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The Problem with the Biggest Tax Break in America

Monday, June 15, 2009

How can we cut back on employer-provided health insurance and at the same time reduce the number of households that are uninsured? We must reconceive the very concept of health insurance.

“The biggest tax break in America—tax-free health benefits from employers—could be scaled back to pay for President Obama’s overhaul of the nation’s healthcare system.”
      — Richard Wolf, USA Today, June 10, 2009

As Congress digs into the issue of healthcare reform, an important issue lurks: what should be done about employer-provided health insurance? Should it be encouraged, by strengthening the carrots and sticks that lead employers to provide health insurance? Or should it be discouraged, by treating employer-provided health insurance as taxable compensation, thereby removing some of the incentive for obtaining health insurance on the job?

Employer-provided health insurance is the primary mechanism by which Americans under 65 obtain health insurance. Of those households that are in the individual health insurance market, because they are neither eligible for public assistance through Medicaid nor are covered by employer-provided health insurance, the majority choose to go uninsured. Those of us who would like to see employer-provided insurance phased out have the burden of coming up with something that would replace it.

The problem with the Massachusetts approach is that it puts the state in the position of designing health insurance policies. This stifles innovation in the health insurance market. Moreover, it politicizes the process.

Economically, employer-provided insurance has one natural advantage. It provides a means of pooling health insurance risks that mitigates problems with adverse selection. If an individual household tries to obtain insurance, the insurance company has an incentive to determine the health status of members of that household. If someone is obviously at risk for requiring expensive treatment, the insurance company will try to charge a high premium or to deny coverage. On the other hand, when faced with a large pool of employees at a firm, the insurance company’s premiums are based on the risks in the entire pool, not those of any individual household.

In addition, employer-provided health insurance enjoys artificial regulatory advantages. The employer contribution to health insurance is tax deductible to the corporation as compensation but is not treated as income by the employee. This creates an incentive to provide compensation to employees in the form of health insurance rather than higher take-home pay.

It has been suggested that the government could offer health insurance plans similar to those offered to government employees. But the private sector competing with a government service provider is a bit like playing a basketball game where the other team supplies the referee.

A second regulatory advantage is the ability to evade state regulations. If I buy my own health insurance in the individual market, the insurance company must comply with the regulations in Maryland, where I live. These are so heavily freighted with mandated coverages and other rules that few insurance companies will write health insurance in the state. On the other hand, if I work for an employer that has offices in other states as well as in Maryland, the insurance is regulated by the Employee Retirement Income Security Act, which overrides Maryland law. As a result, the employer can obtain a much more competitive insurance premium.

Disadvantages of Employer-provided Health Insurance

However, employer-provided health insurance has a number of disadvantages:

  • The cost of health insurance is disguised from consumers, because firms do not report what they pay in premiums. Workers are under the illusion that their health coverage is inexpensive, and if they subsequently find themselves having to obtain their own health insurance, they are offended by the cost and instead choose to go uninsured.
  • Workers who are concerned about the availability of health insurance may suffer from “job lock.” They might wish to leave their job for self-employment, pursuit of formal education, an opportunity with a smaller firm, or early retirement, but the potential loss of health insurance is a deterrent.
  • Workers may not enjoy the range of insurance choices that they would have if health insurance were not negotiated for them by employers. For example, if they could choose their own insurance, some workers might elect coverage with higher co-pays and deductibles but lower premiums, in order to have more cash income.
  • Because employer-provided health insurance is subsidized through the tax system, the benefits accrue relatively more to high-income workers.
  • Workers who are fired or laid off can find themselves without health insurance at a point where they can least afford to be uninsured.
 

Getting from Here to There

The disadvantages of the employer-provided health insurance system are significant. I think we ought to be aiming for a future without employer-provided health insurance. However, this raises the issue of how we get from here to there. In particular, how can we cut back on employer-provided health insurance and at the same time reduce the number of households that are uninsured?

One approach, pioneered in Massachusetts, is to set up a state agency (which Massachusetts calls a “connector”) to organize households into large insurance pools. This addresses the problem of individual adverse selection. In case households might choose to remain uninsured until a health problem develops, the Massachusetts plan includes a health insurance mandate, in the form of a stiff tax penalty for households that do not obtain insurance.

Our existing health insurance, including Medicare, is designed to give people nearly unlimited access to medical services without having to pay for them. This is unsustainable.

The problem with the Massachusetts approach is that it puts the state in the position of designing health insurance policies. This stifles innovation in the health insurance market. Moreover, it politicizes the process, with the predictable result that health insurance coverage is very broad and expensive, in order to satisfy provider interest groups. In Massachusetts, this has resulted in soaring health insurance costs.

Another approach is to have the government offer a competing insurance plan. For example, it has been suggested that the government could offer health insurance plans similar to those offered to government employees. This raises questions about how the private sector and the public sector would compete. Competing with a government service provider is a bit like playing a basketball game where the other team supplies the referee.

The government plan also could stifle innovation. New forms of health insurance could have difficulty competing with a government plan, particularly if that plan is heavily subsidized.

I believe that we need considerable innovation in health insurance. Our existing health insurance, including Medicare, is designed to give people nearly unlimited access to medical services without having to pay for them. This is unsustainable.

One illusion about healthcare reform is that the only problem we have to tackle is the uninsured. The larger problem is that those of us with insurance have too much coverage, so that neither patients nor doctors have to pay attention to costs when making decisions. That is going to have to change.

The Obama administration’s policy wonks, such as Office of Management and Budget Director Peter Orszag, promise “cost containment” as part of future healthcare reform. But there is no evidence that a government-driven, top-down approach to “cost containment” can succeed. Market innovation is needed instead.

One illusion about healthcare reform is that the only problem we have to tackle is the uninsured. The larger problem is that those of us with insurance have too much coverage.

Market innovation in health insurance would mean increasing the consumer’s responsibility to pay for most medical services. The insurable event should not be the provision of a medical service. The insurable event should be that the consumer is confronted with an ailment that is going to require costly treatment. Health insurance should not involve frequent, small claims and high premiums. Instead, like fire insurance, it ought to involve rare, large claims and affordable premiums.

We should aim to phase out employer-provided health insurance. However, instead of trying to create a household insurance market that reconstitutes the unsustainable features of employer-provided health insurance, we need to allow for radical innovation in the very concept of health insurance.  

Arnold Kling was an economist on the staff of the board of governors of the Federal Reserve System and was a senior economist at Freddie Mac. He co-hosts EconLog, a popular economics blog, and is the author of “Crisis of Abundance: Rethinking How We Pay for Healthcare.”

FURTHER READING: In “How to Fix Healthcare Delivery,” Kling imagines a system in which doctors answer to corporate management and corporate management answers to patients. He also wrote “Would Keynes Have Supported The Stimulus Bill?

Image by: Darren Wamboldt/Bergman Group.

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