The Balancing Act: Health Care and the Economy

Charles E. Phelps is the provost emeritus, professor of community and preventive medicine, and professor of politics and economics at the University of Rochester.  His most recent book is titled Eight Questions You Should Ask About Our Health Care System (Even if the Answers Make You Sick).

One of America's most serious economic problems is the apparently perpetual growth in health-care costs, which contributes to a large and growing federal deficit. With a single policy change, Congress could significantly diminish both the health-care cost and federal deficit problems, with no meaningful adverse consequences. While Congress debates whether to amend or repeal the new health laws enacted this year, they should understand that repealing a 46-year-old law could also address a root cause of our health cost predicament.

Wage controls imposed during World War II made it difficult for employers to attract scarce workers. They found they could work around the wage controls by offering health insurance, and a friendly IRS ruling exempted employer-paid health insurance premiums from taxation. Until Congress codified this IRS ruling in 1964, America's employer-based health insurance system was largely an unintended consequence of these two policies.

Congress should reverse this law and repeal the exclusion of employer-paid health insurance premiums from federal taxation. Eliminating this tax subsidy would create enormous benefits for the U.S. economy.

On average, tax subsidies cover about 30% of employer payments for health insurance. These subsidies reduce the price of health insurance, encouraging people to buy more. Workers and their families choose overly generous coverage because it's subsidized, contributing significantly to health-care cost growth over the past half century. Removing this subsidy would slow future health-care cost growth.

The primary benefit of this policy change comes from what Congress could do with the revenue raised. Including employer health insurance premiums would add about $650 billion to the taxable income base, resulting in about $135 billion more in income tax receipts and $95 billion more in Social Security and Medicare tax receipts. These new receipts would represent about 10%-11% of their respective totals.

For both policy and political reasons, Congress wants to avoid raising taxes by so much for so many citizens. In parallel, Congress should reduce all federal marginal tax rates by 10%, returning all the higher tax receipts to taxpayers. The combination of expanding the tax base and lowering marginal tax rate would leave many Americans better off, and most at least no worse off.

A 10% reduction in marginal tax rates would stimulate economic growth in ways otherwise unavailable to Congress. There is virtually no debate among economists that lower marginal income tax rates create a more robust economy. A vigorous literature debates the extent to which this occurs, but I do not need to resolve that issue for this to be good policy.  The larger tax base arising from the inclusion of employer payments would offset the parallel reduction in tax receipts, even if economic growth were unaffected. Any higher tax revenue flowing from increased economic growth arising from the reduction in marginal tax rates would be pure gravy.  The additional growth -- and hence, increased tax receipts and reduced federal and state deficits -- would be large and beneficial.

Why would Congress not leap to enact this seemingly win-win situation? They have apparently not considered the possibility of combining this change in the tax base with a parallel cut in marginal tax rates. Furthermore, some clearly identifiable taxpayers would be worse off, even with the combined change in tax base and marginal tax rates.

Most obviously, those who get high employer payments for health insurance would suffer -- most notably labor unions and high-income individuals. Labor unions vigorously opposed the so-called "Cadillac tax" on high-premium plans in the recent health reform legislation. They would vigorously oppose full taxation of employer-paid health insurance premiums, even with the offsetting decrease in marginal tax rates.

Additionally, some health-care providers might be hurt.  In a no-subsidy world, many people would opt for insurance plans that led to more cost-consciousness on the parts of consumers -- more managed care, higher deductibles, and tighter constraints on the use of new medical technologies. Any of these changes would squeeze the incomes of some health-care providers.

Taxing all employer-paid health insurance premiums with an offsetting reduction in marginal tax rates would unambiguously both stimulate the economy and help control future health-care costs. A statesman-like Congress could find a way to do it. Can this one?

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  • Report this Comment On August 05, 2010, at 9:35 AM, ChrisBern wrote:

    Completely agree that we need to discontinue the health insurance tax exemption. Would love to see the mortgage interest exemption to go by the wayside at the same time. In fact, I can't think of any subsidies I really like...they simply distort the natural price mechanism. But back to health care, I guarantee you that if people shopped for and chose their own health care plans in a truly "open" way, prices would go down and quality would go up.

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