Health Reform, Meet Tax Reform

In last year's abortive health care debate, the Clinton administration's fatal error was to make a universal entitlement to coverage the sine qua non of reform. The public rejected the administration's argument that its program would reduce costs while eliminating inequities and inefficiencies. To get reform back on track, Democrats need to recognize that controlling costs is the key not only to expanding coverage but to preventing its further erosion.

Rising cost is the one health care crisis that affects the insured and uninsured equally. It leads insurers and providers to reduce or deny care, and it absorbs public resources otherwise available to expand access. Furthermore, the government can check the cost spiral simply by refusing to subsidize it. Federal tax policy distorts private choices about health care, driving up costs and distributing subsidies inequitably. Reforming the tax exemption for employer-paid health benefits can make insurance markets more competitive, hold down costs, and free public funds better spent on expanding coverage.

Under current law, workers pay taxes on wages but not on health benefits that employers provide. Many people do not even know how much their company pays for their health insurance. As a result, many have the false impression that health benefits are a cost to their employer but not part of their compensation. Economists generally agree, however, that the more employees receive in health benefits, the less they are likely to get in take-home pay.

The tax exemption favoring health benefits over wages is open-ended: The more your employer spends on an insurance policy, the bigger the tax break you get. When employers appear to be paying the bill and Washington subsidizes more expensive choices, employees have little incentive to choose the best buy among health plans. In effect, the federal government picks up a large chunk of the bill when employees pick more costly options.

The cost to the federal government is enormous: $74 billion in foregone revenue last year (not to mention another $20 billion to the states). The tax exemption is Washington's third largest health program after Medicare ($158 billion) and Medicaid ($87 billion).

The benefit is also inequitable. That's because the exclusion for health benefits, like any tax deduction, is worth more to people in high tax brackets than to people in low brackets. And, of course, millions of Americans without employer-provided insurance get no tax subsidy at all. Government figures illustrate the exemption's starkly regressive impact. Households earning less than $10,000 receive a tax subsidy only one-tenth as large as the benefit enjoyed by households earning more than $100,000.

Alternatives to Current Policy

There are three main proposals for changing the federal tax treatment of health benefits:

  • Eliminate the tax exemption and redistribute the savings in the form of individual tax credits. This option would make employer-provided health benefits taxable as income, but it would provide an offsetting credit and give everyone an incentive to purchase health insurance, a major step toward universal coverage.
  • Extend the tax break to include medical savings accounts. This option would allow workers to take their employer's contribution to their health insurance, deposit part of it in a tax- free medical savings account for routine expenses, and use the balance to buy catastrophic insurance.
  • Cap the tax exemption at the level of an average- or low-cost health plan. This would end subsidies for inefficient, high-cost plans, generating savings that could be applied toward covering the uninsured.

The first option--converting the current deduction into a tax credit--would offer equal benefits for everyone who had insurance. This would be a great improvement over current policy, which originally developed without careful thought or scrutiny. When the federal income tax was enacted in 1913, it did not apply to employee health benefits because there were hardly any. They did not become widespread until World War II when employers began to use health benefits to attract workers at a time when wages were subject to wartime price controls. Since then, federal tax policy has encouraged companies to give compensation in the form of health benefits instead of wages. But it has shortchanged the unemployed, the self-employed, and workers with wages too low to trade for benefits.

It is easy to imagine a more equitable way to distribute the $74 billion annual subsidy: simply tax all health benefits as wages and give everyone a fixed share of the revenue in the form of a refundable tax credit. According to the Congressional Budget Office (CBO), this would yield a credit worth about $742 each year for every household. Three out of five households would get a tax cut, while those with incomes over $40,000 would pay, on average, an additional $384 in taxes.

This change would promote efficiency by ending the current tax subsidy for high-cost health plans. Credits would expand coverage by giving everyone an incentive to buy insurance. Wider coverage, in turn, would reduce the widespread practice of shifting costs from patients who lack insurance to those who are covered. While tax credits would move us closer to universal coverage, additional steps would still be necessary to achieve that goal. These include subsidies to low-income families and a "free rider" tax or other requirement that everyone purchase insurance.

By severing the link between employment and health insurance, however, tax credits would undermine the chief advantage of the existing system: its ability to pool risks among large groups of employees. Businesses provide their employees a group rate, not different rates for healthy and sick employees. But if individuals rather than companies are buying policies, insurers have a strong incentive to cherry-pick the healthy and exclude people with costly conditions. Instead of offering group rates to the employees of one company, insurers would try to group together healthy customers from many companies. The result would be prohibitively high premiums for the very people who most need insurance.

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Turning the deduction into a credit also presents a forbidding political challenge: higher taxes for millions of middle-class voters. The shift to tax credits may be feasible only in the context of broader tax changes that include middle-class tax relief.

The Conservative Panacea

Despite their manifestly redistributive intent, tax credits have garnered surprising support from the Heritage Foundation and other fonts of conservative wisdom. However, the health care reform of choice for most Republicans is the medical savings account (MSA). Instead of buying comprehensive health plans, employers would buy less expensive catastrophic policies and use the difference to open medical savings accounts for their workers. Workers would use those tax-free accounts to pay for routine medical expenses--up to $3,000 per family--and rely on their catastrophic coverage for more serious problems.

The idea is to give people an incentive to curb their demand for health services by letting them use whatever they don't spend on health care for other purposes. Presumably, the prospect of pocketing unused savings account balances would lead people to avoid risky behavior. In addition, people would be more likely to shop carefully for medical services if they had to pay 100 percent of the bill instead of 20 percent, the typical co-payment of a fee-for-service insurance policy.

MSAs undoubtedly would make consumers more cost-sensitive to ordinary expenses. But they also could have the perverse effect of undermining sound medical practice. They might, for example, encourage people to delay or neglect routine checkups, immunizations, prenatal care, and other services that have a long-term payoff. Skipping preventive care to save money in the short term may mean poorer health and higher costs later. Timely care also avoids unnecessary hospitalizations. The New England Journal of Medicine recently reported that patients at risk of a ruptured appendix are more likely to seek prompt treatment if they belong to a health maintenance organization (HMO), which has low out-of-pocket costs, than if they have a fee-for-service insurance plan, which typically has a higher deductible.

In any case, the impact of MSAs on health care inflation is likely to be small. Most health care spending stems from serious illnesses or accidents, not from routine care. The cost of an even minor hospital stay these days exceeds $3,000; at that point, the MSA no longer constrains costs. According to the Employee Benefits Research Institute, about 60 percent of all health spending is for catastrophic care that costs more than $3,000. In addition, many consumers already face hefty co-payments and deductibles for ordinary expenses.

Another defect of MSAs is that they create new opportunities for insurance companies to cherry- pick. The young and healthy would be most likely to sign up for an MSA because they don't expect to spend much on health care and can therefore use their accounts for other purposes. Parents, older workers, and people with medical problems or other disabilities are likely to stick with insurance policies that cover both routine and catastrophic care. Their premiums will rise as healthy people move into MSAs. The result will be to make both traditional insurance and managed care more expensive.

In addition to favoring the healthy over the sick, MSAs also channel federal subsidies to those who need them least. As with any tax deduction, MSAs are worth more to individuals in higher tax brackets. Yet low-income workers will have a tougher time covering the gap between the MSA and the high deductibles characteristic of catastrophic insurance policies. While Republicans couch their support for MSAs in the language of personal responsibility, it is revealing that their prescription for health care reform is most enticing to the healthy and the wealthy.

The progressive alternative to MSAs is managed competition. This approach also starts from t

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