Tax Credits For Health InsuranceCommentary by John C Goodman
April 01, 2000
Tax credits for health insurance is not a new idea. A refundable tax credit for low-income families became part of the tax code in 1990, primarily due to the efforts of Texas Senator Lloyd Bentsen. Very few families took advantage of this tax subsidy, however (because of mechanical problems discussed below), and the tax credit was repealed a few years later.
The idea of systematically replacing the current tax treatment of health insurance with a system of tax credits for all families was systematically addressed in a task force report published by the NCPA in 1990. The task force was composed of representatives of more than 40 think tanks and organizations including the American Enterprise Institute (AEI), the Hoover Institute and the American Medical Association. The report advanced three ideas that radically departed from traditional thinking. First, the bold claim that the tax system has shaped and molded our health care system. Therefore, health reform is tax reform. Second, a proposal to put individually purchased insurance and group insurance on a level playing field under the tax law. Third, a proposal to put third-party insurance and self-insurance through Medical Savings Accounts (MSAs) on a level playing field under the tax law.
These ideas were subsequently expanded into the book Patient Power, co-authored by NCPA president John Goodman and NCPA Senior Fellow Gerald Musgrave, and published by the Cato Institute. Patient Power, which presented an alternative vision to the Clinton health plan, sold more than 300,000 copies and formed the basis for a Congressional alternative to Hillary Clinton's health care plan in 1994.
In the mid 1990s, the idea of tax credits was refined and further developed through a series of meetings with health economists and health policy analysts, informally referred to as the Consensus Group. Some of the Consensus Group's thinking was reflected in an article by NCPA president John Goodman and Wharton economist Mark Pauly that was published in Health Affairs (Spring 1995). The full range of Consensus Group ideas may be found in Grace-Marie Arnett, ed., Empowering Health Care Consumers Through a Tax Reform (Ann Arbor: University of Michigan Press, September 1999).
More recently, a group of health policy analysts, congressional staff and industry representatives (the Wye Group) have been pursuing tax credits through a series of informal meetings. These discussions have directly impacted a number of proposals on Capitol Hill.
Members of both parties have gradually come to realize that health reform must involve tax reform. Last year, the NCPA helped Sen. Jim Jeffords (R-Vermont), Chairman of the Health, Education, Labor and Pensions Committee, Sen. Bill Frist (R-Tenn.) and Sen. John Breaux (D-Louis.), in formulating a bipartisan proposal in the Senate, which provided a tax credit of up to $2,000 for the purchase of health insurance. The NCPA also helped House Majority Leader Rep. Dick Armey (R-Texas) and Rep. John Doolittle (R-Cal.) put together a similar bipartisan plan in the House. And President George W. Bush adopted a similar plan as part of his presidential campaign. A slightly different approach is taken in a bipartisan plan developed by Reps. Jim McDermott (D-Wash.) and Jim McCreary (R-Louis.).
Resistance to tax credits have come in different forms. On the Republican side, the traditional preference has been for tax deductions, and GOP measures are largely responsible for gradually increasing the amount the self-employed can deduct for health insurance expenses. House Ways & Means Health Subcommittee Chairwoman Nancy Johnson (R-Conn.) has proposed a combination tax credit, tax deduction approach to deal with this concern. On the left, the primary obstacle has been resistance from the labor unions, who view the tax credit approach as too individualistic.
Within the health insurance industry, companies that sell a lot of individual insurance tend to prefer a tax credit approach. Their interests are represented by the Council for Affordable Health Insurance (CAHI). The large group insurers, especially the large HMOs represented by the American Association of Health Plans (AAHP), have been less enthusiastic about proposals that would expand subsidies to a market in which they do not sell. The official trade union for the industry - the Health Insurance Association of American (HIAA) - still favors group insurance. However, the HIAA has recently endorsed a limited tax credit approach in conjunction with Families USA and the American Hospital Association.
Almost all conservative-to-moderate organizations have endorsed individual tax credits. Liberal-left groups have tended to oppose them (see the American Prospect). The left-leaning Families USA being a recent exception.
The employer-based system is a tax exclusion system. Unlike wages, employer payments for health insurance are excluded from the employee's taxable wages. This tax subsidy is estimated at $125 billion a year by the Lewin Group. But according to the Urban Institute, families in the top fifth of the income distribution get six times as much subsidy as families in the bottom fifth. This is because the exclusion is more valuable, the higher the worker's tax bracket. Proposals to make health insurance deductible for people who purchase their own suffer the same problem: 75 percent of taxpayers don't itemize and, even if they do, a tax deduction gives the least help to those in the lowest brackets (zero or 15 percent). An above-the-line deduction would allow non-itemizers to deduct, but again this would still confer the highest tax subsidies on families who least need help.
A uniform tax credit, by contrast, gives the same tax relief to every family - regardless of the tax bracket. If made refundable, it confers the same benefit even on those who owe no taxes. Tax credits could also be skewed - offering a higher credit to lower-income families. They could also be phased out for higher income families, as they are in most proposals.
A fixed sum tax credit (e.g. Armey-Doolittle, Jeffords-Frist-Breaux, etc.) allows a dollar-for-dollar reduction in taxes up to the maximum credit amount. This approach subsidizes core insurance, but makes the taxpayer bear the full cost of any extras by paying with after-tax dollars. Exclusions and deductions by contrast are open-ended. They subsidize the last dollar of insurance purchased just as generously as the first. For a family in the 50 percent bracket, the federal government is paying half the cost of any extra insurance under the exclusion system. In this way, the current system encourages over-insurance and waste.
The current system also encourages third-party payment of every medical bill (the HMO approach), since employer payments for health insurance are excluded from taxable income, but employer deposits to Medical Savings Accounts are fully taxed (with the exception of the self-employed and small businesses participating in a federal pilot program). Many proponents of tax credits also support expanding tax free MSAs.
One of the reasons why the Bentsen tax credit was under-utilized was that it required the family to pay insurance premiums during the year and claim the credit the following April. This created an impossible cash flow problem for families who lived from paycheck-to- paycheck. An NCPA backgrounder proposes a way for individuals to access the credit at the time premiums are paid. The NCPA also proposes a way to integrate the credit with the system for claiming the Earned Income Tax Credit (EITC). Some of these ideas have been incorporated in the Jeffords-Frist-Breaux and Armey-Doolittle plans.
Two Unresolved Issues
Most tax credit proposals on Capitol Hill ignore two related issues: the role of the employer and the role of a safety net.
NCPA scholars believe that individual purchase of insurance and group purchase should be on a level playing field under the tax law. One way to ensure this is to give individuals with employer-paid coverage a choice: they can either be taxed under the exclusion system or under the credit system. Without such a choice, a generous tax credit for individual purchase could encourage employers to end their health plans, increase the wages of their employees, and allow them to purchase their own insurance. Paradoxically, this might lead to more people without health insurance.
NCPA scholars also believe that tax credits and safety net spending should be directly linked. The safety net is the entire hodgepodge of programs that fund indigent care for the uninsured. We should not spend more on these programs than we are willing to give people to encourage the purchase of health insurance. Otherwise, we are encouraging them to remain uninsured. States should have complete flexibility over the spending of safety net funds, but the amount available should be directly related to the number of uninsured. If people elect to turn down the tax credit and remain uninsured, they will pay higher taxes. These higher tax payments should go directly to the states to fund a safety net. On the other hand, if people claim the credit, the tax reduction should be funded by reducing safety net spending. If everyone becomes insured, safety net money should drop to zero.