This paper provides a brief summary of the impact on health care utilization and federal revenues of three policy changes: making all purchases of health services tax deductible, reforming insurance regulation, and reforming medical malpractice liability laws. All numbers below are on an annual basis using 2008 values.
Under our proposed policy, the current and complex web of health care tax deductions would be superceded by a policy that allows full deductibility of all health care spending, except spending on long-term care (LTC). The deduction would be “above the line” so that it would be available to taxpayers who claim the standard deduction as well as those who itemize. It would only be available to people who are covered by a qualified health insurance plan. It would only apply to income taxes; out-of-pocket spending and previously taxed purchases of insurance would still be subjected to payroll taxes.
Full deductibility will have two effects on health care consumption that work in opposing directions. First, it will lower the price of out-of-pocket health care purchases relative to purchases through insurance. This effect will induce people to shift to health plans with higher copayments and deductibles, which will lower utilization. We calculate that full deductibility will increase the average coinsurance rate in private health plans from approximately 25 percent to approximately 33 percent. Second, it will lower the overall price of health services, which will raise utilization. Previous research, including work by us, suggests that the first effect is significantly larger in magnitude than the second. We estimate that, on net, full deductibility will reduce private health spending by approximately 6 percent, or $61 billion.
To assess the budget consequences of full deductibility, we decompose the $61 billion decrease into two parts: the decrease in spending on employer-sponsored insurance net of LTC (ESI), and the increase in out-of-pocket spending. We estimate that full deductibility will decrease spending on ESI by $110 billion, but increase spending out-of-pocket (net of LTC) by $49 billion.
This decomposition has important budgetary implications. Full deductibility will generate three types of revenue losses. First, it will generate a revenue loss of $25 billion from making currently taxable out-of-pocket spending tax deductible. Second, it will allow people to deduct premiums for individually purchased insurance and for the employee portion of ESI.1 The revenue loss from allowing deductibility of previously non-deductible (or excludable but not currently deducted) insurance premiums will be $11 billion. Third, by granting an income-tax deduction to $49 billion in new out-of-pocket spending, it will generate a revenue loss of $9 billion. Full deductibility therefore will lead to a gross revenue loss of $45 billion (= 25 + 11 + 9).
However, revenue gains from the decrease in spending on ESI will offset much of this revenue loss. Reductions in ESI are not a loss to the economy — that is, GDP does not decline. The tax-free resources no longer used for health care will be channeled to other, taxable, economic activities. As tax-deductible ESI costs decline, workers’ taxable wages will rise so as to leave total labor compensation unchanged. Because this $110 billion increase in taxable wages will be subject to both income and payroll taxes, it will lead to a gross revenue gain of $35 billion.
Thus, in total, full deductibility will reduce revenues by $10 billion (= 35 - 45).
Insurance market and medical malpractice reform
Our other two policies — insurance market and medical malpractice liability reform — will also lead to a reduction in health spending. Although the magnitude of this reduction is uncertain, our most conservative estimates suggest that insurance market and malpractice reform will lead to a reduction in health spending of 3 percent. Under the conservative assumption that 67 percent of private health spending, after full deductibility, will be through ESI and 33 percent will be out-of-pocket, we calculate that insurance market and malpractice reform will increase federal revenues by $7 billion.
Thus, in total, our three policies will reduce revenues by $3 billion (= 7 - 10).
1Although the employee portion of ESI can be excluded from taxable income by directing it through a Section 125 cafeteria plan, not all employers take advantage of this provision.