A Health Reform Republicans and Democrats Agree On

The most important question in health reform is this: How should the government subsidize private health insurance? And both parties are in broad agreement on the answer. The subsidy should be in the form of a fixed sum tax credit.

Consider the traditional way of encouraging health insurance. For employer-provided insurance, the subsidy is in the form of an exclusion. Unlike wages, employer premium payments are not included in the taxable income of the employee. For the self-employed, the subsidy is in the form of a deduction. And for other individuals, health insurance premiums and medical expenses can be deducted to the extent that they exceed a certain percent of income (currently 10%).

In all three cases, people face the following perverse incentive: If they purchase more insurance their taxes will go down and if they purchase less health insurance their taxes will go up. In this way, the tax system encourages all of us to choose more generous coverage than we would otherwise select.

If we combine a 15% (FICA) payroll tax with a 25% federal income tax and a 5% state and local income tax, a middle income family is facing a 45% marginal tax rate. In high tax states, the rate can exceed 50% — even though the family is far from wealthy.

At a 50% marginal tax rate, government at all levels is paying for half the cost of any additional insurance the family chooses to buy. Insurance that costs $1 will be viewed as worthwhile, even if it is worth only 51 cents to the buyer. In other words, insurance can be extremely wasteful and still be attractive to subsidized purchasers. Alternatively, if the buyer saves a dollar by choosing less generous coverage, that dollar will become taxable income. The government will seize one-half of it.

No wonder our health care system has so much waste in it.

I’m so excited, I just can’t hide it 

With a fixed sum tax credit those incentives change remarkably. Here is how it works in the ObamaCare exchange:

Subsidy = Premium* (1 – hY)

where Premium* is the second lowest premium charged for Silver plans, Y is the buyer’s income and h is the maximum percent of income people have to pay for such a plan. Notice that this sets the subsidy at a fixed dollar amount.

The subsidy is refundable: the buyer gets the credit even if he doesn’t owe any income taxes. It is also advanceable: within the exchange, the subsidy goes directly to the insurer, bypassing the buyer altogether. But most important, the subsidy is the same whether the individual chooses another Silver plan or a Bronze, Gold or Platinum plan. That means that buyers who choose more expensive plans pay 100% of the extra premium out of their own pockets. Alternatively, buyers who choose a less expensive Bronze plan get to keep 100% of the savings from making that choice.

Any extra expense is paid with after-tax dollars. Any reduction in expense increases the buyer’s after-tax resources. Since most other consumption is also paid for with after-tax dollars, this puts health insurance premiums and other goods and services on a level playing field.

With a fixed sum tax credit, buyers are not encouraged to over-insure or under-insure. Every costly feature of health insurance (lower deductibles and copayments, wider networks, more generous benefits) will be at the expense of all other ways of spending the consumer’s dollars.

ObamaCare is, of course, a Democratic health reform. But all the Republican health reform proposals make use of this idea as well.

If there is a fault in ObamaCare in this regard it is that it doesn’t go far enough. The credit vanishes after family income reaches 400% of poverty and the traditional subsidies (described above) kick in. Also, it leaves the traditional tax treatment of employer-provided coverage fully in place.

In the 2008 election, John McCain proposed a more radical approach: a fixed sum tax credit to replace all existing tax subsidies for health insurance. The credit would be the same regardless of where the insurance is obtained — at work, in the marketplace or in an exchange. The legislative version of the McCain plan was the Coburn/Burr/Ryan/Nunes bill.

Although President Obama and Democrats in Congress often say the Republicans have no alternative to ObamaCare, they appear to have very short memories. The Obama campaign spent millions of dollars attacking the McCain health plan (demagoguing it, actually). Judging by the number of Obama TV ads, it was the principal issue of the entire election. And when ObamaCare finally came to a vote in the Senate, Harry Reid refused to allow a vote on the Coburn/Burr alternative.

Other Republican approaches have not gone as far as the McCain approach, but they too adopt the fixed tax credit as the vehicle for subsidy:

  • The House Republican Study Committee plan (Roe bill) replaces existing tax subsidies with a uniform tax credit, but since the credit is not refundable, it provides very little benefit to the bottom half of the income distribution.
  • Rep. Tom Price has a bill that creates credits for those who buy their own insurance, but leave the employer-based system in place.
  • A new Coburn/Burr/Hatch bill mimics the ObamaCare approach (tax credits that phase out for the individual market, but less generous than under the ACA), but it limits the amount of health spending that can be excluded from income at work.
  • A 2017 Project proposal would make the new Coburn tax credit independent of income and would even create a special tax credit for Health Savings Accounts, but it would leave the current employer system intact.

Here’s the bottom line: it is now well established in both political parties that the credit approach is better than all others. For example, prior to becoming President Obama’s economic adviser, Jason Furman endorsed a health reform that looked very much like the John McCain proposal. So in thinking about how to reform ObamaCare (or replace it) we all should be thinking about how to extend tax credits to everyone.

All of the approaches above are primarily focused on how to subsidize third-party insurance. But presumably, we don’t want third-parties (insurers, employers and government) to pay every medical bill. Significant cost-sharing means that individuals must self-insure for their portion of the costs and one way to formally do that is through a Health Savings Account (HSA). How does that fit into the tax credit scheme?

Mark Pauly and I answered this question almost 20 years ago.

Consider again how the tax credit works. Taxpayers get a dollar for dollar subsidy for a certain amount of health insurance. Presumably this is the core insurance that we want everyone to have. The current system subsidizes the last dollar just as much as the first dollar. The tax credit only subsidizes the first dollars. Marginal purchases are all made with unsubsidized, after-tax dollars.

So in order to put third-party insurance and individual self-insurance on a level playing field, we need deposits to HSA accounts to also be made with after-tax dollars. That means that the appropriate account must be a Roth-type account, with after-tax deposits and tax-free withdrawals.

A Roth HSA could replace the plethora of existing accounts: Regular HSAs, Medical Savings Accounts (MSAs), Health Reimbursement Arrangements (HRAs) and Flexible Spending Accounts (FSAs). (See my survey article in Health Affairs.) It should be completely flexible — wrapping around any third-party insurance plan and permitting maximum experimentation and innovation to find new and better ways of managing health care costs, especially the cost of chronic illness.

A model to follow is the Cash and Counseling program in Medicaid, where homebound disabled patients manage their own budgets. (See this international survey of similar accounts.)

From their inception HSAs were criticized by many Democrats as being a sop for the wealthy and the healthy. Yet Jay Rockefeller was one of a number of Democrats who greatly admired the Cash and Counseling program. Given this history, perhaps we should engage in some relabeling.

To get bipartisan harmony, we might consider calling the Roth HSA accounts “Rockefeller Accounts.”

Comments (21)

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  1. Thomas says:

    “The Obama campaign spent millions of dollars attacking the McCain health plan.”

    It is funny how McCain’s health reform proposal was blasted by Democrats in 208, when his is more progressive and was similar to Obama’s economic advisor’s proposal. Its all about which side it is coming from.

  2. Buddy says:

    “No wonder our health care system has so much waste in it.”

    You can say that again. Great post John.

  3. Matthew says:

    “With a fixed sum tax credit those incentives change remarkably.”

    This really is the best way to change Obamacare. No more perverse incentives to appease to how much a consumer will pay in taxes.

  4. James C says:

    If the democrats labeled the HSAs as “sop for the wealthy and the healthy,” calling them Rockefeller accounts can be ironic considering that the Rockefellers were (or are) one of the richest families in the nation. That name won’t get more supporters for the HSA; in fact it can create more detractors. Unless you used it as sarcasm and I missed the point entirely, if that is the case disregard this comment.

  5. Lance says:

    “If they purchase more insurance their taxes will go down and if they purchase less health insurance their taxes will go up.”
    “With a fixed sum tax credit, buyers are not encouraged to over-insure or under-insure.”
    That is the right logic.

  6. Franklin T says:

    We need to incentivize having insurance. If everyone were covered by some sort of insurance, all of us would be benefited. People react much better to positive incentives, such as tax credits, than how they react to negative incentives, penalties for not having insurance under Obamacare. I believe that if the goal is universal healthcare, the government should give everyone tax credit proportional to their expenditures on healthcare. More people would enroll if they knew that they would receive money for being covered with insurance. Penalties will not force people to buy insurance, especially when for some it is cheaper to pay the fine than to actually get coverage.

  7. Andrew A says:

    The elections of 2008 were not focused on arguments. The campaign was geared towards highlighting Obama’s strengths rather than on his ideas. There was never an actual debate on healthcare, and Obama won because he was a better salesman, he convinced the American people that he had the correct reform to the health care system. It is sad when one looks back and realizes the mistakes that were done in the past; so many issues that might have been prevented. If there had been a single formal debate on the healthcare reform, probably we would have the right reform being implemented, not this mess called Obamacare.

  8. Ralph E says:

    The proposed tax credit can be summarized as following: everyone gets a credit for purchasing insurance. The average American would receive enough money to get an average coverage, something similar to what they had. Those patients who are healthier than the average American would buy plans that cover less than the average insurance plan. They would keep the tax credit and spend it somewhere else. Premium plans, those with broad coverage, would be purchased by patients who are relatively sicker than the average. They would use their personal income to make up for the difference. At the end this makes lots of sense, it is logic and it doesn’t impact the nation’s economy. Americans would have the plan that they feel comfortable with, without government’s involvement.

    • Jenny says:

      Other than the fact that with the current deficit, the government doesn’t have the luxury to start giving away taxes. The government needs to collect every single penny from taxpayers if we want to reduce the deficit sometime in the future.

      • Andrew says:

        Reducing our $17 trillion debt can’t be reduced anytime in the future, or ever. The government is on a spending spree.

  9. Betty M says:

    It sounds so simple that I don’t believe it is possible. Government overcomplicates everything, and they are not very good at working with complicated matters. We shouldn’t expect a reasonable adjustment to Obamacare primarily because the government seems to not use reason when they discuss these matters.

  10. Vicki says:

    Good song pairing.

  11. DoctorSH says:

    Don’t govt subsidies just end up increasing spending and costs?
    Do you really honk HSA’s along with govt subsidies will lower the “cost curve”?
    Third party interference in the marketplace is the major cause of hc inflation. There is no competition on cost or quality, only how many procedures can I do.
    None of these suggestions will work until a true crony-less free market based on quality and costs all transparent to the real consumer, the individual patient is developed.

    • Wanda J. Jones says:

      One reason that clear prices based on cost are not revealed is that government patients are subsidized by charting private patients more. And the government does not want us to see how much that is, as it keeps bragging on how much more efficient government medicine is than private.

      Wanda Jones
      San Francisco

      • DoctorSH says:


        I know that, but why can’t we get out this message?
        Why do we remain stuck behind the govt message/propaganda?

  12. Barry Carol says:

    The problem with this idea is that the cost of a given health insurance plan varies wildly both from one region to another and even from one county to another with a state. Exchange policies are priced on a county by county basis. So are Medicare Advantage plans for that matter. By contrast, the standard beneficiary premium for Medicare Part B coverage is $104.90 per month nationwide even though the cost to CMS also varies materially on both a regional and county by county basis.

    If it were up to me, I would get rid of the tax preference for employer provided health insurance and health savings accounts as part of a revenue neutral tax reform effort. Many lower, middle and even upper middle income people need a subsidy to afford adequate health insurance. I think a better approach would be to cap the premium cost for the 2nd cheapest Silver level plan in the market to some reasonable percentage of income, say 10% with a somewhat lower sliding scale cap for those with incomes from just above the Medicaid eligibility threshold to 250% of the federal poverty level (FPL) income. I would not cap potential eligibility for subsidies at any specific income level. So, if family coverage in an expensive county costs $20,000 per year for the 2nd cheapest silver plan, anyone with an income below $200K would be eligible for a subsidy to buy that plan in that county. It’s called a circuit breaker provision.

  13. Bill Ceverha says:


    As I mentioned to you on the plane to Washington a couple of weeks ago, I really appreciate your frequent columns and pass them along to friends.

    I also wanted to call your attention to a grossly-overlooked question that no one seems to be asking…even from folks like Rush Limbaugh or the Fox News crew…

    If there really are “millions” of people who have signed up for ObamaCare, why have we not seen ONE example of a successful signup who has gotten insured (not those in Medicaid) and is paying less for health care insurance? Wouldn’t you think that if those people existed they would be paraded front and center by the current administration? I know that the HIPPA laws don’t allow talking about individual health problems or treatments, but there is nothing to prohibit identifying people with their health insurance. Maybe you should pose that question!

  14. A minor point, but I expect the formula is
    S = P – hY

  15. Rich Osness says:

    To elaborate on Doctor SH’s line, could the most important question be “Should the Government subsidies health care?” Any government subsidies or regulations will increase costs, reduce quality AND slow innovation. An economics student should learn that in their first year of study. Unless, of course, their education is government susidized.

    Wanda, you are probably correct about private insurance subsidizing government programs. But, private insurance has really made things difficult for those of us who would rather pay cash. It is much more efficient than any form of insurance or government regulated/restricted savings account. I am not against insurance, just regulated or subsidized insurance.

    Rather than cutting the red tape lengthwise by trying to reform screwed up programs (Medicare anyone) and making the situation worse, just start eliminating government interference of any kind whenever it can be done. Don’t try to reform a morally and logically flawed law, just eliminate it.