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

1. The Best of the Second Best: Using Tax Breaks to Manipulate Health Insurance Mark V. Pauly, Ph.D. ARIA Meeting August 7, 2006

2. 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)?

3. 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.

4. 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.

5. 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.

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.