Health Reform One Year Later: Replacing Employer-Monopoly Health Benefits: Tax Deduction or Tax Credit? | Health Reform Report

Obamacare is now one year old. It’s unlikely to make it to its third anniversary, and may fail before its second. The promise to repeal and replace Obamacare was fundamental to Republican electoral success last November, and a GOP Presidential candidate will have to make a firm commitment to sign a repeal bill soon after he or she takes office in January 2013.

But then comes the hard part. One challenge Republicans have never successfully grappled with is how to give Americans more choice of health benefits outside the current system. Currently an employee must accept health benefits offered by his or her spouse’s employer to earn those benefits tax-free. The government’s grant of monopoly privilege to our employers is clearly absurd.

What is needed is a reform to the tax code such that the tax benefit for having a health plan goes to the household instead. What has never been agreed upon is whether this tax benefit should be a tax deduction or a tax credit. Both have challenges.

If the value of the health benefits is deducted from taxable income, all parties should be indifferent to the change. Employers pay exactly the same amount of remuneration. Employees enjoy the same net compensation as they did before, and the government takes the same tax revenue. This is the first benefit of a tax deduction: minimal disruption to the status quo. Unfortunately, it also preserves some of the problems of the status quo.

First, because of the progressive income tax regime, higher-income earners will value the deduction more than lower-income workers. This will lead to higher-income households over-consuming health goods and services at a higher rate than lower-income households. Second, any individual will face a lower marginal price for each purchase of an eligible health good or service, further motivating overconsumption. Third, people who earn less than a certain threshold of income will not be able to enjoy the deduction, which implies that they will continue to be dependent on Medicaid and other taxpayer-funded programs.

If we introduce a tax credit instead, the household which buys a qualifying health plan gets a fixed dollar tax credit. If the credit is small, higher earners will suffer a tax hike. We can solve this by increasing the credit, but this will result in “too much” credit. Also, a large credit is likely to cause a higher number of lower earners to buy health insurance, leading to higher government spending than anticipated.

Indeed, many people who don’t pay taxes will get refundable tax credits. This is less of a problem, however, if the tax credits also replace Medicaid and other tax-payer funded programs. Unfortunately, politicians who propose universal tax credits (such as Senator John McCain in his 2008 presidential campaign) have never been able to persuade fiscal hawks that such a reform will not lead to more government spending.

One “fix” to the problem of expensive tax credits is to means test them. While popular among some conservatives, means testing is often described as imposing punitively high marginal income tax rates on people at certain income levels. This reduces, or even eliminates their incentive to earn higher incomes.

Tax credits have a key advantage, especially if the individual can “bank” the any unspent tax credit for future use. They do not reduce marginal prices of health goods and services, so individuals have less of an incentive to over-consume than under the status quo or a tax deduction.

Individual ownership of health insurance is necessary for coverage that is portable from job to job and state to state. After the defeat of Obamacare, Republican leaders will have to be comfortable with discussing all the consequences of such reform. The question is, which type will lead the way.

Graham is director of Health Care Studies at the Pacific Research Institute. This column is excerpted from his briefing paper on tax credits versus tax deductions and can be found at

via Health Reform One Year Later: Replacing Employer-Monopoly Health Benefits: Tax Deduction or Tax Credit? | Health Reform Report.


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