Blowing up things is a popular and successful strategy if one is making an action film for the summer movie market. But it is exactly the wrong image when discussing the future of health policy, and especially if one is considering the effects of a change in tax policy. To understand why requires some appreciation of the deliberate but forceful economic conditions that shaped the evolution of our healthcare system over the last 100 years. A system that took this long to evolve is not going to be blown away by some sudden change in policy. But an appropriate change in tax policy could begin a gradual evolution that could help control the cost of medical care and improve both the quality of and access to care.

Resident Scholar Robert B. Helms

The first half of the 20th century saw many advances in medical science and the beginnings of the health insurance industry. The rate of growth in health expenditures accelerated in the postwar period as a result of a number of economic, medical, and policy developments. The introduction of penicillin during World War II and new antibiotics in the 1950s and 1960s expanded the possibilities to control infection and thereby made much of modern surgery possible. Those and other advances in medical knowledge increased both the cost of healthcare and the demand to insure against large medical expenses. Meanwhile, the large increases in employment and income in the postwar period gave consumers the ability to purchase health insurance and other types of protection against financial losses.

The private health insurance industry responded to this increase in demand for health insurance by expanding the scope of health insurance products offered for sale. But the expansion of this industry was profoundly affected by another World War II event, an obscure change in tax policy that was to have unanticipated effects throughout the postwar period. Faced with wartime controls on wages and a shortage of labor, more firms began to offer pension and health insurance (fringe benefits) as a way to attract workers. The War Labor Board, the government authority responsible for enforcing wartime wage and price controls, ruled in 1943 that the value of employer-provided fringe benefits was not to be included in the calculation of workers' wages for the purpose of enforcing the wage controls. That principle of not treating employer-provided health insurance as taxable income was also adopted by the IRS. The IRS later attempted to reverse this ruling, which prompted Congress in 1954 to pass legislation specifying that employer-provided health insurance was to be excluded from taxable income (hence the term "tax exclusion"). The policy, put in place as a way to encourage wartime production, was established at a time when the health insurance industry was relatively small and health insurance was a minor cost to employers. While unintended, it had profound effects on the development of commercial health insurance as the demand for insurance increased in the postwar period.

In 1940 approximately 12.3 million people (9.3 percent of the population) had insurance covering part of the cost of hospital care, the predominant form of health insurance at that time. By 1970 the number of Americans with hospital coverage had grown to 175.4 million (86.4 percent of the population). The tax exclusion played an important role in channeling this growth primarily into employer- provided group coverage. The growth of group coverage also expanded as a result of favorable selection that occurred when employment groups were used as risk pools. People who are actively employed are younger and healthier than the general population, so health insurance companies learned early on that they could price group policies at a lower level than individual policies because they could expect to attract only average risks. Loading factors could also be lower in group policies because of the economies of scale of selling and administering policies to large groups. It was also relatively easy for insurance companies to adjust their premiums up or down when they had reason to expect that a group might be more or less risky than the average. Meanwhile, as incomes grew in the postwar period and more people were shifted into higher tax brackets, the tax advantage of getting health insurance tax-free through an employer rather than by individual purchase continued to promote employer- provided health insurance. The tax treatment of health insurance was not the only factor promoting group policies, but it was a strong force in creating a climate conducive to this type of health insurance.

The tax treatment of health insurance also affected the competitive environment of the entire health market. It was to the advantage of unions and other employees to push for the expansion of covered benefits since the value of those benefits was not included in a worker's taxable income. An additional dollar spent on health benefits was not subject to income and payroll taxes as would be the case if the worker received an additional dollar in wages. Over time this helped to expand the scope of health benefits and reduce the amount of consumer cost-sharing, although there has been some retrenchment in these trends since the mid-1990s. These forces, along with the passage of Medicare and Medicaid in 1965, helped to increase the percent of national health expenditures paid by third parties from 45 percent in 1960 to more than 80 percent today, while reducing consumer out-of-pocket payments from 55 percent to 18 percent. Having more people covered for more benefits was an obvious advantage to providers, but it also helped to reduce the incentives to get both consumers and employers to worry about the cost or effectiveness of healthcare services, what is commonly referred to as moral hazard. That lack of incentives to seek value in health purchases still dominates the healthcare market, even though the increasing cost of health benefits and global competition is causing some firms to try to reverse those basic incentives. In summary, the tax treatment of health insurance was a major factor in creating a health system in the United States that is more extensive and more expensive than it would have been without the inducement of tax policy. This policy, while unintended, helped to expand health insurance coverage and enhance the incomes of most providers while raising the cost of care for public health programs and for those without access to employer- based coverage.

How to reform the U.S. healthcare system is not a new topic, but it is taking on new life as costs increase for both public and private coverage. There are two basic approaches to reform. One, we can follow the example of Canada and most European countries and nationalize the healthcare sector (as the single-payer proponents seem to want) or, as the Clinton administration proposed, expand the use of global budgets and price controls as a way of controlling the cost of care. While we followed this basic approach in most of Medicare and Medicaid, there is still strong opposition to giving more power to the government to control more of our healthcare market.

The second basic approach is to take steps to make the healthcare market more competitive and economically efficient. Antitrust policy could help, but the main policy tool to effect this type of change is tax policy for two basic reasons--tax policy still has a large effect on the demand for health insurance and healthcare, and it is too difficult to pass direct regulatory controls that would effectively make markets more efficient. Several approaches are available from the tax policy toolbox: refundable tax credits to subsidize health insurance for low-income people, tax deductibility for out-of-pocket payments and individually purchased health insurance, more tax advantages for the purchase of high- deductible plans (like the health savings account (HSA) policies proposed by President Bush), the elimination of the current tax exclusion, or capping the value of the tax exclusion. Of those choices, tax credits and HSA-promoting policies could have some beneficial effects, but they do not get at the basic incentive problems caused by the tax exclusion. The elimination of the tax exclusion would have the strongest effect on the market, but it is too drastic a change to be seriously considered in today's political environment. That leaves capping the value of the tax exclusion as the policy approach that is likely to be the most effective, and even the policy that is likely to have the best chance of actually being adopted.

How would a tax cap actually work and what effect would it have on insurers, providers, and employers? That would depend on where the cap was set relative to existing health insurance premiums. Based on the two times a cap has been proposed (by the Reagan administration in 1984 and by the tax reform panel in 2005), I would assume that the cap would be set at the upper end of the distribution of health insurance premiums from around the nation. Setting a relatively high cap on what can be excluded from taxable income has both practical and political advantages since it would affect only the high-cost plans and leave the majority of employers unaffected. But even a relatively high cap would send a strong message to everyone in the market that it is time to get serious about controlling the cost of insurance benefits. One of the primary policy advantages of this approach is that it gives stronger incentives to control costs than now exist, but leaves it to the market to determine what is the best approach to achieve this control. This restores the incentive for both employers and employees to seek value in the purchase of medical goods and services rather than specifying that HSAs, managed care, or some set of draconian controls is the best approach. The result would be more market experimentation, but instead of following the historic practice of expanding benefits with little regard to either medical effectiveness or costs, the emphasis would now be on finding the best value while avoiding paying any extra taxes for health insurance costs above the cap.

That experimentation could also have the advantage of expanding health insurance coverage for the uninsured. Critics of tax policy changes often assert that any change in tax policy will induce companies to drop health insurance coverage for their employees. The reality would be quite different. If a company were to offer health insurance that was below the cap, the company would not have any additional incentive to drop coverage. If a company were above the cap, completely dropping coverage would not be an efficient way to either avoid the extra taxes or continue to use health insurance as a way to compete for employees in the labor market. Again, the most efficient way to avoid the extra taxes would be to redesign the health insurance policy in ways that keep the cost of the insurance under the cap. Some firms would take the high-deductible/HSA approach; some firms might contract with managed care companies that promise more restrictive use controls; others would use various combinations of those policies. Almost all firms would have reason to pay more attention to, and do more research on, the performance of providers, the medical effectiveness of various procedures and products, and the cost of purchased services. Some of those new approaches are being used now, but a tax cap would intensify these efforts across all types of employers. Rather than reduce health insurance coverage, the existence of more cost-effective alternatives would provide more firms with more economical ways to offer health insurance. Expanding those opportunities into the small-employer market could have a beneficial effect on expanding health insurance coverage to a larger proportion of the population. Refundable tax credits could increase coverage even more by subsidizing health insurance premiums for more low-income people, especially if they were allowed to purchase cost-effective policies in the private sector or to use their subsidy to offset the cost of their employer's plan.

There is obviously a lot of skepticism about the politics of using tax policy to reform the health sector. This is easy to understand if one considers a change in tax policy to mean the elimination of the tax exclusion or otherwise, "blowing up the system." There are those who would like to paint this picture, but this is not what proponents of more moderate tax changes such as a relatively high tax cap have in mind. A tax cap might become more politically acceptable for several reasons. First, as pointed out above, the likely effects of a tax cap would be to improve the efficiency of both health insurance and medical delivery. If employers and employees realize this possibility, they could develop a mutual interest in promoting this policy as a way to improve their economic well-being. Both profits and wages could be improved if we did not waste so many resources on ineffective and overly-expensive care.

Second, the growing competitiveness of global markets will put more pressure on businesses to control the cost of their labor force, including the cost of health insurance. Sixty years of using health insurance as a way to compete for labor would not allow firms to drop coverage, but a more competitive market would give them stronger incentives to make marginal changes to control costs. This could raise the reward for supporting a change in tax policy that promises to help firms be more competitive.

Finally, even though it is highly unlikely that Congress would ever adopt a tax cap for the purpose of improving basic incentives, they might be tempted to pass it for revenue reasons. Since some firms would elect to have their employees pay some additional taxes rather than reform their policies to stay under the cap, it is logical to expect that any binding tax cap proposal would be scored to bring in some additional revenue. This could play an important role in future years as the costs of entitlement programs put more pressure on the federal budget.

The proponents of using tax reform to reform healthcare are not talking about blowing up anything. But we are talking about creating incentives that will bring about a more efficient and cost-effective healthcare system and a somewhat faster rate of change. The current system took about 100 years of evolutionary change to create, so the best we can hope for now is a new set of policies that will start us on the gradual change to a better system. This mission is possible.

Robert B. Helms is a resident scholar and director of health policy studies at AEI.