Chapter 7

Toward a Universal Marketplace for Health Care
David B. Kendall¹

The U.S. health care system needs an alternative to employment-based health insurance. Although such insurance proved reliable for much of the period following World War II, runaway medical inflation has undermined it. During the past decade, the link between jobs and health insurance has been deteriorating.

Both the spread of coverage and the subsequent explosion of costs have been driven by a single government policy: the tax treatment of employment-based health insurance. Employers have a strong incentive to provide health care benefits because, unlike wages, these benefits are not taxed. Because this tax break is unlimited, workers have demanded, and employers have provided, the most costly health insurance.

Employers themselves have taken the first step away from the current system through their efforts to fight medical cost inflation. They no longer offer coverage with an unlimited choice of providers at no cost to workers; instead, they increasingly act as agents for workers and arrange a menu of health plan choices either directly or through a purchasing group. This approach empowers workers to decide for themselves whether they prefer the more expensive fee-for-service plan, a less costly health maintenance organization (HMO), or some other alternative. In effect, employers are transforming the character of the health insurance marketplace from wholesale to retail.

Reforming the tax treatment of health insurance offers the opportunity to buttress the fight against medical inflation, expand coverage to the uninsured, and broaden individual choice. A cap on the tax break would check the cost spiral simply by refusing to subsidize it. A tax credit for individuals would benefit those who lack job-based coverage or do not like the choices offered by their employers. The combination of a tax cap and tax credits would steel the employment-based system by creating a competitive alternative. Employers would have an even more compelling reason to meet the health coverage demands of their employees.

Both extremes of the political spectrum assert that the employment-based system is beyond repair, and would eliminate the tax break for job-based coverage altogether. In its place, liberals would establish a single-payer system, while conservatives would prefer an unregulated marketplace for individual insurance policies.

A "scorched earth" approach that needlessly threatens the existing coverage of millions of Americans is likely to produce the same ideological polarization and gridlock that has frustrated reform of the private marketplace and health care entitlements since 1993. It is important to remember that two-thirds of all workers and their families still get health insurance through a job.

Both the means and the opportunity to break the deadlock over reform are close at hand. A competitive alternative to the employment-based system would expand coverage to the uninsured without creating a vast new entitlement. The debate offers the opportunity to move toward a universal marketplace for health care based on the principle of securing progressive social goals through market means.

  The Need for Change

Federal tax policy regarding health insurance has not been altered significantly since the income tax was enacted in 1913. At first, the income tax did not apply to employee health benefits because they were offered only rarely. Benefits did not become widespread until World War II, when employers began to use them to attract workers whose wages were frozen by wartime price controls.

Like many other government policies that have escaped scrutiny, the tax treatment of health insurance is riddled with contradictions:

• It encourages people to seek coverage when they have a job but offers no help to workers who are laid off.
• It promotes personal responsibility by encouraging workers to rely on insurance rather than charity care, but it also encourages wasteful spending on "Cadillac" coverage because the tax break is unlimited.
• It puts small companies at a competitive disadvantage versus large companies, which can lower their administrative costs-and thus their labor costs-significantly by avoiding the underwriting and marketing expenses that are peculiar to the small-employer health insurance market.
• It achieves a measure of equality by pooling high-risk and low-risk employees but produces inequitable benefits for low-income workers because, like all tax deductions, it is worth more in higher tax brackets. Families with incomes less than $10,000 receive one-tenth the subsidy of families earning more than $100,000.

These contradictions are even more glaring in light of several recent trends: large layoffs due to corporate downsizing, the drive to restrain medical inflation, and the widening income gap between rich and poor. The time has come for an overhaul.

  The Tax Reform Threat

Tax reform would seem to provide the ideal opportunity to reform the treatment of health insurance. A top-to-bottom review of the tax system would have to include its deeply rooted connection with the health care system. At the moment, however, the tax reform debate is ignoring the issue and putting the health care system at risk.

Every major reform proposal would eliminate the tax break for employment-based health care coverage. The flat tax proposed by Representative Richard Armey (R-TX) and Steve Forbes would eliminate the deduction that businesses take for covering their workers. The consumption tax plans of Senator Pete Domenici of New Mexico and former Senator Sam Nunn of Georgia and of Representative Bill Archer (R-TX) and Senator Richard Lugar (R-IN), as well as the tax reform proposed by Representative Richard Gephardt (D-MO), would end the exclusion of employer-paid premiums from the income of employees.

Ordinarily, eliminating a government subsidy would be a welcome event because a subsidy can drive up the cost of a product by insulating consumers from the real price. In the case of health care markets, however, the tax subsidy plays an integral role. It encourages consumers to buy health insurance when they are healthy rather than take a "free ride" on charity care when they get sick. The result is lower insurance rates for everyone. In addition, health insurance secures better health outcomes when care is available in a timely fashion. The tax subsidy establishes health care as a key public expenditure.

Even though eliminating the tax break for health insurance would end the federal subsidizing of medical inflation, the cure would be worse than the disease. The Congressional Budget Office (CBO) estimates that the number of Americans with insurance would fall by 16 to 26 percent.² In addition, insurance premiums would skyrocket by 35 percent because young healthy individuals are likely to drop their coverage. Eliminating this tax break would disrupt a source of financing for health coverage that benefits 146 million Americans-more than twice the number covered by Medicare and Medicaid.

If tax reform were accompanied by a mandate that everyone had coverage, the free-rider problem would be minimized, but a mandate without subsidies for low-income workers is unlikely to be enforced or enacted.

The tax break for health insurance may be politically vulnerable because many Americans are not aware of it or of its value. Unlike itemized deductions, it requires no tax filings by individuals. Insurance premiums appear nowhere on any tax forms because they are exempt from all major taxes (federal and state income, payroll, and corporate taxes). Some employers do not even inform their employees of the value of their health care benefits. Perhaps the threat of tax reform will spur them to do so.

  From Threat to Opportunity

A strategy to defend the tax subsidy for health insurance based on the status quo is likely to fail. To be sure, the prospect of a 35 percent insurance premium hike punctures the promise that eliminating tax breaks and lowering tax rates would save workers money. Tax reform poses three additional challenges on which the status quo falls short.

1. Forty million Americans would be better off with the lower rates from eliminating the tax subsidy because they lack coverage and do not benefit from the subsidy.

2. Second, those who do not like their job-based coverage might be better off because most employers would cash out their health care benefits in the form of higher wages, which workers could use to purchase their own coverage (even though it might cost them more money).

3. Third, medical inflation is likely to reignite if the tax subsidy remains open-ended.

The most straightforward response to these challenges is to expand insurance coverage and individual choice through tax credits and restrain medical inflation with a tax cap.

  Tax Credits to Expand Access

A tax credit should be broadly available for individuals to apply toward the purchase of insurance through an employer, through a purchasing group, or directly in the marketplace. The tax credit would be refundable for those with no tax liability but would not be available to people covered by Medicare or Medicaid.

The amount of the tax credit would depend largely on the amount of revenue available to finance it. A $900-per-person tax credit used by half of the uninsured would cost $18 billion each year, which is roughly equal to the revenue raised by a tax cap.³ State legislatures could provide additional credit by adopting a similar reform. Yet another source of revenue is a means test for Medicare benefits. Low-income workers, who often lack coverage and are raising families, should not be required to subsidize the coverage of wealthy retirees.

Tax credits are a well-established method for assisting lower-income workers. Like the earned income tax credit, a health care tax credit would avoid the stigma of welfare. The tough question is what size tax credit would induce most of the uninsured to purchase coverage. Since a $900 tax credit would cover roughly half the cost of basic coverage, a supplemental tax credit would be appropriate for the very poor who are not covered by Medicaid.

  Tax Credits to Expand Choice

A $900 tax credit would enable about half of all families with job-based coverage to opt for individual coverage without paying higher taxes.⁴ According to the CBO, the current tax break is worth $900 or less to families earning less than $40,000. Families with higher incomes who opt out might pay as much as $1,000 more in taxes, but they also have more resources with which to do so.

Workers still would face a penalty for giving up their job-based coverage if their employers did not make up the difference with extra wages, but requiring employers to cash out benefits on an individual basis would be an open invitation for insurance companies to "cherry-pick" healthy employees and leave behind the less healthy, more costly employees. It would be much better to let employers and employees make the decision to cash out as a group.

Giving workers a real choice to opt out of job-based coverage has the potential to diffuse the sentiment against managed care. Even though the claim that employers are forcing their employees into managed care plans has been exaggerated, the ability of employers to offer a wide range of high-quality choices varies widely, particularly among smaller businesses. Over 70 percent of large employers and 50 percent of medium-size companies continue to offer a fee-for-service plan.⁵ Employers without a fee-for-service option usually offer a managed care/fee-for-service hybrid such as preferred provider organizations or point-of-service options. With the advent of these new products, the appeal of HMOs that restrict choice to a closed panel of providers is fading.

For smaller businesses, purchasing groups offer the expertise and purchasing power of large employers. Tax credits would accelerate the development of purchasing groups by empowering workers to press their employers for wider choices. Purchasing groups provide a menu that compares benefits, premiums, and quality for all types of health plans. They also enable workers to keep their health plan if they change jobs and their new company does not offer their plan as a choice. In short, purchasing groups offer the best hope for a competitive alternative to employment-based health care.

  A Tax Cap to Restrain Medical Inflation

Although medical inflation has fallen to 30-year lows for employment-based coverage, most health care analysts expect higher rates in the near future. Such countervailing forces as new technology will drive up costs despite the success of cost-restraining competition among health plans. A tax cap would ensure that consumer decisions over added costs are not distorted by the tax subsidy, which causes consumers to place an inflated value on health care products. Enacting a tax cap now would be well-timed because it appears less threatening when inflation is moderate.

A tax cap also would provide the opportunity to resolve the dispute over Medical Savings Accounts (MSAs). MSA supporters argue that the tax code has promoted too much health care spending through insurance coverage and too little from out-of-pocket sources. MSAs would encourage the purchase of high-deductible plans by giving out-of-pocket expenses the same generous tax treatment as employer-provided insurance.

Economist Mark Pauly has asked the appropriate question: "Do Two Wrongs Make a Right?"⁶ Creating an expensive new subsidy for out-of-pocket costs only adds to the current problem and diverts limited federal resources away from covering the uninsured. The tax cap avoids this dilemma by setting an overarching limit on the tax break, allowing employers and employees to sort out their preferred mix of insurance and subsidies for out-of-pocket expenses.

There are, of course, many additional issues that would need to be resolved to implement a tax cap/tax credit reform. For example, the rules governing insurance rates that prevent discrimination against the sick should be the same in all segments of the marketplace: employment-based coverage, purchasing groups, and individual coverage. Additional reforms are necessary to respond to concerns about the quality of care in the current marketplace, such as unequal access to innovative medical technology.

In sum, creating a competitive alternative to the employment-based system will give it the best chance to survive tax reform and into the period beyond reform.

  Health Care Reform in 1996

A system of tax credits and a tax cap would pick up where recent legislation falls short. In 1996, Senators Nancy Kassebaum (R-Kan.) and Edward Kennedy (D-Mass.) successfully sponsored legislation that guarantees access to insurance coverage, regardless of preexisting conditions, as long as an individual maintains continuous coverage. Although this new law poses little problem for employers, it probably will drive up insurance premiums for individual coverage because it lacks a tax break to encourage healthy individuals to maintain continuous coverage. Tax credits would make portability reform in the individual marketplace much less likely to drive up premiums.

A strategy based on tax credits and a tax cap also provides an alternative to the expansion of MSAs, which were enacted on a trial basis as a part of the Kassebaum-Kennedy legislation. As currently structured, MSAs would expand the regressive, inflationary, and outdated employment-based tax subsidy system.

Regardless of the outcome of the current health reform debate, the key concern for the future is whether the extremes will continue to dominate or a strong center will emerge. Advocates from the left and right may believe that neglecting the immediate problems of the employment-based health system will work to their advantage in the long run, but such an approach is more likely to hurt everyone by increasing cynicism and weakening the country's capacity for self-governance. Progressive forces should seize this opportunity to move the United States toward a universal marketplace for health care.

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Notes
¹ The views expressed in this paper are the author's and do not necessarily reflect the views of the Progressive Policy Institute.

² Congressional Budget Office, The Tax Treatment of Employment-Based Health Insurance (Washington, D.C.: U.S. Government Printing Office, March 1994), p. 48.

³ Part of the overall cost of a tax credit stems from the choice by some low-income workers to use the credit rather than the income exclusion for employer-paid coverage because the tax credit could be worth more than the exclusion for many workers in lower tax brackets. A $900 tax credit would tempt roughly 30 percent of families with employment-based coverage to "trade up" from the tax exclusion to the tax credit. See Congressional Budget Office, The Tax Treatment of Employment-Based Health Insurance, pp. 30, 58.

⁴ Ibid., p. 30.

⁵ Foster Higgins, "National Survey of Employer-Sponsored Health Plans," Philadelphia, Pa., 1995.

⁶ Mark V. Pauly, "An Analysis of Medical Savings Accounts: Do Two Wrongs Make a Right?" American Enterprise Institute, Washington, D.C., 1994.