President Bush's proposal to reform the tax treatment of health
care takes a bold step toward fixing America's health care system
by widening the availability of affordable and "portable" health
plans available to Americans and by defusing some of the pressure
that currently leads to higher health costs. It is a sound basis
for a serious discussion on how the tax treatment of health care
should be reformed, consistent with good tax policy.
No Tax Increase
The President proposes a revenue-neutral reform that would give
all Americans a new "standard deduction" for buying health
insurance somewhat like the standard deduction for dependents. This
would replace the unlimited "tax exclusion" currently available
only to Americans who participate in company-sponsored plans. The
current exclusion helps primarily those who do not really need a
tax break and gives nothing to Americans without plans arranged by
their employer. The proposal would make the tax treatment of health
care fairer and more consistent with the goal of fundamental tax
reform. Although some Americans would have more of their
compensation subject to taxes, this revenue-neutral proposal is no
more a tax increase than limiting or ending tax deductions to move
toward a flatter tax system. It would remove distortions and
inequities and make tax relief for health insurance more widely
available.
While the proposal can be improved in ways that would further
reduce uninsurance, it is a big step toward sound tax and health
policy. It would treat all Americans equally by ending the tax
discrimination against families who buy their own health insurance,
either because they do not have insurance offered by employers or
because they prefer other coverage. Ending that discrimination
would have the added advantage of stimulating wider choice and
greater competition in health coverage, which will help moderate
the growth in health care costs. Such tax neutrality would also
make it easier for families to keep their chosen plan from job to
job, and this improved coverage portability would reduce the gaps
in coverage and loss of coverage that often accompany job
changes.
Today's tax exclusion means that any amount of an employee's
compensation earmarked by the employer for the purchase of health
insurance is not subject to income or payroll taxes. There are no
limits on this tax break. The proposal would replace this exclusion
with a new, limited standard deduction that would apply to
company-sponsored plans and to any health insurance purchases by
families. This deduction would eliminate payroll taxes and income
taxes on insurance worth up to $15,000 for families and $7,500 for
individuals--well above the cost of typical plans.
Higher Cash Earnings
Today's unlimited tax exclusion especially benefits well-paid
workers, such as those in the boardroom who avoid all taxes on
their Cadillac health plans. But there are two big downsides with
the unlimited exclusion that the President's proposal would begin
to fix.
First, forgone tax revenue due to the exclusion on this form of
compensation means that taxes are imposed elsewhere--namely on
those who buy their health coverage directly. So giving the same
standard deduction to all Americans would achieve a more neutral
and fairer tax system.
Moreover, by reforming and limiting the tax exclusion, the
reform actually means that many Americans would see an increase in
their paychecks. This is because workers with expensive
plans--often loaded with unnecessary but seemingly "free"
additional services--would bargain for more of their compensation
to come in cash income rather than Cadillac health coverage. In
fact, more and more worker compensation has taken the form of
tax-free fringe benefits--especially health insurance--in recent
years, at the expense of taxable cash earnings.[1] Under the
President's reform, employees and employers would have less
incentive to bargain for compensation such as top-of-the-line
tax-free health plans. Rather, they would face greater incentives
to bargain for higher cash earnings to pay for other needs, such as
housing and education.
Second, the unlimited tax exclusion for health insurance
actually means that compensation spent on health care is invisible
to almost all employees, because it is not even identified on
paycheck stubs, year-end W-2 forms, or tax returns. Employers and
health economists know that one of the effects of this invisibility
is that employees have little incentive to question medical costs,
or even to review bills from the hospital, because they do not see
these costs directly showing up in reduced cash compensation.
Employees grumble about slow wage growth, but few link wages to
their desire for their employer to "pay for" better health
benefits.
Placing a limit on the tax-free status of the health insurance
part of worker compensation will lead employers to disclose health
costs to employees and prompt more workers to question these costs
and to demand more value for money, just as they do when buying a
car or negotiating a mortgage package. That would put greater
consumer pressure on the health industry to taper down the growth
in costs, to everyone's advantage.
Encouraging State-Based Innovation
The proposal would have another, related advantage for families.
By giving families a new tax break to purchase their own health
coverage, it would encourage more states to create an insurance
"Connector" like that being set up in Massachusetts. A Connector is
a state-chartered exchange that organizes the offering of a broad
menu of private health insurance plans, much like the wide
selection available to Members of Congress and other federal
employees in the Federal Employees Health Benefits Program (FEHBP).
With a Connector in place, families could choose a plan and keep it
from job to job without interruption. With the proposed standard
deduction for such plans, families using the Connector
option--particularly attractive to those in small firms without
coverage--would receive the same tax benefits as those with
company-sponsored coverage.
Some Room for Improvement
The President's proposal could be improved. While replacing the
current tax treatment with a new standard deduction is a big step
in the right direction, an even better step would be to replace it
with a tax credit more like the current child tax credit--at least
for those buying health coverage outside the place of work. A tax
credit would especially help lower-income families. The problem is
that many families would still be unable to afford basic coverage
with a deduction, while a credit set at a flat dollar amount or a
high percentage of premium costs would make coverage more
affordable to these families.
The President has previously proposed a tax credit for
lower-income families. And recently a wide coalition of
organizations--including the U.S. Chamber of Commerce, the American
Medical Association, and Families USA--made a tax credit the
central part of its proposal to boost health coverage. A tax credit
could be grafted onto the President's current proposal and would
strengthen it considerably. Congress should refine the Bush
proposal by incorporating a tax credit and should explore a
transition over time from today's tax deductions to a tax
credit-based treatment of health care. With the laudable goal of a
simple tax system with low rates on all income, a tax credit would
be a more targeted and efficient way to assure basic health
coverage with the least distortions in the tax code.
The President has taken a bold step toward an essential overhaul
of the tax treatment of health care. By taking this step,
especially if improvements are added, Congress can help make the
tax treatment of health care more equitable and efficient, help
more Americans to choose the coverage they want and retain it from
job to job, and begin to reduce the tax break-induced pressure that
is a factor in rising health costs.
Stuart M. Butler, Ph.D.,
is Vice President for Domestic and Economic Policy, and Nina Owcharenko is
Senior Policy Analyst for Health Care in the Center for Health
Policy Studies, at The Heritage Foundation.