Consumer Choice Matters: The Importance of Tax Reform

Published January 1, 2005

President George W. Bush has made a fundamental rewriting and simplification of the nation’s tax code a stated priority for his second term. He also says he wants to use federal tax policy to expand health insurance coverage.

As it happens, in recent years several plans have been offered that would help achieve both of these goals, as outlined later in this article. First, however, an analysis of the current problem is in order.

Tax Code Encourages Employer-Based Coverage

The health care system that we have today is the direct result of 60 years of federal tax policy that has consistently subsidized employer-sponsored health insurance (ESHI). Section 106 of the IRS code allows employers to exclude the value of health insurance premiums from employees’ taxable income. The coverage is free of all taxes–federal and state, income and payroll.

But there is no similar relief for direct payment of health care services outside the workplace, or for people who buy their own health insurance (except for taxpayers who are self-employed, in which case they may take a full deduction for the cost of health insurance when they itemize their tax returns).

The federal tax cost of the subsidy for ESHI is estimated to be $189 billion this year, according to John Sheils and Randall Haught in the February 2004 issue of Health Affairs. The subsidy is available without limit and without review. If health spending goes up 10 percent, the subsidy will rise by $18.9 billion in one year–without a vote in Congress and without debate.

The subsidy is extremely regressive, with lower-income families getting a tax benefit of about $125 per year and upper-income families receiving a tax benefit of $2,600 or more.

Inevitably, this special treatment provided solely to ESHI drastically distorts the market both for health insurance and for heath care services. Anyone who can possibly get coverage through an employer will do so, and the employee will want to run virtually all health care services through that coverage, to keep it free of taxes.

Reliance on employer-sponsored insurance also results in people losing their coverage when they lose or change jobs, and it makes it difficult for two-income families to be on the same insurance program without one wage earner forfeiting an earned benefit. It interferes with normal market functions since the insurance buyer is not the insurance user. And most importantly, it insulates consumers from knowing the full cost of the insurance purchased for them or the medical services they consume.

Many Workers Don’t Receive Tax Benefit

Workers whose employers don’t provide coverage get no tax subsidy at all unless they are self-employed or their health care expenses exceed 7.5 percent of their Adjusted Gross Income (AGI), in which case they get a simple deduction of the excess–if they itemize their tax return.

Not surprisingly, the uninsured tend to be lower-income people employed by small businesses. Their bosses can’t afford to provide coverage, so they get no tax help whatsoever, even if they purchase coverage on their own. Thus, those who need help the most get the least.

Bush and many members of Congress have proposed offering workers who don’t get health insurance at work a refundable tax credit of up to $3,000 for a family or $1,000 for an individual to help them purchase their own health insurance coverage. The credit would phase out as income rose, up to a maximum income of $30,000 for an individual or $60,000 for a family.

Such a credit would be more valuable than a deduction to those in lower tax brackets. For example, allowing someone in the 15 percent tax bracket to deduct $1,000 in health insurance expenses provides a tax savings to them of only $150. But a tax credit of $1,000 is worth the full $1,000, especially if it is refundable (as the president’s proposed credit is). Someone who doesn’t owe $1,000 in income taxes could get the full credit. The credit is also a way of offsetting the cost of payroll taxes, which are higher than income taxes for many lower-wage workers.

For people not eligible for the tax credit, the president has proposed allowing an above-the-line tax deduction for high-deductible health insurance premiums purchased in association with a health savings account (HSA), plus new incentives for small employers to create HSAs for their workers.

The cost of the president’s tax credit and premium deduction proposals was estimated in a report issued in June 2004 by the Kaiser Family Foundation at $95 billion over 10 years, or $9.5 billion a year–paltry compared to the $189 billion available in tax support for ESHI in just one year.

Many Solutions Suggested

But the president has a dilemma: He has offered proposals that include tax credits and deductions for health insurance, but these new provisions would add complexity to a tax code he wants to simplify.

As long as Congress is focused on rewriting the tax code, there is an opportunity to revise the tax treatment of health care to be more equitable and more efficient. Over the years many approaches have been suggested, such as the following:

  • Equality. Some have proposed making all health care spending tax-free, to level the playing field between employer-sponsored health insurance, individually purchased health insurance, and direct payment for health care services. This would enable consumers to make more rational decisions about the best way to finance health care services. The role of third-party payment would be reduced, and direct payment would increase. New forms of financing through savings accounts or credit arrangements would evolve. Administrative waste would be reduced as consumers sought the most efficient payment mechanisms.
  • Lower the AGI threshold. Others have advocated lowering the threshold for the medical expense deduction from 7.5 percent of AGI to zero. All Section 213(d) expenses would be deductible. Of course, such a deduction doesn’t account for the payroll taxes avoided by the exclusion of employer-sponsored health insurance, so it would not be very attractive or helpful to lower-wage workers.
  • Credits for all. Another idea would be to subsidize health care spending partially but extend the same subsidy to all Americans, regardless of how they finance their health care services. Congress could, for instance, provide a tax credit to every adult and child to pay for health insurance. Lower-income people or those with extraordinary needs could be eligible for additional funds, possibly from state coffers. A worker whose employer provided coverage would have to pay taxes on the value of the insurance, but those new taxes could be largely offset by the value of the credit. Individuals who did not avail themselves of the credit would automatically get coverage through a safety net mechanism, funded largely by the credit that would otherwise go to them.
  • Tax cap. Congress could continue to allow the exclusion for employer-sponsored health insurance, but cap the tax subsidy at some reasonable level so only an average premium would be excluded from income. Richer benefits could be purchased, but only with after-tax money.
  • Remove the tax preference. A more libertarian approach would remove any and all tax advantages from health care spending so that health care would compete on an equal footing with every other way we might spend our money. Employers could still provide health coverage, but workers would have to pay taxes on the value of the benefit. This would be especially appropriate if we moved to a system of consumption taxes in which all savings are free of taxes but all spending is done with taxable dollars.
  • Defined contributions for all. Funds currently spent on a list of covered services would be available to consumers to buy benefits and insurance packages of their own choosing. The funds could be made available on a need-adjusted basis so that older, sicker, and poorer people would receive a larger contribution than others. Employers are already moving in this direction, first with pension programs, then with retiree medical benefits, and more recently with health coverage for active employees. Some states are exploring this approach with “Cash & Counseling” Medicaid waiver projects, and Medicare, too, is giving seniors the option of a “premium support” financing system.

The Health Policy Consensus Group, a task force of leading health care economists and health policy analysts, has noted the health care market “is distorted by a tax policy that is mistargeted, miscalibrated, and open-ended. This tax policy provides generous benefits to those who have higher incomes and receive health insurance through the workplace. Yet it offers little or no assistance to those at the lower end of the income scale.”

Any of these approaches would result in a more efficient and equitable system of health care financing than we currently have. Of course, a transition period would probably be necessary if any of the more thorough overhauls considered here were undertaken.

The president’s interest in simultaneously achieving tax reform and expanding health care coverage provides a unique opportunity to reinvent the nation’s system of health care financing. The critical next step will be to initiate a full, vibrant, and informed debate over the best way to strengthen and revitalize the health care market.

Greg Scandlen ([email protected]) is director of the Galen Institute’s Center for Consumer Driven Health Care and assistant editor of Health Care News. Grace-Marie Turner ([email protected]) is president of the Galen Institute, Inc.