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President Bush proposed a practical health care reform during the annual State of the Union Address. Alas, with health care shaping up to be a major issue in the 2008 Presidential election campaign we do not expect Congress to give it deserved serious consideration.

Government wage controls during World War II induced American employers to use health insurance benefits to attract quality workers. Price controls ended with armistice, but the illogical connection between employment and health care remains today. The tax-favored employer-based system is inequitable, inefficient, and unduly encourages consumption of health care.

It is inequitable because employees are tax-favored over otherwise self-employed individuals, and higher income individuals and those with more expensive health plans receive higher subsidies than more modest income families and those with less expensive health plans. It is inefficient because large subsidies are paid to people that would have purchased insurance anyway – and at an estimated cost of over $150 billion it would represents the fourth largest item in the federal budget if it were reported. Subsidizing health care encourages consumption of it over other goods and services, and guides individuals to purchase more elaborate coverage, with more third-party coverage, than they would otherwise choose to purchase.

President Bush offered two proposals to partially undo this arrangement. The first would treat employer contributions for health insurance premiums as taxable income to employees. The second would create a standard federal tax deduction that all taxpayers, including itemizers, purchasing a health insurance policy can claim – $7,500 for individuals and $15,000 for families and indexed to the rate of consumer price inflation. Over time, the value of the deduction will erode since historical health care costs have increased faster than overall consumer prices. The deduction is non-refundable and fixed – families with no income tax liability will not receive payments from the government, and those with liability can deduct the full amount, even if their plan cost less. Workers with little or no income tax liability would benefit because the deduction also reduces their payroll tax liability.

Your tax liability depends on your income and payroll tax rates and the amount your employer contributes to your health insurance plan. For example, the net impact on tax liabilities for a family earning $50,000 with a company insurance contribution of $8,000 will be a savings of $1,586 in the first year.

The fixed deduction results in the largest tax savings for those with the least expensive employee health plans, for those who purchase insurance on their own, and for the uninsured who newly purchase a policy. Those with more expensive health plans will incur tax increases. More costly plans may reflect more generous insurance (such as first dollar coverage or fewer specialist restrictions), but may also reflect regional cost differences and poorer health – leading some to believe that the new plan is unfair. Regardless, the plan will encourage individuals and employers to seek out lower cost plans, such as high-deductible health insurance plans, in order to maximize tax savings.

The Bush proposals have four merits. They promote equity by leveling the playing field for those purchasing insurance on their own and limiting subsidies enjoyed by workers who purchase expensive policies. Second, they make the full costs of health expenditures transparent for the 60 percent of Americans currently receiving insurance though their employers – which might introduce more competition and cost consciousness among insurance companies. Third, they would eliminate the arbitrary favoritism in the tax code to health care over the purchase of other goods and services. Finally, labor mobility and the quality of job matches may improve as there is less pressure on workers to remain in or seek jobs solely for the health insurance benefits.

The proposals’ impacts will be limited. The non-refundable income tax deduction will not benefit the 32 percent of Americans who filed federal tax returns and paid no income tax in 2006. Among the uninsured, over half have no income tax liability while only a quarter owe more than $2,000. Thus, the program is, at best, expected to remove only five million people (of 47 million) from the uninsured ranks. Workers benefiting from a reduction in taxable payroll earnings would incur potentially substantial declines in their future Social Security retirement incomes because benefits are dependent on lifetime taxable wages – a non-trivial loss for lower-income families. The Bush plan is unlikely to restrain national health expenditure growth since it does little to address its fundamental causes such as the high demand for expensive new medical technologies.

Nonetheless, this small step away from the employer-based system merits consideration.

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