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.

Another inefficiency of the tax system is that it continues to provide subsidies for insurance, no matter how generous the plan is. The tax subsidy for a basic health insurance plan that has an employer contribution of $4,000 is just as large as the added subsidy for a plan that has an employer contribution that grows from $8,000 for a good health insurance plan to $12,000 for a more generous plan. While it would be nice for everyone to have a generous health plan, our limited resources would be more effective if they provided larger subsidies to help make decent health insurance affordable and smaller subsidies to go from good plans to more generous ones.

This incentive is compounded by an asymmetry in the tax code: if your employer pays $1,000 in premiums to your insurance company, that money is effectively tax deductible to you. But if your employer raises your salary by $1,000 and you use the extra money to pay for medical bills, you generally will not get a tax deduction. As a result, many people end up with more-generous health insurance plans than they would otherwise choose to have. These plans have lower deductibles, lower co-payments, and lower co-insurance and are often focused around providing first-dollar coverage for routine medical expenses, rather than genuine insurance. As a result, individuals in the health system are often spending someone else’s money, which is never a recipe for cost consciousness. Unfortunately, ultimately it is not really someone else’s money: the cost is paid in higher premiums, which in turn are reflected in lower wages.

While the notion that anyone can be "overinsured" may be jarring, the idea that many people are underpaid should be easier to accept. Although one might hope that everyone could be paid higher wages and better health benefits, even higher compensation would not repeal the basic rules of arithmetic: the more an individual spends on health care, the less they have to spend on everything else. The tax system stacks the deck in favor of health care. Furthermore, the issue of "overinsurance" and the problem of underinsurance are related. Anything that leads to more health spending by some drives up the cost of insurance for everyone, making it less affordable and thus increasing the number of uninsured.

The critical question is whether people cut back on needed care when they have to pay more of their own money. The large-scale Rand Health Insurance experiment conducted in the 1970s provides what is still the best evidence on this question. The experiment randomly assigned individuals to health insurance plans with different levels of cost-sharing. People in plans that required them to pay more of the costs themselves reduced their spending with little evidence of any adverse effect on their health, with the important exceptions of lower-income and chronically ill people, who appeared to cut back on some preventative care and as a result had somewhat worse health outcomes.