Category: tax policy

A quick update to two posts last December about the tax treatment of health insurance: The Tax Policy Center has posted a brief and a discussion paper by Len Burman and Jonathan Gruber on the impact of various policies to provide tax credits to promote health insurance coverage. The bottom line seems to be that the President's plan gives the lowest cost per newly insured person, though reaching only a small proportion of those currently uninsured.

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A comment on my last post on the tax treatment of health insurance pointed to a December 8 editorial by John Cogan, Glenn Hubbard, and Dan Kessler in the Wall Street Journal, "Brilliant Deduction." According to the editorial:

We propose a simple change to tax law that would cut unproductive health spending, reduce the number of uninsured and promote greater tax fairness. For anyone with at least catastrophic insurance coverage, all health-care expenses--employee contributions to employer-provided insurance, individually purchased insurance and out-of-pocket spending--would be tax-deductible. The deduction would be available to those who claim the standard deduction and to those who itemize.

Is this a good idea? Maybe. Is it a better idea than eliminating the excludability of health insurance purchases from income and using the higher tax revenues to provide refundable tax credits to lower income households who purchase insurance, as I suggested in my first post on this topic? I don't think so. Here are my reasons:

1. Both proposals eliminate the tax distortion between insurance premiums and out-of-pocket expenses. Both would serve to encourage plans with lower premiums and higher co-pays and deductibles, providing better incentives for consumers to economize on their health care purchases.
2. Administratively, the CHK plan seems much more difficult to implement. The proposal to eliminate excludability requires only one piece of information on the W-2 form--an indication of whether the person has purchased insurance through the employer plan--or an analogous document from an insurance company in the case of non-group purchases. With the CHK plan, every purchase of health care now needs to be documented and submitted to some entity, whether the government or a benefits management company, and then reimbursed. These companies need to be periodically audited to make sure they are allowing all valid expenses (and only valid expenses). This entails a large amount of paperwork, particularly in the sort of high-deductible plans that CHK envision. My own experience with my employer's flexible spending account does not make me optimistic.
3. In terms of equity, the CHK plan suffers from the same problems as the current system. If we believe that the income tax is supposed to tax income, regardless of how it is spent, then we judge the equity of the proposal by how much of the tax deductions for health care go to different income groups. Even under CHK, high-income households will derive the largest benefits because they have higher tax rates and greater rates of coverage. CHK argue that this is an improvement over the current system, but it is clear that it is still less progressive than the alternative--eliminate the excludability and redistribute the incremental revenues back to low-income households for refundable tax credits.
4. In terms of efficiency, the biggest issue is that the CHK plan lowers the overall cost of health care by expanding tax deductibility. Thus, we expect more health care to be purchased (before making allowances for the improved incentives). Eliminating excludability in favor of tax credits can have the same incentive effects without lowering the overall price of a good that is already overconsumed. In a comment on the original post, Tom Miller points out (in his point #4):
   

   On another front, expanding tax deductibility to all out-of-pocket health expenses would indeed add new misincentives to spend more on health care than it’s worth. By making OOP spending appear to be “cheaper” with a pre-tax discount, it would dilute the cost constraining effects of the recent shift already underway toward higher levels of cost sharing (deductibles and coinsurance) in today’s employer-sponsored health plans. Unlike tax-advantaged Health Savings Accounts, it would only reward taxpayers for spending health care dollars today, instead of saving them for tomorrow. Replacing one set of third-party payers (insurers and employers) with another one (the Treasury, on behalf of invisible taxpayers) won’t make individual consumers much more sensitive to the real costs of the health care decisions they make. A better way to level the playing field is to level down, instead of leveling up, by reducing the tax rate differential imposed on everything else we earn, save and spend. Eliminating the current tax exclusion for health insurance could be swapped for an equivalent across-the board reduction of about three and a half percent in all marginal rates for personal income taxes.

   This is a reasonable point, with an alternative suggestion about what to do with the tax revenues generated by removing excludability. Tom also has some useful suggestions about how exactly to generate better incentives through the tax code.

Overall, I don't think the CHK plan is better than my alternative, but it does have one advantage politically. It lowers the individual tax burden, whereas mine leaves it about the same (by intent). In the current political climate, tax cuts can pass, but large redistributions--even ones that increase both equity and efficiency--are probably dead politically.

UPDATE: Follow the discussion elsewhere in the blogosphere, including Arnold Kling, The Lowest Deep, and Marginal Revolution.

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In a comment on my earlier post, Adam O'Neill points me to another article by Jon Gruber, this time co-authored with Michael Lettau,** that is relevant to my argument that a more rationale tax treatment of health insurance would replace the current exclusion* of health insurance premiums from income by refundable, progressive tax credits.

Quoting from the article (p. 1275):

[O]ur results imply that complete removal of the tax subsidy to health insurance spending would lead to about 15 million fewer workers being offered health insurance, and a total reduction in insurance spending on the order of 45 percent.

Note that this is a only half of the policy change that I discussed. Specifically, it does not incorporate the use of the new revenue to provide low-income workers with a refundable tax credit if and only if they spend it on health insurance. I conjecture that doing so would undo the reduction in the number of workers offered the insurance. Although I cannot speculate as to the magnitude of this offset, the Gruber-Lettau article also reports (p. 1286) that the probability that a firm offers health insurance is lowest when low-income workers are prevalent at the firm. This result obtains controlling for the tax subsidy to offering health insurance. By providing "use-it-or-lose-it" resources directly to the lowest earning groups, we increase the likelihood that they will join with higher earning workers to demand that the firm shift some compensation into group health insurance, even if the marginal tax incentive is gone.

*A comment on Brad DeLong's blog corrects my terminology--premiums are excluded from income. They are not a deduction, in the sense of an itemized deduction, from taxable income.

** My apologies to Michael--in the original post, I confused him with Martin Lettau.

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Brad DeLong is disappointed in Jonathan Weisman's recent Washington Post story on likely directions for economic policy during Bush's second term, motivated at least in part by CEA Chairman Greg Mankiw's speech at the American Enterprise Institute last week. I'm going to guess that the offending paragraph, in Brad's view, is this one:

The argument points to a certain truth about President Bush's free-market economic policies that Bush supporters say is unappreciated: In crafting a broad agenda for his second term, Bush is trying to adhere strictly to economic theory, perhaps even more so than during the Reagan administration's early battles over deregulation and taxes.

Brad goes on to point out elements of economic theory that would argue against removing the tax deductibility of employer-sponsored health premiums. I'll get to those in a minute.

I don't recall having met Jonathan Weisman while in DC, but I spoke to enough reporters to know the sort of assignment he may have had in writing about this: Mankiw gave a high-profile speech, in which he laid out some key issues and linked them with theory; so go get some alternative viewpoints and try to tie them together in a story to keep the discussion going. There are bound to be problems with a story that tries to string together viewpoints rather than, say, evidence. I don't envy the task of writing such a story--it's neither art nor science.

What Brad (and I) would like reporters to be good at is doing something like this, the first entry of which would lead to this paper by John Sheils and Randall Haught, which estimates the total cost of providing the tax-deduction to employer-sponsored health premiums and its distribution by income. In addition, we'd like for the reporters to know where to look for solid economic research, for example, by keeping up with this publication every month. Searching that page for the words "health insurance" leads to a summary of this paper by Jon Gruber and Ebonya Washington on the extent to which tax subsidies induce people to purchase health insurance.

Now we're ready to start talking about how to craft policy with an eye toward economic research. The question at hand is whether we can positively affect the market for health care by removing the tax-deductibility of premiums, or, more specifically, the differential tax treatment of premium relative to out-of-pocket expenses. The fact that premiums are deductible while out-of-pocket expenses are not (if they are not reimbursed by a flexible spending account) causes health insurance plans to have high premiums and generous first-dollar coverage of health expenses. At the margin, individuals and their doctors do not pay for the treatments that are undertaken. This should cause more treatments to be undertaken. This is the economic theory part. It is recognized by all of the sources in the article, and it is the "moral hazard" problem listed as #3 on Brad's list.

There are two ways to remove this distortion--by allowing both types of expenses to be deducted or by allowing neither type to be deducted. The introduction of Health Savings Accounts (HSAs) in the Medicare bill last year was a way to do it based on the former. I favor the latter. Here's why.

The deduction exists because there is a notion that the government ought to encourage people to get health treatments that they need. Deductibility is a terrible way to do this, on equity grounds. Take a look at Exhibit 1 in the paper by Sheils and Haught. It estimates that $209.9 billion of tax receipts are foregone in 2004 because of deductibility, with $188.5 at the federal level and $21.4 billion at the state level. Of the federal portion, $101.0 billion is due to the income tax deductibility, with another $66.4 billion due to exemption from the payroll tax for Social Security and Medicare. That's one large chunk of change.

Who benefits from this deductibility? Exhibit 2 in their paper shows that the average family with $100,000 or more in income receives a benefit of $2,780. Compare this to an average benefit of $1,231 for a family with $30,000 - $39,999 in income. Because tax rates are higher at higher income levels, and those with higher incomes are more likely to have coverage, the benefit goes up with income. Exhibit 3 in their paper estimates that, in the aggregate, the 14 percent of the families with incomes over $100,000 receive 26.7 percent of the federal tax benefits, compared to 28.4 percent of the benefits received by the 57.5 percent of the families with incomes below $50,000.

The portion of this disparity that is due to the progressivity of the tax system is ridiculous. Subject it all to tax, and take some portion of the $100 - $200 billion saved and use it to provide refundable tax credits to purchase health insurance, whether through an employer or an individual policy. The credits should phase out at higher income levels. (Credits offset a tax liability dollar-for-dollar. Deductions offset taxable income dollar-for-dollar, and are those more valuable to people who pay higher tax rates on that income.) This is a far more equitable way to use tax revenues (or their absence) to promote health insurance coverage, in addition to its efficiency consequences for reducing moral hazard.

Brad's concern, which is expressed in the other 4 pieces of economic theory that he says are relevant for the article in the Post, pertain to possible consequences of making such a shift. He writes:

The other four principles of economic theory strongly suggest that trying to push the country out of its current pattern of health-care financing into one in which individuals bargain one by one with insurers for their coverage would be a very bad idea.

It is worth pointing out that replacing deductions with credits as I have described does not necessarily push us to a situation where there is no group coverage. In fact, it may not be appreciably less of a group market than it already is. Would Dartmouth (or Berkeley), for example, now drop its group health coverage? Not a chance. Would the lack of a marginal subsidy to purchase health insurance cause the ranks of the uninsured to swell? Not if I am reading the paper by Gruber and Washington correctly. The authors estimate that a 10 percent higher tax subsidy for premiums increases voluntary take-up of health insurance by only 0.2 percent. This is a tiny response, and it seems reasonable to assume that it would also apply to a policy change that lowered a tax subsidy as well.

With the tax deductibility eliminated, we would have a more progressive means of offsetting health insurance costs across families and a more efficient means of delivering the care, since employers would have good reason to substitute toward plans in which employees pay more of their costs at the margin, for a given average cost.

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