VOL. 20, NO. 2
SUMMER 2007
BENEFITS LAW
JOURNAL
Real Health Care Reform Starts
with the Tax Deduction
T
he goal of health care reform is a cost-effective system in which
everyone can get the medical care they need. Many things need fixing, including an outdated approach to information and record management; a medical malpractice environment that induces overly defensive
medicine; an underdeveloped market for nongroup insurance coverage;
a Medicaid/welfare system focused on emergency care; the high cost
of dying; and a payment bureaucracy that purportedly controls costs
through a labyrinth of billing codes but creates an incentive for providers to perform added tests and procedures rather than promoting good
health. Yet, serious as these problems are, reform should begin with
the Tax Code.
Think about it: Health care is the only basic necessity that can
be purchased with pre-tax dollars. Employer-paid health insurance
is income, and FICA tax-free—ditto for employees’ share of premiums—while flexible spending accounts also allow employees to pay
unreimbursed costs with pre-tax dollars. Employer-provided retiree
health coverage similarly avoids the tax man. In contrast, individuals who must purchase coverage on their own or who pay for their
medical care out-of-pocket must use after-tax dollars to foot the bills.
(Special rules apply to the self employed and HSAs.) This approach
not only is inherently unfair, it also serves as an incentive for people
to buy too much insurance coverage and to think of health care as
an almost no-cost entitlement.
The federal tax subsidy for employer-provided health care is over
$208 billion a year. With graduated tax rates, this subsidy is tilted
towards the high earners who can most easily afford to buy their own
coverage. A top earner living in a high-tax state gets the government
to pay for roughly half of his or her health care, while the income tax
savings to someone on the bottom of the pay scale with employerprovided health coverage is much lower. Lower-income employees
From the Editor
do benefit more heavily from the FICA tax savings (because FICA
is a flat tax that only applies to earnings up to the wage base). But
this savings is largely illusory since, assuming no changes to Social
Security, these employees will see a roughly equivalent reduction in
the value of their future Social Security benefits.
Besides favoring the highly paid, the tax rules also subsidize workers who receive health care through their employers. This encourages employers to offer health benefits, but penalizes workers whose
employers do not offer health care, as well as the unemployed and
those who prefer to purchase coverage outside of their company
plan. Even worse, the subsidy encourages employees to buy extra
coverage: It is actually cheaper for an employee in the 40 percent federal
and state bracket to pay $100 in additional premiums for a more generous plan that will save $70 in out-of-pocket expenses. Just about any
health care economist will tell you that the Code’s promotion of such
over-insurance leads to higher costs for all of us.
Perhaps worse than the basic inequity of favoring high-wage earners over lower earners and favoring employer-provided group coverage over individual insurance is that the Code hides the actual cost
of insurance from employees. Decades ago, when many employers
offered no-cost health benefits, workers did not place much value in
the coverage—perhaps somewhere between free office coffee and an
extra paid holiday. Now that virtually every employer health plan is
contributory, employees tend to view the cost of health benefits as
their share of the premiums, not the total employer/employee cost.
Not appreciating the real cost of their health benefits makes workers
much more resistant to any changes to reduce costs. The national
firestorm that arose over attempts to cut unnecessary care through
managed care programs is Exhibit A for the disconnect between
employees and the actual cost of health care.
So, what to do? The obvious and most simple answer is to treat the
entire value of employer-provided health care as W-2 income, while
eliminating FSAs and requiring that employees pay their share of
premiums with after-tax dollars. Unfortunately, while this prescription
would eliminate the misdirected incentives built into the Tax Code,
it is also unworkable. Consider the prospect of a worker earning
$30,000 suddenly having to pay taxes on an extra $10,000 in income
for employer-paid family coverage. Since the worker certainly could
not afford the added income and FICA taxes, he or she would probably have to decline the free coverage.
The Bush Administration and other officials favor an alternative
approach to address the problems with the Tax Code without clobbering the lower-paid and middle class. They seek to use the Code
to subsidize the purchase of insurance, without the bias towards
employer-sponsored coverage and the incentive to over insure. As
BENEFITS LAW JOURNAL
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VOL. 20, NO. 2, SUMMER 2007
From the Editor
proposed, the cost of employer-paid coverage would be taxable for
income and FICA purposes and Section 125 FSAs and pre-tax premium payments would be eliminated. Additionally, anyone with a
minimum level of health insurance would be entitled to an above-theline standard tax deduction of $15,000 for family coverage and $7,000
for single coverage, regardless of the actual cost of their insurance.
While this approach might solve the problem of misguided tax
incentives, it misses the mark. The new standard tax deduction is
regressive because it would provide the largest tax subsidy for those
in the highest brackets. This defect would actually be easy to fix by
simply turning the deduction into a tax credit of equivalent value.
That would level the playing field, since every taxpayer with health
insurance would receive the same government subsidy. (Both the tax
deduction or credit approach would increase employer costs since
the value of health premiums would be taxed for FICA purposes.
Employers also may need a credit to stay whole.)
Some wonks criticize any attempt to remove the Tax Code’s tilt
towards employer-provided coverage, fearing that many employers
would drop their health benefits and force employees to purchase individual coverage on the open market, which can be very expensive for
those with health problems or who are just older. There also is a risk
that the altered tax incentives would encourage younger and healthier
employees to opt-out of their employer plans and purchase cheaper
individual health insurance, making employers’ claims experience less
favorable and driving up costs. These are legitimate concerns. But these
problems with the nongroup health insurance market will not be exacerbated by making the tax deduction rules fair and market neutral. If
anything, the Tax Code’s preferential treatment of group insurance has
retarded the development of the market for individual coverage.
Amending the Tax Code will not fix health care. But, taking taxes
out of the equation, while still providing a uniform subsidy for purchasing health insurance, is the critical first step on the way to genuine
health care reform.
David E. Morse
Partner
K&L Gates LLP
New York, NY
Reprinted from Benefits Law Journal Summer 2007, Volume 20,
Number 2, pages 2-4, with permission from Aspen Publishers, Inc.,
Wolters Kluwer Law & Business, New York, NY, 1-800-638-8437,
www.aspenpublishers.com