The President's Health Care Reform Proposal: Small and Positive Steps

The President’s radio address last Saturday offered an initial look at a plan for reforming health care that involves the tax code. This plan would provide an annual deduction (or exclusion - I'm not quite sure which at this point) from taxable income for a fixed amount -- $7500 for individuals or $15,000 for couples – related to the purchase of health insurance. If your health insurance plan is currently being provided at a higher cost, then you must pay the incremental taxes on the value above this limit. (A similar proposal was included in the 2005 report of the President’s Advisory Panel on Federal Tax Reform, though with lower amounts.) This plan is a step in the right direction, but it is admittedly a small one.

Currently health insurance is provided largely through employers, with section 106 of the Code providing an exclusion for employer-provided health insurance. This is a good deal for both employers and employees, as it allows an employer to pay after-tax dollars for something that most employees would like to purchase anyway with their hard-earned wages. Through this system, employees accept health care coverage as part of their compensation package, and it comes to them as a tax-free benefit.

This exclusion from the tax base is the largest single “tax expenditure” – totaling $146.78 billion under the 2007 budget estimates. (See Table 19-3 of the 2007 Budget). Thus, it already represents a large reduction from taxable income for employees who work for firms that provide this benefit. Self-employed persons, including partners in partnerships and S corporation shareholders, have also enjoyed a tax benefit for health care costs since 2003, when section 162(l) was amended to allow a deduction for 100% of the costs of health insurance. (Note that there are some complexities in how this works for partnerships and S corporations – which I am leaving out here.)

Some taxpayers are not currently eligible for this benefit, however: employees who are not otherwise covered by their firms. These taxpayers must generally bear a significant tax burden, as their expenditures for health insurance are made with after-tax dollars. True, they may deduct such expenditures as a medical expense, but only to the extent they exceed a “floor” of 7.5% of their adjusted gross income. Thus, a taxpayer with AGI of $40,000 may only begin to deduct his or her health insurance costs to the extent they exceed $3,000, and then only to the extent that the itemized deduction generates a tax benefit.

The Bush proposal would rectify this disparity for employees. And that would be a good thing. However, using the tax code for this purpose presents a real problem: lots of people in the uncovered category do not pay any federal income taxes under the current system. We have created an income tax system where the lower earners do not pay any federal income taxes, and thus incentives coming through taxation do not impact them. Perhaps equally significant, from a political perspective, is the fact that disincentives from raising taxes do not affect them either, so they may feel free to select political leaders who will raise taxes on others with impunity.

The Bush proposal will not fix all health care problems, but it is a step in the right direction. Unfortunately, the sensible contribution it makes may well be lost on those who will invoke the usual political demagoguery (e.g., invoking tax increase language for those few affected by the cap) while refusing to acknowledge the benefit of this proposal and refusing to propose anything more effective.