Would Tax on Benefits Rein In Spending?

By Alec MacGillis
Washington Post Staff Writer
Thursday, July 30, 2009

The heath-care bill that has been wending its way through the Senate Finance Committee is likely to contain a provision that President Obama opposed during his campaign: a tax on at least some employer-provided insurance plans.

The case for that step is twofold -- it would raise revenue to pay for universal coverage, and it would restrain soaring health-care spending. Proponents say any Econ 101 student knows that because premiums on the plans are now excluded from taxes, people are more likely to sign up for expensive policies and consume more health care. The Congressional Budget Office director has made it clear that taxing insurance plans would be one of the few ways to get his endorsement that reform will truly "bend the curve" of health-care spending.

But is this assumption correct? Do Americans spend so much on health care because the benefits they receive through work are not taxed?

A vocal minority of participants in the debate warn that the effect of taxing health-care benefits is being overstated. They concede there is a case for limiting the tax exemption -- to raise money for universal coverage, as well as to equalize the status between employer benefits and individual coverage bought with after-tax money -- but say the strategy is no golden key for reining in costs.

"The waste in our system is enormous, but it's not the consumer driving that waste. To the extent that consumers ask for care, it's because they've been told they need it by providers," said Donald Berwick, a professor of health policy at Harvard University.

Obama, after opposing a tax on benefits during the campaign, has signaled he might be open to the more limited version now being discussed, a tax on only the most costly of plans. As it now stands, workers pay no taxes on the insurance plans their employers provide, and they pay their own share of premiums on a pretax basis.

One option would be to tax as regular income the value of plans that fall above a certain threshold. The Finance Committee may instead opt for legislation that would tax the insurers or employers that provide expensive plans, a cost that would presumably be passed to employees as higher premiums -- unless employers stopped offering the expensive plans altogether. A tax on costly benefits would fall most heavily on upper-income professionals, union members, people living in areas where health-care costs are high and employees in small businesses with a high share of workers who are older or sicker.

To skeptics, the dispute is a classic clash between economic abstractions and real-world practice. While not taxing health insurance should in theory encourage employees to sign up for costly plans and spend more freely, they say the reality of how people consume health care does not conform with pure economic dictates.

The vast majority of health-care spending, they note, is on behalf of people who genuinely need care, not just those heading to the doctor because their insurance covers it. And the vast majority of treatments occur because doctors recommend them, regardless of patients' coverage. The key to restraining spending, they say, is getting providers to deliver care in more cost-effective ways.

Maggie Mahar, a Century Foundation fellow, says the assumption that tax-free benefits are a cost driver overlooks the fact that health care is not something most people enjoy paying for. "That guy with good coverage is not going to have bypass surgery unless someone tells him he absolutely has to. He does not want to crack his chest open," she said.

Steven Kreisberg, director of collective bargaining for the American Federation of State, County and Municipal Employees, was even more derisive. "Right. I have great chemo coverage, so I think I'm going to go get cancer," he said. "This all starts with the economists -- they just apply traditional economic theory that if you give something preferable treatment in the tax code you'll get more of it. But health care is not a traditional good or service. It's a vital service."

The economists are undeterred. Labor unions, they say, push for generous benefits because those benefits are not taxed, as higher wages would be. If benefits were taxed, employees would give more thought to less costly plans and be more aware of their health-care spending.

"The next time you got a W-2 there would be a line listing additional income tax" paid on benefits, said Mark B. McClellan, who was a senior health-care official in George W. Bush's administration. "People would pay attention to that."

It is hard to test the effect of the tax-free status for benefits, given that the exemption applies to all employers. The Congressional Budget Office estimates that doing away with the tax exclusion -- beyond just limiting it, as is more likely to happen -- would result in people selecting plans with premiums 15 to 20 percent cheaper. But the CBO notes that "the reduction in overall spending on health care would be smaller than the reduction in premiums because some costs would be shifted from covered spending to out-of-pocket spending."

Economists also point to a Rand Corp. study in the 1970s that found that people reduced their outpatient care, and their inpatient care to a slightly lesser extent, when their co-payments and deductibles rose, as they would in less costly coverage plans. Jonathan Gruber, an economist at the Massachusetts Institute of Technology, said it is "irrefutable" that taxing plans would cause a drop in spending as employers offered cheaper benefits and employees used less care, though it is less clear whether it would continue to bend the curve over the long run.

It is true, he added, that most cost-cutting will have to be done by providers. But people who aren't aware of the cost of their care are more likely to object to efficiencies. "It's hard to [make reforms] in a world where people aren't paying the true cost of their care," he said.

That is the thinking behind the proposal of Sens. Ron Wyden (D-Ore.) and Robert F. Bennett (R-Utah) to replace employer-provided plans with a tax deduction and subsidies people would use to purchase an individual plan. The idea is that health-care consumers would become cost-conscious and force insurers to lower prices and providers to deliver care in more cost-effective ways.

Skeptics say such an approach overstates people's ability to make informed health-care decisions. They note that about half the care that people in the Rand study decided to forgo because of out-of-pocket costs was deemed necessary by their doctors. Many of the chronically ill chose not to purchase needed medications, which resulted in more hospitalizations. Such counterproductive decisions would tend to fall on lower-income patients who cannot afford out-of-pocket costs.

"What you're really talking about is a buyer who is sick and sometimes old and often scared, who is very much inclined to buy whatever the seller tells him to buy," Mahar said. "That's why consumer-directed health care doesn't work."

And the skeptics note that spending has soared even as deductibles and co-pays have increased, undermining the argument that higher out-of-pocket costs would bend the curve. As their premiums have shot up, many employees still select the more expensive option. And spending increases have been higher this decade, when income taxes were lower, than they were in the 1990s. Under the economists' theory, spending should be strongest when the disparity between income taxes and tax-free benefits is greatest.

"The idea that [the tax disparities] rule the world and are game changers is really hard to see," said Josh Bivens, an economist with the left-leaning Economic Policy Institute.

Urban Institute economist Stephen Zuckerman falls in between.

"The primary reason for putting a cap on the tax exclusion is that is a potential source of funding for health reform," he said. "But how large an impact that's going to have on spending is an educated guess."

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