By Shawn Tully
September 27, 2011

FORTUNE — Congressman Paul Ryan, Chairman of the House Budget Committee, introduced a radical, market-driven plan for healthcare reform in the “Path to Prosperity” budget that passed the House, then died in the Senate in May. Today, Ryan (R-Wisconsin) is scheduled to present an updated and augmented version of that blueprint at Stanford’s Hoover Institution. Fortune reviewed a copy of the speech a few hours before Ryan is scheduled to deliver it at 10AM in Palo Alto, California. The talk, titled “The Optimist’s Guide to Repeal and Replace,” keeps the pillars of the original Ryan plan in place — such as giving seniors fixed monthly Medicare payments to purchase private insurance — but adds a revolutionary proposal that hasn’t been aired seriously since it helped sink John McCain’s presidential run in 2008.

Ryan wants to dismantle the tax laws supporting the system that’s insured most Americans for seven decades. It’s vintage Ryan: Whether you agree or disagree with his views, he stands in sharp contrast with the rest of the political class in his willingness to take unpopular positions backed by strong intellectual arguments.

His campaign to grant workers the advantages they now receive only through employers is his most daring proposal yet. Ryan is right on the economics, but it will take a gigantic leap of faith for Americans to embrace such a jarring change. Ryan’s view is that the cost of the current system so endangers our economic future that only a manifesto that allows everyone from seniors to employees to shop for their own policies with their own money will fix it.

In the Stanford speech, Ryan states: “Under current law, employer-sponsored insurance plans are entirely exempt from taxation, regardless of how much an individual contributes to their policy. With regard for health insurance for working Americans, patient-centered reform means replacing the inefficient treatment of employer-provided care.”

Ryan argues that the tax laws make it far cheaper for a corporation to purchase coverage for workers than for the worker to buy a similar policy on their own. He’s correct. For example, ABK Auto Parts (a hypothetical employer) can provide a worker with a $50,000 salary with a $15,000 family policy without including that $15,000 in the worker’s compensation, so the benefit is tax-free to the employee. Under the current tax regime, if the company simply increased the worker’s salary by $15,000 to $65,000, he or she would have to pay tax on that extra income — say at a 25% rate, including payroll levies. Hence, the worker would be to buy only an $11,250 policy with the extra pay. “This tilts the compensation scale toward benefits, which are tax-free, and away from wages, which are taxable,” the speech says.

He also argues that the system is especially helpful to the “rich:” “It also provides ways for high-income earners to artificially reduce their tax-able income by purchasing high-cost health coverage — which in turn can fuel the overuse of health services.”

So what’s Ryan’s solution? He proposes shifting the tax exemption that now goes only to company-provided plans to individuals instead. In our example, if ABK Auto Parts keeps providing coverage, employees will need to pay tax on the value of the policies. But the employee will be able to buy a policy on their own and get a tax credit for the entire cost of the plan.

If Ryan’s plan becomes law, it’s likely that most companies would drop their plans. Why provide coverage when employees now pay tax on the benefit but get a tax credit if they buy their own plans? The advantage is that employees would no longer lose their coverage if they lose their jobs. The policies would belong to them and be fully portable to the next job. It would also turn workers into consumers, giving them an incentive to shop for the lowest cost plans with their own money.

Here’s the rub: Can workers really be sure employers would pad their paychecks with the same dollars those corporations now pay for their coverage? The laws of economics say yes. In a competitive labor market, the total cost of workers should stay the same, and employers should care little whether they pay in benefits or direct wages.

But it’s not clear to America’s workers, now deeply distrustful of corporations, that they will see that money. And in these uncertain times, the concept of shopping on your own for benefits, with raises that may not be there, for coverage you now receive automatically, may look extremely scary to millions of Americans.

Indeed, it was those fears that made the McCain plan a major problem for his campaign. It would be extremely helpful if America’s employers would reassure workers that they will be “made whole” if Ryan’s plan become law. Indeed, companies would relish shedding their role of providing healthcare insurance. To make that happen, they have a strong incentive to tell workers they will receive the full value of their current benefits in raises. Ryan’s skill in enlisting companies to make those assurances could determine the success of his plan.

The Stanford speech also renews the call for reform in Medicare and Medicaid, both included in Ryan’s 2012 budget. The concept, as with the elimination of the employer exemption, is to move America from today’s “defined benefit” system to a type of “defined contribution” regime. It mirrors the shift in the private sector from guaranteed pension benefits to fixed 401K contributions. Ryan advocates “premium support” for Medicare beneficiaries, fixed monthly payments that would be as much as twice as big for low-income Americans as for high earners. Seniors would then use that money to shop for private plans, and the incentive to choose the lowest-cost, highest-quality coverage would be strong, since any cost over the fixed payment would be covered by the newly empowered customer.

Ryan draws a strong contrast between his own philosophy of controlling costs through market forces and the approach advocated by President Obama. Put simply, Obama is relying chiefly on price controls to control costs. But price controls do not lower costs. The 2010 Patient Protection and Affordable Care Act limits the growth of Medicare, starting in about ten years, to GDP plus one percentage point. In his most recent budget proposal, Obama lowered the number to GDP plus one-half a point. But Medicare costs are now rising at two to three times the rate of growth in national income. Hence, the price controls will simply drive providers out of business, encourage doctors to turn down Medicare patients and generally cause waits and rationing. As Ryan points out, Medicare’s chief actuary, Richard Foster, has frequently stated that blunt caps on spending won’t work.

The Ryan speech doesn’t address one of the most damaging, and least discussed, problems in our healthcare system. The market is rife with cartel-like, anti-competitive practices that wouldn’t be tolerated in any other business. Many exist at the state level; they need to be eliminated to create the flexible market that Ryan advocates. For example, in over half of America’s 314 urban areas, a single insurer holds over half the market, severely dampening price competition. About half the states have strict “certificate of need laws” that restrict the number of hospital bed, clinics and imaging centers, granting regional monopolies to high-cost, entrenched providers and making it extremely difficult for insurers, or Medicare, to negotiate discounts. It’s the same story for physicians: the doctor supply is essentially fixed even as demand for services explodes, guaranteeing that practitioners are always busy and, hence, reluctant to lower prices.

The Obama plan would, believe it or not, further limit the supply of physicians by reducing Medicare’s contributions to residency plans. Like many of these restrictions, the justification is that more providers leads to higher costs. Nowhere else in business does such an argument work, nor does it work in medicine.

Put simply, the plan Ryan outlines in his new speech is the best approach to avoiding what’s now looming: A future of price controls and rationing. He makes a strong point in his speech when he says, “The system that shields us from the cost of services has left us paying much more.” It’s not at all clear America is willing to make that leap — but to escape the current shambles, the leap is well worth taking.

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