The Best of the Second Best: Using Tax Breaks to Manipulate Health Insurance Mark V. Pauly, Ph.D. ARIA Meeting August 7, 2006

Goals of this talk To summarize the design of ideal tax incentives for health insurance. Having observed that movement to the ideal is not politically feasible next week, what are possible second best arrangements that represent improvements if not perfection? How do these alternatives compare on efficiency (where I am an expert) and on political likelihood (where we are all amateurs)?

Ideal Insurance Subsidies No subsidy at the margin for additional coverage beyond the level that assures socially approved use and financial protection. Translation: Dives (high income, healthy) does not need a subsidy, but Lazarus (low income, high risk) does.

Ideal Subsidies in Detail Subsidize the premium of the minimum policy needed to produce ideal use; probably larger for lower incomes and higher risks. Make the subsidy fixed dollar; people can buy whatever insurace they prefer as long as it is more at the minimum but with no marginal subsidy. Deal with insurance risk change through GR or other devices.

What Current Subsidies Do Subsidize high incomes more than low. Subsidizes employment based coverage so employers choose rather than individuals. Offers an open-ended subsidy to insurance HAS/CHP too little, too limited to help much so far.

Where are the distortions? 1. Subsidize health insurance rather than out of pocket payment—leads to excess moral hazard. 2. Subsidizes health care rather than other goods— leads to too much health and too little wealth. 3. Bribes people to let their boss pick their insurance, and take it away if they get too sick to work. 4. But it is the American way.

Second Best solution fix some but not all distortions Health Savings Accounts-CHP fixes employer choice ( a little) and overinsurance (but crudely); creates bias toward high deductible plans (relative to Rambo HMO) in individual market. Cogan, Hubbard, Kessler fix bias toward group insurance by making all spending on care or insurance deductible, but this leaves bias toward medical care. Caps on exclusion fix bias toward insurance and health care but not toward employer choice.

Away at the Windmill: Why not first best? Best estimate of spending reduction is CHK, about 6%. Phelps estimate suggests eliminating the exclusion entirely would save 10-20% (all based on Rand data). As a % of total spending, these changes are reduced by Medicare and Medicaid. CHK “everything deductible” approach still leaves biggest subsidies for those who need them the least; abolishing the subsidy (and then filling in with credits) will be better.

A modest proposal: treat group health like group life Exclusion of group life premiums are capped at face amount of $50K. This has not destroyed group life but probably has caused it to be lower relative to individually chosen life. Little reduction in risk pooling that we know about. No big fuss about the level of the cap. Easy for employers to offer choice of levels of coverage.

The analogy Set up a cap at the cost of a modest plan. Encourage employers to offer at least that plan, but also alternatives. Increase the cap at a rate that is socially approved. Convert to refundable credit for lower income people. Might allow the exclusion to wither away and the credit to grow.

Why Politics Is Hard I currently exclude more than $10,000 of my income through employer payment, cafeteria plan, and FSA (where I have defeated use it or lose it). Estimate the tax savings to be $4500. If I were selfish I would want to keep this. But if I were rational, I want you to offer me a $4500 closed end tax cut, and then I would be happy to spend more frugally. The problem: converting an inequitable but inefficient loophole into an efficient one makes the inequity too obvious to be tolerated. Since I can only keep my ill- gotten gains in an inefficient form, I support inefficiency.

Why Middle Class Cost Containment is Also Hard We could get non trivial but not breathtaking one time spending reductions for sure by changing tax treatment. Need not have an effect on risk pooling in large firms, and there really is very little pooling in small firms relative to individual insurance with GR. But it will not obviously slow the rate of growth much, for very long. Some positive research but nothing definitive. We need a change of mind as well as a change of taxes. Face up fearlessly to rationing new technology or to foregoing some other growth in real income.