The president's proposed standard deduction for health insurance: evaluation and recommendations.

INTRODUCTION

President Bush's FY 2008 budget proposed major changes in tax incentives for health insurance and health care. His plan would eliminate most current tax exclusions and deductions for health insurance premiums and out-of-pocket costs; for the first time, employer contributions to health insurance would be included in taxable income. In place, the plan creates a separate standard deduction for health insurance in the federal income and payroll taxes for all taxpayers who obtain qualifying health insurance. The plan's intent is to increase the tax incentive to purchase some form of insurance while eliminating the current system's bias in favor of insurance provided through employers and reducing the current tax incentives for over-consumption of health care services and the commensurate under-consumption of other goods and services.

The President's plan effectively turns the existing tax subsidy for health insurance into a kind of voucher. It would increase the amount of tax relief that subsidizes acquisition of some health insurance while eliminating the tax advantages at the margin for increased consumption of health care over all other goods. The proposal will almost certainly encourage some people who currently lack insurance, particularly middle-income families, to get it. And the new standard deduction is not biased towards the provision of favored forms of insurance over others. However, the President's Budget also proposes to continue and even expand tax subsidies for health savings accounts tied to high-deductible health insurance plans. It would, thus, favor such plans over other forms of insurance that could reduce spending (e.g., managed care or plans with higher copayments).

The de facto voucher in the President's plan shares a peculiar feature with the subsidies for health insurance under current law: it is worth more to high-income people than for those with lower incomes, and worth virtually nothing to low-income households with no income tax liability. This is an issue not just for equity (low-income families need more help purchasing insurance) but also for efficiency (the subsidy could be too large for high-income families who would have purchased insurance already and too low for low-income families who might be more responsive to a somewhat larger incentive).

A more fundamental concern about the plan, as proposed, is that the standard deduction would be available to all who obtained qualifying insurance, whether through an employer or as an individual. That would level the playing field between employer-sponsored insurance (ESI) and insurance purchased in the individual market. But in the process it would also eliminate a method for reducing the market failure associated with adverse selection. Removing the existing advantage for employment-based plans would lead some employers, especially small and medium-sized businesses, to stop offering health insurance to their employees, exacerbating a trend that is already well underway. Assuming that employers raise wages when they stop offering health insurance, healthy employees will often be able to use their wage boost to purchase inexpensive health insurance in the individual nongroup market, (1) but many who have health problems, especially those with low incomes, will find health insurance unaffordable. Mitigating or remedying these problems would require some combination of expanded public programs, new pooling arrangements, fundamental reform of the individual market, or additional subsidies for targeted groups, such as small employers that offer health insurance, people with chronic health conditions, and low-income households.

Obvious improvements could be made to the proposal to increase the chances that it would expand coverage for those most at risk. First, the deduction should be converted to a refundable tax credit or a voucher. That way, the subsidy could be targeted to those with lower incomes who are least likely to be able to afford health insurance. Second, the problems in the nongroup market should be addressed directly by conditioning eligibility for the subsidy on states' setting up effective pooling mechanisms in the nongroup market. For example, states could require that nongroup insurance be sold through pools similar to the Federal Employees' Health Benefits Program (FEHBP), which covers federal employees without regard to health status.

Replacing the ESI exclusion with a progressive refundable credit would create many winners and losers. Those with higher incomes and more generous employer-sponsored health insurance would pay more taxes and those with lower incomes or who purchase their insurance outside of work would gain. Although only about one-quarter of tax units would pay higher taxes under such a plan, they could be expected to raise political hurdles to bar such a dramatic reform. For that reason, we also consider incremental options that involve capping the subsidy for ESI at the average level for premiums and then allowing the cap to grow at only the rate of overall price inflation. That option would raise tax revenues by about $680 billion over ten years. The revenue raised could be used to expand public programs that help lower-income households and those with especially high health costs, or for refundable tax credits or vouchers. We show that such tax credits, if targeted at those with lower incomes, could become significant over time, although the targeted credits would markedly shift tax burdens over time.

This paper summarizes the President's proposal and its likely effects on the health insurance market and the level and distribution of tax burdens. We consider some alternative approaches that would also restrict or eliminate the tax preference for employer-provided insurance but do so as part of a plan that would increase the affordability of health insurance and reduce the ranks of the uninsured without collateral costs for vulnerable workers.

THE PRESIDENT'S PROPOSAL

The President's plan would replace most existing tax subsidies for health insurance with a new standard deduction for health insurance of $15,000 for family coverage or $7,500 for single coverage. (2) The deduction would be allowed regardless of the cost of the health insurance policy (subject to minimum quality requirements) and whether the qualifying insurance comes through an employer or is purchased in the individual nongroup market. The amount would be pro-rated and would be indexed for inflation. The value of health insurance premiums paid by employers or through cafeteria plans would be included in taxable compensation. The standard deduction would also reduce earnings subject to Social Security and Medicare payroll taxes. The proposal would take effect on January 1, 2009.

States would have incentives to organize nongroup pools providing renewable and affordable plans. States could use Disproportionate Share Hospital (DSH) funds under Medicaid to provide subsidies for pooling arrangements, including subsidies for families with income below 200 percent of the federal poverty level and with chronic health care conditions to purchase private health insurance. States could also apply to the Department of Health and Human Services for supplemental grants to fund such programs. The funds could not be used for public programs like Medicaid and the State Children's Health Insurance Program (SCHIP).

The proposal was designed to be approximately revenue neutral, although the actual revenue effects are highly uncertain because of the inherent difficulty in projecting medical cost inflation and the effect of the proposal on health insurance coverage. The Department of the Treasury (2007) estimates that the proposal would reduce tax revenues by $32.8 billion (including $37.9 billion in additional refundable tax credits) over the ten-year budget period. The Joint Committee on Taxation (2007) estimates that the proposal would increase tax revenues by $333.6 billion over the same period. Over the long run, estimators at both agencies agree that the proposal would raise increasing amounts of tax revenue (and shore up the Social Security and Medicare trust funds).

Analysis

The proposal would have important effects on both health insurance coverage and the form of health insurance. The administration's proposal would approximately maintain the amount of money currently provided through the tax code to subsidize health insurance. However, it redirects that money so that it would all go to encourage families to acquire some form of coverage and none would be used to encourage them to purchase more generous insurance.

Health Insurance Coverage

The proposal would affect coverage three ways:

* The new insurance-conditioned standard deduction would increase the demand for both employer-sponsored insurance and individual market insurance. The fixed tax deduction would increase the incentive to acquire insurance relative to the incentive under current law, increasing the demand for both employer-sponsored insurance and individual market insurance. For example, under current law, employees whose employers contribute $5,000 towards family health insurance coverage can exclude the $5,000 contribution from taxable income. (3) Under the proposal, such households could exclude $15,000--providing three times the tax incentive to acquire insurance coverage.