Bad Advice to the GOP on Health Care

I have refrained from commenting on the idea — hoping it would wither on the vine and simply waft away. I had not heard much about it in some time and was not missing it at all. But then there it was. In The Wall Street Journal last Thursday, on the very day of President Obama’s Health Care Summit! Being urged on Republican summiteers by Republican policy wonks, no less.

The idea: allow all out-of-pocket spending on health care to be deductible. Or, put differently, allow people to buy health care directly with untaxed dollars, just as they can now (through an employer) buy health insurance. What’s wrong with that?

If you’re getting insurance at work, your employer’s premium payments are escaping, say, a 25% income tax, a 15.3% payroll (FICA) tax, and a state and local income tax of 6% or more. For a middle-income family, the government’s share of the cost of your health insurance is approaching 50% — which is why so many people obtain too much of it.

Now suppose that we had the same tax treatment for out-of-pocket medical expenses — for deductibles, copayments, and spending on items not covered by your health plan. All of a sudden, government would be paying almost half the cost of those expenses as well. This would have the effect of cutting in half the net cost to you of any medical expense not paid by your insurer. A $1,000 MRI scan would now have an aftertax cost of only $500. A $100 acupuncture session would cost you only $50. A $15,000 in vitro fee would now be $7,500.

You don’t need Econ 101 to figure this one out. If you cut the price of anything in half, people are going to buy more of it — and medical care is no exception. In fact, people would have an incentive to buy medical services until they were worth only 50 cents on the dollar. We would inevitably get more spending, more waste, and more health care inflation. All the problems we now have in health care would become worse — not better.


I Ain’t Missing You

The idea I am discussing was one of three proposed in the Journal by John F. Cogan, Glenn Hubbard and Daniel Kessler (hereafter CH&K), and they have editorialized on it before. They have even written an entire book on this approach to health care. The book is not all bad. But how did otherwise smart people get their policy advice so wrong?

They begin with an observation that is right on the mark. Americans are overinsured. On average, every time we spend $1 on health care, only 12 cents comes out of our own pocket. The rest is paid for by third parties (insurance companies, employers or government). That means our economic incentive is to consume care until it’s worth 12 cents on the dollar to us.

The reason we are overinsured is the aforementioned tax subsidies. When we buy health insurance, it appears to us to be half-priced. If we bought a dollar less of insurance and received it instead as take home pay, we would only receive 50 cents after tax. So at the margin, a dollar spent on health insurance trades against 50 cents spent on everything else. CH&K reason that if out-of-pocket spending by employees were given the same tax advantage as third-party premiums, people would want less insurance and would rely more on out-of-pocket payment. They may be partly right about that. But people don’t really know in advance what medical needs will give rise to spending — whether spending third-party money or their own. It is this uncertainty which gives rise to the desire to have insurance in the first place.

More importantly, the alternative to third-party insurance is not out-of-pocket spending! The alternative to third-party insurance is self-insurance through, say, a Health Savings Account (HSA). What needs to be equalized is the tax treatment of third-party insurance and self-insurance. Moreover, the importance of being able to make unbiased choices (not distorted by the tax system) between third-party insurance and self-insurance was thoroughly explained by yours truly in “Designing Ideal Health Insurance.”

The way to encourage insurance without creating perverse incentives is to subsidize both types of insurance with a lump-sum tax credit, and make the HSA a Roth-type account. This means that the marginal dollars spent on third-party insurance and contributed to the HSA would all be aftertax dollars. This would eliminate the incentive to overinsure in any dimension.

Since withdrawals from the HSA for any reason would be aftertax, the money could be spent on health care or any other good or service without tax penalty. At the time of purchase, health care and any other use of money would trade off against each other on a level tax law playing field.

Mark Pauly and I explained all of this in a Health Affairs article, published more than a decade-and-a-half ago. I believe this is still the ne plus ultra prescription for health care and tax law.

Comments (27)

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  1. Ken says:

    Thanks for clearing this up. I thinks a lot of people are confused about this point.

  2. Tom H. says:

    Good analysis. And way overdue. Thanks.

  3. Joe S. says:

    Making out-of-pocket health expenses deductible is one of the dumbest ideas that I have heard in quite some time. It is a recipe for more wasteful spending on health care. Exactly what we do not need.

  4. John R. Graham says:

    I’m afraid that I don’t see the significant difference between Dr. Goodman’s position and Prof. Cogan et al. Cogan et al propose “expanding” HSAs, which implies that their term “out of pocket spending” includes self-insurance, e.g. saving the pre-tax dollars rather than just one year’s worth of out-of-pocket spending.

    Sure, using pre-tax dollars for health care results in relative over-consumption of health care. I believe Milton Friedman stated that in a perfect world, health care would be taxed the same as all other consumption goods and services.

    However, the current tax prejudice also biases health spending in favor of control by third parties. So, by moving spending to an HSA, you remove at least one of the causes of over-consumption (perhaps better called “mal-consumption).

    Is Dr. Goodman proposing to square the circle by preserving some element of the status quo? For example, if we made everyone pay 7.5% of their after-tax adjusted gross income on medical care before accessing their HSA, that would address the problem somewhat. But I don’t think that’s what Dr. Goodman is suggesting.

    I think where Cogan et al are off-base is exemplifying Healthy San Francisco, which is actually a harmful tax hike on small business, as I have written about elsewhere (

  5. Devon Herrick says:

    Under current tax law, people can deduct the cost of third-party insurance, purchased through a job. But self-insurance mostly requires after-tax dollars.

    If we want to minimize the negative externalities of third-party payment (while allowing people to deduct medical expenses) doesn’t it make more sense to require people use after-tax funds for insurance premiums?

  6. Bob Blandford says:

    Absolutely right, John. I also suggest this and also resolve the pre-existing conditions problem by strongly encouraging cradle-to-grave HSA catastrophic guarenteed renewable catastrophic insurance, using the ideas of Pauly, Douglas, et. al.

  7. John Seater says:

    John remarks near the end that

    “The way to encourage insurance without creating perverse incentives is to subsidize both types of insurance with a lump-sum tax credit,…”

    What I don’t understand is why there is any reason to encourage insurance at all. We don’t usually argue for the government encouraging life insurance, house insurance, car insurance, accident insurance, personal liability insurance, trip insurance, or any other kind of insurance. What is different about health insurance? I agree with John that we need to equalize the tax treatment of third-party insurance and self-insurance, but why not do that by just not giving any tax breaks at all for health insurance? As always, an exception can be made for poor people, who could be paid some lump-sum amount, perhaps conditioned on their income.

  8. Greg Scandlen says:

    Hmmmm. I rarely disagree with you, John, but I have never been fond of your Roth approach to health reform. Yes, you and Pauly proposed this before as a substitute for HSAs, but if HSAs are going to compete with tax-favored employer sponsored comprehensive third party payment, they must be treated the same way under the tax code.

    Now, above you seem to be hinting that employer coverage should also get the Roth treatment. I wouldn’t mind that, but applying Roth to HSAs would have to be contingent on it.

    But I also fail to see how passing the money through an HSA is superior to simply paying for the service out-of-pocket. Perhaps I’m missing something, but I am not persuaded that all health care spending should not be treated the same way in the tax code. If that is too great a subsidy, then by all means lower the tax advantage, but lower it for ALL health spending.

  9. Omar says:

    Dr. Goodman, you make a strong point, and you are right to an extent, but I believe you are mistaken to discount the tax deductible approach.

    Let’s look at all of the conservative health care reform approaches that we have today:

    (1) Tax employer benefits – this was the McCain campaign’s approach which was one of the most boldly free market healthcare plans that has ever been released by a Republican candidate. Its advocated by the Heritage Foundation, and a number of bills on the Hill put out by some Republicans feature this. It moves people into the individual market, yet at the same time it raises taxes – something anathema to conservatives – taking money out of the private sector and into the government coffers, but yet again it may raise some revenue.

    (2) Your HSA-based approach which is also a good idea and is also basically featured in all of the GOP and free market healthcare plans – for instance the CATO Institute endorses them, so does the Ryan-Coburn “Patient’s Choice Act,” so does Jim DeMint’s healthcare reform bill, and so does Rep. Ron Paul’s “Healthcare Freedom Act.” I love your book “Patient Power” and I think we can expand HSAs regardless of what is done to the tax code treatment of healthcare.

    But I think you are really getting to the crux of something with this post and it really does show some major differences within market-based healthcare policy circles. We can all agree to expanding the market and competition through allowing the purchase of healthcare across state lines (although, whether healthcare would then have minimum federal standards is another story), we can all agree that we need to expand the individual market to increase competition, and most conservatives can agree that we are over-using essential healthcare services and so we need a more consumer-based healthcare were rationing can be done by the patient instead of the government or insurance companies (Michael Tanner of CATO has a good brief about this that came out yesterday).

    Your right that a tax deduction is basically a tax subsidy. That’s why McCain wanted to tax employer based plans instead of give a tax deduction. But then there is another approach, and probably the most free market of them all. While Jim DeMint’s bill proposes healthcare vouchers and a new national entitlement (albeit market-based, coupled with a converting of Medicare and Medicaid into a means-based voucher program) that could be used to invest in HSAs or private insurance, Rep. Ron Paul of TX’s “Healthcare Freedom Act” which instead of a tax deduction gives a TAX CREDIT (which is significantly different in that it decreases the net amount of tax owed) to all medical expenses.

    I know, I know, it would severely reduce government revenue, but coupled with the HSA approach it could give people more money to spend on healthcare. I disagree with you that the overconsumption resulting in increased access would happen in necessarily the same way under a tax credit instead of a tax deduction. Instead, a tax credit – especially if we did more radical reforms such as allow an opting out of Medicare – would increase competition, and give people more money to spend on healthcare increasing a consumer-based approach.

  10. Tom H. says:

    If John Graham and Greg Scandlen aren’t seeing this, then you have done a great service by bringing the issue to the surface — so we can at least be aware that we do not all think as one on this point.

    I suspect that the others have not thought through this as thoroughly as you have, John. Maybe you should do another post on this subject.

  11. Virginia says:

    I think this post is indicative of the unnecessary complexity of the American tax code. We should either tax all health care spending the same or not tax it at all.

    Making health care spending tax deductible is not only a huge hit to tax revenue (in a time when the government consistently spends more than it makes), but it is also a huge market distortion. The answer should be clear. Everyone should pay for health care with after-tax dollars.

    Is there something about America where our legislators have a propensity to make things overly complicated? Why create all of these complex tax laws when we can save ourselves the time and headache and just pay for EVERYTHING with after tax dollars.

    Surely humanity would be better off if we stopped calling our accountants every other day to ask for tax advice.

  12. Neil H. says:

    I think you have stirred up a hornet’s nest, John. And i suspect none of these people have read your piece with Pauly (or, if they did, they don’t remember much about it). So I second Tom’s idea. Why don’t you spell it out again?

  13. Frank Timmins says:

    This is all very thought provoking, and to me raises a basic question. Is the holy grail of reform to “reduce healthcare consumption”? Other than the federal revenue reduction impact as a negative, why do we care how much healthcare a person uses? It seems we are primarily talking about “elective” healthcare here. We don’t care how many automobiles a person buys. On the contrary we encourage consumption for just about any other good or service. I suppose another way of looking at it is considering whether we should or should not be viewing healthcare as a global expenditure that needs to be budgeted or limited somehow. Just asking.

    By the way John Seater, the answer to your questions summarized as “why encourage the purchase of health insurance?” is pretty simple IMO. Having a vehicle for shifting the cost of catastrophic healthcare expenditure is is necessary to prevent same from winding up in the public sector. It would seem to be wise from a public policy standpoint to make it advantageous for people to see to this personal obligation.

  14. Tom P says:

    Anyone who is unclear on this should just look at the old-fashioned FSA. Consumers risk the ‘use-it-or-lose-it’ because they know that they are getting their consumption on sale due to a tax subsidy. And therefore, unsurprisingly, they buy more. They have for years.

    If we want the cost of healthcare to be clearer, tax it. All of it. And consumers will make trade-offs as they do in any other sector of the economy.

    Roth-style HSA is elegant, but we’d still be subsidizing future expenditures. The purist would say ‘why bother do that’, although I can see a practical argument to give folks an incentive to save for future medical costs. We aren’t today, and heaven knows Medicare will be in full meltdown before most Americans ever see a nickel out of it.

  15. Paul P. says:

    Tom P is not quite right. The Roth HSA does not subsidize future spending on health. Since withdrawals can be spent for any purpose, the tax law does not favor health over nonhealth. And since deposits are after tax, the Roth account also does not favor future consumption over present consumption.

  16. Grace-Marie Turner says:


    I totally agree with you.

  17. Bart Ingles says:

    John, your blanket statement that “When we buy health insurance, it appears to us to be half-priced” is only true for those few individuals whose employer-sponsored insurance premium is exactly equal to what they would have paid on the individual market. This is by far the exception rather than the norm.

    For individuals in excellent health, the ESI premium could easily be double that of comparable coverage on the individual market. A 50% tax advantage merely compensates for the difference, so that the net cost for ESI is the same as for individual coverage. Here there is no real incentive to overconsume, if individual coverage is the baseline.

    On the other hand, for those with an extensive medical rap sheet, the premium for individual coverage could be several times that for ESI. As an incentive to consume, the tax advantage itself would then be dwarfed by the group insurance cross-subsidy. The real incentive to consume is the discounted price of community-rated group coverage; the tax subsidy is only important in that it makes community rating possible.

    I know that you have written many times about how community rating gives sick people incentive to overconsume. But what you haven’t made clear (to me, at least) is how any other form of risk-adjustment, e.g. individual subsidies or reinsurance, would be any different. It seems to me that any form of cost-relief for people with chronic conditions would result in the same incentive to overconsume relative to risk-rated insurance or no insurance. We’ll need similar measures to mitigate this perverse incentive regardless of how we choose to subsidize sick people.

    As to the tax exclusion itself, there are less ambiguous objections. It’s regressive. The tax incentive, desirable or not, is inconsistent, being merely coincident with the individual’s tax bracket. And at the top bracket, the incentive is undoubtedly excessive. But repealing it seems unlikely. It would be more productive to go for the minimal change that addresses the above objections. Anything more radical needs to be extremely well justified or else deferred.

  18. Bart Ingles says:

    P.S. I agree wholeheartedly with Frank Timmins. I don’t see why we’re worried about reducing health care spending for those willing to pay for it. The main problem with employer-sponsored insurance is not cost; the main problem with ESI is ESI. Or at the least lack of alternatives. The real spending problem is in Medicare and Medicaid.

  19. Kemmeth A. Fisher, M.D. says:

    Mr. Goodman,
    In many instances in health care, financial incentives do not apply. Patients will frequently do what the doctor suggests. The problem is that most physicians have been trained in an overly technological style of medicine. This is because almost all training centers practice a technological expensive style of medicine (see the Dartmouth Atlas of Health Care). Thus to control both demand and supply, I have suggested real time peer review so that only beneficial care is delivered. Much more detail is available on my blog,

  20. Stuart Prescott says:

    As you know, we sell a high percentage HDHP to clients. Strong advocates. However, what’s different about the items we buy with untaxed money through our HSA and the “bad idea” you’re commenting on below? I’m starting to struggle with this a little. We have more dollars to spend, because the gov’t is subsidizing us, potentially increasing utilization, just as you said. No?

  21. John Goodman says:

    Response to everybody, but especially John, Greg and Stuart:

    The goal is to have government subsidize insurance (at least catastrophic insurance) without distorting any decision at the margin. This is done by making every marginal decision aftertax.

    So the choice between an extra HSA deposit versus extra third-party insurance is made with aftertax dollars. On withdrawals from the HSA, the choice between current health care, current other goods, future health care and future other goods is all made on a level (aftertax) playing field.

    The only way to get the incentives right at every margin is with a lump sum tax credit, coupled with a Roth HSA.

    And, again, subsidizing health savings is not the same thing as subsidizing health spending. The former is good policy. The latter is bad policy.

  22. Bart Ingles says:

    “The goal is to have government subsidize insurance (at least catastrophic insurance) without distorting any decision at the margin.”

    Here’s a silly question. Why is it necessary to eliminate every trace of market distortion? And why should this take absolute priority over every other reform?

    It seems to me the problem is more of excess and of inconsistency, and in some cases of the incentives going the wrong way. Wouldn’t it make more sense to limit market distortion and to harness it for some useful purpose? Which makes more sense, harnessing the overflow from a dam to drive a turbine, or shunting it all into a spillway?

    I suppose if one were a religious fanatic it would make sense to eliminate all greed, lust, and gluttony rather than harness those drives to fuel society. Then we wouldn’t have any markets to distort.

  23. John Seater says:

    I understand Frank Timmins’s justification for subsidizing health insurance, and it is reasonble. Nonetheless, I don’t buy it. The question is what you are going to take as given. IF you are going to assume that every uninsured person who suffers a catastrophic medical condition will be treated at public expense, then Frank has a point. I don’t accept that premise. In my opinion, if we already have subsidized the poor, then we have no obligation to care for people who do stupid things. If someone with the means to buy insurance chooses to gamble and not buy it, then I am perfectly willing to let him live with the consequences, including his own death even if said death could be prevented by giving him care he now cannot afford because he freely chose not to buy insurance. If we are not willing to do that, then just what kind of behavior are we willing to hold people accountable for? Anything serious, or just trivial stuff? What are the incentives implied the answer to that question?

  24. Paul H. says:

    John: thanks for the further explanation in your comment.

  25. John R. Graham says:

    Why do we need HSAs or MSAs at all, if purchasing a health-insurance policy triggers a tax credit to the individual, after which the dollars are after-tax whether the patient spends them on health care or not? The 1995 Goodman & Pauly Health Affairs article obviously did not mention “Roth” but noted that the MSA’s earnings could be tax-free, perhaps with a cap (p. 134). Today, we’d call that a “Roth HSA”, I suppose. However, it seems like another unnecessary investing vehicle, with administrative costs. We don’t get a tax credit for a Roth IRA. If the individuals are simply going to get a tax credit for buying health insurance, why not just forget about the HSA or MSA altogether?

  26. John Goodman says:

    Reply to John Graham: For individuals to self-insure, they need to be able to do individually what an insurance company does — allow money to accumulate over several years without tax penalty until a health need arises. That’s why we needed HSAs and MSAs.

    To get the incentives right at the margin, however, the HSA should be a Roth type account — with aftertax deposits and tax-free withdrawals.

  27. G Ruggles says:

    This is so outragous you are saying the government is paying 50% of your healthcare because they are not getting tax revenues? This implies the government is entitled to my earnings which is just wrong they are MY earnings not the governments. It is thie logic in Washington that has us in the mess we are in now. I earned the money it is my money to do with as I please it has never been the governments money and it should never be considered their money.