Better Tax Regime Needed to Fix Health Care

Published August 1, 2009

After spending hundreds of millions of dollars in the last election campaign accusing Sen. John McCain (R-AZ) of wanting to “tax the health insurance benefits” of ordinary Americans, President Barack Obama now says he is open to the very same idea. It seems likely Congressional Democrats will opt to tax health insurance benefits as part of overall health care reform.

Is this a complete flip-flop? Yes. But can the Democrats claim Republicans have endorsed the same idea? If they are intellectually honest, I think not.

‘Better Tax Regime’ Needed

What McCain proposed—and what health economists have been advocating for years—is different from what the Democrats are now proposing.

More than a decade ago I proposed the idea of replacing the current tax subsidy with a different and better tax regime, one that would make about 80 to 90 percent of taxpayers better off. It is now the centerpiece of a plan by Sens. Tom Coburn (R-OK) and Richard Burr (R-NC) and Reps. Paul Ryan (R-WI) and Devin Nunes (R-CA)

In fact, to ease the transition we should probably give people a choice of tax regimes for several years.

Obama and the congressional Democrats, by contrast, are going to tax some people’s health insurance for the express purpose of collecting funds to subsidize insurance for others. Under this approach, half the population is going to be made worse off so that the other half can supposedly be made better off.

Need for Reform

The case for a change of tax regimes is very strong. Consider two alternatives for family insurance. The first case describes the current system of excluding health insurance benefits from income and payroll taxes.

Case I
Employer paid premium $15,000
Tax bracket (including payroll taxes) 40%
Tax subsidy  $6,000

Now consider treating health insurance just like taxable wages, but giving people a tax break on their personal tax return:

Case II
Employer paid premium $15,000
Tax on the benefit $6,000
Lump sum tax credit $6,000

On the surface, the outcome appears to be the same. The family has the same amount of health insurance and the same after-tax income in both cases. But on closer inspection, Case II is much better.

More Valuable Tax Treatment

In Case I, the only way the family can get a $6,000 tax subsidy is by spending $15,000 on health insurance (technically, the employer pays it rather than paying taxable wages). If, for example, the employer/employee spent only $10,000 on health insurance, the tax subsidy would be only $4,000.

In Case II, by contrast, the tax subsidy is concentrated on the core insurance we want everyone to have, and any extra insurance is paid for with after-tax dollars. The first $6,000 of insurance gets a dollar-for-dollar tax credit. After that, every dollar spent on insurance is a dollar that could have been spent on other goods and services.

Suppose again that the employer or employee spent only $10,000. In this case, the tax subsidy remains the same, and the family will have $5,000 to spend in other ways.

The fixed-sum tax credit, therefore, is far more valuable than the current tax exclusion system. It will allow people to make more economical choices and keep every dollar they save.

‘Perverse Incentives’

Good incentives also may be created by the Congressional health plan. But don’t count on it. Congress’s goal is not to create good incentives. To the contrary: Any health care legislation that makes it through Congress is likely to be replete with perverse incentives of all sorts.

The goal, after all, is to collect money from some people to pay for the health insurance of others. And judging by its past actions, Congress is likely to pursue that goal in ways that make economic incentives worse, not better.

John Goodman ([email protected]) is president of the National Center for Policy Analysis.