Code Red: Two Economists Examine the U.S. Healthcare System

March 7, 2008

The 800 Pound Gorilla

Filed under: Health insurance,Tax deduction — David Dranove and Craig Garthwaite (from Oct 11, 2013) @ 9:56 am
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David Dranove:


A new NBER working paper by John Cogan, Glenn Hubbard, and Dan Kessler (three very prominent economists) does a clever and convincing job of documenting the pernicious effect of the health insurance tax benefit.  As you know, employer contributions towards the purchase of health insurance (and, to a lesser extent, individual purchases) are exempt from income taxes.  This rule is the legacy of wage controls during World War II.  Firms were unable to attract workers so the federal government exempted certain benefits from taxation.  Well, WWII ended 63 years ago but we are still paying the price, in two big ways.

First, the government does not collect income taxes on the employer contributions.  The resulting tax expenditure, as it is called, amounts to $200 billion annually.  You read that right, $200 billion.  We could easily cover all the uninsured for a fraction of that amount.  To make matters worse, the tax expenditure is regressive—wealthier individuals in higher tax brackets get the lion’s share of the benefits.

Second, health care is artificially cheaper than other goods and services.  If you are in a 25% income tax bracket, then if your employer gives you an additional $4000 in wages, you have $3000 left over after taxes to spend on stuff.  But if instead your employer gives you a more generous health insurance benefit costing an additional $4000, you keep the full amount of the benefit.  In other words, if you give up $3000 worth of stuff, you get $4000 worth of health care.  The result is that most Americans have too much health insurance, relative to what they would purchase if the tax playing field was level.  (The dramatic exception, of course, is the uninsured.  How ironic that the U.S. is the one country where we simultaneously have too little and too much health insurance.)

Thus far, the federal government seems mostly interested in further extending the tax subsidy, first to individual coverage, and most recently to consumer directed health plans.  The latter really gets my goat – why favor one type of low cost insurance plan (CDHP) and not others (HMO)?  This is pure politics and not good policy.

There is virtual unanimity among health economists on these points.  And virtually unanimous frustration that nothing ever gets done about it. The tax subsidy is the 800 pound gorilla in the health policy arena.  No one dares mess with it.  Do you think Congress will ever do away with even a small piece of the tax subsidy?  There is no shortage of proposals, including capping deductibility at the median premium.


FYI, the paper is “The Effect of Tax Preferences on Health Spending” NBER Working Paper 13767

William White:


It’s hardly news that economists don’t like tax subsidies of employment based health insurance.  They’ve been criticizing them for decades.  I see the problem as a political one: How to sell reform of subsidies to key stakeholders?  It’s a formidable group.  Not just employees, but firms, who may use subsidized benefits as a hiring tool, and insurers with lucrative group contracts. I don’t think simply offering to expand coverage for the uninsured is going to do it, especially if this is coupled with a leap into the unknown.  To carry the day, even for incremental caps, there needs to be some kind of quid pro pro.  Tying caps to reform of the alternative minimum tax is a possible starting point.  However, on its own, this didn’t fly in the past.  Adding some sort of combination of tax credits and/or relief for firms from retiree benefits to the mix might help with workers and firms, but begs the question of what would be in reducing subsidies for insurers.



  1. The mortgage-interest tax deduction encourages home buyers to buy the most house they can possibly afford (or, in many cases, can afford until the ARM adjusts). Yet that isn’t going anywhere anytime soon either! I think that, politically, the most that could be hoped for is to equalize the tax treatment of individual- and employer-purchased health insurance by making any purchase of health insurance tax-free, period. And why bias the game toward health insurance? Why not make all health expenses tax-free as well by allowing individuals to deduct any expenses before they even meet their standard deduction/exemption? This way you equalize the tax treatment of any kind of health expense, whether self-pay or third-party/insurance.

    Comment by Kevin O'Reilly — March 10, 2008 @ 11:15 am

  2. Kevin,

    I like the idea of leveling the entire playing field. But can the government afford tens of billions in additional tax subsidies? What makes economic sense may not make fiscal sense.

    Comment by David Dranove — March 10, 2008 @ 11:57 am

  3. In turn, what makes economic sense may not make political sense.

    Comment by Kevin O'Reilly — March 11, 2008 @ 1:31 pm

  4. I’m surprised employers would fight being rid of an obligation to be the conduit for the healthcare tax subsidy to their employees. I would have guessed they would embrace a simplification of their payroll administration, so long as they wouldn’t be at a competitive disadvantage in the labor market.

    By transferring the incidence of the deduction (credit?) to individuals, employees qua consumers would once again be in a position to make economic decisions on the margin; which should augur for less aggregate consumption from the employed population. This part looks tax neutral to the government, as far as I can tell.

    The tax subsidy burden comes about from covering those currently disenfranchised. I would guess if Government got all the way out of the healthcare price distortion business, including how Medicare/Medicaid services are allowed to be priced, society would have a net gain. (Of course, expecting Congress/bureaucrats to not meddle with distortive/inefficient schemes is not something one should do while holding one’s breath…)

    Comment by Mark R. Knight — March 11, 2008 @ 4:57 pm

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