The private health insurance system in the U.S. has been erected on
a foundation of tax incentives that promote employment-based coverage
over the individual purchase of insurance. In 2006, persons taking
advantage of tax breaks for health insurance will save about $150
billion in federal and state income taxes and an additional $75 billion
in payroll tax contributions (Sheils and Haught, 2004; Sheils, 2006).
(1) Most Americans--some 174 million people, or about 70 percent of
those with insurance--are covered by employment-based health insurance
(DeNavas-Walt, Proctor and Lee, 2005). Included in that count are about
12 million seniors covered by Medicare who also have supplementary
retiree coverage through a former employer.
Although tax incentives have helped millions of people buy health
insurance through their employers, this policy approach brings a host of
problems. Millions of people do not have access to tax-favored
employment-based insurance, and many go without coverage. Many who are
offered such insurance turn it down because it is too expensive or does
not meet a worker's individual financial and health needs.
Employees may find themselves locked into their current jobs to retain
coverage, especially if someone in their family develops a serious
medical condition. Even then, there is no guarantee that the employer
will not reduce benefits or drop coverage in the future.
Current tax incentives for health insurance also fail on equity and
efficiency grounds. The tax expenditure is regressive, providing a
greater subsidy to those with good jobs and high incomes and much less
to the unemployed and disadvantaged. In addition, the tax system
promotes the purchase of excessive insurance coverage that blunts the
incentive for efficiency in the production and use of health services.
The resulting cost escalation in our health system affects everyone, but
its greatest impact is arguably on the uninsured, many of whom do not
have the option to take advantage of current tax benefits.
Those flaws in our current system of subsidizing employment-based
health insurance are well known. Experts inside and outside government
have advanced a variety of policy reforms intended to improve the
performance of tax incentives for health insurance. Recent proposals
include capping the tax exclusion for employment-based health insurance,
tax credits for the purchase of private insurance, tax subsidies for the
purchase of high-deductible insurance and health savings accounts
(HSAs), and expanding tax subsidies for out-of-pocket health spending.
The proposals address different problems in our current system of tax
incentives for health spending, and they represent only part of broader
health system reform.
In this paper, I discuss how such proposals could help (or hinder)
the purchase of private health insurance and how the health system might
react to changes in tax incentives. Following a critique of the current
tax provisions affecting health spending, I discuss issues raised by the
recent reform proposals, including their potential impact on insurance
markets. The final section attempts to answer the question, is there a
right way to promote health insurance through the tax system?
CURRENT TAX PREFERENCES FOR HEALTH SPENDING
The third largest federal subsidy program for health care is
operated by the Internal Revenue Service, not the Department of Health
and Human Services. The two largest programs are Medicare, with outlays
of $380 billion in FY 2006, and Medicaid, with federal outlays of $190
billion (CBO, 2006b). Federal tax expenditures for private health
insurance or other spending for health services will total about $143
billion in 2006 (OMB, 2006a). (2)
The three subsidy programs address different beneficiary
populations. Medicare pays for a substantial part of the health care for
the elderly and disabled. Medicaid covers the cost of care for the poor.
The tax code subsidizes private health spending, primarily the cost of
insurance premiums, and benefits accrue primarily to working-age people
with substantial incomes.
All three health subsidy programs are entitlements, in the sense
that spending proceeds automatically without any necessary intervention
by Congress. Reflecting rapid growth in the health sector, spending in
the three programs has been expanding at high rates for decades,
substantially faster than growth in the economy or other major federal
However, Congress takes an active interest in Medicare and
Medicaid, enacting in most years some legislation intended to modify how
money is spent under those programs (not always to good effect). In
contrast, Congress rarely debates and even more rarely adjusts the major
tax provisions for health spending.
The institutional bias in favor of the health tax provisions is
illustrated by legislative actions taken in 2005. After heated argument
about the wisdom of cutting Medicare and Medicaid spending, Congress
reduced program outlays by $11 billion over the next five years in the
Deficit Reduction Act of 2005 (CBO, 2006a). At the same time, no action
was taken on tax provisions affecting private health spending. Those
provisions are expected to grow by more than $16 billion annually over
the same time period (OMB, 2006a).
Tax subsidies favor employer-sponsored health insurance rather than
insurance purchased in the non-group market. Employer contributions to
health insurance premiums are excluded from the employee's income
subject to income and payroll taxation. The exclusion is worth $132
billion in foregone federal income tax receipts for 2006, by far the
largest tax subsidy for health spending (OMB, 2006a). In addition,
Section 125 plans permit employees to pay their share of premiums using
pre-tax dollars, making the entire premium tax free to participating
employees. These two subsidies account for more than 95 percent of total
health-related tax expenditures.
The tax code gives far less benefit to people who purchase their
health care directly rather than through insurance. Employees who
contribute to a flexible spending account use pre-tax dollars to cover
out-of-pocket health spending. Tax filers who itemize may deduct
out-of-pocket health spending that exceeds 7.5 percent of their adjusted
gross incomes. People with HSAs may contribute to those accounts on a
pre-tax basis. Less than five percent of health-related tax expenditures
flow through these provisions (OMB, 2006a).
The current set of preferences dominated by the tax exclusion has
serious limitations as a way of promoting the purchase of private health
insurance. Although the tax exclusion helps many workers obtain coverage
through their employers, the incentives established by this policy have
also contributed to the runaway growth, inefficiency, and inequity of
the health system.
Promoting One Type of Risk Pool
The tax exclusion promotes the workplace as the primary source of
health insurance in the U.S., although the association of health care
with employment is an even older idea (Glied, 1994). Even at the
inception of the federal income tax in 1913, health and other benefits
provided by employers were excluded from taxation on the grounds that
they benefited the employer and they were of minimal size. Some fringe
benefits, but not health care, became subject to taxation as they grew
in prevalence and cost.
Employer-sponsored health insurance began to expand rapidly during
wage and price controls during World War II, but that growth did not
cease with the end of controls. (3) The spread of employer-sponsored
insurance during the 1950s came about as employers and labor unions
recognized that, on the margin, employer contributions to health
insurance premiums were more valuable to the average worker than an
equivalent increase in their taxable wages. (4)
There are a number of advantages to organizing health insurance
around the firm. Since workers seek employment for reasons other than
simply gaining health insurance, the firm can pool health risks across a
diverse group of individuals who are healthier, on average, than
non-workers. Employers also can reduce the insurers' cost of
marketing and administration by taking on some of those responsibilities
through their human resources departments. Both factors help to lower
the average premium, particularly for large employers.
Employer-sponsored insurance has grown not only because of lower
insurance costs and the tax subsidy. In addition, the employer
contribution to premiums fosters the illusion among many workers that
their health insurance is less expensive than it actually is.
For example, the premium for family coverage under employer plans
averaged $10,880 in 2005, with employers contributing about $8,167 of
that amount (Kaiser Family Foundation and Health Research and
Educational Trust, 2005). Most workers probably focused on their direct
payment for that coverage, which averaged a little more than $2,700 (or
about $225 per month), even though they paid the full cost of the
insurance by accepting wages lower than they otherwise would have been
without the coverage. While this premium illusion has resulted in more
workers accepting their employer's benefit offer, most workers are
unaware of the true cost of their health coverage and are likely to buy
more generous insurance than they would otherwise.
Despite both the real and illusory advantages of employer-sponsored
insurance, several million workers refuse their employer's offer of
coverage (Thorpe and Florence, 1999). This is partly because few
employers are able to offer a wide choice of insurance products. The
health benefit offered by employers is often generous, meeting the needs
of a middle-aged worker rather than someone just starting a career out
of school. This "one size fits all" approach does not provide
the right balance of coverage and cost for many workers. Not
surprisingly, such workers tend to be young, lower-income, and working
for small firms (Blumberg and Nichols, 2001).
The lack of choice manifests itself in other ways that can
disadvantage employees. The employer may unilaterally change the terms
of coverage (such as the employee's share of the premium,
cost-sharing requirements, coverage of specific services, and breadth of
the provider network) or drop it altogether, with the worker having
little or no say in such changes (Gabel, Claxton, Gil, Pickreign,
Whitmore, Holve, Finder, Hawkins and Rowland, 2004; Reschovsky, Strunk
and Ginsburg, 2006).
Those who buy their health insurance through their employers may
find themselves locked into their current employment for fear that they
might lose coverage (Madrian, 1994). If the worker or a family member
develops a serious health condition, a job change could mean the total
loss of insurance or exclusion of that condition from coverage. The
Health Insurance Portability and Accountability Act limited the use of
pre-existing condition restrictions for group coverage, but such
restrictions remain possible for non-group coverage.
The tax exclusion has had the effect of crowding out alternative
pooling arrangements that are not eligible for the subsidy (Burman and
Gruber, 2005). This is a particular problem for the millions of people
who have no access to employer-sponsored coverage, including many who
work in small firms that do not offer health insurance or who are not in
the labor force. (5)
Consumers who must purchase coverage in the non-group market are
disadvantaged in three ways. Their premiums are paid with after-tax
dollars. They pay higher rates, reflecting larger costs of marketing
insurance to individuals and greater health risks of people wishing to
buy non-group insurance in the face of high premiums. They are often
subject to state regulations and insurance mandates that increase the
cost of coverage even further, while employees participating in a
self-insured plan are exempt from those rules by Employee Retirement
Income Security Act (ERISA). These factors contribute to the rising
number of people without health insurance.
Exacerbating Health Spending Growth
Health insurance with lower cost-sharing requirements and higher
premiums takes greater advantage of the tax preferences, but such
coverage has adverse consequences for the health system. More generous
health insurance coverage blunts the consumer's sensitivity to
health care prices and encourages greater use of services.
Consumers directly paying a fraction of the cost of care are apt to
use services worth less than the full cost, a phenomenon known as moral
hazard (Pauly, 1968). The cost of additional care induced by this moral
hazard effect of insurance is reflected eventually in higher insurance
premiums. By promoting first-dollar coverage, tax incentives help fuel
the escalation of health care costs and insurance premiums.
Numerous studies have confirmed that consumers are sensitive to the
price of health care, and will use fewer services if the price they must
pay increases. The RAND health insurance experiment, for example, found
that the imposition of a $3,200 deductible (in 2004 dollars) for family
coverage reduced health spending by 31 percent, compared to completely
free care (Manning, Newhouse, Duan, Keeler and Leibowitz, 1987;
Morrisey, 2005). Higher deductibles and other cost-sharing requirements
are customarily imposed by insurers to limit covered health spending,
which helps keep premiums down.
There is growing evidence that additional spending for health
services may not yield full value in terms of improved health status
(Fisher and Welch, 1999). However, people subject to high cost sharing
are likely to forego both unnecessary and necessary services (Schoen,
Doty, Collins and Holmgren, 2005).
The tax exclusion favors those with higher taxable incomes and
discriminates among individuals based on their employment status. After
income and payroll taxes, a high earner could save as much as 50 cents
for every dollar spent on health insurance premiums, at the margin. (6)
In contrast, a low earner might save as little as three cents on the
dollar for employer-sponsored insurance (Burman and Gruber, 2001).
People without access to employer-sponsored insurance are not helped by
the exclusion, regardless of their income or health status.
Because high-income families tend to buy more insurance, their
average tax savings rise faster than income. Approximately a quarter of
federal tax expenditures for health spending accrue to families with
incomes above $100,000, even though that group accounts for only 14
percent of the population (Sheils and Haught, 2004). Families with
incomes below $50,000 also receive about a quarter of the total subsidy,
but they represent nearly 60 percent of the population. As a tool for
promoting the purchase of private insurance, the tax exclusion is poorly
targeted, providing the least help for those with the most limited
ability to pay for coverage.
RECENT REFORM PROPOSALS
The tax exclusion and other provisions have provided a strong
incentive to expand employer-sponsored health insurance over the past
six decades. Millions of workers have benefited from the reduction in
their insurance premiums net of taxes, but millions of others have not.
Those who gain the most from this system are least likely to be without
coverage. The tax incentives promote excessive use of health services,
in too many cases yielding only marginal value to the patient. This
system of providing health insurance has slowed job mobility and imposed
other inefficiencies on the economy.
There are certainly better ways to spend $143 billion in federal
tax expenditures. A variety of reforms have been advanced in the recent
past to ameliorate some of the problems with existing tax preferences
for health spending. Those reforms include:
* Capping the exclusion,
* Tax credits for insurance,
* Tax incentives for HSAs, and
* Tax breaks for out-of-pocket health spending.
The discussion that follows focuses on the impact such proposals
have on insurance markets. Although these proposals address different
aspects of the tax structure, each of them intends to alter tax
incentives that could lead to broader changes in the health care system.
An overarching concern for any tax reform is the potential
disruption of existing employer risk pools. Tax credits can be used to
target subsidies to the low-income uninsured, and are included in most
reform proposals. In addition, state insurance regulations could be
modified or eliminated to promote competition among insurers and reduce
the cost of health insurance in individual and small group markets.
Alternative risk pooling arrangements also could be developed, including
association health plans (AHPs), state-sponsored purchasing groups, and
high-risk pools or other arrangements to cover people who are
Each of these risk pooling approaches has been considered or
implemented by policymakers. Federal legislation has been proposed for
several years to exempt AHPs from state benefit mandates. By giving such
associations (which could include fraternal or religious organizations,
clubs, civic groups, and others) the same exemptions from state benefit
mandates available to large employers under ERISA, they have the
potential to offer insurance at attractive rates (McClellan and Baicker,
Thirty states have created high-risk pools to cover persons who
have been denied coverage by private insurers (Achman and Chollet,
2001). Individuals receiving pool coverage pay substantial premiums in
most instances, and the states also provide significant subsidies.
However, enrollment in high-risk pools has been low, totaling 105,000 in
1999. That is in part due to high premiums, limited benefits,
ineffective outreach to prospective enrollees, and caps on enrollment
imposed by some states to limit their budget outlays. An alternative to
high-risk pools would provide a subsidy to help chronically ill persons
with predictably high medical costs purchase private insurance (Cogan,
Hubbard and Kessler, 2005). The total cost of the subsidy would probably
be substantial if it was effective in buying most of the chronically ill
into private insurance.
The most prominent recent example of a state purchasing group is
the Massachusetts Health Care Reform Plan, signed into law by Governor
Mitt Romney on April 12, 2006 (Kaiser Commission on Medicaid and the
Uninsured, 2006). The plan will establish a purchasing organization
known as the Connector, which will provide one-stop shopping for
individuals, small employers, and insurers. In addition to simplifying
the purchase of insurance, that arrangement is likely to reduce
marketing and administration costs. It also creates a way for employees
of firms that might not otherwise offer a health benefit to pay their
premiums using pre-tax dollars.
Capping the Exclusion
Proposals to limit the amount of employer premium contributions
that can be excluded from a worker's taxable income have surfaced
from time to time over the last two decades. The Reagan administration
proposed such a cap on the exclusion in its Health Incentives Reform
Program, submitted to Congress in 1983 (Steinwald, 1983; Rubin, 1983).
That year Sen. Robert Dole (R-Kansas) introduced S.640, the Health Care
Cost Containment Tax Act of 1983, which would have limited that
open-ended subsidy for employer-sponsored insurance. Most recently, the
tax panel appointed by the Bush administration proposed a similar cap on
the tax exclusion in their 2005 report (President's Advisory Panel
on Federal Tax Reform, 2005).
A well-designed tax cap could be the key to finding solutions to
problems plaguing the health system. Bias in the current tax structure
toward inefficient first-dollar coverage would be blunted by capping the
exclusion. Many workers would find that extra coverage above the tax cap
is not worth its full cost after the taxpayer subsidy is reduced.
Workers would seek more affordable insurance, and employers and insurers
would be under pressure to offer more efficient health plans.
To minimize potential disruption of employer risk pools, the cap
could be phased in by setting a high initial level and indexing that
amount to general inflation rather than medical inflation. (7) A cap
with that design becomes more binding over time as medical inflation
outstrips general inflation. A longer phase-in would give the insurance
system more time to adjust to a fundamental change in the financial
calculus of health care. In addition, tax revenue from limiting the
exclusion could be used to help fund tax credits or other subsidies
better targeted to the low-income uninsured who wish to buy private
Given enough time, even the complex health insurance system could
accommodate the new demands that would arise. Alternative pooling
arrangements and new insurance products would develop in the individual
market as the value of the exclusion declined, resulting in more
competition in the insurance market. There would be new consumer
pressure to deregulate the individual insurance market and make more
affordable types of coverage available.
Consumer demand can be a powerful inducement for changes that have
long been recognized as necessary but which have been difficult to
achieve by legislation or public cajoling. We are beginning to see that
with the growth of consumer-driven health plans. Such plans increase
consumer awareness of health costs through higher deductibles and
personal accounts that allow the consumer to pay directly for services
using tax-advantaged dollars. As consumer-driven plans have become a
more significant part of the market, insurers have begun to experiment
with ways to make information on the price of health services available
to consumers (Butcher, 2006).
In contrast, there has been little demand for such information with
conventional insurance. With that type of coverage, the consumer is only
directly responsible for a small fraction of the price and generally
cannot benefit by seeking to economize on the cost of care.
Employer-sponsored health insurance has not been reliable for many
workers. Even without legislation to reduce tax subsidies, employers
have been paring back or dropping coverage. Some policymakers have
proposed additional subsidies as an inducement to employers who maintain
their benefits. (8) Additional employer subsidies might slow the
departure of employers from health Insurance, but eventually cost
pressures are likely to unravel this system.
Tax Credits for Insurance
There are good arguments for increasing the number of people with
health insurance. Uninsured individuals impose a cost on everyone else
when they need health care and are unable to pay. Uncompensated care
could amount to as much as $35 billion annually (Hadley and Holahan,
2003). If we can increase the number of people with insurance, the newly
insured will begin to contribute to the cost of their care by paying
premiums. Moreover, people without insurance tend to delay treatment,
which can cause them to suffer needlessly, lead to complications, and
require more aggressive and expensive medical interventions.
Subsidizing the purchase of health insurance can be an effective
policy approach, but as we have seen, the form of the subsidy matters.
An open-ended subsidy such as the tax exclusion promotes insurance but
contributes to the rising cost of health care. That makes insurance less
affordable and causes an increasing number of people to go without
Analysts have long recommended the use of refundable tax credits
for the purchase of health insurance as a substitute for the tax
exclusion (Arnett, 1999; Hoff and Pauly, 2002). The Bush administration
has endorsed refundable tax credits for health insurance to supplement
the tax exclusion, but the 2007 budget narrowed the availability of the
proposed credit to those who purchase high-deductible insurance (OMB,
2005 and 2006b). The latter approach is discussed in the next section.
A health tax credit could be targeted to low-income people or made
available to everyone, particularly if other tax subsidies for insurance
were curtailed. Unlike the exclusion, which increases in value along
with taxable income, a tax credit can be structured to provide the
greatest benefit to those with the least financial means. A tax credit
would also be more flexible than the exclusion, allowing individuals to
purchase any coverage on the market rather than being restricted to one
or a few plans offered by most employers.
To be effective for the low-income, the credit must be refundable,
providing a benefit even to those who do not have any income tax
liability. In addition, the credit must be available at the time health
insurance is purchased rather than when income taxes are filed, a year
or more after the first insurance premium had to be paid. The Health
Care Tax Credit, a small scale program authorized by the Trade
Adjustment Assistance Reform Act of 2002, has recently solved many of
the technical challenges of implementing a refundable, advanceable tax
credit (Dorn, 2004).
Sizeable tax credits may be needed to increase substantially the
number of newly insured individuals, particularly if the available
coverage is expensive (Pauly and Herring, 2001). Those with the lowest
incomes would probably not purchase insurance unless nearly all of the
premiums were subsidized. The working uninsured may be better able to
pay some of the cost of insurance. However, the tax credit would have to
exceed the value of the tax exclusion for a worker who has rejected the
offer of coverage from his employer.
Offering a tax credit worth more than the exclusion raises the
possibility that younger, healthier workers would opt for the credit and
leave the employer's risk pool. That is more likely if there is a
wider choice of plans in the non-group market than offered by the
employer, allowing the worker to select a plan that better meets his
financial and health needs. Migration out of employer plans is also more
likely if the administrative cost savings of the employer plan are not
very large relative to the non-group market.
Conditions could be such that an employer, particularly a small
employer, would discontinue the offer of health insurance. Although such
an outcome would be welfare-improving for some workers, older and sicker
workers would be medically underwritten and charged higher premiums or
able to purchase only limited coverage in the non-group market.
A frequently proposed way to minimize this problem would limit
eligibility for the tax credit to people who are not currently enrolled
in a group plan. (9) That would help preserve the risk pools of smaller
employers by preventing out-migration.
However, restricting the tax credit to people without group
coverage leaves intact the inequitable distribution of subsidies under
the exclusion. Such a restriction reinforces the loss of consumer
sovereignty and job mobility that results when health insurance is tied
to the workplace. Moreover, lower-income workers who were not offered
the option of a tax credit instead of the exclusion would be
disadvantaged compared to others with equally low income who were
offered the credit.
The restriction also disadvantages lower-wage employees of large
firms without any compensating gain to the insurance system. Such a
restriction would not substantially contribute to preserving the risk
pools of large employers. Large firms can offer insurance at better
rates than found in the individual and small group markets. Any employer
contribution to the insurance premium further reduces the premium paid
directly by the worker. Large firms may also offer a range of health
insurance options that may closely match the preferences of workers.
Consequently, the threat to the risk pool by introducing a choice of tax
subsidy is minimal in the large group market.
A widely available refundable tax credit would reduce the inequity
in our current system of subsidizing private health insurance. Such a
credit would increase the number of people buying non-group insurance,
which is likely to spur the development of more affordable insurance
products. Premiums in the individual and small-group market are likely
to decline in relative terms with the influx of lower--risk purchasers
who previously did not have the means to buy insurance.
A well-designed tax credit would increase the number of newly
insured, but that means setting the subsidy high enough so that
low-income individuals can afford to pay their share of the premiums.
Tax credits and other reforms of the current tax subsidy for insurance
could cause some small firms to drop their health benefits. As discussed
earlier, steps can be taken to improve the operation of the insurance
market and ameliorate such problems. The continuing decline of
employer-sponsored health insurance calls for action on such
improvements in any event.
Tax Incentives for HSAs
The tilt of the tax exclusion toward conventional health insurance
with low cost-sharing requirements and high premiums exacerbates the
moral hazard problem. That leads to higher utilization of services that,
on the margin, are not worth their full cost. Employers turned to
managed care in the 1990s in the hope of slowing the rapid rise in the
cost of health benefits. By imposing controls on the use of services
through gatekeepers, utilization review, preadmission screening, and
other mechanisms, managed care could in concept assure that care was
appropriate but not excessive.
The managed care experiment ended in the economic boom of the late
1990s. It was brought down by employee dissatisfaction and a health plan
business model that relied more on negotiating discounts from providers
than on managing care. As health costs continued to rise, employers and
individuals began to adopt insurance with higher deductibles as a way of
keeping premiums more affordable. That movement gained momentum in 2003
when Congress created a new subsidy for HSAs--tax-favored savings
accounts, which can be used only if the individual purchases
high-deductible insurance. (10)
High-deductible insurance is designed to make consumers more aware
of the cost of health services, which reduces both the utilization of
services and cost of coverage. With more of their own money at stake,
consumers have a greater incentive to seek higher value in the care they
receive. Ultimately, heightened consumer awareness of cost and value
will cause health care providers to adopt a more efficient practice
style, focusing on services that are proven to be cost-effective.
HSAs could initiate a cultural revolution in our health system that
may, over time, lead to greater efficiency and slower growth of
spending. Many other changes are needed, including more
consumer-friendly information on prices, quality, and effectiveness of
care. Physicians and other providers would see their roles expand,
placing more emphasis on advising the patient about treatment
alternatives and serving as the patient's expert advocate. Such
changes will not come quickly, and they probably will not come easily.
Under current law, individuals may contribute to HSAs on a pre-tax
basis. The inside build-up is tax free, and withdrawals are also
tax-free as long as that money is used to pay for out-of-pocket medical
costs. This triple tax incentive has been criticized as creating a tax
shelter for the wealthy, but the potential for abuse may be limited by
two factors. First, there is a low limit on maximum annual
contributions, currently $2,700 for individuals and $5,450 for families.
Second, wealthy individuals are likely to have comprehensive health
insurance and may not wish to have greater exposure to health costs by
shifting to high-deductible insurance.
The Bush administration has advanced several proposals to expand
the tax advantages of HSAs tied to high-deductible insurance (U.S.
Department of the Treasury, 2006). Those provisions include:
* An above-the-line deduction and tax credit for the purchase of
high-deductible insurance purchased in the non-group market,
* Increases in the maximum amounts that may be saved in an HSA plus
a tax credit to offset payroll taxes on contributions made by the
* A refundable tax credit to low-income individuals who purchase
high-deductible insurance in the non-group market.
The refundable low-income tax credit proposal is narrower than in
previous years, when the administration supported such a tax credit for
the purchase of both high-deductible and conventional insurance.
The long-standing bias in the tax structure in favor of
first-dollar health coverage has created unrealistic expectations of
what basic insurance must mean, particularly when skyrocketing health
costs are absorbing a rising share of employee compensation and growing
numbers of people forego insurance altogether (Weller, 2006). One might
argue that it is necessary to counter those deep-seated expectations by
tilting the tax structure in favor of more efficient insurance products.
The administration has attempted to strike a compromise. Rather
than eliminating the tax exclusion (and risking disruption in the
insurance arrangements of most Americans), the administration has opted
to add a new tax subsidy to promote coverage requiring greater
out-of-pocket payments by consumers. This approach recognizes that
alternatives to employer risk pools currently are limited, but it also
creates a new distortion affecting the consumer's decision of what
type of insurance to purchase.
Tax Breaks for Out-of-Pocket Health Spending
Repealing the tax exclusion would eliminate the tax system's
bias in favor of excessive and inefficient health insurance, but only if
such a policy could be enacted. Repealing a tax break that helps
millions of voters is improbable under the best of circumstances, but
such an action is even more unlikely in the face of rapidly rising
health care costs.
An alternative strategy would equalize the tax advantages of paying
for health care through insurance and paying for care out of pocket.
John Cogan, Glenn Hubbard, and Daniel Kessler propose to make
out-of-pocket health spending fully deductible as long as the individual
purchases insurance that at least covers catastrophic health expenses
(Cogan, et al., 2005). They include this proposal in a broad agenda that
includes refundable health tax credits for low-income individuals,
insurance market reforms, expansion of health information, policies to
promote health sector competition, and malpractice reform. The Bush
administration adopted the concept of full deductibility, but limited
the additional tax break to individuals purchasing high-deductible
insurance in the non-group market.
Leveling the playing field between paying for health care through
insurance and paying for care out of pocket eventually would cause
consumers to re-evaluate the wisdom of paying routine expenses through
insurance. This proposal preserves the consumer's ability to choose
the type of insurance product that is most appropriate for his
circumstances, and it largely eliminates the tax advantage of
first-dollar coverage over leaner insurance products. This is not simply
adding fuel (in the form of a new subsidy) to the fire of health
spending. Full deductibility also reduces the incentives in the current
system to purchase inefficient forms of health insurance.
However, as mentioned above, the tax exclusion has had a powerful
influence on consumer attitudes toward health care and insurance that
may not easily be reversed through indirect policy means. The additional
infusion of resources through the tax system would be immediate, while
changes in individual attitudes and institutional conventions would
occur over time. The budgetary cost of this approach could be
substantial in the near term as the health system adjusts to the full
package of reforms proposed by Cogan, Hubbard, and Kessler.
A RIGHT WAY?
The employment-based insurance system is under increasing pressure.
Rising health costs threaten the bottom lines of even the largest firms,
forcing reductions in promised benefits (Sloan, 2005). There are
increasing numbers of uninsured and a growing sense of unease among
insured workers that they might not be able to keep their health
Tax expenditures worth hundreds of billions of dollars have helped
create this increasingly dysfunctional insurance system. If we hope to
improve the system, we cannot simply add new subsidies on top of the
existing structure. The open-ended tax exclusion has contributed to the
moral hazard problem of insurance that leads to excessive coverage and
excessive use of services. The tax subsidy coupled with employer
contributions disguises the true cost of health insurance, causing
workers to buy more coverage than they might otherwise.
Lynn Etheredge, a well-known health policy expert, observed that
"the aver age working family wouldn't go out and spend
[$10,000] to buy insurance if they had to buy it in the individual
market. They'd be shocked at the sticker price and they would look
for something less expensive" (Cunningham, 2002).
The irony is that the average working family unknowingly is paying
every penny of that full premium. That payment takes three routes: the
worker's share of the premium (paid directly), the employer's
share of the premium (paid through lower wages), and the tax subsidy
(paid through higher income taxes or lower government services). There
is no free lunch, nor even a reduced price lunch, in this system.
Redirecting current tax expenditures could promote the purchase of
insurance and encourage more efficient use of health services, but any
reform risks upsetting the insurance arrangements of millions of
workers. Capping the exclusion to finance tax credits for those most in
need is a conceptually straightforward approach that could only be
accepted if those with higher incomes were prepared to pay more for
their own health insurance. The right tax reform recognizes that
political reality and balances the need for institutional improvements
in health insurance with the need to maintain some stability in the
insurance market. Such a reform is essential if we hope to resolve the
larger problems of the health sector.
I am grateful to Bob Helms, Grace-Marie Turner, and participants at
the National Tax Association Spring 2006 Symposium for helpful comments.
Achman, Lori, and Deborah Chollet. Insuring the Uninsurable: An
Overview of State High-Risk Health Insurance Pools. New York:
Commonwealth Fund, August, 2001.
Arnett, Grace-Marie (ed.). Empowering Health Care Consumers Through
Tax Reform. Ann Arbor: University of Michigan Press, 1999.
Blumberg, Linda J., and Len M. Nichols. "The Health Status of
Workers Who Decline Employer-Sponsored Insurance." Health Affairs
20 No. 6 (November/December, 2001): 180-7.
Burman, Leonard E., and Amelia Gruber. "First, Do No Harm:
Designing Tax Incentives for Health Insurance." National Tax
Journal 54 No. 3 (September, 2001): 473-93.
Burman, Leonard E., and Jonathan Gruber. Tax Credits for Health
Insurance. Urban-Brookings Tax Policy Center Discussion Paper No. 19.
Washington, D.C.: Urban Institute, June, 2005.
Butcher, Lola. "Plans Put Provider Prices Out For Their
Enrollees to Inspect." Managed Care 15 No. 2 (February, 2006):
Cogan, John F., R. Glenn Hubbard, and Daniel P. Kessler. Healthy,
Wealthy, and Wise: Five Steps to a Better Health Care System.
Washington, D.C. and Stanford, CA: The AEI Press and the Hoover
Congressional Budget Office (CBO). Cost Estimate: S. 1932, Deficit
Reduction Act of 2005. Washington, D.C., January 27, 2006a.
CBO. Fact Sheet for CBO's March 2006 Baseline: Medicare.
Washington, D.C., March 2006b.
Cunningham, Robert. "Joint Custody: Bipartisan Interest
Expands Scope Of Tax-Credit Proposals." Health Affairs Web
Exclusive (September 18, 2002): W290-W298.
DeNavas-Walt, Carmen, Bernadette D. Proctor, and Cheryl Hill Lee.
Income, Poverty, and Health Insurance Coverage in the United States:
2004. U.S. Census Bureau, Current Population Reports, P60-229.
Washington, D.C.: U.S. Government Printing Office, 2005.
Dorn, Stan. How Can National Policymakers Improve Health Coverage
Tax Credits Provided under the Trade Act of 2002? Washington, D.C.:
Economic and Social Research Institute, May 2004.
Fisher, Elliott S., and H. Gilbert Welch. "Avoiding the
Unintended Consequences of Growth in Medical Care: How Might More Be
Worse?" Journal of the American Medical Association 281 No. 5
(February 3, 1999): 446-53.
Gabel, Jon, Gary Claxton, Isadora Gil, Jeremy Pickreign, Heidi
Whitmore, Erin Holve, Benjamin Finder, Samantha Hawkins, and Diane
Rowland. "Health Benefits in 2004: Four Years of Double-Digit
Premium Increases Take Their Toll on Coverage." Health Affairs 23
No. 5 (September/October, 2004): 200-9.
Glied, Sherry. Revising the Tax Treatment of Employer-Provided
Health Insurance. Washington, D.C.: The AEI Press, 1994.
Hadley, Jack, and John Holahan. "Covering The Uninsured: How
Much Would It Cost?" Health Affairs Web Exclusive (June 4, 2003):
Helms, Robert B. "The Tax Treatment of Health Insurance: Early
History and Evidence, 1940-1970." In Empowering Health Care
Consumers Through Tax Reform, edited by Grace-Marie Arnett, 1-26. Ann
Arbor: University of Michigan Press, 1999.
Hoff, John S., and Mark V. Pauly. Responsible Tax Credits for
Health Insurance. Washington, D.C.: The AEI Press, 2002.
Kaiser Commission on Medicaid and the Uninsured. Key Facts:
Massachusetts Health Care Reform Plan. Washington, D.C.:The Henry J.
Kaiser Family Foundation, April, 2006.
Kaiser Family Foundation and Health Research and Educational Trust.
Employer Health Benefits 2005. Publication 7315. Menlo Park: The Henry
J. Kaiser Family Foundation, 2005.
Madrian, Bridget C. "Employment Based Health Insurance and Job
Mobility: Is There Evidence of Job Lock?" Quarterly Journal of
Economics 109 No. 1 (February, 1994): 27-54.
Manning, Willard G., Joseph P. Newhouse, Naihua Duan, Emmett B.
Keeler, and Arleen Leibowitz. "Health Insurance and the Demand for
Medical Care: Evidence from a Randomized Experiment." American
Economic Review 77 No. 3 (June, 1987): 251-77.
McClellan, Mark, and Katherine Baicker. "Perspective: Reducing
Uninsurance Through the Nongroup Market: Health Insurance Credits and
Purchasing Groups." Health Affairs Web Exclusive (October 23,
Morrisey, Michael A. Price Sensitivity in Health Care: Implications
for Health Care Policy. Washington, D.C.: NFIB Research Foundation,
Office of Management and Budget (OMB). Budget of the U.S.
Government, FY 2006. Washington, D.C.: U.S. Government Printing Office,
OMB. Analytical Perspectives: Budget of the U.S. Government, FY
2007. Washington, D.C.: U.S. Government Printing Office, 2006a.
OMB. Budget of the U.S. Government, FY 2007. Washington, D.C.: U.S.
Government Printing Office, 2006b.
Pauly, Mark V. "The Economics of Moral Hazard: Comment."
American Economic Review 58 No. 3 (June, 1968): 531-7.
Pauly, Mark, and Bradley Herring. "Expanding Coverage Via Tax
Credits: Trade-Offs and Outcomes." Health Affairs 20 No. 1
(January/February, 2001): 9-26.
President's Advisory Panel on Federal Tax Reform. Simple,
Fair, & Pro-Growth: Proposals to Fix America's Tax System:
Report of the President's Advisory Panel on Federal Tax Reform.
Washington, D.C.: President's Advisory Panel on Federal Tax Reform,
Reschovsky, James D., Bradley C. Strunk, and Paul Ginsburg.
"Why Employer-Sponsored Insurance Coverage Changed,
1997-2003." Health Affairs 25 No. 3 (May/June, 2006): 774-82.
Rubin, Robert J. Statement on the Administration's Proposal to
Limit the Exclusion of Employer-Paid Health Insurance from Employee
Taxable Family Income. Washington D.C., Committee on Finance, U.S.
Senate, June 22, 1983.
Schoen, Cathy, Michelle M. Doty, Sara R. Collins, and Alyssa L.
Holmgren. "Insured But Not Protected: How Many Adults Are
Underinsured?" Health Affairs Web Exclusive (June 14, 2005):
Sheils, John. Personal communication. February 2, 2006.
Sheils, John, and Randall Haught. "The Cost of Tax-Exempt
Health Benefits in 2004." Health Affairs Web Exclusive (February
25, 2004): W4-106-W4-112.
Sloan, Allan. "General Motors Getting Eaten Alive by a Free
Lunch." Washington Post (April 19, 2005): E03.
Steinwald, Bruce. "The Case for the Tax Cap." Office of
the Assistant Secretary for Planning and Evaluation, U.S. Department of
Health and Human Services. Mimeo June, 1983.
Thorpe, Kenneth E., and Curtis S. Florence. "Why Are Workers
Uninsured? Employer-Sponsored Health Insurance in 1997." Health
Affairs 18 No. 2 (March/April, 1999): 213-8.
U.S. Department of the Treasury. General Explanations of the
Administration's Fiscal Year 2007 Revenue Proposals. Washington,
D.C.: Department of the Treasury, 2006.
Weller, Christian E. Statistical Snapshot. Washington, D.C.: Center
for American Progress, May 8, 2006.
Joseph R. Antes
Institute, Washington, D.C. 20036
(1) In general, reducing Medicare payroll taxes does not lower the
benefit a worker will receive once he reaches age 65 and enrolls in the
program. Reducing Social Security payroll taxes lowers the amount that
program eventually pays to retirees, although that is not likely to have
a measurable effect on their decision to buy employer-sponsored health
insurance. Sheils' estimate of payroll tax savings includes all
payroll tax reductions.
(2) That figure represents foregone federal personal and corporate
income tax revenue associated with the purchase of health insurance,
contributions to health savings accounts, and out-of-pocket health
spending. The estimates reported here and later in this report exclude
another $6.7 billion in tax expenditures for activities not directly
tied to the consumption of health services (which include hospital
construction, charitable contributions, and research). They also exclude
reductions in payroll taxes or state and local income taxes. One
estimate of the total reduction in tax collections at all levels of
government is $237 billion in 2006 (Shells, 2006).
(3) A 1943 ruling by the Internal Revenue Service excluded employer
payments for health insurance premiums from the taxable income of
employees (Helms, 1999). An attempt by the IRS to make such payments
taxable was overruled by Congress in 1954.
(4) One analyst asserts that the rise of employer coverage did not
occur because of the tax exclusion, citing the fact that employers did
not typically contribute to such benefits during the 1940s (Cunningham,
2002). That ignores the 50-year record since then.
(5) In 2005, 98 percent of firms with 200 or more workers offered
health insurance benefits compared to 59 percent of firms with 3 to 199
workers (Kaiser Family Foundation and Health Research and Education
(6) The top income tax bracket is 35 percent. Medicare and Social
Security payroll taxes are levied at a total rate of 15.3 percent. Many
states and some localities levy an additional income tax, often with a
top marginal rate around seven percent. Note, however, that the 12.4
percent Social Security tax is paid on incomes up to $94,200 in 2006;
above that income, people pay no additional amount. The marginal tax
rate for high earners is, thus, about 45 percent. We follow the standard
economic convention that workers pay the employer's share of
payroll taxes by receiving lower wages than they otherwise would.
(7) The initial dollar amount of the cap could be set a variety of
ways. One might use the 90th percentile of group insurance premiums, for
example, or the average cost of providing a basic package of health
benefits (such as hospitalization, physician services, and other
services deemed "essential"), both adjusted to reflect the
typical employer contribution to the cost of the full premium. A cap
based on a basic benefit package would have less impact on older, sicker
workers than a dollar-denominated cap (Glied, 1994).
(8) Sen. John Kerry offered such a proposal in his 2004 run for
president. Medicare's prescription drug program offers a subsidy to
employers who maintain their retiree drug benefit.
(9) Another approach is to offer credits whose value is lower for
people who currently have employer-sponsored insurance. That reduces but
does not eliminate the incentive to leave the employer risk pool.
(10) Medical savings accounts (MSAs) are the precursors of HSAs,
and also tie tax-preferred savings to the purchase of high-deductible
insurance. Restrictions on the scope of the MSA market (such as the
limitation to employers with 50 or fewer employees) made MSAs
unattractive to insurers, who largely ignored this product. Flexible
spending accounts and health reimbursement arrangements, which also
provide tax advantages for health spending, preceded the enactment of