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.

4. Equity/Fairness Analysis:Vertical 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.

5. 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 AffairsWeb Exclusives, February 25, 2004.

6. Value of tax exclusion and private insurance by income as % of poverty line * Value of exclusion = additional tax on excluded income.

7. 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%.

8. 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.

9. 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.

10. 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.

12. 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.