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What is the Economic Rationale for the Health Care Law’s Individual Mandate?

Tomorrow, the Supreme Court will hear oral arguments on the constitutionality of the individual purchase mandate, which requires most individuals to pay an annual tax penalty if they do not have health insurance by 2014. While some have portrayed the mandate as a novel and dangerous encroachment on freedom, it’s important to realize that it has a reasonably long and well-thought-out rationale supporting it.

Austin Frakt, PhD

The Brief of Amici Curiae Economic Scholars in Support of Petitioners Urging Reversal on the Minimum Coverage Issue makes both the legal and economic cases for the individual mandate. It is signed by 4 Nobel Prize winners, 3 of whom (Kenneth Arrow, George Akerlof, and Peter Diamond) have won for work relevant to health economics. Four others who signed the brief have won the Arrow Award (the International Health Economics Association’s highest award), and 6 have won awards from AcademyHealth.

Last Friday, on this blog, Lawrence Gostin echoed some of the brief’s content while summarizing the legal cases for and against the mandate. The mandate is necessary, he wrote, “because it ensures that health insurance spreads the risk across the entire population so there are enough healthy individuals to keep overall expenditures lower than premium costs.” This idea is so fundamental to the health insurance reforms of the ACA, I’d like dig a bit deeper into the health economics concepts and work that support it.

The purpose of the mandate is to address some of the externalities of health insurance coverage decisions made by individuals. (“Externalities” is handy economics jargon for any effects a decision—like buying or not buying health insurance—has on those not directly involved in the decision.)

Several of these externalities involve cost shifting. First, without a mandate (but maintaining the provisions of the law that prohibit insurers from denying coverage or from charging higher premiums because of an individual’s medical history), it’s likelier that relatively sicker individuals will purchase coverage than relatively healthy individuals. Healthy individuals would forego coverage and enroll only when major health care needs arise. This is commonly known as adverse selection and also called “gaming” or “free riding.”

This type of behavior causes premiums to be higher than they otherwise would be, because the pool of people being covered includes more individuals who are sicker and more expensive to cover than would be the case with a mandate. That’s a type of cost shift, not from the uninsured to the insured per se, but from the “gamers” to the “gamed.”

This isn’t just a theoretical argument. Free riding is a real phenomenon, observed in actual markets and documented in the literature, with measured economic effects. For example, studying the Massachusetts health reform experience, Chandra et al1 showed that when that state’s mandate kicked in, almost 4 times more healthy people signed up for coverage than unhealthy ones. In other words, the mandate addressed the type of gaming explained above.

Also studying the individual mandate in Massachusetts, Hackman et al reported at the 2012 annual meeting of the American Economic Association that preventing free riding reduced average premiums from what they would have been.

Without a mandate (or equivalent incentive), another type of cost shift occurs from the uninsured to taxpayers. This happens when previously uninsured individuals become eligible for Medicare, as shown by the work of McWilliams et al.2,3 Across many studies, they found that previously uninsured individuals incurred higher (tax-subsidized) Medicare costs on entering the program than those who were insured prior to Medicare eligibility.

Negative consequences to others clearly exist when individuals do not purchase insurance, and those consequences do not seem amenable to being managed privately. When that occurs, it’s reasonable for the government to step in. As Harvard economist Greg Mankiw wrote,

“When people cannot solve the problem of externalities privately, the government often steps in. Yet, even with government intervention, society should not abandon market forces entirely. Rather, the government can address the problem by requiring decision-makers to bear the full costs of their actions.”4

Accordingly, the mandate requires decision makers (individuals) to bear the costs of their actions either by purchasing insurance or paying a penalty. This at least partially transfers some of the cost of free riding back to the decision maker in such a way as to reduce the degree of market failure and bring the health insurance market closer (but by no means all the way to) the ideal. Though it is of course possible, in the eyes of the court, that such a thing is unconstitutional, it strikes me as odd that our constitution would preserve and protect market failures by blocking means to reduce them.

Other economists might disagree, and some who do have signed a separate amicus brief. You’ll find it here. More than 150 other briefs have been filed. A compendium of them, organized by topic and with links to their full text, is here.

About the author: Austin B. Frakt, PhD, is a health economist and an assistant professor at Boston University’s School of Medicine and School of Public Health. He blogs about health economics and policy at The Incidental Economist and tweets at @afrakt. The views expressed in this post are that of the author and do not necessarily reflect the position of Boston University.
Chandra A, Gruber J, McKnight R. The importance of the individual mandate—evidence from Massachusetts. N Engl J Med. 2011;364(4):293-295.
McWilliams JM, Meara E, Zaslavsky AM, Ayanian JZ. Health of previously uninsured adults after acquiring Medicare coverage.JAMA. 2007;298(24):2886-2894.
McWilliams JM, Meara E, Zaslavsky AM, Ayanian JZ. Use of health services by previously uninsured Medicare beneficiaries.N Engl J Med. 2007;357(2):143-153.
Mankiw G. Principles of Economics. 6th ed. Thomson South-Western: Mason, OH: 212-213.
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