The curse of the cross subsidy

John Cochrane's wrote an interesting piece on what he calls "the second original sin of healthcare regulation" (the first being the tax deductibility of employer provided group insurance of course). His post describes what's fundamentally broken about the US healthcare system, but his observation applies to far more than just healthcare.

Our political system is allergic to the word "tax." Instead of straightforwardly raising taxes in a non-distortionary way (a VAT, say), and providing charity care or subsidies -- on budget, please, where we can see it -- our political system prefers to fund things by forcing cross subsidies.

Medicare and medicaid don't pay what the service costs, because we don't want to admit just how expensive that service is. So, large hospitals make up the difference by overcharging you and me instead. The poster child (though not really a cost driver) is emergency room care. The government passed a law saying hospitals must provide emergency room care for free. But money does not grow on trees, so again you and me (via private insurance) must get overcharged to cross-subsidize. The ACA tried to force young healthy wealthy (not getting subsidies) to vastly overpay for insurance, to cross subsidize the poorer and sicker.

Cochrane argues that this is much more harmful than simply raising the money through taxes and doling it out through the state.

Low prices, efficiency, and innovation in the provision of services like health care come centrally from competition, and especially disruptive competition.  With no competition -- especially no entry by new doctors, hospitals, clinics, insurance companies -- costs spiral up. As  costs spiral up, the cost of the charity care spirals up. As that spirals up, the size of the cross-subsidies spirals up. As that spirals up, the need to restrict competition spirals up.

In a sensible world, government assistance lives beside a free market, where innovation and price discovery happen. That keeps the cost of government assistance somewhat in check. But when we choose assistance by cross-subsidy, then kill off competition and force us all in the regulated system, that check disappears.

The UK obviously doesn't have this problem with healthcare, but the problem of cross-subsidy still creeps up in a number of markets. 

"Affordable Housing" mandates are a classic example. In the absence of real planning reform there'll be a shortage of housing within the price range of ordinary Britons. Policymakers looking for a second best solution have a choice. Either leave the market alone and offer cash subsidies to those who struggle to afford a home, or require house builders to not only build what the market is demanding, but also to sell a percentage of the houses they build at "affordable" (below market value) rates. The latter option is clearly sub-optimal, it's essentially a specific tax on new construction and makes construction much riskier for developers raising barriers to entry. Affordable housing requirements are meant to make housing more affordable but by penalising new development they make the shortage worse for all.

Another example is the energy market. Prof. Stephen Littlechild (who served as a top energy regulator in the 80s) has set out in great detail how over the past 10 years Ofgem undermined competition in the energy market. Energy companies used to offer low prices online and in competitors' areas to encourage consumers to switch supplier. Ofgem decided that firms should instead offer the same price to everyone. The price sensitive consumers who frequently switch were to subsidise the lazier consumers. But just like in the case of healthcare, the results were much worse than simply taxing one group and giving it to another. Not only did prices rise for price sensitive consumers, but prices didn't fall for the rest. The number of people switching suppliers fell and the market became much less competitive. 

Rather than a lesson being learned, this was followed by calls for even greater cross-subsidisation. The consumer affairs magazine Which? then called for energy companies to provide a simple, uniform price. That would have required massive geographic cross-subsidisation but thankfully Ofgem rejected the proposal. The coast isn't clear however with Theresa May seriously considering capping the difference between the 'cheapest and 'most expensive' tariff.

Taxes do affect behaviour and discourage productive activities, but the solution isn't to cook the books and shift taxes off the balance sheet. Doing so only makes things worse. It distorts prices and damages competition. Worse of all, it leads to even deeper calls for regulation when the existing rules fail to deliver. Subsidies are bad, but cross-subsidies are worse.