Debate Over How To Replace Obamacare Comes to a Fork In the Tax Code

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When Capitol Hill Republicans and other conservative health policy analysts focus on developing viable "replacement" alternatives to Obamacare, they usually start with changing how the tax code subsidizes purchases of health insurance coverage. The two main proposals would expand the benefits of the current tax exclusion for employer-sponsored insurance (ESI) premiums to other insurance purchasers - either through tax deductions or through tax credits - and then limit its maximum amount per insured person. But neither one by itself strikes the right balance between efficiency, equity, and sustainability.

The first approach may involve a simple expansion of the limited income tax deduction for certain health care expenses (above ten percent of adjusted gross income) under existing law. It could become a full deduction for all health insurance premium costs (if not all heath care costs) against both federal payroll taxes and federal income taxes. A more refined version would recycle and update the "standard deduction" proposal by the Bush administration in 2007 that essentially traded in the ESI tax exclusion for a more fixed amount of health care expenses that all taxpayers could deduct from their federal taxes.

The second approach relies on a partial, or complete, shift to refundable tax credits for health care expenses. The amount of the tax credits usually would be fixed in dollar amount, although more recent proposals would adjust them partially to reflect the relative age of the beneficiary (on the assumption that older people, on average, incur greater health care expenses). This tax credit might be limited just to individuals without access to ESI and its remaining tax exclusion, or it could provide a complete replacement for everyone purchasing health insurance. Unlike tax deductions, distribution of the "refundable" credits would not be limited just to persons who earn enough income to pay federal taxes.

The key weaknesses behind these and similar tax reform proposals for health policy stem either from trying to achieve several different, conflicting policy goals all at the same time, without accounting for tradeoffs; or from choosing the wrong order of priorities. Tax reform that aims to do too many things at once will inevitably fall to accomplish most, or all, of them very effectively.

These types of Republican proposals generally have aimed to redistribute current tax subsidies for health care more fairly, provide more financial assistance to lower-income Americans, encourage a rapid transition from employer-based insurance to individually owned and controlled insurance, cap tax advantages for the most expensive and comprehensive types of coverage, and steer health plans more toward high-deductible catastrophic insurance. Yet at the same time, they have hoped to minimize disruption of existing ESI plans for currently insured workers and avoid creating larger budget deficits.

To be sure, a foolish consistency may not only be the hobgoblin of little minds; it is also rarely found among successful politicians. Treating the tax code as an alternative vending machine for dispensing public benefits to favored political groups is more appealing to many conservative Republican incumbents and their allies than expanding on-budget entitlement spending programs more directly. The "Two Santa Claus Theory" of political economy at least hopes that reducing federal tax revenue, instead of increasing federal spending, has pro-growth effects in the private economy.

To construct a more principled approach to tax policy for health care that still recognizes the practical need for a less-disruptive, phased transition away from today's embedded arrangements and expectations, we will need to establish some clearer long-term policy priorities.

· Tax policy should aim to be as neutral as possible regarding how one chooses to purchase health care. The tax code needs to become simpler, rather than more complicated than it already is.

· The economic problems facing lower income Americans are much greater than just whether they can afford better health insurance coverage. Moreover, even if the primary policy remedy for them was a matter of income redistribution (i.e., a welfare, rather than health, policy problem), Yogi Berra might advise that we instead could give them cash, which is just as good as money."

· Although improved macroeconomic and social policies, as well as other better-targeted interventions, will do much more to assist poor individuals and their families, generous tax subsidies directed toward the most vulnerable ones can help ensure their access to necessary health care services.

· Broad-based tax subsidies for health insurance premiums do not actually lower their overall costs. They simply transfer, and arguably increase, them through additional sets of indirect payers. Making the real price of health insurance more transparent, rather than hiding it in tax expenditures and regulatory cross-subsidies, is a necessary step in lowering future health care costs.

· Reducing inefficient distortions and inequities in health care spending under the current tax code should not require "net" income tax increases on millions of working Americans with more generous ESI coverage.

· Sudden, radical changes in the tax treatment of health care are not only politically unwise but simply hard to implement in practical terms.

We need to remember that changing the tax treatment of health care spending is a necessary, but not sufficient, element of a broader approach to replacing Obamacare with more effective and sustainable health policy reform. By itself, it will help, but still fall short, of our hopes to improve the performance of the health care delivery system and the health outcomes of all Americans. Nevertheless, we can start moving in the right direction by combining the best elements of the tax deduction and tax credit approaches in a manner that overcomes their respective weaknesses.

Fixed-dollar tax credits, even when partly adjusted for age bands, remain politically arbitrary and disconnected from the wide variation in health insurance costs in different markets and for different types of health risks.

Tax deductions within the "progressive" tax rate structure of the current federal income tax are inherently regressive in their distributional effects. Wealthier individuals receive larger tax subsidies, for the same amount of premium costs.

Hence, we should consider instead moving toward a fixed-percentage tax credit, which would eventually provide the same level of tax code "discount" for health insurance premium costs for anyone purchasing coverage - whether as individuals or through group purchasing arrangements (like ESI). That would effectively subsidize low-income Americans more, and high-income ones less, than occurs under the current tax exclusion for workers receiving job-based coverage. It also would allow tax subsidies to adjust in proportion to the actual premium costs that insured individuals face.

The move toward a single tax discount rate (that mirrors the equivalent of a flat federal income and payroll tax rate for everyone) should be phased in over a number of years, rather than imposed overnight, to limit sudden disruption to current employer-based health benefits arrangements. An accompanying cap on the maximum amount of premiums per household from which tax subsidies are based may well be necessary, too. But it should be justified as a way to reduce the distorted incentives created by the currently unlimited tax exclusion (until the ACA's Cadillac tax on high-cost employer coverage kicks in during 2018), rather than as a revenue-generating mechanism to finance expanded health insurance subsidies for low-income individuals or others not benefitting from the ESI-based tax exclusion. Roughly equivalent adjustments in marginal rates for federal income taxes can offset any potential net hikes in federal income taxes for upper-income workers or those with more costly insurance plans. The fiscal need to finance any additional tax subsidies for new beneficiaries should be addressed through other federal spending reductions, or after a broader review of overall tax and budget policy.

The debate over how to replace Obamacare is coming to a fork in the tax code for health policy. We should take the road less traveled that leads to a more sustainable and principled destination.


Mr. Miller is a resident fellow at the American Enterprise Institute, and the co-author of Why ObamaCare Is Wrong for America.

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