This is a special combined edition of Health Policy Matters and Consumer Choice Matters. We want to draw attention – and discussion – to a once-in-a-lifetime opportunity to bring essential change to health care financing. It would be a shame to let this opportunity slip through our fingers.
President Bush has made a fundamental rewriting and simplification of the tax code a priority of his second term. He also wants to use tax policy to expand health insurance coverage.
The health care system that we have today is the direct result of 60 years of tax policy which has lavishly subsidized employer-sponsored health insurance (ESHI). Section 106 of the IRS code allows employers to exclude the value of health insurance premiums from employees’ income. That means 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 (unless taxpayers 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 cost of the subsidy for employer-sponsored health insurance 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%, the subsidy will rise by $18.9 billion in one year – without a vote in Congress, without a debate, without a word being spoken.
And 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 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.
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% of their Adjusted Gross Income, 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 their own coverage. So we have a system in which those who need help the most get the least.
President 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% 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). That means that even if someone doesn’t owe $1,000 in income taxes, they still 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, 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 by the Kaiser Family Foundation at $95 billion over ten years, or $9.5 billion a year – paltry compared to the $189 billion available in tax support for ESHI in just one year.
But the president has a dilemma: While he has offered proposals that include tax credits and deductions for health insurance, these new provisions would add complexity to a tax code that he wants to simplify.
As long as Congress is focused on rewriting the tax code, we have 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:
? 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 would seek the most efficient payment mechanisms.
? Lower the AGI threshold. Others have advocated lowering the threshold for the medical expense deduction from 7.5% 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. As mentioned above, any deduction is worth less to lower-income people because they are in lower tax brackets.
? Credits for all. Another idea would be to partially subsidize health care spending but extend the same subsidy to all Americans, regardless of how they finance 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 that 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. Yet another idea has come from the movement toward defined contribution approaches to benefits in both the public and private sectors. 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 Consensus Group has agreed that 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 be an improvement over the current system. All would result in a more efficient and more equitable system of health care financing than we currently have. Obviously they would all need to be carefully designed to minimize the shock of sudden change and to ensure that the most vulnerable Americans are protected. We might want to have a ten-year phase-in or move selected population groups before others. We might want to try several approaches on a limited demonstration basis to get some empirical information on what works best.
But we have before us a unique opportunity to re-invent our system of health care financing. We need a full, vibrant, and informed debate over the best way to strengthen and revitalize the health care market.
If you are a member of the Galen Institute’s Consumer Choice Community, let’s continue this discussion on the web site. Please log-in and tell us what is right and wrong with each of the options laid out above, and give us your own ideas. Let’s start the dialogue now, so we will be well-armed with ideas and information when the next Congress convenes in January.
Health Policy Matters and Consumer Choice Matters will take a break over Thanksgiving week. All of us at the Galen Institute wish you a happy and restful Thanksgiving holiday.
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