk clients.
Rather than fighting market forces, the best way to promote affordable health care for everyone is to allow entrepreneurs competing in the market to devise a solution that would make it profitable for insurance companies to cover those with high healthcare costs. One solution, proposed by the Heritage Foundation, is health status insurance, whereby people insure against declines in their health status. If early in their lives people could pay extra for insurance against developing a chronic health condition in the future, then insurance companies could afford to cover everyone regardless of what happens to their health over their lives. Premiums for health status insurance would be affordable, even if set high enough to compensate insurance companies for the expected cost of providing high quality care for chronic illnesses, because only a relatively small fraction of a pool of originally healthy young people will eventually develop chronic illnesses that are costly to treat.

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.

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.

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.

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.

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.