Tax Reform and Health Care Costs

On the heels of the Ryan budget comes word that the President will release a long term deficit reduction plan Wednesday, the details of which are unknown. This week, I am going to look back at several aspects of the Fiscal Commission final report that was released in December, 2010 to provide some context for the coming debate.

It is worth recalling that the report was approved 11 to 7, but that it needed 14 (of 18) yes votes to guarantee an up or down vote on the Report in Congress.*  12 of the 18 members of the commission were members of Congress at the time, and it is interesting that 5 of the 6 U.S. Senators on the Commission voted for the report, while 5 of the 6 members of the U.S. House voted against it.  If there is momentum towards any sort of bipartisan health reform deal or long range deficit reduction approach that includes tax reform, Medicare, Medicaid or Social Security, it could be expected to bubble up first in the Senate, where a bipartisan gang of six has been discussing deficit reduction along the lines of the Commission report.

Tax reform is the general term for alterations of the income tax code, and includes changes in marginal tax rates as well as deductions and tax credits. The last major tax overhaul came in 1986. Over time, Congress has enacted many deductions and credits which are together called tax expenditures, and which either reduce a persons taxable income or directly reduce their income tax owed. Tax expenditures serve to advantage some tax payers over others, based on their circumstances (such as having children). Each of these changes were no doubt well intentioned policy changes, but they serve to reduce the amount of tax revenue received by the Treasury just as increases in explicit spending does (Military, Medicare, Agricultural subsidies, etc) and are viewed by some as unfair since many benefit relatively high wage earners. Further, they are not as widely understood as is direct spending to increase the budget deficit. To achieve a balanced budget, the ins (taxes) must match the outs (explicit spending and tax expenditures). There is a trade-off between marginal rates and tax expenditures and different combinations could raise the same amount of revenue, holding all else equal. These seemingly esoteric tweaks of the tax code are very important policy choices.

One of the key tables in the Fiscal Commission Final Report, is Table 6 on p. 29:

This table demonstrates the relationship between the marginal tax rates of the 2010 (and current) tax code** and what a revised tax code with fewer and lower marginal tax rates could be IF different combinations of tax expenditures are removed.  If all expenditures are removed (like the home mortgage deduction, preferential tax treatment of employer paid insurance, child tax credit, deduct money given to your church, etc.) then the lowest rate would be 8% and the highest 26%.  Note, that in each of the 3 scenarios shown, $80 Billion is dedicated to deficit reduction in 2015; the point being that if the increased revenue is spent on new programs, or to finance further tax cuts, there will be no deficit reduction effect. Fewer and/or smaller tax expenditures mean lower marginal rates, and vice versa, all else equal.

The Fiscal Commission identified an illustrative tax reform plan that ended many tax expenditures and capped others. Table 7 on p. 31 of the Fiscal Commission report details the mix of tax expenditures that would remain, and which would result in a lowest marginal rate of 12% and a top one of 28%. I want to highlight what this illustrative plan did to the tax exclusion of employer paid health insurance.  From Table 7 (this is only part of the original table, the full table is at the end of the post):

The Fiscal Commission illustrative proposal would cap the tax exclusion of employer provided health insurance at the 75th percentile of premiums in 2014, and slowly move to end this tax expenditure totally by 2038. If the 75th percentile of premiums was $23,000 in 2014, then if your employer paid $23,000 or less for your health insurance in that year you would incur no tax liability on those premiums. If your employer paid $25,000 in premiums, for example, then $2,000 of this (amount above the cap) would be taxable as income in your marginal tax bracket. In 2038, the full amount paid by an employer on behalf of an employee for health insurance would be taxable income. The excise tax on high cost health insurance that is set to come into force in 2018 via the Affordable Care Act would be reduced to 12% under this proposal. Overall, this proposal would do two things as compared to ACA.

  • Address the tax treatment of employer paid insurance in 2014 instead of waiting until 2018 to do so via the excise tax on high cost insurance; this would increase the cost saving potential of the ACA.
  • Help focus attention on the fact that it is people like me who get employer based insurance who benefit from this tax expenditure.

The tax on high cost health insurance could work to slow health care costs by putting downward pressure on premiums in the same way that capping the tax exclusion could; indeed, there should be some tax on high cost insurance that would have the same impact as capping the tax exclusion at a certain level.  However, I believe that it would be preferable to achieve most or all of this effect via capping the tax exclusion instead of imposing the tax on high cost insurance because it would help to highlight that the subsidy flows to employees receiving the health insurance. The high cost excise tax was sold rhetorically as a tax on insurance companies, while it is actually just a capping of a now unlimited tax benefit that flows to persons obtaining insurance from their employer. This subsidy is not understood by most employees. During the health reform debate I became obsessed with asking coworkers about the amount of tax free income they received via Duke’s employer paid health insurance premiums. Most said none. They were of course wrong, and I work at a school of public policy! Further, I believe that it would be simpler administratively than imposing an excise tax on high cost health insurance. The exact mechanism through which the tax on high cost insurance will be levied and passed onto employers and employees is unclear to me, but the tax would have to be passed on to have the intended effect, which is to incentivize less generous insurance as relatively expensive policies are taxed. Capping the tax exclusion has the same health policy goal.

Reforming the tax treatment of employer paid health insurance is a simple way (that is politically hard) to slow the rate of health care cost inflation. If the country turns to tax reform in the next weeks and months, health policy types shouldn’t tune out, because changing the tax preference of employer provided insurance is likely the most consequential way of improving the cost saving potential of the ACA, or any health reform alternative that I can imagine.

*I am unsure of what ‘an up or down vote in Congress’ would have really meant since the entire plan is not in legislative language.

**note the scheduled rates for 2011 in table 6 did not come to pass as the 2010 rates were extended in Dec. 2010.

About Don Taylor
Associate Professor of Public Policy at Duke University and author of Balancing the Budget is a Progressive Priority. On twitter @donaldhtaylorjr

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