Brilliant Deduction

The coming tax-reform debate will bring forth discussion of saving and investment and cries for simplification to be sure. This is all to the good. But our politicians and policy makers in Washington and beyond should bear in mind that the tax code lies at the heart of the problems in America's largest market -- accounting for one-seventh of the nation's GDP -- health care.

We propose a simple change to tax law that would cut unproductive health spending, reduce the number of uninsured and promote greater tax fairness. For anyone with at least catastrophic insurance coverage, all health-care expenses -- employee contributions to employer-provided insurance, individually purchased insurance and out-of-pocket spending -- would be tax-deductible. The deduction would be available to those who claim the standard deduction and to those who itemize.

The most important effect of tax deductibility would be to reduce unproductive health spending. Under current law, medical care purchased through an employer's insurance plan is tax-free, while direct medical care purchased by patients must be made with after-tax income. As we and many others have observed, this tax preference has given patients the incentive to purchase care through low-deductible, low-copayment insurance instead of out-of-pocket, which in turn leads to cost-unconsciousness and wasteful medical practices. In addition, the tax preference for insurance creates incentives for the health-care system to rely on gatekeepers rather than deductibles and copayments when it does try to control costs. The cost of gatekeepers are financed out of insurance premiums that are paid with before-tax dollars; deductibles and copayments are paid with after-tax dollars.

According to our calculations, based on research from the RAND Health Insurance Experiment and others, we estimate that tax deductibility would reduce spending by approximately $40 billion in 2004 dollars, or 6% of total private health spending. These savings could be achieved without significant adverse consequences for health outcomes. This occurs in spite of the fact that tax deductibility makes health care overall look cheaper relative to all other goods, which leads to higher spending. By making insured health care look more expensive relative to out-of-pocket health care, tax deductibility leads patients to choose health plans with higher deductibles and copayments, and therefore to reduce spending enough to more than offset this effect.

Tax deductibility also will reduce the number of people who are uninsured. Tax deductibility decreases the price of insurance for a large number of uninsured persons. We estimate that approximately 20 million uninsured live in a household with a working member who pays federal income taxes. For the approximately 12 million uninsured taxpayers who are not offered insurance by their employer, the increase in the incentive to purchase insurance is especially large. By purchasing insurance, such an individual could deduct both his or her insurance premiums and any out-of-pocket expenses, neither of which is deductible under current law. For example, consider someone who is contemplating the purchase of an insurance plan that costs $1,000 and would leave him or her with expected out-of-pocket expenses of $1,000. Assuming a marginal tax rate of 15%, he or she would receive a tax reduction of $300, which translates into a 30% reduction in the price of insurance. Depending on how price-sensitive uninsured people are, we calculate that tax deductibility would reduce the number of uninsured by two million to six million people.