Taxing Health Insurance Benefits

After spending hundreds of millions of dollars in the last campaign election accusing John McCain of wanting to "tax the health insurance benefits" of ordinary Americans, President Obama now says he is open to the very same idea and it seems likely that the Congressional Democrats will themselves opt to tax health insurance benefits, as part of overall health reform.

Is this a complete flip flop? Yes. And other than Kimberley Strassel's Wall Street Journal editorial last Friday, the media is giving the President a free pass. But can the Democrats claim that Republicans have endorsed the same idea? If they are intellectually honest, I think not.

What McCain proposed — and what health economists have been advocating for years is different. The idea, which is also the center-piece of a Republican plan by Senators Tom Coburn (OK) and Richard Burr (NC) and Representatives Paul Ryan (WI) and Devin Nunes (CA), was proposed more than a decade ago in an article by Mark Pauly and me. It would replace a current tax subsidy with a different and better tax regime — one that would have made about 80 to 90% of taxpayers better off. In fact, to ease the transition, we should probably give people a choice of tax regimes for several years.

By contrast, Obama and the Democrats in Congress are going to tax some people's health insurance for the express purpose of collecting funds to subsidize insurance for others. Under this approach, half the population is going to be made worse off so that the other half can be made better off.

The case for a change of tax regimes is very strong. Consider these alternatives for family insurance. The first case describes the current system of excluding health insurance benefits from income and payroll taxes:

Case I:

Employer paid premium

$15,000
 

Tax bracket (including
payroll taxes)

40%

Tax subsidy

$6,000

Now consider treating health insurance just like taxable wages, but giving people a tax break on their personal tax return:

Case II:

Employer paid premium:

$15,000
 

Tax on the benefit

$6,000

Lump sum tax credit

$6,000

On the surface, the outcome appears to be the same. The family has the same amount of health insurance and the same after-tax income in both cases. But on closer inspection, Case II is much better.

In Case I, the only way the family can get a $6,000 tax subsidy is by spending $15,000 on health insurance (technically, the employer pays it rather than paying taxable wages). If, for example, the employer/employee spent only $10,000 on health insurance, the tax subsidy would be only $4,000.

In Case II, by contrast, the tax subsidy is concentrated on the core insurance that we want everyone to have and all extra insurance is paid with after-tax dollars. The first $6,000 of insurance gets a dollar-for-dollar tax credit. After that, every dollar spent on insurance is a dollar that could have been spent on other goods and services. Suppose again that the employer/employee spent only $10,000. In this case, the tax subsidy remains the same and the family will have $5,000 to spend in other ways.

The fixed sum tax credit, therefore, is far more valuable than the current tax exclusion system. It will allow people to make more economical choices and keep every dollar they save.

Note: Good incentives may also be created by the Congressional health plan. But don't count on it. Congress's goal is not to create good incentives. (To the contrary, the bill is likely to be replete with perverse incentives of all sorts.) The goal is to collect money from some to pay for the health insurance of others. They are likely to pursue that goal in ways that make economic incentives worse, not better.

Comments (26)

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  1. Bruce says:

    The solution to the flip flopping problem is easy. Take all the TV ads Obama used to attack McCain and use them against Obama. All you need to do is reverse the names.

  2. Steven Watkins says:

    Succinctly stated: “Obama Lied”

  3. Bret says:

    Agree with Stephen.

  4. Mark Kellen says:

    A tax credit would be a step in the correct direction. Of course, we need to continue with deductions for Health Savings accounts to improve the average persons control over their health and medical care dollars.

    http://www.aapsonline.org

  5. Jim Kneser says:

    The tragedy of all this is that McCain did not understand his own proposal well enough to skillfully point out the differences between his actual plan and the perversion of it as described by Obama. Obama will now attempt to gain Republican support for his proposal by claiming that he is conceding and accepting the plan Republicans proposed in the last election as a bipartisan compromise. Any Republicans objecting to the Obama (true) tax increase will be accused of partisan flip-flopping. The guy is slick.

  6. Uwe E. Reinhardt says:

    What an angry young man you are, John.

    Presidents do change their minds. Ronald Reagan swore he’d never trade arms for hostages, but did just that when, through Israel, he sent US made TOW missiles to Iran to free our hostages (along with a Bible and a cake). George W Bush said he would not do nation building a la Kosovo and then did just that in Iraq.

    So now Barrack Obama is listening to his economists after blasting John McCain for taxing employer paid HI premiums, and you stamp your li’l bootie in frustration?

    Relax, my friend. There will be more flip flops. There always are.

  7. Ftimmins says:

    The reason the dems cannot allow the Coburn approach is that it does not give the government the latitude to dictate the minimum and maximum level of benefits. They are not interested in efficiency of the system, only to be able to control it for their purposes. Just about any argument from the liberals can be backed down to that one simple concept. No matter how appropriate or feasible any opposing solution may be, it will not be accepted by the dems unless they have top to bottom control (including the ability to fix all prices).

  8. P. J. Denker says:

    John,
    The NCPA and its readers will be better served if you keep politics out of your comments and simply provide the analysis. Taking swipes at Congress and the Administration should be left to the evening talk shows.

  9. DoctorSH says:

    Ftimmins said it perfectly above.

    The Dems want control.

    The repubs and the fiscal conservatives want a fair system that puts control of the dollar in individuals hands.

    It is really that simple !!

  10. Juan O. says:

    It is all about federal revenue generation.

    Few policymakers in Washington are talking about improving health care quality or fundamentally decreasing costs. But almost everyone is talking about ways to raise the $1,500 billion needed to pay for health reform.

  11. Clark Havighurst says:

    Well said, John.

    You might have mentioned that the tax credit could cover contributions to health savings accounts, allowing coverage to be both purely catastrophic and selective in areas where benefits may be modest in comparison to costs, making it even less a driver of uneconomic spending. It would be reasonable, however, for the administration to tax earnings on HSAs like other income, so that HSAs will be used in fact for health needs rather than simply as a tax shelter for the affluent.

    Ironically (especially in light of the Strassel column about organized labor’s role), the tax subsidy almost certainly explains why the US stands alone as the only developed country without a national health plan. In other countries, trade unions led the political fight for government health care. Not so here, because labor leaders found long ago that bargaining with employers for generous health benefits – paid for (in fact, but mostly unknowingly) by the rank and file themselves – served their own interests better than strongly lobbying for national health insurance. And workers with good coverage, like Harry and Louise, saw little reason to expand the role of government.

    Working Americans are now paying the price for what has come to be unaffordable health care. The tax change you suggest is probably the best way to make them see that it’s better to be compensated in cash than by an entitlement to marginally beneficial (or useless) health services. Although Democrats are not generally drawn to market-based approaches, they may finally recognize that universal health coverage will not be affordable unless consumers face the full costs of expensive coverage. Indeed, Obama’s people might eventually see that letting people make economizing choices about their health care will increase their purchasing power in other sectors, which in these times badly need a stimulus that the health sector decidedly does not.

  12. Bart says:

    I for one am happy to hear Obama admit that he was wrong for defending the tax exclusion during his campaign. Unfortunately I haven’t seen a specific proposal to replace it with which I am completely comfortable. From either party.

    But I do agree that this should be the place to start, and a prerequisite to more radical approaches to health care reform.

  13. Linda Gorman says:

    Please, please, please! When the government lets you keep your own money by not taxing something it is not subsidizing you! At least as its role has been traditionally understood in the United States, the government has no a priori right to your earnings. Therefore, letting you keep what you have earned is not a subsidy. Taxing someone else and giving you the money–that is a subsidy.

    One can discuss whether it is a good thing to tax this or that more heavily and so screw up incentives, but that is not the same as saying you are getting a subsidy simply because government does not take 100% of your income.

    Words matter. Because the government subsidized the financial industry, the administration feels that it has every right to start setting pay levels. It therefore follows that if one incorrectly allows that it subsidizes private insurance by not taxing it, there is no particular reason why it shouldn’t control levels of health care, too.

  14. Jimmy jackson says:

    Very good informative post on health insurance. health insurance is very important. To know more on this topic, refer http://www.zippy-health.com/coverage-from-health-insurance-only-becomes-rockier-with-time/

  15. Ron Greiner says:

    Clark Havighurst said…

    “It would be reasonable, however, for the administration to tax earnings on HSAs like other income, so that HSAs will be used in fact for health needs rather than simply as a tax shelter for the affluent.”

    Clark, The HSA is the only account with tax free deposits, growth and withdrawals, Amen. Total tax freedom. You want to distroy tax freedom to insure that HSA balances will be used for qualified medical expenses? The truth is, HSA funds are already taxed if they are not used for qualified medical expenses.

    I just can’t believe you would come to the “Father” of Health Savings Accounts (HSA) blog and blurt out that HSA growth should be taxed and not give at least one reason. It’s just too pathetic.

    Yes we should tax all short term medical insurance including employer-based insurance. Any insurance that can terminate the insurance of their cancer patients should be taxed. We need to tax the health insurance at FOX News. I know a FOX News employee who had a 19-year-old son dying of cancer who repeatedly was sent health insurance termination letters. She said her husband was taking the son’s death pretty hard.

    I bet Tony Snow wasn’t hit with employer-based insurance termination letters with his losing battle with cancer. Tony Snow is the exception and not the rule at FOX News.

    If FOX News really wanted to report the truth about the health care crisis in America they could start with their own employees.

  16. mike oliphant says:

    Look…guys this is crazy. I sit on the board with Utah association of Health underwriters and http://www.BenefitsManager.net as well as http://www.HealthInsuranceSource.net for health insurance reform. Several interesting changes took place with H.B. 188 passage earlier this year that seems all too familiar on the federal level. The spirit of the bill allows private market place remedies. It essentially guarantees insurance providers a “no loss” or “no gain” over competing carriers in the insurance exchange portal which is http://www.UtahInsuranceExchange.info. On the surface it seems not to be attractive to participating carriers (voluntary at this point). But you have to understand the carriers’ goal is to cover their administration fees. That can be accomplished now. The other half of the equation is providers and their billing practices that need to be reformed. That is on the agenda. Keep an eye on Utah because the national health care debate seems much the same ground we have already covered.
    In http://www.UtahInsuranceExchange.info which is the beginning of a state sponsored program addresses issues on a local state level that the federal level might look at. Coming from an underwriting background I know where the dime falls. I am of the opinion that large waste occurs from providers billing for procedures that developed “no outcome”. Insurance carriers are not the only bad guys on the block. In most of our purchasing decisions….don’t we pay ONLY when we know that we will get a desired outcome? Why is it if you ask the doctor how much this test or procedure is he doesn’t know? Shouldn’t providers be held to a transparent cost standard?
    You must be in the health care business from some touch point to make statements of fact in face of historical proposed changes. When you are in the system from any touch point (insurance, provider, hospital, Medicare or patient) you get it because of real time experience.
    I often quote the Switzerland health care system as an example of tough questions that we will have to face at some point down the time line. Did you know that premature babies there are not resuscitate upon birth if they cannot draw breath? Did you also know that is the same with senior care with system failure? They don’t extend life of a senior with multiple failures like intubation as example. Anyone in the business of paying claims knows that single most expensive bill in NICU for newborns and seniors in acute intensive care / hospital.
    These decisions were made based upon cost vs. quality outcome. Are we as a nation prepared to make that type of decision or definition of when to incubate a newborn or a senior? To define the conditions? With a litigious society I think not. This is why we need tort reform. Without tort reform medical provider costs will never drop. Liability costs with medical providers are nearly half of operating expenses. With health insurance carriers it translates to about 10% of every premium dollar collected.
    I don’t think we are hearing about tort reform because most of the house and senate are lawyers. In the healthcare system there is no total innocence. Insurance executives with bonuses, doctors overbilling, hospitals overbilling because the street gang thug got dropped at their door with no insurance.

  17. Bart says:

    …on the other hand, employer-based insurance doesn’t have the problem of post-claim underwriting and policy rescission. At least in California, HIPAA coverage is available after COBRA runs out. What happens in other states is presumably up to the citizens of those states.

    Not that I’m happy with the status quo. I just hate to see a discussion about federal health care reform muddied by conflating too many different issues.

  18. Ron Greiner says:

    Taxing employer-based health insurance is the issue Bart.

    Bart, I have a small company in California that wants to switch to individual insurance but the owner’s son is uninsurable because of drug use. He is going to be terminated in 2 months because of his age.

    What number do I call to find this HIPPA coverage for him? Are you talking about the CA High Risk Pool?

  19. [...] hundreds of millions of dollars attacking John McCain for proposing to tax insurance benefits. Goodman explains the differences in proposed changes to the tax treatment of health [...]

  20. Bart says:

    > What number do I call to find this HIPPA coverage for him?

    Here is Kaiser’s page. They also offer a “conversion plan” that’s almost identical.
    https://kaiser.healthinsurance-asp.com/expressweb/user/hIPAANorthern.jsp

    > Are you talking about the CA High Risk Pool?

    I don’t think so. The plans above are offered through Kaiser, and I know Anthem offers something similar (but even more expensive). They are not accessible through a waiting list, so I suspect not.

  21. Marti Settle says:

    John:

    Taxing health insurance benefits? What does that mean? Last year I had breast cancer. My insurance paid almost $300,000 in medical costs including surgery, radiation, chemotherapy MRI’s, CAT scans bone scans x-rays medications and one 8 day hospital stay for an infection. Does this mean that I would be liable for paying taxes on the $300,000 on the benefits paid by my insurance? I would have had to forgo treatment and die because I would not be able to pay taxes on the benefits paid. Tell me this is not true.

  22. John Goodman says:

    Reply to Marti:

    The tax would be on the value of health insurance, not health expenses. So if the average family plan funded by an employer cost $12,000 each employee with family coverage would be taxed on a $12,000 benefit — irrespective of how much the employee and the family actually spent on health care.

  23. Mike Davis says:

    Taxing the employee benefits of a few in order to pay for insurance for others ignores the fundamental inequity between individuals who pay for their own insurance with after-tax dollars (no matter their income level) and those who receive insurance tax-free as an employee benefit. How does our government justify a tax penalty on Jill, who buys her own insurance, and tax favor Jack, who receives his insurance passively through his employer? Equity requires taxing the value of all compensation received by Jack and Jill, whether as salary or benefits. Besides being fair it has the virtue of broadening the tax base, which would allow Obama to keep his pledge of reducing taxes (rates) while maintaining revenue.

    John, this is not a new idea. Why is it not embraced?

  24. Laurence A. Levine, M.D. says:

    John:

    I totally agree with DoctorSH and FTIMMINS. It is all about control of finances and the people.

  25. Spec Bowers says:

    I suspect the big difference between Obama’s proposal and previous proposals is that the Democrats want to get more revenue for the federal government. Past proposals were revenue-neutral.

    A good way to describe the revenue-neutral approach that John describes is “transferring the tax advantage from the business to the individual as part of giving the individual more control over health care decisions.”

    The Obama approach is “eliminating the tax advantage to give more money and more control to the federal government.”

  26. John Goodman says:

    Response to Clark Havighurst:

    The savings account should be a Roth-type HSA. Deposits should be made with after tax dollars and withdrawals for any purpose should be tax free. Growth should be tax free for the same reason that third party insurance is allowed to carry over reserves from period to period without taxation.

    I’m assuming that the tax credit will be completely exhausted by third party premiums. If any of the credit is left over, however, it could be contributed to the Roth account as well.