Trump’s proposed price controls on Medicare and Medicaid could reduce government spending

President Donald Trump recently signed an executive order that seeks to reduce prescription drug prices in the United States. Trump argues that the U.S. should pay the same prices for prescription drugs as foreign nations, which currently pay half the prices of the U.S. This order is an excellent idea for reimbursements from Medicare and Medicaid. Although some center-right voices have equated Trump’s proposal to “socialist” price controls, keeping tight limits on government spending is, in fact, libertarian.

The executive order signed on May 12 seeks to reintroduce the most favored nations (MFN) reimbursement model, which was originally formalized during Trump’s first administration. The idea of MFN is to peg prescription reimbursements from the Centers for Medicare and Medicaid Services (CMS) to a basket of drug prices paid by foreign countries, which typically pay much less than the U.S. does. As I wrote for Discourse Magazine last year, the policy has tradeoffs, but it is clearly a win for limited government.

The primary issue with the current reimbursement model is that public reimbursements set private prices, not the reverse, as designed. Medicaid, Medicare Part B, and some aspects of Medicare Part D currently match private prices in the U.S. to set reimbursement rates for CMS. When introduced in 2003, the original purpose of price-matching was to introduce  “market-based solutions” to federal entitlement spending. If the government must pay for some sort of service, the crafters of this policy argued that the price should avoid arbitrary negotiations and reflect the prices that prevail in the private market.

However, when payments are based on rigid formulas, they can be gamed. According to the Government Accountability Office, because “federal prices are generally based on prices paid by nonfederal purchasers such as private health insurers, manufacturers would have to raise prices to those purchasers in order to raise the federal prices.” And that’s exactly what they do. Although increasing prices to private insurers leads insurers to demand fewer of those drugs, drug manufacturers can make up for lost sales volume by selling more to public insurers at higher prices. In other words, drug manufacturers are profit-maximizing across their whole range of customers and not just private insurers. They’ll sacrifice some private-sector earnings to earn more in the aggregate.

Consider an extreme example: Suppose a manufacturer increased the price of an insulin prescription to $1 million, and only one person in the private market could afford it. Currently, insulin manufacturers make billions on the private U.S. market, so such an extreme price increase would reduce profit from the private market through lost sales. However, if Medicare purchases a million doses, even after the dramatic price increase, total revenue would increase by $1 trillion and far outstrip the company’s lost private-market earnings.

This extreme example is unlikely, but the general idea is borne out in real data: Despite overly stable rates of diabetes between 2007 and 2016, the number of insulin patients on Medicare increased from 1.6 million to 3.1 million. During this period, the list price of Lantus (insulin glargine) increased 257%, leading to a 764% increase in revenue from Medicare Part D. Consequently, between 2017 and 2019, CMS represented 59.7% of the Lantus market.

The current financial incentives disadvantage the U.S. private market and encourage patients to migrate from private to public insurance, further exacerbating the problem. As patients with private insurance increasingly cannot afford medications, they seek a public provider that will push their costs to taxpayers. Meanwhile, drug manufacturers can take advantage of this patient migration by further increasing prices after they switch to Medicare or Medicaid. Trump’s MFN plan would refocus these incentives by tying CMS prices to international markets. In that environment, the U.S. should expect private market prices to fall in addition to reimbursement rates by CMS. The bottom-up knowledge that informs prices in competitive markets is largely absent from governments, but international competition at least brings more buyers into the calculation for price-setting.

What is interesting is that Trump’s legal path to codify MFN as permanent policy is through Obamacare, which he unsuccessfully tried to repeal during his first administration. However, that failure might serve him well, because according to the added Section 1115A of the Social Security Act, Trump can test alternative pricing systems as “experiments” through the CMS Innovation Center—and make them permanent. If the experiment maintains quality while reducing costs, according to standards set by the CMS chief actuary and the secretary of the Department of Health and Human Services, the reimbursement scheme can enter rulemaking to be indefinitely expanded to the rest of CMS. Such a statute allows Trump to implement one of the most significant cost-saving measures in decades without Congress. Still, his administration must carefully follow the statute to avoid defeat through legal challenges.

If Trump can successfully separate Medicare and Medicaid reimbursement rates from prices in the U.S. private market, we should expect pharmaceutical prices in all markets to drop. Under the status quo, price increases reduce sales volume and patient access under commercial insurance and lead to more government spending on CMS. Instead of waiting to see whether pharmaceutical companies voluntarily reduce prices after his threats, Trump should immediately leverage Obamacare to implement MFN for Medicare and Medicaid reimbursements. Trump can legally do this without Congress, but he must move fast if he wishes to implement this policy by the end of his term. If MFN is not fully implemented by 2028, the next president may terminate the program.

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