ECONOMIC ANALYSIS: How tax reform could fix ailing health care system

August 6, 2007

Will a new president and the next Congress finally take meaningful action to address the financial storm looming for health care? Perhaps. In the meantime, the pressures created by rising health care costs have been too strong for everyone else to wait. Businesses have been adapting to rising premiums for employer-provided coverage in predictable ways. And beginning with Massachusetts, states are responding to rising Medicaid costs by crafting solutions of their own.

But much of the solution, whatever shape that takes, must come from Washington. Not only does federal spending on programs like Medicare, and Medicaid jointly account for $685 billion of the roughly $2 trillion we spend on health care, but it is the fastestgrowing piece of the pie. Even more important, the influence of federal laws and regulations extends far beyond the dollars directly spent.

My last column showed how the tax treatment of employer-funded health care premiums encourages firms and workers to craft insurance plans that pay for as many things as possible, since spending paid for by the plan escapes taxation and is effectively cheaper than out-of-pocket spending. That, in turn, increases the disconnect between prices paid and services rendered that helps fuel the increases in prices and utilization that is at the heart of spending growth.

So how could we get this problem fixed?

Ending the tax-favored treatment of premiums paid by employers is one obvious answer, but no one is suggesting that. We're too used to it, and legislating what would be a significant tax increase on more than 100 million voters would be political suicide.

On the other hand, we could extend the tax-favored treatment of employer-paid premiums to health care spending from any source-out-of-pocket or otherwise. That at least levels the playing field.

But expanding tax benefits for health care spending isn't really in the cards, either. For one thing, it would cost the Treasury much more than the roughly $133 billion already lost due to the current tax policy.

The best idea, put forth by Katherine Baicker of the President's Council of Economic Advisors, essentially replaces the tax deduction for employer-paid premiums with a fixed-dollar exemption. Like any tax matter, things get a little complicated, but in its essence it goes like this:

Does your employer provide health insurance? If the answer is yes, you get to claim a deduction of, say, $5,000 on your income tax. But there's a catch. The dollars your employer pays for premiums on your behalf now count as taxable income.

If those payments add up to $5,000 over the year, things are unchanged. But if your employer offers-and you sign up for-a minimal plan that pays only for catastrophic coverage, your tax bill may be lower. Or if you opt for a lavish plan that pays for eyeglasses and cosmetic surgery, you may pay a higher tax bill. In doing so, the tax system steps completely aside on the question of how your health care spending is paid for.

That brings the decisions on what you buy and how much you pay closer to your own pocketbook. And does anyone think spending can be controlled any other way?



Barkey is a research economist at Ball State University.
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