The economic effects of the president's proposal for a standard deduction for health insurance.

INTRODUCTION

Health care costs continue to rise rapidly in the United States. The growth in health care costs has been exceeding GDP growth by two percentage points annually since 1940. In 1960, health expenditures were just 5.3 of Gross Domestic Product (GDP). More recently, national health expenditures as a percentage of GDP were 13.8 percent in 2000, 16 percent in 2004, and are expected to rise to nearly 20 percent by 2015 (Figure 1) (Borger, Smith, Truffer, Keehan, Poisal, and Clemens, 2006). These rising costs impose a substantial burden on the U.S. economy. Higher spending on public programs like Medicare and Medicaid strains state and federal budgets. Higher insurance premiums pose a challenge for employers and burden workers with higher health costs and lower wage increases.

The burden of rising health care costs is particularly problematic for small businesses, who tend to have much smaller pools of workers to spread risk and increasingly choose not to offer any health insurance to employees. According to the Kaiser Family Foundation's annual survey, nearly 100 percent of firms with 200 or more workers offer health insurance to their employees. Yet only 60 percent of firms with fewer than 200 workers offered insurance in 2006, a decline from 69 percent in 2000 (Kaiser Family Foundation, 2006).

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At the same time health care costs are rising, the number of uninsured also continues to grow. To a large extent, individuals are uninsured because the cost of health insurance exceeds the value people place on insurance coverage. As health care costs grow faster than incomes, an increasing number of individuals are unwilling to purchase health insurance. The latest estimates indicate that 45 million people are without insurance at any given time during the year.

A substantial portion of rising health care costs is due to the effects of the insurance system itself. Health insurance provides valuable protection against unforeseen illness. However, many insurance policies are structured in a way that dulls consumer sensitivity to price and, in some cases, a price signal is absent from the market place altogether. The direct expenditure for health care by an insured person may be only a small portion of his or her total health care costs. This is characteristic of low deductible or first dollar health insurance, whereby an individual covers little of the direct cost of health care. Moreover, the prevalence of this type of insurance is rooted in the tax treatment of health care generally.

Today the single largest tax expenditure in the tax code is the employee exclusion for employer-provided health insurance that, together with the other health care tax subsidies, averages roughly $300-$400 billion per year. (1) Individuals pay neither income nor payroll taxes on health care that is financed through employer-provided health insurance. Thus, the tax code reduces the cost of health care when it is "pre-paid" or purchased in advance through an employer sponsored insurance plan. This has contributed to the prevalence of low deductibles, low co-insurance rates, and prepaid coverage and may lead to the over-consumption of health care. (2)

President Bush announced in his State of the Union address and in the Administration's FY 2008 Budget a proposal to dramatically reform the tax treatment of health care with the twin goals of making basic insurance more broadly affordable and improving the economic incentives that underlie the provision of health care and health insurance. Addressing the tax biases that encourage people to purchase overly generous health insurance and receive more of their compensation in the form of tax-preferred health care, rather than wages, is an important first step in dealing with the rapid rise in health care spending. This paper explores some of the analyses of the effects of this proposal and discusses other approaches for reforming the tax treatment of health care.

CURRENT TAX TREATMENT

The tax code generally allows people who purchase insurance through their employer to exclude the value of their health insurance from both income and payroll taxes. People who purchase insurance on their own typically receive no tax benefit, with the exception of the self-employed who can deduct insurance premiums from income tax, but not the payroll tax. Other major health tax subsidies include flexible spending accounts (FSAs), health savings accounts (HSAs), and the itemized deduction for medical expenses above 7.5 percent of a taxpayer's adjusted gross income. These other subsidies also allow taxpayers to exclude some out-of-pocket expenses from tax. FSAs apply for both income and payroll tax purposes, while HSAs and the itemized medical-expense deduction generally only apply for income tax purposes. (3) As shown in Figure 2, together these tax subsidies total over $300 billion per year, with the employee exclusion for employer-provided insurance comprising nearly 90 percent of the total tax subsidies for health care.

The current tax treatment distorts health care decisions in several important ways by changing the price of health care relative to other consumption and depending on how health care spending is financed. (4) First, taxpayers only receive the tax subsidy if they purchase health insurance through their employer. The difference in the after-tax cost of purchasing insurance through an employer or directly in the non-group market can be substantial. For a taxpayer in the 15-percent income-tax bracket and subject to the 15.3-percent Social Security tax rate, the after-tax cost of purchasing a dollar of insurance through an employer plan is just 70 cents, while the person purchasing insurance on his own receives no tax benefit and pays the full dollar. Only employees who work for businesses that offer insurance receive the tax subsidy. Moreover, linking health insurance to employment creates "job lock," whereby people with poor health status may be more reluctant to switch jobs because of concerns of finding adequate health insurance. Job lock is a significant concern because nearly 40 percent of businesses do not offer any health insurance.

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Second, there is a tax bias to channel health care spending through employer-provided insurance because this ensures that the health care spending is exempt from income and payroll taxes. The individual can purchase a dollar of "prepaid" health care through an employer-provided health insurance policy for every dollar of wages received. Thus, the current tax system builds in a large tax subsidy for "pre-paid" health care in the form of employer-provided health insurance. This tax distortion has encouraged overly broad, first-dollar insurance coverage. Equivalently, this tax bias discourages individuals from purchasing high-deductible health plans. The consequence is an overreliance on first-dollar coverage, which dulls the incentives for consumers to shop carefully for cost-effective health care. Research has indicated that there is considerable responsiveness of health care spending to price (Newhouse, 1993).

Also, the existing health care tax subsidy creates an incentive for individuals to receive compensation in the form of employer-provided health insurance rather than wages. Compensation received as health insurance is free of income and payroll taxes, while compensation received as wages is not. The more compensation that can be funneled through employer-provided insurance (or simply health care for those with FSAs), the larger is the tax benefit. These features of the current tax treatment help fuel higher expenditures on health care.

PRESIDENT'S PROPOSAL FOR A STANDARD DEDUCTION FOR HEALTH INSURANCE

The President announced in his State of the Union address and included in his FY 2008 Budget a proposal to replace most existing health care tax subsidies with a standard deduction for health insurance (SDHI) set at $15,000 for family coverage and $7,500 for individual coverage. The SDHI would apply for both income and payroll taxes, and the SDHI amounts would be indexed by the Consumer Price Index (CPI). The SDHI would be fully available to those purchasing qualifying insurance that meets certain minimum standards regardless of how much individuals spend on health care or health insurance. (5)

The SDHI would also be available regardless of whether a person purchases insurance through their employer or directly, thereby providing the same tax benefits currently available through employer-based insurance to those who purchase insurance on their own in the non-group market. (6) The flat, uniform nature of the SDHI is a crucial feature of the proposal that effectively breaks the link between the size of the tax subsidy and how much a person spends on health care or health insurance. Under the SDHI proposal, consumers of health care no longer receive a larger tax benefit if they consume more health care. Also, the tax subsidy would be no larger or smaller if consumers choose to channel health care spending through an insurance policy or pay for health care out-of-pocket, provided they have a least the minimal insurance coverage needed to qualify for the SDHI. Individuals would have a substantial incentive to purchase at least basic coverage in order to claim the SDHI. The proposal, in effect, provides a substantial incentive to purchase basic insurance, but removes taxes from most other health care decisions.