Sunday, December 05, 2004

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 would have good reason to substitute toward plans in which employees pay more of their costs at the margin, for a given average cost.

Other blogs commenting on this post


Adam O'Neill said...

Gruber and Lettau's paper "How Elastic is the Firm's Demand for Health Insurance?" (NBER WP 8081) provides estimates of the elasticity of insurance offering with respect to the net-of-tax rate that are more relevant for assessing the effects of tax reform on insurance coverage than are those in the Gruber and Washington paper. Their estimate is considerably higher (-.31 to -.41). As they write "Our simulation results suggest that major tax reform could lead to an enormous reduction in employer-provided health insurance spending."

You are right, however, that deductions for employer-provided health benefits are regressive. [More generally, so are all tax deductions, including those for mortgage interest and state income tax.]

Anonymous said...

I don't think it is reasonable to assume that the response to an increase in the subsidy (Gruber/Williams) will be symmetric with a removal of the subsidy. The response is likely to be asymmetric for at least two reasons:

1) the risk averse and well to do have already chosen to accept the health insurance offer, leaving only the poor and risk neutral to respond to the subsidy. Yet the whole population will respond to the removal of the tax advantage (Bush proposal)

2) Kahneman and Tversky have spent a lifetime demonstrating that people respond asymmetrically to different types of losses (see "Prospect Theory"). Additionally, they also demonstrate how people incorrectly assess small risks. Consequently, the removal of the subsidy will be percieved as a large utility loss.

Finally, (and I'm surprised that Brad didn't mention it), the idea that MB=MC in the healthcare exchange is hard to fathom. Who can reasonably assess when the cost of a treatment outweights the benefit? Isn't the inherent information asymmetry the reason we go to the doctor?

Anonymous said...

"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."

And back here on planet earth, the Republican majority would actually "subject it all to tax, and take some portion of the $100-200 billion saved" to reduce taxes on capital gains and corporate dividends...

It's good to see that a Republican economist has some concern for the regressivity of federal policy, but I tend to think you're part of a very small minority.

TomMiller said...

How Elastic Is Bad Heath Care Theory?

It’s not surprising that reporting on the tax treatment of health insurance is so poor when even good economists get tangled up in misused terms and old clich├ęs of health policy.

Starting with Andrew (I’ll come back to Brad DeLong in a separate post):

(1) The Gruber and Washington NBER study focused on the marginal effects of premium conversion for the employee share of group insurance premiums. It’s unremarkable that the impact on increased take up of coverage for federal employees was very small (given the amounts at stake and the particular population and health program – FEHBP --involved). The more notable finding was that increasing total tax subsidies for insurance premiums even a relatively modest amount (the average federal employee share of premiums was about 20 percent during the period studied) resulted in higher overall health expenditures and significantly raised program costs in the FEHBP. The cost per newly insured was an estimated $31,000 to $83,000.

(2) The old story about overly generous tax subsidies encouraging lavish first-dollar, comprehensive coverage might be starting to run out of gas at the margin. With the average cost of employer group premiums rising so rapidly in recent years, employer plans have increased early-dollar cost sharing in response because, even taking into account tax benefits, a growing number of employer sponsors don’t see the value in covering the most discretionary component of health spending even on a tax-advantaged basis. Most of the spike in increased cost sharing in 2003, for example, happened in conventional PPO plans that had not yet taken advantage of either HRA or HSA tax benefits for OOP spending. Individual in-network deductibles of $1,000 or higher were required in 34% of PPO plans, compared to just 20% of plans in 2002, according to Mercer. (The share looks slightly lower, however, for 2004; Mercer reports that 31% of SMALL-employer PPO plans included in-network deductibles of $1000 or more, while only 6% of large-employer plans have deductibles that high. Large employers are likely to rely more on consumer-directed plan versions of HRAs and HSAs in the next plan year, with somewhat more complex structures of cost sharing).

(3) There’s a huge difference between changing the employer deduction for health insurance (an ordinary and necessary business expense of longstanding under the Code) and the employee tax exclusion (propelled historically by the administrative rulings by the War Labor Board and the IRS during WWII, and cemented into law by Congress in 1954). In neither case, by the way, did any policy goals of “encouraging people to get health treatments that they need” come up when the tax treatment of health insurance was first considered. The proper place to remove the tax benefit is at the employee end, not the employer end. Politics makes not even too-clever-by-one-quarter politicos think that no one will catch on that they have lost part of their tax benefit if it is take away upstream at the employer deduction side. But the big problem is that this would create an uneven playing field for employer choices between paying out deductible wages (or other untaxed fringe benefits) vs. newly taxable health insurance benefits. Given enough transition time, and improvements in the capacity of the individual market, or a different non-employer “group” market, to absorb a large wave of workers as customers, this might eventually sort itself out. But, in the dangerous short run, a significant number of employer-sponsored group plans would crater, without alternative market capacity to make the transition more bearable, if not seamless. The tax code currently does at least one thing (but not much more than that) right --- it says to employers that it does not care how it compensates workers in terms of wages versus authorized fringe benefits (leaving aside certain non-discrimination rules). The problem in the tax code is the tax exclusion further downstream, at the employee end. I’m all in favor of ending that, of course, but the Administration ultimately won’t go there, and it’s not going to get the other item in any event.

(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.

(5) Which is one of the reasons why trying to pull off a bait and switch instead (trading in the entire tax exclusion for a LESSER overall amount of refundable tax credits that phase out at higher income levels) by itself is economically unwise (it raises marginal rates on higher income workers) and politically misguided (visibly punishing core constituencies to provide benefits for less supportive voting blocs is no formula for electoral success). But even aside from the problems involved in raising marginal tax rates for upper income workers and trying to mix income redistribution goals with efficiency incentives, there’s a tendency to overprescribe the wrong remedy for the inevitable workings of a progressive rate structure within our federal income tax code. EVERY itemized deduction (e.g. mortgage interest, charitable giving, casualty and theft losses, unreimbursed employee expenses) is subject to the same sort of critique, as are a worker’s accruing pension benefits excluded from income.

(6) There is a different way to skin the progressive/regressive cat (in which regressive tax benefits are the mirror image of progressive marginal rates), however, by combining the characteristics of tax credits and tax deductions into a hybrid. Using either fixed dollar tax credits across-the-board or more limited tax credits that are capped and then phased out at higher income levels run into such problems as differences in insurance premium costs related to geography and health status that make fuzzy policy judgments about their amount and adequacy even more difficult. Using simple tax deductibility, on the other hand, not only recreates problems of regressivity, but it cannot achieve tax parity with the tax exclusion. Unlike the tax exclusion, just making health insurance deductible for individual purchasers fails to shield their premium expenses against the payroll tax, which accounts for the largest federal tax obligation for lower income workers. A better alternative vehicle, initially, would be to offer the option of a fixed-percentage tax credit for any taxpayer (or beneficiary of refundable credits) who needs to purchase individual insurance or wishes to opt out of an employer group plan offer. The percentage could be set at a level with progressive effects, approximately between 25 to 30 percent, so that it took into account the value of the first federal income tax marginal rate bracket and the combined employer/employee FICA rate, to make lower earning workers whole for tax equity purposes but set a lower rate ceiling on tax advantages for upper income workers opting in to individual, or non-employer-group coverage. The initial goal should be greater tax equity among all health insurance purchasers, acknowledging that our political system isn't about to blow up the employer-based group insurance system overnight. The separate goal of reducing the tax code's distortion in favor of health insurance spending primarily and health spending secondarily, over other non-health spending would be better addressed by a more comprehensive repeal of all tax-advantaged health spending (offset by across-the-board cuts in marginal tax rates. That would avoid political exercises in arbitrary line-drawing and crude calculations of individual insurance benefits to workers in employer group plans that are community-rated for internal purposes. But we can't get from here to there, until we first take some incremental steps to facilitate transition in the health insurance market.

Tom Miller

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