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April 25, 2011 | Wall Street Journal

How Health Reform Punishes Work

Supporters of ObamaCare acknowledge it will have some unintended consequences. Yet surprisingly little attention has been focused on the law's most problematic provision: government subsidies to help individuals and families purchase health insurance.

This new entitlement—which the chief actuary of the Centers for Medicare and Medicaid Services estimates will cost more than $100 billion per year once it is fully implemented—will damage the country's long-term fiscal outlook. It also will introduce far-reaching negative effects on rewards to work and bizarre new inequities into American life.

The health law establishes insurance exchanges—regulated marketplaces in which individuals and small businesses can shop for coverage—and minimum standards for the insurance policies that can be offered. Because the policies will be so costly, there's a subsidy for buyers that phases out as family income rises. This sounds reasonable—but the subsidies required to make a "qualifying" insurance policy affordable are so large that their phaseout creates chaos.

Starting in 2014, subsidies will be available to families with incomes between 134% and 400% of the federal poverty line. (Families earning less than 134% of poverty are eligible for Medicaid.) For example, a family of four headed by a 55-year-old earning $31,389 in 2014 dollars (134% of the federal poverty line) in a high-cost area will get a subsidy of $22,740. This will cover 96% of an insurance policy that the Kaiser Family Foundation predicts will cost $23,700. A similar family earning $93,699 (400% of poverty) gets a subsidy of $14,799. But a family earning $1 more—$93,700—gets no subsidy.

Economists call large, discontinuous changes in program benefits like this "notches." Although notches might be administratively convenient, they have terrible incentive effects. As Prof. Raj Chetty of Harvard points out in a recent National Bureau of Economic Research working paper, prior research on notches show that they induce sharp reductions in labor supply.

Consider a wife in a family with $90,000 in income. If she were to earn an additional $3,700, her family would lose the insurance subsidy and be more than $10,000 poorer. In addition, she would also pay more in income and Social Security taxes. Taken together, these policies impose a substantial punishment on work effort.

Notches also lead to unfairness. The principle that families of the same size with similar incomes should be treated similarly by tax law and transfer programs has deep philosophical roots and appeals to basic notions of equity. The notch turns this principle on its head. Next-door neighbors with virtually identical circumstances could receive very different levels of government assistance, depending on which side of the notch they happen to fall. This feature will justifiably increase public cynicism about the law and government in general.

Fixing the notch is not so easy. To phase out the subsidy smoothly for families with incomes of 134% to 400% of poverty, the law would have to take away $22,700 in subsidies as a family's income rose to $93,700 from $31,389. In other words, for every dollar earned in this income range, a family's subsidy would have to decline by 36 cents. On top of 25% federal income taxes, 5% state income taxes, and 15% Social Security taxes, this implies a reward to work of less than 20 cents on the dollar—in economists' language, an implicit marginal tax rate of over 80%. Although economists may differ on the effect of taxes on work effort, it is hard to fathom how anyone could argue that this will not reduce economic activity.

It gets worse. There are also subsidies to cover the deductibles and copayments of insurance policies purchased through an exchange—and like the premium subsidies, these subsidies also phase out with income. There is also the likelihood that federal and state income taxes on upper-middle income families will have to be raised above current levels to finance the cost of the subsidy, the Medicaid expansion, and other provisions of the new law. Both of these effects exacerbate the law's negative work incentives.

Either leaving the notch in or smoothing the notch out seems impossibly unattractive. Yet these choices are the inevitable consequences of the law's attempt to redistribute around $20,000 to someone making $30,000, but nothing to someone making $94,000. The only fix is to drastically reduce or eliminate the premium subsidies. As the 2012 elections approach, voters will have to decide: For middle-income families, should economic success be determined by work and savings, or by participation in a government program?

Mr. Kessler is professor of business and law at Stanford University and a senior fellow at the Hoover Institution.