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A recent TPC< analysis looked at the effect of both candidates' plans on marginal tax rates–the tax paid on an additional $1 of income. Spurred by a comment from Greg Mankiw, we also reported an alternative analysis that tilted the numbers more in Senator McCain's favor. That prompted a complaint from Obama advisors pointing out that TPC's analysis failed to consider how the McCain health plan could boost marginal effective tax rates.
Senator McCain's health care proposal would replace the existing tax exclusion for employer-sponsored health insurance (ESI) premiums with a refundable tax credit of $2,500 for individuals and $5,000 for those families who obtain qualifying health insurance. A Tax Policy Center (TPC<) analysis concludes that this plan would be much more progressive than the current system and would slightly reduce the number of people without insurance, but would also cost about $1.3 trillion over 10 years.
Two factors cause marginal rates to increase.
First, the proposal would raise the cost of purchasing more health insurance. Workers choosing to work more may want to spend some of their added compensation to buy additional coverage. For instance, they may demand more comprehensive plans from their employers. Under the current system, workers receive these extra benefits tax-free. McCain would require that added premiums come out of after-tax pay, effectively raising the marginal tax rate on labor.
Second, adding ESI premiums to taxable compensation will push some taxpayers into higher tax brackets, further raising the marginal cost of additional work. For example, a single taxpayer with taxable income of $75,000 and $7,000 in ESI premiums is in the 25 percent bracket. McCain's plan would raise her taxable income to $82,000 and push her into the 28 percent bracket.
McCain's plan might also change workers' employment decisions. Since he would reward taxpayers for obtaining health coverage, regardless of whether they get it through an employer, some workers may switch from a position that offers health benefits to one that doesn't, or they might switch from full-time to part-time if they do not need to work 40 hours to get tax-subsidized health insurance. Some might elect to not work at all.
There is no formal estimate of the effect of the plan on marginal tax rates but a Congressional Budget Office analysis of a somewhat different plan suggests that a plan like McCain's could raise marginal tax rates by perhaps 1.5 to 2 percentage points above the estimated 31 percent current rate.
In a sense, these effects are by design – one of the strengths of McCain's proposal is that it reduces the incentives for taxpayers to buy overly comprehensive insurance. The downside is that he raises the after-tax price of purchasing additional insurance. We may have to raise the cost of coverage to limit the increase in health costs, but we should not ignore the accompanying impact on labor supply.
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