WILL TAX-BASED HEALTH INSURANCE REFORMS HELP THE SELF-EMPLOYED STAY IN BUSINESS?

I. INTRODUCTION The self-employed face a tax-induced disadvantage relative to wage and salary workers when it comes to the payment of health insurance premiums. Wage and salary workers often pay their premiums out of pre-tax dollars for both income and payroll taxes but the self-employed are not able to deduct premium costs when calculating payroll taxes. This study examines whether expected claims of the health insurance deduction affect household self-employment decisions and serves as a source of empirical evidence for the ongoing policy debate over health reforms. The analysis expands the existing literature on the behavioral effects of taxation by focusing on a change in tax base, namely the deductibility of health insurance premiums, rather than tax rates. Using a panel of tax return data, this paper investigates whether the 25% self-employment health insurance deduction implemented under TRA86 had an effect on the probability of exit from self-employment. Admittedly, the 25% deduction represented a modest savings for a self-employed filer as would recent proposals for an exemption from Self-Employment Contributions Act (SECA) taxes. For example, among those claiming the deduction in 1988, the average value was $431. For a household in the 28% tax bracket, this represents a tax savings of $121 or 7% of the premium total. (1) In comparison, full deductibility in calculating SECA taxes, as proposed in recent bills in the House and Senate, would represent about a $250 tax savings. (2) The self-employed are an economically important group as they are most often associated with entrepreneurship. And entrepreneurs are thought to drive much of the growth and innovation in the economy. Permitting deductions of health insurance premiums in calculating the payroll tax would lower the after-tax price of health insurance premiums, increasing self-employment income and potentially reducing the variance in out-of-pocket health expenditures. The increase in income makes self-employment more attractive relative to the wage and salary sector. The reduction in health-related risks is also important from a policy perspective because although the self-employed are often assumed to be less risk averse than wage and salary workers, there is little empirical evidence on this issue and high-ability households, those most likely to generate innovation and economic growth, might have relatively lower risk tolerances. This work contributes to a growing literature on the effects of tax policy on labor markets. Most previous analyses of the effects of tax policy have focused exclusively on tax rates or entry into self-employment. This paper contributes to the literature by moving beyond rates and assessing the impacts on the currently self-employed. Results of the analysis also provide general insight into whether aspects of the tax code outside of tax rates affect employment sector decisions. The results also offer specific guidance in terms of whether equalizing the tax treatment of health insurance premiums would enhance the survival of sole proprietorships. Prior studies of the labor market effects of health insurance have examined the effects of portability or availability of health coverage but few have specifically addressed the effects of the tax treatment of premiums. The remainder of this document is organized as follows. Section II provides a brief history of the relative tax treatment of health insurance premiums paid by the self-employed. Related literature is summarized in Section III, and Section IV contains a description of the data and empirical methodology. Results are presented in Section V, and Section VI concludes with policy implications, limitations, and directions for future work. II. TAX POLICY AND INCENTIVE EFFECTS Health insurance premiums paid by employers on behalf of employees have historically received different tax treatment than premiums paid by the self-employed for themselves and their dependants. …