Friday, November 22, 2019

The Economics of Healthcare in America #3: Why Are Pre-Existing Conditions Even a Problem? (Hint: they weren’t until FDR made them one in 1943-Part 1 of 4)

Click here to read the original Cautious Optimism Facebook post with comments

6 MIN READ - The Cautious Economics Correspondent for Economic Affairs and Other Egghead Stuff resumes his series on the economics of healthcare in America.

Prologue note: The Economics Correspondent does not find great satisfaction and interest in studying the subject of American healthcare economics. Although the industry and its perverse outcomes are heavily the consequence of thousands of government laws that distort pricing, consumer, and provider incentives, the Correspondent tends to specialize primarily—albeit not exclusively—in monetary and banking history, monetary policy, and the history of business cycles.

Nevertheless, U.S. medicine is in crisis right now—just as it has been for decades. And most Americans are fairly clueless about the cause, because the root cause can’t be fit into a soundbite like “single payer now!” or “let insurance companies compete across state lines” or “We’re the only industrialized country in the world without socialized medicine.”

Liberal progressives want government run medicine or nothing. Conservatives distrust handing over their healthcare to the government bureaucracy, but often have difficulty articulating why American medicine is so wrought with inflation, leaving it for others to assume it must be the result of the flawed free market (it's not, not by a long shot)..

Thus I feel it necessary to continue the series on Healthcare Economics, starting with understanding, and then fixing, the pre-existing conditions coverage problem.


Pre-existing conditions is a healthcare issue that’s been heavily discussed in the last few years. The cruelly named Patient Protection and Affordable Care Act (ie. Obamacare) claimed to finally solve the longstanding problem by simply prohibiting insurance companies from denying enrollees who had undergone treatment for a medical condition in the previous twelve months.

Then a white elephant commitment to preserve that clause sank President Donald Trump’s attempts to repeal Obamacare when moderate Senate Republicans refused to support any bill that removed the pre-existing conditions protection while Congressional Freedom Caucus members refused to vote for any bill that retained it. Hence even with a Senate majority Republicans couldn't muster the votes for repeal.

Yet today’s familiar problem of insurance denials due to pre-existing conditions never had to exist in the first place, didn’t exist before World War II, and can be solved without the heavy handed mandates of Obamacare. In fact the Obamacare pre-existing protections "solution" has made healthcare far more expensive--acting as a major contributor to skyrocketing insurance premiums that have decimated household budgets since its enactment.

What did the health insurance system look like when pre-existing conditions weren’t a common problem? Why did it change for the worse? And how can it be fixed with far fewer market interventions that actually reduce cost instead of inflating it?

To understand we first have to go back to a time when there was no such thing as a pre-existing conditions crisis.


In the 1930’s and early 1940’s health insurance was a small, immature, but growing industry. Although direct payments for most medical services were very low—a trend that would succumb to steady price inflation beginning with the enactment of Medicare and Medicaid in 1965—millions of Americans were nevertheless already insuring themselves against major medical expenses buying plans through “The Blues” (Blue Cross and Blue Shield) or medical cooperatives where a monthly fee was paid to an association of doctors and/or hospitals in exchange for services when needed.

A key distinction of health insurance during this period is that individuals overwhelmingly shopped the insurance market and purchased their coverage directly. Employers were almost never buyers of insurance, much the same way employers don’t provide workers car insurance today, or homeowners insurance, or renters insurance, liability insurance, boatowners… etc.

But today health insurance premiums are paid very differently, dominantly funded by employers—not individuals—in an arrangement that started in the mid-20th century. Why the dramatic shift?

The answer lies in World War II government policy.

During the war, the federal government turned to Federal Reserve monetary expansion and inflation to fund enormous military expenditures. The predictable result: prices and wages rose rapidly. And as is frequently the case, government officials clamped down by imposing price and wage controls.

Given the extremely low unemployment rate, businesses tried to lure potential new workers from outside the labor force or from other employers, but wage controls prevented them from offering higher wages as an incentive.

Industry leaders complained and President Franklin Roosevelt, himself looking to ever-expand military production, offered a compromise.

In a seemingly small and insignificant edict, Roosevelt ordered the Internal Revenue Service to classify employer-sponsored health insurance premiums as both a tax-free business expense and employee pre-tax benefit.

Businesses may not have been able to offer higher wages due to price controls, but FDR allowed them to deduct any health insurance they bought on behalf of the employee from their corporate tax bill.

This tax deduction lives on to this day as any employee can attest when looking at his paycheck stub. Health insurance benefits are paid pre-tax, and companies deduct the cost of insurance premiums as an operating expense.

The health insurance tax credit was instantly popular with both employers and workers. Even if there had been no price controls at all, employers calculated that an additional dollar in salary would be whittled down by taxes to only 65 or 75 cents for workers. But an employer could offer a dollar in health insurance premiums and the employee would receive the full one hundred cents in benefits.

For the employee, corporate-paid health insurance was attractive because it made a service they originally paid for out of pocket virtually free (although in the face of spiraling post-1965 price inflation, companies have insisted employees contribute a minority amount).

Previously on the open individual market workers had bought insurance with their own after-tax money, but now they could get health coverage nearly free at work. Great, or so they thought...

Incidentally, employers continue to receive a tax credit for health insurance benefits even today while health insurance purchased directly by individuals still doesn’t qualify for a tax-deduction (with a few rare exceptions).


In hindsight the unintended consequence of the government’s encouragement of employer-paid health insurance is quite clear. Millions of Americans who had previously bought their health insurance directly on the open market made the economically rational decision to drop their old plans and switch to nearly free employer-sponsored health plans.

Tens of millions more Americans signed up for employer-sponsored health insurance into the 1950’s and 1960’s. By the 1970’s and 1980’s, an expectation of employer health insurance had become so rooted in the American mindset that job candidates now automatically demanded health insurance coverage during hiring interviews.

Unfortunately the same expectation is so ingrained in worker mentality that few ask why businesses are supposed to be providing us health insurance at all. No one expects their employer to provide car insurance, homeowners insurance, renters insurance, etc…

Well the unintended consequence has been far-reaching. Unbeknownst to workers, employers, and possibly even government officials, the curse of pre-existing conditions was born overnight with the 1943 change in tax policy.

How you ask?

Consider other insurance plans you purchase directly on the open market—say, car insurance. You don’t rely on your employer to pay for car insurance nor do you expect it. You shop around, sign up with an auto insurer like State Farm or Allstate, and so long as you’re happy with their coverage/service, you keep paying your annual or biannual premiums—regardless of whether you or your spouse are employed or not.

The same arrangement existed in health insurance until 1943. No matter who you worked for—regardless of whether you even worked or not—you always had the same health plan because your relationship with your insurer had nothing to do with your job status.

But when the employer insurance tax credit was introduced, millions of Americans immediately dropped their perfectly good and uninterrupted (uninterrupted being the vital trait here) plans to sign up with their employers instead.

And in the blink of an eye Americans opened themselves up to a pre-existing conditions conundrum. Because if you lost your job, you lost your health coverage. Worse yet, if you lost your job because you got sick, you lost your health coverage right when you needed it most.

Imagine getting cancer and a month later being laid off, losing your employer health plan, and only then trying to buy a new policy on the direct individual market. The new insurer is understandably going to reject your application given that you’ve never paid a dollar in premiums but have a pre-existing cancer problem that is going to instantly cost them hundreds of thousands of dollars in new claims.

If Americans had continued to buy health insurance on the individual market as before—divorced from their employment status—getting cancer and losing a job wouldn’t present a continuity problem. Their individual insurance policy would pay for treatment while they searched for another job.

But continuity in health coverage died the moment the federal government placed a tax benefit on employer-provided health plans and enticed Americans to break that coherence (the same coherence they still enjoy today with car insurance or homeowners insurance). Overnight Americans became completely dependent on their job for medical coverage—ie. vulnerable to a badly timed job loss.

Thus with the stroke of the good-intentions pen the federal government created the scourge of the pre-existing conditions problem in 1943.

Free market economists and libertarians have often lauded every tax break that comes their way. Milton Friedman famously said “I never met a tax cut I didn’t like.” But the employer-provided health insurance tax credit story proves that some tax cuts can be harmful—particularly those that encourage people to make irrational and harmful decisions. Imagine a government tax credit to buy heroin, syringes, and provide documents to prove narcotic injections were administered to at least 100 grade school students each day.

In the words of many free-market leaning economists and even non-ideological health care policy experts, America’s current system of employer-based health insurance is an “insane” way to administer medicine. And it is, the outcome of an accident that needs to be reversed if we're to solve the pre-existing conditions problem that plagues so many hard-working Americans.

In the next installments we’ll discuss documented proposals to break America’s irrational dependence on employers for health insurance—most of which are probably unworkable for economic and/or political reasons—and one innovative solution that can actually solve the pre-existing conditions problem and find acceptance among enough politicians to have a chance of passing, at least in a Republican controlled Congress.

(click below for a brief corroborating history of the World War II provisional tax policy change encouraging employers to provide health insurance for workers)

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