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.