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Welfare Reform’s Unfinished Business
Medicaid has to be reined in.


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Michael F. Cannon

I n the 40 years since it was created to provide medical care to the needy, Medicaid has metastasized beyond this narrow purpose. According to the National Association of State Budget Officers, in 2004 Medicaid surpassed elementary and secondary education as the largest item in state budgets, consuming an estimated $309 billion of tax revenue.

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This would be less of a problem but for the significant portion of its budget that provides coverage to those who could obtain it elsewhere. The problem is not merely (or even principally) fiscal. Like other components of the old welfare system, Medicaid harms many purports to help by lulling them into dependency. And it constantly draws more Americans toward dependency through an ever-increasing tax burden and higher health-care costs.

For the sake of the truly needy and everyone else, Congress and the states should pare this behemoth down to a flexible program focused solely on those who cannot help themselves. The Left’s predictable response presents only a minor obstacle to reform. Still intent on expanding the program to cover all Americans and thus deepening the crisis, Medicaid’s apologists have nothing to offer but echoes of the dire and famously inaccurate predictions the Left made about welfare reform ten years ago. The real obstacles to reform are Republicans who are willing to accept the status quo.

Medicaid’s Perverse Incentives

Medicaid operates much like other components of the old welfare system, notably the now-repealed Aid to Families with Dependent Children (AFDC) cash-assistance program. In each program, Congress created: a legal entitlement to benefits for anyone who meets the eligibility criteria; a scheme where the more money a state spends, the more it receives from Washington; and centralized control over how states run their programs. Each feature creates perverse incentives that increase Medicaid spending, overall health-care costs, and dependency on government.

Medicaid typically offers services to beneficiaries free of charge, which creates the program’s first perverse incentive: encouraging beneficiaries to consume medical care without regard to cost. Requiring the truly destitute to contribute to the cost of their care is of course impossible, not to mention undesirable. Yet allowing 50 million Americans to consume care as if it were free brings its own raft of undesirable consequences.

As the RAND Health Insurance experiment demonstrated, removing price-sensitivity induces patients to consume more medical care–43-percent more under the conditions tested–but fails to produce measurable health gains. Though few data exist for Medicaid, leading researchers at Dartmouth College estimate that 20 percent of Medicare expenditures purchase care that provides no clinical value.

Medicaid’s second perverse incentive is that it discourages private efforts that provide for those who are eligible. Anyone who meets federal eligibility criteria (regarding age, income, assets, etc.), or a particular state’s broadened criteria, is entitled to benefits, which encourages many to enroll even when they could obtain care and coverage elsewhere.

Researchers at the Robert Wood Johnson Foundation surveyed 22 leading studies on whether “free” government coverage crowds out private coverage and concluded that crowd-out “seems inevitable.” While the scale is uncertain, over half of these studies found that expansions of public coverage were accompanied by reductions in private coverage. Some even found that enrollment growth in public programs was completely offset by reductions in private coverage. The lure of “free” medical care is a powerful draw, and an entitlement makes it impossible for states to focus resources on the truly needy.

The states’ open-ended entitlement to more federal funding creates Medicaid’s third perverse incentive. States receive an average of $1.30 from Washington for every dollar they spend. This encourages states to broaden their programs beyond what is necessary to assist the truly needy. According to the Urban Institute, close to one-fifth of Medicaid-eligible adults and children have private coverage, which strongly suggests that states have expanded Medicaid well beyond its original purpose.

Inflating Health-Care Costs

Medicaid undermines private health insurance in more ways than just giving some people a “free” alternative. It also makes private health insurance more expensive by shifting part of its costs onto private parties.

Price controls enable Medicaid to pay below-market rates, and providers make up the difference by charging private payers more. Mark Duggan of the University of Maryland and Fiona Scott Morton of Yale University estimate that Medicaid increases the price of non-Medicaid prescriptions by 13.3 percent. So if Grandma’s medications cost her $1,000 per year, upwards of $110 of that is her contribution to Medicaid. When unleashed market-wide, this mix of inflated demand and cost-shifting makes private health coverage less affordable, particularly for low-income Americans who are already Medicaid-eligible or on the cusp of eligibility.

A convention among health policy writers is to hail Medicaid as the white knight that rescues the uninsured when employers find they can no longer afford private coverage. As Jonathan Cohn wrote in The New Republic this February, “If Medicaid hadn’t grown to fill the yawning gaps in private coverage over the last decade, today we would probably have 50 million uninsured Americans instead of 45 million.” It’s a convention that turns reality on its head. Medicaid is a prime culprit behind rising health-insurance premiums.

Promoting Dependency

Because Medicaid is a means-tested program, many beneficiaries become or remain eligible by avoiding constructive behaviors–such as earning, saving, and purchasing private insurance–that would make them ineligible.

Jonathan Gruber of MIT and Aaron Yelowitz of the University of Kentucky found that Medicaid beneficiaries save less and consume more in order to remain eligible. They estimate that in 1993, Medicaid reduced asset holdings among those eligible by the equivalent of $1,600 to $2,000 in today’s dollars. Those disincentives are even greater today, thanks to subsequent expansions of eligibility and benefits.

The program also discourages private insurance for nursing home and other long-term care expenses. Jeffrey Brown of the University of Illinois at Urbana-Champaign and Amy Finkelstein of the National Bureau of Economic Research found that 60 percent to 75 percent of the benefits from private long-term care insurance “are redundant of benefits that Medicaid would otherwise have paid.” They estimate that Medicaid by itself discourages 66 percent to 90 percent of seniors from purchasing such insurance. Even seniors with considerable means are able to avoid tapping those resources; gaping loopholes in asset tests make them eligible for Medicaid as well.

A Familiar Ring

The congruity with to the old welfare system could not be more striking. Medicaid encourages the poor–and the not-so-poor–to become dependent on government. It encourages people to behave in ways that increase the cost of government and of health care, which makes self-reliance more difficult for their neighbors. And it encourages states to get more people to behave that way.

With so many similarities, many have proposed reforming Medicaid along the same lines as welfare: end the entitlement to benefits; eliminate open-ended entitlement to matching federal funds by capping federal payments to the states; and give states greater flexibility to pursue a few broad goals. This was the Republican plan in 1996 before President Clinton threatened to veto welfare reform if it included Medicaid reform. Perhaps wisely, Republicans sacrificed Medicaid reform and reformed welfare.

Yet if Republicans were intent on enacting meaningful Medicaid reforms ten years ago, and welfare reform was an enormous success, why are we no closer to Medicaid reform today?

[EDITOR'S NOTE: Read part II of this article tomorrow...]

Michael F. Cannon is director of health-policy studies at the Cato Institute. Parts I & II of this article are adapted from his upcoming book, Healthy Competition: What’s Holding Back Health Care and How to Free It, co-authored with Michael D. Tanner (Cato Institute, forthcoming).



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