Friday, December 10, 2004

Brilliant Deduction?

A comment on my last post on the tax treatment of health insurance pointed to a December 8 editorial by John Cogan, Glenn Hubbard, and Dan Kessler in the Wall Street Journal, "Brilliant Deduction." According to the editorial:

We propose a simple change to tax law that would cut unproductive health spending, reduce the number of uninsured and promote greater tax fairness. For anyone with at least catastrophic insurance coverage, all health-care expenses--employee contributions to employer-provided insurance, individually purchased insurance and out-of-pocket spending--would be tax-deductible. The deduction would be available to those who claim the standard deduction and to those who itemize.
Is this a good idea? Maybe. Is it a better idea than eliminating the excludability of health insurance purchases from income and using the higher tax revenues to provide refundable tax credits to lower income households who purchase insurance, as I suggested in my first post on this topic? I don't think so. Here are my reasons:

  1. Both proposals eliminate the tax distortion between insurance premiums and out-of-pocket expenses. Both would serve to encourage plans with lower premiums and higher co-pays and deductibles, providing better incentives for consumers to economize on their health care purchases.

  2. Administratively, the CHK plan seems much more difficult to implement. The proposal to eliminate excludability requires only one piece of information on the W-2 form--an indication of whether the person has purchased insurance through the employer plan--or an analogous document from an insurance company in the case of non-group purchases. With the CHK plan, every purchase of health care now needs to be documented and submitted to some entity, whether the government or a benefits management company, and then reimbursed. These companies need to be periodically audited to make sure they are allowing all valid expenses (and only valid expenses). This entails a large amount of paperwork, particularly in the sort of high-deductible plans that CHK envision. My own experience with my employer's flexible spending account does not make me optimistic.

  3. In terms of equity, the CHK plan suffers from the same problems as the current system. If we believe that the income tax is supposed to tax income, regardless of how it is spent, then we judge the equity of the proposal by how much of the tax deductions for health care go to different income groups. Even under CHK, high-income households will derive the largest benefits because they have higher tax rates and greater rates of coverage. CHK argue that this is an improvement over the current system, but it is clear that it is still less progressive than the alternative--eliminate the excludability and redistribute the incremental revenues back to low-income households for refundable tax credits.

  4. In terms of efficiency, the biggest issue is that the CHK plan lowers the overall cost of health care by expanding tax deductibility. Thus, we expect more health care to be purchased (before making allowances for the improved incentives). Eliminating excludability in favor of tax credits can have the same incentive effects without lowering the overall price of a good that is already overconsumed. In a comment on the original post, Tom Miller points out (in his point #4):
    On another front, expanding tax deductibility to all out-of-pocket health expenses would indeed add new misincentives to spend more on health care than it’s worth. By making OOP spending appear to be “cheaper” with a pre-tax discount, it would dilute the cost constraining effects of the recent shift already underway toward higher levels of cost sharing (deductibles and coinsurance) in today’s employer-sponsored health plans. Unlike tax-advantaged Health Savings Accounts, it would only reward taxpayers for spending health care dollars today, instead of saving them for tomorrow. Replacing one set of third-party payers (insurers and employers) with another one (the Treasury, on behalf of invisible taxpayers) won’t make individual consumers much more sensitive to the real costs of the health care decisions they make. A better way to level the playing field is to level down, instead of leveling up, by reducing the tax rate differential imposed on everything else we earn, save and spend. Eliminating the current tax exclusion for health insurance could be swapped for an equivalent across-the board reduction of about three and a half percent in all marginal rates for personal income taxes.
    This is a reasonable point, with an alternative suggestion about what to do with the tax revenues generated by removing excludability. Tom also has some useful suggestions about how exactly to generate better incentives through the tax code.
Overall, I don't think the CHK plan is better than my alternative, but it does have one advantage politically. It lowers the individual tax burden, whereas mine leaves it about the same (by intent). In the current political climate, tax cuts can pass, but large redistributions--even ones that increase both equity and efficiency--are probably dead politically.

UPDATE: Follow the discussion elsewhere in the blogosphere, including Arnold Kling, The Lowest Deep, and Marginal Revolution.

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