Fairness and the Federal Tax Treatment of Health Insurance and Medical Care

1
Fairness and the Federal Tax Treatment of Health
Insurance and Medical Care

• Mark Pauly
• Wharton School
• University of Pennsylvania
• Prepared for
• The President's Advisory Panel on Federal Tax
  Reform
• New Orleans, LA
• March 23, 2005

2
Main Points to Be Made

• Provisions in the tax code cause households net
  tax to be significantly affected by the amounts
  and types of health insurance they obtain and by
  their uninsured medical care spending.
• By most definitions of equity, the resulting
  patterns of tax payments, health insurance
  coverage, and medical spending are made more
  inequitable by these provisions.
• These unfair tax provisions also may increase
  medical care spending.

3
Major Tax Provisions Related to Insurance and Care

• Compensation paid by employers in the form of
  health insurance premiums is excluded from
  taxable income and payroll.
• Cafeteria (Section 125 Plans) permit explicit
  employee premiums to be excluded.
• Taxable income may also be reduced through
  flexible spending accounts.
• Deductibility of spending in excess of 7.5 of
  AGI is permitted to itemizers for income taxes.
• (Future) HSA/CHP arrangements lower taxes.

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Equity/Fairness AnalysisVertical Inequity

• Note Employer premium payments are assumed to
  come out of what would otherwise be taxable
  employee income.
• Exclusion leads to tax expenditures that are
  larger for higher income households vertically
  inequitable.
• Higher income households benefit more because
  they have higher tax rates, they are more likely
  to have insurance, they buy more generous and
  costly insurance, and live in high-priced areas.

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Estimated Value of Federal Tax Exclusion, 2004
(Sheils/Haught)

• Total value 188.5 billion (about 29 of private
  insurance spending).
• Income tax exclusion 100 Billion OASDI tax,
  50 Billion.
• Exclusion of employment based premiums is 80 of
  subsidy income tax deduction is 7 smaller
  percentages for flex accounts, self employed,
  HSA/CHP (very small now)

John Shiels and Randall Haught. The Cost of
Tax-Exempt Health Benefits in 2004. Health
Affairs Web Exclusives, February 25, 2004.
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Value of tax exclusion and private insurance by
income as of poverty line
of Poverty Line Average Value of Exclusion of Total Exclusion with Private Insurance (adults) of Total Uninsureds
gt400 2,500 61 91 17
300-400 1800 16 86 10
200-300 1300 15 76 19
100-200 500 8 59 29
lt100 175 1 26 25
Value of exclusion additional tax on excluded
income.
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Summary Effects by Income

• The half of the population above the median
  income gets 75 of the subsidy half below gets
  25.
• The half of the population above the median
  income makes up 25 of uninsured half below
  makes up 75.

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Equity/Fairness Analysis Horizontal Inequity

• Within a full income class, those who work for
  a firm offering insurance pay less taxes.
• Those whose employers offer cafeteria plans pay
  lower taxes.
• Those who chose higher priced insurance pay lower
  taxes.
• Those who use flex accounts, especially those who
  clean out the account, pay less taxes.

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Equity/Fairness Analysis Horizontal Inequity

• In a given tax bracket, taxes differ for
  households with the same average medical
  spending
• In the group market, using cost containing HMO
  coverage shields more income than using a high
  deductible plan.
• HSAs redress this somewhat in the group setting,
  but lower taxes in the individual market only for
  those who choose a high deductible plan.

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Tax Benefits Lead to Uneven Distribution of Risk
Protection and Medical Care Use

• Higher income people are induced to buy more
  generous coverage with high administrative costs,
  may also be more likely to obtain coverage.
• This more generous coverage causes higher
  spending for them.
• The tax treatment thus worsens disparities in
  insurance coverage, use of care, and perhaps
  health outcomes.

11
Tax Subsidies and Medical Spending

• Tax subsidies cause medical spending to be higher
  by higher income people.
• Estimates are imprecise, but removing subsidies
  could lower private spending by 5-20.
• Removal of tax distortions would increase our
  confidence in the operation of competitive
  markets in health care and insurance.
• Subsidies to the well off may raise premiums for
  lower income people too and discourage coverage
  they may also lead to a higher rate of growth of
  spending for all.

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Conclusions

• Limiting the tax subsidy would improve fairness
  and efficiency in private health insurance
  markets.
• Including all compensation as taxable income is
  best second best is to allow all spending and
  insurance to be excluded.
• My view subsidies for the upper middle class
  should be limited but refundable insurance tax
  credits should be used for lower income people
• In a flat tax setting, make the size of the
  allowance conditional on obtaining
  (yet-to-be-defined) basic insurance coverage.