Externalities and Taxation of Supplemental Insurance: A Study of Medicare and Medigap

Private and public health insurance coverage typically includes cost-sharing. However, public insurance often allows beneficiaries to cover out-of-pocket costs with top-up, supplemental insurance. This supplemental insurance blunts cost sharing and can induce moral hazard, increasing the costs of the public insurance program. This paper studies the interaction of public Medicare insurance and a form of private supplemental insurance called Medigap. The primary objective of this paper is to estimate the externality Medigap imposes on the Medicare system---and to estimate how a corrective tax on Medigap would impact Medicare spending and utilization. Our research design uses Medigap premium discontinuities within Hospital Service Areas (HSA) that straddle state borders. HSAs are hospital catchment areas, defined by sets of zip codes where individuals go to the same hospital for medical care. Approximately 250 of the 3,436 HSA cross state lines, accounting for 11% of the individuals in our sample. We show that individuals who live on different sides these cross-border HSAs are demographically identical and see the same doctors for medical care. Because Medigap premiums vary at the state level, individuals on different sides of these HSA can face vastly different Medigap premiums and enroll in Medigap at sharply different rates. Our paper demonstrates how this differential Medigap enrollment translates to differences in Medicare utilization and spending. We then use our estimates to analyze the financial impact of taxing Medigap premiums on the spending of the public Medicare system and the impact on welfare.