The Best of the Second Best: Using Tax Breaks to Manipulate Health

Insurance

Mark V. Pauly, Ph.D.

ARIA Meeting

August 7, 2006

Goals of this talk

• To summarize the design of ideal tax incentives for health insurance.

• Having observed that movement to the ideal is not politically feasible next week, what are possible second best arrangements that represent improvements if not perfection?

• How do these alternatives compare on efficiency (where I am an expert) and on political likelihood (where we are all amateurs)?

Ideal Insurance Subsidies

• No subsidy at the margin for additional coverage beyond the level that assures socially approved use and financial protection.

• Translation: Dives (high income, healthy) does not need a subsidy, but Lazarus (low income, high risk) does.

Ideal Subsidies in Detail

• Subsidize the premium of the minimum policy needed to produce ideal use; probably larger for lower incomes and higher risks.

• Make the subsidy fixed dollar; people can buy whatever insurace they prefer as long as it is more at the minimum but with no marginal subsidy.

• Deal with insurance risk change through GR or other devices.

What Current Subsidies Do

• Subsidize high incomes more than low.

• Subsidizes employment based coverage so employers choose rather than individuals.

• Offers an open-ended subsidy to insurance

• HAS/CHP too little, too limited to help much so far.

Where are the distortions?

• 1. Subsidize health insurance rather than out of pocket payment—leads to excess moral hazard.

• 2. Subsidizes health care rather than other goods—leads to too much health and too little wealth.

• 3. Bribes people to let their boss pick their insurance, and take it away if they get too sick to work.

• 4. But it is the American way.

Second Best solution fix some but not all distortions

• Health Savings Accounts-CHP fixes employer choice ( a little) and overinsurance (but crudely); creates bias toward high deductible plans (relative to Rambo HMO) in individual market.

• Cogan, Hubbard, Kessler fix bias toward group insurance by making all spending on care or insurance deductible, but this leaves bias toward medical care.

• Caps on exclusion fix bias toward insurance and health care but not toward employer choice.

Away at the Windmill: Why not first best?

• Best estimate of spending reduction is CHK, about 6%. Phelps estimate suggests eliminating the exclusion entirely would save 10-20% (all based on Rand data). As a % of total spending, these changes are reduced by Medicare and Medicaid.

• CHK “everything deductible” approach still leaves biggest subsidies for those who need them the least; abolishing the subsidy (and then filling in with credits) will be better.

A modest proposal: treat group health like group life

• Exclusion of group life premiums are capped at face amount of $50K.

• This has not destroyed group life but probably has caused it to be lower relative to individually chosen life. Little reduction in risk pooling that we know about.

• No big fuss about the level of the cap.• Easy for employers to offer choice of levels of

coverage.

The analogy

• Set up a cap at the cost of a modest plan.• Encourage employers to offer at least that plan,

but also alternatives.• Increase the cap at a rate that is socially approved.• Convert to refundable credit for lower income

people.• Might allow the exclusion to wither away and the

credit to grow.

Why Politics Is Hard

• I currently exclude more than $10,000 of my income through employer payment, cafeteria plan, and FSA (where I have defeated use it or lose it). Estimate the tax savings to be $4500.

• If I were selfish I would want to keep this.• But if I were rational , I want you to offer me a $4500

closed end tax cut, and then I would be happy to spend more frugally.

• The problem: converting an inequitable but inefficient loophole into an efficient one makes the inequity too obvious to be tolerated. Since I can only keep my ill-gotten gains in an inefficient form, I support inefficiency.

Why Middle Class Cost Containment is Also Hard

• We could get non trivial but not breathtaking one time spending reductions for sure by changing tax treatment.

• Need not have an effect on risk pooling in large firms, and there really is very little pooling in small firms relative to individual insurance with GR.

• But it will not obviously slow the rate of growth much, for very long. Some positive research but nothing definitive.

• We need a change of mind as well as a change of taxes. Face up fearlessly to rationing new technology or to foregoing some other growth in real income.