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A Market-Based Approaches to Insurance Reform Robert B. Helms1 American Enterprise Institute, Washington, DC Although 26 percent of the American population have health coverage through public programs, the majority of Americans, approximately 61 percent in 1994, are covered by health insurance arranged through their place of employment.2 The private sector is especially important when it comes to the coverage of children, because in 1995 approximately 59 percent of children were covered by their parents' employer-based plans. Eighty-three percent of the 9.8 million children who are not presently covered are dependents of working Americans.3 This appendix will look at the history and present characteristics of private sector health insurance and the pros and cons of several policy proposals designed to increase health insurance coverage for children. A Brief History Of Employer-Based Health Insurance The history of health insurance in the United States has always been tied to the development of modern medicine. There was little reason to buy health insurance until medicine created the ability to affect medical outcomes. The cost of these new forms of medical care created a desire to spread the risk of a relatively large medical expenditure among a large number of individuals, any one of whom would face a low probability of an expensive medical condition.4 Although the development of modern scientific medicine can be traced to the 19th century, several developments during and after World War II were most important in shaping the unique form of health insurance in the United States.5 1 This appendix was prepared at the request of the Committee on Children, Health Insurance, and Access to Care as background material about private sector health insurance coverage of children. The views expressed are the author's and are not necessarily shared by any other member of the committee, the Institute of Medicine, or the American Enterprise Institute. 2 Employee Benefit Research Institute, Sources of Health Insurance and Characteristics of the Uninsured, EBRI Issue Brief No. 170, February 1996. 3 Alliance for Health Reform, Health Coverage: Insuring America's Children, March 1997, Figure 2. 4 For readable explanations of the basic economics of insurance, see Mark A. Hall, Reforming Private Health Insurance. (Washington, D.C.: The AEI Press, 1994), especially Chapter 2; and Mark V. Pauly, "Overinsurance: The Conceptual Issues," in Pauly, ed., National Health Insurance: What Now, What Later, What Never? (Washington, D.C.: American Enterprise Institute, 1980), pp. 201-219. 5 For reviews of the history of American medicine and health care delivery, see Paul Starr, The Social Transformation of American Medicine. (New York: Basic Books, Inc., 1982); Herman M. Somers and Anne R. Somers, Doctors, Patient, and Health Insurance. (Washington, D.C.: The Brookings Institution, 1961 ); and Marilyn J. Field and Harold T. Shapiro, eds., Employment and Health Benefits. (Washington, D.C.: National Academy Press, 1993), pp. 49-86.
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Health insurance in this country is unique in two ways. First, unlike most other developed countries, the United States relies on the private sector rather than the public sector to provide health insurance for most of the population. Second, health insurance is unlike most other forms of insurance because it is provided through a person's employer rather than being purchased directly by an individual, as is commonly the case with casualty, automobile, and life insurance. This unique development is primarily the result of unintended employment and tax policies that had their origin during World War II. In an effort to control wartime inflation and reduce the cost to the government for war materials and services, the government established a system of wage and price controls during the early 1940s. Unable to compete for scarce labor by raising wages, employers began to expand their use of fringe benefits as a way to attract and hold employees. The value of these benefits, including employer-based health insurance, was not considered by the IRS to be part of taxable income. This principle of excluding the value of employer-based health insurance from taxable income became part of established tax law following the war. The economic effect of this policy was to give a preference for health insurance obtained through an employer rather than purchased individually with after-tax dollars. This part of tax law was established at a time when marginal tax rates were relatively low and the cost of health insurance was a relatively small part of the total cost of compensation. This situation was not to last. 6 In addition to the growth of modern scientific medicine, the 20 years following World War II were a period of unusually rapid growth of population and personal income. These factors combined to increase the demand for health insurance to protect against the cost of expensive medical events. This had two effects: the growth of employer-based health insurance relative to individually-purchased insurance and an expansion in types of coverage offered. To contrast the period before and after World War II, Somers and Somers point out that in 1930 only two percent of the labor force ( 1.2 million workers and about 2 million of their dependents) had any form of health coverage7 although in 1958, 123 million Americans had hospital insurance and 75 percent of these individuals obtained this coverage through their employer.8 The tax treatment of health insurance created strong incentives for unions and employees to bargain for tax-free health insurance relative to taxable wages and to expand both the completeness of insurance (reduced cost sharing) and the range of medical coverage to be included in the employer's plan. In addition, tax policy may also be partially responsible for extending coverage to dependents, because providing coverage for an employee's family was an additional way to purchase insurance with tax-free dollars. The Effects Of Health Insurance The private sector health insurance industry has grown to become a major sector of our economy. The latest figures indicate that there are approximately 2,900 insurance companies providing individual 6 For a more complete history of the tax treatment of health insurance with numerous references, see Robert B. Helms, "The Tax Treatment of Health Insurance: Early History and Evidence, 1940-1970" in Grace Marie-Arnett, ed., Health Care Reform: Solutions for a New Century. (Ann Arbor, MI.: The University of Michigan Press, forthcoming); Ronald J. Vogel, "The Tax Treatment of Health Insurance as a Cause of Overinsurance," in Mark V. Pauly, ed., National Health Insurance: What Now, What Later, What Never? (Washington, D.C.: American Enterprise Institute, 1980), pp. 220-249; Congressional Budget Office, The Tax Treatment of Employment-Based Health Insurance, March 1994; Sherry Glied, Revising the Tax Treatment of Employer-Provided Health Insurance. (Washington, D.C.: The AEI Press, 1994); Walter M. Cadette, Prescription for Health Care Policy: The Case for Retargeting Tax Subsidies to Health Care. Annandale-on-Hudson, New York: The Jerome Levy Economics Institute of Bard College, Public Policy Brief No. 30/1997, 1997. 7 Somers and Somers, Doctors, Patients, and Health Insurance, p. 230. 8 Somers and Somers, Doctors, Patients, and Health Insurance, p. 228.
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and group policies to about 164 million Americans who have private health insurance coverage.9 This growth of insurance has had both positive and negative effects on the performance and efficiency of the health care sector. A partial description of some of these effects follows.10 Health insurance has provided financial protection to a majority of the American work force and their dependents. The special tax treatment of health insurance has increased both the absolute number of people covered and has extended the range of medical services provided in a typical policy. This insurance coverage has been provided by a relatively large number of diversified firms, which has increased the choices of types of coverage and the efficiency and adaptability of the insurance industry. The business firm has provided a convenient method of spreading risk and efficiencies in the administration of the insurance plan. From the health insurance company's point of view, it is cheaper to insure an employer group than a similar number of individual policies for three reasons: (1) there are economies of scale in the administration of a group of employees, resulting in lower loading factors; (2) on average, working individuals are younger and healthier than individuals who are not working,11 and (3) if the group is large enough, the insurer can be relatively sure that the employees did not accept the job to obtain health insurance (the probability is low that the group has attracted individuals who are sicker than average).12 Because individuals with health insurance use more health care services than uninsured individuals, the special tax subsidies for employer-based health insurance have increased the demand for health care above the amount that would have existed without the subsidy. As research by Martin Feldstein and others has shown, this increase in the demand for health care resulted in higher health care prices and higher rates of growth in health care expenditures than would have existed without the subsidies.13 Tax policy has also contributed to the health cost problem by reducing the extent of consumer cost sharing in health insurance plans. During the period of a rapidly increasing demand for health insurance, health insurance companies competed for business by offering policies with lower deductibles and copayments. Such policies were more expensive than policies with more cost sharing, but because the extra cost was partially subsidized by the tax exclusion, the average amount of cost sharing declined in health insurance policies for most of the 1960s, 1970s, and into the 1980s. Since the mid-1980s, there has been some retrenchment on cost sharing as employers have attempted to control the rapidly rising cost of their plans. Because the purpose of cost sharing is to control the insurance-induced consumption 9 Statistical Abstract of the United States, 1996, Table 767; EBRI, Sources of Health Insurance and Characteristics of the Uninsured, Issue Brief No. 179, November 1996. Not all employer-based insurance coverage is provided through insurance companies because the current ERISA law gives firms strong incentives to self insure, that is, instead of paying premiums to an insurance company, they set aside funds to directly pay the medical costs occurred by their employees and their dependents. Some firms who self insure may contract with insurance companies to provide administrative services for their plan without paying an insurance company to assume risk. 10 For more on the effects of insurance, see Mark V. Pauly, ''Taxation, Health Insurance, and Market Failure in the Medical Economy," Journal of Economic Literature, vol. 24 (June 1985), pp. 629-675; Field and Shapiro, Employment and Health Benefits. 11 Self-employed individuals may be just as healthy as individuals working for an employer, but the cost of determining their health status is greater. In addition, insurance companies face higher risks to the extent that the self-employed and small employers have incentives to include relatively unhealthy dependents in their group policies. 12 The health insurance industry has been accused of "redlining," that is refusing to cover some employers in certain locations or occupations where they perceive that the employer group may have attracted employees with a high risk of having an expensive disease (e.g., AIDS) or who may engage in work activities (e.g., a tree surgeon) with a high risk of injury. Almost all states have some regulations that attempt to control unfair discrimination. 13 Martin Feldstein, Hospital Costs and Health Insurance. (Cambridge, Massachusetts: Harvard University Press, 1981).
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of health services, the principal effect of lower cost sharing has been to further reduce the incentives of individual consumers with insurance to be cost-conscious in their use of health care services. Individuals with insurance have little incentive to shop for cost-effective providers because they typically do not pay for services directly and cannot share in any savings that may result from their actions. The tax treatment of health insurance has also exacerbated the problems of those without health insurance. The uninsured are individuals and their dependents who are not eligible for public programs, who are unemployed, self-employed, or working for an employer who does not offer health insurance. All of these individuals face a higher cost of purchasing individual or small group policies because current tax policy has artificially inflated the cost of health care and the cost of all health insurance. The cost of individual policies could be reduced if it were possible to purchase catastrophic policies with higher deductibles and cost sharing, but the availability of these policies is limited due to the dominance of low deductible policies in the group market and state regulations that inhibit the sale of such policies in some states. The tax treatment of health insurance has also contributed to a very regressive distribution of tax subsidies. Because the value of a benefit that is excluded from taxable income increases with one's marginal tax rate, the result of the present tax policy is to distribute the value of the tax subsidies more to higher income individuals who work for employers offering health insurance than to lower income workers. For taxpayers in the 28 percent federal tax bracket (Adjusted Gross Income in a joint return beginning at $38,000), their marginal tax rate can easily exceed 40 percent considering the 7.65 percent payroll tax for Social Security and Medicare and state income taxes. For such a worker, a dollar spent on health insurance is worth approximately 40 percent more than a dollar spent on taxable wages. This advantage can go as high as 60 percent for some high-income individuals in some high-tax states. By contrast, an individual purchasing an individual policy must use after-tax dollars and thus receives no tax subsidy. The Congressional Budget Office uses the 1987 National Medical Expenditure Survey (NMES) and its own tax model to estimate the distribution of tax benefits for the year 1994. For families with employment-based health insurance (61 percent of the population), they estimate that the tax subsidy averages 26 percent of health insurance premiums (which average $4,310). This subsidy increases with income, going from 11 percent of premiums for those with family incomes under $10,000 to 33 percent for those with incomes over $200,000.14 When the tax subsidy is compared to after-tax income, they find that the tax subsidy averages 2.4 percent of after-tax income for families with employment-based health insurance but only 1.9 percent when those taxpayers who do not have health insurance provided by their employer are added in. 15 Current tax policy also contributes to the difficulties of welfare recipients attempting to make the transition from public assistance to productive employment in the private sector. The high cost of health insurance is one of the principal reasons that many businesses do not offer health insurance to their employees. Surveys indicate that the incidence of uninsurance in the private sector is greater in the southern states and in the service sector of the economy, exactly the places where most welfare recipients seek jobs as an alternative to welfare. The welfare reform legislation in 1996 attempted to ease this transition from welfare to work by extending the ability of working parents to keep their dependents on Medicaid, but these benefits are limited, so that the number of uninsured children can be expected to increase as more welfare recipients are forced to accept jobs in firms that cannot afford to offer health insurance. The unavailability of low-cost group or individual policies will continue to make this problem worse, especially for children. 14 Congressional Budget Office, The Tax Treatment of Employment-Based Health Insurance, March 1994, Table 4, p. 30. 15 CBO, The Tax Treatment of Employment-Based Health Insurance, Table 4, p. 31.
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Options For Expanding Health Insurance For Children The desire to expand access to health care for children through health insurance has been a central part of the health policy debate for most of this century. The following section presents several basic policy options that have been, or might be, considered as ways to expand health insurance coverage for children. The organization of this analysis into discrete policy options does not mean that other options and variations of these options could not be considered. The objective here is to present a range of realistic policy options and illustrate the tradeoffs that must be made among conflicting objectives.16 Federal Preemption of State Insurance Laws and Regulations One option is to establish federal requirements that forbid state laws and regulations that interfere with the coverage of children. Such an approach is controversial because it goes against the Constitutional and legal tradition of granting maximum autonomy and flexibility to states. However, many state laws and regulations have been established at the behest of special interests, thereby raising the cost of health insurance and making it more difficult for the uninsured to buy affordable health insurance. Mandated benefits increase the cost of offering health insurance, making it more difficult for small firms to offer group policies or for individuals to buy insurance directly. Several studies have documented the growth of state laws affecting the health insurance and managed care markets. Gail Jensen presents data showing that state mandates increased from 37 in 1970 to 854 in 1990.17 She also reports on studies showing that these mandates significantly raise the cost of health insurance, which has especially strong effects on the ability of small firms to offer health insurance to their employees.18 More recent studies indicate that the nature of state legislative action is changing, with more laws now being passed to regulate the activities and coverage of managed care plans. 19 And, as shown by recent activity by Congress to mandate mental health parity and regulate maternity coverage, the legislative urge to mandate benefits and regulate health insurance is not limited to state legislatures. Numerous proposals for new mandates are continually being debated at both the federal and state levels. One factor making the federal preemption of state laws so controversial is the difficulty of distinguishing between the benefits and costs of the mandates. Some children may benefit from mandating coverage for some preventive and screening services or for the coverage of children with special needs. But there is a trade-off in the design of any insurance plan: the higher costs of the mandated benefits will make it more difficult for the uninsured to purchase health insurance either individually or through their employer. This is further complicated by special interest politics at the federal and state levels. Mandates and other provisions may be promoted by groups of providers as a way to increase the demand for the services they provide or to reduce the ability of other providers to effectively compete in the market.20 Any federal legislation to preempt state laws that are detrimental to the coverage of children would face 16 For detailed descriptions of state and federal proposals, see U.S. Library of Congress, Congressional Research Service, Health Insurance for Children: Legislation in the 105th Congress. CRS Report for Congress 95-385 EPW, May 6, 1997; Kay Johnson, et al., Children's Health Insurance: A Comparison of Major Federal Legislation. Washington, D.C.: Center for Health Policy Research, The George Washington University, May 1, 1997; and, Shelly Gehshan, State Options for Expanding Children's Health Insurance: A Guide for Legislators. Washington, D.C.: National Conference of State Legislatures, May 1997. 17 Gail Jensen, "Regulating the Content of Health Plans," in Robert B. Helms, ed., American Health Policy: Critical Issues for Reform. Washington, D.C.: The AEI Press, 1993, p. 169. 18 Jensen, pp. 180-187. 19 Patricia A. Butler, "Public Oversight of Managed Care Entities: Issues for State Policymakers," National Governors Association, 1996; Susan S. Laudicina, et al., State Legislative Health Care and Insurance Issues. BlueCross BlueShield Association, December 1996. 20 James F. Blumstein, "Health Care Reform and Competing Visions of Medical Care: Antitrust and State Provider Cooperation Legislation," Cornell Law Review, Vol. 79, No. 6, September 1994, pp. 1459-1506.
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two rather difficult problems: identifying the set of state laws that are harmful and overcoming the efforts of special interests to maintain these provisions. The task might be more politically feasible if the objective of the federal preemption were to create a broader range of choice among health insurance plans rather than trying to force all plans in all states to adhere to federal standards. By eliminating state requirements that have little or no benefit for children and requiring preventive and catastrophic benefits that are cost effective, it might be possible to give employers and individuals choices of types of policies that would be cheaper than existing policies. Catastrophic coverage is a lower-cost form of insurance because it covers the high-cost, low-probability events and lets the insured bear the risk of low-cost and predictable health events. The relatively high deductibles in catastrophic plans give consumers incentives to avoid unnecessary care, pick more cost-effective providers, and not to file numerous small claims. Prevention and screening services that are cost-effective can be excluded from the deductibles so the insurance plan gets both kinds of savings: more use of cost-saving activities and less use of cost-increasing activities. To avoid the criticism of federal micro-management, as well as to reduce the cost of enforcement, any such federal legislation would have to allow for insurance companies to compete in benefit design rather than try to specify exactly what benefits should be offered. If federal preemption to create more cost-effective insurance for children were combined with one of several inducements for such coverage (discussed below), this approach has the potential to offer attractive choices to many of the presently uninsured. Federal Mandates for Employer-based Coverage of Children A more direct approach than altering state laws is a federal mandate that all employers must provide health insurance to their workers and their dependents. Variations of federal mandates have been proposed in past years, the most recent in the Clinton Administration's Health Security Act. Although several states have provided state insurance plans for children or subsidies for private coverage, Hawaii is the only state so far to use a mandated benefits approach.21 Most of the actual proposals have included exemptions for small employers as a way to reduce the economic effects of mandates or to phase in the new coverage. To be enforceable, any mandate for coverage must provide some definition of the benefits that must be included in the mandated plan. Again, this presents two difficult obstacles to such legislation, one medical and one political. Ideally, if we had definitive knowledge of the medical benefits of alternative types of procedures and coverage, it would be relatively straightforward to design a mandated insurance policy that included effective treatments and excluded ineffective treatments. But that is not the case, which leads to the political problem. If Congress attempts to mandate a set of benefits that must be provided by all employers, it becomes vitally important for every component of health care, every specialty, every type of provider, to be included in the plan. This creates a difficult situation for the Congress (or any state legislature) attempting to define a mandated set of benefits. The 21 The Hawaii mandate is for employees only and excludes dependents, agricultural workers, and part-time workers. For a study questioning the ability of the Hawaiian approach to reduce the number of uninsured, see Andrew W. Dick, "Will Employer Mandates Really Work? Another Look at Hawaii," Health Affairs, Vol. 13, No. 1, Spring (1) 1994, pp. 343-349. 22 Despite the usual contention that the cost of mandates is imposed on employers, economists have shown that the cost of employment-based health insurance is borne by the employees. For discussions of the cost of health insurance, see Michael A. Morrisey, "Mandated Benefits and Compensating Differentials—Taxing the Uninsured," in Robert B. Helms, ed., American Health Policy: Critical Issues for Refonn. Washington, D.C.: The AEI Press, 1993, pp. 133-151; Mark A. Pauly, Health Benefits at Work: An Economic and Political Analysis of Employment-Based Health Insurance. Ann Arbor: The University of Michigan Press, 1997.
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result is likely to be an expansive set of benefits that will be expensive and have detrimental effects on employment and business growth. The major criticism of mandated benefits is that they impose large economic costs on employees.22 That is why the employment effects of mandated benefits are concentrated in small firms where the incidence of uninsurance is relatively high and why most mandated benefit proposals have some exemption for small firms. This creates an especially difficult dilemma for attempts to increase insurance coverage for children through federal mandates. Because a large proportion of uninsured children are dependents of adults that work for small firms,23 any exemption of small firms reduces the ability of a mandated benefit law to increase insurance coverage for children. If small firms are not exempted, the higher costs of insurance will likely decrease the number of parents employed and thereby force more children to become uninsured or to turn to Medicaid or other public programs for coverage. Another variation of mandated benefits is for the federal government to require states to provide private sector health insurance for families or just for children. States would be required to provide choices of plans similar to those provided to federal employees for all families who are not on Medicaid and who have incomes less than a fixed amount (e.g., $75,000) or less than a percentage of the poverty level (e.g., 200 percent of poverty, the income category where 45 percent of the uninsured children are situated).24 Such proposals could come with or without federal subsidies or be tied to various tax provisions, as discussed below. They are likely to impose lower costs on the states because they allow for less benefits than are required in state Medicaid programs. Their disadvantage is that they require the states to administer a new health benefit plan without using their existing Medicaid program to administer the benefit. Federal Vouchers to Individuals or Families Another mechanism to increase the health coverage for children is a federal voucher that could be used by an individual or family to purchase a private insurance plan.25 A voucher is a means of providing a subsidy to specific recipients that restricts the purposes for which it can be used. An example is food stamps that are given to qualified poor people to subsidize food purchases without allowing them to spend on other items.26 Educational vouchers are often proposed as a more efficient way than public schools to subsidize education. As with any other federal subsidy program, a federal voucher program designed to subsidize health insurance would have to target the population and specify the type of policy that the voucher could be used for. As a standard for benefits, the federal government could adopt the minimum federal Medicaid benefits or a plan that would meet the standard for federal employees (the FEHBP). Alternatively, the federal government could leave the design of a qualifying plan to the states or attempt to establish minimum deductibles and standards for prevention and screening. As is done with Medical Saving Accounts, establishing a minimum deductible, say $4,000 per year for a family policy, is an attempt to 23 EBRI estimates based on the 1996 Current Population Survey indicate that in 1995, 45 percent of the parents of uninsured children worked in firms employing 99 or fewer workers. Eighteen percent of such parents were self-employed. Employee Benefit Research Institute, "Expanding Health Insurance for Children: Examining the Alternatives," Issue Brief Number 187, July 1997, Chart 9. 24 U.S. Library of Congress, Congressional Research Service, Health Insurance for Children: Legislation in the 105th Congress. CRS Report for Congress 95-385 EPW, May 6, 1997, Table 1. 25 The voucher could also be used to purchase Medicaid coverage or a state health insurance plan. This discussion concentrates on the purchase of insurance from the private sector. 26 Restricting an individual's purchases to one specific purpose is not completely possible because the increased income from the voucher may allow the individual to spend more for other purposes. The substitution effects of vouchers are explained in Kenneth W. Clarkson, Food Stamps and Nutrition. Washington, D.C.: American Enterprise Institute, 1975.
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assure that the voucher would go to subsidize catastrophic coverage with high lifetime maximums rather than first-dollar coverage. The voucher could be made available on the basis of income by extending the percent of poverty standards now in place for Medicaid, but excluding children currently on Medicaid. This would be an additional administrative burden on the states, but a system for determining income eligibility already exists for Medicaid and could be expanded. A more complicated procedure would be to try to make the voucher available only to those children who were uninsured. It is more complicated because it creates strong incentives for employers and employees currently paying for dependent coverage to drop such coverage, the so-called crowding out problem. Establishing regulations to prevent crowding out would be difficult in the absence of some inducement to maintain coverage. Enforcement problems associated with vouchers could be reduced to the extent that the federal subsidy did not cover the entire cost of the insurance plan. With a partial subsidy, the individual who would bear some of the cost of the insurance would have an incentive to use the voucher wisely and to purchase a plan that would provide them with the most value. Allowing an eligible employee to use the voucher to buy into his or her employer's group policy might be a way to reduce the danger of crowding-out. Federal Tax Policy to Encourage Additional Coverage Proposals to expand health insurance through the use of tax policy are based on the notion that it is better to offer a positive incentive rather than direct subsidies or mandates. Tax policy proposals to reform health care markets are supported by a number of economists and health policy experts, but are probably the least understood by politicians and the public.27 In addition to being misunderstood, any change in tax policy creates winners and losers, so the losers can be expected to strongly oppose the change. Scholars of tax policy have also criticized any use of the tax system to achieve any social objective because such proposals complicate the tax system, create distorting incentives, and interfere with the objective to create an efficient and fair system of raising revenue.28 Any attempt to use tax policy to encourage more coverage of children will not be immune to that criticism. However, if properly designed, a tax policy proposal could increase children's coverage while removing some of the present complications and distortions of tax law. Any attempt to use tax policy as a positive incentive to expand health insurance for children would face two administrative problems. First, the current federal income tax system is administered by the Internal Revenue Service (IRS), an agency that many feel is already overburdened by the complexity of the tax law. Adding any new provisions to encourage health insurance for children would add to this complexity and to the enforcement and administrative problems faced by the IRS. Keeping any new provision relatively simple would reduce the problems faced by the IRS, but would likely reduce the ability to target new health coverage to the presently uninsured or to assure that private insurance contained the features that would be deemed best for children. For example, if the desire of Congress was to subsidize the purchase by low-income people of catastrophic policies that included good prevention and screening services, the IRS would have to take on some of the functions of a welfare or insurance regulatory agency to assure that the benefit design of the qualifying plans met some federal standard and that only eligible people received the subsidy. The alternative is to have the IRS work 27 For some of the health reform proposals based on tax policy, see Mark Pauly, Patricia Danzon, Paul Feldstein, and John Hoff, Responsible National Health Insurance. Washington, D.C.: The AEI Press, 1992; Stuart M. Butler, ed., Is Tax Reform the Key to Health Care Reform? The Heritage Foundation, 1990; C. Eugene Steuerle, "Beyond Paralysis in Health Policy: A Proposal to Focus on Children," National Tax Journal, Vol. 45, No. 3, September 1992, pp. 357-368. 28 Joint Economic Committee, "The Inefficiency of Targeted Tax Policies," United States Congress, April 1997.
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closely with state welfare and regulatory agencies, institutions that have not traditionally worked closely with either federal or state taxing authorities. The second administrative problem involves using the tax system to target children, who are not typically taxpayers. The IRS deals with taxable units that are usually families. Because children are almost always the dependents of adult taxpayers, it adds a layer of complexity to target any tax incentive only to children. In addition, on the insurance side, most children receive coverage through a family policy that is purchased by at least one of the parents, either through that parent's employer or directly from an insurance company. The practical solution to this problem is to realize that most uninsured children are dependents of parents who are also uninsured, so that any tax policy to subsidize the purchase of family policies will increase the level of coverage of children and adults alike. Because children on average use less health services than adults, a less targeted subsidy that includes more adults will cost more than a subsidy targeted only to children. There are several options for the design of a tax subsidy for children's health insurance, but they vary in terms of their ease of administration and their ability to actually increase the level of coverage. For simplicity, the following section considers two methods of providing tax subsidies—tax credits and tax deductions—and two targets for these subsidies—employers and taxpayers. Tax Deductions In its simplest form, our income tax system works on the principle of imposing a tax that is a percentage of a taxpayer's or business firm's taxable income. Taxable income may be less than gross income to the extent that the taxpaying unit is able to subtract actual expenditures that are allowable as tax deductions or a fixed amount for each member of the taxpaying unit (called exemptions). Examples for families include standard exemptions based on the number of children in a family, mortgage interest payments, and medical expenditures above 7.5 percent of adjusted gross income. Each of these deductions from income is designed to lower the taxes of families that have children, own their own homes, or experience unusually high medical expenses. Business firms are allowed to deduct from gross income almost all costs of conducting their business including the cost of raw materials, labor costs, and the costs of fringe benefits, including what the firm pays for a group health insurance plan for its employees. Because the cost to the employer of providing dependent coverage through a family policy is already fully deductible as a business expense, there is no opportunity for using tax deductions as an additional inducement for employers to expand coverage. The use of the deduction for health insurance expenses could be made contingent on providing all employees and their dependents a specified level of benefits, but this becomes equivalent to a mandate and has all the disadvantages discussed above. In addition, if the employer retains the freedom not to provide health insurance at all, any requirement that the tax deduction could only be used when all dependents were covered would create strong incentives for many firms to drop the provision of health insurance. The result would likely be an increase in the number of uninsured children, not the desired decrease. Using a tax deduction for individual taxpayers is a different story, because the current use of the deduction is so limited that it has very little effect on the purchase of private health insurance. There are two very limited ways that the purchase of health insurance can be deducted from gross income. Self-employed individuals can currently (1998 through 1999) deduct as a business expense 45 percent of the cost of health insurance for themselves and their family. To make this more compatible with the full deductibility of the cost of health insurance for working people who are not self-employed, Congress recently passed provisions to increase the self-employed deduction gradually to 100 percent by the year 2007.29 The coverage of dependents is allowed but is not required by the tax law. A positive incentive for 29 Taxpayer Relief Act of 1997, Public Law 105-34, August 5, 1997, Sec. 934.
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the self-employed could be created by increasing the portion of the cost of a policy that is deductible when it covers children (or all dependents). But because there are only 12.0 million self-employed workers (9.2 percent of the total labor force), and only 2.6 million self-employed people who take the health insurance deduction, this provision would have only a limited effect on insurance coverage for children.30 More children could be affected if an expanded deduction for the cost of health insurance were made available to individual taxpayers regardless of their employment status. This type of tax subsidy would be advantageous to any person purchasing an individual policy directly from an insurance company or any worker whose employer does not provide health insurance or does not cover dependents. Any amount of deduction from taxable income would lower the net cost of the insurance to the purchaser, but because the deduction lowers a person's taxable income, the amount of the reduction in taxes is determined by the person's marginal tax rate. For example, if a single parent with one child made $20,000 in 1996, her tax would be $1,639. If a $1,000 deduction had been allowed for health insurance, the tax would only go down $150 to $1,489, a reduction that is only 15 percent of the $1,000 deduction because that person is in the 15 percent tax bracket. In addition, a major disadvantage of using deductibles as a positive incentive is that it is difficult to target this type of tax subsidy to lower-income workers. Under present law, it is usually advantageous for a low income worker to take the standard deduction ($4,000 for a single taxpayer or $6,700 for a couple filing jointly in 1996) rather than itemize deductions. Therefore, to take advantage of the tax deduction, a person must first have an income high enough to require him or her to pay taxes. And even if the person pays income taxes, he or she would have to itemize deductions unless a change in tax law would allow him or her to take the health insurance deduction in addition to the standard deduction. These difficulties making tax deductions effective for low income taxpayers are why most tax subsidy proposals use some form of tax credit as a way to induce a change in behavior. Tax Credits The use of tax credits is a more efficient way to subsidize the purchase of health insurance for low-income taxpayers. In addition, by making tax credits refundable, it is possible to use the tax system to subsidize those people who do not currently pay income taxes. A tax credit is a direct reduction of taxes owed and does not require a taxpayer to itemize deductions in order to qualify for the credit. This is especially important because those who are most likely to qualify for the tax credit and to need it to purchase health insurance are likely to be among those least likely to itemize their deductions. To illustrate, consider again the single parent with one child earning $20,000 per year and facing a tax bill of $1,639 under current law. If she were allowed a $1,000 tax credit for the purchase of health insurance for herself and her child, her taxes would be reduced by the full amount of the $1,000 tax credit, to $639. The amount of the tax credit could be set to cover most or all of the cost of a defined health insurance benefit for the parent and the child or just for the child. A tax credit has three other advantages over direct subsidies or tax deductions. First, the amount of the tax credit can be based on an actuarial calculation to cover either a portion of or all of the cost of the desired level of benefits for the people that are to be subsidized. The IRS would still have to assure that the taxpayer actually purchased health insurance, but the federal government would not face the difficult task of defining a complicated benefit package and determining that each person's policy contained those benefits. The purchase of health insurance could be left to the individual consumer, who could choose among alternative plans offered by competing health insurance companies. Insurance 30 These figures are for 1995. Employee Benefit Research Institute, "Sources of Health Insurance and Characteristics of the Uninsured," November 1996, p. 9.
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companies are now subject to the scrutiny of both the federal antitrust agencies and state insurance regulation, which could continue to assure that consumers are offered quality insurance products at fair market prices. Some educational activities may have to be undertaken with this new population of potential buyers because most of the people who would qualify for the tax credit to purchase health insurance and who would therefore be the most likely to use it are not now insured and therefore have little experience with purchasing health insurance products. Because the great majority of those who are uninsured do not have the option of receiving health insurance through the workplace, they will not typically have an employer helping them with the choice of plans and therefore will need more information about health insurance products. A second advantage of tax credits is that the size of the subsidy can be relatively easily related to the income of the recipient. For example, if the desire is to give a full subsidy for the coverage of children for taxpayers up to $20,000, but only a partial subsidy for those earning between $20,000 and $40,000, the size of the tax credit could be reduced on a sliding scale for the latter group of taxpayers. In this example, there would be no tax subsidy for any taxpayer earning above $40,000. Instead of an absolute income amount, the starting and stopping incomes of the phase-down of the tax credit could be set as percentages of poverty. In general, the cost of the tax credit program will be greater and more people will be subsidized if the phase-down begins at a higher income (for example, $25,000) and extends to an even higher income (for example, $60,000) before it is ended.31 A third advantage of tax credits is that they can be used to target subsidies to people whose income is so low that they do not owe any taxes. This segment of the near-poor population will likely contain many of the presently uninsured children. To reach people who do not owe taxes requires that the tax credit be made refundable. A refundable tax credit is a cash payment (for health insurance this could be a voucher) from the IRS to the taxpaying family. To qualify, a low-income person would have to file a tax return and show proof of purchase of a qualified health insurance plan. Because the eligibility for a tax credit is not established until after the taxable year is over, a practical way would have to be found to transfer purchasing power to the recipient of the tax subsidy during the tax year. For wage earners, this could be achieved by decreasing their tax withholdings. Transferring purchasing power to recipients of refundable tax credits may be more difficult because they may not be working or working at jobs not subject to wage withholding. Some system of temporary access to a government insurance plan (Medicaid or FEHBP) or verification that would allow access to short-term credit would have to be developed in order to more rapidly enroll the presently uninsured. One of the aspects of tax policy that has not been discussed is the effect on government receipts and expenditures. All three of the major ways to use tax policy to encourage health insurance, as well as the direct payments and vouchers discussed earlier, have negative effects on the budget. Tax deductions and tax credits reduce the revenue that would be collected by the IRS. Refundable tax credits, direct payments, or vouchers, would increase direct government expenditures because they involve sending direct subsidies to those who qualify. Finding a funding source for more health insurance for children while meeting the requirements for a balanced budget is a major challenge for the Congress, but this challenge must be met regardless of the kind of policy that is adopted.32 31 For some examples of actual tax credit proposals, and a more extensive discussion of design features and probable policy effects, see Pauly, Danzon, Feldstein, and Hoff, Responsible National Health Insurance; Stuart M. Butler, ed., Is Tax Reform the Key to Health Care Reform? The Heritage Foundation, 1990; C. Eugene Steuerle, "Beyond Paralysis in Health Policy: A Proposal to Focus on Children," National Tax Journal, Vol. 45, No. 3, September 1992, pp. 357-368. 32 Using the arguments that the present exclusion of employer-based health insurance is a major cause of distorted incentives in health care markets and is a regressive public subsidy, two major plans for refundable tax credits propose to include the value of employer-based health insurance in taxable income as the major source of funding. See Pauly, Danzon, Feldstein, and Hoff, Responsible National Health Insurance, and Butler, ed., Is Tax Reform the Key to Health Care Reform?
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Expanding health insurance to children through the use of tax credits would provide more people with options to select the policies that most suit their needs and would allow the competitive market to develop a range of options to attract business. This type of policy would help to bring about more price competition, the kind of competition that has been missing in the American health insurance system. By driving choice and efficiency in the health care marketplace, consumers will begin to reverse the cycle of high costs that has been forcing people without job-based insurance out of the health care marketplace. This type of health care market has advantages for all consumers, not just the children who receive the tax credits.
Representative terms from entire chapter: