Health expenditures, tax treatment of

Originally published in the NTA Encyclopedia of Taxation and Tax Policy, Second Edition, edited by Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle. The encyclopedia is available in paperback from the Urban Institute Press. Order online at www.uipress.org or call toll-free 1-877-847-7377

Louise Sheiner
Federal Reserve Board of Governors

Federal tax treatment of health expenditures made by individuals and by businesses on behalf of employees.

The federal tax system provides favorable tax treatment to health expenditures in numerous ways, the most important being that employer-paid health insurance expenses are deductible for the employer and not included in employees’ taxable wages; taxpayers with cafeteria plans may be able to deduct their share of premium payments and some out-ofpocket health expenses; and health expenditures exceeding 7.5 percent of adjusted gross income are deductible for taxpayers who itemize deductions.

This favorable tax treatment reduced income and payroll taxes by roughly $100 billion in 2003, making it one of the largest "tax expenditures" in the current income tax system (Joint Committee on Taxation 2003).

Efficiency effects

The largest and most important tax expenditure for health is the exclusion of employer-paid health insurance premiums. As has long been recognized, the tax treatment of employerpaid health insurance provides an incentive for workers to be compensated in the form of health insurance rather than in cash wages. A $1 increase in employer-paid health expenditures costs only (1 - ti - tp)/(1 + tp), where ti is the income tax rate (federal plus net-of-federal state tax) and tp is the payroll tax rate. So, for an employee facing a 20 percent marginal income tax rate and a 7.65 percent payroll tax rate, an additional $1 in employer-paid health insurance costs only 67 cents.

Analyzing this tax subsidy’s effect is not straightforward. The current subsidy is not simply a subsidy for all health expenditures, but rather for health expenditures financed through employer-paid health insurance premiums. Monies employers spend on health insurance premiums are excludable from taxable income, but employee health expenses for the employee’s share of the insurance premium, for coinsurance and deductibles, and for noninsured health expenses are generally not deductible from taxable income. This tax structure can lead to distortions in different dimensions, including how much health insurance to consume, how much health to insure, and whether to purchase insurance through an employer.

Effect on health expenses and health insurance

Feldstein and Friedman (1977) were among the first to analyze how this excludability of employer-paid health insurance premiums affects the structure of employer-paid health insurance. They found that the tax subsidy reduced coinsurance rates (increasing the share of health expenditures covered by insurance) by about 50 percent. Recent work (see Gruber 2001) also found that the tax subsidy raises health spending significantly, both by inducing employers to offer insurance and by increasing the amount of insured health spending. Jack and Sheiner (1997) compared the efficiency consequences of a health insurance subsidy with those of a broad subsidy to health care. On the one hand, limiting the subsidy to health insurance premiums leads consumers to purchase insurance that is more heavily weighted toward premiums-that is, with lower coinsurance and deductibles-thereby increasing health expenditures. On the other hand, providing a subsidy to out-of-pocket payments reduces the effectiveness of any given coinsurance and deductible at holding down health expenditures. However, for reasonable parameter estimates, Jack and Sheiner found that the first effect prevailed, and that a subsidy to health insurance alone leads to lower coinsurance rates and greater health expenditures than would a broader subsidy to all health expenditures. For example, in their model, the current subsidy reduces coinsurance rates by about 40 percent, whereas a tax system that also provided the same rate of subsidy to out-of-pocket health expenditures would reduce coinsurance rates by only about 25 percent. They calculated that these lower coinsurance rates increased health expenditures by 13 and 7 percent, respectively.

Effect of the tax subsidy on pooling

The current tax system provides favorable tax treatment only to health insurance purchased through an employer. This subsidy encourages workers to purchase their insurance through their employer, rather than individually or through other associations. Two questions arise: is employer-based health insurance a good thing, and, if so, would workers purchase insurance this way even without the tax preference? There are differing views as to whether an employer-based insurance system is advantageous (Burman and Rodgers 1992). On the one hand, if individuals choose where to work for reasons unrelated to health status, then employer-based insurance can avoid the adverse selection problems that plague the private insurance market. On the other hand, if the availability of health insurance influences job choice, then the link between health insurance and employment may distort the labor market. For example, workers with preexisting conditions or with a preference for a particular health insurance plan may be less likely to switch jobs, and workers may be less likely to work for small firms because these firms typically face higher health insurance costs.

It is questionable whether employment-based insurance can exist in the absence of some form of employer-based tax subsidy. If workers can get equally tax advantaged health insurance through an individual market, then workers in good health might choose to drop employer insurance or to work in places that do not offer it, subjecting the employer-based insurance market to the same selection problems as those in the individual insurance market. This is a potential problem with proposals to provide greater tax subsidies for the individual purchase of health insurance.

Can the tax treatment of health expenditures explain the high rate of medical inflation?

While the tax treatment of health insurance clearly increases health expenditures, it is not known whether the tax system affects the growth rate of medical expenditures. The major factor underlying medical expenditure growth is the adoption of new technology, and most standard models with exogenous technology growth imply that constant tax policy does not affect the growth rate of technology adoption. But, it is possible that tax policy affects the type of insurance coverage, and that insurance coverage affects take-up rates of technology (Pauly 1986). It is also possible that technology itself is endogenous, and that the level of health expenditures affects the growth rate. None of these issues has been examined empirically.

ADDITIONAL READINGS

• Burman, Leonard, and Jack Rodgers. "Tax Preferences and Employment- Based Health Insurance." National Tax Journal 45, no. 3 (1992): 331-46.
• Feldstein, Martin, and Bernard Friedman. "Tax Subsidies, the Rational Demand for Insurance, and the Health Care Crisis." Journal of Public Economics 7 (April 1977): 155-78.
• Gruber, Jonathan. "Taxes and Health Insurance." National Bureau of Economic Research Working Paper No. 8657. Cambridge, MA: National Bureau of Economic Research, December 2001.
• Jack, William, and Louise Sheiner. "Welfare-Improving Health Expenditure Subsidies." American Economic Review87 (March 1997): 206-21.
• Joint Committee on Taxation. "Estimates of Federal Tax Expenditures for Fiscal Years 2004-2008." JCS-8-03. Washington, DC: Joint Committee on Taxation, December 2003.
• Pauly, Mark. "Taxation, Health Insurance, and Market Failure in the Medical Economy." Journal of Economic Literature 24 (June 1986): 629-75.