The Magazine

Health and Taxes

The Bush plan is good medicine.

Feb 5, 2007, Vol. 12, No. 20 • By DAVID GRATZER
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When asked by a reporter why he robbed banks, Willie Sutton famously replied: "Because that's where the money is." In the State of the Union address, President George W. Bush focused on domestic policy and, in particular, health care by talking about, not Medicare or Medicaid or health savings accounts, but taxes. How to understand the connection? Health care reform must involve tax reform because that's where the money is.

The president proposed ending 60 years of arbitrary tax policy that--by making employer-provided health benefits tax free--punishes the self-employed, rewards society's most affluent, and distorts the entire health care system at a cost of hundreds of billions of dollars to the Treasury. Should Bush's proposal to cap this tax exemption win approval, millions more will have better access to health insurance and 80 percent of workers will get a tax cut. It's the right prescription.

Not everyone sees the tax-health care connection. In the week before the president's speech, Governor Arnold Schwarzenegger of California busily touted his proposal for universal health coverage while his counterpart in Pennsylvania, Ed Rendell, unveiled his own plan. Two separate coalitions of business and union interests held press conferences, announcing proposals to insure the uninsured. On the Hill, congressmen lined up behind two bills with similar aims. And no one mentioned anything about tax policy.

But the tax discussion can't be avoided now that health care is again a big issue. Health insurance premiums have roughly doubled in the past five years and there's no slowdown in sight--which is why the AARP and the Business Roundtable are suddenly holding press conferences together. But only the Bush proposal actually tackles the huge subsidy in the tax code that drives this inflation. For the most part, the other plans offer more subsidies and regulations to save an American health care system drowning in subsidies and regulations.

The president's plan would make health insurance premiums fully tax deductible for individuals, finally putting the self-employed on an even footing with all other Americans. How to pay for this? By capping the tax exemption. Above, say, $15,000 for a taxpayer filing jointly, further employer-provided health benefits would be treated as taxable income, subject to income and payroll taxes. This means that people who now receive gold-plated health plans from their employers would see their taxes go up.

What makes these ideas so sweeping? Consider why most Americans get their health insurance from their place of work. Employer-sponsored health insurance is a quirk of history--companies, of course, don't ordinarily help people with other basic needs, like food, shelter, or clothing. But as an indirect way around wage controls during the Second World War, employers--unable to offer raises--began offering health benefits to attract and retain employees. On October 26, 1943, the IRS ruled that employers could continue to pay health insurance premiums in pre-tax dollars. That ruling legitimized and encouraged the practice Americans now take for granted. After all, if a manager is given a raise of $1,000, he may well take home only $600 (depending on the marginal tax rate); but offer him $1,000 worth of health benefits, and he isn't taxed on them. Not surprisingly, health benefits have evolved to cover massage therapy, marital counseling, sunglasses, and a host of other things that have little to do with health care, strictly defined. The 1943 IRS ruling helped make health benefits a disguised form of income.

Fast forward sixty years, and the result of that ruling is that Americans tend to be insured through their workplace--and overinsured at that. Americans pay just 14 cents out of pocket for every dollar of health care. Carrying so much insurance means that, among other problems, there has been little incentive for people to economize on their health spending.

The tax incentives arbitrarily reward some and punish others. Consider: If a person works for a company that offers health insurance, the premium is paid in pre-tax dollars; if, however, he's a consultant for that company, he must pay significantly more for the identical insurance, because the premium is paid in after-tax dollars. In other words, the 17 million self-employed Americans are penalized under the existing system.

Moreover, for those with employer-sponsored health insurance, the deduction is unlimited, meaning that the more lavish the health plan and the higher the employee's income, the bigger the tax saving. If health benefits were taxed as regular income, the Treasury would take in another $200 billion annually. A quarter of that total goes to people with incomes over $150,000 a year.