The Economics of Taxes and Health Insurance

January 25, 2007

We have posted a new Fiscal Fact regarding the President’s health care initiative detailing various examples of how certain families would fare under the proposal.

While it is often frustrating that the income tax code continues to be the tool that policymakers seek to advance certain agendas, reforming the tax treatment of health care is sorely needed. This policy proposal has both good and bad components. Unfortunately, because the President chose the tax system as the tool with which to enact health care reform, he had only two ways to target the majority of the uninsured in America: either a refundable credit in the income tax system or through the payroll tax system. This is because an additional standard deduction only in the income tax system would be meaningless for the 53 percent of the uninsured who already pay nothing in federal income taxes. Most of them only pay payroll taxes.

On the positive side, part of the economic distortion from the tax treatment of health care has been eliminated by making the marginal cost of an additional dollar of health insurance equal to exactly $1 for all taxpayers. That is, the plan taxes employer contributions for health insurance as ordinary income, and the full standard health deduction being proposed ($7,500 for singles; $15,000 for families) can be claimed by a taxpayer regardless of the cost of the health insurance – just as long as he/she has a health insurance plan. (It is essentially a binary “yes” or “no” deduction with no formula based upon the amount of health insurance.)

Currently, the tax system distorts these choices and creates inefficiency, causing health care to be too large a component of workers’ compensation for those who obtain health insurance through their employers. Currently, for example, an individual in the 15% marginal tax bracket who also pays 15% of his wages in payroll taxes (assuming employer tax incidence falls on workers) would only lose 70 cents in after-tax wage income by shifting $1 from his wage base into his employer-provided health insurance program. The President’s new plan eliminates this distortion as it treats both sources of compensation equally.

Finally, this new plan treats equally those who purchase health insurance on their own and those who receive it through their employers. For those purchasing health insurance on their own, as long as they purchased at least $1 in health insurance, they would receive the full $15,000 deduction. Thereby, this policy does not link the deduction to the amount of health care an individual purchases, which limits the distortions present in the consumption decisions of the individual.

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