How to reform Medicare with faith in market principles – including vouchers

House Budget Chairman Paul Ryan (R) of Wisconsin is proposing major – and highly controversial – changes to Medicare. Though the Senate recently rejected his plan, it may play a big part in the 2012 presidential campaign.

Mr. Ryan is pitching his reforms as “premium support.” What is premium support, exactly? Is it a voucher system? Let’s take a closer look at Ryan’s plan and then weigh the pros and cons.

To understand the Ryan proposal, we first have to understand how Medicare works. Medicare is essentially a single-payer system for Americans older than 65. Part A (which everyone gets by default) pays for most hospitalization expenses. Part B (which is optional but most people pay extra for) covers medical expenses beyond hospitalization like most private insurance plans do. Both A and B employ the fee-for-service approach. Part C (which after 2003 evolved into what’s now called Medicare Advantage) allows people to elect to have the government send its premium support directly to any one of a set of insurers who offer a wide variety of plans.

In some ways, the premium support program that Rep. Ryan has proposed resembles Medicare Advantage. In both plans, government doesn’t actually provide insurance – private insurance companies do – so government is only acting as a funding mechanism. In both plans, people can choose among competing alternatives.

Ryan’s plan attempts to control costs by changing the fee structure: Instead of providing a set of benefits at any cost, the government will provide seniors with a set of funds they can use to pay for medical care. These funds would go directly to insurers, not patients, so it’s not truly a voucher system.

Indeed, a voucher system – such as America’s food stamp program – is a fairly simple operation that provides citizens with public funds to purchase private goods. Ryan’s plan, by contrast, retains much of the complexity of the current Medicare system.

The upsides to Medicare reform plans

As Americans debate proposals to reform Medicare, they should know that all of them involve trade-offs.

The upside of the current Medicare entitlement is that it provides peace of mind to the elderly – they will all be insured. The downside is that since it is based on an unsustainable funding model, they either won’t all be insured for long or the insurance the elderly have will be so heavily rationed it will be politically intolerable.

The upside of the Ryan plan is that, like the present plan, it guarantees that all of the elderly will be insured and builds on lessons learned from the Medicare Advantage program. The downside is that for some elderly people, additional choices creates additional anxiety. And observers worry that the pemium support funding wouldn’t keep pace with fast-rising medical costs.

The upside of a true voucher system is that it is very simple and very transparent. It narrowly solves the crux of the problem, which is making sure everyone gets health insurance. If set up correctly, say, through a national sales tax, it overcomes a “free-rider problem” that results from people knowing that hospitals will treat them even if they haven’t paid into the system.

Most important, it allows free-market competition to work to fullest effect, which tends to increase choice while decreasing costs. The downside is that it’s politically radical. And critics worry that voucher amounts might be too stingy, and that a robust private insurance market wouldn’t materialize because seniors are simply too costly to insure. But if we decide that vouchers are too stingy, then we can raise the national sales tax rate to fund them more generously. If people don’t want to do that, then what they really want is magic.

As for a robust private market not materializing for seniors, this problem in the pre-Medicare 1960s was largely an artifact of insurance being offered increasingly by employers. While it is true that insurance companies didn’t want to add new retirees to their roles, that does not mean they would not have been happy to continue insuring retirees that they had insured all along, because, in this case, the adverse selection problem (the sickest seeking out the most generous policies) would have been minimal.

Had health insurance never gotten tied to employment in the first place, some health insurance companies would have offered policies that smooth premiums over a person’s life while others would have offered policies whose premiums rise as one gets older, just as life insurance companies do now. A voucher plan would eliminate preferential tax treatment to employer provided insurance, thereby severing this unhealthy link.

The downsides of Ryan's premium support plan

Ryan’s premium support concept shares many of the appealing qualities of a voucher system. His plan covers everyone eligible for Medicare and it does so in a way that allows competition to work to fullest effect in raising the quality of care while keeping prices low. The premium support program could also significantly increase the role of competition in the provision of health care services that now fall under Medicare parts A and B. The government will know how much it can afford to contribute and will contribute only that much.

Finally, the specific premium support plan Paul Ryan proposed has the practical benefit of using a model that already works well: the Federal Employees Health Benefits Program. Those on Medicare will be able to choose from a number of plans on an exchange regulated by the federal government.

This exchange is an important element because it means Ryan’s plan, unlike a true voucher system, involves regulators who will be strongly tempted to engage in social engineering. This engineering, even when noble, interferes with the natural process by which competition leads to the most efficient outcomes.

Lobbyists, meanwhile, will attempt to manipulate these regulations to benefit their clients. And if competition between policies results in most policies being more expensive relative to the premium support level than was originally envisioned, there will be political pressure on regulators to push down premiums by mandating artificially low reimbursement rates for procedures. Distortions that are produced by this very practice are one of the greatest problems with Medicare today.

At the same time, firms in the exchange will have a strong incentive to push for regulations that help then collude with one another by eliminating margins of competition between them. This is rather like grocery stores lobbying for laws against being open on Sundays, which is good for them and bad for shoppers. Remember, regulators will inevitably get much of their technical advice from the insurance companies they regulate.

Another problem is that the new plan does not solve the whole health care problem. It continues the status quo of segregating the problem of insuring the elderly from the problem of achieving universal coverage. What, for example, will keep the exchange from issuing mandates that ultimately shift costs to young people, thereby distorting their market for health insurance? The exchange regulators are only responsible for keeping Medicare costs within budget. This would cause distortions that we are all too familiar with already (for example, $20 aspirins and $40 ace bandages). Finally, separating the elderly health insurance problem from the universal coverage problem interferes with transparency.

Why vouchers are the ideal approach

A voucher system, especially one financed by a national sales tax, provides a very transparent connection between costs and benefits. This is good for society and bad for those wish to manipulate health care policy for political gain. Those who want to argue that vouchers aren’t generous enough will have to convince the majority of voters to increase the sales tax rate. By comparison, the premium support program’s funding is very complicated. A murky connection between costs and benefits in government programs has interfered mightily with our ability to solve problems through political channels. It allows people to convince themselves that they can get something for nothing, which they then demand of their elected officials with predictable result.

Vouchers are the ideal approach, but we don’t live in an ideal world. The answer to the question of whether the premium support plan is the best possible solution in the real world will likely come down to details. The biggest detail will be avoiding regulatory capture by insurance companies and social engineers.

Still, one wonders why Paul Ryan didn’t come forward with a more genuine voucher proposal. I suspect that the root of the problem is a lack of faith in markets (witness Newt Gingrich’s claim that even Ryan’s new plan is too radical). The market doesn’t tell you beforehand how it will solve a problem. Policy wonks, on the other hand, do, and can also assure you that because they will be “in charge” there will be someone to deal with unforeseen problems, too. But what assures us that they will know what’s best, that they will know better than the market?

Food is more important than either health care or education, but we don’t have a food crisis while we do have a crisis in health care and in education. Ever wonder why? I submit it is because we were smart enough to put our faith in market competition and therefore clever enough to deal with the hunger problem with vouchers.

David C. Rose is a professor of economics at the University of Missouri-St. Louis. His book, “The Moral Foundation of Economic Behavior,” is forthcoming from Oxford University Press this summer.

Get the best of Monitor opinion. Sign up for our weekly e-newsletter here.