The June luncheon featured Dr. Robert Helms, Director of Health Policy Studies at the American Enterprise Institute, whose talk focused on the problems arising from the tax treatment of health insurance. Dr. Helms began by noting that the tools the government can use to shape the market for health care are relatively crude. Thus, consumers need to be more involved in the making of decisions that shape the delivery of health care. However, the purchase of health insurance remains concentrated in the hands of employers so that the health-care market remains characterized by restricted competition. The fundamental thesis of Dr. Helms’ talk was concerned with the reason why competition in this market is so limited and the cost of delivery so high. Most individuals tend to think that the problem is greedy doctors or other forms of waste and abuse. However, few people recognize that the root cause of the poor market performance is the special tax treatment of employer-provided health insurance.
Dr. Helms noted that the origins of the current system of medical care lie in the forces that shaped the post-World War II economy. Confronted with wartime wage and price controls and a diminished labor supply, firms began to offer non-wage benefits to lure workers. Health insurance and pensions were the primary non-wage benefits offered to employees. At the same time great strides were being made in medical technology, primarily in pharmaceuticals and surgical procedures. Antibiotics led to better control of infections and surgery and advanced techniques became more commonplace. As a result, the demand for medical care increased and the post-war period witnessed a boom in private health insurance enrollment. Thus, events conspired to drive the purchase of health insurance into the employment market, even as other forms of insurance, such as auto insurance, remained entirely private. Other than labor market forces, a strong catalyst in this development was the exclusion of employer-provided health insurance from taxable income. Even though the Internal Revenue Service ruled in 1953 that this benefit would be taxable, its ruling was overturned by the Congress in 1954.
In 1969, Martin Feldstein published an influential study showing that the tax treatment of employer-based health policies pushed up the demand for health insurance. He estimated that the tax exclusion of these policies translated to a fifteen percent discount to the purchaser of health insurance. Estimates for later years by Feldstein and other researchers show that the discount may be in the neighborhood of 25 percent. One study even estimated the discount to be as high as 34 percent. The value of the tax exclusion also increases steadily with the income level. In absolute amounts, Feldstein estimated that the tax subsidy cost the Federal government $2 billion in 1969. A later estimate by Feldstein indicated a subsidy cost of $42 billion in 1978. A Congressional Budget Office study placed the value of the subsidy at over $60 billion in 1995 and some more recent estimates even go as high as $110 billion.
Other researchers who have studied the effects of this tax treatment on the market for health care conclude that not only has the tax exclusion increased the demand for these employer-provided health plans, it has also increased the cost of delivering health care as both the quantity and intensity of health care produced and consumed has gone up. At the same time hospitals elevated costs by competing for doctors and increasing the use of new medical technologies. These developments only served to increase the expected cost of health care along with the financial risk of illness. This led to even further increases in the demand for employer-based health policies, enabling the insured to guard themselves against the future increases in costs. Over time many of these policies expanded their benefits to include a wide range of pharmaceuticals, dental care and many other types of services. These developments eroded the incentive for consumers to search for cheaper sources of insurance and medical care. Confronted with sharp increases in the cost of medical care in the 1980s, employers attempted to increase cost sharing with their employees. The result was the explosion in managed care alternatives. Unfortunately, while managed care addresses the concerns of employers, it does almost nothing to institute the much needed individual consumer incentives.
In conclusion, Dr. Helms noted that health care policies that seek to restore individual consumer choice will help bring about a better functioning health care system. Many countries, including the U.S., have chosen the regulatory path to medical care reform. However, regulation can only lead to higher cost, lesser quality and lesser innovation. Regulatory design and reform can also be affected by special interest groups that do not necessarily represent the best interests of consumers. The key to health care reform is to restore consumer choice and responsibility. Such a development will bring about a new style of competition and bring about improvements in medical services and quality. A first step in this direction would be either the elimination of the tax subsidy or a cap on its amount. Few employers will redesign their health insurance policies if the subsidy is left open-ended.
Reference: Robert B. Helms, "The Tax Treatment of Health Insurance: Early History and Evidence, 1940-1970," in, Grace-Marie Arnett, ed., Empowering Health Care Consumers Through Tax Reform. Ann Arbor: The University of Michigan Press, 1999, pp. 1-25.