# Presentation: 130767

## 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

## 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.

## 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.

## 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.

## 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 Affairs* *Web Exclusives*, February 25, 2004.

## Value of tax exclusion and private insurance by income as % of poverty line

| % of Poverty Line | Average Value of Exclusion* | % of Total Exclusion | % with Private Insurance (adults) | % of Total Uninsureds |
| --- | --- | --- | --- | --- |
| >400 | $2,500 | 61 |  91 |  17 |
| 300-400 |  1800 | 16 |  86 |  10 |
| 200-300 |  1300 | 15 |  76 |  19 |
| 100-200 |  500 |  8 |  59 |  29 |
| <100 |  175 |  1 |  26 |  25 |

- * Value of exclusion = additional tax on excluded income.

## 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%.

## 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.

## 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.

## 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.

## 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.

## 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.