Our Unhealthy Tax Code
If progressives want to cure what ails the health care system, they first have to put the tax code on the examination table.
American health care is beset by a well-known litany of problems. Forty-six million Americans lack health insurance, resulting in, according to the Institute of Medicine, 18,000 avoidable deaths each year. At the same time, the principal mechanism for providing health insurance, through employers, is unraveling: the number of non-elderly Americans without employer-sponsored insurance jumped by 15 million from 2000 to 2004. Health costs are also an increasingly larger share of the economy and rising rapidly. Premiums have jumped 73 percent since 2000 and aggregate health spending is projected to increase by another 49 percent by 2015, when total spending will reach 20 percent of U.S. GDP. We could, as a nation, choose to spend that much of our total income on health care, and one would expect that the country, in return, would enjoy some of the best health outcomes in the world. Unfortunately, that’s not the case. Not only do we spend more than any other country on health care, nearly 50 percent more per capita than the second-highest-spending nation, but citizens in 28 other countries have a higher life expectancy and 33 other nations have lower infant mortality rates.
If this were a government-run health care system, the voting public and policymakers would be up in arms. Yet, perhaps because health care is largely perceived as a private-sector concern, there is relative quiet: while voters tell pollsters that it is a top priority, there appears not to be comparable political pressure for serious reform or any fundamental change in the government’s involvement, either in the provision or funding of health care. This is in part because much of the federal government’s involvement with the health care system is through the hidden backdoor of the tax code. An important principle for modern progressives is that when the government has to intervene in the marketplace, it should not prop up failure. Yet the federal government is, in fact, deeply involved in perpetuating the current “private” health care system and all its flaws, spending approximately $200 billion annually in subsidizing employer-provided insurance. It is the single biggest subsidy in our tax system, more than twice as costly as the mortgage interest deduction. The only government programs that cost more are Social Security, national defense, and Medicare.
The fact that the tax subsidy, which supports the employer-sponsored system, is better than nothing is a feeble excuse for resisting any changes to the status quo. This massive program of tax breaks is ineffective and regressive, wasting money on those who have health insurance while doing little for those who can barely afford it and nothing at all for those without it. Precise statistics are not available, but a reasonable estimate holds that the tax subsidy pays for about $4,000 of the insurance premiums for a high-income family, compared with less than $1,000 for a low-income family and $1,500 for a middle-income family. For higher-income workers who would likely have purchased health insurance anyway, the $4,000 is a pure windfall. For lower-income workers, the $1,000 subsidy may not be enough of an incentive to purchase health insurance. This is part of the reason why workers with lower incomes are more likely to be uninsured and the firms that hire them are less likely to offer health insurance. The tax code also increases wasteful and unnecessary spending by subsidizing health insurance pland that discourage health consumers from being cost-conscious. In the final diagnosis, the tax code is literally making America sick–squandering taxpayer dollars on a health care subsidy system that is failing to provide quality health care to all Americans.
A single-payer national health care system would, by definition, remedy the problem, but it is unlikely to happen any time soon, if ever at all. Beyond the political limitations, it is also an open question whether a single-payer system would be the most efficient way to provide quality health care for all Americans. In the meantime, reforming health care will come down to a set of incremental changes that build on the current system. But that does not mean that change cannot be ambitious. As Massachusetts has shown, achieving a plan for universal health insurance coverage need not wait for the establishment of single-payer government insurance like Medicare or a national health care system like the United Kingdom’s.
In fact, if we turned our irrational health tax subsidies right-side up–by curbing subsidies for higher-income workers and those with more generous health insurance plans–we could raise tens of billions of dollars annually, money that could go toward increasing access to health insurance. Taking it a step further, we could scrap the current deduction altogether and replace it with progressive tax credits that, together with other changes, would ensure that every American has affordable health insurance. In either case, reducing subsidies for pricey plans would likely lead to a health insurance system that includes more cost sharing, promotes more consumer consciousness, and plays a modest, but potentially meaningful, role in restraining health spending. And, unlike President George W. Bush’s Health Savings Account (HSA) proposal, this cost sharing would not require regressive tax cuts and would not be based on a one-size-fits-all, government-prescribed high-deductible plan.
Tax reform is not all there is to health care reform. Many other elements are important, even essential, ranging from ensuring access to affordable health insurance for the chronically ill and small businesses to the promotion of prevention and health information technology. But tax reform is a critical missing link in the way most politicians–progressives and conservatives alike–have thought about confronting America’s health care crisis. When conservatives look at the tax code’s effect on health care, they all too often use the current crisis as a pretext to cut taxes and shift risk onto individuals; some even want to eliminate all the tax incentives for the employer-sponsored system without creating any meaningful alternative.
On the other hand, too many progressives are so (rightly) concerned about taking any step backward in our health system that they are reluctant to open a discussion about the tax code. Some progressives may say that such a plan is timid, that the United States should move aggressively toward a Canadian-style national health service. But both approaches suffer from a similar flaw: they are little more than a parlor game, drawing the perfect system on a blank slate. On the contrary, any meaningful attempts to change the health system have to start from where it is today. For all its flaws, we are starting from a system centered around employer-provided health insurance. Anything that undermines this system without putting in place a comprehensive alternative could easily leave us in worse shape.
The Accidental Birth of our Health Care System To grasp the centrality of tax policy to health care, one must understand the roots of the current health care system. Employer-sponsored health insurance evolved by accident. During World War II, labor was predictably scarce. But in an effort to limit inflation, President Franklin Roosevelt had imposed wage and price controls, meaning that employers could not attract workers with higher wages. So instead, employers attempted to outbid one other by offering health insurance and other benefits as incentives to prospective workers. Wage controls were lifted after peace was restored, but the employer-sponsored system persisted.
This historical accident significantly helped average Americans obtain health care; prior to World War II, health insurance was rare and medical care was often prohibitively expensive. Employer-provided insurance schemes pooled groups of employees together, making it possible to spread risks, reduce administrative costs, and enable employers to bargain for better deals on insurance rates. Of course, these advantages could have been achieved by numerous other pooling arrangements, such as purchasing insurance through churches, labor unions, or professional associations. But one factor made it virtually certain that the employer-provided system would stick: in 1954, Congress changed the tax code to formalize the practice of effectively treating employer contributions to health insurance premiums as tax-deductible, with the tax benefits accruing almost entirely to employees. Specifically, it rendered employer payments for health insurance benefits income- and payroll-tax-free to employees. (Although the company also gets to deduct the insurance premiums, this is not a special tax benefit for the company since all of its labor costs, including wages, are deducted when calculating net profits.)
To be sure, even in the absence of tax breaks, the employer system would be more attractive to many people than purchasing insurance directly from an insurance company. The individual market for health insurance functions poorly: premiums are high; coverage is limited; younger, healthier people often opt out, thinking they can fall back on emergency-room care if needed; and many people with chronic illnesses or other preexisting conditions are denied coverage altogether or get insurance plans that cover everything but what ails them. In total, nearly 90 percent of all private health insurance is through employer-sponsored plans.
But the employer system also has serious flaws, and rising costs are leading many employers to forgo coverage entirely. The employer-sponsored system is very uneven: while 98 percent of large firms offer health insurance to their employees, only 59 percent of small firms do. And firms that hire more low-wage workers are substantially less likely to offer insurance, partly because many low-wage families have the option of Medicaid and S-CHIP (at least for their children) and get few if any tax benefits from health insurance. If they do get insurance, the plans are less generous and their employers pay a smaller share of the premiums. As a result, the uninsured tend to have lower incomes. Our unhealthy tax system makes an important contribution to all of these injustices.
The Upside-Down Health-Tax System At the heart of progressive notions of equality and justice is the principle that those with more of an ability to pay for a social good should shoulder a larger share of the burden through higher taxes. Providing tax incentives for health insurance, like tax incentives for home mortgages or college tuition, effectively overrides this principle: a person who is better off because he has a job with great health benefits could end up paying less in taxes than someone stuck in a dead-end job without such benefits. Sacrificing fairness and progressivity can sometimes be justified in order to further other important social goals. But the form these health tax incentives have taken is both unnecessarily unfair and inefficient.
Consider the situation of three representative Americans in the current system. An investment banker, for instance, might enroll in a family plan that costs $13,000, with her employer paying 80 percent of the premium, or $10,400. The employer contribution is tax free, saving her nearly $4,000 in taxes (the $10,400 employer contribution multiplied by her marginal tax rate, which is 35 percent for income taxes plus 2.9 percent for Medicare payroll taxes). In effect, it only costs 70 cents for every one dollar of health insurance she purchases.
The current system works well for the investment banker, but consider how it treats the man who cleans her office. There is a good chance he will not get, or choose to take, any health insurance from his employer, in which case he will receive no tax breaks at all. But if the cleaner does get insurance, his family plan might cost $7,000, with the employer picking up 70 percent of the cost (a typical package for low-wage service workers). Not only does he get less money in tax-free employer premium payments, he is also in a lower tax bracket, so the money he does receive does not reduce his taxes by as much. As a result, he saves only about $1,000. This smaller subsidy effectively means that the cleaner pays a higher price for health insurance: eighty-six cents for every one dollar of health insurance he purchases. As for the investment banker’s administrative assistant, making a typical middle-class income, she would fall somewhere between these two extremes, although saving an amount closer to the cleaner, at about $1,500 annually.
A government health-insurance program that provides a $1,000 subsidy for a cleaner, $1,500 for an administrative assistant, and $4,000 for an investment banker is plainly unfair But why does it persist? Imagine–as economists Joel Slemrod and Jon Bakija do in a thought experiment–if we replaced the current system with a financially equivalent one in which, instead of tax deductions, everyone receives a flat $4,000 off their taxes, but some pay “tax penalties” that are a function of their income and their employer’s contribution to their health insurance. If your income is above $500,000 and you have a generous health-insurance policy, you are in luck: you do not have any tax penalty. If you make only $50,000 and have an average health insurance plan, you pay a tax penalty of $2,500. If your income falls and you get a lousy health insurance plan, your penalty goes up to $3,000. If your employer does not offer you health insurance, your penalty jumps to $4,000. It is hard to imagine this system lasting very long. But because these inequitable subsidies are distributed opaquely through the tax system, rather than directly through government outlays, few complain.
Not Just Unfair, But Also Inefficient The unhealthy tax code is not just inequitable; it also wastes precious dollars that could be better spent elsewhere in the health system. The subsidy is unnecessarily large for higher-income workers: the investment banker does not need a $4,000 subsidy–or 30 percent off the price of health insurance–to be encouraged to buy it. And the subsidy is too small for many lower-income workers: the $1,000 subsidy for the cleaner is not sufficient to make health insurance affordable for him.
This is not to say that the tax break is of no value. With no subsidy at all, some employers would drop their health insurance plans and some of the 174 million people with employer-sponsored health insurance would lose it, especially those working at smaller companies that are already on the verge of dropping their coverage. But the tax break doesn’t provide a sufficiently high bang-for-the-buck in stimulating additional insurance. If the subsidy were limited for higher-income families, virtually the same number of people would get health insurance at substantially lower federal cost. And expanding the subsidy for more moderate-income workers would be a relatively cost-effective way to expand coverage.
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