Bringing the Market to Health Care

Visiting Scholar R. Glenn Hubbard
Visiting Scholar
R. Glenn Hubbard
Presidential candidate Mitt Romney's recent health-care reform proposals, which rely on free-market principles and federalism, will go a long way to fixing our health-care system's woes.

The centerpiece of Mr. Romney's plan is to attack the tax code's discrimination against cost-effective private insurance. He proposes to allow individuals to deduct out-of-pocket health-care expenditures from their taxable income, allow individuals who purchase health insurance premiums on their own--rather than through their employer--to deduct health insurance premiums, and to expand Health Savings Accounts (HSAs) by eliminating the requirement that a qualifying health plan contain a high deductible.

Virtually all observers have argued that the U.S. tax preference for employer-provided health insurance encourages overconsumption of health services. First, it creates a large financial incentive for workers to purchase as much medical care as they can through their employer's insurance plan. In practice, workers do so by enrolling in health plans with high-premiums, but low-deductibles and coinsurance payments. Such plans, by making the purchase of health-care services appear to be less costly than they really are, create a "moral hazard" that leads to overconsumption of health-care services. Second, the tax preference makes health care look cheaper compared to all other goods and services.

A more level tax playing field would encourage individuals to choose health plans with lower premiums and higher copayments for their routine health-care purchases.

The tax preference's impact has been profound. It is the principal reason why nine out of every 10 private health-care plans in the U.S. are purchased through an employer. It is the principal reason why six out of every seven dollars of health-care spending is made by someone other than the person receiving the care. And, it is a key reason for the U.S. health-care system's excessive cost and waste.

Many economists (including us) have emphasized the large benefits to health care of revoking the tax preference. Yet elected officials have repeatedly failed to enact the change because of strong political opposition.

Over the past 30 years, Congress has instead opted for a second best policy. On a piecemeal basis, Congress has gradually leveled the "tax playing-field" between employer insurance and out-of-pocket expenses by expanding the tax preference to out-of-pocket expenses rather than by eliminating the preference for employer provided insurance.

In 1978, Congress created Flexible Spending Accounts (FSAs) to allow health expenditures to be nontaxable to the employee. In 1996, Congress created Medical Savings Accounts to allow a limited number of employees of small businesses to set aside funds tax-free for their out-of-pocket expenses.

In 2002, Treasury regulations established Health Reimbursement Accounts to allow employees to use pre-tax dollars for medical expenses without the annual use-it-or-lose-it provision of FSAs. And in 2003, Congress replaced Medical Savings Accounts with far more attractive Health Savings Accounts. HSAs allow employers and individuals with high-deductible health plans to set aside money tax-free to pay their current or future out-of-pocket expenses.

Mr. Romney's proposal to allow individuals to deduct out of pocket medical expenses is a significant advance in this 30-year progression to a level tax playing field between out-of-pocket expenses and insurance. And a more level tax playing field would encourage individuals to choose health plans with lower premiums and higher copayments for their routine health-care purchases. With more "skin in the game," individuals would exert more control over their choice of health-care services. The health-care savings would be large. We estimate that a proposal such as Romney's would reduce private health-care spending by 6%.

Some critics have argued that allowing out-of-pocket expenses to be tax-deductible will raise, not lower, health-care spending because the policy will make the price of direct medical-care purchases cheaper relative to all other goods and services. As our empirical analysis with Daniel Kessler demonstrates, the critics are wrong. The cost-reducing impact on health-care expenditures of individuals shifting into health plans with higher copayments swamps by a large margin the cost-increasing impact of making out-of-pocket purchases cheaper.

The benefits don't stop with reducing the growth in health costs. As employer premiums decline, the savings will accrue to workers in the form of higher money wages. In competitive labor markets, workers--not employers and not insurance companies--bear the burden of paying for employer-provided health-insurance premiums. Although employers might write the check for premiums, workers ultimately pay by foregoing money wages.

We estimate that making out-of-pocket expenses tax deductible, combined with Mr. Romney's other proposals, will reduce the average premium of employer-provided family health plans by around $2,300 per year. Workers' wages will rise by this amount on average. To be sure, higher out-of-pocket expenses will offset part of this increase--$1,000 of it. But workers will still experience a net increase of $1,300 in (taxable) income. Mainly because of this economic effect, we estimate that the U.S. Treasury's revenue loss will be modest--about $10 billion per year.

Mr. Romney's proposal also allows persons who purchase health insurance on their own to deduct their premium payments. This tax deduction will make insurance significantly less costly for unemployed persons and workers in firms that don't offer insurance coverage. Because both out-of-pocket spending and individually purchased health insurance would be deductible, a person in a 15% tax bracket who purchases a $2,000 health-insurance plan and who has an additional $700 in out-of-pocket expenses would realize a tax savings of $405--a 20% reduction in the effective cost of the insurance plan. The lower cost provides significant incentive for currently uninsured individuals to buy at least catastrophic insurance.

Some health-policy experts have questioned why Mr. Romney would seek tax changes beyond those embodied in Health Savings Accounts. Indeed, HSAs are one of the most important health-care policy innovations in decades. If they are to achieve their potential, they must be made more attractive to a broader segment of the population. A key deterrent to choosing an HSA has been the requirement that an individual must be enrolled in a high-deductible health-care plan. The requirement, $1,100 for individuals and $2,200 for families, is simply too high for many consumers.

It is also unnecessary. Mr. Romney's proposal to eliminate the "high deductible" requirement will allow individuals to establish an HSA regardless of their health plan's deductible. Eliminating the high deductible requirement will maintain the cost-reducing benefits of HSAs. Evidence from the RAND Experiment indicates that most of the expenditure-reducing effects of health-plan deductibles occur at low levels of deductibles.

The key to reducing the U.S. health-care system's excessive cost without damaging its ability to innovate is to allow competitive market forces to operate. These forces have worked in every other market to keep costs low and improve quality. There is no reason why they won't work in health care. Attacking the tax code's bias against efficient and cost-effective health insurance is fundamental to creating an economically sound health-care system.

R. Glenn Hubbard is a visiting scholar at AEI. John F. Cogan is a senior fellow at the Hoover Institution. With Daniel P. Kessler, they are coauthors of Healthy, Wealthy, and Wise: Five Steps to a Better Health Care System (AEI Press, 2005).

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