RALEIGH – President Bush is reportedly planning to use his State of the Union Address to announce a new push for tax fairness in medical care. This is an excellent idea, and I truly hope the administration doesn’t screw it up.
[Feel free to insert your favorite, gratuitous joke here, guffaw, and move on.]
Knowledgeable analysts of all political stripes have agreed for years that a core problem with America’s health-care system is massive distortion by selective and generous tax breaks. Because of FDR-era decisions made about the tax and regulatory treatment of employer-provided benefits, health insurance purchased at the workplace has enjoyed deductibility from both income and payroll taxes. This is one of the largest exclusions in our tax code at an estimated $150 billion in FY 2006, far larger than the value of tax breaks receiving more widespread and critical scrutiny such as deductions for mortgage interest and tax loopholes for U.S. exporters.
Even that figure underestimates the full fiscal impact because it leaves out such state and local policies as exempting medical services from general sales and use taxes and exempting public and non-profit hospital facilities from local property taxes. It wouldn’t be at all surprising if the total price tag for health-care tax exclusions approached $200 billion, which is more than half the annual on-budget cost of Medicare ($380 billion in FY 2006).
The tax exclusions have several pernicious effects. Because you can get tax-free benefits at the workplace, but must pay income and payroll taxes on the money you spend to purchase benefits directly (the effective tax cost varies according to your bracket and whether you work for someone else or are self-employed), there is a strong financial incentive for employers to offer and employees to accept group coverage at the workplace. That creates a “job lock” problem for people who might want to work somewhere else but can’t permanently take their health plan with them (“portability” reforms to date haven’t fully resolved the problem). More importantly, because tax-free benefits are worth more than taxable wages, these policies have encouraged many Americans to over-insure – to choose plans with expensive, low-deductible coverage of routine medical expenses in which the cost of administration can offer be a large percentage of the total bill. Over-insured consumers, who aren’t spending fungible dollars and aren’t adequately informed about pricing, tend to overspend on medical services of dubious net benefit.
Health savings accounts (HSAs) and consumer-driven health plans in general are a promising solution to the problem, because they extend tax deductibility to cash purchase as well as insurance premiums. But these are only partial solutions under the current model. It remains true that if you are an employee of a firm that, for size or efficiency reasons, does not find it practical to sponsor group coverage, you do not have full access to the favorable tax treatment that other consumers enjoy. In turn, that makes the tax exclusion for health benefits a markedly regressive tax break – wealthier households are more likely to be in a position to receive generous employer benefits, and their higher tax bracket makes the exclusion more valuable, anyway.
Some analysts argue that the entire array of federal and state tax exclusions for health care needs to go away. If government is to subsidize medical spending or health insurance, they argue, the model should be on-budget spending programs financed by generally applied taxes. I used to believe that myself, but years ago I came to the conclusion that a properly designed tax system, either federal or state, should treat some spending on health care (as well as education and child-rearing, for that matter) as a form of investment in human capital akin to investing in stocks and bonds. That is, some component of medical goods and services purchased is really an investment designed to produce a future taxable return. In Investor Politics, I discussed the idea at some length and recommended that we replace the current tax breaks with a capped, age-adjusted amount. Individuals would receive the tax break regardless of whether they bought insurance directly or through their employers, and regardless of whether they bought insurance or paid for medical services with cash or savings. While a deduction would suffice for income taxes, throwing payroll taxes into the mix could justify the use of a refundable tax credit designed to replace the estimated average value of deducting from both income and payroll taxes. By capping the value of the credit, we’d reduce the tax benefits at the top end by enough to offset the fiscal impact of its availability to many families of modest means previously left largely out of the system.
There are many different versions of this proposal to replace the current system with refundable tax credits, advanced by both the Right and Left. This is truly a case where the economics is solid, the politics potentially salable, and a screwy tax break disproportionately benefiting the wealthy and distorting market outcomes can be transformed into a sensible tax policy offering larger benefits to low- and middle-income taxpayers while improving quality and cost containment in health care.
It’s probably too good an idea to survive the legislative process in Washington. Still, hope springs eternal – or at least for a while longer.
Hood is president of the John Locke Foundation.