February 1, 2010 2:14PM

How to Reform Health Care? ‘Let Them Have Choice’

This is big.

The federal tax code creates a large tax preference for employer-sponsored health insurance.  As a result, 61 percent of non-elderly Americans obtain health insurance through an employer.  That tax preference creates all sorts of problems.  It encourages more comprehensive health insurance and wasteful health care spending.  It deprives many workers of their health coverage at the moment they need it most: when they get sick and can no longer work.  And it denies workers the benefits of being able to choose their health plan.  Eighty percent of those who work for an employer that offers health benefits have at most two health-plan choices, which are typically both run by the same insurer.

To date, no one had really quantified the damage done by denying workers the ability to choose their own health insurance.  The only guesstimate of which I had been aware was by Mark Pauly, Allison Percy, and Bradley Herring, who "infer[red] that the true value of the welfare loss may actually be in the neighborhood of 5–10 percent," which was enough to negate any advantage that employer-sponsored insurance offers by virtue of its lower administrative costs.

A new working paper titled, "Let them Have Choice: Gains from Shifting Away from Employer-Sponsored Health Insurance and Toward an Individual Exchange," by Leemore Dafny, Katherine Ho, and Mauricio Varela, offers a more precise estimate of how much workers suffer because the federal tax code denies them their choice of health plan -- and how much they would gain if they had greater choice.  (The authors have a shorter paper explaining their results here.)  They write:

We estimate the median welfare gain from expanding choice amounts to roughly 20 percent of premiums.  For the vast majority of employee groups and alternative model specifications, the gains from choice are likely to outweigh potential premium increases associated with a transition from large group to individual pricing.

Dafny, Ho, and Varela's results provide a huge boost to free-market health care reforms.

One of the main goals of free-market reforms is to eliminate the tax code's preference for employer-sponsored insurance -- and the corresponding tax penalty imposed on people who purchase health insurance directly from an insurer.  There are many ways level that playing field, including health-insurance tax credits, a standard deduction for health insurance, and (my preference) "large" health savings accounts.  Those reforms would give people seamless coverage between jobs, protection against premium increases if they got sick, and much greater choice.

The standard criticisms of those proposals is that they would tax health benefits ("for the first time in American history," no less!) and move people onto the "individual market," where medical underwriting and higher administrative costs would increase premiums. In a recent paper, I explain how Large HSAs would result in an effective tax cut of nearly $10 trillion over 10 years, with the largest effective tax cuts going to the sickest workers.  I further explain how Large HSAs would reduce the problem of pre-existing conditions enabling people to purchase seamless coverage that doesn't become more expensive just because you get sick.

Dafny, Ho, and Varela buttress the argument for Large HSAs and other tax reforms by showing that even though administrative costs may rise slightly, the benefits of giving workers more health insurance choices would overwhelm those costs.

Of course, advocates of greater government regulation will claim that Dafny, Ho, and Varela's results show that the "exchanges" implemented in Massachusetts and envisioned in President Obama's health plan would also benefit workers by giving them more choices than their employers currently offer.   As I explain elsewhere, however, the Massachusetts and Obama health plans would actually limit health insurance choices, both immediately and over time, until they marched all Americans into a narrow range of health plans, or just one type of plan.  Dafny, Ho, and Varela's results are an argument against ObamaCare, not for it.

Many thanks to Dafny, Ho, and Varela for highlighting the harm done by government interference in health care markets, and the benefits of free-market reforms.