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Friday, February 9, 2007

Health Hazard

Back in the days before America had an income tax (yes, son, I've read there really was such a time), proposals to impose the tax were met with warnings that it would be inquisitorial. Opponents apparently didn't also see its potential for manipulating behavior. But what more effective carrot and stick is there than an income tax? And it's not as though taxes had never been used that way before. What's the purpose of a protective tariff except to advantage domestic goods over imports?

But once people grasped the concepts tax-exemption and tax-deduction, we were off to the races. Every industry has an obvious interest in having the government declare spending on its products and services eligible for special treatment. It's an efficient way to attract consumer dollars. The people who sell and finance houses got the message and have been enjoying the deduction for mortgage interest ever since. Do homebuyers really benefit? Or do they simply bid up the price of housing? According to Daniel Mitchell, countries without the deduction have home-ownership rates equivalent to ours. Why should government privilege investing in homes over investing in stocks? Yet a politician risks his career if he proposes ending the deduction.

Another popular tax-exemption/deduction is in the news these days: the one for medical insurance purchased through employers. We've all heard the story of how that got started. During World War II, ceilings on wages prevented companies from attracting employees with higher pay. Someone suggested that adding noncash benefits, such as medical insurance, to the compensation package might be within the law, and this eventually got the government's blessing. Note the two tax implications: employers deduct the insurance premiums as a business expense, and employees don't report the value of the insurance in their gross income. This delivers big benefits to both parties. Employers can offer insurance to attract workers, but since they deduct the premiums from gross revenues, they don't pay the full price. Employees pay for the insurance with pre-tax dollars, which they cannot do if they buy their own insurance. (This is not to say there's no downside to the worker. He also can't choose among a full range of insurance options because the menu is drawn up by his employer. Moreover, in other circumstances he might prefer the cash.)

Employment-based medical insurance of course has social consequences beyond the individual ones. They have been documented repeatedly. If medical insurance, and hence medical care, appear cheap and if employers make the policies increasingly attractive as a lure to potential workers, the demand for medical care is bound to exceed the level it would reach if everyone explicitly confronted the costs of his medical decisions. When one's insurance appears to be purchased by someone else, it becomes an exercise in cost shifting. The heightened demand for services pushes up prices, which in turn pushes up the cost of insurance. But that remains hidden to the consumer, so who cares?

One group that would care if the truth were clearer are people who don't have employer-based insurance. They bear the brunt of the perverse system. This is not how most politicians see it. They believe the uninsured make it hard on everyone else. But in fact it's the overinsured who make it hard on the uninsured. If the system induces artificially higher demand and higher prices, poorer people will be priced out the market and young healthy people will put off buying insurance. (Overinsured means having more insurance than one would buy if the full price were confronted.)

Government makes this bad situation even worse in countless ways. Many states demand that insurers accept all applicants, cover pre-existing conditions, and charge the already-sick no more than the healthy. One of the effects of such policies is to remove the incentive to buy insurance while healthy.

Another thing that state governments do is dictate what must be covered by a basic policy. If people paid the full price, most might prefer a high-deductible catastrophic policy that would do what insurance was supposed to do: prevent bankruptcy should an unlikely event take place. They would pay smaller, routine medical bills out of savings. If insurance covers annual physical exams, it's not really insurance. It's pre-payment for services (along with a lot of administrative overhead). But state legislatures have outlawed no-frill policies by mandating coverage for things most people would never willingly pay for, such as substance-abuse treatment. Nationally, buyers of insurance are burdened by close to 2,000 such mandates. Some states are far worse than others in this regard.

Notice the flagrant privilege-seeking involved here. Service providers lobby state legislators to impose mandates forcing insurance companies to cover what they sell. Providers can be confident they will have many more customers if those customers get a yes to their question, Does my insurance cover that? than if they get a no. Legislators are happy to oblige because they will look like benefactors and rake in campaign contributions in return.

Thus a huge reason for the medical mess can be attributed to the screwed-up insurance industry. Thank you, government. (There are other reasons: such as Medicare and Medicaid, which also stimulate demand, and the many ways government restricts supply, including licensing and certificates of need, which prohibit services from being offered without government permission.)

Now along comes President Bush to do something about the insurance problem. He proposes to convert the employee-insurance exemption to a standard deduction of $7,500 for individuals and $15,000 for families and extend it to those who buy their own insurance. Under this plan, people whose insurance is worth more than the deduction would pay more in taxes and people whose insurance is worth less would pay less. The Treasury boasts that the plan would make the income tax more progressive. (Doesn't the President favor a flat tax and a simpler code?)

The Beginning of Reform?

Given what is stated above, the Bush plan would seem to be the beginning of reform. But it's not so simple. First, note that formerly excluded noncash income will now be included in gross income, albeit subject to the new deduction. While that may partly undo a long-standing distortion, it will also raise some people's taxes. The original exemption manipulated behavior, although perhaps not intentionally. Now the limited tax-deduction would also manipulate behavior — this time by intention. The government will be saying: Buy too much medical insurance and we'll punish you by taking more from you in taxes. Buy the right amount and we won't. Buy less than the right amount and we'll reward you by letting you keep some of your own money. Government will define too much and right amount. How do we know the bill authors will get the definitions right? From that angle the plan seems less a removal of a distortion than an addition of a new one.

This can been seen in another part of the Bush plan, which would allow the states to devote $30 billion in federal health-care money to help the uninsured buy insurance. Clearly, the President wants to manipulate the tax system so that some people will buy less insurance and others will buy more. That sounds like social engineering.

Forgive my natural skepticism, but it seems that any proposal for tinkering with the tax system under current levels of spending can be a snare. In 1986 President Reagan and Congress offered a deal to the American people: a flatter and lower tax-rate schedule in exchange for the repeal of many tax-deductions (a broader base). The flat-tax advocates said it was a move in the right direction. What happened? Within a short time a new top rate was added, then raised, but the old deductions were not restored. That's how political deals work.

The tax system has no doubt distorted the medical industry along with lots of other things. But any piecemeal way out will surely introduce its own distortions by upsetting long-standing plans and depriving people of their money. (See Cleaning Up After the Elephants.) The early critics were right: The income tax is poison to a society that values freedom and spontaneous order. We should have never gotten started with it.

  • Sheldon Richman is the former editor of The Freeman and a contributor to The Concise Encyclopedia of Economics. He is the author of Separating School and State: How to Liberate America's Families and thousands of articles.