Health Reform, Meet Tax Reform

I n 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.

A nother 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 premise that the current health care financing system, built on employer-paid benefits, federal tax subsidies, and third-party insurance payments, is inherently inflationary. As long as someone else is paying for my health care, who cares if the bills are padded? Both approaches aim at making providers and consumers more cost-conscious. But here's where their economic logic diverges: MSAs throw a life preserver to an archaic and costly system of fee-for-service medicine that is rapidly being displaced by managed care. Managed competition would reinforce the shift to managed care while maximizing its potential for providing quality care at lower cost. By subsidizing the direct purchase of health care by individuals, MSAs also would undermine the traditional role of insurance in spreading the costs of illness across the whole community.

The Cap and Market-based Reform

Unlike MSAs, the third option--a cap on tax benefits--puts the onus on health plans to deliver better value at less cost. Insurance companies could no longer count on federal tax subsidies to insulate consumers from the pain of ever-rising premiums. Instead, they would be forced to lower their prices to attract more cost-conscious consumers. A tax cap would weed inefficient firms out of the market and promote competition on the basis of price and value. Consumers could still choose more expensive policies, but they would have to pay taxes on employer-paid premiums for amounts that exceeded the cap.

According to CBO, a tax cap set at the cost of a typical plan would raise taxes for households earning more than $40,000 by $119 on average. This would raise $19 billion in revenue--enough to subsidize coverage for roughly half the 41 million Americans who lack insurance. Unlike the conversion of the deduction into a credit, a tax cap would permit anyone to avoid paying higher taxes by switching to more cost-effective plans.

In last year's health care debate, an improbable coalition of labor unions and conservative Republicans joined in condemning the cap as a tax increase. Unions understandably resist the idea of taxing benefits they have fought hard to win in lieu of higher wages. However, health care costs have grown much faster than wages over the past decade. Limiting the tax subsidy would slow health cost inflation and thereby help restore the wage growth that labor wants to achieve. And the tax cap is the kind of progressive tax policy that unions have historically supported.

Ultimately, the best argument for the tax cap is that it would powerfully reinforce the restructuring of health care delivery and finance. Under fee-for-service coverage, providers face no financial incentive to find the most cost-effective way to treat their patients. On the contrary, the more services they provide, the higher their income. Under managed care, providers have an incentive to keep patients healthy and treat them cost effectively.

Some critics say the incentive to control costs will lead to undertreatments. But a managed care plan that undertreats its patients risks damaging its bottom line as well as its reputation, since it will be responsible for the higher costs of remedial treatment. The same incentives, to be sure, could lead unscrupulous plans to scrimp on care for seriously ill patients, hoping to drive them to other plans. That's why managed competition envisions "report cards" that hold health plans accountable by grading their patient retention, satisfaction, and outcomes.

Managed care is spreading rapidly: 64 percent of the nation's private workforce is enrolled in some form of managed care, up from 29 percent in 1988. The evidence strongly suggests a one- time efficiency gain from switching to managed care, and competition among plans holds great potential for substantially slowing the rate of medical inflation. In the regions of California where competition is most intense, health insurance premiums are now actually falling.

While not all other areas of the country have seen the same extent of competition, the accelerating reorganization of health care markets has begun to slow costs nationally. Since 1985, the growth of national health care spending has slowed from 12 percent to 8 percent a year. But that's still much faster than the economy's overall growth rate of 5.4 percent.

A tax cap would promote managed care by ending the federal subsidy for more expensive, fee- for-service health insurance. To keep their health care spending under the tax cap, employers would have a strong incentive to offer their employees a menu of competing managed care plans.

A tax cap works best with other key elements of managed competition: a standard package of health benefits, health purchasing groups, and insurance market reforms that ban "experience rating" or discrimination against people with "preexisting" medical conditions. Without them, it will be difficult to determine the low-cost plan in a given area, which is the best benchmark for setting the tax cap.

Palatable Compromises

The next best approach is to set the cap initially at the average price of health insurance, as determined by government surveys of private health plan costs. This would maintain pressure on costly plans to reduce their prices, but it would offer no incentive for plans to drive their prices below the average. To remedy this problem, Paul Ellwood, a leading architect of managed competition, proposes a "health bonus account." Workers who chose a plan priced lower than the average could deposit the difference tax-free into an account for covering medical expenses not paid for by their health insurance.

Health bonus accounts would capture the advantage of MSAs without their negative consequences. Health plans could use them to encourage responsible behavior; for instance, by lowering premiums for nonsmokers or making tax-free contributions to their bonus accounts. Like MSAs, bonus accounts would give consumers an incentive to limit their demand for medical services. Unlike MSAs, however, people would still have health plans that covered preventive and other appropriate care.

Although a tax cap would lead to lower health care costs and yield savings that could extend coverage to millions, it will likely still face opposition from unions and "no new taxes" Republicans. An interim step, proposed late in last year's debate by managed competition advocates, would be to require employers to set a flat rate on their contribution to their workers' health benefits. This would act like a tax cap. Whatever workers chose to spend above the flat rate would be taxable as income; if they chose a plan that cost less, they could deposit the difference in a health bonus account.

While this approach would not be as effective as a tax cap, it might overcome union resistance because companies and unions could negotiate a flat contribution high enough to protect existing contracts. However, it would create a new incentive to buy lower-cost plans, which would fuel competition in the health insurance market. Employers who have adopted this "equal contribution rule" have realized significant savings from increased competition. For example, average health plan premiums at Harvard and Stanford Universities and the University of California dropped 8 to 10 percent last year after they began using this rule.

Whatever the method chosen for reforming the tax exemption, government has a crucial role to play in controlling health care costs. But it is not, as the Clinton administration thought last year, to replace broken markets with bureaucratic mechanisms that set prices and allocate resources. Americans are also unlikely to support a Canadian-style, single-payer health system. It is time for progressives to coalesce behind a strategy for comprehensive reform that has some realistic chance of being adopted. Capping the current tax subsidy for employee benefits would address the interlocking problems associated with the current system. It would promote consumer choice and affordable quality care; it would encourage wider access to private insurance; and it would reduce the inflationary pressures that affect Medicaid and Medicare. Reform of tax policy would be consistent with the public's intuition about health care: If you want everybody to have it, you'd better first control its costs.