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Individual Mandate Not Necessary for Universal Coverage

03/22/2012 12:07 pm ET | Updated May 22, 2012

Republicans name repealing Obamacare their top priority if they win the next election. But what are they proposing to replace it with? Unfortunately, clear thinking on this issue seems to be lacking in the GOP. Let me help by clarifying the choices.

The Pareto principle is fully applicable in health care. In 2009 half of the U.S. population accounted for only 3 percent of all health care spending, while 5 percent accounted for half of all expenditures (at about $36,000 each) and just 1 percent accounted for 22 percent of all health care costs (at over $90,000 per person). It is safe to assume that many (if not most) of the top spenders could not afford their health care if they had to pay for it themselves. This brings us to a simple conclusion. Either a lot of people just do without the basic health care they need or some people pay for other people's health care. If we reject the former alternative, we have to accept the latter, it's that simple.

Of course, people can contribute to others' health care voluntarily or involuntarily. Let's ponder the feasibility of a purely voluntary system. Non-coerced contributions can be made for both altruistic and non-altruistic reasons. In a libertarian fantasy private philanthropy can take care of all the needy. Unfortunately, in real life charitable giving amounts to about 2 percent of the GDP. Health care constitutes 17 percent of the GDP. Health care for just 1 percent of Americans makes up almost 4 percent of the GDP, and they cannot afford most of it. A lot of others cannot afford their care either. It would be necessary for charitable giving to increase several times in order to cover those expenses, and that's just not realistic.

Still, there remains the possibility of non-altruistic voluntary contributions in the form of health insurance premiums. After all, insurance works reasonably well in some other areas. However, while there is a very significant random component in health risks (e.g. injuries and infections), most risks are highly dependent on individual medical history, and it can be determined in advance which people are much likelier to end up among the top medical spenders in the near future (in fact I happen to be in the job market right now and have interviewed for some positions where the job description includes identifying customers who are likely to file expensive claims in the future). As our understanding of genetics dramatically improves over the years to come, such predictions will become more and more accurate. In a truly free market that would mean prohibitively high premiums for people who need insurance the most.

For a long time we have tried to circumvent this problem with group rates offered to employees by their employers. Unfortunately, skyrocketing premiums not only have caused prolonged wage stagnation, but also make the system unsustainable in the long run. Let us consider a hypothetical case of a very fit and healthy man in his early 20's who has just started an entry level job. He wants to sign up for the health plan offered by his employer but quickly discovers that he has to pay exactly the same premium as his morbidly obese and heavily smoking manager in his early 60's with a thrice bigger paycheck (in fact he has to pay more than the manager in after-tax dollars, since health premiums are tax exempt and the manager is in the higher tax bracket). The young man may well think that it is grotesquely unfair for him to subsidize his manager. If he declines the offer of seriously overpriced insurance, he's not necessarily a freeloader - maybe just a rational economic actor. As, on the one hand, the cost of insurance keeps increasing and, on the other hand, new cheap genetic tests inform millions of relatively young people that their near-term health risks are quite low, more and more people will opt out of the system, sending it into an adverse-selection death spiral.

And so we are left with a stark choice. Either millions of Americans will endure unnecessary suffering or the government will force some people to contribute towards other people's medical expenses. Anything else is just wishful thinking. If the Republican Party wants to avoid electoral oblivion, it has to choose the latter option and propose some credible plan to that effect.

There are, of course, many possible ways of achieving universal coverage. Both Romneycare and Obamacare force people to buy health insurance and provide subsidies to those who cannot afford it. I am still open to persuasion on individual mandate, but so far I don't think it's the best option, especially in its current form, with its heavy reliance on employer-based coverage at group rates.

The irrational connection of health coverage to a job has been causing multiple problems for decades and is not worth preserving. It creates distortions and inefficiencies in the labor market by making it a lot harder for people to compare compensation packages offered by prospective employers, by reducing the attractiveness of temporary or part-time employment vis-à-vis open-ended full-time employment and by adding unnecessary hassles to the process of job changing. Even worse, constant increases in health care costs become hidden in inadequate wage increases and thus largely invisible to people.

But the worst feature of employment based coverage is group rates. We don't have much problem with auto or home insurance because those policies are underwritten on the basis of individual risk. As a result, not only the customers are usually not overcharged a lot, but they are also encouraged to drive carefully, obey traffic laws, install home security systems etc., while overuse (especially in the form of filing small claims frequently) is discouraged. Not surprisingly, the costs are controlled better than in health care. Health insurance at group rates provides no incentive for healthier lifestyle and may in fact encourage overuse (because people start thinking along the lines of "if I am overpaying so much for this product, I might as well use it" and they know that their individual choices will not seriously affect the group rate).

Make no mistake, those 50 percent of the population who incur only 3 percent of all medical expenses are overcharged by hundreds of percent when they get health insurance at group rates (and most of the other 50 percent are seriously overcharged too). So the problem with the individual mandate is not just the oft-repeated objection that the government forces people to buy a product from a private company, but that it forces most people to buy a seriously overpriced product.

For all intents and purposes, the individual mandate is a tax. The government orders the majority of low-risk individuals to subsidize health care for the minority of high-risk individuals. Of course, the government has already been doing a very similar thing for almost half a century with Medicare and Medicaid. However these programs are financed with direct taxes. The individual mandate is an indirect tax (the government deputizes insurance companies both to collect it and to spend the money on providing health care to everyone). And therein lies another problem.

Good governance requires transparency in both taxes and spending. Our tax code already hides hundreds of billions in government spending masquerading as tax credits, and the last thing we need is to add a trillion dollar hidden tax. This tax is not transparent. Most people don't even know the full cost of their health insurance (since the employer subsidy is seldom mentioned on paystubs) and they won't know the size of their indirect tax.

This tax can be increased at any moment by unelected bureaucrats writing regulations and adding coverage mandates. It will also keep increasing automatically as the health care costs keep rising. This tax is not fair. If everybody buys insurance at roughly the same group rates, then it's essentially a poll tax, and a very big one at that. This tax will be very difficult to reform in the future (while payroll and income tax rates can be easily changed with just several lines of legislation).

It would be much better for our political class to acknowledge the reality and replace the individual mandate with explicit direct taxes. New taxes would need to raise a lot of revenue, but for most of the middle class they would be offset by big pay increases once health insurance is no longer part of the compensation package.

There is, of course, still the question of just how exactly the government will help people cover the cost of their health care. There are many possible ways of doing it. I would suggest letting people buy health insurance at individual rates based on individual risks with the government providing significant premium support ranging from maximum for the portion of the premium due to pre-existing conditions (including genetic risks) to none for lifestyle risks (such as smoking).

The fact that nobody is overcharged and most people actually receive a government subsidy would greatly increase the attraction of buying insurance even for young healthy people. But in order to reduce the temptation to get insurance only after getting sick, we could stipulate that once the system is in place, people over the age of 25 will be eligible for premium support only after having maintained continuous coverage for, say, two years. We can also make hospital debts easier to collect and harder to discharge in bankruptcies. I am sure that some people will still refuse to buy insurance, but there will be no need to force them to buy it, since they'll still contribute towards health care costs of other people through their taxes.