January 22, 2007

President to Propose Large Tax Deduction to Spur Health Insurance Purchases

Fiscal Fact No. 74

In his weekly radio address this past Saturday, President Bush previewed a major new tax proposal that he will more publicly unveil Tuesday night in his State of the Union speech.

His stated goal is to reduce the number of uninsured people, a hazy number to begin with, but which Census has pegged at 45.3 million (see Table 1). The vehicle the President has chosen to accomplish this is a large tax deduction for health insurance spending: $7,500 for a single person and $15,000 for a couple.

But since most of the uninsured owe little or nothing in income tax, how can a deduction prompt them to buy health insurance?

As Table 1 shows, over 50 percent of uninsured Americans owed no income taxes in 2004 after taking all credits and deductions. Therefore, if a healthcare tax incentive were passed in the form of either a deduction or a nonrefundable credit inside the income tax system, over half of the uninsured would not even be able to claim any of it. The only way in which such an initiative would entice them to purchase any health insurance at all would be if the credit were made refundable, or if it were done outside the income tax system such as via payroll taxes.

Table 1. Majority of Uninsured Americans Pay Nothing in Federal Individual Income Taxes, 2004

Federal Individual Income Tax Liability(after Refundable Credits)

Percentage of Uninsured Americans on Tax Return by Amount of Tax Liability

All Returns

100.0%

Less than Zero

32.5%

Zero

20.5%

$0 – $499

7.1%

$500 – $999

7.3%

$1,000 – $1,999

9.3%

$2,000 or greater

23.3%

Source: 2005 Current Population Survey (March Supplement)
Note: Number of uninsured is equal to the number of uninsured Americans who are part of a “tax unit” that has the given liability. Also, uninsured Americans filing dependent returns are included if the tax liability of the claimant is in the given group. Definition of “uninsured” is from Census’s Current Population Survey. See http://www.census.gov/hhes/www/hlthins/hlthinsvar.html. Many scholars have asserted that the Census overestimates the uninsured by counting people who may misreport their insurance status, many of which are on government-provided plans, and that the core of uninsured working adults may be less than half as large as the Census number.

For decades, presidents and legislators have passed tax reforms with promises “to take millions of people off the tax rolls.” They’ve done it, and none more than President Bush. The number of “non-paying” tax returns–people who get back every dollar they’ve had withheld during the year–has gone from 29 million to 43 million during this administration. A large health insurance credit would further increase the number of nonpayers, to the point where more than one-third of American tax returns would have a zero or negative liability.

If the plan were changed to a refundable credit, it would be much more expensive, but would it work to stimulate health insurance purchases?

The IRS already dispenses more than $50 billion in refundable credits through the tax code. These are not tax refunds but simply government checks, like welfare but funneled through the tax code and administered by the IRS instead of the usual welfare agencies at the Department of Health and Human Services. Congress and the IRS have struggled constantly to rid them of fraud and waste but with only limited success. Expanding refundable credits is probably not a good way to stimulate health insurance purchases.

The President has likened his new plan to the mortgage interest deduction. While often referred to as the most popular tax deduction, the home mortgage interest deduction is considered ineffective by most economists. It may raise the level of home ownership slightly, but the massive subsidy mostly succeeds in pushing up home prices by the amount of the deduction, enriching home builders and real estate agents but doing little for individuals.

How would the plan treat people who are already insured?

People who are currently covered by their employers would receive the deduction, but they would also have to include the value of their employer-provided plan as income. Economists have long observed that fringe benefits such as generous health plans should be counted as income, and it would unquestionably be a good idea to treat all health insurance purchases equally in the tax code, ending the current preference for business purchases. For a fairly small number of people whose employers provide more than $15,000 in annual health benefits, the plan could be a tax hike, while it would be a tax cut for those already buying health insurance policies with their own after-tax dollars.

Ideally, the income tax code would not be used to subsidize certain industries and individual purchases. The income tax could collect the same amount of revenue with much lower rates, but exemptions, deductions and credits continue to accumulate, as politicians see the tax code as a vehicle to solve social problems.

A tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.

The mortgage interest deduction is an itemized deduction for interest paid on home mortgages. It reduces households’ taxable incomes and, consequently, their total taxes paid. The Tax Cuts and Jobs Act reduced the amount of principal and limited the types of loans that qualify for the deduction.

A tax refund is a reimbursement to taxpayers who have overpaid their taxes, often due to having employers withhold too much from paychecks. The U.S. Treasury estimates that nearly three-fourths of taxpayers are over-withheld, resulting in tax refunds. Overpaying taxes can be viewed as an interest-free loan to the government.

A tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state/local taxes paid, mortgage interest, and charitable contributions.

A payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue.

An individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S.