Unwise federal policies are the chief cause of rising health care costs for three reasons: federal tax law encourages wasteful spending in the private sector; the design of federal health programs causes wasteful spending in the public sector; and direct federal spending keeps upward pressure on health care costs. State governments may attack the symptoms by imposing price controls [see the discussion below], but they cannot affect the underlying problem.

Rising Costs Due to Federal Tax Policy. The primary reason why health care spending is out of control is that most of the time when we enter the medical marketplace as patients we are spending someone else's money rather than our own. Economic studies - as well as common sense - confirm that we are less likely to be prudent, careful shoppers if someone else is paying the bill. Although polls show that most people fear they will not be able to pay their medical bills from their own resources, the reality is that few of us will have to. On the average:¹

• Every time we spend a dollar in a hospital, we pay only 5 cents out-of-pocket and 95 cents is paid by a third party (employer, insurance company or the government).

• Every time we spend a dollar on physicians' fees, we pay less than 19 cents out-of-pocket.

• For the health care system as a whole, we pay only 23 cents out-of-pocket every time we consume a dollar's worth of services.

Moreover, the explosion in health care spending over the past three decades parallels the rapid expansion of third-party payment of medical bills. The patient's share of the bill has declined from 56 percent in 1960 to 23 percent today. There is substantial evidence that a great deal of waste in our health care system is caused by people who have too much insurance. For example, Rand Corporation studies imply that if every family in America had a $2,500 deductible,² personal health care spending would drop as much as one-fourth³ with no adverse effects on health.⁴ Market prices for health insurance also provide powerful evidence of the wastefulness of low deductibles:⁵

• If a family in a city with average health care costs increases its deductible from $250 to $1,000, its premium savings will be $1,315 - almost twice the amount of the increase in the deductible.⁶

• If the family increases its deductible from $250 to $2,500, it will save $1,749 on premiums - roughly the amount of coverage the family would forgo, considering the effects of the deductibles and copayment.⁷

Most individuals and families would be much better off if they had the opportunity to choose high deductibles and place the premium savings in an account to be used for small medical bills.⁸ Yet, while the federal government generously subsidizes third-party insurance, it discourages self-insurance by heavily taxing funds that individuals put aside for medical expenses:

• Under current law, every dollar of health insurance premiums paid by an employer escapes, say, a 28 percent income tax, a 15.3 percent Social Security (FICA) tax and a 4, 5 or 6 percent state and local income tax, depending on where the employee lives.

• On the other hand, these taxes are imposed on every dollar of income that employees try to save.

• Thus government is effectively paying up to half of the premiums for third-party health insurance and taxing up to half of the income people try to save.

The federal government could eliminate this distortion by giving just as much tax incentive to individual self-insurance as it now gives to third-party insurance. [See sidebar on Medical Savings Accounts.] Without this change, there is little reason to think health care costs can be controlled without government-imposed health care rationing. Although some state governments (including Oklahoma) are considering Medical Savings Accounts, the effect of federal tax law is so large that state efforts alone are likely to accomplish little.⁹

Rising Costs Due to Federal Spending. Prior to 1960, health care spending as a percent of gross national product (GNP) increased very slowly in the United States. After the enactment of Medicare and Medicaid in 1965, however, health care spending soared:

• Between 1940 and 1960, health care spending rose modestly, from 4 percent of GNP to 5.2 percent.

• Since 1960, the percent of gross domestic product (GDP) spent on health care has almost tripled, reaching an estimated 13.4 percent in 1992.¹⁰

When federal tax subsidies for health insurance¹¹ are combined with direct spending, government at all levels (federal, state and local) now spends more than half of all health care dollars. Moreover, spending on Medicare and Medicaid has skyrocketed from 5.9 percent of total health care spending in 1967, the first full year of the two programs, to 28 percent in 1990.¹² Overall:¹³

• Direct government spending has increased from 24 percent of all health care spending in 1960 to 42 percent in 1990.

• When tax subsidies for health insurance are included, the government's share of health care spending has increased from 33.8 percent in 1960 to 53 percent today. [See Figure I.]

Many view Medicare and Medicaid as necessary programs, providing services to people who would not otherwise be able to afford them. But increased government spending has mainly increased prices rather than services:

• According to the Health Care Financing Administration (HCFA), which administers Medicare, every extra dollar spent on health care buys 65 cents in increased prices and only 35 cents in real services.¹⁴ [See Figure II.]

• According to the NCPA/Fiscal Associates health care model, every extra dollar spent on health care buys 57 cents in increased prices and only 43 cents in real services.¹⁵

Rising Costs Due to the Design of Federal Health Programs. In the Medicaid and Medicare programs, the federal government has codified wasteful first-dollar coverage. For example, Medicare pays many expenses that most patients could pay with their own resources - a practice that encourages overconsumption by Medicare patients who see few reasons to compare the value of diagnostic tests or physician visits with other uses of the same money.¹⁶ Federal regulations governing the Medicaid program also limit the ability to charge patients for low-cost items.¹⁷

The federal government also has adopted other policies that impede cost control. City and county health officials can point to many federal rules and regulations that prevent them from spending health care dollars wisely. For example, almost one-fourth of all Medicaid spending is for nursing home care. But federal regulations impose tight restrictions on the type of facility that can be used as a nursing home and prohibit less costly, equally effective alternatives.¹⁸

The kind of health insurance most of us have is determined by what the federal tax law subsidizes. This has led to an employer-based system under which people lose their health insurance when they switch jobs.¹⁹ Moreover, not everyone is treated equally. General Motors employees have one of the most lavish health insurance plans in the world - with Uncle Sam footing up to half of the cost. At the same time, the self-employed, the unemployed and employees of small companies that do not provide health insurance are discriminated against.²⁰ They must pay taxes first and buy health insurance with what's left over. As Figure III shows, this makes their effective price of health insurance twice as high as the price for people who have employer-provided insurance. Small wonder that almost 90 percent of the population under 65 years of age with health insurance is insured through an employer.²¹

Under current employee benefits law, employers have few opportunities to institute sound cost-containment practices without substantial income tax penalties, and employees have few opportunities to purchase less costly health insurance or policies tailored to individual and family needs.

How Federal Policy Affects Small Business.²² Suppose a small firm is considering purchasing an individual health insurance policy for each employee in order to take advantage of the favorable treatment of health insurance under the tax law. As Table 1 shows, this firm will immediately confront four problems. First, the cost of the policy will vary with the age of the employee. (A 60-year-old male, for example, is about three times more expensive to insure than a 25-year-old male.) The obvious solution is to pay the premiums for the policies and reduce each worker's salary by the premium amount. Second, not all employees may want health insurance (e.g., some may be covered by another policy). The obvious solution is to give health insurance only to those employees who want it, reducing the salary of each by the amount of the premium. Third, some employees may have preexisting illnesses, and the insurer may want to insert exclusions and riders into their policies. The obvious solution is to get each employee the best possible deal. And fourth, employees may have different preferences about the content of their policies. Some may want to trade off a higher deductible for a lower premium. Others may want coverage for different types of illnesses and medical services (e.g., infertility coverage). The obvious answer is to let each employee choose a policy best suited to the employee's needs and preferences.

Despite the fact that these solutions seem obvious and that every employee may gain from them, they are generally unavailable. In general, the federal tax law forbids employees from choosing between wages and health insurance and insists that all employees be offered the same coverage on the same terms. The result is that the employer must turn to a more expensive group policy with a package of benefits that no single employee may want.

How Federal Policy Contributes to Rising Costs. One consequence of the barriers described above is that employers are forced to adopt a health care plan in which benefits are individualized, but costs are collectivized. Although large employers have a few more options, they too are forced into a system which has two devastating defects.

First, under the current system there is no direct relationship between health insurance premium costs and individual employee wages. In many cases employees do not know what the premiums are. In those cases where they do (e.g., where they are asked to pay part of the premium), each is charged the same premium - regardless of age, sex, place of work, type of work or any other factor that affects real premium costs. The upshot is that the individual employee sees no relationship between the cost of employer-provided health insurance and personal take-home pay. Small wonder that employees of large companies demand lavish health care benefits.

Second, under conventional employer health plans there is no relationship between wasteful, imprudent health care purchases and salary. Under most policies, it is as though the employee has a company credit card to take to the hospital equivalent of a shopping mall. The employee will find many interesting things to buy, all chargeable to the employer. Under this system, employees have no personal incentives to be careful, prudent buyers of health care.

How Federal Policy Causes More People to be Uninsured. In the face of constraints imposed by federal policy, employers are trying to hold down health care costs by taking actions that have very negative social consequences. Unable to adopt a sensible approach to employee health insurance, many large firms are asking employees to pay (with aftertax dollars) a larger share of the premium. Often employers pay most of the premium for the employee, but ask employees to pay a much larger share for their dependents.²³ These practices result in some employees' opting not to buy into an employer's group health insurance plan. More frequently, employees choose coverage for themselves but drop coverage for their dependents. Three million people who lack health insurance are dependents of employees who are themselves insured.²⁴

Because employee benefits law prevents smaller firms from adopting a sensible approach to employee health insurance, many are responding to rising health insurance premiums by canceling their group policies. Often, employers give bonuses or raises to pass along their corporate savings and encourage employees to buy individual health insurance policies (with aftertax dollars). Many, of course, do not.

Needed Changes in Federal Policies. Most proposed state health care reforms operate either through employers or through government. As a result, they fail to consider all of the other options. This is not so strange when we consider that employee benefits and tax payments are both tax deductible, whereas every other method of paying for health care is not. Thus the federal tax system has greatly constrained the types of reforms state governments can realistically consider. Two important federal policy changes would help solve a great many problems for individuals, employers and state legislators.

First, health insurance benefits should be made personal and portable, with each employee free to choose an individual policy and keep it in spite of job changes. Health insurance benefits should be included in the gross wages of employees, who could claim deductions or tax credits for premiums on their personal tax returns - directly gaining from prudent choices and bearing the direct costs of wasteful ones. [See the sidebar on federal policies needed to solve the problems of employer-based insurance.]

Second, the federal tax law should give just as much tax encouragement to those who purchase their own health insurance as to employer-provided insurance and base the size of the subsidy on family need. [See the sidebar on "A Play-or-Pay Plan that Works."]

All too often, help from the federal government goes to those who need it least. Both tax and spending policies are designed to undermine a reasonable social safety net.

Regressive Tax Subsidies for People with Health Insurance. This year the federal government will "spend" about $60 billion in tax subsidies for health insurance. These subsidies will be distributed in a highly regressive way for two reasons. First, the ability to exclude employer-provided health insurance from taxable wages is more valuable to employees in higher tax brackets. Second, by restricting this tax subsidy to employer-provided insurance, the law favors people who work for larger firms. The result is a system that favors high-income over low-income families. As Figure IV shows:

• Families in the bottom fifth of the income distribution get an average benefit of $270 a year from federal tax subsidies for health insurance.

• Families in the highest fifth of the income distribution get an average annual benefit of $1,560.

• Thus the tax law benefits high-income families six times more than it benefits low-income families.

Tax Penalties for the Uninsured. A common fallacy is that people who lack health insurance are getting a free ride at the expense of the rest of us. When the uninsured get sick, it is argued, they usually get medical care. And when they can't pay for it, the rest of us pay through cost shifting or higher taxes.

What this argument overlooks is that the uninsured pay higher taxes precisely because they do not get tax subsidies. The problem is that the extra taxes go to Washington while the free care is delivered locally. A reasonable reform would be to require the federal government to return the extra taxes to the providers that deliver uncompensated care. [See sidebar on "A Play-or-Pay Plan that Works."]

Regressive Spending Programs. This year the federal government will spend about $215 billion on health care. How much goes to low-income families who need help? Surprisingly little. Only one out of every four dollars spent by the federal government goes to a poor family that qualifies for benefits under a means-tested program. The bulk goes to middle- and upper-middle-income families, even though the taxes used to pay for these benefits often come from low-income workers. For example, take the $130 billion the federal government spends on Medicare. Under the program:

• The lowest income workers pay 2.9 percent of their income to support Medicare.

• Yet the primary beneficiaries of Medicare - the elderly - have higher after-tax incomes and considerably more assets than the nonelderly.²⁵

For the most part, federal health dollars benefit the nonpoor. In the process, they force up prices for the poor.

About one-third of all employees work for an employer who provides postretirement health care benefits, covering items not paid for by Medicare.²⁶ Yet partly because of federal tax law, many of these workers will never collect a dime of those benefits. At the same time, the federal government's Medicare program covers many small items the elderly could easily pay for themselves, while leaving them exposed to catastrophic medical bills. Such policies place the burden of catastrophic coverage on individual families and state and local governments.

Employer-Provided Health Insurance. Although federal tax law allows unlimited spending for current health care needs - and excludes all of it from employee income - it severely limits the ability of the private sector to save for postretirement health care.²⁷ As a result, most employers have not put aside funds to pay for future promises:²⁸

• According to one estimate, unfunded liabilities of employers for postretirement health care now total $332 billion.

• This is equal to about 30 percent of the net worth of large companies.

Not only does federal tax law discourage employers from saving for postretirement medical expenses, but it also discourages individuals. Although the tax system generously subsidizes current health care spending, the government taxes personal savings and provides no deduction for long-term care insurance.

Medicare. As noted, the federal government pays many small medical bills for Medicare patients. For example:²⁹

Following a deductible of $100, Medicare pays 80 percent of all remaining physicians' fees.
• Medicare pays all expenses for the first 20 days in a nursing home.

• Following a deductible of $652, a Medicare patient faces no additional costs for a hospital stay of up to 60 days.

Unfortunately, Medicare leaves the elderly exposed for the most expensive bills - paying nothing after the 100th day in a nursing home and the 150th day in a hospital. Moreover, because Medicare offers too much first-dollar coverage and too little catastrophic coverage, state and local governmees are required to pay small-dollar claims but are free to skimp on catastrophic coverage in the same way that Medicare does.³⁰

There is something intrinsically wrong with a policy proposal if its proponents argue that in order to reform health insurance and health care delivery for some people, all other people must be included. Yet that's what many state reformers are arguing.

Currently, federal employees, employees of self-insured companies and Medicare enrollees are exempt from state health insurance regulations - mandated benefits, premium taxes, forced risk pool contributions and other cost-increasing taxes and regulations. Some reformers want to end that exemption.

Take self-insured companies, for example - companies that pay employees' health care claims themselves instead of relying on outside insurance companies.³¹ More than half of the nation's labor force works for a self-insured company, and state regulations are a major reason why. Health economists Jon Gabel and Gail Jensen looked at a sample of 280 firms that were not self-insured in 1981.³² By 1984, 24 percent had chosen self-insurance. Using a model that correctly predicted a firm's decision to self-insure 86 percent of the time, they found that:

• Increasing the state premium tax from 1 percent to 3 percent increased the probability of self-insuring from 20 percent to 24 percent.

• Imposing a risk pool and mandating continued coverage increased the probability by 55.8 percent and 165.6 percent, respectively.

• Mandates for psychological treatment raised the probability of self-insuring (by 93.2 percent), as did mandates for alcohol treatment (5.9 percent) and drug dependency treatment (58.8 percent), although the latter two mandates were not statistically significant.

• The impact of all state regulations taken together caused half of the firms that self-insure to make that decision.

Despite the fact that employers turn to self-insurance to avoid cost-increasing state regulations, a delegation of 14 governors recently went to the White House seeking the Bush administration's support for a proposal to end the exemption for self-insured companies.³³ Among other goals, the governors wanted to overturn the effects of a federal court ruling that the state of New Jersey cannot impose a 19 percent tax on the hospital bills of employees of self-insured plans.³⁴ Fortunately, the Bush administration has resisted.

Most of the state health care reform proposals being seriously considered are likely to do more harm than good. Before considering specific proposals, let's take a closer look at the visions behind them.

Two Competing Visions. One reason why health care debates rarely resolve anything is that the debaters often rely on diametrically opposed assumptions - assumptions that are rarely disclosed. Those who hold a "bureaucratic" vision of health care invariably talk of "needs" and "resources." They rarely mention the word "individual." Those who hold an "individualistic" vision know that all behavior is individual and that behind most serious social problems is a system of distorted individual incentives. The individualistic vision leads one to identify and eliminate these distortions. The bureaucratic vision leads one to expand and multiply them.

Individuals vs. Bureaucracies. When forced to confront the reality of individual choice and behavior, those who hold a bureaucratic vision of health care invariably point to unconscious patients in hospital emergency rooms - arguing that choice is impossible. They conveniently ignore the fact that probably 80 percent of all procedures are elective and that, in the vast majority of cases, patients have ample opportunity to reflect and choose. It would be a mistake, however, to conclude that the bureaucratic vision cannot see past the hospital emergency room. The issue is much more profound. Many who hold the bureaucratic vision are fundamentally anti-individual and anti-choice. They oppose individual empowerment on principle.

Three Assumptions Behind the Worst Health Care Reform Proposals. Behind the bureaucratic vision of health care are three bad assumptions. To one degree or another, they are responsible for most unworkable reform proposals. They are:

• No one - especially not patients, but preferably not even physicians or hospital personnel - should be forced to choose between health care and other uses of money.

• Insurance premiums (or payments for government-provided insurance) should never reflect individual health risks.

• Decisions by bureaucracies are always better than decisions by individuals.

When a health care system is based on these assumptions, social problems are inevitable. To the degree that patients perceive health care as free, they will overconsume health care resources. If insurance prices do not reflect real risks, some people will be overcharged and others undercharged. Those who are undercharged will overinsure (or demand more insurance from their employer or through the political system). Those who are overcharged will tend to be underinsured. When power is concentrated in the hands of bureaucracies, individual incentives are distorted in hundreds of ways, and people find it in their self-interest to take actions that defeat legitimate social goals.

Three Assumptions Behind the Best Health Care Reform Proposals. The individualistic vision of health care recognizes that we will get better outcomes in the long run if people bear the costs of their bad decisions and reap the benefits of their good ones. On the whole, good incentives for individuals lead to good social outcomes. Accordingly:

• Since society as a whole must choose between health care and other uses of money, as often as possible those choices should be made by individual patients.

• Although society as a whole may choose to subsidize the less fortunate, most people should pay the real cost of what they get - in medical care and in health insurance.

• Ideal institutions are based on social goals that are consistent with the self-interested behavior of individuals.

Reform proposals based on these assumptions are likely to improve our health care system. Reform proposals that reject these assumptions are likely to make our health care crisis worse.

The United States vs. Other Developed Countries. The three assumptions underlying the bureaucratic view of health care have been fully accepted and institutionalized in every other developed country. They have also been influential in our own. In fact, they formed the basis for the original Blue Cross/Blue Shield vision and shaped the development of our largely private health insurance system. Blue Cross believed that anyone who had a health insurance deductible or copayment requirement was underinsured, that the ideal policy was first-dollar coverage for all medical expenses, and that everyone should be charged the same price for health insurance - regardless of any indicator of health risk.³⁵

Whereas other countries chose public sector socialism, the United States chose private sector socialism. The mechanisms were different, but the ideals were the same. Indeed, one reason why the United States is perceived to have greater health policy problems than most other countries is that we have more successfully implemented a system based on the three bad assumptions. Virtually every major corporation in America has institutionalized the system of community rating originally favored by Blue Cross.³⁶ And ours is the only country in which people can freely enter the medical marketplace, consume every service from an MRI scan to a cholesterol test and have most of the bill paid by someone else.

Serious problems exist in the market for private health insurance. Among them: (1) many people discover that after they get sick their insurance can be canceled or they can face unreasonable premium increases; (2) employees find that when they leave employment they lose insurance coverage, even if they have a medical problem; and (3) people with medical problems who lose coverage may find that no other insurer will insure them.³⁷

In theory, the problems in the market for private health insurance are not difficult to solve. [See the sidebar on solving the crisis in private health insurance.] In practice, they have so far proved impossible. A number of proposals which purport to solve these problems would in fact make them worse. Some would also exacerbate other problems - causing more people to be uninsured and contributing to rising health care costs.

Good Idea: Guaranteed Renewable Insurance. Most of the problems in the market for private health insurance do not exist in the market for life insurance, which can easily be taken as a model. Once a person becomes insured, health insurers should be required to continue to offer coverage in the future at reasonable prices.³⁸

With this reform, the market for small group health insurance would begin to resemble the market for individual life insurance policies. In the latter, insurers cannot selectively raise prices for different policyholders based on last year's experience. The same premium increase must apply to the entire class of people who purchase a particular type of policy. Thus insurers cannot change the rules of the game for a single policyholder after an illness has occurred.

Good Idea: Collectively Renewable Insurance. There is some evidence that state regulation is largely responsible for the absence of guaranteed renewable health insurance. Insurers have been unwilling to make long-term commitments to policy holders in the face of arbitrary and unpredictable rate regulations.

Even without guaranteed renewability, however, many of the same benefits could be obtained if insurance were required to be collectively renewable. This requirement, which usually applies to individual policies, often is not a feature of policies sold to small groups. Thus insurers can refuse to renew the policy of one employer (because, say, an employee has an expensive illness) while agreeing to renew an identical policy of another employer.

If insurance were required to be collectively renewable, insurers would either have to renew all similar policies or none of them. They could not single out the healthiest clients and discard the unhealthiest after the policies have been purchased.³⁹

Good Idea: Personal and Portable Benefits. As noted above, the federal tax law has encouraged an employer-based system under which people lose their health insurance when they leave a firm. Almost all economists believe that fringe benefits are a substitute for wages. Thus fringe benefits are "paid for" by workers in the form of lower take-home pay. Yet today's employees have no ownership rights. Employers can cut back on coverage, even after an employee gets sick.⁴⁰ And when employees with a preexisting illness leave, they may find it impossible to get insurance elsewhere. A much fairer system would be one under which no tax subsidy is available for employer-provided health insurance unless the policy is personal and portable. State governments cannot change federal tax law. But they can adopt policies that encourage personal and portable health insurance benefits.⁴¹

Bad Idea: Guaranteed Issue. An ideal insurance market is one in which risk is priced accurately. Each person entering an insurance pool is charged a premium based on the expected cost and risk that person brings to the pool. Put another way, in an ideal insurance market, people pay for what they get.

A number of reform proposals, however, would force insurers to sell policies at fixed prices - no matter how sick or how well the applicants are. Under these proposals, insurers would be forced to overcharge low-risk (healthier) people in order to undercharge high-risk people.⁴² Whereas guaranteed renewability would encourage people to purchase health insurance (because they would be confident that once sick, they would be able to continue coverage at reasonable rates), guaranteed issue would have the opposite effect. Why buy health insurance today if you know you can buy it for the same price after you get sick?

Virtually all studies of guaranteed-issue insurance have concluded that it increases premiums.⁴³ For example, a recent study for the Society of Actuaries compared medically underwritten policies with guaranteed-issue insurance, under which all preexisting illness limitations were waived after 12 months.⁴⁴ The study showed that:

• The cost of guaranteed-issue insurance was 23 percent higher the first year and 50 percent higher the second year.⁴⁵

• The seven-year cost of guaranteed-issue insurance was 39 percent higher.⁴⁶

• These numbers imply that if people who are now medically underwritten could buy only guaranteed-issue insurance, from one-fifth to one-half of them would choose to be uninsured.⁴⁷

According to one estimate, no more than seven-tenths of 1 percent of Americans under the age of 65 are uninsurable.⁴⁸ Yet in an attempt to make health insurance more affordable for this tiny number, guaranteed-issue reforms would impose price controls and raise premiums for the other 99 percent. The result would almost certainly be a larger number of people who are voluntarily uninsured. [See the sidebar on charging healthy people more for health insurance.]

Worst Idea: Community Rating. The concept of guaranteed issue is often combined with community rating. Under "pure" community rating - such as the plan recently adopted in New York⁴⁹ - insurers are forced to charge the same price to every policyholder, regardless of age, sex or any other indicator of health risk. Thus, despite the fact that health costs for a 60-year-old male are typically three to four times as high as for a 25-year-old male, both pay the same premium.⁵⁰ Under "modified" community rating, price differences are allowed based on age and sex. Other than that, however, sick people are able to obtain health insurance for the same price as healthy people. Thus:

• A person who has AIDS would be able to purchase health insurance for the same price as someone who does not.

• People in hospital cancer wards would be able to buy health insurance for the same price as people who do not have cancer.

Community rating also is being implemented in Vermont and is about to be implemented in Minnesota.⁵¹ Variations on the idea are under consideration in a dozen states. The most important difference among the proposals is the ease with which sick people can enter a pool and healthy people can leave - thus destabilizing the health insurance marketplace. [See the discussion of the Bush plan below.]

Case Study: The Jackson Hole Proposal. An idea implicit in most price-fixing proposals is that health insurers should not engage in the same kinds of activities as insurers in other fields. That idea is explicit in a health care reform proposal developed by Alain Enthoven and other members of the Jackson Hole Group,⁵² who argue that insurers should not compete on their ability to price and manage risk but on their ability to manage health care costs.

Under the proposal, insurers would be forced to charge the same premium to all policyholders of the same age (modified community rating)⁵³ and to accept all applicants (guaranteed issue). The insurers would compete and try to keep their premiums low by developing skills at managed care.⁵⁴ To the degree there is a trade-off between cost and quality, insurers would compete based on their ability to manage that trade-off in ways pleasing to potential customers.

To see one problem, imagine two competing HMOs. In the first, enrollees can see a primary care physician at the drop of a hat, but there are screening procedures and sometimes lengthy waiting periods for kidney dialysis, heart surgery and other expensive procedures. In the second, dialysis and heart surgery are available when needed, but there are few primary care physicians. Given a choice, most of us would enroll in the first HMO until we really got sick, then switch to the second. But if everyone did that, the second HMO could not survive financially.⁵⁵ Just as is the case with national health insurance, absent a market for real insurance there would be a natural tendency to gravitate away from expensive, lifesaving medical technology.⁵⁶

To see another problem, imagine several HMOs offering identical services. Because they must take all applicants at the same premium, each has an incentive to attract healthy people and avoid those likely to generate high health care costs. Since insurers are not allowed to discriminate on the basis of price, they will try to discriminate in other ways. In the attempt to avoid sick people - a game, like musical chairs - some will be more successful than others. The less successful will have higher costs, which will require higher premiums, which will result in fewer customers, etc.⁵⁷

For these reasons, the Jackson Hole proposal - and, indeed, any plan that combines community rating with competition - is inherently unstable. In order to keep the market from disintegrating, proponents invariably propose a complex government bureaucracy designed (a) to redistribute funds from profitable to unprofitable insurers or (b) to tightly regulate the content of health insurance policies, preventing insurers from offering higher deductibles on any other feature that is likely to attract healthier subscribers. The Jackson Hole reformers propose both approaches.

The proposal is also unstable because its approach is all-or-nothing. Small changes in the plan - such as changes that are likely in the legislative process - will cause it to fall apart. For example:

• Under the plan, the government would force everyone to purchase health insurance, but if the choice to insure remains voluntary (as in the Bush version of the plan), healthy people who can always buy insurance later if they get sick will drop out as premiums invariably rise. [See the analysis of the Bush plan below.]

• If insurers are allowed to alter their benefit packages and genuinely compete (as the Heritage Foundation seems to advocate),⁵⁸ then healthy and sick people will gravitate to different plans and the plans with sicker subscribers will not survive.

Although the Jackson Hole reformers talk about "competition," they do not advocate competition among firms in the business of insurance. Indeed, they want to get rid of insurance as such and turn insurers into managers of health care delivery. This is comparable to insisting that auto insurers get out of insurance and into managing (and perhaps delivering) automobile repairs. Or that fire and casualty insurers turn from insuring homes to managing home repairs.

Despite inherent problems, the proposal has been influential. It forms the basis for President Bush's health insurance reform proposal, Bill Clinton's proposal, a proposal developed by House Democrats⁵⁹ and proposals being considered in California,⁶⁰ Maryland⁶¹ and other states.

Case Study: The Bush Plan. President Bush has endorsed a much-needed reform of our health care system: tax credits for people who purchase their own health insurance. Yet for many, the financial advantage of the tax credit would be more than wiped out by the effects of the president's plan for community rating⁶² - a plan to be implemented at the state level. Moreover, other provisions of the proposal would assure that almost no healthy person would purchase health insurance.

Most proposals for guaranteed issue and community rating give healthy people at least some incentives to buy health insurance. For example, a typical provision is that preexisting conditions are not covered until after a 12-month waiting period. Thus people who purchase insurance after an illness occurs risk 12 months of medical bills beore the insurer picks up the tab. The Bush proposal, by contrast, has no waiting period.

Page 22 of the President's "white paper" on health care reform policy proposes that hospitals be able to get patients insured when they enter the emergency room. Uninsured people would face no financial risk. They could get insurance coverage as they enter a hospital and drop it as they leave.⁶³ Apparently the White House failed to consider that under such a system only sick people would buy health insurance.

Case Study: The Clinton Planer than the insurance business. So far, the Clinton plan is long on rhetoric and short on detail. Nonetheless, it clearly endorses guaranteed issue, community rating and competition among insurers based on their ability to manage care.

There are, however, important differences between the candidates' plans. Whereas Bush would make the purchase of health insurance voluntary, Clinton would make it mandatory - requiring employers either to purchase insurance directly or to pay a tax and shift the responsibility to government.⁶⁵ (Both options, of course, are an alternative to paying wages.) Whereas Bush would grant special tax relief to low-income families, Clinton would not - presumably requiring low-income employees to purchase health insurance (through their employer) whether they could afford to or not.⁶⁶ Moreover, Clinton is firmly committed to global budgets - the practice of giving providers a fixed sum and forcing them to ration health care. Some of these concepts are discussed in greater detail below.⁶⁷

Case Study: The Federal Employee Health Benefits Program (FEHBP). Almost anyone familiar with the health benefits program for federal employees knows that it is in desperate need of reform. This is the opinion of the Office of Personnel Management (OPM), which oversees the program, and of other analysts inside and outside of government. For example, a Towers, Perrin, Forster & Crosby study concluded that "fundamental legislative reform is urgently needed."⁶⁸ Nonetheless, the program is interesting for three reasons. First, over the past two decades reformers have called for a national health insurance program based on the FEHBP.⁶⁹ Second, the FEHBP is the model for the Jackson Hole approach.⁷⁰ And third, the FEHBP shows what can go wrong with the Jackson Hole approach.

The program has three main features: (1) federal employees in most places can choose among eight to 12 competing health insurance plans;⁷¹ (2) government contributes a fixed amount that can be as much as 75 percent of each employee's premium; and (3) the plans are forced to community rate, charging the same premium for every enrollee. Despite the appearance of competition and the large number of HMO enrollees, the program has not succeeded in controlling costs:

• Over the decade of the 1980s, the federal government's spending on employee health benefits grew at a rate that was over a percentage point faster than for employer-provided health insurance generally (11.22 percent vs. 10.01 percent).

• When spending is adjusted for the number of employees, the federal employees plan grew more than 25 percent faster than private-sector plans. [See Figure V.]

One reason why the FEHBP has not held down costs is that deductibles in the fee-for-service plans are quite low. Even though most private employers are increasing their deductibles, Blue Cross's FEHBP "high-option" plan has a deductible of $200 and its "standard-option" plan has a deductible of $250. Why are the deductibles so low? Because OPM won't allow Blue Cross, or any other plan, to raise its deductibles or copayments. The reason? Other things being equal, plans with greater patient cost-sharing are likely to attract younger, healthier employees. In fact, OPM rigorously reviews every tiny change in plan design to make sure that any attempt to taylor the plans to the needs of the employees does not appeal to good risks more than to bad ones. For example, it won't allow a plan to include coverage for teeth cleaning but omit coverage for dentures - on the theory that such a change would make the plan more attractive to young people.

Even with this regulatory micromanagement, outside analysts say that virtually all the competition that exists is only competition for good risks - not competition in the sense in which Jackson Hole advocates imagine.⁷² And it is precisely the adverse selection that results because insurers cannot price risk accurately that has caused Aetna, the only systemwide insurer other than Blue Cross, to leave the FEHBP.⁷³ Despite glowing descriptions by its defenders,⁷⁴ the FEHBP has none of the desirable characteristics of a competitive system:

• When competition is working, price reflects value; yet although there is a 42 percent difference in value of benefits between highest and lowest option plans, the premiums differ by 264 percent.⁷⁵

• In order for competition to work, people have to be able to perceive differences or similarities in value; yet despite the fact that there is virtually no difference between the Blue Cross high-option and standard-option plans, many federal employees pay four times as much for the high option plan - believing incorrectly that they are getting four times more value.⁷⁶

• Whereas workable competition should naturally lead to customer-pleasing innovations, none of the FEHBP plans are allowed to offer a Flexible Spending Account - a highly valued and common feature of private employer-provided health insurance.⁷⁷

• Whereas the Jackson Hole Group imagined that insurers in such a system would compete based on their ability to manage care, the fee-for-service plans now instituting managed care are doing so not because they see it as good business, but because federal law requires it.⁷⁸

Case Study: Prospects for Managed Care. As noted above, sensible reform of private health insurance has been prevented because all too often the reformers have hidden motives. Rather than encourage a workable market for health insurance, misguided reformers want to get rid of health insurance altogether and replace it with managed care. Instead of seeing if managed care can survive the market test in competition with its alternatives, some of its advocates want to use government to automatically declare it the winner. Is it a good idea to get rid of health insurance and force insurers to compete based on their ability to manage care? Let's take a closer look.

Traditionally, "managed care" meant combining payment with provisions of health care - typically in a Health Maintenance Organization (HMO).⁷⁹ More recently, the term has been applied to a whole range of activities whose goal is to make medical care more cost-effective. In all its guises, managed care means interfering with the conventional doctor-patient relationship.

Most studies show that HMOs save money by substituting less expensive for more expensive therapies. For example, physician therapy and drug therapy are both less expensive than hospital therapy. The next generation of cost management techniques, however, seeks to subject every medical decision to cost-benefit analysis. For example, the American Medical Association and the Rand Corporation are working on "practice guidelines" for physicians, and Congress has mandated that the Department of Health and Human Services draw up similar guidelines. The goal is to develop "computerized protocols" that will tell physicians what to do when confronted with certain patient symptoms and conditions.⁸⁰

Will the guidelines work? That's not clear. Many people believe they will be a waste of money. Some argue that their development is such a lengthy process that computerized protocols will always be years behind state-of-the-art medical practice. Others say that such protocols assume that computer programs will usually make better decisions than the physicians who meet and talk with patients. Though many physicians could benefit from properly designed protocals, in one test, judgments of general practitioners were matched with three different computerized protocols in the treatment of patients with abdominal pain; the GPs outperformed the protocols each time.⁸¹

Most advocates of managed care envision a world in which a bureaucracy tells physicians and patients what to do. The techniques of managed care form the basis of these instructions. Yet if the techniques had value, they might be adopted voluntarily in the marketplace. For example, if workable computerized protocols were available to physicians, they might be valuable tools. Physicians could consult the computer, then substitute their own judgments where appropriate. Less complicated protocols might be available for home computers, giving patients advice on whether to see a physician, for example.

In other areas of economic life, we subject ideas to the market test and allow competition to determine which ones survive. That's a good practice to follow in health care as well. Whether managed care should supplement health insurance or replace it should be determined by the market, not by politicians. Similarly, which managed care techniques are valuable and which ones aren't is best determined by competition rather than by fiat.

If managed care is forced on people by government policy, it could threaten the quality of patient care. Unfortunately, the threat is real. Rand Corporation researcher Robert Brook has argued that Rand's techniques can be used to ration health care under the Medicare system.⁸² And William Schwartz (Tufts) and Daniel Mendelson (Lewin-ICF) argue that managed care has already achieved most of the savings that are achievable by reducing hospitalization. The only way for managed care to control the long-term rise in health care costs, they argue, is to deny people access to expensive but useful technology.⁸³

In any one month, about 34 to 35 million people are uninsured, and the number appears to have increased over the past decade.⁸⁴ This is not a stable population, however. Although many people become uninsured during their lifetimes, few remain in that status for long periods. Only 30 percent stay uninsured for more than one year, and only 4 percent of the nonelderly stay uninsured for much longer than two years.⁸⁵

Why are so many people temporarily uninsured? The evidence suggests three reasons, which have been discussed above. First, the constraints of federal tax law and employee benefits law have made it increasingly difficult for small businesses to provide health insurance for employees. Second, although the federal tax law generously subsidizes employer-provided health insurance, there are few or no subsidies for individuals who purchase their own health insurance. Finally, state regulations are increasingly pricing lower-income, healthy people out of the market for health insurance.

What can state governments do?

Good Idea: Deregulate. As we shall see below, cost-increasing state government regulations are pricing as many as one out of every four uninsured people out of the market for health insurance. Regulations that increase the price of insurance include mandated benefits, risk pool assessments and premium taxes. In addition, as discussed above, an increasing number of states are imposing price controls - which have the effect of raising premiums for low-risk people in order to subsidize the premiums of high-risk people. The most straightforward way to lower the cost of health insurance for the vast majority of people is to deregulate.

Good Idea: Direct Subsidies. Another way to help lower-income families is through direct subsidies. As noted above, there is an urgent need to reform federal tax policy toward health insurance - redirecting $60 billion per year in federal tax subsidies from high-income to low-income families. Meanwhile, a number of state governments are seizing the initiative. For example, several states now exempt small business policies from state taxes levied on health insurance premiums, and at least six states extend tax credits to employers who are first-time buyers of health insurance. Iowa, for example, exempts "bare bones" policies from premium taxes and provides a tax credit to employers who pay at least 75 percent of the premium for low-income employees and half of the premium for the employees' dependents.⁸⁶ Premium taxes also have been waived for small businesses in Nevada, New Mexico and West Virginia. Other states that give employers tax credits for the purchase of health insurance include Kansas, Kentucky, Montana, Oklahoma and Oregon. The credit is $15 per employee per month in Oklahoma and up to $25 in Oregon.⁸⁷

Bad Idea: Employer Mandates. Virtually all economists agree that fringe benefits are earned by workers and that they substitute for wages. Requiring employers to provide health insurance, therefore, is simply a disguised attempt to force workers to take health insurance rather than wages. The mandates nominally apply to employers. In reality they force workers to purchase health insurance, whether they want to or not.

There are two types of proposals to mandate employer-provided health insurance. One simply requires employers to provide insurance.⁸⁸ The other gives them a play-or-pay option - either to provide health insurance or pay a tax.⁸⁹ Both are far more regressive than proposals to offer tax subsidies to individuals. The mandates require workers to be able to produce enough to finance their own health insurance or go without a job. [See Table II.] Tax credits would give more help to those who need it most without interfering with job opportunities. More importantly, employer mandates are an unstable solution - one which would inevitably lead to national health insurance. [See the sidebar on Employer Mandates.]

Bad Idea: Individual Mandates. If a fair system of tax credits for the purchase of health insurance were instituted, there would be no need to mandate anything. People who did not purchase health insurance would pay higher taxes. The higher taxes would be used to pay for uncompensated care for the uninsured, after they exhausted their own resources. Nonetheless, the Heritage Foundation proposes to force individuals to purchase health insurance.⁹⁰ The trouble is that mandated health insurance would likely be similar to mandated auto liability insurance in California, Massachusetts and New Jersey. [See the sidebar on Individual Mandates.] And like employer mandates, individual mandates would create irresistible pressures for government to keep down the price of health insurance by regulating the entire health care system.

Worst Idea: National Health Insurance. National health insurance would be comparable to enrolling everyone in the Medicaid program. Inevitably it would lead to health care rationing and waiting lines. [See the sidebar on Canada's global budgets.] In other English-speaking countries with national health insurance, the central question is: How easy is it to get out of the system and take advantage of private sector medicine?

• Although health care is theoretically free to all in England, 10 percent of the population has found it necessary to purchase private health insurance with aftertax income.⁹¹

• In New Zealand, one-third of all families have private health insurance and one-fourth of all surgeries are performed in the private sector.⁹²

• Although private health insurance has been effectively outlawed in Canada, an increasing number of Canadian patients are crossing the U.S. border to get health care they cannot get in Canada.⁹³

Case Study: The Massachusetts Plan. In the 1988 presidential campaign, Michael Dukakis claimed that he had provided health insurance for everyone in Massachusetts. In fact, the mandate for employers was not scheduled to take effect until 1992. Before that could happen, the state legislature postponed it until 1995, and it may never be implemented. Governor William Weld has argued that it would devastate the struggling Massachusetts economy.⁹⁴

This early attempt at play-or-pay legislation would have required Massachusetts employers to provide health insurance for their employees or pay a tax of 12 percent on the first $14,000 of wages. Other provisions in the bill would have required college students to carry health insurance and attempted to expand access for the poor and uninsured, in part through a state-subsidized insurance program.⁹⁵

Although the intent of the bill was to make health care "universal" and affordable within the state, only college students would have been required to have health insurance. And perversely, more people might become uninsured if the program were fully implemented. Since the maximum tax would be $1,680 per employee (the "pay" option), and since health insurance is likely to cost much more than that, many employers would find it cheaper to pay than to play.⁹⁶ As employers dropped health insurance, opting to pay the tax instead, many employees - those who are young and healthy - would be unlikely to purchase a state-sponsored health insurance policy, even at subsidized prices.

If enacted, the Massachusetts plan would be especially harmful to small businesses. In a study for the Boston-based Pioneer Institute, economists Attiat Ott and Wayne Gray found that the Dukakis plan would force Massachusetts businesses to increase spending on employee health insurance by at least 32 percent. Because of the increased cost of employing workers, as many as 9,000 jobs would be lost, with the lowest paid workers being the hardest hit.⁹⁷

Case Study: The Hawaii Plan. Proponents of a universal system of health insurance have pointed to the Hawaii Plan as a model for other states, noting that some 98 percent of Hawaiians are covered by health insurance compared with only 85 percent of nonelderly Americans as a whole. Proponents also claim that even with a near-universal system, Hawaii's medical costs and insurance premiums have been rising more slowly than in other states. Let's take a closer look.

In 1974 the state of Hawaii enacted the Prepaid Health Care Act, requiring employers to provide health insurance for all employees working over 20 hours a week. Although the Supreme Court invalidated the law in 1981, declaring its application to self-insured companies to be in violation of the Employment Retirement Income Security Act, Hawaii got an ERISA exemption from Congress.⁹⁸ Those not covered by the law - employees working fewer than 20 hours a week, government employees, small family businesses, the unemployed and seasonal workers - or not covered by Medicaid are covered by a program established in 1989 known as the State Health Insurance Plan (SHIP).⁹⁹

One reason why Hawaii has had fewer problems than other states could expect is that the state's population is apparently healthier and medical costs are much lower. The state's extensive network of HMOs probably contributes to the state's ability to contain health care costs. And a tradition of employer-provided health care means that the state mandate may not be changing the behavior of many people. For example, by one estimate, only 5,000 additional people - out of a population of over a million - acquired health insurance as a result of the employer mandate.¹⁰⁰ Moreover, employer-provided health insurance is usually much more generous than the minimum benefits required by the state and employers usually cover workers' dependents, even though they are not required to.¹⁰¹ Generalizing from Hawaii's experience to places where many employers are not now providing health insurance would be a mistake.

It would also be a mistake to conclude that those who are not covered by employer plans receive comparable benefits under the state plan. SHIP is much more limited in its coverage than the employer-based insurance. For example, it covers only five days in the hospital and only 12 physician visits.

In addition, Hawaii is made up predominantly of small businesses, many of which avoid hiring employees in order to avoid paying the cost of health insurance. This practice may have affected the state's economic performance in the decade following the enactment of the program. In the 1980-86 period, the state's employment grew by only 9 percent, compared with 13 percent for the nation and 20 percent for the U.S. Pacific Coast states. Another cost is reduced money wages. In 1975, when the law first went into effect, Hawaii was 25th among the states in average annual employee wages. By 1986 it had fallen to 36th.¹⁰²

If policies were guaranteed renewable and portable, people would have strong incentives to become insured before they got sick. But what about people who are already sick and uninsured and are generally thought to be uninsurable?

Best Idea: Direct Subsidies. The best approach is to subsidize directly people who are uninsurable, making the amount of subsidy highest for those with lowest incomes. The subsidies should be funded by general taxes. Government might pay a portion of their medical bills - say, everything above 30 percent of income - or part of the cost of having an insurer manage their health care. A less attractive option is to subsidize premiums for these people to join a risk pool. But even this option is much better than proposals to impose price controls and force insurers to sell policies to sick people at artificial premiums.

Mediocre Idea: Create Risk Pools. One way in which state governments have attempted to provide health insurance for high-risk individuals is through risk pools. Currently 27 states have passed legislation creating risk pools.¹⁰³ Under this arrangement, insurance is sold to individuals who cannot obtain policies outside of the pool. Premium prices are regulated and generally are set as a percentage of the prices of similar policies sold in the marketplace. For example, in most states the premium for risk pool insurance is 50 percent higher than for comparable policies.¹⁰⁴ In Florida, however, risk pool premiums may be three times as high, and in Montana they may be four times as high. In Minnesota, the most generous state, risk pool insurance is only 25 percent more expensive.¹⁰⁵

Since all states cap the price of risk pool insurance (thus creating an artificially low price), risk pools almost always lose money.¹⁰⁶ In most cases, losses are covered by assessing insurers - usually in proportion to their share of the market. However, in Maine, losses are covered by a tax on hospital revenues. In Illinois and California, the subsidies are funded by general tax revenues.¹⁰⁷ The most common approach is to assess participating insurers in proportion to their share of the state health insurance market. In many states that assess insurers for risk pool losses, companies are allowed to fully or partially offset their assessment against premium taxes paid to state governments.¹⁰⁸

Precisely because risk pools lose money and because there is a natural resistance to the higher taxes needed to fund these losses, many states refuse to sell risk pool insurance to all who would like to buy it. In Illinois, for example, the price is kept artificially low, but there is a waiting list of potential buyers. An extreme case is Texas, which has a risk pool but no funding - and therefore no policyholders.

The most serious problem with risk pools is that they raise the cost of health care and/or health insurance for everyone not in the pool. When risk pool losses are paid by a tax on hospital revenues, the burden is placed on sick people. When losses are covered by assessing insurers, the burden is placed on other policyholders. And when insurers are allowed to offset their assessments against state taxes, additional pressure to maintain (or even increase) taxes on insurance premiums is created and causes further distortion in the health insurance marketplace.

In general, risk pools cause the least distortion if they are funded with general tax revenues and if the subsidies are based on the policyholder's ability to pay. [See the discussion below on paying for health care reform.]

Worst Idea: Regulating All Insurance. As noted above, less than 1 percent of the nonelderly population is uninsurable. Yet some misguided reformers would impose price controls and other regulations on the other 99 percent in order to solve the problems of a tiny minority of people. As we have seen, guaranteed issue is one example. Community rating is another. In all cases, the social cost of the "reform" far outweighs the social benefit.

State-mandated health insurance benefits laws tell insurers what services and providers they must cover in ordeg the freedom of choice of consumers. They force people either to purchase a Cadillac plan - bloated with extra benefits - or to remain uninsured.

Mandated benefits laws cover diseases ranging from mental illness to alcoholism and drug abuse, services ranging from acupuncture to in vitro fertilization, and providers ranging from chiropractors to naturopaths. They cover everything from the serious to the trivial: heart transplants in Georgia, liver transplants in Illinois, hairpieces in Minnesota, marriage counseling in California, pastoral counseling in Vermont and deposits to a sperm bank in Massachusetts. As Figure VI shows, in 1965 there were only eight mandated health insurance benefits laws in the United States. Today, there are more than a thousand.¹⁰⁹

Although the same objectives can be achieved in much less harmful ways [see the sidebar], state mandates are pricing millions of people out of the market for health insurance:

• According to one study, mandated coverage increases premiums by 6-8 percent for substance abuse, 10-13 percent for outpatient mental health care and as much as 21 percent for psychiatric hospital care for employee dependents.¹¹⁰

• According to another study, one out of every four uninsured people has been priced out of the market by state-mandated benefits laws.¹¹¹

In addition to mandates, private insurance is burdened by premium taxes, risk pool assessments and other regulations. As noted earlier in this study, most large corporations are exempt from these regulations because they self-insure. The full weight of such regulations falls on the most defenseless part of the market: the self-employed, the unemployed and the employees of small businesses.

Good Idea: Total Repeal of State-Mandated Benefits. The most straightforward way to lift the burden of state mandates is to repeal them. As noted below, a number of states have already repealed mandates for small businesses. But if mandates are bad for small businesses, why aren't they also bad for other businesses? There is no reason to substitute the judgment of politicians for the judgment of buyers and sellers in determining the extent of health insurance coverage.

Good Idea: Allow No-Frills Alternatives. Failing total repeal of mandated benefits, state governments should allow insurers to sell a no-frills policy to any buyer within the state. Mandate-free insurance could compete side-by-side with regulated insurance. This would extend to the rest of the population a right now enjoyed only by employees of the largest corporations.

Second-Best Idea: Exempt Small Businesses. At one time it was thought that significant progress could be made in exempting small businesses from mandated benefits. Over the past few years, 24 states have done so to one degree or another.¹¹² Take Washington state, for example. Normally, health insurance policies there would be subject to 28 mandates - covering alcohol and drug abuse, mammography and the services of chiropractors, occupational therapists, physical therapists, speech therapists, podiatrists and optometrists. Under a law passed in 1990, firms with fewer than 50 employees can buy cheaper insurance with no mandated benefits.

While a step in the right direction, most mandate-exemption laws are so narrowly constructed that the qualifying firms are few and dispersed. Unable to identify a large enough market, most insurers have simply ignored it. For example, in 14 states such exemptions apply only to firms with no more than 25 employees. In addition, many states allow a small business to qualify only if it has been without insurance for some period of time. In seven states the qualifying period is at least one year; in Kansas, Maryland and Rhode Island, two years; and in Kentucky, three years. In these states, small employers who currently provide insurance coverage are penalized for doing so. All the benefits from the new legislation go to their uninsured competitors.¹¹³

Second-Best Idea: Social and Financial Impact Statements. Following the lead of Washington, Arizona and Oregon, more than a dozen state legislatures now require social and financial impact statements before they will pass additional mandates.¹¹⁴ For example, because of concern about costs, in 1983 Washington state began putting the burden of proof on mandate proponents to show that its benefits exceed its costs. As a result, no new mandates have been adopted by the Washington legislature for several years.¹¹⁵ Clearly, impact statements slow the passage of mandated benefits, if only because the proponents of mandates need more time and money to overcome the new legislative hurdles.

It is widely believed that certain groups of people are being underserved by the U.S. health care system. They include (1) low-income families, (2) uninsured people and (3) those who live in rural areas.¹¹⁶ The following proposals meet the needs of these people innovatively - not by spending more money but by using current funds more effectively. Some of the proposals would require waivers from the federal government, but the Bush administration has indicated a willingness to grant waivers for innovative solutions.

Good Idea: Medical Enterprise Zones. In certain areas of the country, especially rural areas, the number of doctors and hospital beds per capita is well below the average for the country as a whole. These areas are often called "underserved." The people who live in them are not necessarily deprived of medical care. They can travel to a neighboring area that is not underserved. But the cost and inconvenience of travel may be burdensome, especially for low-income patients. Overall:¹¹⁷

• In 1988, 111 rural counties in the United States had no physician.

• About half a million rural residents live in counties with no physician trained to provide obstetric care and 49 million in counties with no psychiatrist.

• Although hospitals are closing in most parts of the country, rural hospitals are closing at twice the rate of urban hospitals.

Many people assume that the only way to meet the health care needs of rural citizens is to spend more government money on rural health care programs. In fact, current government programs and policies are probably a far greater obstacle to good quality care at a reasonable price than a lack of funds.¹¹⁸

In most states, medics who treated soldiers in the field in the Vietnam or Persian Gulf wars are not allowed to treat ordinary citizens, even if no doctor lives in the area. The same restrictions apply to nurses and physicians' assistants, despite studies showing that paramedical personnel can deliver certain kinds of primary care as well as licensed physicians.¹¹⁹

Many state and federal regulations discriminate against rural areas in other ways by placing onerous, cost-increasing restrictions and regulations on health care providers and facilities. These regulations often cause existing facilities to close and prevent new facilities from opening. [See the sidebar on the Case for Medical Enterprise Zones.]

The concept behind Medical Enterprise Zones (MEZs) is that underserved areas should have the freedom and flexibility to make their own decisions about the best way to meet health care needs with scarce resources. Accordingly, within MEZs, many of the normal restrictive rules and regulations would be suspended, creating new options and opportunities for the people who live there.¹²⁰

Good Idea: Medical Enterprise Programs. Closely related to the MEZ is the concept of Medical Enterprise Programs (MEPs). Whereas an MEZ is defined in terms of a geographical area, an MEP is defined in terms of a market being served. The urban poor often face many of the same problems as rural residents - not because of a lack of physicians and facilities, but because they have been priced out of the market by government regulations that have resulted from special-interest pressures. Accordingly, providers and facilities providing medical services primarily to low-income families should be allowed to participate in Medical Enterprise Programs that are exempted from many government regulations in a manner similar to those in an MEZ.

Good Idea: Decentralized Medicaid. One of the biggest problems with the Medicaid program is that the decision makers who write the rules and regulations are often far removed from the problems they are attempting to solve. Politicians, pressured by special-interest groups, decide who is eligible and who is not, and in many ways dictate how health care is to be delivered. Often, their decisions result in an enormous waste of resources and prevent local communities from solving problems in a reasonable way. The regulations governing nursing homes is an example.

Almost all people involved in indigent health care can suggest better ways of spending health care dollars, were it not for federal and state regulations. They should have the opportunity to implement their suggestions. Medicaid funds should be turned over to local communities with only one caveat: that the funds be spent on indigent health care. This would give the local people who actually have to solve problems the freedom to decide who is eligible for assistance and what type of health care is appropriate.

Best Idea: Community-Centered Welfare. Given limited resources, it is not obvious how much money should be spent on physicians and hospitals rather than on housing, food, and other goods and services. Currently, those decisions are made by politicians who govern what we loosely call the welfare state. Better decisions are likely to be made by people in local communities faced with real problems. Accordingly, we propose that all means-tested welfare spending be turned over to local communities with only one restriction: that funds be spent to help low-income people. Under Community-Centered Welfare (CCW), the amount given by federal and state governments would not be determined by arbitrary eligibility standards devised in the political process. Instead, the amount of CCW funds each community receives would be solely a function of the amount and degree of poverty in that community.

Good Idea: Medicaid Waivers. All of the proposals in this section would require a fundamental change in the Medicaid program. But many needed changes might be accomplished through administrative waivers - which do not require new legislation. Although Medicaid for a time was reluctant to grant waivers, over the past decade it has been more open to state innovation.¹²¹

Case Study: What's Wrong with Medicaid? At its inception in 1965, proponents claimed that the Medicaid program would provide the poor with expanded access to medical care, which would in turn save on future costs. No one today believes Medicaid has lived up to those early expectations. Though program funding has increased significantly, the number of recipients has not increased proportionately.¹²²

• In 1980, for instance, more than 21.5 million Medicaid recipients received $23.3 billion in benefits.

• By 1988, though only 1.7 million recipients had been added to the rolls, spending had more than doubled to $48.7 billion.

Currently, Medicaid covers only about half of nonelderly people living in poverty.¹²³ Even so, Medicaid spending is expected to absorb one-fourth of state budgets by 1995.¹²⁴ [See Figure VII.]

On average, about 60 percent of Medicaid expenses are paid for with federal tax dollars.¹²⁵ And one of the strangest features of Medicaid is the way in which federal dollars are spent. For example:¹²⁶

• In Alaska, federal tax dollars help pay the medical bills of a family of three on Aid to Families with Dependent Children (AFDC) with an income of $11,076.

• But since the threshold for a comparable family in Alabama is only $1,788, the family would be denied help if their income were, say, $2,000.

The services paid for by Medicaid also differ considerably from state to state. Although the federal government mandates certain services, the states add on a variety of options, including the services of chiropractors, optometrists and podiatrists, and devices such as dentures, prostheses and eyeglasses. Although many below-poverty-level families are denied coverage for basic medical care in some states,¹²⁷

• Medicaid patients are entitled to the services of chiropractors in eight states, dentures in eight states and eyeglasses in 16 states.

• In one state they are entitled to the services of Christian Science nurses, and in four states patients may enter Christian Science sanitariums.

Clearly, the federal taxpayer's dollars do not go first to those who are most in need nor are they spent first on those services which meet the most important medical needs.

In principle, people on Medicaid are entitled to virtually any services covered by the program. In practice, patient care is rationed by Medicaid reimbursement practices. In most states, Medicaid payments for medical services are well below the payments made by other third-party payers. And Medicaid patients cannot add to Medicaid reimbursements with their own funds. For example:¹²⁸

• In only four states is the Medicaid payment as high, or higher than, the payment made by Medicare.

• In New York, the Medicaid payment is only 30 percent of the Medicare payment, and in West Virginia it's only 35 percent.

• As a result, many physicians who used to accept Medicaid patients no longer do so and those who do may deliver a lower quality of care.

A similar phenomenon is occurring in the hospital and nursing home industries.¹²⁹

• According to the American Hospital Association, Medicaid paid more than 90 percent of the cost of hospital care for Medicaid patients in 1980.

• By 1988, that figure had dropped to 78 percent. One consequence is that many hospitals no longer want to accept Medicaid patients.

Things would be even worse were it not for the intervention of the federal courts, which are somewhat insulated from political pressures. In response to lawsuits filed by nursing homes in 20 states and hospitals in 21 states, the courts are ruling that Medicaid payments do not meet the standards of "reasonable and adequate" compensation and are ordering higher reimbursement levels.¹³⁰

In principle, there is nothing wrong with paying lower prices in return for taking a hospital bed when it becomes available, rather than paying top dollar for immediate services. The trouble is that these decisions are being made not by patients but by the health care bureaucracy. The principal customer of medical providers is not the patient, but Medicaid, which, through its policy of setting reimbursement rates, increasingly determines the type and quality of care that Medicaid patients receive.

Case Study: Oregon's Rationing Program. In 1987 the Oregon legislature decided to cancel Medicaid funding for about 30 organ transplant recipients so that the state could expand services to poor women and children and still balance the Medicaid budget.¹³¹ Since then, the state has been openly advocating health care rationing.

A ranking of medical treatments in terms of priority takes into consi-deration such factors as costs, benefits to the patient, the extent to which treatment would affect the patient's quality of life and community values.¹³² The list of 709 procedures was established by a first-of-its-kind public process that included public hearings, community meetings and telephone surveys. The legislature cannot change the order on the list. It can only determine where on the list to draw the line and cease funding (currently after item 587).

Medical conditions considered "economically worthwhile" include prenatal care, several types of pneumonia, appendicitis, hernia and tuberculosis. Conditions not covered include those which individuals can treat themselves, such as superficial wounds; benign conditions such as a cyst on the kidney; conditions that are untreatable such as anencephaly (a child born without a brain); and conditions that have a low success rate such as treatment for extremely low-birth-weight babies (less than 1.1 pounds and less than 23 weeks of gestation) and terminal AIDS patients.¹³³

Proponents argue that the plan makes open and explicit rationing decisions that are being made covertly under the present system. Critics argue the plan unfairly reduces care for the young, the elderly and those with terminal illnesses such as AIDS.¹³⁴ The Department of Health and Human Services rejected the Oregon Health Plan on the grounds that it might conflict with the Americans with Disabilities Act.¹³⁵

If we tried to meet every health care need, we could easily spend the entire gross national product on health care. As a consequence, we must choose between health care and other uses of money. One benefit of the Oregon plan is that it draws our attention to this uncomfortable fact. The plan also invites us to consider alternatives. If government controls our health care dollars, then government must make the rationing decisions. If people control their own health care dollars, they can make their own rationing decisions.

Joseph Califano, former Secretary of Health, Education and Welfare (now the Department of Health and Human Services), has estimated that one out of every four dollars spent in our health care system is wasted.¹³⁶ Robert Brook of the Rand Corporation maintains that "perhaps one-fourth of hospital days, one-fourth of procedures and two-fifths of medications could be done without."¹³⁷ But like waste in government, waste in health care is not tagged for easy identification. What is wasteful to one person is not necessarily wasteful to another. And waste has its own constituency.

Good Idea: Use Markets. Virtually the entire world has come to realize that markets are powerful tools for encouraging efficiency. With competitive markets, 250 million Americans would have a self-interest in eliminating waste. Buyers would patronize low-cost providers. Providers would search for low-cost methods of delivering services. As noted above, creating Medical Savings Accounts which empower patients is probably the single best step towards market-based solutions. [See sidebar on Making Markets Work.]

Good Idea: Deregulate. Standing in the way of the use of markets are numerous legal barriers to competition. Take certificate-of-need (CON) laws, for example. Encouraged by the federal government in the 1970s, these laws require permission from government before a new hospital may be opened or an expensive piece of medical equipment purchased. They tend to protect existing suppliers against potential competitors by raising barriers to market entry. Although many states have eliminated these regulations, they remain an anticompetitive force elsewhere.¹³⁸

Another anticompetitive force is legislation that limits the ability of third-party payers to engage in managed care. As noted below, there is not much evidence that managed care saves money, except on the most expensive procedures. But whether managed care works or not should be determined by the market, not by politicians. Unfortunately, too many special interests in the health care industry are unwilling to allow the market to work. In 1991, for example, 195 pieces of state legislation were introduced to stop, or cripple, managed care and other cost-control techniques.¹³⁹

Among laws currently on the books, one in Indiana requires that Preferred Provider Organizations (PPOs) accept any physician willing to join. Thus Indiana Bell's PPO includes every physician in the state. Montana and Oklahoma have adopted similar measures. In some states hospital and physicians' groups are supporting legislation that would (1) require all utilization review to be done by local providers, (2) mandate that utilization review firms remain open 24 hours a day and (3) require state-specific statistical reporting. Such legislation would raise the cost of utilization review and inhibit its aggressive application. In addition, some states (including Texas) restrict the discount that insurers can give to patients who choose PPO doctors.

Good Idea: Reform the Tort System. No one knows exactly how much the tort liability system adds to an average medical bill. Most people think the number is quite large. Apart from measurable items (such as attorney's fees, court costs, damage awards and settlement checks), there are thousands of unseen ways in which the tort system affects costs. Out of fear that adverse medical events will trigger a lawsuit, for example, physicians order extra tests, perform extra procedures, and otherwise practice defensive medicine. The American Medical Association estimates that $5.6 billion is being spent each year on insurance premiums to protect doctors from lawsuits and another $15 billion is spent annually on defensive medicine tactics.¹⁴⁰ Other estimates place the number even higher.¹⁴¹

The rise of medical malpractice suits has led to escalating malpractice premiums - with an average annual increase of about 15.1 percent between 1982 and 1989.¹⁴² In some specialties the increase has been even higher. As Figure VIII shows, insurance premiums for obstetricians soared during the 1980s and are much higher in areas where lawsuits are more likely. Obstetricians in New York's Nassau and Suffolk counties pay about $100,000 a year and obstetricians in southern Florida pay $200,000.¹⁴³ These costs ultimately are borne by patients, either directly or through health insurance premiums.

So far, 15 states have adopted arbitration laws to encourage out-of-court settlements, and 25 states have capped malpractice awards. Of these, 21 place caps on "pain and suffring," Nebraska, South Dakota and Virginia have caps of $1,000,000 on the total award and Indiana has a cap of $750,000.¹⁴⁴ Maine has taken a different direction by establishing "risk management protocols" in the four specialties hardest hit by malpractice claims: anesthesiology, emergency medicine, obstetrics/gynecology and radiology. If physicians in these specialties stay within established parameters in the