tax treatment of health insurance

The Tax Treatment of Health Insurance

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