Merging Employer Based and State Exchange Insurance Markets

Is it time to merge employer-based and state exchange insurance markets?

The Affordable Care Act (ACA) created state-exchange health insurance markets to allow access to health insurance for people with pre-existing conditions, link premiums to age instead of health status, and provide subsidies for low-income households.  The ACA also maintained long standing tax preferences provided to employer-based insurance and includes rules favoring employer-based coverage over state exchange coverage. Currently around 11 million Americans obtain health insurance from state exchanges compared to around 157 million who obtain health insurance from their employer.  

The continued dominance of employer-based health insurance has resulted in several problems leaving many Americans uninsured or underinsured.  Many of these problems could be fixed by changes to regulations and tax laws which have employers subsidize the purchase of health insurance on state exchanges and have the government, through a tax credit, share part of the cost of premium payments.   

Economists have long favored separating the provision of health insurance from employers.  Senator John McCain, in his 2008 campaign favored replacing all employer-based insurance with a market where all individuals would pay insurance premiums with a tax credit.  The McCain plan would have provided the same subsidy to all households, which is a fairer outcome than the current system where some employers pay most or all of their worker’s health insurance premium and some workers receive little or no premium subsidy.   However, people with employer-based coverage and generous subsidies like and support the current system and there was little support for abolishing the employer-based system.  

The idea discussed here allows for direct contributions from employers for health insurance on state exchanges rather than having each employer select and administer a health plan exclusively for its own employees.   The employer contribution towards health insurance premiums would be deductible to the employer and untaxed to the household as in current law.  Part of the cost of state exchange health insurance would be funded with an individual tax credit.  Also, low-income people without employer contributions for health insurance or with an employee contribution that did not cover the entire premium could continue to claim the existing premium tax credit available for the purchase of state exchange insurance. 

These revised rules alleviate several problems impacting participants in U.S. health insurance markets.   

The partial separation of the responsibility of providing health insurance to employers greatly benefits workers who become unemployed or experience a job transition.  Potential benefits from a system which keeps people enrolled in their health insurance plan after becoming unemployed are vividly demonstrated by the current economic situation.  A recent study by the Economic Policy Institute found that around 9.2 million people have lost their health insurance due to the COVID pandemic.  Many of these people will be unable to maintain their current health insurance coverage, either because COBRA, the program used to continue coverage is unaffordable to many newly unemployed individuals, or the coverage is unavailable in a bankruptcy situation.  

People with employer-based health insurance who become unemployed can maintain health insurance coverage through COBRA, however, they are responsible for the entire insurance premium plus a 2 percent administrative fee.   By contrast, people with state exchange health insurance could claim the premium tax credit if their income fell below 400 percent of the federal poverty line and any newly created tax credit as advocated in this proposal.  Also, there would be no administrative costs or fees for simply maintaining coverage.  

Employers experiencing a Chapter 11 bankruptcy often eliminate coverage or reduce subsidies.   Chapter 7 bankruptcy generally results in the termination of all employer-based health insurance including COBRA.  State exchange health insurance is unaffected by corporate bankruptcy.

The migration of all employer-subsidized health insurance to state exchanges would benefit all people going through a job transition, not just the unemployed. People switching jobs would maintain the same insurance plan and would not have to meet a new deductible in the middle of the year prior to receiving new insurance benefits.

Several other problems with the U.S. health insurance system could be alleviated through the merger of ACA and state exchange insurance markets and the creation of additional subsidies separate from the employer for insurance premiums. 

Current ACA rules prevent a person with an “affordable” offer of employer-based coverage from accepting a premium tax credit on state exchanges even if the state exchange plan would offer better value.   The affordability rule is complex and as written leads to unaffordable outcomes for many households seeking family coverage.  Some health care reform proposals include a provision changing the definition of affordable in the statute to reduce burdens on households needing family coverage.  The creation of a single health insurance market would allow households to accept premium tax credits and choose the appropriate health plan if the employer contribution did not result in the health plan being affordable.    

Currently, health insurance choices at many small firms are extremely limited.  In 2020, around 75 percent of small firms offering health insurance to their employees offered only one plan.   In addition, 42 percent of self-only coverage at health plans offered by small firms had a deductible exceeding $2,000.  A large single market serving all people with or without an employer subsidy would increase choices for many people with employer-based coverage, especially employees of small firms. 

Many state exchange markets are not highly competitive. A report by the Kaiser Family Foundation found in 2020 two state exchanges were served by only one insurance company and another fourteen state exchanges had two insurance companies offering products.  Research has revealed that health insurance plans offered on state exchanges often lack access to top hospitals or specialists.    A larger market serving people both with and without employer-based subsidies would increase competition among insurance firms and would offer consumer more and better choices.  

The large single market would include current protections for people with pre-existing conditions.  Current state exchange markets are adversely impacted by people who delay the purchase of health insurance until they become sick. The repeal of fines for the individual mandate has led to litigation, which could abolish protections against pre-existing conditions.   A new tax credit funding part of the cost of health insurance premiums, which would only be available to people with health insurance would serve the same function as an individual mandate.  Regardless, people foregoing health insurance because of cost would likely have a negligible impact on the larger combined market serving the entire working-age population than they currently do in the small state exchange markets.

Currently, many small firms with low-income workers cannot afford and do not provide employer-based coverage for their employees.   The proposed premium tax credit for part of the cost of premiums will could result in more small firms subsidizing health insurance for their employees.

The new tax credit for and existing premium tax credits would only be available for people obtaining health insurance on state exchanges and would not be available for people obtaining health insurance at firms that self-insure.  Firms that self-insure are exempt from government regulations including protections against surprise medical bills.  The use of state exchange markets rather than self-insurance could improve consumer protections for many households. 

The current premium tax credit phases out at 400 percent of the federal poverty (around $50,000 for a person seeking individual coverage) leaving many self-employed workers and workers without an offer of employer-based insurance without tax subsidies for the purchase of health insurance.   The proposed tax credit for part of the health insurance does not phase out with income guarantees that all people have a partial subsidy for the purchase of health insurance.   

The combination of marginal tax rates which increase with income and a premium tax credit that decreases with income results in both health insurance costs and taxes increasing with income for many middle-income people.  A new tax credit that does not phase out would reduce the premium tax credit and the increase in health insurance costs caused by people working more and earning more. 

The combination of a merger of state exchange and employer-based health insurance markets and new tax credits for the purchase of health insurance will not make health insurance affordable to all Americans.   The achievement of universal coverage requires more ambitious actions, perhaps the creation of a robust public option coupled with automatic enrollment for people who cannot afford private health insurance.  The merger of employer-based and state exchange markets and the additional tax credits proposed here will assist many middle-income people and is a good first step toward improving the affordable care act.

David Bernstein is a retired economist, formerly employed by the U.S. Treasury.   He resides in Denver Colorado with his family, is working on a book on health insurance policy, and is author of a policy primer Defying Magnets: Centrist Policies in a Polarized World.

An Overview of Health Insurance Problems


The health insurance system in the United States is in crisis.  The Affordable Care Act (ACA) reduced the number of Americans without health insurance coverage but still left many households without coverage or substantially underinsured.   The number of uninsured started increasing as soon as President Trump replaced President Obama and more recently skyrocketed due to the economic showdown caused by the COVID epidemic.   The number of people with insurance who are underinsured and face substantial financial exposure is larger than ever and problems associated with inadequate health insurance coverage were largely unaffected by the enactment of the ACA.

This memo describes problems impacting health insurance coverage in the United States.  Its purpose is to lay the groundwork for a health care reform addressing these problems.

Barriers to Health Insurance Access for Low-Income People

The ACA reduced the number of people without health insurance coverage; however, many people, especially low-income people, remained uninsured for three reasons.  

First, enrollment and reenrollment in both Medicaid and state exchanges is not automatic leaving many people who are eligible for health insurance uninsured. This report by Brookings discusses potential advantages of automatic enrollment both for public and private insurance programs. 

Second, the ACA Medicaid expansion was reduced by a Supreme Court decision, which found the decision to expand Medicaid belonged to the states not the federal government.  The Medicaid expansion has been adopted by 38 states and the District of Columbia as of August 2020.  States that had not yet expanded Medicaid like Texas, Oklahoma and Georgia, tended to be states with the highest uninsured rates.  

Third, even in states expanding Medicaid the income threshold for Medicaid benefits is quite low (138 percent of the federal poverty line or $17,608 in most states) leaving many low-income adults ineligible for the program.

The limited scope of Medicaid coverage and the lack of a universal public option leaves many relatively low-income people without employer-based health insurance coverage dependent on the premium tax credit for state exchange health insurance.   The premium tax credit is expensive to taxpayers, especially when insuring older low-income households.  A lower cost pubic option automatically enrolling people without private insurance would be substantially less expensive to taxpayers than subsidies for premium tax credits.

Loss of Health Insurance Coverage During Periods of unemployment:

The overwhelming majority of working-age people and their dependents obtain their health insurance from their employer.  The attachment between health insurance and employment often results in disruptions in coverage during periods of unemployment.  A recent study by the Economic Policy Institute found that around 9.2 million people have lost their health insurance due to the COVID pandemic.  

Many people who become unemployed lose employer-based health insurance either because COBRA, the program used to continue coverage for people with employer-based policies, is unaffordable or unavailable in a bankruptcy situation.  

The most obvious way to reduce the loss of health insurance coverage for people who become unemployed is to reduce the link between employment and health insurance coverage by having employers subsidize health insurance coverage for employers through state exchanges rather than sponsor firm-specific health plans.

Inadequate subsidies for middle-income people lacking employer-based health insurance coverage:

Middle-income people without an offer of employer-based insurance are usually charged much higher health insurance premiums on state exchanges than comparable people with an offer of employer-based insurance.  The current premium tax credit phases out at 400 percent of the federal poverty line, around $50,000 for a single person seeking self-only coverage.  Premium estimates obtained from the Kaiser Family Foundation Health Insurance Marketplace Calculator reveal that a single adult age 35 making around $50,000 per year would pay $5,288, the full health insurance premium for a self-only policy.  By contrast, most firms offering employer-based health insurance pay a substantial share of the insurance premium.  Statistics presented by the Employer Benefits Survey conducted by the Kaiser Family foundation indicate the average employee share of premiums for a single-only policy was around $1,250 in 2019. 

President-elect Biden plans to increase the generosity of the premium tax credit and eliminate the income threshold governing eligibility for the premium tax credit. This proposal would, like the current premium tax credit, leave many young adult single workers paying their entire health insurance premium.  This problem could be resolved by altering the premium tax credit to assure a minimum payment for all workers regardless of income.    

New public benefits or programs have the incentive to partially or totally crowd out private benefits.  For example, the more generous premium subsidies offered under President-elect Biden’s plan create an incentive for some firms to eliminate their offers of employer-based insurance.  The crowd-out incentive could be reduced or eliminated by having the government and employers share premium costs for all workers.

Lack of access to premium tax credit for people with offer of affordable health insurance:

ACA rules do not permit people with an affordable health care offer to claim the premium tax credit for health insurance on state exchanges if they have an offer of affordable health insurance from their employer.  The affordability rule creates an incentive for some firms to drop employer-based coverage in order for other workers to claim the premium tax credit.  A decision to drop employer-based coverage would adversely impact people who don’t qualify for the premium tax credit or are only eligible for a small tax credit.

The IRS definition of affordable health insurance, based on the cost of insuring a single individual, results in family plans from employer-based insurance being unaffordable for many households.   Analysis presented by the Center on Budget and Policy Priorities found the affordability rule increases costs of employer-based health care relative to potential costs for state exchange health care for some low-income households.  

The solution to this problem favored by President-elect Biden and Congressional Democrats involves altering the definition of affordable health insurance.  My preferred approach involves having employers subsidize employer-based insurance on state exchanges and the creation of a partial tax credit for the purchase of health insurance for all workers.  These changes would allow all workers access to the health plan that best suits their needs and budget. 

Increased Deductibles and out-of-pocket health expenses for people with comprehensive health insurance coverage:

Around four of ten employers now only offer a health savings account with a high-deductible health plan.  The higher deductibles reduce insurance plan premiums and provide substantial tax advantages for some households.  However, the deductibility of contributions to health savings accounts is much more favorable to higher-income taxpayers.

High out-of-pocket expenses under high deductible health plans encourage many people to forgo necessary medical procedures or treatments, resulting in future health problems or costs.  Studies have shown the use of health savings accounts and high-deductible health plans substantially reduce use of prescription drugs for chronic diseases. The lack of adherence to prescription drug treatments has contributes to 125,000 deaths, at least 10 percent of hospitalizations, and increased annual health costs ranging from $100 billion to $289 billion.

President-elect Biden proposes to reduce adverse impacts of high-deductible health plans by linking the premium tax credit for the purchase of state exchange health insurance plans to a health plan that imposes lower out-of-pocket expenses on households than the current default state-exchange health plans.   This approach increases premiums for all households purchasing state exchange health insurance.   A less expensive and more efficient way to assist people with high out-of-pocket expenses is through subsidies targeting low-income people and for extra benefits for some prescription drug regimens.

The growth of short-term health plans:

Many middle-income people without an offer of employer-based health insurance and with income near the eligibility threshold for the premium tax credit often cannot afford a comprehensive health insurance.  A Trump Administration executive order expanded the use of short-term health plans and made it easier for middle-income young adults to underinsure.  

Short-term health plans with arbitrary benefit provisions, large deductibles, and no out-of-pocket limits create substantial financial exposure for people they cover. The rules governing the purchase of short-term health plans do not guarantee coverage for people with pre-existing conditions and allow for premiums to be based on the health of the individual applying for insurance.    Since most people seeking short-term health plans are healthy, a shift towards short term health plans results in higher premiums for state exchange plans covering essential benefits.

There have been a number of cases where people covered by short term health plans have, despite their coverage, been responsible for large medical bills. Short term health plans need to be outlawed and replaced with automatic enrollment in either a public health insurance option or a lower-cost private option that covers all essential medical needs.

The growth of narrow network plans and lack of access to top hospitals and networks:   

Many insurance plans have small provider networks and offer limited access to top hospitals and specialists.  The literature on this topic finds that health plans sold through state exchange markets are more likely to have small inadequate networks.   (See a study in JAMA which revealed one in seven ACA health plans did not provide access to in-network doctors in at least one specialty.  Also, see an Associated Press survey which found many top cancer hospitals do not accept people with state exchange coverage.)   The disproportionate number of narrow-network health plans in state exchange markets may be caused by the low number of firms serving many state-exchange markets.

Narrow network health plans with relatively few provider networks also exist in the employer-based market. Some small firms only offer a single possibly narrow-network health plan to their employees.

The problems of narrow networks in state-exchange health markets would be reduced if there were more competition and choice in state-exchange markets.   The level of competition in state exchange markets would be increased by combining state-exchange and employer-based health insurance markets where employers subsidize the purchase of health insurance for their employees on state exchange markets.

There may also have to be some regulation mandating insurance firms provide adequate medical networks because the prevalence of firms with inadequate networks is a factor contributing to surprise medical bill.  

Growth of surprise medical bills:

Surprise medical billing occurs when a person is treated in an in-network facility by a health care provider that is not inside the network.  Out-of-network medical bills can also occur when a person goes out of network because there are no available in-network options.

An analysis of surprise medical bills by the Kaiser Family Foundation, found 18 percent of emergency room visits and 16 percent of in-patient hospital stays involve at least one out-of-network charge.  Surprise medical billing was larger in rural areas and was also affected by differences in level of competition and state regulations. 

In theory, surprise medical billing could be a larger problem for HMOs than for fee-for-service insurance companies because HMOs are designed to provide all service inside their own exclusive network.  Some large HMOs like Kaiser are highly effective at working out these issues.

President-elect Biden as a candidate supported barring “health care providers from charging patients out-of-network rates when the patient doesn’t have control over which provider the patient sees.”   This approach does not reduce incentives for insurance companies to maintain insufficient provider networks or the incentive for specialists to join practices charging higher out-of-network fees.  An outright ban of surprise medical bills could result in the shortage of specialists in some rural hospitals.   Solutions to surprise medical billing probably require some regulation of insurance network adequacy and the creation of some incentives for doctors to refrain from charging high out-of-network prices.

Erosion of ACA during the Trump Administration:

The Trump Administration and the Republican Congress repeatedly voted to repeal the ACA and took several steps to undermine the law.  Effort to repeal the law failed but some Trump Administration actions have undermined the ACA.

The most notable success involved a provision of the 2017 Tax Reconciliation Act, which repealed fines for violating the individual mandate and created a set of legal and economic problems impacting health insurance markets.  The individual mandate discouraged healthy people from opting out of insurance coverage and quickly purchasing health insurance should their health status change.  In the absence of the individual mandate, fewer healthy people would obtain health insurance and more people would take out short-term health plans leaving themselves underinsured.  The decision of healthy people to forego continuous comprehensive health insurance coverage increases insurance premiums and impacts the viability of state-exchange health insurance markets.  The Supreme Court is considering a legal case seeking to invalidate part or all of the ACA because of the zeroing out of fines for the individual mandate.

The Trump Administration executive order allowing people to purchase short-term health plans increased demand for comprehensive health plans on state exchanges.  See discussion of short-term health plans above.

The Trump Administration reduced the budget for advertising and promoting enrollment in ACA state exchanges from $100 million to $10 million.  The best way to mitigate state exchanges from future budget cuts to enrollment efforts is to make the enrollment process automatic.

The Trump Administration cut off direct federal funding for cost sharing on state exchange health insurance plans, although, some cost sharing payments are still available.  Several court rulings have found that insurers are entitled to cost-sharing subsidies that were cut by the Trump Administration.   Future cost sharing payments would be better insulated from political pressures if the payments were made directly to households, perhaps through a tax credit for contributions to health savings accounts, than to insurance companies.

Several  Medicaid waivers approved by the Trump Administration increased premiums for Medicaid recipients, cut some Medicaid benefits and imposed a work requirement of eligibility for Medicaid.   The future role of state waivers to the Medicaid program could be reduced through creation of a public option entirely funded with federal funds.

The Trump Administration has cut risk-adjustment payments to insurers who took on a high number of high-cost patients.   Risk adjustment payments would be better insulated from political pressures if they were made directly to health care providers treating households incurring high health care costs than to insurance firms.

Concluding Remarks:

The ACA initially reduced the number of uninsured Americans by around 20 million people.  However, the number of uninsured increased early during the Trump Administration, largely due to Trump Administration policies, and skyrocketed during the pandemic.   

Moreover, the ACA did not reduce financial exposure of people with health insurance coverage.   Today, people with comprehensive health insurance have higher deductibles and higher out-of-pocket expenses than people 15 years ago because of the growth in the use of high-deductible health plans.  The Trump Administration executive order expanding the use of short-term health plans that fail to cover essential health benefits is creating substantial financial risk for people selecting these bare-bone health plans.

Many of the health insurance problems identified in this memo including the large loss of health insurance in periods of high unemployment and problems associated with the lack of competition in state exchange markets are caused by a tax code that favors employer-based insurance over state exchange insurance. These problems could be resolved or mitigated by tax reforms that partially decouple the responsibility of health insurance from employers.  This could be accomplished by a new rule allowing employers to subsidize health insurance for their employees on state exchange rather than pay for firm-specific health plans and a new tax credit where the Treasury would pay part of the cost of health insurance premiums.  The case for combining the employer-based and state-exchange health insurance markets is made here.

The proposed tax changes differ from the approach outlined by the incoming Biden Administration.   The Biden approach increases the generosity of the premium tax credit but maintains separate employee-based and state-exchange markets.   

The dominant factor increasing the number of uninsured and underinsured people is affordability.   A successful health care reform effort requires the creation of a low-cost public option or a lower cost private option providing comprehensive health coverage.   A comprehensive low-cost private option could only be achieved through cost sharing arrangements with the government.

https://bernstein-book1958.medium.com/overview-of-health-insurance-problems-a4b8039a5e2e?sk=7d40e96b9d55398136c1027f5c99881b

Fixing Problems with Short-term Health Plans

Abstract:   People with short-term health plans often experience catastrophic financial losses, despite their insurance coverage.  The Biden health plan would reduce but not eliminate demand for short-term health plans.  Problems with short-term health plans could be fixed through executive order and/or state Medicaid waivers.

Fixing Short-term Health Plans

Many people cannot afford comprehensive health insurance sold on state exchanges.   The Trump Administration responded to this affordability problem by expanding the use of short-term medically underwritten health plans, which are not compliant with ACA regulations and do not cover essential health benefits.   

A recent report by the Democratic staff of the House Energy and Commerce Committee found short-term health plans have arbitrary benefit packages, fail to cover many needed health care procedures and often provide households little or no financial protection when faced with an existential medical situation.  

Short-term health plans include several features that can lead to extremely adverse health or financial outcomes.   These plans do not cover treatments for pre-existing conditions and exclude coverage for many common medical treatments, preventive care and prescription drugs.   

Short term health plans often limit physician office visits, hospitalizations, emergency services and coverage for surgery.  Limits can take the form of number of days or visits of coverage or the reimbursement rate per day or visit.   Some short-term health plans have rescinded coverage for high-risk patients and for cancer patients.  

Arbitrary benefit limits often lead to unusual and unpredictable health care bills.  The report by the Energy and Commerce committee describes situations where one patient received a $14,000 bill for two-day hospital stay for pneumonia and another situation where the short-term policy only paid $7,000 on a $35,000 bill for an emergency procedure. 

Short-term health plans can cause physical or financial ruin for the customer.   In many situations, people with short-term health insurance plans are de facto uninsured. 

Short-term health plans with arbitrary health insurance provisions are fundamentally different than the high cost-sharing arrangements used in conventional catastrophic health plan.   A catastrophic health plan with high deductibles and coinsurance rates can result in high out-of-pocket health care costs and can cause a sick individual to forego some necessary health care treatments.   However, the existence of a high deductible will generally not result in financial ruin when the health plan covers essential services and has a reasonable maximum out-of-pocket limit.

Catastrophic health care plans are a potentially rational choice for people who are willing to tradeoff higher deductibles for lower premiums.   Short-term health plans with arbitrary benefit limits basically do not reduce risk.

President-elect Biden’s health plan attempts to reduce the demand for short-term health insurance plans by offering a more generous premium tax credit for the purchase of state exchange insurance and an affordable public option. The Center for Medicare Services projects that most people selecting short-term health plans have income over 400 percent of the federal poverty line and are ineligible for a premium tax credit.  The more generous premium tax credit offered by President-elect Biden’s plan does not provide much assistance to young adults with income slightly above 400 percent of the federal poverty line.  Young adults with income near 400 percent of the federal poverty line are unlikely to be eligible for the new public option.

There is a need for a low-cost insurance option for people who cannot afford comprehensive health insurance.   This need is likely to persist even if President-elect Biden’s health care reforms are fully enacted. However, the low-cost insurance option should not expose people to catastrophic losses even though on paper they have insurance coverage. 

The incoming Biden Administration can fix some of the more flagrant problems with short-term health plans through executive order.  The executive order would create a short-term health plan with higher deductibles and higher out-of-pocket limits than current state-exchange health plans similar to the copper plan considered by Senator Alexander and Senator Murray.   

New copper plans could attract healthier people and increase premiums for more generous plans.  This problem could be minimized by targeting copper plans towards people without access to premium tax credits.

The executive order would prohibit many or all of the arbitrary benefit limitations including limits on nights in hospital, use of emergency rooms and doctor visits. The executive order would require short-term health plans to cover all medically necessary health procedures.   The executive order would prohibit underwriting based on health status and any discrimination against people with pre-existing conditions in short-term insurance markets. 

The ACA prohibits insurance companies from imposing caps on annual and lifetime health care benefits on all comprehensive health plans with the exception of short-term health plans. Caps on health care benefits used by short-term plans reduce the cost of the health plans but create catastrophic health and financial situations for people who hit the benefit limit.  

The incoming Biden Administration and Congress needs to either prohibit short-term health plans from imposing annual benefit caps or consider innovative ways to provide additional coverage to people once they reached their annual or lifetime benefit caps on their short-term health plan. 

One approach would involve the government sharing costs above some benefit threshold.   Cost sharing could occur at any level perhaps the annual cap.   The cost sharing could be implemented by direct payments from the government to health care providers for a portion of the health care bill once annual expenditures reach the chosen threshold. Previous risk-sharing programs making payments to insurance companies with a large number of expensive health care cases were criticized as corporate welfare.  Direct payments to providers for servicers above the annual cap would be easier to defend than subsidies to insurance companies.  

A new broad cost-sharing subsidy would require Congressional approval.  It may be possible for the Biden Administration and certain states to implement cost sharing through a Medicaid waiver, which allows states to use Medicaid funds to pay health expenditures for people with health expenditures over their annual cap.   This type of cost-sharing arrangement was first described in this SSRN paper.   

The focus of most health care reform discussions is on reducing the number of uninsured.   The growth of short-term health plans during the Trump era created a class of people with insurance on paper that would still be subject to potentially catastrophic financial losses or health outcomes.   Even if fundamental efforts for health care reform fail, the Biden Administration can fix some of the problems caused by the growth of short-term health plans through executive order or through the Medicaid waiver process.

Modifying 401(k) Plans


According to the Bureau of Labor Statistics around 29 percent of people with access to a 401(k) plan choose to not contribute to their plan.  In addition, The Employee Benefits Research Institute (EBRI) reports that in 2015 around $92 billion was removed from 401(k) plans prior to retirement.   The combination of people refusing to contribute to their 401(k) plans and people taking premature contributions will result in many people with inadequate retirement income. The rules governing 401(k) plans need to be changed so that fewer people choose to forego making contributions and distributions prior to retirement are limited to a certain extent.

Current rules governing contributions to 401(k) plans provide significant financial advantages to workers who contribute.   The contributions are not subject to federal or state income tax in the year they are made.  Returns on investments are not taxed until retirement.   Many firms match or partially match employee contributions.   Many financial advisors believe that workers who fail to contribute, especially those at firms that provide an employee match, are irrational.  

There are several rational reasons why some workers forego contributions to 401(k) plans. Recently reported statistics indicate that around 40 percent of households do not have enough savings to cover a $400 bill.  A person without a basic emergency fund could be late on her mortgage or rent, unable to pay for a doctor or emergency room or fix a car.  A decision to place funds in a 401(k) plan that leads to late payments on bills will lead to late fees, a bad credit rating, higher borrowing costs and other adverse financial outcomes.   

A decision to make substantial 401(k) contributions might result in a person selecting a 20-year student loan over a 10-year student loan.  Consider a married couple with $60,000 of combined student debt at a 5 percent interest rate.   Lifetime student debt payments are $19,000 lower if student debt is repaid in 10 years rather than 20 years.   Many student borrowers could only afford the shorter-term student loan by reducing 401(k) contributions.

A decision to make substantial 401(k) contributions might force a person to take out a 30-year mortgage over a 15-year mortgage.   A person taking out a $400,000 30-year mortgage at 3.9 percent would have an outstanding balance of $257.000 after 15 years.   The 15-year mortgage would have been totally repaid, and in addition the borrower would have obtained a lower interest rate.  Again, many student borrowers can only afford the shorter-term mortgage by reducing 401(k) contributions.

In some states a person with assets in a 401(k) plan are not eligible for food stamps or Medicaid for nursing home expenses.   Go here for a paper on how retirement savings impact eligibility for food stamps.   Go here for a paper on how retirement savings impact eligibility for Medicaid nursing home expenses.   The underlying assumption behind such laws is the worker who comes upon bad times must deplete her retirement account prior to receiving any financial assistance from the government.

Many people retire early often because of the loss of a job or for health reasons.   People who retire early and have all of their funds in a 401(k) plan will be worse off than people who have saved both inside and outside their retirement plans both because early distributions from a 401(k) plan are subject to a 10 percent penalty and because distributions from conventional 401(k) plans are fully taxed.

Many older workers must choose between paying off their mortgage prior to retirement or increasing the amount of funds they place in their 401(k) plan.   Financial planners tend to favor additional accumulation in 401(k) plans over more rapid paydown of mortgage debt.  This choice often fails to work out well because people with a mortgage in retirement must, all else equal, make a larger distribution than people without mortgage obligations and the entire distribution from the conventional 401(k) plan is fully taxed.   The higher 401(k) distributions due to the need to make mortgage payments is especially difficult for retirees when a market downturn occurs at the beginning of retirement.

A household that is 401(k) rich and cash poor faces substantial financial risks.  Some households with 401(k) wealth but other financial needs raid their 401(k) plan and pay a 10 percent penalty in addition to tax on their early distribution leading to inadequate funds in retirement.  These problems could be reduced by changing the rules governing distributions from a 401(k) plan.  

Three rules should be modified.  First, workers should be allowed to withdraw 30 percent of funds contributed to a 401(k) plan without financial penalty.   Second, the worker should be prohibited from withdrawing any other funds from the 401(k) plan (the other 70 percent of contributions and all returns if any) until after age 59 ½.   Third, loans from 401(k) plans would be prohibited.

This combination of rule changes incentivizes workers to make additional contributions to their 401(k) plan while assuring that they do not raid their account prior to retirement.  

The provision for penalty-free withdrawal creates an emergency fund inside a 401(k) plan.  The provision for penalty-free withdrawal will allow a worker with student debt or mortgage debt to pursue a more aggressive repayment strategy while simultaneously saving for retirement.

Under current law, workers are allowed to distribute their entire 401(k) account prior to retirement.  This outcome could be forced upon a worker who loses his job in order to obtain Medicaid or food-stamp benefits.   The new rule by prohibiting most distributions prior to retirement will leave all workers with most funds in their 401(k) funds at retirement.

A final advantage of the rule change is that it allows more workers to reduce their tax obligations in retirement.   Under current tax rules, contributions to 401(k) plans result in tax savings in working years and higher tax obligations in retirement.   Some taxpayers use Roth accounts to minimize future tax obligations.  The new rules create a simpler way for workers to minimize their tax obligation in retirement. They can simply transfer 30 percent of their funds outside of their 401(k) account and purchase either stock, which is taxed at long term capital gains rates or an inflation linked Treasury bond, which is taxed at preferential rates.

The current 401(k) rules are not working for a lot of people, especially people with limited liquidity and large debts in relation to their income.   The proposals presented here provides incentives for people who can’t contribute to start savings and also benefits current savers reduce their tax obligations in retirement.  

David Bernstein is an economist living in Colorado.   He is the author of a policy primer on student debt, health care, and retirement income titled “Defying Magnets:  Centrist Policies in a Polarized World.”

Policy Question on Payroll Tax Holiday

This post will be updated sporadically with a policy question that troubles me. People who want to follow these thoughts need to either check this blog or my groups Policy & Politics and Finance Memos on Facebook.

The payroll tax holiday in the 2.0 trillion pandemic stimulus bill includes a requirement that businesses repay payroll tax relief in the future. A previous payroll tax holiday created in 2010 had the Treasury reimburse the Trust fund with general tax revenue.

Many defenders of Social Security thought the 2010 approach was bad policy because historically only payroll taxes and not general tax revenue was used to fund the trust fund. They though this approach might, by increasing deficits, reduce support for Social Security.

My view is that no one cares about the deficit anymore. Trump increased the deficit during a prosperous economy and the new stimulus bill is 50 percent of the budget without meaningful offsets.

My concern is that small companies will be unable to simultaneously pay back payroll taxes and new tax on ongoing payrolls. The double payments after the payroll tax ends will bankrupt some companies and slow the economy.

Should the Treasury reimburse the Trust funds for revenue lost from the payroll tax or should the government require companies make extra payments in the future to make up for this lost revenue?

My vote is that the Treasury should use general tax revenue to shore up the Social Security system both now in this emergency and in an ongoing basis. Hard for Republican budget hawks to argue for cuts to Social Security when every single one of them voted for Trump’s corporate tax cuts in relatively prosperous times.

Put your vote in the comment section of Policy & Politics.

The Politics of Student Debt

The Politics of Student Debt

There are two distinct lanes in the Democratic party. The progressive lane gravitates towards big ideas, which if implemented would transform society and the economy. The centrist land proposes modest changes to existing programs, which often would not substantially change the status quo. Most of the focus of the political discussion centers on the big proposals offered by participants in the progressive lane often leading to their rejection. Proposals offered in the centrist lane receive much less scrutiny. Problems and limitations of centrist proposals are often ignored.

The debate among candidates on student debt closely follows this pattern. The progressive lane advocates for free college and for immediate and substantial debt forgiveness for all or almost all people currently with student debt. The centrist lane advocates additional assistance for community college, and expansion of existing programs including Pell grants, Income Driven Loans, and Public Service Loans. The discussion centers on the economic and political feasibility of proposals offered by the progressive lane and does not consider the adequacy or potential problems with solutions offered by centrists.

An objective analysis of the progressive agenda suggests that its enactment requires a complete transformation of the U.S. economic, political, education, and tax systems. The consensus from this discussion is that a solution that works in a high-tax high-regulation European economy cannot be easily or quickly transferred to the United States. Moreover, many people argue that large subsidies for student borrowers are unfair to workers and taxpayers who do not attend school and are unfair to previous cohorts of student borrowers who paid off their student debt.

Centrist plans for making college more affordable and alleviating student debt burdens get far less scrutiny than progressive plans. In recent decades, there has been a substantial increase in the number of student borrowers, average student debt and the number of people entering retirement years with outstanding student loans. Centrist proposals, while more generous than policies espoused by the Trump Administration, are unlikely to reverse these trends.

A major education policy goal for many politicians in the centrist lane is on assuring an adequate supply of workers in hard to fill positions. Klobuchar in her New York Times interview on education spoke about the lack of shortage for MBAs or CEOs and the need to fill positions for home health care workers. The financial incentives in her proposals and the proposals offered by other centrists would steer many students away from academic four-year colleges towards two-year schools emphasizing practical career choices. The argument that people with substantial talent need to gravitate towards practical career choices early in their life because of economic reality is not highly inspirational or consistent with the view that education can lead to upward mobility.

The emphasis on education for practical positions leads centrists to support substantial increases in funds for community colleges. A policy that decreases the relative price of community college to four-year college could lead to fewer students from low-income households at four-year colleges. This approach could create a two-track academic structure where students from low-income households are slotted towards community college and students from households with more financial resources are slotted towards more prestigious four-year institutions. The student from the low-income and mid-income household may have enough talent to become a CEO or an MBA or a doctor. It is not clear whether the increased emphasis on community colleges will keep these doors open.

The centrist plan also includes increases in the budget for Pell grants. Pell grants target relatively low-income households and would have a relatively small impact on student debt for the typical student borrower. It would be extremely difficult and expensive to expand the Pell grant program to reduce debt burdens on students from middle-income households. Funds for Pell grants are part of the annual budget and subject to the whims of Congress.

Two additional ways to assist students from low-income households deserve consideration.

The first method involves free tuition or substantially reduced costs for the first year of four-year colleges. A free first year of college would decrease student debt for all student borrowers. Benefits would be especially large for students who fail to ever complete their degrees or students who take a long period of time to graduate, two populations that often experience repayment problems.

A free first year of college would allow for private grant funds to be allocated across a smaller population. (First year students would theoretically not need private grants if the first year was free.) An increase in grant funds per student after the first year of college would further reduce student debt burdens.

The second method involves the creation of additional two-year degrees at major four-year institutions. This approach allows more students access to major universities. The availability of more two-year degrees at four-year colleges could reduce the number of people who leave school without a degree. There may also be some students ready for graduate school after two years of undergraduate work.

The debate over debt relief options also centers on extremely ambitious proposals offered by candidates in the progressive lane. Less attention is focused on options favored by candidates in the centrist lane including the expansion of income driven loan programs and the Public Service Loan Forgiveness program.

A proposal offered by Senator Warren would discharge $50,000 of student debt for people with income less than $100,000 and a reduced amount of debt relief for borrowers with income above that threshold. Senator Sanders has offered universal discharge of student debt for student borrowers.

These broad debt relief programs are not economically efficient because they divert scarce resources away from more pressing problems. Many of the student borrowers who would receive assistance under these proposals are able to repay their loans without government assistance. The proposals are also unfair to workers who don’t benefit from higher education and to previous students who repaid their loans.

The candidates in the centrist lane favor expanding Income Driven Loan programs and the Public Service Loan Forgiveness programs. There are major problems with loan programs that link student loan payments to income and programs that offer debt relief for public service. However, problems with these programs and potential improvements are barely addressed because all of the attention is focused on the more ambitious progressive proposals.

Income Driven Loan programs link loan payments to annual income and allow for the possibility of loan discharges after a number of years. There are many problems with this approach. Student borrowers must choose to enter an Income Driven Loan program or remain in a conventional loans program when leaving school. Whether a student borrower is better off under an Income Driven Loan program or a conventional loan program depends on income and marital status over the lifetime of the loan and is often impossible to predict when students make their loan selection.

Moreover, student borrowers must reenroll annually in income driven loan programs. Errors by loan services could result in the denial of loan discharge applications for some student borrowers. The loan discharge is contingent on student borrowers making 240 on-time loan payments. Income driven loan programs may fail to provide debt relief to student borrowers who fail to make payments because of financial hardship. This is the group most in need of assistance.

The Public Service Loan Forgiveness program does not have a great track record. The program makes loan discharges contingent on an applicant staying in a public service position for 10 years. Some applicants lose debt relief when they switch careers. Over 99 percent of people in the first cohort of applicants to apply for a loan discharge under the Public Service Loan Forgiveness program had their discharge applications denied, even though the applicant had made loan payments for 10 years. There are several reasons for the large rejection rate on loan discharge applications. Some applicants were informed that they were employed at firms in positions, which were not eligible for the public service loan program. Some applicants were informed after 10 years or payments they had chosen a payment plan that was not consistent with the public service loan forgiveness program. Problems involved with administering the public service loan program are documented in this report written by the Consumer Finance Protection Board.

There are superior alternatives to Income Driven Loan programs and Public Service Loan Forgiveness programs that are not even currently being considered.

A provision in a loan contract eliminating interest charges near the end of the loan term would be simpler to administer and fairer to both borrowers and the taxpayer than a program offering loan discharges after 20 year of payments. A loan discharge provision creates an incentive for some students to increase the amount they borrow and discourage quick repayment of student debt. Students with a loan that allows interest rate reductions near the end of the loan term will always repay more if they borrow more and are not discouraged from entering a short- term payment plan.

The elimination of interest near the end of the loan term also offers some debt relief to student borrowers who miss payments and are ineligible for a loan discharge.

The Trump Administration and Congress propose to eliminate the Public Service Loan Forgiveness program because of its cost to taxpayers. In order to obtain debt relief from a public service loan program, applicants must stay in a public service career for 10 years. Some applicants may choose to eschew more productive positions to obtain a debt discharge.

A narrower Public Service Loan Forgiveness program that provided less debt relief for a short period of time when student borrower begin repayment could increase loan repayments when people are starting their careers and salaries are relatively low. This program would be easier to administer and less expensive than the current Public Service Loan Forgiveness program. More importantly, the revised shorter-term benefit would not create job lock.

The discussion and the energy in the Democratic party revolves around support for or opposition to big ideas. The potential and problems associated with modest proposals are not fully evaluated. Not surprisingly, this debate is not leading to the formation of practical policies that would actually reduce student debt burdens. We need a third lane offering pragmatic progressive policies, which could lead to real change.

Observations on the 2020 Economic Crisis — March 18, 2019

I have several comments about the severity of the current situation and prospects for bailouts.

  • Many financial analysts believe the stock market is oversold and will rebound quite quickly once the pandemic ends.  However, many companies with debt are likely headed towards bankruptcy.  The economic fallout could result in an economic downturn that leads to a long recession and a sustained downturn in stock prices.
  • Many politicians in the “center” are going to want to bailout Boeing, airlines, hotels and other industries.  A distinction has to be made between bailing out companies and bailing out shareholders.   Hard for me to justify unconditional bailouts of companies that issued a lot of debt and used cash to buy back stock to reward shareholders and CEOs with large bonuses.  Taxpayers should receive an equity stake in businesses receiving financial assistance as they did for bailing out companies like GM and AIG in 2009.   There should be restrictions on management salaries and dividends at companies accepting federal funds.  Some bailouts will occur through a chapter 11 bankruptcy process and reorganization that impacts creditors and shareholders.  I suspect Congress will eventually bail out some firms but there must be conditions and the process towards a bailout may not be a smooth one.
  • One way to structure a bailout so that the American people obtain some financial benefit is to give each household shares of companies receiving financial assistance.  Another way for American taxpayers to benefit from a bailout is to give the Social Security Administration ownership of share in companies purchased with general Treasury funds.
  • The tax code needs to be modified to reduce incentives for companies to issue debt and purchase company shares. 
  • Bank stocks are cratering even though bank analysts argue that banks are in good financial shape.   The banking sector is likely to realize large losses from loans to oil sector on top of losses related to the pandemic.  
  • The 10-year U.S. government bond interest rate is rising rapidly going from 0.65 on Monday 3/16 to 1.26 on Wednesday 3/18.  Rate was even lower last week.  The Fed does not have much control over long rates and may be out of ammo.  Typically, investors count on increased bond prices to coincide with and offset downturns in stock prices.   This result is unlikely this time because interest rates are starting at such a low level and people are selling all assets, including bonds, to get cash.  

Reinventing the 401(k) plan

According to the Bureau of Labor Statistics around 29 percent of people with access to a 401(k) plan choose to not contribute to their plan.  In addition, The Employee Benefits Research Institute (EBRI) reports that in 2015 around $92 billion was removed from 401(k) plans prior to retirement.   The combination of people refusing to contribute to their 401(k) plans and people taking premature contributions will result in many people with inadequate retirement income. The rules governing 401(k) plans need to be changed so that fewer people choose to forego making contributions and distributions prior to retirement are limited to a certain extent.

Current rules governing contributions to 401(k) plans provide significant financial advantages to workers who contribute.   The contributions are not subject to federal or state income tax in the year they are made.  Returns on investments are not taxed until retirement.   Many firms match or partially match employee contributions.   Many financial advisors believe that workers who fail to contribute, especially those at firms that provide an employee match, are irrational.  

There are several rational reasons why some workers forego contributions to 401(k) plans. Recently reported statistics indicate that around 40 percent of households do not have enough savings to cover a $400 bill.  A person without a basic emergency fund could be late on her mortgage or rent, unable to pay for a doctor or emergency room or fix a car.  A decision to place funds in a 401(k) plan that leads to late payments on bills will lead to late fees, a bad credit rating, higher borrowing costs and other adverse financial outcomes.   

A decision to make substantial 401(k) contributions might result in a person selecting a 20-year student loan over a 10-year student loan.  Consider a married couple with $60,000 of combined student debt at a 5 percent interest rate.   Lifetime student debt payments are $19,000 lower if student debt is repaid in 10 years rather than 20 years.   Many student borrowers could only afford the shorter-term student loan by reducing 401(k) contributions.

A decision to make substantial 401(k) contributions might force a person to take out a 30-year mortgage over a 15-year mortgage.   A person taking out a $400,000 30-year mortgage at 3.9 percent would have an outstanding balance of $257.000 after 15 years.   The 15-year mortgage would have been totally repaid, and in addition the borrower would have obtained a lower interest rate.  Again, many student borrowers can only afford the shorter-term mortgage by reducing 401(k) contributions.

In some states a person with assets in a 401(k) plan are not eligible for food stamps or Medicaid for nursing home expenses.   Go here for a paper on how retirement savings impact eligibility for food stamps.   Go here for a paper on how retirement savings impact eligibility for Medicaid nursing home expenses.   The underlying assumption behind such laws is the worker who comes upon bad times must deplete her retirement account prior to receiving any financial assistance from the government.

Many people retire early often because of the loss of a job or for health reasons.   People who retire early and have all of their funds in a 401(k) plan will be worse off than people who have saved both inside and outside their retirement plans both because early distributions from a 401(k) plan are subject to a 10 percent penalty and because distributions from conventional 401(k) plans are fully taxed.

Many older workers must choose between paying off their mortgage prior to retirement or increasing the amount of funds they place in their 401(k) plan.   Financial planners tend to favor additional accumulation in 401(k) plans over more rapid paydown of mortgage debt.  This choice often fails to work out well because people with a mortgage in retirement must, all else equal, make a larger distribution than people without mortgage obligations and the entire distribution from the conventional 401(k) plan is fully taxed.   The higher 401(k) distributions due to the need to make mortgage payments is especially difficult for retirees when a market downturn occurs at the beginning of retirement.

A household that is 401(k) rich and cash poor faces substantial financial risks.  Some households with 401(k) wealth but other financial needs raid their 401(k) plan and pay a 10 percent penalty in addition to tax on their early distribution leading to inadequate funds in retirement.  These problems could be reduced by changing the rules governing distributions from a 401(k) plan.  

Three rules should be modified.  First, workers should be allowed to withdraw 30 percent of funds contributed to a 401(k) plan without financial penalty.   Second, the worker should be prohibited from withdrawing any other funds from the 401(k) plan (the other 70 percent of contributions and all returns if any) until after age 59 ½.   Third, loans from 401(k) plans would be prohibited.

This combination of rule changes incentivizes workers to make additional contributions to their 401(k) plan while assuring that they do not raid their account prior to retirement.  

The provision for penalty-free withdrawal creates an emergency fund inside a 401(k) plan.  The provision for penalty-free withdrawal will allow a worker with student debt or mortgage debt to pursue a more aggressive repayment strategy while simultaneously saving for retirement.

Under current law, workers are allowed to distribute their entire 401(k) account prior to retirement.  This outcome could be forced upon a worker who loses his job in order to obtain Medicaid or food-stamp benefits.   The new rule by prohibiting most distributions prior to retirement will leave all workers with most funds in their 401(k) funds at retirement.

A final advantage of the rule change is that it allows more workers to reduce their tax obligations in retirement.   Under current tax rules, contributions to 401(k) plans result in tax savings in working years and higher tax obligations in retirement.   Some taxpayers use Roth accounts to minimize future tax obligations.  The new rules create a simpler way for workers to minimize their tax obligation in retirement. They can simply transfer 30 percent of their funds outside of their 401(k) account and purchase either stock, which is taxed at long term capital gains rates or an inflation linked Treasury bond, which is taxed at preferential rates.

The current 401(k) rules are not working for a lot of people, especially people with limited liquidity and large debts in relation to their income.   The proposals presented here provides incentives for people who can’t contribute to start savings and also helps current savers reduce their tax obligations in retirement.  

David Bernstein is an economist living in Colorado.   He is the author of a policy primer on student debt, health care, and retirement income titled “Defying Magnets:  Centrist Policies in a Polarized World.”

Should Big Tech be Broken Up?

This post evaluates Senator Warren’s plan to break up big tech firms.  The analysis presented here supports the view that some of her proposals would assist large established firms and would reduce choices for consumers.  Google and Facebook have monopoly power in search and social media, but other large tech firms are capable of contesting these markets, the two firms compete with each other for ad revenue and face substantial competition in many markets from Apple, Amazon, Walmart and other firms. 

Introduction:

Senator Warren proposes major changes to anti-trust law and increased enforcement against big tech firms in her article  “It’s Time to Breakup Amazon, Google and Facebook.” 

Warren’s approach includes the following

She wants large companies with major Internet marketplaces to either sell only third-party goods or its own goods.   Marketplaces serving third-party sellers would be set up as a regulated platform utility.   The rule would require Amazon to separate Amazon Basics from Amazon marketplace, could prevent Amazon Prime and Netflix from selling the movies it produces and would require changes to the Apple Istore.  

She wants the newly created platform utilities to follow a standard of fair, reasonable, and nondiscriminatory dealing with users.  She also wants to restrict data transfer to third parties by platform utilities.

Separately, she would require Google to separate Google Ad sense from Google Search.

She would reverse some previous Tech mergers and make future tech mergers more difficult.  Previous mergers to be reversed include – Amazon’s purchase of Whole Foods and Zappos, Facebook’s purchase of WhatsApp and Instagram, and Google’s purchase of Waze, Nest and DoubleClick.

Warren has a really clear and simple vision of the world.  Google, Apple, Amazon, and Facebook all have monopoly power.   All four companies use their monopoly power to obtain large profits from consumers. The solution to this problem is to break up existing firms, reverse previous mergers, prevent future mergers and increased regulation.  

My view of the world is less black and white than Warren’s view.   Some of the major tech firms have high market shares potentially creating substantial monopoly power.  Some of the previous mergers were anti-competitive and need to be reversed but in some cases the advantages of the previous merger outweighed costs.  Moreover, some future mergers and acquisitions by competitors of Google and Facebook could increase competition and expand choices for consumers. 

In some cases, on-line regulation of Internet marketplaces is desirable but in other cases the regulation would leave the Internet firm at a significant disadvantage compared to traditional retailers. 

Analysis:

The theoretical case for applying antitrust procedures to Internet firms differs greatly from the theoretical case associated with applying antitrust to traditional industries like steel or oil.  Traditional firms attempt to get monopoly power in order to increase price and get large profits.  Many Internet firms like Google and Facebook do not charge anything for their services.  These firms get profit from ad revenue and from the use of their data on consumers.   They are willing to spend money to attract customers because an increase in the size of their network increases the scope and value of their network.  

Google and Facebook are not like swimming pools where at some point (typically pretty quickly on a hot day) additional swimmers make the pool less attractive.   There is no real cost of additional users to Google and Facebook.   Also, since the basic purpose of these networks is to allow people to interact and work together an increase in the size of the networks increases their value.  Why are Google Docs and Microsoft Office so popular?   People share documents.  An increase in the number of people sharing stuff or interacting can increase the value of the software or network.   

Google and Facebook have overwhelming market share and monopoly power in search and social media respectively.  Both firms have higher profitability levels than they would if the industry was competitive.  Google’s dominance in search allows it to manipulate results and favor certain sellers or merchants over other sellers and merchants.   The unchecked and unregulated power of Facebook has led to privacy violations, misuse of data and political manipulation of Democratic elections by bad actors.  The manipulation of consumers by Facebook may have resulted in Donald Trump being elected president and may similarly impact the 2020 presidential race.

High market share is an important indicator of potential monopoly power and is of great concern to industrial organization economists.   However, high market share does not automatically lead to monopoly power when markets are contestable.   The theory of contestable markets created by William Baumol asserts that high concentration may not lead to problems associated with monopoly if there are low barriers to entry and exit.  The implication of this theory for Big Tech is that the way to deal with the potential search and social media monopolies is to facilitate the entry of additional competitors.

One of the reasons why Google has a monopoly position in search is that both Google Android and Apple phones default to the Google search engine.   Google pays Apple a whole lot of money to make google search the default on its phone.  This side payment is basically an incentive to not compete and is in my view illegal collusion under existing antitrust law.  Warren did not flag this problem in her article.  Anti-trust authorities should end this arrangement.  This change would make the market for search not only contestable but actively contested.

The problem of Google’s monopoly power in search cannot be resolved by separating Google search from Google ads.  Google makes no money from search.   Virtually all of Google’s entire revenue is from its ad division.   A separate Google search division with no ad revenue would probably not be financially viable.

Believers in the theory of contestable markets assert that the key to taking on the Google and Facebook monopolies is to encourage entry and greater competition from existing tech firms. Microsoft with its unsuccessful Bing search engine and with its LinkedIn social network is already in competition with both Google and Facebook.     Ironically, Microsoft could more actively compete with both Google and Facebook by purchasing firms an activity that would be restricted by the adoption of Warren’s approach.  

For example, Microsoft could more easily compete with Google by purchasing Yelp and integrating Yelp with its search engine Bing.  Yelp may be receptive to a partnership with Microsoft because it has accused Google of anticompetitive behavior.   Microsoft would also have to purchase or develop a mapping company to compete with Google Maps, Waze and Apple Maps. 

A useful search engine must be complemented by mapping software for cases where the customer needs to move towards the item or business being searched.  The primary purpose of Google’s purchase of Waze was to prevent another firm from integrating Waze with their search algorithm.  Waze is now experiencing a slow death.  I agree with Warren that Google’s purchase of Waze was anti-competitive and should be reversed.  This type of antitrust action might prompt Apple or Microsoft to start competing with Google on search.  

Microsoft’s ability to compete with Facebook would similarly be enhanced if it purchased the blog platform Medium and integrated it with is social network LinkedIn.   This move would increase the number of LinkedIn members and would also increase activity by current users.

The case for reversing previous acquisitions made by Facebook is weak.   Prior to their purchase, Instagram and WhatsApp had fairly low revenue and income.   These firms may not have been viable on their own and other social media companies including Twitter and Snap did not have the money to make these acquisitions.  

These acquisitions did expand Facebook’s monopoly in social media, but the acquisitions also increased the ability of Facebook to compete with Amazon and Google for ad revenue.   I am unsure how the courts would weigh the benefits and harm of these mergers.  I am pretty sure that prohibiting these mergers would have reduced growth in Silicon Valley, stifled innovation and reduced tax revenues and charitable giving.

The case for breaking up Amazon is also weak at best.  Amazon is huge and has disrupted many industries and firms but large size without abnormal profits is not a reason for antitrust enforcement.    Amazon, aside from the cloud computing division the company, has low profits margins.   Amazon is in stiff competition with many brick and mortgage retail firms including Walmart, Target, CVS and other drug companies. Many of these competitors have higher profit margins than Amazon.  

Sometimes it appears as though the established firm uses anticompetitive methods to prevent competition from an on-line competitor owned by Amazon.  CVS and Target are refusing to honor their customer’s valid requests to transfer prescription to PillPack and Express Scripts has removed PilPack from its network.

The acquisition of Whole Foods by Amazon resulted in a huge shakeup in the grocery industry decreasing stock prices of several firms.  However, Whole Foods only had slightly more than 1 percent of the U.S. grocery market at the time it was acquired by Amazon, hardly a reason for concern.

Warren’s plan potentially treats a large retail firm like Walmart or Kroger differently than Amazon.   Inside a Walmart and Kroger one can find name-brand products and products produced by the store side by side.  Presumably, the same arrangement would be available on the store web page.  Under Warren’s rule, Amazon would not be allowed to put its own brands up next to a competitor’s brands.   Why should it permissible for Walmart to list name and Walmart options on the same shelf or web page and impermissible for Amazon to do the same?

The growth of Amazon by increasing competition has reduced prices to consumers and has kept inflation low.  The growth of Amazon has hurt some retailers but has helped the economy in many other ways.  An antitrust action against Amazon would do more to strengthen many of Amazon’s large competitors and would not clearly benefit consumers who benefit from the low prices offered by Amazon. 

One of the most interesting and innovative aspect of Warren’s anti-trust approach involves regulation of platform utilities, companies that arrange sales from third parties to customers.    Warren, when explaining the platform utility regulation, says companies should not be allowed to umpire and play in the same game.   

The largest adverse impact of the regulation of platform utilities involves competition in the entertainment industry.  The proposal to regulate Internet marketplaces as platform utilities favors the cable industry, Disney, and network TV over Amazon Prime, Apple, itunes, and Hulu and potentially Netflix.  Many of the best current movies and television shows are now produced by Netflix, Amazon and Apple.   These streaming services have increased choices for consumers and have allowed some people to cut the cord with local cable company monopolies.  

Streaming companies are constantly looking for high quality material from independent producers.  These company gets a fixed monthly fee from consumers who buy a subscription.  They don’t appear to guide people away from independently produced shows and movies towards content they finance. I am not sure what could be gained from preventing companies from distributing their own films.

Another area where Warren’s proposal could have a large impact is in competition for Internet related devises inside a home.  Google purchased Nest but there are still several other makers of smart thermostats.   Amazon own Ring but there are still  several other makers of smart doorbells.     There seems to be plenty of competition in this area and little need for an intervention by antitrust authorities.

Concluding Thoughts:

The growth of companies on the Internet has created a lot of competition for older established companies in the brick and mortar economy.   Consumers have often benefited through lower prices and the introduction of new products.     

Two companies, Google and Facebook, have a significant monopoly position in their respective fields.  Both companies have used their monopoly power to obtain abnormal profits, have not properly safeguarded consumer information and have at times used their power to impede competitors.  

Warren’s stringent antitrust approach would curb the power of large Internet firms but would also favor large traditional established companies.  In some cases, it is the large established firm that engages in anticompetitive behavior. Some restrictions on large Internet companies could result in higher prices and fewer choices for consumers.

 A more effective strategy for expanding competition in the Internet industry involves creating incentives for existing large tech firms to compete with Google on search and incentives for existing large tech firms to compete with Facebook on Social Media.

David Bernstein is an economist living in Colorado and the author of a policy primer addressing issues pertaining to student debt, health insurance and retirement income called “Defying Magnets:   Centrist Policies in a Polarized World.”

Six Reasons 401(k) Contributions Should Not be Your Top Priority

Many financial advisors believe contributions to 401(k) investments should almost always be their client’s top priority.   They sort of recognize that people who can’t pay their current bills on time and have no funds for basic emergencies need to limit or even forego contributions to illiquid retirement accounts.  However, in almost all other circumstances financial advisors favor expanding 401(k) contributions over other financial priorities.  

My view is that financial advisors tend to overprioritize the importance of 401(k) contributions at the expense of several other financial priorities. Many households should lessen the accumulation of 401(k) growth when it leads to higher borrowing costs, increased lifetime debt burdens, and outstanding mortgage obligations in retirement.  Households need to evaluate the impact of excessive reliance on 401(k) savings on tax obligations in retirement, the impact of 401(k) fees on retirement savings, and how use of alternative assets outside a 401(k) account might reduce financial risk in retirement.

Six goals – (1) Improved liquidity, (2) reduction of lifetime debt payments, (3) accumulation of house equity and mortgage reduction, (4) reduction of tax obligations in retirement, (5) reduction of 401(k) fees, and (6) management of financial risks — can lead a person to delay or reduce 401(k)  contributions. We consider circumstances where these six financial goals might override the need to increase 401(k) contributions.

Improved Liquidity:   

Many young adults are leaving college with substantial debt and little or no funds saved for emergencies.   These individuals need to reduce debt, create a fund for emergencies.  They are not in a position to tie up funds in an illiquid retirement account. 

Failure to create an emergency fund and eliminate credit card debt could lead to a deterioration in a borrower’s credit rating, which could result in much higher interest rates and a lifetime of higher borrowing costs.  A person with good credit could obtain an interest rate around 60 less than a person with bad credit for a private student loan or an auto loan.   A mortgage rate could be 40 percent lower for the person with good credit.

  • I considered the impact of credit quality on lifetime interest payments for a person with good credit and a person with bad credit.   My example involves people with three loans – a $15,000 auto loan, a $40,000 student loan and a $300,000 mortgage.   The person with good credit pays $159k less than the person with bad credit over the life of the three loans.  The largest potential savings from good credit is associated with the mortgage because it is the largest loan.

Low liquidity and high debt could lead to a great deal of discomfort and distress. In the case of a natural disaster, this could involve the difference between staying in a public shelter or flying away to a vacation.  Many people without credit or cash will find it difficult to move to a new city even if the move will lead to a higher paying job.  Bad credit can make it difficult to be approved for an apartment, may result in required down payments on utilities or cell phones, may result in the denial of a job opportunity, and higher insurance premiums.

A person who decides to tie up funds in an illiquid retirement account and allows her credit rating to deteriorate will have high borrowing costs and a more stressful life.   These adverse impacts could be avoided through the following steps. 

  • Establishment of a substantial fund for emergencies prior to tying up funds in an illiquid 401(k) account.
  • Evaluate the likely impact of contributions to your 401(k) plan on your ability to repay your loan. Make sure all bills will be paid on time prior to starting 401(k) contributions
  • Reduce 401(k) contributions and make additional debt payments as soon as debt payment problems occur.

Lifetime Debt Reduction:  

Some financial analysts acknowledge that reduction in high-interest rate credit card debt should be a high priority but are okay with long term student loan or mortgage obligations because these loans have lower interest rates.  The problem is that student loans and mortgages are often huge and lead to large lifetime debt burdens. 

  • Lifetime debt payments can be reduced by around 18 percent by selecting a 10-year student loan over a 20-year student loan and by around 20 percent by selecting a 15-year mortgage over a 30-year mortgage.

Many people can only afford the payment on the shorter-term loan by reducing payments to their 401(k) plan.  People need to consider actions that minimize lifetime debt payments even if these actions result in lower contributions to a 401(k) plan.

Here are some options.

  • Young adults who take their first job after college but plan to reenter school should almost always save for their graduate school tuition rather than tie up funds in a 401(k) plan. 
  • Student borrowers should attempt to take a 10-year student loan rather than a 20-year student loan if at all possible.  Income based replacement loans and public service loans that offer the possibility of loan forgiveness exist; however, the Department of Education has refused to discharge some of these loans and reliance on these loan programs is a risky financial strategy.  A 10-year loan may be the most effective way to limit your lifetime student loan payments. 
  • Borrowers should consider repaying their student loans in fewer than 10 years to further reduce interest payments.
  • The use of a 15-year mortgage rather than a 30-year mortgage probably requires total elimination of the student loan and may require that you delay purchasing your first house.   One problem with this approach is that when housing prices rise a delay in the first house purchase will result in a higher house price.

Mortgage Debt Elimination:

More and more older people must pay mortgages during retirement.   One study using Census Department data found that people over 60 were three times higher to have a mortgage in 2015 than they were in 1980.  

Many financial advisors are okay with their clients taking a mortgage into retirement and recommend additional catch-up 401(k) contributions over additional mortgage payments.  This is often terrible advice.

Stocks tend to have higher returns over other asset classes over long term investment horizons.   However, stock returns over a 5-year to 10-year time frame are often quite low.   By contrast, a dollar invested in reducing the mortgage balance results in a certain return.

During working years contributions to 401(k) plans are exempt from income tax.   However, during retirement all disbursements from traditional 401(K) accounts are fully taxed as ordinary income.  A person with an outstanding mortgage in retirement will, all else equal, have to disburse a larger amount than a debt-free person.  The larger disbursements lead to a higher tax obligation in retirement.  

Moreover, a person with a large mortgage balance in retirement may not be able to reduce 401(k) disbursements during a market downturn, which may lead an increased risk of the person outliving her savings.

People who pay off their mortgage on or before the date they retire tend to have planned for that outcome.   Often this outcome entails taking out a 15-year mortgage when purchasing their final home.   The simplest comparison involves a person planning to retire in 15 years who takes out either a 15-year or 30-year fixed rate mortgage.  For purposes of illustration assume the loan amount is $450,000 and the interest rates are 3.8 percent for the 30-year loan and 3.3 percent for the 15-year loan.  This is similar to current mortgage rates.   The outstanding loan balance after 15 years of payments is $0 for the 15-year loan compared to $287k for the 30-year loan.

People need to make the elimination of mortgage debt prior to retirement a high priority in their financial plan.  The following steps should be considered.

  • Taking out 15-year mortgage rather than 30-year mortgages on all homes purchased during their lifetime, even if higher mortgage payments result in the borrower having to reduce 401(k) contributions.
  • Rolling over all funds received from the sale of a home into the down payment on the purchase of the subsequent home.
  • Foregoing 401(k) catch up contributions at age 50 in order to accelerate mortgage payoff prior to retirement.

The decision to take a 15-year mortgage rather than a 30-year mortgage and the decision to reduce your 401(k) contribution could increase your current year tax liability.  However, the tax reform act of 2017 reduced the number of homeowners who claim the mortgage deduction on their tax return.  My view is that financial advisors and clients often place too high a priority on immediate reductions in tax obligations and should be more focused on reduction of risk and long-term financial objectives.   

Tax Considerations:  

There are two major tax benefits associated with 401(k) contributions. Contributions to conventional 401(K) plans are exempt from tax in the year the contribution is made.   All capital gains and investment income accumulate tax free until the income is disbursed from the 401(k) account.  As a result, contributions to a 401(k) plan are a highly effective way to reduce current year taxes and to forego taxes until disbursements in retirement. 

During retirement all disbursements from conventional 401(k) plans are taxed as ordinary income, which for most people is a substantially higher rate than the tax on capital gains on assets held outside a 401(k) plan.    

Increased 401(k) contributions decrease current year taxes and delay tax obligations.   People with a high concentration of their wealth in 401(k) accounts have higher tax obligations in retirement.   People must consider the tradeoff between immediate tax reduction and future tax obligations.

Several recent tax changes have reduced the importance of the exemption of 401(k) contributions from taxes for some middle-income household.  First, the increase in the standard deduction established in the 2017 tax law reduced potential tax saving from 401(k) contributions for some households with lower marginal tax rates.   Second, households have increased contributions to health savings accounts, which are also exempt from federal and state income tax.  These recent changes may have resulted in a decrease in 401(k) contributions. 

There are several different ways you might minimize tax obligations during retirement.   All of these techniques involve investing more funds outside your conventional 401(k) plan.

  • Funds placed in Roth accounts are fully taxed in the year they are contributed but are never taxed in subsequent years.  Roth 401(k) accounts are a relatively new innovation not available at all firms.  People with income above certain levels are not allowed to contribute to a Roth IRA.   Financial advisors tend to do a good job analyzing the relative merits of Roth versus conventional retirement accounts.
  • The elimination of a mortgage prior to retirement will reduce required 401(k) disbursements, which are fully taxed.
  • Capital gains on stock not in a retirement account are taxed at a lower rate than the ordinary income tax rate.  There are significant tax advantages with holding I-bonds issues by the Treasury and municipal bonds instead of bond funds inside a 401(k) plan.

It is important to consider both current year and future tax obligations when evaluating different investment opportunities and retirement savings options.

The importance of 401(k) fees

Many small firms with 401(k) plans charge fees of more than 1.5% per year of total assets.  Fees exceeding 2.0 % per year are not uncommon.

Fees at this magnitude can substantially erode retirement savings. In a recent blog post I calculated lifetime fees for a worker who contributes to a 401(k) fee with an annual fee of 2 percent of assets.   I found lifetime fees were roughly 25 percent of the 401(K) balance on the date of retirement.   

Should you invest in a 401(k) plan, an IRA or both?

https://medium.com/@bernstein.book1958/should-you-invest-in-a-401-k-plan-an-ira-or-both-finance-memos-3d5047c1b87b

High 401(k) fees pose significant challenges to investors in the current low-interest rate environment.  The current 10-year rate is around 1.5 % and the annual fee on some plans is over 2.0 %.  This results in a negative return on bonds invested inside a 401(k) plan.

Experts argue contributions to a high-fee 401(k) plan are still appropriate when there is an employer match. Perhaps this is correct but there is something wrong with a system that provides people incentives to save in high fee accounts.  

There are steps you can take to minimize the impact of high 401(k) fees.

  • Limit contributions to the amount needed to take full advantage of the employer match.
  • In the current low-interest rate environment, decrease 401(k) investments inside bond funds. Retain a balanced portfolio by purchasing bonds directly through the Treasury at Treasury Direct where there are no transaction costs.
  • On the day you leave your present employer convert your high-cost 401(k) plan to a low-cost IRA offered by Schwab, Vanguard, or Fidelity.

People need to fully evaluate fees charged by their firm’s 401(k) plans and adopt appropriate steps to reduce the impact of these fees on the erosion of their retirement savings.

Financial Risks:

I am concerned about two types of financial risks in 401(k) plans – (1) inappropriate investments options and (2) Interest rate exposure.   

Inappropriate Investment Options:

There is a substantial finance literature indicating that low-cost index funds outperform high-cost actively managed funds.   Some firm managers ignore this literature and choose actively managed funds.  Often this choice leads to poor results and litigation.  Below is a link to an article on litigation over 401(k) investment performance.

https://www.marketwatch.com/story/401k-lawsuits-are-surging-heres-what-it-means-for-you-2018-05-09

The optimal strategy for a person working for a firm with a 401(k) plan that has poor investment options may be to only contribute enough funds to take full advantage of the employer match.  Employees at such firms need to consider opening an IRA instead of contributing to the firm 401(k) plan.   The employee should then rollover their 401(k) funds into an IRA as soon as they leave the firm.  (Some 401(k) plans may allow current employees to rollover funds into an IRA.  I don’t know the rules on this.)

Interest Rate Exposure:

Interest rates remain below historical levels and central bank interest rates are actually negative in some countries.   This situation will not last forever.  When interest rates rise the price of bonds and the price of bond funds will decrease leading to losses.

Most 401(k) plans allow for investment in broad funds but do not allow for investments in government bonds with a specific maturity date.   The advantage of investing in a government bond with a specific maturity date is the holder of the bond will receive the full par value of the bond on the day the bond matures.   By contrast, the value of shares in a bond fund will be below the purchase price of the bond fund should interest rates rise and remain high.

Most 401(k) plans include a fixed income fund as an investment option and many 401(k) investors allocate a substantial share of their funds to the fixed income funds.   These households could result in large financial losses once we return to a more normal interest rate environment.   

My only recommendation on this problem is to consider investments in zero coupon Treasury bonds that are guaranteed to have a specific value on their maturity date.

The financial exposure associated with the eventual rise in interest rates is a scenario that keeps me up late at night.  I don’t see an obvious solution.

Concluding Remarks:

Financial advisors have always stressed the importance of investing in 401(k) plans.  This advice is better suited for people with high income, abundant funds for emergencies, and little or no debt than for the typical highly leveraged young adult.   

Even after a young adult gets a decent job, eliminates onerous credit card debt and builds up a decent emergency fund there is a need to balance competing financial objectives.  Often it makes more sense for a person to minimize lifetime debt payments and increase the accumulation of house equity than to increase contributions to a 401(k) plan.  Many people can also obtain better financial results (reduced tax obligations in retirement, lower fees, and better investment opportunities) by reducing their wealth holdings inside a 401(k) account and increasing holdings outside a 401(k) account.

The author is an economist living in Colorado.   He is the author of “Defying Magnets:   Centrist Policies in a Polarized World.”  This book can be obtained on Kindle or Amazon.