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January 29, 2007
Bush Wants CEO Tax Increase, Democrats Say No
by Martin A. Sullivan

Full Text Published by Tax Analysts®

Document originally published in Tax Notes
on January 29, 2007.



Former Clinton administration Treasury tax official Len Burman was right when he told the Senate Finance Committee that the tax exemption for employer-provided health insurance is "an upside-down subsidy." It provides the most incentive for those who need it least. The rich with Cadillac healthcare coverage in high tax brackets get the lion's share. The poor with Chevrolet coverage and low tax rates get the scraps.

So it is understandable if you were confused when President Bush, a Republican, announced his plan to cap tax benefits for "gold-plated" healthcare plans and then use the added revenue to expand tax breaks for lower-end healthcare plans, whether or not those plans are employer-provided. That would be using the tax system to redistribute income from the rich to the poor -- a definite Republican no-no. According to Treasury's own estimates, the proposal would raise taxes for the 20 percent of employees with the most expensive health insurance to pay for a lowering of taxes on the other 80 percent of insured employees.

Only more befuddling than the president's proposal was the opposition's response. Congressional leaders -- Democrats -- told the president to take a hike. "Health care is a crisis in costs and coverage, and the President's plan will make both fronts worse for millions of Americans," said House Speaker Nancy Pelosi, D- Calif., and Senate Majority Leader Harry Reid, D-Nev., in a joint statement. Sen. Edward M. Kennedy, D-Mass., called the plan "deeply flawed." And Rep. Fortney Pete Stark, D-Calif., chair of the pivotal House Ways and Means Subcommittee on Health, flatly stated that his subcommittee would not even consider the proposal.

So what's up with the Democrats? Don't they like progressive tax cuts?

In a January 24 op-ed in The Washington Post, Ruth Marcus suggested the Democrats' response to the president's health insurance tax reform proposal is nothing more than "knee-jerk opposition." If Bush proposes it, they must oppose it.

Only slightly less flattering to the Democrats is the suggestion that their close ties to organized labor are more important than tax progressivity. After negotiating expensive healthcare benefits for their members, unions strongly oppose any notion of limiting the tax subsidy for health insurance. During the 2006 election cycle, unions contributed $62.6 million to candidates for Congress. Democrats got 86 percent of that total. Perhaps Democrats are now just returning the favor.

Of course, official responses to the president's plan contain no hint of that. Most are filled with economic nonsense and half-truths. For example, from Kennedy's office: The plan "taxes middle class Americans to benefit the wealthiest." (The opposite is true.) But amid all the blather, there is one claim by Democrats that deserves serious attention.


Safety in Numbers


The Democrats assert that by leveling the playing field for employer-purchased (currently untaxed) and individual-purchased (currently taxed) health insurance, the president is damaging the employer-provided market and that will reduce overall health insurance coverage.

The italicized portion of that statement is key. We would never expect a subsidy to shrink the market if the target of the subsidy was a normal economic commodity like lettuce or the migrant labor that picks it. But health insurance is a special case. It does not obey the usual laws of supply and demand.

For contrast, let's first look at a standard economic analysis of a normal commodity: downtown commuter parking. Suppose new government policy sets out to level the playing field between (tax- advantaged) employer-provided parking and (unsubsidized) individual- pay parking by allowing a deduction for the latter. Quite naturally, that would shift demand between the two types of parking. And nobody would think that it would reduce the total number of commuters who drive to work. In other words, the decline in employer-provided parking would be less than the increase in individual-pay parking.

But health insurance has features that result in deviations from the usual market outcomes. For the market to work efficiently, health insurance would have to be priced fairly. For that to happen, an insurance company would need good information about the health of an individual it's insuring. But an individual typically has a much better idea of his future health than an insurance company does. That asymmetry of information means the insurance market will begin to malfunction.

Competition among insurance companies would tend to drive the price of insurance to the average of what it ideally would be for healthy and unhealthy customers (assuming one could make the distinction). But this type of averaging is not a tenable situation. Because their insurance is overpriced, healthy customers will drop out of the market. At the same time, unhealthy customers gladly remain because they are getting a good deal. Prices must rise for insurers to remain profitable. And then the process may repeat itself and create a price spiral. This emigration of the healthy from the insurance market is what economists call adverse selection.

A partial solution to the adverse selection problem is risk pooling. If individuals are arranged in groups according to characteristics that have little to do with the state of their health, insurance companies can have some confidence that the group contains a standard distribution of healthy and unhealthy individuals. The risk of adverse selection is limited by selling insurance to the group.

One such grouping of individuals is a company's workforce, so employer-provided health insurance reduces the potential for adverse selection. That's the main reason employer-provided health insurance is significantly less expensive than health insurance purchased by individuals.


Recipients of Labor Union Campaign Contributions
During the 2006 Election Cycle




Source:
Federal Election Commission data compiled by the
Center for Responsive Politics.


Applied Economics



Now let's return to Bush's proposal to make tax benefits for individual purchases of health insurance as generous as employer- provided health insurance. First there's the good news: Some currently uninsured individuals will purchase health insurance on their own because its after-tax price will drop. (That's the effect the president wants you to focus on.)

Then there's the bad news: Knowing their employees have other options, some small and midsize employers will drop their healthcare plans. Some employees who lose their employer-provided health insurance will purchase more expensive individual plans, and some will become uninsured. (That's the effect the Democrats want you to think about.)

Now if we were talking about parking instead of health insurance, employers ceasing to provide the benefit would be no particular problem from an economic perspective. Employees would have less employer-provided parking, but there's no reason why, in a free market, that loss would not be offset by an increase in wages or other benefits.

But an analogous shift in health insurance is not so benign. It means individuals would move out of the relatively cheap and efficient employer-provided insurance market to the cold, cruel individual market. Workers and their families who have preexisting conditions will be hit particularly hard. Anyone who is displaced from the employer-provided insurance market will face a price increase, and some people will drop their health insurance coverage altogether.


Can't Have It Both Ways


So the Democrats have a valid point. But whether it justifies the intensity of their opposition to Bush's audacious plan is questionable. Their main argument -- that the number of Americans without health insurance would increase under the president's plan -- would require that the number of currently uninsured individuals who would purchase their own insurance under the president's plan be smaller than the number of individuals who would exit the employer- based system and not purchase individual insurance.

No doubt some economists will support the Democratic view that health insurance coverage would decrease under the Bush proposal, and other economists will conclude that insurance coverage would increase. For example, Katherine Baicker of the president's Council of Economic Advisers estimates that the number of Americans with health insurance would increase by three million under the plan. But nobody really knows.

Even if we assume health insurance coverage would fall, Democrats don't clinch the policy argument. There is a fundamental unfairness that workers without employer-provided insurance -- often the most oppressed of the working poor -- get fewer tax benefits than more affluent workers who have insurance. The Democrats look a little silly abandoning a key constituency -- and perhaps this is one reason Bush floated the healthcare proposal.

There is a logical and economically sound way to solve the adverse selection problem and provide health insurance to the working poor. It's called universal healthcare, a system in which every individual is provided health insurance through the government. That's too scary for most people, so Democrats dance around the issue. They want to provide the benefits of universal healthcare, but they don't want to actually propose it.

That leaves Democrats with no choice but to support the employer-based system at all costs. That's nice for the health insurance haves, but it's nasty for the health insurance have-nots. Plus it leaves Democrats in a trap of their own making: They must oppose any relief to those unfortunates whose employers provide no health plan. And to make matters even worse, sometimes Democrats must oppose repealing tax breaks for the CEOs they claim are obscenely compensated.


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