An Analysis of the Effect of Tax Policy on Health Insurance Purchases by Risk Group

By Ketsche, Patricia G. | Journal of Risk and Insurance, March 2004 | Go to article overview

An Analysis of the Effect of Tax Policy on Health Insurance Purchases by Risk Group


Ketsche, Patricia G., Journal of Risk and Insurance


ABSTRACT

There is an extensive body of literature dealing with the welfare loss associated with generous levels of health insurance as a function of the tax subsidy. The theoretical discussion in this study considers the effect of the tax subsidy on pooling within plans, and suggests the hypotheses that the tax subsidy will have a disproportionately positive effect on the likelihood that a high-risk worker will be eligible for and participate in employment-based coverage, while the effect of the tax subsidy on plan generosity will be greatest for low-risk employees. If coverage of high-risk individuals enhances social welfare, this result may offset, at least in part, the welfare loss associated with generous plans. Data from the 1987 National Medical Expenditure Survey are used to test these hypotheses. The results provide evidence that the subsidy works to expand risk pools in the employment-based health insurance market.

INTRODUCTION

The exemption of health insurance benefits from state and federal income tax and from payroll tax represents a substantial tax expenditure to the federal and state governments. The Congressional Budget Office (CBO) estimated the federal subsidy to be $74 billion in 1994. Sheils and Hogan (1999) estimate the subsidy to be $111 billion by the federal government and an additional 13.6 billion by the states in 1998. The level and distribution of this tax expenditure and its effect on the health insurance market are the subject of much debate.

Analysis of a change in the tax subsidy requires a clear understanding of potential consumer response to the pre- and posttax price of coverage. A change in tax policy would result in a change in the real price of coverage within employment groups. Any response to changes in insurance premiums must be considered within the context of risk pooling in the employment-based insurance market. The demand for insurance coverage depends, in part, upon the perceived risk of incurring an insured loss. Thus a change in price is likely to affect the level of pooling in employment-based coverage.

Monheit, Nichols, and Selden (1995) analyzed the distribution of net health insurance benefits in the employment-based market using the 1987 National Medical Expenditure Survey (NMES) data. They demonstrated that without the tax subsidy, substantial negative net benefits could be anticipated by most workers. However, the tax subsidy narrows the loss experienced and thus may promote participation in the employment-based health insurance market by those who would otherwise anticipate net losses from participation. Their study provides some evidence that the tax subsidy affects the extent of risk pooling in the employment-based system. Likewise, Royalty (2000) evaluated the effect of state tax rates on group health insurance to show that the tax subsidy expands worker eligibility for coverage.

This study contributes to the existing literature and the policy debate by considering the effect of the tax subsidy within the context of the selection problem in the insurance market. The following section provides the theoretical background through a review of risk pooling in insurance markets and within employment-based markets. This is followed by a discussion of the welfare effects of pooling and the effect of the tax subsidy on the level of pooling. The theoretical discussion is followed by a presentation of empirical work that provides evidence of the effect of the tax subsidy on risk pools, a discussion of the results obtained, and the implications of this study for policy with respect to the tax subsidy.

THEORETICAL BACKGROUND

Pooling in Insurance Markets

Many authors have addressed the problem of the effect of asymmetric information on insurance markets. Akerloff (1970) showed the potential for asymmetric information to eliminate a potential risk market. Rothschild and Stiglitz (1976) consider the application of the problem of asymmetric information to insurance markets. …

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