The Heritage Foundation

Backgrounder #1528 on Health Care

March 20, 2002

March 20, 2002 | Backgrounder on Health Care

Time for Bipartisan Action to Help Families Without HealthInsurance

In passing the recent economic stimulus bill, Congress missed yet another opportunity to help families who lack affordable health insurance by enacting a refundable tax credit.1 Such a credit, which would help these Americans afford the health care coverage they need, has support from the Administration as well as a bipartisan group in Congress that includes Senators John Breaux (D-LA), Olympia Snowe (R-ME), and James Jeffords (I-VT). Last December, the House passed a stimulus package that included a refundable tax credit provision.

Despite such broad support, however, the Senate Democratic leadership made it clear that it would use Senate procedures to block passage of a credit in any stimulus package. Reluctantly, the White House and the House of Representatives accepted the stimulus package that lacked such a provision.

The Senate's failure to act on the bipartisan proposals to improve access to health insurance means that millions of Americans will continue to lack affordable protection against the potentially catastrophic costs of an illness or accident. Such Americans find themselves uninsured for several reasons. Some are unemployed workers who could continue coverage under their former employer's plan as long as they pay the premiums but do not have the money to do so. Other unemployed workers and some working families are uninsured because their employers do not offer any coverage. Still others, generally low-income workers, may be offered employer-based insurance for themselves or their families but cannot afford the premiums. A refundable tax credit would help families in each of these groups to afford at least a basic level of private coverage.

Members of Congress concerned with the plight of the uninsured need to take action now to address this problem, either as free-standing legislation or as an amendment to a pending bill. Even if the economy improves significantly, millions of American families will remain uninsured--and others will become uninsured--because of the structure of the current system. A refundable tax credit that these Americans could use to purchase their own health coverage has gained broad support because it would significantly reduce the numbers of families who lack affordable coverage. It is time for Congress to act.

Why a New Approach is Needed

All responsible lawmakers want some form of action to help the uninsured. The argument is over how best to do that. And although most Members of Congress believe that the employer-sponsored insurance system should continue as the basis of coverage for most working families, there has been a gradual recognition that, in today's economy, the traditional employer-based system cannot serve all families effectively. In particular, that system does not assure stable, continuous coverage for all. Two factors demonstrate this problem:

  • There are very high rates of uninsurance among employees of small firms. According to a Kaiser Family Foundation survey, while 99 percent of large firms offer insurance, only 55 percent of firms with fewer than 10 employees do. Among low-wage workers (those who earned less than $7 an hour in 1996), 45 percent are not even offered insurance.2 One major reason: Employers who try to offer coverage to very small groups tend to face high administrative costs. According to data collected by the Congressional Budget Office, overhead costs for providing insurance can exceed 30 percent of the premium costs for firms with fewer than 10 employees, compared with about 12 percent for firms with more than 500 employees.3 Another reason: Small employers typically lack the resources and skills to assemble good and affordable options for their workers. Consequently, many such firms adopt a competitive compensation package that emphasizes cash income rather than health benefits.
  • The federal tax code blocks workers from obtaining coverage from anyone other than an employer or former employer. The current tax system excludes from taxable income (federal and state income taxes and payroll taxes) all compensation provided to a worker in the form of employer-sponsored insurance. But workers who purchase insurance for themselves rarely can claim any tax relief or receive any other assistance toward the cost of coverage. The lack of tax benefits for such workers can mean, in effect, that their families will face a tax penalty of hundreds or even thousands of dollars if they seek coverage outside the place of work. This fact explains the high uninsurance rate among lower-income working families and especially among the employees of smaller firms that do not offer insurance. The tax code's bias against non-employer-sponsored coverage also discourages the growth of alternative insurance offered by large non-employer organizations with which a worker may have had a long-term affiliation, such as unions or churches.

Three Approaches to Helping the Uninsured

Congress has considered various proposals that are based on three broad approaches to address the problem of uninsurance.

Approach #1: Expand government programs, such as Medicaid, to include more working families.
For some politicians and organizations, this approach is seen as a step toward achieving their goal of a national single-payer health system. But besides the chronic problems besetting Medicaid, as well as the national systems of Canada, Britain, and elsewhere, there is strong resistance to this costly approach among Americans generally, Members of Congress, and within the Administration.

Extending Medicaid eligibility to the uninsured raises serious concerns. Among them:

  • Putting uninsured workers and their families in a different system would further segregate them from the rest of society that has private coverage. Over 85 percent of the uninsured live in homes headed by a worker. It makes little sense to require these families to seek coverage from a program designed primarily for the unemployed welfare population rather than to help them afford the coverage they most prefer and which they could obtain from their employer or another organization. Moreover, under the government program approach, if the family's income rises enough to make the family ineligible for Medicaid or another public program, the family would be required to change its form of coverage--resulting in either the loss of coverage or, at the very least, different coverage.
  • States already are facing severe budget shortfalls and are very reluctant to add to their Medicaid obligations. Some 37 states overspent their Medicaid budgets in FY 2001, and Medicaid is already over budget this year in 23 states, according to a survey of state budget officers.4 States are looking to keep their health costs down, not to add to these costs by expanding program eligibility.

Approach #2: Condition any assistance for laid-off workers on their remaining with the former employer's plan.
Some proposals, such as that offered late last year by the Senate Democratic leadership, would provide assistance to laid-off workers only if they continued to purchase temporary coverage under COBRA.5 Subsidizing COBRA-only coverage, however, whether through direct subsidies or through a tax credit, raises several problems. Among them:

  • Many unemployed workers would not qualify. Many unemployed workers, especially low-income workers, do not qualify for COBRA now because their previous employers did not offer insurance or because those firms, because of their size, were exempt from the obligation to extend coverage. Some 42 million employed workers would be ineligible for COBRA if they lost their jobs, and about 60 percent of low-income families do not qualify.6
  • Many families still could not afford coverage. The COBRA-only approach would merely give many families only a "choice" of an unaffordable comprehensive plan when their economic condition makes only a leaner plan affordable, even with a subsidy. In other words, many families would continue to be uninsured because COBRA-only coverage would prevent them from using the assistance to buy less expensive coverage.
  • Many unemployed workers would be faced with accepting coverage from the firms that laid them off--even firms in financial trouble like Enron. COBRA-only coverage means that an unemployed worker's family would be dependent on the former employer for the quality and continued availability of coverage organized by that employer, which laid off the worker and has no other connection to the family. The firm may even be facing severe financial problems that could lead to coverage cutbacks; if the firm is forced into complete bankruptcy, the COBRA coverage would be lost. Understandably, many of these families would be very reluctant to depend on certain employers. For example, under this approach, a former Enron worker who has just lost his or her job and pension would be told he or she could get help for insurance only if it is used to buy coverage through the same firm that threw the employee out on the street.

Approach #3: Offer a refundable tax credit for the uninsured and allow them to use it for any plan of their choosing.
A number of proposals, including one from the Administration, one passed by the House, and plans offered in both chambers by a remarkably bipartisan group of Members, would provide a refundable tax credit for the purchase of insurance from any source--in most instances including an existing or former employer. This approach makes far more sense than does offering subsidies that are restricted to COBRA coverage. Moreover, these proposals would allow a parallel "third way" system to develop alongside employer-sponsored and government-sponsored coverage for Americans working in smaller firms that do not now offer coverage. The tax credit approach would help families who want not only private insurance but also the stability and control that comes with a plan they have chosen from an organization they trust.

Key Design Elements for a Tax Credit Program

There are several desirable elements that Congress should consider in designing an effective tax credit, especially one that enables laid-off workers and low-income, uninsured populations to obtain affordable insurance. Specifically:

Key Element #1: Eligibility should include those with employer-sponsored coverage.
Ideally, some level of credit should be available regardless of job status--that is, available to unemployed workers, workers who are not offered employer-sponsored insurance, and workers who are offered such insurance but cannot afford it. With a properly designed credit, this eligibility criterion would eliminate any of the current bias against employer-sponsored coverage by providing an equivalent level of help to those with or without that benefit.

One tax credit bill that is designed to help each of these groups is the REACH Act (S. 590), sponsored by Senators Jeffords, Breaux, and Snowe. This bill contains a lower credit for employees with employer-sponsored plans. When combined with the tax exclusion already available to workers for employer-sponsored coverage, this lower credit is designed to provide a level of subsidy to insured employees that is equivalent to the full credit available to the uninsured in order to cover their out-of-pocket costs.

Key Element #2: The credit should be refundable and advancable.
For the credit to be meaningful to lower-income families, it must be refundable. In addition, a credit, rather than a deduction, is needed to ensure that families with low marginal tax rates receive adequate help. A credit also should be available "up front" so that a family does not have to wait until the end of the year to apply it. This availability can be achieved through the tax withholding system for employed, taxpaying individuals in the same way that other tax benefits, such as the mortgage deduction or child care credit, are "advanced."7

In addition, a simple alternative method of obtaining the credit would be to "assign" the credit to a health plan in return for a lower premium, which would be especially helpful for workers who do not file a tax return or do not wish to use the withholding system. Members of Congress and other federal workers already receive an "assigned" government health subsidy in the Federal Employees Health Benefits Program (FEHBP), and thus receive a discounted premium. Assignment can be organized easily for a fixed or percentage credit, with no income phaseout. Income-adjusted credits pose small complications that can be reconciled through the tax system.

An unemployed person with an assigned credit similarly would face a reduced premium. A refundable tax credit system for unemployed workers could be organized through the unemployment insurance system. This approach would require a funds transfer between the U.S. Treasury and the U.S. Department of Labor, with the money then distributed to state unemployment offices (similar to the way the supplemental benefit programs have been delivered for decades) or directly to the insurer. Unemployment offices, which are already responsible for verifying unemployment, would be required to verify worker eligibility for the credit.

Key Element #3: Different forms of credit will have different effects on recipients.
There are several forms of tax credits, each of which has subtly different effects. One is a fixed dollar credit, as proposed by the President and others such as Senator Jeffords. This is a simpler form that makes calculating after-credit premium costs easy for both the insurer and the recipient. For a given budgeted amount, moreover, the fixed credit does concentrate the assistance on those with the most financial need. On the other hand, individuals with greater health care costs would face 100 percent of additional out-of-pocket costs if they needed elaborate coverage.

Another form would be a percentage credit, such as that included in the House stimulus package and in legislation offered in the past by several lawmakers, including Representative James McDermott (D-WA).8 This approach would be more expensive if the minimum assistance available was at least equal to the fixed credit, but it would help families with higher health care costs by reducing the marginal after-tax premium cost of more expensive coverage. In addition, by making the purchase of more comprehensive plans more affordable for younger, healthier individuals, it would reduce adverse selection concerns.9 Unpublished research by Emory University professor Kenneth Thorpe suggests that there would be very little adverse selection at all with a credit equivalent to the FEHBP subsidy (approximately 75 percent).

Key Element #4: The place of employment may be the best location through which most families get coverage even though employers are not necessarily the best sponsors of coverage.
Most people in America pay their taxes through a place of work. This is a very convenient system under which employers withhold income and Social Security taxes and send the money to the government. In addition, employees typically adjust their withholdings to take advantage of any tax breaks for which they may be eligible (for example, the mortgage interest deduction). Employers thus facilitate the tax system but do not in any sense design or "sponsor" the tax code. They could more appropriately be considered a clearinghouse for tax payments.

The place of employment likewise would be particularly convenient and efficient for handling health insurance payments. With individual tax credits available, employers who do not currently sponsor insurance could still carry out the critical clearinghouse role for plan choices, tax adjustments, and premium payments. In other words, smaller employers could handle the bookkeeping aspects of arranging for payroll deductions and premium payments (similar to their role in the tax collection system) without having to sponsor a plan. With individual credits, eligible employees could join any plan available in their area, not just one sponsored by their employer, and still obtain tax benefits. Thus, very small employers could play a very important role in facilitating coverage without having to organize coverage.

Key Element #5: Minimum benefits requirements should be avoided.
Some argue that any tax credit should be conditioned on the eligible family's purchasing a health plan with a federally determined comprehensive benefits package. This would be a mistake. A federally mandated comprehensive plan would be very expensive, putting it out of reach for many families, yet in many cases still would not include certain benefits needed by some families. A comprehensive federal benefits package (which would set the ceiling as well as the floor for most lower-income families) would also invite provider and other special-interest lobbying to include often-marginal benefits. This pattern, seen at the state level, could make insurance prohibitively costly for lower-income families, as the experience with state mandates has demonstrated.10

If Congress unwisely insists on a benefits package, it should be for a minimum package, primarily catastrophic insurance protection, and not comprehensive coverage. It should also be in the form of broad areas of coverage, such as hospitalization and major medical, similar to the requirements for plans participating in the FEHBP or the California Public Employees' Retirement System (CalPERS), rather than a precisely defined set of specific benefits, such as Medicare fee-for-service.

Key Element #6: Washington should work with states to make new forms of groups and intermediaries available as vehicles for insurance.
The individual market does not have to be the only choice for coverage. Indeed, with a tax credit reducing the obstacles to new forms of group coverage emerging, it is likely that other purchasing options--in some cases similar in structure to employer-based coverage--would arise. This development can be hastened through government action. Three types of groups are particularly attractive additions to traditional employer-sponsored coverage:

  • Affinity groups and associations. Several common institutions in American communities are well placed to serve this function for insurance and to act as intermediaries negotiating with insurers on behalf of families. For example, unions , as "friendly societies," have had a long history of involvement in health care. Many religious denominations also have a long history of providing insurance services for their congregations. Lower-income African-Americans and others tend to have a more stable long-term affiliation with churches than with small employers, and churches have the long-term social welfare of families firmly in mind. Such groups would not act as insurers themselves, any more than the Mailhandlers union does in the FEHBP, but instead as buying agents that reach agreements with insurance plans that actually shoulder the risk.
  • The Federal Employees Health Benefits Program. While technically an employer-based system, the FEHBP actually provides the equivalent of individually chosen and controlled insurance coverage to the equivalent of a small country (with nearly 10 million covered individuals). The FEHBP offers a very broad choice of plans. While a federal worker's immediate employer does not sponsor plans, the place of employment is still the "entry point" for selecting a plan. The FEHBP plans are regulated at the federal level through a combination of general statutory and administrative regulations, supplemented by a process of negotiations between the Office of Personnel Management (on behalf of the federal government) and the plans wishing to market to federal employees and retirees through the FEHBP. There have been several proposals to open the FEHBP to non-federal workers under various conditions, typically using a separate insurance pool. On a small scale, this model could be implemented by states using their state employee plans.
  • Large corporate health plans available to non-employees. Providing tax credits to individuals also would create a market for large corporations to offer their own health plans to non-employees. It is quite common for large firms to take products developed initially as an internal service to the firm and market them to external customers. For example, General Motors formed the General Motors Acceptance Corporation (GMAC) out of its huge automobile loan service and markets a broad range of financial services to non-employees. But this does not happen with health insurance, principally because the tax code provides no tax benefits to families buying health insurance from a corporate plan that is not their employer's.

An individual tax credit would remove this obstacle by allowing uninsured families to join any health plan using the credit. This would change the incentives in the current market dramatically, opening up a potentially large new market for existing corporate plans and an opportunity for many working families to form groups to negotiate coverage under these plans.

One firm whose activities hint at what could happen in a more liberalized environment is the John Deere Company. Some years ago, Deere created its own health maintenance organization (HMO), which it markets to some workers of other firms and to some federal workers under the FEHBP. Out of more than 400,000 enrolled in Deere plans in the Midwest and Southeast, less than 20 percent are John Deere employees. The tax code, however, currently makes it very uneconomic for Deere to offer coverage directly to groups of working families (except federal workers) other than through their employer.

The federal government could work with the states to foster new forms of purchasing arrangements, in addition to the high-risk pools and other vehicles already being developed for high-risk individuals. To do this, Congress could enact legislation to permit a range of new kinds of groups, such as opening the FEHBP system to groups of the uninsured in each state, and new forms of purchasing groups such as groups sponsored by churches and unions. The federal government could then enter into discussions with each state to create a federal-state package of new forms of group insurance, selected from a "menu" of federal options combined with state measures.

Addressing Two Common Criticisms of Tax Credits

Critics of tax credits raise a number of arguments, two of which are widely heard.

Argument #1: The proposed credit is not sufficient to afford coverage, so the take-up rate would be low.
To be sure, a large tax credit would make insurance affordable for more families than a small credit would, just as a public program with a large budget would cover more people than one with a small budget would. If Congress were to raise the budget amount devoted to a tax credit program, it would certainly be more effective. But there are still good reasons to believe that the recent Administration and Hill proposals for tax credits would have a significant effect on the uninsured.

First, the individual market may not be as inaccessible as critics perceive. Surveys by eHealthinsurance Inc. show that there are quite affordable coverage options available in most states, especially those that do not impose a high level of mandated benefits.11

Second, a federal tax credit should be viewed as a foundation upon which other financing bricks are added. Put another way, a $3,000 federal health insurance credit would put the family $3,000 closer to obtaining affordable coverage. Under current law, and with waivers from the federal government, state governments can provide families with State Children's Health Insurance Program (SCHIP) and other funds to subsidize the purchase of private coverage. The federal government should combine a tax credit program with an aggressive waiver initiative that is designed to complement the federal credits. In addition, if workers are allowed to join large pools utilizing a credit, many small employers in a competitive labor market--especially those who do not now offer coverage because of the administrative cost--also would have incentive to make contributions on behalf of their employees' coverage.

Third, the take-up rate of coverage is likely to be greater than some estimates, even at the credit levels now under discussion. A recent study by Mark Pauly of the University of Pennsylvania's Wharton School of Finance and Bradley Herring of Yale University's Institution for Social Policy Studies, for instance, estimates that a fixed tax credit equal to 50 percent of the cost of a standard plan would lead to a 48 percent reduction in the number of uninsured.12

Determining the take-up rate is difficult--as it is with, say, expansions of Medicaid. The influence of two contributing factors illustrates this difficulty. If alternative government programs (and emergency room care) are inexpensive to families, this would have the effect of "crowding out" tax credit-subsidized coverage by rendering it relatively more expensive, leading to lower take-up rates of a tax credit program. But if these alternatives are less available or more costly, the take-up rate would be much higher.

The ease of obtaining the subsidy and signing up for coverage is also a significant influence. With assignment and automatic enrollment at the place of work, take-up rates likely would be quite high. Evidence from pension plans indicates that an automatic enrollment system for health insurance could have dramatic effects on sign-up rates. Such an automated system could make a tax credit program operated through the place of work (though not necessarily with the employer actually sponsoring the coverage) a very effective method for increasing coverage.13

Argument #2: A credit would "crowd out" traditional employer-sponsored plans.
Some critics maintain that providing a tax subsidy to the uninsured is inefficient because many employers currently providing insurance would drop their employees' coverage.

The simplest response to this charge is that it applies, of course, to any proposal to help the uninsured, including expansions of public programs. Indeed, there have been a number of studies of "crowd out" in Medicaid and other programs, and these indicate a significant substitution effect. David Cutler of Harvard University and Jonathan Gruber of the Massachusetts Institute of Technology, for instance, found a range of crowd-out effects for Medicaid expansions in the late 1980s and early 1990s, depending on exactly what was measured. They found that the decline in private coverage, as a share of the persons who enrolled in Medicaid directly as a result of the expansions, was as much as 50 percent.14

A recent study of state-based expansions of coverage by Richard Kronick and Todd Gilmer of the University of California, San Diego, indicates a variety of crowd-out effects, depending on the design of the program. Oregon and Washington, for example, reduced uninsurance with very little crowding out of private insurance, while in Tennessee almost half of the increase in publicly covered individuals resulted from a decline in private coverage. In Minnesota almost all the enrollment in the new public plan "was accompanied by a decline in the number of privately insured persons and virtually no change in that of uninsured persons."15

Thus, tax credits are no different from other approaches in having some substitution effects. But some steps can be taken to reduce crowding out. The smaller credit available in Senator Jeffords' REACH Act for individuals with employer-sponsored coverage, for example, likely would reduce crowding out. In addition, it would be wise to include a prohibition against workers' dropping out of an employer-sponsored pool and claiming the credit--not just to discourage crowding out, but also to prevent the employer's insurance risk pool from being eroded.

Conclusion

Millions of American families need help to afford adequate health insurance. The need is particularly acute for workers who have lost their jobs and for workers in firms that do not offer coverage. Creating a refundable tax credit for insurance not necessarily provided through the place of employment is a sensible step that Congress could take this year while it also takes steps to improve the availability of group coverage throughout the states.

Such an approach already has strong support in each chamber and in the White House, and such a proposal has already been passed by the House of Representatives. It is time for the Senate leadership to embrace this approach so that many uninsured families at last will gain the protection of insurance that best meets their needs.

Stuart M. Butler, Ph.D., is Vice President for Domestic and Economic Policy Studies at The Heritage Foundation.


1. A refundable tax credit arrangement is one in which, if an available credit exceeds the family's tax liability, the family would receive the difference from the U.S. Treasury (or it can be "assigned" to a provider of services; see below).

2. Kaiser Commission on Medicaid and the Uninsured, Uninsured in America: Key Facts (Washington, D.C.: Kaiser Family Foundation, 2000).

3. Congressional Budget Office, The Tax Treatment of Employment-Based Health Insurance (Washington, D.C.: 1994), p. 8.

4. Medicaid Budgets Under Stress: Survey Findings for State Fiscal Year 2000, 2001 and 2002 (Washington, D.C.: Kaiser Family Foundation, 2001), p. 12.

5. The 1986 Consolidated Omnibus Budget Resolution Act, known as COBRA, includes a provision permitting certain families to continue their previous employer-sponsored health insurance coverage when they change or lose their jobs.

6. Michelle Doty and Cathy Schoen, Maintaining Health Insurance During a Recession: Likely COBRA Eligibility (New York: Commonwealth Fund, 2001), p. 2.

7. For example, workers who have purchased a home and are eligible for a mortgage deduction typically instruct their employer to change their tax withholdings so less tax is taken out of each paycheck. In this way, they receive the tax relief through the year, when the mortgage payments are due.

8. H.R. 539, introduced in 1998.

9. Adverse selection is the phenomenon by which younger, healthier families tend to select lower-cost, basic plans while older and generally less healthy families select more comprehensive coverage. This can lead to sharply higher costs and premiums for comprehensive coverage.

10. Melinda Schriver and Grace-Marie Arnett, "Uninsured Rates Rise Dramatically in States with Strictest Health Insurance Regulations," Heritage Foundation Backgrounder No. 1211, August 14, 1998.

11. See testimony of Vip Patel, Chairman, eHealthinsurance Inc., before the Committee on Ways and Means, U.S. House of Representatives, February 13, 2000, at http://waysandmeans.house.gov/fullcomm/107cong/2-13-02/2-13pate.htm. See also James Frogue, "Recent Survey Points to Affordable Individual Health Insurance," Heritage Foundation Executive Memorandum No. 740, April 17, 2001.

12. Mark Pauly and Bradley Herring, "Expanding Coverage Via Tax Credits: Trade-Offs and Outcomes," Health Affairs, Vol. 20, No. 1 (January/February 2001), p. 16.

13. A recent study found that automatic enrollment for 401(k) plans boosted participation rates from 37 percent to 86 percent for such voluntary pensions, with even sharper increases for young and lower-paid employees. See Brigitte Madrian and Dennis Shea, "The Power of Suggestion: Inertia in 401(k) Participation and Savings Behavior," National Bureau of Economic Research Working Paper No. 7682, May 2000, p. 51.

14. David M. Cutler and Jonathan Gruber, "Medicaid and Private Insurance: Evidence and Implications," Health Affairs, Vol. 16, No. 1 (January/February 1997), pp. 194-200.

15. Richard Kronick and Todd Gilmer, "Insuring Low-Income Adults: Does Public Coverage Crowd Out Private?" Health Affairs, Vol. 21, No. 1 (January/February 2002), p. 235.

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