Subsidy Targeting with Market Power

Public programs frequently use observable characteristics of recipients, such as income, to target benefits. We show theoretically that when the provision of the subsidized good is decentralized to intermediaries with market power, targeting of subsidies induces a “demographic externality” that can distort the incidence and efficiency of public transfers. We examine this possibility empirically in the context of means-tested subsidies for privately-provided health insurance under the Affordable Care Act (ACA). We estimate that the overall incidence of premium subsidies on consumers in ACA Marketplaces is less than 50 percent, and a third of net government spending on premium subsidies is a deadweight loss. Market power in the presence of means-tested subsidies leads to regressive redistribution, lowering consumer surplus and rates of insurance in the poorer population targeted by subsidies. Under sufficiently high social preferences for redistribution, however, means-tested subsidies still dominate income-invariant transfers.