One Simple Step With Big Implications

President Bush’s health insurance tax reform is the simplest and yet most radical proposal to emerge in decades.

To understand why, readers need a little background.

U.S. Health Insurance Tax Policy

During World War II, the country imposed wage and price controls to limit inflation during wartime shortages. Employers started offering health insurance as a way to attract good employees in a tight labor market, raising the question whether those benefits would be considered taxable income. In October 1943, the IRS announced that employer-provided health insurance benefits would not be considered income for tax purposes — what is known as a “tax exclusion” because the money spent on health insurance is excluded from income.

In the economic boom after World War II, more and more employers began offering health insurance as a benefit. The result is that the U.S. now has an employer-based health insurance system where between 85% and 90% of those with private health insurance (i.e., those not part of public programs such as Medicare or Medicaid), get their coverage through an employer plan.

Current Tax Disparities

While employer-based health insurance has both pluses and minuses, it also creates some huge disparities. Employees who work for an employer who provides health insurance get a significant tax break. The average cost of a family policy is about $11,500 a year. If an employer is paying all of the premium, that represents a sizeable amount of untaxed income. [Note: economists see that as income because it is part of the total compensation package.] It’s a good deal if you can get it.

The self-employed get a 100% deduction for their health insurance premiums — though that is a fairly recent addition to the tax code.

However, employees who work for employers who do not provide health insurance — often small employers and companies engaged in the service sector where profit margins are thin — get no tax break for insurance. If they buy a policy, they have to do it with after-tax dollars. Since these tend to be lower-income workers, they are the ones who can least afford paying for coverage out of their own pockets.

Economists have long grumbled about these disparities. Nobel Prize-winning economist Milton Friedman argued that all health insurance tax breaks should be eliminated. That would make health insurance similar to just about every other kind of insurance — auto, life, homeowner’s policies, etc. — none of which receives a tax break.

The alternative to eliminating the tax break for health insurance is to give everyone the same tax break. That is what President Bush has chosen to do.

The Bush Proposal

Under his plan, what employers spend on an employee’s health benefits would become taxable income. However, single employees would get a $7,500 standard deduction off their income tax if they had qualifying coverage, and a family would get a $15,000 deduction. And you get the whole deduction even if you or your employer spends less on coverage; but that’s all the deduction you get even if you or your employer spends more.

For example, suppose an employee is making $50,000 a year and his employer is kicking in $5,000 for health insurance. Currently, that employee pays taxes on $50,000 in income and nothing for the health insurance. Under the president’s plan, that employee would report an income of $55,000. However, he would also get the full $7,500 deduction for an individual, so he would only pay taxes on $47,500 — a net decrease in his income tax obligation.

By contrast, if the employer were spending, say, $8,000 on his health insurance policy, the employee would now have taxable income of $58,000. With the $7,500 deduction, he would be paying takes on $50,500. In other words, he would have to pay income taxes on an additional $500 in income — or an extra $100 or so.

Who Wins, Who Loses?

Under this plan, employees who don’t currently have access to employer-provided coverage would get the same tax break as everyone else — a clear winner.

The vast majority of people with employer-provided coverage would see little real change from the current system. Many, as in the first example above, would actually be better off. However, the administration estimates that about 20% of workers have policies that cost more than the proposed standard deductions. They would either pay income taxes on the amount above the deductible, or, more likely, change their policy to lower its cost under the cap.

The self-employed can already deduct their premiums. But because the new standard deduction escapes payroll taxes also, they might see a small benefit.

Policy Implications

For a plan that is estimated to be revenue neutral over 10 years and creates no massive new government programs telling patients what they can and can’t have, this program has huge policy implications.

  • Transparency: One of the biggest problems facing our health care system is that most consumers have no idea how much health insurance and health care cost. The president’s plan makes it clear just how much is being spent on health insurance.
  • Reduced Subsidies for the Rich: Today, people get a tax break for health insurance regardless of how much they spend. That means middle-class taxpayers are subsidizing Cadillac policies for wealthy CEOs. This change says it’s fine if those CEOs want a Cadillac policy, taxpayers just don’t have to subsidize it.
  • Real Insurance: The purpose of insurance is to cover large, unforeseen costs. In the health insurance market, by contrast, workers have been demanding coverage for virtually any health care expense. Capping the tax break will likely begin a slow but steady process of returning health insurance to real insurance, where people are covered for large catastrophic costs.

Employer-Based Health Insurance

The president’s plan decouples the health insurance tax break from employment. That is exactly the direction we need to move because of the changes in the economy.

More and more people are abandoning the traditional working pattern. Workers increasingly are self-employed or choose non-traditional work arrangements. In addition, many households have two-earner families. The employer-based health insurance system reflects a mid-20th century industrial economy, where people have one job and stay with it for many years. We need a 21st century health insurance system for an information economy that centers around the individual, not the employer.

Would this change begin to unravel the employer-based health insurance system?  Except in the state of Hawaii, no employer is required to offer health insurance today. They do it because they choose to do so. There is nothing in the proposal that forces employers to cancel their health plans. Indeed, if employers offer health benefits in order to attract the best workers — as economists see it — employers may decide it is in the company’s best interest to continue coverage.

But it is also true that many employers increasingly see health coverage as an added expense that their competitors in India and China don’t have to provide. The president’s plan reduces some of the pain of an employer dropping coverage — which many are already doing — by giving the tax break to the individual instead.


President Bush’s plan is a big step in the right direction. It doesn’t reshape the health care system from the top down — as the old Clinton plan did and several states are trying to do. It recognizes the changes in the economy, a dynamic workforce and the evolving health care system and tries to position health insurance to be more consumer-focused to meet the needs of a dynamic, competitive economy.