Health Insurance and Tax Policy

By Jeske, Karsten; Kitao, Sagiri | Federal Reserve Bank of Atlanta, Working Paper Series, August 1, 2005 | Go to article overview

Health Insurance and Tax Policy


Jeske, Karsten, Kitao, Sagiri, Federal Reserve Bank of Atlanta, Working Paper Series


Abstract: The U.S. tax policy on health insurance favors only those offered a group insurance through their employers. This policy is highly regressive since the subsidy takes the form of deductions from the progressive tax system. The paper investigates alternatives to the current policy. We find that the complete removal of the subsidy results in a significant reduction in the insurance coverage and serious welfare deterioration. However, eliminating regressiveness in the group insurance subsidy and extending benefits to the private insurance market improve welfare and raise the coverage. Our work is the first in highlighting the importance of studying health policy in a general equilibrium framework with an endogenous demand for the health insurance. We use the Medical Expenditure Panel Survey (MEPS) to calibrate the process for income, health expenditure shocks, and health insurance offer status and succeed in producing the pattern of insurance demand as observed in the data, which serve as a solid benchmark for the policy experiments.

JEL classification: E21, E62, I10

Key words: health insurance, risk sharing, tax policy

1 Introduction

The aim of this paper is to study the effects of tax policy on the health insurance decision of households in a general equilibrium framework with heterogenous agents. Motivating the economic importance of health care and health insurance poses no difficulty. Both in absolute and relative terms Americans spend a sizeable amount of resources on health care. According to the Bureau of Economic Analysis (BEA), health care expenditures account for 11.9% of GDP in 2004, more than housing services (10.6%), food (9.8%) or durable goods consumption (8.5%). (1) In absolute terms, an average American spends about the $4,887 on health care. At the same time a record number of 45 million people or 15% of the population lack health insurance.

Not surprisingly, the government is actively involved in the health insurance market through government-run medical programs and the tax policy. In 2003 Medicare and Medicaid combined spent $420 billion, almost 4% of GDP. A lesser-known health policy is an estimated $140 billion a year government subsidy in the form of tax-deductibility of employer-provided health insurance. (2) The origin of this policy lies in the price and wage controls in the U.S. during the World War II when companies used the employer-provided health benefits to compete for workers that were in short supply, thereby circumventing the wage controls. Even after the price and wage controls were lifted employers kept providing health plans because they could be financed with pre-tax income. The tax deductibility was extended to health insurance premiums of self-employed individuals more recently.

We set up a general equilibrium model to evaluate the merits of the tax-deductibility of health insurance. We investigate two main issues about the current U.S. tax policy on health insurance. First, the policy is regressive with the progressive income tax and fails to provide vertical equity across different income groups. Second, the tax benefits are limited to the group insurance market and fails to satisfy horizontal equity depending on the offer status of group insurance.

To see the first point of regressiveness, imagine that person A has low productivity, worth $20,000 of annual labor services putting him in the 15% tax bracket, while person B has high productivity, worth $1,000,000 of labor services putting him in the 35% tax bracket. Moreover, a health insurance plan costs $5,000. Assume that initially employees pay for the health insurance plan with after-tax money. If we then introduce tax-deductibility of the insurance premium person A will save $750 and person B will save $1,750, that is, the already well-off person gains more from the tax subsidy. From a risk-sharing point of view this regressive policy is detrimental to welfare and our paper attempts to set up a general equilibrium model to assess the welfare costs of this policy. …

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