Stanford and Columbia Scholars Propose Novel Tax Plan that Could Reduce Private Health Care Spending by $86 Billion a Year

STANFORD, Calif.--(BUSINESS WIRE)--Long before Democrats passed their sweeping health care reform in 2010, economists across the political spectrum had argued that bad tax incentives were a major contributor to the soaring cost of American medical care.

Unfortunately, the main target of that ire was also the biggest and most politically untouchable tax subsidy in the entire code: the exclusion for employer-sponsored health insurance.

Now, a group of top health care economists at Stanford University and Columbia Business School has come up with a tax proposal that they say could break the political logjam and reduce waste even more than earlier proposals. It could even mesh with "Obamacare."

The idea comes from four veterans in the health care wars: John Cogan, a former adviser to President Reagan and a senior fellow at Stanford's Hoover Institution; Joseph Bankman of Stanford Law School; Daniel Kessler of Stanford's Graduate School of Business, Law School, and Hoover Institution; and R. Glenn Hubbard, dean of Columbia Business School and chairman of the Council of Economic Advisers under George W. Bush.

The tax exclusion for employer-paid health insurance is the nation's biggest tax break, and costs the Treasury about $300 billion a year. It’s also the anchor of American health care finance. The vast majority of Americans who have health insurance get it through a tax-free, company-sponsored plan. Many employees also get to deduct their out-of-pocket expenses up to a limit, which in 2013 is $2,500.

Economists have complained that these tax breaks, especially the larger employer tax deduction, create perverse incentives for everybody involved — employers, workers, doctors, and hospitals. Employers have an incentive to offer gold-plated health insurance, because the after-tax cost is lower than paying workers the same amount of money in higher wages.

Employees have an incentive to spend more than they need, or even want, because they pick up only a small part of the bill. Health care providers, if paid on a fee-for-service basis, have a big incentive to prescribe extra tests and treatment.

Conservative politicians have tried to chip away at this, without much luck. Republicans have pushed through modest tax deductions for out-of-pocket costs, but didn't touch the basic system. In the 2008 presidential elections, U.S. Senator John McCain essentially proposed replacing the employer-based tax break with a much bigger individual tax deduction for out-of-pocket expenses. But McCain lost that election, and Republicans haven't pushed it.

Even President Obama ran into trouble when he proposed a limited surtax on "Cadillac" insurance plans to help pay for health care reform. Labor unions fiercely objected, and Democrats effectively limited the surtax to what you might call "Rolls Royce" insurance.

In a new paper for the National Bureau of Economic Research, the four economists propose an alternative fix. Instead of replacing the employer-based exclusion, they propose neutralizing much of its moral hazard by adding a novel tax deduction for out-of-pocket medical expenses.

Unlike previous proposals for a deduction on all actual out-of-pocket expenses after an individual incurs them, the new deduction would be an upfront benefit based on that individual's estimated out-of-pocket costs for the coming year.

The economists argue that the task would be easier than it sounds, and outline a formula based on insurers' own calculations about the actuarial value of their policies. Under the formula, estimated out-of-pocket costs would depend on commonly available statistics about insurance policies like their premium, co-payments and deductibles, and enrollees' average age and health status. People with more comprehensive insurance would get smaller tax breaks than those with higher co-payments.

One advantage of a tax break for estimated out-of-pocket costs is that it would be simpler: People wouldn't have to save receipts and document expenses in order to get the tax benefit. They would simply get their deduction, regardless of how much they spent.

Most people would still keep their company-sponsored insurance, the economists predict. But some people would have an incentive to take on more of the cost sharing, because their tax breaks would be higher if they chose plans that require higher co-payments and deductibles. That, in turn, would discourage wasteful spending, the economists argue, because those who pay more out of pocket will be more likely to keep total spending down.

Cogan, Kessler, Bankman, and Hubbard argue that their new twist would also eliminate more of the perverse incentive for waste, since a deduction for actual expenses is only valuable if an individual runs up medical bills. A deduction based on estimated expenses would be valuable whether or not an individual runs up bills — there's no "use it or lose it" element. If patients feel they don't really need a particular treatment, they can spend their tax benefit on something they want more.

The risk is that an individual's actual out-of-pocket expenses might turn out to be much higher than the estimate. But the economists argue that the risk would be modest, because people would still be relying on traditional insurance for most of their health care.

How much would the new deduction cost taxpayers? The economists estimate that the cost would be relatively modest, about $5 billion a year, because the revenue loss would largely be offset by the declining use of the exclusion for employer-paid insurance.

Meanwhile, the economists estimate that the altered incentives could reduce private health care spending by about 8.5% or $86 billion a year. If that reduction in demand were to put a brake on overall health care spending, which has chronically climbed faster than general inflation, the changes might dent the biggest government spending spiral of them all: Medicare and Medicaid.