The Kerry plan would harm the economy. Higher taxes on capital and labor will discourage savings, investment and work. High rates of health care inflation will strain government budgets, create pressures for higher taxes and lower the take home pay of workers. Inadequate revenues from Kerry’s tax plan, coupled with his promise to balance the budget, will force higher taxes on middle-income families.

A. Higher Marginal Tax Rates.

Kerry’s plan phases out most of his proposed subsides as individual incomes rise. This feature adds to the stiff work penalties that are already in the tax code.

Premium Caps. As discussed above, people who pay their own premiums to the FEHBP look-alike system will enjoy a limit on the amount of premiums they have to pay. For example, at a poverty level income, the premium will be no more than 6 percent of income. At 300 percent of poverty and above, the premium will be limited to 12 percent of income. This means that individual health costs go up as income rises. Specifically:

• An individual at the poverty level income ($9,310) will pay no more than $559 in premiums every year; but at 300 percent of poverty ($27,930) the maximum premium rises to $3,352.
• A family of four at the poverty level ($18,850) will pay only $1,131; but at 300 percent ($56,550) the maximum premium rises to $6,786.

The increase in the premium cap increases the penalty imposed on those who increase their earnings. For example, between a poverty level income and an income of 300 percent of poverty, the premium cap creates a 15 percent marginal tax rate, on top of other taxes and entitlement withdrawals. To put this in perspective, families in this income range already face effective marginal tax rates in excess of 50 percent due to income and payroll taxes and the withdrawal of the Earned Income Tax Credit (EITC) and other welfare entitlements! 62 Once individuals reach 300 percent of income, their health costs rise by 12 cents for each $1 increase in income, assuming that the health plan they choose pushes them to the cap. This means that:

• An individual in the 25 percent tax bracket (say, due to a 15 percent FICA tax and a 10 percent income tax) will now face a 37 percent marginal tax rate.
• An individual in the 35 percent tax bracket (say, due to a 15 percent FICA tax, a 15 percent income tax and a 5 percent state income tax) will now face a marginal tax rate of 42 percent.

Ironically, Kerry’s attempt to help low-income families forces them to face marginal tax rates that are normally paid only by the very wealthy.

Withdrawal of Other Subsidies. The withdrawal of other Kerry subsidies also imposes marginal tax rates that are quite high. As Figure XI shows:

• The small employer tax credits can add nearly 11 percentage points to the marginal tax rates of low-income employees — assuming (as Kerry does) that employees reap all the benefits of these subsidies and bear all the cost of their withdrawal, even though an employer may be paying the entire premium. 63
• However, if the employee chooses the highest-cost plan (a likely case if the premium is fully paid by the employer) the additional marginal tax rate will be 19 percent. 64
• The withdrawal of the subsidy for workers between jobs creates an additional marginal tax rate between 16 percent and 29.2 percent, depending on the plan chosen.
• The subsidy for older workers increases marginal tax rates between 8.1 and 14.17 percent, depending on the plan chosen.

Medicaid Eligibility. Kerry would continue the current practice of making eligibility for Medicaid an all or nothing proposition. Due to arbitrary income cut offs in both the Kerry plan and the current system, individuals could face marginal tax rates far in excess of 100 percent. Consider an individual who earns 300 percent of poverty and is enrolled in Medicaid. If this person receives a salary increase of $1, he or she will lose family (Medicaid) health coverage worth from $5,000 to $10,000!

Readers may wonder: What is the alternative? The alternative is to give people a subsidy that can be applied to Medicaid or to private insurance, with any shortfall being paid from the enrollee's own resources. The ideal subsidy is a lump sum, independent of income. Such a subsidy has no effect on marginal tax rates. If the subsidy must phase out as income rises, this can be done in a way that only modestly increases marginal tax rates. Bush's tax credit phase out, for example, raises marginal tax rates by only 5 percentage points.

B. Lower Take Home Pay.

Employer-provided fringe benefits often substitute for wages. Other things being equal, an expansion of fringe benefits lowers after-tax wages more than they otherwise would be.

To a certain extent, we want people to substitute health insurance for wages, because there is a social interest in whether people are insured. The uninsured, as we have seen, are often able to get free care (paid by taxpayers). The current system's problem is not that government encourages people to have health insurance, but rather, that it distorts the choice between health insurance and other uses of money at the margin. 65 By making the tax subsidies for health insurance open-ended, we have created a situation in which people can always lower their taxes by purchasing more health insurance. Kerry's proposal accepts this defect and makes it much worse.

A far better approach would be to give people a tax credit for the core insurance that we want everyone to enjoy and let them buy extra insurance with (unsubsidized) aftertax dollars.

C. Medical Inflation.

Prior to the advent of Medicare and Medicaid in 1965, health care spending never exceeded 6 percent of gross domestic product. Today it exceeds 14 percent. These two government programs unleashed a torrent of new spending. But because demand increased without a corresponding increase in supply, the new spending led to higher prices rather than more health care. The federal government estimates that each additional $1 of health care spending yields only 43 cents worth of additional care, and the other 57 cents buys higher prices. 66

Just as health care prices began to rise with the influx of new government spending in the 1970s, Kerry's addition of $100 billion per year in federal health care subsidies will almost certainly fuel even higher health care prices. Moreover, when the 27 million newly insured obtain insurance, they will add both their employer’s and their own money to the pot, making the total amount of new spending several times the magnitude of the government's largesse. To make things worse, these myriad subsidies will encourage people to overinsure and overconsume health care.

D. Higher Taxes on Capital.

As noted earlier, Kerry hopes to pay for much of the cost of his health plan by rescinding President Bush’s tax cuts for people earning more than $200,000 a year. Although there has been much rhetoric about how the “rich” have benefited from the Bush tax cuts, they have received only a modest reduction in their tax bracket from 39.6 percent to 35 percent — a proportionately smaller reduction than the drop from 15 percent to 10 percent for those at the other end of the income spectrum. For those highly-paid rock stars and professional athletes who spend everything they make, that was the only tax cut they got. The more significant reductions in the capital gains tax rate and the dividends tax rate are only available to people who save, rather than consume. Moreover, these tax cuts are accomplishing three important goals.

First, they send a message to the rich, as well as everyone else, that saving will be rewarded. If a rock star saves and invests (instead of consuming), her tax rate on any subsequent income will be 15 percent instead of 35 percent. This gives all taxpayers an incentive to put money back into the economy — where the primary beneficiaries will be workers who will have more job options, higher productivity and more pay.

Second, lower rates on capital gains and dividends lower the cost of capital to all U.S. business concerns. Lower capital costs encourage further investment and job expansion. This also helps U.S. companies to compete in the international marketplace.

Third, the tax changes favored by the Bush administration place debt and equity financing on a more level playing field. Under the previous tax regime, interest payments made by companies were deductible, but dividend payments were not. Because of this, the tax law favored debt over equity. It also encouraged firms to retain and re-invest earnings — even if their investment prospects were not as good as their shareholders. Thanks to Bush’s tax changes, investment decisions can be made on the basis of economics, not tax law. Similarly, the choice between debt and equity finance is now more likely to be made on the basis of market considerations rather than tax considerations.

Kerry proposes to undo all of this. By repealing Bush’s tax cuts, he would raise the cost of capital for all U.S. companies, and return us to the days when corporate debt structure and investment decisions reflect the tax law, rather than economics.

E. Higher Taxes for the Middle Class.

Kerry has pledged to pay for his health plan by repealing the Bush tax cuts for those who earn $200,000 a year or more. Reversing Bush’s intent to make these tax cuts permanent, Kerry anticipates an extra $800 billion in new revenue over 10 years. However, Bush’s intent is not the status quo. These tax cuts are scheduled to expire anyway. Against the budget that Kerry has promised to balance, immediate repeal of the tax cuts raises only $300 billion — less than one-third of what he really needs. 67 Higher taxes on the middle-class seem to be inevitable consequence of the Kerry plan. Indeed, most of the financing would probably come from the middle-class.