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If President Obama really wants to improve the health care system and stimulate economic growth—he’s done neither so far—he might want to start with the income tax reform plan outlined by his own fiscal responsibility commission.
The U.S. has an employer-based health insurance system, with nearly 90 percent of privately insured working Americans getting their coverage from their employers. That system emerged because employers, restricted by federal wage limits during World War II, started offering tax-free health coverage to attract workers. Congress subsequently sanctioned the practice into law.
That health insurance tax break—a “tax exclusion” because the employer’s contribution is excluded from an employee’s income—can amount to thousands of dollars in tax-free income. I say “income” because most economists consider money spent on health insurance or pension benefits as part of the employee’s total income package.
The fact that employers paid most of the cost of coverage encouraged workers—especially unions—to demand expensive, comprehensive coverage that insulated patients from the real cost of care. That cost insulation is the principle factor driving the explosion of health care spending.
By contrast, an employee who doesn't get employer-provided coverage must buy health insurance with after-tax dollars, creating a tax disparity.
For years economists and health policy experts have debated how best to level the tax playing field and reduce some of the economic distortions caused by it. President George W. Bush proposed eliminating the tax exclusion while giving everyone—not just those with employer-provided coverage—either a $7,500 standard deduction for an individual or a $15,000 deduction for a family.
As a presidential candidate, Senator John McCain proposed a $5,000 refundable tax credit for a family. A tax deduction is subtracted from a worker’s total income; a tax credit is subtracted from the actual taxes owed.
Like the Bush plan, McCain’s proposal required employees with employer-provided coverage to pay normal income taxes on whatever the employer spent on coverage. But families would also be able to subtract up to $5,000 from what they owed in taxes. If the employee didn't owe that much, he would still get the balance of the $5,000 refundable credit, which would be applied toward the cost of coverage.
But there is a third option, one long supported by Noble Prize-winning economist Milton Friedman: completely eliminating the tax break for health insurance. No tax exclusion, no tax deduction, and no tax credit—just like life, auto and property insurance.
Importantly, that’s one of the tax-reform scenarios offered by President Obama’s National Commission of Fiscal Responsibility and Reform, co-chaired by Republican Alan Simpson and Democrat Erskine Bowles.
The commission’s “zero-based budgeting” plan proposed replacing the current six individual income tax brackets (ranging from 10 to 35 percent) with just three: 8 percent, 14 percent and 23 percent. In return for the lower rates, all “income tax expenditures”—i.e., income tax breaks estimated to “cost” the government about $1.1 trillion a year—would be eliminated. No deductions for IRAs, no home mortgage deduction, no charitable deductions and … no tax break for health insurance.
Critics, mostly labor unions, have always attacked such proposals as a thinly veiled effort to eliminate employer-provided coverage. But it is not clear that employers would stop offering coverage.
From a tax standpoint, employer spending on wages and benefits is the same. The reason employers offer health insurance is to attract and keep good employees, and that rationale doesn’t change if employees have to pay income taxes on the coverage.
It is entirely possible that employers, because of economies of scale, would be able to offer employees much better coverage at lower prices than employees could get on their own, in which case employers might continue providing coverage as a way to lure good employees.
However, the types of policies offered would surely change—significantly. Employees would want affordable policies, and that would mean basic coverage without all the bells and whistles that they demanded when their employer was footing the bill. That one change alone would do more to “bend the cost curve” in health care than anything in the president’s health care bill.
There’s also a stick-it-to-the-rich argument here. Taxing the rich has become the new liberal article of faith—one fully embraced by the president. So the president needs to understand that the current health insurance tax exclusion favors the rich. For example, a worker in the 15 percent income tax bracket whose employer spends $20,000 on health coverage gets a $3,000 income tax break. But a high-income earner in the 35 percent tax bracket gets a $7,000 tax break—for exactly the same policy. If the president were to push through a Simpson-Bowles type income tax reform he could rightly claim he just forced the rich to pay higher taxes.
Reforming the tax system would also set in motion a new economic dynamic, as the complexities and pitfalls of the current tax code were set aside and entrepreneurs and investors started looking for the best ways to invest their money rather than the best ways to hide it. That would certainly help jumpstart the economy.
There may not be much public stomach for more health care reform, but there is a lot of support for substantive tax reform. By following the recommendation of President Obama's Fiscal Responsibility Commission we could get both.
Merrill Matthews is a resident scholar with the Institute for Policy Innovation in Dallas, Texas. http://twitter.com/MerrillMatthews
