February 2007

How Will the President’s Tax Deduction for Health Insurance Work?

The White House proposal to replace the current tax break for employer-sponsored health insurance with a standard tax deduction available to anyone buying insurance has raised a storm of controversy. Proponents argue that the proposal is fairer than the current system, provides real help for the uninsured, and promotes efficiency in health care that can yield meaningful cost savings for everyone. Critics claim that the plan will raise taxes, increase the number of uninsured, and seriously undermine the way 170 million people buy their insurance.

In the first panel, Katherine Baicker, a key member of the president’s economic team, made the case for the new proposal. Former Congressional Budget Office official Roberton Williams and former Joint Economic Committee economist Thomas P. Miller responded.

The second panel focused on the likely impact of the proposal on employer-sponsored health insurance and the ability of the insurance market to accommodate a shift to non-group coverage. Speaking on the second panel was Employee Benefits Research Institute director of health research Paul Fronstin, University of Minnesota Blue Cross Professor of Health Insurance Roger Feldman, and Hay Group consulting actuary Tom Wildsmith.

The event concluded with a keynote address on health reform and the tax system by former chairman of the House Committee on Ways and Means Bill Thomas.

Panel I: The President’s Plan: Overall Impact

Katherine Baicker
Council of Economic Advisers

Rapidly increasing health-care costs have made the tax exclusion of employer-provided health insurance the biggest tax expenditure in the federal budget. Ample evidence, both from the United States and Organisation for Economic Co-operation and Development nations, suggests that we do not get maximum value from our health expenditures. The current biased tax treatment of health insurance contributes to such inefficiency by favoring people who purchase employer-provided health insurance or the most expensive private plans.

The president’s proposal eliminates both biases by offering a standard tax deduction of $7,500 for an individual, or $15,000 for a family, regardless of whether one purchases health insurance through an employer or individually. The uninsured will have a substantial incentive to buy health insurance with pretax dollars, individual purchasers will receive much-needed tax relief, and the taxes of people with employer-sponsored health insurance plans worth less than the deduction will decrease. Those with employer-sponsored insurance plans worth more than the deduction will be able to re-optimize their compensation by shifting health insurance benefits to wages. The Treasury Department estimates that the effects will be somewhat progressive.

The revenue-neutral proposal provides an incentive for everyone to purchase health insurance without over-insuring. The standard deduction, coupled with better health-care price and quality information, should induce a shift in behavior that will slow the growth of health spending and make the market more efficient.

Roberton Williams
Urban Institute

While the president’s proposal addresses many of the problems in the present tax treatment of health expenditures, it introduces substantial risk to the current system of health insurance. Small businesses could discontinue sponsoring health insurance without a tax incentive to provide it; meanwhile, pools of employer-sponsored health insurance plans could become riskier as healthier individuals move into the individual health insurance market. The proposal favors the wealthy by basing the deduction on an individual’s tax rate, and the benefit to the insured will decrease over time due to the deduction being indexed to the Consumer Price Index rather than to the rate of health-care cost inflation.

Several improvements are possible. Offering a voucher or tax credit would shift the proposal’s benefit to those populations with the highest need. Without the assurance that the individual insurance market can operate efficiently, expanding Medicaid and the State Children’s Health Insurance Program, as well as subsidizing small businesses’ provision of health insurance, could eliminate much of the proposal’s risk to the present health insurance system.

Thomas P. Miller
AEI

The current tax treatment of health care is inefficient and inequitable and has unintended spillover effects. For example, as it exacerbates over-spending on health care and causes health insurance to become unaffordable for many people, the cost of the tax exclusion has unexpectedly started to resemble an unbudgeted entitlement.

President Bush’s proposal correctly highlights the intersection of tax policy and health policy, though other issues may be more important, such as improving the information infrastructure, offering relative measures of provider efficiency and effectiveness, and changing net costs on the supply side. A two-tiered method of first fixing the market for the majority of people, followed by providing subsidies to those left out, may be better suited to improving the health care system. Matching policy objectives with policy instruments and overcoming the typical problems of tax code revisions will test the proposal’s policy life.

The concern that adverse selection would cause the departure of healthier workers from employer-sponsored health insurance risk pools is merely an objection to riskier people paying risk-adjusted premiums. Moreover, angst over the efficiency of the individual health insurance market is mostly unfounded. Research has shown that individual health insurance markets can work--for example, long-term care insurance--and appropriate risk-pooling can be accomplished in a variety of ways. Nevertheless, fiscal and political obstacles will defer any meaningful improvements in health policy until 2008.

Panel II: The President’s Plan: Market Reaction

Roger Feldman
University of Minnesota

The president’s proposal creates complicated incentives that are difficult to project using existing studies’ models of the price elasticity of demand for health insurance. According to my simulation, which takes 27.3 million people as a base uninsured population, the president’s proposal would reduce the number of the uninsured to 7.1 million (that is, 20.2 million newly insured). The proposal is not budget-neutral: in 2009, it would cost $204 billion. That is calculated as a $104 billion subsidy to the individual health insurance market, a $265 billion subsidy to the employer-sponsored health insurance market, and an offsetting tax recovery of $165 billion.

The model predicts that the number of health savings accounts and low-option preferred provider organizations (PPOs) with co-insurance and deductibles will increase tremendously because individuals are sensitive to the prices of different types of health insurance. The employer-sponsored health insurance market will not be hollowed out, but expensive PPOs will virtually disappear. In addition to leveling the playing field for employer and individual markets in the tax code, the proposal will lead to smarter and more realistic insurance coverage, resulting in less use of health care and more competition among providers on prices and quality.

Paul Fronstin
Employee Benefits Research Institute

Advantages of the President’s proposal include de-linking health insurance from one’s employer, increasing the portability of health insurance plans, and establishing more effective means of containing health-care costs. Nevertheless, a lack of protection for people buying coverage in the individual market and rising health-care costs (unrelated to the comprehensiveness of health insurance plans) will mitigate the benefits derived from the proposal. Disadvantages include adverse selection, the loss of group purchasing efficiencies, and the diminished role of employers as health-insurance advocates on behalf of their employees.

If the standard deduction were enacted, the reactions of employers, employees, and insurers would end the current form of employer-sponsored health insurance. Employers, especially small and mid-size businesses, would use the standard tax deduction as an opportunity to drop health insurance coverage for their employees. (However, large businesses may be more reluctant to end coverage unless dysfunctions of the individual market are addressed.)  Young and healthy workers may decline coverage from their employers or may select jobs that do not offer health insurance coverage in response to the new tax advantage of individual coverage, thereby leaving a riskier group of workers to be covered in the employer-sponsored health insurance market. Insurers’ increasingly innovative benefit designs will attract more healthy people into the individual market, deepening the adverse selection issues facing the employer-sponsored market.

Tom Wildsmith
Hay Group

The benefits available in the employer-sponsored health insurance market are comparable to those in the individual market. However, cost-sharing tends to be higher to keep premiums down in the individual market because all of the cost is borne by the individual. Although employer-sponsored health insurance reduces other employee benefits, once one has been hired, the marginal cost of enrollment in the employer plan is substantially decreased by the employer’s level of contribution. This subsidized cost of employer-sponsored health insurance is a strong force compelling young and healthy workers to enroll in employee plans.

Premiums in the individual health insurance market are not subsidized and vary according to age, health status, and a variety of other factors. Mandating coverage of risky populations or restricting premium costs for low-income populations creates significant cross-subsidies: one population’s premiums rise to subsidize the premiums for another population. In a voluntary individual market without a substantial external subsidy, those cross-subsidies become a tax that can be avoided by refusing health insurance coverage. In order to make the individual market function more like the employer market, comparable levels of participation rates and natural risk pooling must occur. Marginally changing tax policy will not induce such outcomes, but providing a subsidy large enough to make enrollment in the individual market a “no-brainer” may.

Keynote Speech

The Honorable Bill Thomas
AEI

The problems facing America’s health insurance system can be addressed only by shifting our focus from the parameters of an employer-sponsored system and redefining the role of the individual market. As the individual market becomes increasingly dependent upon quality and price information, transparency and health information technology must be strengthened.

Enrolling citizens eligible for existing public health assistance programs is a crucial component to improvement. Furthermore, creative risk pooling--such as state-based and interstate arrangements and pooling employees from multiple small businesses--should be used. If the government can accept responsibility for the riskiest of populations at the margin and if a minimum level of catastrophic coverage can be decided upon, leaving the market to handle the majority of the population will be more palatable to legislators.

AEI research assistant Jonathan Stricks prepared this summary.