Whenever there is head-to-head competition to meet the same needs, markets routinely outperform government. For that reason, in Part I and Part II I argued that we should rely on the private marketplace to meet all the health care and health insurance needs it can meet. The role of government should be restricted to meeting only important needs that the market leaves unmet.

Here is the final suggestion:

Rule 3: Eliminate public policies that give people perverse incentives to raise costs and reduce quality.

One of the reasons the health care system fails to produce high-quality, low-cost care is that it is in no one’s interest to do that. As noted above, in many ways our system subsidizes consumption of care and penalizes frugality. Here are some examples.

Perverse incentives to overspend on care. On average, every time patients spend a dollar on medical care, only 10 cents comes out of their own pockets. The remainder is paid by third parties – employers, insurance companies and government. This means that as patients our incentive is to spend on medical care until its value is just10 cents on the dollar. 

On the provider side, most medicine is provided by fee-for-service. The more providers do, the more they get paid.

The real question is not, “why is there so much waste?” The real question is, “why aren’t things worse?”

A partial answer to this problem is individually owned Health Savings Accounts. Under current law, however, there are two problems with these accounts—and they are easily solved. 

First, withdrawals for nonmedical purposes are subject to income taxes and a 20 percent penalty. For a person in the 15 percent income tax bracket, that means $1 paid for health care is trading against 65 cents of other goods and services. 

As an alternative we should consider creating a Roth HSA, with after-tax deposits and no taxes or penalties on withdrawals at the end of the insurance period. With a Roth account, a dollar of medical care trades against a dollar of other goods and services.

The other problem relates to direct primary care (DPC), where doctors provide all primary care 24/7 for a monthly fee. This type of practice used to be called “concierge care” and was reserved for the rich. But the prices have come way down, and the practice could now easily serve Medicaid patients.

Currently, employers cannot put money in Health Savings Accounts, from which employees can select a DPC doctor of their choice. (Fortunately, this restriction will go away, thanks to the “big, beautiful bill.”)

Perverse incentives to over-insure. Under current law, every dollar an employer spends on employee health insurance avoids income and payroll taxes. Here is what that means for someone facing a 50 percent marginal tax rate (not all that unusual for senior executives who actually choose health plans). If the company spends a dollar less on health insurance and uses it to pay a dollar more in wages, the employee gets to take home only 50 cents.

A better solution is similar to what I suggested earlier for Medicaid and the exchange plans: fix the government subsidy and let people face the full cost of their marginal decisions. This is accomplished by means of a fixed sum tax credit, which is independent of the amount the firm spends on health insurance.

Perverse incentives to over-provide to the healthy and underprovide to the sick. This is a problem not just in our health care system, but in health care systems the world over. 

In general, similarly situated individuals pay the same premium, regardless of their medical conditions. Put differently, no one who acquires health insurance ever pays an actuarially fair price. That means that insurers invariably lose money on people who are known to be relatively sick and make money on people who are known to be relatively healthy before they ever enter the insurance pool.

As a rule of thumb, in any given year, 5 percent of the  enrollees in an insurance pool will be responsible for half the spending. No health plan wants the 5 percent. No employer. No commercial insurer. No marketplace insurer. And if the truth were known, no government-run system wants a high-cost enrollee either – including Medicare and Medicaid.

Insurers respond to these incentives in various ways, but the bottom line is this: their incentive is to attract and keep the healthy and avoid and repel the sick.

There is one exception to all of the above: the Medicare Advantage (MA) program. This is the only place in our health care system where a doctor who discovers a change in a patient’s health condition can send that information to the insurer (in this case Medicare) and receive a higher premium, reflecting the higher expected cost of care.

Because of a highly sophisticated risk-adjustment system, MA plans not only do not try to avoid the sick, they try to attract them. There are “special needs plans” for diabetics, for heart disease, for respiratory ailments, etc. By specializing in a particular type of care these plans have the potential to evolve into what Harvard Business School professor Regina Herzlinger calls “focused factories,” or centers of excellence.

The MA program should be a model for reform of the rest of the health care system.

Extra perverse incentives in the (Obamacare) exchanges. The current subsidy system caps the individual’s premium at 8.5 percent of income (for a benchmark plan). In 2025, 55 percent of enrollees reported an income that would have qualified them for a zero premium plan. Four out of five (19 million) enrollees are paying $10 or less. This means that almost all buyers are unaffected by premium increases. Since insurers are subjected to cost-plus regulations, they are actually better off when they charge higher premiums. So, no one – neither buyer nor seller – has any incentive to care about cost.

Because of these defects, the exchange plans have become increasingly expensive through time.

• Since 2014, premiums in exchange plans have increased twice as fast as employer plan premiums and three times as fast as the consumer price index.
• The deductible in a typical silver plan is more than twice as high as in a typical employer plan.
• The out-of-pocket exposure in a typical exchange plan is about twice as high as it is in a typical employer plan.

In addition, precisely because of imperfect risk adjustment, the plans are very attractive to the healthy and very unattractive to the sick. If you are healthy, the insurance is free, or almost free. And the only care you need is preventive care, which is also free. But if you are sick, exchange plans are usually not accepted by the best doctors and the best medical centers. This year, the out-of-pocket exposure is $9,200 for an individual and twice that for a family. And that’s every year.

To make matters worse, the subsidy system creates very high implicit marginal tax rates. Writing in the Wall Street Journal, Beverly Gossage and I gave the example of a Dallas couple who loses $18,300 in subsidies if they earn $10,000 of additional income. That’s a 182 percent marginal tax rate!

 If we subsidized buyers the way the government subsidizes insurance for its own employees and if we allowed insurers to compete in the way they do in the Medicare Advantage market, we could have real price competition. Further, firms could specialize in care for conditions such as diabetes and heart and respiratory disease instead of trying to be all things to all enrollees.

An ideal health care system. Markets are wonderful institutions that can solve our needs quickly and efficiently if we allow them to do so. If something goes wrong with my iPhone, I can pop into an Apple store with no appointment and get high-quality repair for a reasonable price.  What’s more, iPhones keep getting better and better and their real price has barely changed over time.

With sensible public policies, there is no reason why the market for medical care could not function in much the same way.