Why We Need Market-based Health Care Reform: Part 1 of 2

Published March 1, 2001

The United States does not have a properly functioning market for health care, and the financing system needs to be reformed.

The 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. Particularly at a disadvantage in the current system are those who fall through the cracks between this tax subsidy and Medicaid.

Reforming the tax treatment of health insurance is essential to creating a more efficient and equitable market for medical services and health insurance in the United States. Correcting the tax distortion would lower the costs of health insurance coverage in both the public and private sectors and thereby allow broader access to quality health care.

This article describes the Consensus Group’s vision for consumer-driven health care reform based upon tax reform. These principles and recommendations are integral to the market-based proposals for health care reform of each of the health policy experts in the Consensus Group. There is unanimous agreement on the nature of the problem, and consensus on direction indicated by the recommendations for reform.

A Rich but Hidden Tax Subsidy for Employment-based Health Insurance


Early in the 20th century, the link between health insurance and the workplace began to be established in the United States. During and after World War 11, however, employment-based health insurance became more widespread, and the link became stronger.

Factories were pushed to meet wartime production schedules. Competition for good workers was intense but was hampered by wartime wage controls. Employers found they could compete for scarce workers and boost compensation without running afoul of these controls by offering health insurance as a benefit in lieu of cash wages. In 1943, the Internal Revenue Service ruled that employers’ contributions to group health insurance would not count as taxable income for employees. That ruling, a later codification of it by Congress in 1954, rising tax rates on middle class incomes, and the rising demand for health insurance all combined to create a strong incentive for health insurance to be obtained through employment-based groups.

The generous tax preference accorded job-based health insurance is a historical accident that has increased automatically over the decades without legislative authorization or appropriations. It has percolated through the economy for 50 years to become the foundation for a system that provides subsidies and therefore strong incentives for at least 150 million Americans to get their health insurance through their jobs. The subsidy for employment-based health insurance now is worth an estimated $125 billion a year in forgone federal taxes.

How the Tax Subsidy Works

The tax code offers an exclusion from taxable income to those who get their health insurance at work.

Employment-based health insurance is part of the compensation package many employers provide to their employees–a form of non-cash wage. Employers can take a tax deduction for the cost of this health coverage, as they do for most other forms of employee compensation. They write the check for the premiums, and some pay medical bills directly if they self-insure. Businesses can deduct these costs from their earnings since they are part of the total compensation package paid to workers and must be deducted to measure net profits correctly.

What makes health insurance different from cash wage or salary compensation, however, is that workers do not pay taxes on the part of their compensation package they receive in the form of health benefits.

Section 106 of the Internal Revenue Code provides that the value of health benefits is not counted as part of the taxable income of employees–in tax terminology, it is excluded from their taxable income. However, workers may receive this tax-favored benefit only if health coverage is provided through an employer. The value of the health coverage, the tax benefit employees receive, and the costs in forgone wages are largely invisible to them.

How it Distorts the Health Care Marketplace

Tens of millions of Americans receive little or no benefit from this rich but hidden tax subsidy. In addition, it distorts the health care marketplace in a number of ways:

  • It undermines cost consciousness by hiding the true cost of insurance and medical care from employees.
  • Because the full cost of health insurance is not visible to employees, it artificially supports increased demand for covered medical services and more costly insurance.
  • As a result, inefficient health care delivery is subsidized at the expense of efficient delivery.
  • Cash wages are suppressed.
  • Many employees with job-based coverage are frustrated because they have little choice and control over their health insurance and their access to medical services.
  • The tax benefits are skewed to favor higher-income individuals and those who demand the most expensive health coverage and medical treatments.
  • Those with equal incomes are taxed unequally.
  • The self-employed, the unemployed, and those whose employers do not offer health insurance are discriminated against because they receive a much less generous subsidy, if any at all, when they purchase health insurance.


This Vision Statement provides guiding principles for reform, specific recommendations for change, and guidelines to achieve greater equity and efficiency in the health sector, leading to more affordable, accessible health insurance.

Guiding Principles of Consumer-driven Reform

The following are guiding principles to assist policymakers and the public in making key decisions to achieve a true consumer driven health care system.

Consumer Choice. Individuals should have choices in the medical care and health coverage they obtain, whether they secure coverage as individuals or through their employers or other groups. Government policies should expand the opportunities for individual choice without dictating or distorting these choices.

Competition. Consumers of medical services will receive the best value when providers are competing to offer the best price, quality, and services. Therefore, the system should rely on market competition, not government regulation or price controls, to promote efficiency, quality, and value.

Responsible Budgeting. Government incentives to help targeted populations obtain private health coverage should be explicit, on budget, and reviewable.

Fixed and Limited Incentive. Individuals and families with the same incomes should receive the same assistance when purchasing health insurance, regardless of their employment status or whether their employers offer health insurance. Individuals should not be able to increase their claim on taxpayer revenues by purchasing more health coverage.

Expanded Access. In a market based upon consumer choice, a more attractive range of options for health coverage will be available to a wider range of people, including those currently without health insurance. Once the market is functioning more efficiently, it will be clearer whether further legislation is needed to enhance people’s ability to secure health coverage.

Responsible Insurance. Health coverage should provide, at minimum, protection against catastrophic loss-namely, high cost, low-probability medical events. The tax system has encouraged movement away from this basic principle of insurance. Instead, health coverage has become a way to prepay routine medical bills. A first step toward reducing the number of Americans without health insurance is to return to the principles of insurance and thereby protect against large expenses in the event of catastrophic medical events.

Public-sector Choice. Given the rapidly rising costs in federal health care programs, especially Medicare and Medicaid, the federal government should make full use of private-sector competition to control costs by giving beneficiaries more options to participate in the private market.

Cost Awareness. Programs that enhance individual purchasing powers will be more efficient because costs will be more visible to consumers. Programs and plans that make payments directly to providers insulate consumers from costs, artificially increase demand, and distort the health care marketplace.

Full Information. Employers who provide health insurance should periodically inform their employees about how much of their compensation is being spent on health benefits and that this spending has reduced their cash wages by a commensurate amount.

Community Versatility. The strength, diversity, and vitality of private-sector community organizations are an important resource in the health sector. Communities should experiment with public-private partnerships and other solutions for providing health care to low-income citizens, utilizing local resources to solve unique community problems.

Group Purchasing. Tax and regulatory barriers to creating competitive private health care purchasing groups should be eliminated. Barriers to the creation of innovative provider groups should also be eliminated.

Value. As a result of implementing these principles, consumers will obtain better value for their health care dollars. The price system will convey consumers’ needs and demands. Competition will facilitate more efficient use of technology and continued innovation in products and service delivery and will reduce waste and duplication.


Grace-Marie Arnett
Consensus Group Coordinator
Galen Institute

Bradley D. Belt
Center for Strategic
and International Studies

Stephen Entin
Institute for Research on the Economics of Taxation

Carrie Gavora
The Heritage Foundation

John C. Goodman, Ph.D.
National Center for Policy Analysis

Robert B Helms, Ph.D.
American Enterprise Institute

John Hoff, Esq.
Health Policy Attorney
Galen Institute

David Kendall
Progressive Policy Institute

Naomi Lopez
Pacific Research Institute

Merrill Matthews, Ph.D.
National Center for Policy Analysis

Marty McGeein
The McGeein Group

Robert E. Moffit, Ph.D.
The Heritage Foundation

Mark V. Pauly, Ph.D.
The Wharton School
University of Pennsylvania

Greg Scandlen
Cato Institute

Eugene Steuerle, Ph.D.
The Urban Institute

Jack Strayer
National Center for Policy Analysis

Michael Tanner
Cato Institute

Kevin Vigilante, M.D., M.P.H.
Brown University School of Medicine