President Bush has made expansion of health coverage to the uninsured a top priority of his health reform agenda. A key element of that initiative is providing refundable tax credits to the uninsured to assist them in purchasing private health insurance.
The idea of providing refundable tax credits has broad support on both sides of the political aisle, but it is often rejected by experts in tax policy as adding yet another layer of complexity to the tax code.
However, tax credits for the uninsured can help to solve some of the most difficult health policy issues, and they also are a step in the right direction for tax reform. In fact, before we can close the books on our highly burdensome, overwhelmingly complex, internally inconsistent income tax system to create a flatter, fairer tax system, we must take a hard look at the current tax treatment of health insurance. Unless a careful strategy is developed, the current favored tax treatment of employment-based health insurance could well be the Achilles Heel of overall tax reform.
The challenge is worth taking: The tax treatment of health insurance needs to be modernized both for the sake of tax reform and health reform.
It is no coincidence that the United States offers the highest-quality health care in the world and that, during the twentieth century, it repeatedly has turned its back on government-run health systems. The challenge for the twenty-first century is to modernize policy decisions made nearly 60 years ago that are increasingly out of step with today’s economy in order to make high-quality health care accessible and affordable for all Americans. The key is tax reform.
Today, the tax code provides a generous yet highly invisible subsidy for the health insurance that more than 160 million Americans receive through the workplace. This tax benefit is worth more than $130 billion in tax savings to working Americans and their families,2 a benefit that is much more valuable than the mortgage interest deduction.
Yet this subsidy leaves millions of people behind, especially those at the lower end of the income scale. Further, the subsidy is invisible to those who do receive it, causing a cascade of distortions in the marketplace for health insurance.
The political battles over a new tax system could run into a brick wall unless strategies are developed for alternatives subsidies and people are educated about these other options. Because people are not well-informed about how the current tax subsidy contributes to their health insurance, they are particularly susceptible to scare tactics by opponents of tax reform. This is not an idle threat: Opponents already have signaled they will use the health care issue to try to derail tax reform.
Reforming the tax treatment of health insurance is essential to achieve 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.
Early in the 20th Century, the link between health insurance and the workplace began to be established in the United States.3 During and after World War II, however, employment-based health insurance became more widespread, and the link became much 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 the workplace.
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 nearly 60 years to become the foundation for a system that provides subsidies and therefore strong incentives for working and retired Americans and their families to get health insurance through the workplace.
But this form of subsidizing health insurance is increasingly out of step with our rapidly changing economy and workforce. When people change or lose their jobs, they also lose their health insurance. In addition, the current subsidies for job-based health insurance are very regressive: Current tax law 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. A taxpayer earning $100,000 a year or more gets an annual subsidy worth $2,638 while one earning $15,000 gets only $79 a year in assistance toward the purchase of health insurance.4
What that means is that an executive with a high-paying job gets a generous tax subsidy for health insurance from the taxpayer while the waitress serving her lunch gets little or no help in purchasing health insurance.
As long as Americans remain under the mistaken illusion that they are getting “free” or heavily subsidized health insurance at work, they will be shielded from the full cost of their health care consumption decisions. They will not understand that their cash compensation is lower because of high health insurance costs. And they will not see the generous tax break they are getting for their job-based health coverage. They also will become increasingly frustrated with a system that robs them of control and choice over their health care and health coverage decisions.
Clearly, it is not a system we would have designed if we were starting from scratch. It is a relic of World War II wage and price controls, and changes are needed.
Making reform a reality
The convergence of frustration with the tax system and frustration with the health care system may provide a historic opportunity for change. In 1999, the average household paid nearly 40 percent of its income in federal, state, and local taxes.
This high tax rate during peacetime and prosperity, coupled with growing disaffection with centralized government, leads many political analysts to believe that the country is ripe for tax reform. However, a debate over a major simplification or restructuring of the federal tax system would necessarily focus attention on the generous tax benefit provided for employment-based health insurance. It is imperative that tax reform advocates approach changes to the tax treatment of health insurance with an understanding of its politically volatility and alternatives that are being developed.
There is a solution in a system of reforms advanced by the Health Policy Consensus Group5 and supported by political leaders on both sides of the aisle. These reforms could provide a tax cut to individuals, targeted to those who currently do not have health insurance. This would give individuals more choice as to where and how they obtain medical care and could create new incentives for a competitive, consumer-driven market for health insurance and medical services.
Coupling tax reform with free-market health reform could finally make a win-win political scenario possible.
Even with the generous $130 billion subsidy for job-based health insurance, more than 40 million people are without coverage at some point during the year because they don’t receive or can’t afford the health insurance offered by their employers.
Therefore, as an interim measure to move toward greater fairness, the Health Policy Consensus Group has advocated providing tax credits to individuals for the purchase of private health coverage. It may seem odd to discuss the merits of tax credits in the context of a debate over a simpler, fairer, flatter tax system. But in fact, as will be argued below, enacting tax credits for private health insurance actually puts in place a system of subsidies that will make the transition to overall tax reform much easier.
President Bush, in embracing the concept of tax credits as the centerpiece of his initiative to assist the uninsured, would provide a tax credit worth $1,000 for individuals and $2,000 for families to cover up to 90 percent of the cost of a policy. Others, like House Majority Leader Dick Armey, would provide even more generous credits of $1,000 for individuals and up to $3,500 for families.
Such credits could be turned into direct subsidies or an expansion of the basic personal exemption in a simplified tax system. This transition would be much more difficult when the subsidy for private health insurance is expressed as a deduction or exclusion from income of the cost of the premium. In the current system, the amount of the subsidy varies with a person’s tax bracket and with how much he or she spends on health coverage.
In making a direct subsidy through a credit, the expenditure can move to the spending side of the budget where it belongs rather than being run through the tax code with all of its complexity and confusion. The key to this new system is that individuals know they have a specific subsidy for health insurance qualified in dollars rather than in an open entitlement to benefits.
In the new system, consumers, and not government bureaucrats, politicians, or human resource directors, would decide how the money will be spent.
More than 80 percent of the uninsured are working Americans or their dependents; they either can’t afford to purchase health coverage on their own with after-tax dollars or they can’t afford to pay their share of the premium costs for health insurance their employers may offer. Tax credits would provide millions of Americans and their families the boost they need to purchase their own health coverage.
Tax credits also would provide a measure of equity that is missing from the current system. Right now, two families in otherwise identical income situations can be treated very differently by the tax code. If one has access to health insurance at work, their family can get a generous tax break. If the other does not have the option of job-based health coverage, they will get little if any tax benefit toward the purchase of health coverage.
The tax credit would be a direct subtraction from taxes owed. The Consensus Group also proposes that the tax credit be refundable toward the purchase of health insurance. That means that if taxpayers owe less than the credit for which they are eligible, they can claim the difference as “refundable” subsidy.
Tax credits are a step toward individual ownership of health insurance, selected in a competitive private marketplace. The alternative proposed by those on the political left would lure more and more of the uninsured into existing government-run health programs like Medicare, Medicaid, and the State Children’s Health Insurance Program (SCHIP) as it is currently configured.
It should be emphasized the tax credits are not the ultimate solution. They are an incremental step toward a more equitable system of subsidies that would help eliminate many of the current distortions. The new tax credit subsidies would be visible to the recipients, empowering them to make decisions about how to obtain the best value for their health insurance dollar in a competitive marketplace.
Because more than four-fifths of Americans get their health coverage either through the workplace or through government programs, the market for individual health insurance is not nearly as vibrant as it could or should be. Targeting subsidies to individuals to make their own health care arrangements would inject new vitality into the market for individually-purchased health insurance and provide incentives for companies to offer a much broader range of more affordable insurance products.
Further, if the market for privately purchased health insurance is not strengthened, there will be fewer and fewer options available for those shut out of the employment-based system. This will give proponents of expanded government programs greater leverage.
Time for change
The changes that are needed in the health sector should come not through the collective solutions that have been attempted again and again in this century to expand government control of the health system. Rather, they should come through solutions that focus on individual authority, competition, diversity, and freedom of choice that will drive the rest of economy in the twenty-first century.
The goal is to expand freedom by limiting the role of government in the health sector, which is – by count of the number of pages of regulation governing it – the most heavily regulated sector of the U.S. economy. In order to restore competition and freedom for patients and doctors, we must begin to move away from a system that would bring more and more Americans under the authority of politicians and government regulators in directing health care. Limiting the role of government will expand freedom and promote individual responsibility, competition, and diversity.
Implementing new subsidies for health insurance now through tax credits would make a transition to a new system easier in the long run. As part of a tax reform initiative, explicit, capped subsidies for health insurance could easily be converted into credits or an expanded personal exemption, available only to those who use the funds to purchase health insurance.
Ultimately, the road to health care reform will run through tax reform. The invisible and regressive tax break for health insurance will be brought to light when the country debates a major overhaul of the tax code. As a result, the route to the health care reform that has eluded policymakers for decades may very well be through a simpler, fairer, and flatter tax system.
Envisioning a Consumer-Driven Health Care System Goals:
- Empowering consumers to restructure the health care system to meet their demands for quality, access, and cost-effectiveness
- Providing direct subsidies to individuals to encourage the purchase of private health insurance
- No one should go without needed medical care.
- Private sector options for obtaining coverage should be encouraged through tax incentives rather than by creating new federal entitlement programs.
- Incentives should be properly structured so consumers can have a wide variety of choices at competitive prices.
- Individuals must be responsible, whenever possible, for making their own decisions about the coverage they want and the costs they are willing to pay for health insurance and medical treatment.
- Changes to the current system should focus on creating a properly functioning market, not injecting more government micro-management.
- Assistance to those with lower incomes should be structured so as not to discourage work, compromise individual self-respect, create dependency, or lock people into poverty.
A plan for expanding health coverage through credits
Many of the problems that politicians have been wrestling with for at least 20 years can be minimized and even solved by empowering consumers to transform the health sector through free-market competition rather than regulation.
In a market-based economy, whoever controls the money controls the choices. The only way for Americans to get back in control of costs and choices is to get control of the money. When that happens, consumers will be able to choose the doctors and medical care that they, and not an insurance clerk or government bureaucrat, deem necessary. And they, and not a bureaucrat or employer, will decide what compromises they are or are not willing to make to get medical care and health insurance.
Over the last several decades, modern medicine has evolved to a point that medical professionals can diagnose life-threatening diseases early enough to provide life-saving therapies. With these advances have come the social questions of who is entitled to medical care and at what price. Today, care is not denied to those in critical need of medical treatment. But haphazard access to medical care is expensive, inefficient, and diminishes individual dignity.
The political process has struggled and failed to produce a sweeping reform proposal that would address the needs of 280 million Americans through a government-designed program. No one single solution will ever work.
During the last major health care reform debate in the 1990s, Americans consistently said they wanted universal coverage but just as consistently said they did not want the government bureaucracy that accompanied a centralized government approach. The American people, committed to the imperative of equality, want everyone to have access to medical care, but they want it done in a way that does not compromise the strength of the health care system or the economy, or place an undue burden on individual or government resources.
As the United States leads the world into the information age, people have greater access to more and more information about health care options. Government cannot and should not stop this information explosion, and it cannot and should not stop people from seeking the medical services they need to promote and maintain their own health.
In a true free-market system, costs would be controlled, not by government restrictions, but by individual consumers seeking the best value for their premium dollars in a competitive marketplace.
The solution that has broad bi-partisan support is to provide tax credits to individuals and families to assist them in purchasing private health insurance.
1 Grace-Marie Arnett is president of the Galen Institute, a not-for-profit health and tax policy research organization based in Alexandria, VA. The author wishes to thank researcher Tara Persico for her assistance with this article.
2 John Sheils, Paul Hogan, and Randall Haught. “Health Insurance and Taxes: The Impact of Proposed Changes in Current Federal Policy,” Policy Study published by the National Coalition on Health Care, October 18, 1999. Washington, D.C.
3 The description and history of the tax treatment of health insurance are taken from A Vision for Consumer-Driven Health Care Reform by the Health Policy Consensus Group, Grace-Marie Arnett, editor, University of Michigan Press, 1999.
4 Ibid. Sheils, et al.
5The Health Policy Consensus Group was formed in 1993. It is a network of health policy experts, including researchers from the major market-oriented think tanks, who meet regularly to produce statements, hold conferences, and provide policy advice to policymakers and opinion leaders about ideas for free-market health reform.