The Republican Party is facing resistance from both the left and the right as it tries to undo key provisions of the Obama administration’s Affordable Care Act (ACA) of 2010. Even if the current GOP bill, called the American Health Care Act (AHCA), bites the dust, some changes will surely have to be made, so the only question is which ones and why. President Trump’s demands for the bill are unhelpful: "Affordable coverage for everyone; lower deductibles and health care costs; better care; and zero cuts to Medicaid." No responsible reforms can meet these populist expectations.

The only way to move the debate forward is to consider the first principles of health care economics. Any sensible health care reform has to simultaneously (1) reduce costs, (2) ensure better access, and (3) provide higher quality care. There is an obvious tension among these goals. The best way to raise quality, for example, is to invest more resources in health care, which could raise costs and reduce access. It looks as though no one government program could meet all three goals at once.

Yet what is left out of this account is the role of innovation in expanding health care choices. Market solutions to health care problems are widely derided for stripping vital services from the poor to line the pockets of the rich. But the obsession with redistribution overlooks how new forms of health care services—which rely on choice, competition, and deregulation—can drive down costs, while improving both quality and access.

Market-based innovations are driven by the threat of entry and exit. Thus, a producer that holds the dominant position in the market can be undercut by a new entrant that offers a mix of lower prices and higher quality to its customers. Some competitors streamline traditional forms of services. Others replace traditional insurance plans with “concierge” medicine, walk-in clinics, or both. The incumbents, who are well aware of that risk, in turn push to reduce costs and increase quality in order to maintain their customer base. All players, both current and potential, are, thus, constantly attuned to the need to make improvements to all three elements of the health care equation, without any form of government subsidy. With open entry, the level of product differentiation in health care markets will start to resemble those available for other consumer goods. All consumers do not purchase food, clothing, shelter, transportation, or internet services of the same quality level, or in the same way. With time, innovation lets consumers at the bottom of the market get services that formerly were available only to people at the upper end of the market. Just think of how services have expanded in telecommunications. And, if the level of competition gets too stiff, the weaker firms can exit the market, which in turn reduces the cost pressures against the firms that remain.

This market-based process never works seamlessly, but government subsidies that rescue weak technologies or firms from their deserved extinctions are not the answer. And those subsidies, moreover, never come cost-free, for the subsidies generate tax and regulatory burdens that hamper other players in the system. Indeed, one of the great failures of the ACA was that it relied on a suite of selective taxes, most notably on medical devices, that had two dire consequences. First, they distorted the operation of these collateral markets. Second, they avoided the political resistance that comes with directly taxing voters—a powerful check on any new government program. The result was bigger health care subsidies, which today have become ever harder to root out. At this point, there is a clear strategy for lawmakers to follow. First, try to remove all the inefficiencies in the current system, and only then experiment with various programs of subsidy and taxation to correct the remainder.

One objection to this market approach, often raised in health care settings, is that consumers lack the necessary information to make intelligent health care choices. But there are a number of responses to this. First, the overall levels of knowledge are highly variable among consumers. To be sure, many people will remain ignorant about what choices they can make, and they may lack critical information or be unable to act on it. But those people who can make adjustments have an incentive to acquire knowledge that will lead to better choices, including gaming the ACA. They don’t need to rely solely on their own expertise. There are all sorts of third parties and websites to which they can turn to acquire the needed information. Oftentimes, they are part of larger groups—as employees of organizations, for example—that have agents who can help. The information gap can never be entirely closed, but it surely can be narrowed. Consumers tend to make sensible choices in areas for which they have no insurance, such as cosmetic surgery or veterinary care, after all.

The second objection—that markets do not help those who cannot afford the services at all—is more difficult to handle. In some cases, the difficulty lies with the consumer’s lack of funds. In other cases, it stems from the high cost of the services, which rise steeply with age. How, then, to fill the gap, especially for services needed in life-threatening situations? The traditional methods relied on a mix of strategies for limited cross-subsidies. Some physicians offered services at little or no cost; various charitable institutions filled in the gap; and modest government programs offered barebones assistance. This collection of stopgap measures was not perfect, but it was not futile either. The increases in life expectancy between 1900 and 1965 (the year before Medicare) were dramatic, from 47.3 years in 1900 to about 70.3 years in 1965, very little of which was attributable to government support of health care.

Nonetheless, over the past 50 years, government cross-subsidies are now formally embedded through Medicare, Medicaid, and the ill-fated health care exchanges, which in combination have driven out many private plans that were in fact economically viable. At this point, it is difficult to root out large subsidies on which people of advanced age have come to rely. Retirees cannot be expected to go back to the market under a new set of market-oriented rules. Bad systems are hard to undo.

An example is this: The ACA contained a statutory limitation providing that insurance carriers could only charge their most expensive patients (those pre-Medicare patients between 50 and 64) three times what they charged their least expensive patients (roughly those in their 20s). Since the insurance carriers can only make money if they enroll a large group of low-cost customers, the patient mix is critical in these health care markets. Note that this source of plan instability never arises in a purely voluntary market that bleeds out all cross-subsidies, by accurately pricing risk. The voluntary insurance pool remains stable no matter what its composition by age because the insurance company makes a profit on each customer. Not so with the ACA, for now some provision has to be made to prevent some firms from going out of business, given that they are required to offer substantial subsidies to some of their customers. The ACA exchanges have largely broken down, as insurers both large and small have withdrawn from the system because of their inability to make money under the current rules. The failure is an object lesson of the dangers of cross-subsidies.

One design feature of the ACA was to impose a set of cross-payments from those firms that had a better book of business to those firms that did not. Unfortunately, that system only works, if at all, if some of these companies are able to turn a profit from their insureds. However, it was wholly unrealistic to expect companies that were losing money to make payments to other companies with even greater losses. Hence the government sought to make up the shortfall by charging the general judgment fund of the United States, for which there is no clear statutory authority and a manifest disagreement among federal judges as to whether these additional payments were legal under the ACA—a matter that will take years to resolve, leaving everyone in limbo in the interim.

In an effort to reduce the sting to the transfer program, the Republican bill allows for the introduction of a five-fold difference in premium rates from the bottom group to the top group. This greater differential will stem the outflow of insureds among the younger group. The size of the effect is anyone’s guess, for no one knows how permanent the change will be. Yet at the other end of the market, the removal of the subsidy creates financial pain among older individuals who now face higher insurance premiums. The Republican legislation contains some additional support to offset the size of the cross-subsidy, but the AARP estimates treat the cash subsides as too little, too late. The lesson is that once a subsidy is embedded in the system, it becomes a strong entitlement of its own. It is far easier to stop the introduction of a new subsidy than it is to remove it once in place.

The battle over redistribution should prompt both sides to find some way to wring inefficiencies out of the current system. But here a key design mistake in the Obama bill complicates things. The ACA rigidly structures all activities of participating carriers on its exchanges. The latter should look more like platforms on voluntary exchanges like eBay, whose operator does not seek to set terms of exchange, but only to enforce the terms that the parties choose for themselves. The ACA exchanges, however, impose all sorts of misguided substantive restrictions on the terms of these trades. They have high definitions of minimum essential benefits, many of which have no parallel in any voluntary markets. The exchanges require state and federal officials to review the price terms. They limit the total amount of expenditures that can be made for “administrative expenses,” making it difficult for insurers to recruit new enrollees or introduce other cost-effective plans to reduce the risk of illness or injury. And they invite opportunism by allowing people to sign on just before they need services, which has taken its toll: low-risk persons flee the plans to which high-risk persons of all ages flock.

The plans were a prescription for failure. No wonder that the enrollment projections of the Congressional Budget Office (CBO) for 2017 have run high—at about 24 million, compared to the current base of 12.2 Million. But the CBO blockbuster projection—namely that “the number of uninsured Americans would increase by 14 million in 2018 and rise to 24 million in a decade” as a result of the Republican bill, is shutting down the discussion before it can begin. That one number may well doom the current version of the AHCA. Perhaps that is a blessing in disguise. What the Republicans need to do is to figure out how to make the current system more efficient, for otherwise they will lose the next major battle over redistribution. 

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