Mankiw on Healthcare and the Tax Code

April 03, 2006

N. Gregory Mankiw—Harvard economist and former head of the President's Council of Economic Advisers—discusses the distortions introduced in healthcare markets by the federal tax code on his new weblog.

In the process, he reproduces a textbox on the economics of healthcare and the tax code from the 4th edition of his famous principles textbook, which is below. Be sure to see his insightful comment at the end about the problem of exempting health expenses from the tax code, as healthcare grows as a percentage of GDP (i.e., it forces up tax rates on the rest of the non-healthcare economy):

The Peculiarities of Health Insurance Many economists believe that health insurance in the United States is often poorly designed and, as a result, Americans spend too much on healthcare. Three features of typical health insurance distinguish it from other kinds of insurance, such as car insurance.

First, health insurance often covers routine expenses, such as annual checkups and vaccinations. If an expense is perfectly predictable, there is no reason to buy insurance to cover it. In this sense, health insurance is more like a prepayment plan than it is protection against risk. It is as if your car insurance covered oil changes and tire replacement.

Second, health insurance often covers small, random expenses, such as a doctor's visit for a child with an earache. For most people, such expenses would not have a major financial impact, so there is no need to buy insurance to protect against them. It is as if your car insurance covered the contingency that your taillight might burn out.

Third, many people obtain their health insurance through their employers rather than directly from an insurance company. As a result, when a person loses a job, he or she often loses health insurance as well. By contrast, a person’s car insurance continues as long as the premiums are paid.

Why does health insurance have these three unusual features? One reason is the tax system. According to U.S. tax law, employer-provided health insurance is a form of compensation that is exempt from income and payroll taxes. This tax treatment does not apply to other types of insurance: Your employer could not reduce your tax burden by reducing your salary and paying your car insurance premiums for you. Because of the preferential tax treatment given to health insurance, you and your employer have an incentive to make health insurance part of your compensation and an incentive to have the insurance cover items that could easily be paid out of pocket.

Many economists believe that because of this tax treatment, Americans have health insurance that covers too much. Excessive insurance can lead to excessive use of medical care, driving up the amount Americans pay to stay healthy. It would be better, these economists argue, if people bought less expensive insurance that covered only catastrophic losses and paid for small, routine, and discretionary medical expenses out of pocket.

There are various ways policymakers might induce people to change the kind of health insurance they have. Some economists have advocated eliminating the preferential tax treatment now given to health insurance. Others have proposed giving similar tax treatment to medical expenses paid out of pocket. Either reform would level the playing field between different ways of paying for healthcare, thereby reducing the current incentive for employer-provided health insurance.

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A couple observations beyond what's in the text:

1. We should be careful not to overstate what health-insurance reform will do. The main reason health care is more expensive today than it was a generation ago is technological progress that yields new but expensive ways to prolong and improve our lives. That probably won't stop. Health spending is likely to continue to rise as a share of GDP.

2. As the new box makes clear, there are two ways of leveling the playing field. Al Hubbard advocates making out-of-pocket expenses deductible. A case could be made that it would be better to eliminate or cap the tax exclusion for employer-provided health insurance. If we exclude all health spending from the tax base, as Hubbard suggests, then as health spending rises over time as a share of total expenditure, the rest of the economy will have to pay ever higher tax rates even to maintain a constant ratio of tax revenue to GDP.

Read the full piece here.

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