Leading Members of Congress and certain officials in the Obama
Administration are reportedly considering changes to the federal
tax treatment of health insurance as a means of financing health
reform.[1]
If there is one area in health policy where there is a powerful
consensus among serious analysts, conservative and liberal alike,
it is the need to change the existing tax treatment of health
insurance.[2] President Ronald Reagan first proposed a
change to the tax law governing health insurance in 1983, but
Congress never acted on the proposal. Six years later, analysts at
The Heritage Foundation unveiled a national health reform proposal
grounded in comprehensive tax reform.[3]Now, the idea could-depending
on its details-potentially serve as the basis of a bipartisan
compromise on health reform in the coming months.
The Current Tax Treatment
The current tax treatment of health insurance is a byproduct of
wage and price controls imposed by the Roosevelt Administration
during the World War II era. The federal tax code currently
excludes, without limit, the value of employer-sponsored health
insurance from an individual's income for the purposes of both
income and payroll taxes. This tax exclusion for employer-sponsored
insurance is a huge, but hidden, tax subsidy. The Joint Committee
on Taxation estimated that value of the tax exclusion in 2007 was
$246.1 billion in foregone income and payroll taxes.[4] The
exclusion represents the largest federal tax expenditure as well as
the third largest health care expenditure, following only Medicare
and Medicaid, the nation's two largest entitlement programs.
Health economists generally agree that this Roosevelt-era policy
is poorly designed and has many perverse incentives.[5] The
employee exclusion is inherently unfair, inefficient, and
inequitable.
It is unfair because only individuals with employer-sponsored
insurance are able to receive tax relief, while individuals without
access to such coverage typically pay for health insurance with
after-tax dollars and, in effect, face a sizeable tax penalty. It
is inefficient and inequitable because the largest tax benefits go
to those who need them least; given the progressive structure of
the tax code, the exclusion is regressive since it is worth less to
taxpayers in lower marginal tax rates and more to those in higher
marginal tax rates. Therefore, if the goal is to extend coverage to
the uninsured, the tax break is poorly targeted because it provides
little or no tax relief to those with low incomes, who are least
able to afford health insurance.
The tax treatment of health insurance also has the perverse
effect of increasing health care spending and driving up costs by
essentially lowering the effective price of employer-sponsored
health insurance. The exclusion does encourage individuals to
obtain insurance. But it also encourages many individuals to have
more generous insurance than they typically need, because the
higher the cost of the insurance and the higher the person's
income, the bigger the tax benefit for the individual.[6] The
exclusion creates a bias toward overly generous insurance-even
first-dollar coverage-with low cost-sharing in the form of
co-payments, coinsurance, and deductibles because out-of-pocket
expenditures, for the most part, do not enjoy a similar tax
preference. This incentive reduces the price sensitivity of health
care consumers and leads to higher prices and greater utilization,
which in turn puts a strain on resources and makes health care more
expensive for those who lack insurance.
The Right Way to Change the Tax
Treatment
The best way to change the current tax treatment would be to
replace the existing tax exclusion with a more equitable and
efficient system of individual tax relief, leveling the playing
field for robust competition among insurers and creating a level of
consumer choice that is routine in every other sector of the
American economy.
Short of that, Congress could limit or cap the exclusion,
perhaps only for income tax purposes, while simultaneously using
the new revenue to provide health care tax credits for taxpaying
households. The government could also provide vouchers-which, for
lower-income households, could be combined with the credit-so that
more individuals and families can afford health insurance.
Under this scenario, any revenue generated from the value of
premiums that either exceeds the cap or is no longer excluded from
taxable income should be used exclusively to finance tax credits to
individuals and families to offset their federal taxes. The
existing tax exclusion on health benefits should be gradually
phased out over time while the new system of health care tax
credits for individuals and families is phased in. The health care
tax credits should apply to a significant portion of a health
plan's premium-but not all of it (consumers should have some "skin
in the game")-and be used to offset some of a taxpayer's income tax
liability.
Americans with no tax liability, or tax liability that is
currently less than the value of the credit, should receive
vouchers to purchase their own insurance. The voucher component
would be somewhat like a traditional refundable tax credit (such as
the earned income tax credit), although with a key difference:
These health care vouchers should be paid for entirely by
reductions in other government spending in the budget-and there are
plenty of options available to finance such direct assistance to
low-income persons. But assistance to families currently not paying
taxes should not be funded by the revenue raised from
changes in the tax treatment of health insurance for taxpaying
Americans.
Essential to Bipartisan Reform
Changing the tax treatment of employer-sponsored health
insurance has for years enjoyed support from across the political
spectrum. Although President Obama has not yet included tax
treatment reforms in his health care plan, it is not too late.
Senate Finance Chairman Max Baucus (D-MT) has proposed limiting the
current tax exclusion, which suggests there is still some room for
a compromise on this front. If President Obama and leaders in
Congress are sincere about passing-and fully
financing-comprehensive health care reform legislation with broad
bipartisan support, changes to the tax treatment are essential.
There are several ways to design a new system of health care
financing that is more efficient and more equitable than what
Americans have today. The right way is to restructure the tax code
to promote competition among health plans and give Americans real
personal choice of health care options. A proposal that gradually
phases out the current income tax exclusion while phasing in a more
equitable and efficient tax treatment will achieve serious
bipartisan health care reform.
Greg D'Angelo is Policy
Analyst in and Robert E.
Moffit, Ph.D., is Director of the Center for Health Policy
Studies at The Heritage Foundation.