The Senate Health Bill Is Less Economically Damaging

Last month, both the House and Senate passed versions of health care reform bills designed to expand health insurance coverage to a large majority of Americans. Both bills include substantial tax increases, but they diverge greatly in the taxes they would raise, and the Senate bill's tax provisions stand out as much less economically damaging.

While the House Bill takes a "soak the rich" approach, the Senate bill includes few tax rate increases. Instead, it includes a new tax on "Cadillac" health plans that would offset the existing tax exclusion for employer-provided health insurance. This proposal would inflict low economic cost and is one of the few proposed reforms that would help "bend the cost curve" on health care.

First, let's look at the execrable House bill. It raises taxes by $561 billion over 10 years, on top of any tax increase that will come from the likely sunset in 2011 of many of the Bush tax cuts. A large majority of that tax increase ($461 billion) comes from a new surtax of up to 5.4% on the adjusted gross income of high-income taxpayers.

The high income surtax is an economically damaging way to finance an expansion of health insurance. A paper this summer by Robert Carroll of the Tax Foundation estimates that, for every dollar of new revenue raised, the proposed health care surtax would impose an "excess burden" - that is, lost economic activity - of fifty cents. By comparison, the excess burden of the income tax as a whole is just 11.5% of revenue raised -meaning the new tax would be over four times as costly to the economy per dollar of revenue. A new tax on rich people also does nothing to contain health care costs.

The Senate bill contains "only" $372 billion in tax hikes over 10 years. More important than the reduced scope is the nature of the tax increases. While the Senate bill contains a more modest ($54 billion) high-income tax hike imposed through the Medicare tax, most of its tax increases relate directly to the health care system.

The largest revenue component is an excise tax on so-called "Cadillac" health plans, set to raise $149 billion over 10 years. Because this change would have little effect on the effective marginal tax rates faced by workers, it would do little to discourage economic activity and is a relatively good way to raise revenue.

The Cadillac tax is a backdoor way of limiting the tax exclusion for employer-provided health insurance. Plans costing over $8,500 for an individual or $23,000 for a family (rising in later years with CPI + 1%) would be subject to a 40% tax on the premium amount over the threshold. Currently, employer-provided health insurance gets very favorable tax treatment, as it is not subject to federal income and payroll taxes. The excise tax would roughly offset this treatment for premium costs above the cap.

The existing health insurance tax exclusion has several negative consequences. It artificially links health insurance to employment, discouraging job mobility and increasing the cost of unemployment. It encourages pre-payment of routine health care expenses through insurance premiums, which discourages patients from paying attention to the cost of routine care. (Pop quiz: do you know what your last physical exam cost? How about your last oil change?) And it increases the share of economic activity that is spent on health care activities to a level that is inefficient.

The exclusion is what economists call a "tax expenditure": a loss of government revenue caused by excluding certain items from the tax base or providing tax credits. Tax expenditures can have economic effects that are indistinguishable from direct subsidy payments, and are used to achieve many of the same policy goals; indeed, many programs can just as easily be structured as direct payments or refundable tax credits. Tax expenditures also distort economic activity by generating more of the tax-favored activities.

Some conservatives don't like the term "tax expenditure," because it suggests that the public's money belongs to the government and declining to tax it away is an expense. But whatever we call it, it's important to consider the consequences of these provisions, as they are a key way in which the government influences and distorts the economy.

The effects are large: in 2007, the federal tax expenditures for employer-based health insurance totaled $246 billion, with billions more in tax subsidies at the state and local levels. By contrast, federal spending on Medicaid was $191 billion, meaning the insurance tax expenditure is the federal government's second largest health care "program."

Ideally, reform would eliminate the exclusion entirely, and replace it with means-tested health care subsidies. Senators Ron Wyden and Robert Bennett have proposed a bipartisan reform along these lines. Martin Feldstein, former chairman of the Council of Economic Advisors under Ronald Reagan, has advanced another such proposal.

Unfortunately, a complete elimination is off the table politically, in part because President Obama has strongly supported retaining a system that is built around employer-provided insurance. Indeed, when John McCain proposed to scrap the tax exclusion in his 2008 campaign platform (in favor of a flat $5,000 tax credit per family) Obama's campaign attacked him for wanting to "tax health care." The Cadillac tax at least puts a dent in the current tax exclusion regime, which may be the most we can hope for in the current environment.

The Senate bill is not a good package on balance. Nearly half its cost is financed with Medicare cuts that are likely to prove illusory: doctors and patients will scream when scheduled reimbursement rate cuts approach, and Congress will inevitably "fix" the reform by spending more money. There is also doubt about the estimated cost of new subsidy programs, and the bill fails to promote consumer direction in health care spending.

The tax side also has lots of problems. The phaseout of new insurance subsidies will expose some middle-income people to effective marginal tax rates over 70%, a significant disincentive to productivity. The introduction of progressivity in Medicare tax sets a troubling precedent. And even the Cadillac tax itself has holes, including caps that are initially set too high and special favorable treatment for police and firefighters, included at the behest of public employee unions.

But it is highly likely that Congress will pass a health care bill this year or next that combines elements of the House and Senate bills. We will be much better off if the revenue side of the bill looks like the Senate version's, which mostly stays away from "soak-the-rich" tactics and takes some steps to contain bloat-inducing tax expenditures for health care.