Why Subsidies are Bad, Especially for the Middle Class

The Small Investor
The Small Investor

It’s a simple idea:  Everybody needs something.  Some people can’t afford it.  Let’s subsidize then so that they can afford it.  We’ve seen this for years with college tuition and more recently with healthcare in the Affordable Care Act.  At its face value, providing a subsidy makes sense – everyone pays what they can afford to pay and then gets a free ride on the rest.  The trouble with providing a subsidy that covers what you can’t afford to pay, however, is just that – you pay what you can “afford to pay,” and all that you can afford to pay.  Because the subsidies decrease with income, combined with a lack of the normal controls on price and usage that free enterprise normally creates, the middle class end up paying everything they have. 

Think about how you run a buffet.  You tell everyone they can eat as much as they want, you limit what they can get (the kinds of food) based on what they will be willing to pay for the buffet, and then charge enough so that the average customer pays enough to cover food and service costs, plus a reasonable profit.  If you have a buffet filled with pasta and pizza, you might charge $6.99.  If you have a seafood buffet, you might charge $24.99.  People who cannot afford to go to the seafood buffet go to the pasta buffet.  The cost of the buffet is based on the cost of the food.  So long as you price the buffet correctly and the mix of people using the buffet remain about constant (you don’t get an influx of super-eaters), you will make a predictable profit.  You don’t have foods on the buffet that will cost you so much that the price would be too high for the buffet to get enough customers.

Now let’s say that you have a buffet but the food is in the style of a cafeteria, where everything that someone takes normally would cost them extra and you have all kinds of foods, including some that are very expensive like lobster tail and caviar, but you only charge people what they are “able to pay.”  Let’s say to start that your average cost per person is $30. One person comes in who has $20, so you charge him $20 and give him a $10 subsidy.  The next person has $5, so you charge her $5 and give her a $25 subsidy.  A third person comes in who has $40.  You charge him $40, even though the average cost is only $30, because you need to pay for the subsidies.  It is only if someone has $100 that you might charge him only $50 or something and allow him to walk out the door with some money in his pocket.

Now the people coming in can pick anything, and there is no reason for them not to load up bowls full of caviar and plates full of lobster tail, ignoring the iceberg salad and the spaghetti and meatballs, because it all costs the same to them.  This would cause your average cost per person to increase, forcing you to increase your full price.  Because this would mean that fewer people would be able to pay full price, you would need to increase the subsidies you give out, increasing the full price still more to cover the increased subsidies.  This would cause some of the people to stop coming (the ones who were paying the most, meaning you’d have more subsidized people and therefore need to raise the full price higher) and have the effect of encouraging everyone to go for the more expensive foods so that they could “get their money’s worth.”  This would cause the price to continue to increase and more people to go on subsidies.

This cycle would continue until almost every one was highly subsidized and almost no one paid full price.  The quality would then need to decrease since it would not be possible to raise the full price anymore, so you would remove the lobster tail and the caviar while keeping the full price the same.  Eventually you would have the equivalent quality of the pasta buffet, but the full price would be $50, meaning that everyone who had up to $50 would be walking out with nothing in their pockets even though the food they were buying was worth nowhere near $50.  If people were forced to buy the buffet no matter what, even if they didn’t want to eat at your buffet, then everyone who had less than $50 would be trapped eating your buffet.   Even though they were paying way too much for the buffet (unless they only had $6.99 or less and had a huge subsidy, such that the food was worth at least the price they were paying out of their pockets), because they would not have any money left over after paying for the subsidized buffet, they would not have the choice to go anywhere else.  They would not have the money because they were forced to overpay for your buffet that they really didn’t want.  The choice to go somewhere else would be reserved for the very rich who could afford to pay for both (or the people who mandated everyone pay for the buffet but then excluded themselves from the requirement).  

(Note that most people in the middle class send their kids to public schools even if the private schools in their area are better and cost about the same per student as the public schools.  To do so would require they pay twice.  How many would choose the private school instead if they could direct their public school dollars there?)

So the price for something that is subsidized and which has no other form of price control is “everything you have” unless you are very rich.  For the middle class, things like the Affordable Care Act will take everything they have left after paying for the bare necessities because that is how the subsidies are set.  This will mean they will not have any money left over to invest and to save up for healthcare on their own.  They will be trapped in the subsidized system, paying way more than the value of what they are receiving because they’ll be paying for everyone else and because the costs will continue to grow and grow since there is no incentive for people to spend less.  People will get the $20 per pill name brand instead of the $20 per bottle generic because it costs the same to them.  Then they’ll talk about how much they’re saving on pills, ignoring the huge amount they and their neighbors are paying in premiums.

Colleges are the same way since students are subsidized.  It costs no more to the students to go to a school that has high-speed internet galore, an expensive work-out center, and a lavish student union, so they demand it and the costs go up.  There is no reason not to pay professors who teach no classes and just come in once a week to use the school’s resources $150,000 per year since the school can just add the costs to tuition, so tuition goes up.  There is no reason not to pay $300,000 per tree to move two large trees across a path rather than cut them down (true story while I was at Berkeley) since they can just add the costs to tuition, so tuition goes up.  Tuition goes up to pay for these things, which would normally cause fewer people to attend since they could not afford the new price without the subsidies, but the subsidies just rise so the same number of students attend.

So what is the solution?  End the subsidies, or at least limit the subsidies to a very  low threshold such that only the very poor would get a subsidy.  Also, make the most expensive things, those that go beyond just the bare necessities, cost more to limit their use.  If our buffet charged extra for lobster and caviar, providing only the pasta bar in the base price, the food costs for the people buying just the basic buffet would match the price they were paying, so the costs would stay reasonable.

In the case of college, if almost everyone was paying full price and raising tuition would result in fewer students attending, the price would be a lot lower.  Schools would need to get rid of unnecessary things that cost a lot of money to keep the costs low enough that almost everyone could afford to pay.  They might limit high-speed internet to educational needs, meaning the students couldn’t spend all weekend watching YouTube videos, but they could still get a great education and tuition costs would only be what most students could earn in a summer.  They might have to run the track or ride their bikes around campus to exercise rather than go to a rec center with a lap pool and a sauna, but they would be able to leave college with a good education without a house payment’s worth of loans.

For healthcare, because you don’t want people dying in the streets, special considerations would need to be given.  Still, most people earn plenty of money to pay for their own healthcare during their lives if they would just save it for healthcare instead of spending it on stupid stuff like smart phones and new cars.  If you required that everyone put away 3% of their pay into a health savings account, and set up those accounts with special debit cards that could only be used at doctor’s offices and for prescriptions and OTC medicines, most people would have plenty of money to pay their bills when needed.  Costs would also decrease since most people would be paying their full bills and doctor’s wouldn’t need to pay the cost of filing everything through insurance.  Add on a required major medical insurance policy that kicks in for big things like hospital stays and major surgeries and the problem would be solved for 99% of people.

For the final 1% – the people who are just really unfortunate because they get a serious condition early in life or get something that cleans out their health savings account but they still need care – their costs could be covered by a combination of charity from doctors and individuals because the cost would be very low relative to the size of the population.  If really needed, a small surcharge could also be applied, but again it would be almost nothing per person paying because almost everyone would be paying for themselves.

For those who squander their health care money, free clinics could be set up that would provide minimal care.  These should not be equal in quality to the care that is paid for since that would provide an incentive for people to not squander their money.  People would know that if they waste their HSA money, or don’t get a job to put money into an HSA, their healthcare would not be as good as if they did, maybe involving limited procedures and longer waits.  Keeping the differential in care is what makes the system work and makes care for almost everyone better.

Your investing questions are wanted. Please send to vtsioriginal@yahoo.com or leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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