June 2, 2003 | Backgrounder on Health Care
Representative Richard Gephardt (D-MO), a presidential candidate, recently offered a major proposal--estimated at $689 billion over three years--to expand health insurance coverage through a combination of new corporate and individual tax credits and expansions of Medicare, Medicaid, and the State Children's Health Insurance Program. Representative Gephardt would fund the new health plan by repealing the Bush tax cuts enacted in 2001.1
The Gephardt proposal, if enacted, would combine bad economic policy with bad health policy. In health policy, Gephardt's proposal would likely aggravate already rising health care costs and could lead to the kind of explosive growth in health spending that America experienced in the late 1970s and early 1980s. Indeed, The Washington Post concluded in a recent editorial that Gephardt's plan "may be calculated to cause the least amount of political friction, but it will also expand the extremely expensive employer-based health care system that we now have, and at an enormous and unpredictable cost."2
The biggest problem with Gephardt's health proposal is that it would effectively double the corporate income tax subsidy for employer-provided health insurance while at the same time failing to address the real determinant of employer health coverage--the large personal income tax and payroll tax exclusion that workers receive on the value of those benefits. The effect of adding a new corporate tax subsidy on top of the existing personal tax breaks for employer-sponsored health benefits would make the after-tax value of those benefits more than twice the after-tax value of cash wages for millions of middle-income Americans.
While Gephardt's proposal would undoubtedly help some of the currently uninsured gain coverage, it would do so at the price of stimulating inefficient and wasteful health spending by those who already have coverage. A good example of the behavior that Gephardt's plan would likely stimulate is the now common practice of workers with unspent, tax-free dollars in their flexible spending accounts at year's end rushing to buy extra eyeglasses or other "health care" items of marginal benefit.
The proper goals of health policy should be to help those who need assistance in purchasing health insurance and medical care while at the same time ensuring that the incentives in the system encourage all consumers to be prudent purchasers of health care goods and services.
Instead of replacing the corporate tax deduction for employee health insurance with a new refundable tax credit for those benefits, a better policy would replace the existing personal income tax and payroll tax exclusion for employer-provided health insurance with a new system of personal health care tax credits. The result would be a more rational, targeted, and effective tax break that could also dramatically expand health insurance coverage.
The centerpiece of Gephardt's proposal is the abolition of current corporate tax deductibility for all employer contributions to employee health insurance. Instead, Gephardt would substitute a new 60 percent refundable federal tax credit against corporate income taxes for company payments for worker's health insurance.
A new mandate on employers would accompany this proposed tax change. Employers who had not previously purchased health coverage for their workers would be required to use the new 60 percent credit to purchase coverage. In addition, a new federal rule governing health care financing would prohibit employers from charging workers more than 40 percent of the cost of the benefits. Similarly, the Gephardt plan would provide new federal payments to state and local governments equal to 60 percent of their costs for employee health insurance.
Gephardt argues that his new 60 percent tax credit for employer-sponsored insurance would enable employers who currently provide health insurance to reduce spending on those benefits and pay workers higher cash wages. In his analysis of Gephardt's plan, Professor Kenneth Thorpe, a nationally prominent health economist at Emory University, estimates that employers would pass through between 60 percent and 70 percent of the new credits in the form of cash wages, with the remaining 30 percent to 40 percent going to enhanced fringe benefits--not all of which would be health insurance.3
If that indeed did happen, the new corporate tax credit would not do much to expand health coverage, but would instead effectively turn into an earned income tax credit (EITC) type of wage subsidy for millions of middle- and upper-income workers who already have health insurance. Presumably, state and local governments would do the same with their new federal payments for 60 percent of employee health insurance premiums. Thus, Gephardt views his proposed tax change as an economic stimulus plan as well as a health care coverage plan. However, employers (both private and public) in theory could pocket some or all of the savings and use them for other purposes.
At best, such an outcome would be a dubious economic stimulus based on the failed Keynesian approach of stimulating the economy by having the government hand out money. Policymakers should have learned from the experience of the past half-century that the true path to economic growth is to encourage individuals to work, save, and invest more by reducing the marginal tax rates on their earnings and investment income.
However, the Gephardt proposal, if enacted, would probably have a somewhat different impact. In the most likely scenario, it would cause workers to put significantly increased pressure on employers to use the new funds to expand existing coverage. The real effects of the Gephardt plan would occur not because the plan would give employers a new incentive to offer health benefits to their workers, but because it would give workers a much bigger incentive to have employers pay them a larger share of their wages in the form of health insurance.
Under the Gephardt plan, workers would seek to use this money--tax-free to them and subsidized to their employers--to pay for more of the routine health costs that they currently pay for with after-tax dollars. For example, they would pressure employers to have "first dollar" health insurance coverage to avoid using their after-tax dollars to pay insurance deductibles, co-pays, or premiums. They would also seek to have the new subsidies converted into expanded coverage for more predictable or discretionary health care goods and services that they now buy with after-tax dollars or do not purchase at all because the marginal benefits are not worth the after-tax costs--e.g., a spare pair of eyeglasses, more frequent doctor visits for minor ailments, and additional diagnostic tests.
In short, today's middle-income workers with employer-sponsored health insurance would suddenly have powerful new incentives not only to demand elimination of all of the co-pays and deductibles that employers have built into their plans over the past 20 years to encourage prudent purchasing, but also to start consuming health care services like rich hypochondriacs. Under Gephardt's proposal, this would likely occur because of the changes in marginal tax rates on the employee side of the equation.
From the employer's perspective, it does not much matter whether workers are paid in the form of cash, pension contributions, health benefits, use of a company car, or even bags of groceries delivered to their doorsteps--all are employee compensation. Moreover, under the corporate income tax code, almost any employee compensation is a deductible business expense.
On the other hand, from the employee's perspective, the manner in which the employer pays the employee matters a great deal and can make a big difference. The personal income tax code treats cash wages, use of a company car, and most other non-cash compensation--such as employer-purchased bags of groceries--as personal income and imposes payroll and income taxes on the value of those items.
Employer-provided health insurance and most pension contributions, however, are a big exception to this rule. Current tax law does not consider the value of those benefits as taxable personal income. This provision in the personal tax law is known as a "tax exclusion." In other words, the portion of a worker's compensation that the employer pays in the form of health insurance benefits is "excluded" from any calculation of the worker's taxable income. Thus, those benefits are tax-free income to the worker.
Without this provision in the tax law that makes employer-paid health insurance tax-free to workers, employees would have little reason to ask their employers to pay for any of their health insurance, and most employers would have little reason to offer health care benefits. Instead, workers would receive all of their wages in cash and buy their own health insurance, just as they now do with auto, life, and homeowners insurance.
Thus, the fundamental flaw in Gephardt's plan is its failure to recognize that almost all existing employer-paid health insurance is an artifact of the tax exclusion from payroll and personal income taxes on the employee side of the ledger, not the deductibility of those benefits on the corporate tax side. Table 1, which compares the marginal tax rates on different types of worker compensation, clearly reveals this fundamental flaw in the design of Gephardt's plan.
Health Care Inflation
As shown in Table 1, a dollar paid to a worker in wages or in taxable non-cash compensation, such as use of a company car, has an after-tax value of 57 or 70 cents to the worker, depending on the worker's marginal personal income tax rate.4 In contrast, because of the personal tax exclusion for health insurance and most retirement contributions, a dollar paid to the worker by purchasing those benefits on his behalf has the same one-dollar after-tax value to the worker. Note that in neither option is there any impact on corporate taxes because employee compensation, in whatever form, is deducted as an expense from the employer's gross revenues.
For one type of employee compensation--health insurance--the Gephardt plan would replace the deductibility from corporate income taxes with a refundable 60 percent tax credit. While marginal corporate income tax rates vary among businesses, the average effective corporate tax rate is 27 percent.5 Therefore, on average, employers would be trading a 27 percent deduction for a 60 percent credit for money spent on employee health benefits under the Gephardt plan, resulting in an average, net new corporate tax subsidy of 33 percent for money spent by them on those benefits.
In other words, the employer could use a dollar it would otherwise pay the worker in cash to claim 33 cents from the federal government and then buy the worker $1.33 worth of health insurance. Since personal tax treatment of worker benefits does not change, having the employer withhold a dollar from the employee's cash wages and use it to buy more health insurance for the employee provides the employee with $1.33 in health benefits. In contrast, taking the dollar as cash wages leaves the worker with only 70 or 57 cents of purchasing power after taxes.
Thus, the current tax exclusion for health insurance and other fringe benefits makes those benefits between 43 percent and 76 percent more valuable than taxable cash wages to workers. The new Gephardt corporate tax credit would increase that disparity between cash wages and health benefits to between 90 percent and 134 percent.
This means that under Gephardt's proposed arrangement, health benefits would become more than twice as valuable as cash wages to many workers--particularly those in the upper income tax brackets. It would also compound the current bias in the system that provides more tax relief for employer-provided health benefits to higher-wage earners and less tax relief for those benefits to lower-wage earners. Furthermore, for all workers, health benefits would become 33 percent more valuable than even other tax-free fringe benefits such as pensions and 401(k) plan contributions.
This will likely result in powerful worker pressure for more comprehensive, first-dollar health insurance coverage, dramatically escalating health care spending and medical inflation. However, the new spending would produce little in the way of improved health outcomes or expanded insurance coverage because the bulk of the new subsidies would go to those already insured and would only encourage them to buy additional services of marginal or questionable value. Gephardt's plan would produce an economic stimulus, but for only one sector of the economy--health care--and a dubious stimulus at that.
Faced with this set of incentives, employers would have difficulty in controlling health care spending and medical inflation and would likely turn to government regulation. Indeed, with the federal government paying 60 percent of employer health insurance premiums, the federal government's role in that segment of the market would likely become similar to its role in Medicaid, in which it provides states with 50 percent to 75 percent in matching funds for Medicaid benefits. Just as in Medicaid, that kind of direct subsidy enables the federal government to dictate program rules. Under the Gephardt plan, the federal government would soon face a rapidly escalating cost for the new 60 percent subsidy and would likely respond by restricting benefits and services covered by employer plans, how often a particular service could be used, and how much doctors and hospitals could be paid.
Furthermore, Gephardt's proposed additional 25 percent personal income tax credit for workers with incomes below 100 percent of the poverty level would bring the total federal subsidy for those workers up to 85 percent. This would certainly help low-income individuals obtain health insurance coverage (at, effectively, 15 cents on the dollar) and be an improvement on providing subsidies to businesses. However, without any caps on the total dollar amounts of either credit, consumers, regardless of their financial status, would have little incentive to be prudent purchasers of medical care.
In contrast, Representative Gephardt is on the right track with his proposal to replace the current 70 percent personal income tax deduction for health insurance premiums for the self-employed with a 60 percent refundable tax credit. Because the current deduction for the self-employed applies only to income taxes, not payroll taxes, it is the equivalent of a 10.5 percent credit for those in the 15 percent income tax bracket or a 19.6 percent credit for those in the 28 percent tax bracket.6 The current tax exclusion for employment-based health insurance is the equivalent of a 30.3 percent credit or a 43.3 percent credit for workers in those same income tax brackets.7
While replacing the self-employed partial deduction with a tax credit is an improvement, leaving the corporate tax treatment of health insurance as is and replacing the personal tax exclusion for employer-sponsored health insurance with a new refundable tax credit for health care would be a better choice. Indeed, the best way to expand health insurance coverage would be to replace the current tax exclusion in the personal income tax code for employer-provided health insurance with a new personal tax credit for health insurance purchased from any source. Under such a reform, individuals could still obtain coverage through their employers, but they could also get the same subsidy for buying coverage from another source if their employer did not offer a plan.
One option is a sliding scale credit. While the Gephardt tax credit is 60 percent, the credit could be varied based on income, health care costs, or a combination of both to target assistance more effectively to those that need the most help.
Another option would be a fixed-dollar tax credit. Previous proposals for such credits have ranged from $1,000 per person to $5,000 per family. Another option would be a fixed-percentage credit like Gephardt's, although the credit percentage should be more in line with the current tax exclusion--perhaps 40 percent--and have a cap on the maximum amount of the credit to discourage overconsumption of health insurance and services. That would be better policy. It would also mean less escalation in health care spending and medical inflation.8
Representative Gephardt's tax credit proposal is misdirected. Instead of focusing on individuals, it targets corporations. The proposal would compound the flaws of the current tax treatment of health insurance and lead both to expanded federal control and to a continued loss of personal choice and control by individuals and families over their health care decisions.
There is much room for legitimate debate over how best to structure tax credits for health insurance. It makes sense to structure them to account for disparities in incomes and health status. But that debate is based on the recognition that when health policy intersects with tax policy, it is on the individual, not the corporate, side of the ledger where the important effects occur. After all, it is people, not businesses, that consume health care services and use insurance to help pay for them.
Edmund F. Haislmaier is a Visiting Research Fellow in the Center for Health Policy Studies at the Heritage Foundation.
1. Kenneth E. Thorpe, "A Preliminary Estimate of the Gephardt Economic Stimulus and Health Insurance Plans," April 22, 2003, at www.dickgephardt2004.com/releases/pp_guaranteedcare4.pdf. At the Gephardt campaign's request, Kenneth E. Thorpe, Ph.D., of Emory University developed estimates of the federal budget and insurance coverage impacts of Gephardt's plan. Thorpe estimates the total cost for the plan at $689.3 billion over the first three years. For the text of the Gephardt plan, see "Guaranteed Care for All Americans," at www.dickgephardt2004.com/releases/pp_guaranteedcare6.html.
4. Since the Gephardt proposal would repeal the Bush tax rate reductions, the analyses and examples in this paper use the pre-Bush marginal personal income tax rates of 15 percent and 28 percent. Furthermore, although payroll taxes are divided into an employee share and an employer share of 7.65 percent each, economists have long recognized the "employer share" as part of the total compensation paid to the worker; thus, the full 15.3 percent tax burden falls on the employee side of the ledger.
5. Thorpe's study derives an average 27 percent corporate effective tax rate from the summary table in Patrice Treubert, "Corporate Income Tax Returns, 1999," U.S. Department of the Treasury, Internal Revenue Service, October 2002, at www.irs.gov/taxstats/article/0,,id=96249,00.html. For consistency, this figure is used as the average corporate tax rate in the analyses and examples in this paper.
8. For discussions of better approaches to reforming the tax treatment of health insurance, see Nina Owcharenko and Robert E. Moffit, Ph.D., "How the President's Health Care Plan Would Expand Insurance Coverage to the Uninsured," Heritage Foundation Backgrounder No. 1636; Stuart M. Butler, Ph.D., "Laying the Groundwork for Universal Health Care Coverage," testimony before the Special Committee on Aging, U.S. Senate, March 10, 2003; Stuart M. Butler, Ph.D., "Time for Bipartisan Action to Help Families Without Health Insurance," Heritage Foundation Backgrounder No. 1528, March 20, 2002; Stuart M. Butler, Ph.D., "Health Care Tax Credits and the Uninsured," testimony, February 13, 2002; Lynn Etheredge, "How to Administer Health Insurance," Heritage Foundation Backgrounder No. 1516, January 31, 2002; Nina Owcharenko, "How Congress Can Help the Uninsured Obtain Health Coverage," Heritage Foundation Backgrounder No. 1475, September 21, 2001; Robert E. Moffit, Ph.D., "What the Latest Market Research Reveals About the Viability of Tax Credits for Health Insurance," Heritage Foundation Web Memo No. 23, July 13, 2001; and James Frogue, "A Guide to Tax Credits for the Uninsured," Heritage Foundation Backgrounder No. 1365, May 4, 2000.