McCain’s Health Plan: Tax Cut or Tax Hike, and To What End?

The Tax Foundation sent me an e-mail pointing me to Gerald Prante (who’s participated in our comments section in the past) taking Joe Klein to task for calling McCain’s proposed $5,000* refundable tax credit that would offset income tax on health insurance benefits “insufficient.”

Here’s what the McCain web site has to say:

While still having the option of employer-based coverage, every family will receive a direct refundable tax credit – effectively cash – of $2,500 for individuals and $5,000 for families to offset the cost of insurance. Families will be able to choose the insurance provider that suits them best and the money would be sent directly to the insurance provider. Those obtaining innovative insurance that costs less than the credit can deposit the remainder in expanded Health Savings Accounts.

The McCain campaign already deserves a few demerits for this representation of the plan. First, they don’t mention the tax increase that the health insurance credit offsets. Second, a credit that’s provided directly to insurers in lieu of (some) insurance premiums and then could be rolled over into an HSA if there’s something left over (which there won’t be for any family buying low-deductible health insurance) doesn’t sound much like it’s “effectively cash.”

Klein calls the McCain credit “insufficient” because it won’t pay the premium for typical employer-provided family coverage. (Analysis [PDF] of the plan by the Tax Policy Center indeed yields the result that the McCain plan would not provide for much insurance uptake among the currently-uninsured.) Prante claims that Klein doesn’t know the difference between a credit and a deduction, and provides a calculation purporting to show that the value of the deduction that McCain would repeal is less than the credit:

What [Klein] fails to understand is that the $5,000 value of the credit would be worth more than the current exclusion for almost any taxpayer. For example, a family in the 25% bracket would have its income tax before credits increase by .25 * 12,000 = $3,000. However, the family would be getting a $5,000 CREDIT that trumps the $3,000 extra in taxes from the elimination of the exclusion. Even… in the 35% bracket, the family having $12,000 in insurance would come out ahead.

End of story? Not quite.

In the quibble department, Prante assumes that the federal income tax exclusion can be repealed without state tax consequences. To the extent state income definitions follow the feds, state taxes would take away several hundred more dollars of the credit.

The big question is whether today’s $12,000 employer-sponsored plan would still be available for no more than $12,000. That depends on factors such as the employer exercising its “option” to continue to offer a group plan, and healthy members of the group resisting the incentives that the McCain plan provides to defect to the high-deductible insurance/HSA combination.

While McCain promotes the “option” of retaining existing coverage, the McCain plan’s incentives exacerbate “adverse selection death spiral” problems that particularly affect small groups under current policies. That is, increasing the price of insurance coverage on the margin would encourage the healthy and/or lucky-feeling to exit relatively expensive group plans, with the tax credit intended to encourage substituting the combination of a high-deductible individual plan and accompanying HSA. This leaves the comprehensive plans’ members sicker, or at least lossier, and drives up prices for remaining participants. (Repeat until the high price collapses the plan.) The Buchmueller et al. review of the McCain plan in Health Affairs mentions but does not quantify the potential effects of breaking up existing risk pools.

For employees sent to the individual market because employers drop group coverage, Buchmueller et al. suggest that insurance expenditures would increase markedly. They indicate that the typical $12,000 group policy for a family would cost roughly $2,000 more to obtain in the individual market (and note that many plans in the individual market have lower prices but much lower coverage).

In Prante’s calculation, the $12,000 policy costs someone in the 25% bracket $9000 after income tax. The $14,000 equivalent individual policy with the McCain family-level tax credit costs $9000 after income tax. So we’ve already exhausted the purported net benefit of the McCain tax credit for a family that wants to keep its coverage but is knocked out of the employer-sponsored group market. But the situation is actually worse than that, because shifting $9000 in compensation from benefits, which apparently the McCain plan would still exempt from payroll taxes, to wages subjects the compensation in lieu of benefits to payroll tax as well. This can increase taxes up to $1377 (at 15.3%) in this example, depending on where the hypothetical family’s wages stand with respect to the Social Security contribution and benefit base (currently $102,000).

Having recently seen the Tax Foundation concerned about Obama policies that would raise tax rates a few percentage points on high earners, it would be remiss of me to point out that the combined tax rates on wages paid in lieu of health benefits would be just as high for middle-class taxpayers under McCain’s health plan. That’s 25% for federal income tax, 5% or so for state taxes, and 15.3% for payroll taxes, 45.3% altogether, for compensation that current law and Obama policies would tax at 0%! (A new Tax Foundation issue brief on the subject which otherwise mostly invents a big number for the McCain plan’s reduction in the uninsured does at least acknowledge this in passing.) Since the McCain plan would, in the estimation of Buchmueller et al., shift millions of workers and their dependents to the individual market (representing 5 to about 15 percent of individuals covered under employer-sponsored plans; references in the article), the prospect of tax increases under the McCain plan is by no means vanishingly rare. Indeed, shifting people to the individual market is basically a feature of the plan, and not a bug — a part of the program is to de-link employment and health insurance and that’s a legitimate policy goal.

This also leaves the question of just why conservative health reformers think we need to impose what amounts (vs. current policy) to a Pigovian tax on health insurance. In the companion piece on the Obama plan by Antos et al. also in Health Affairs, there’s talk of “perverse incentives” under the current system but not a lot of beef beyond econ 101-style handwaving:

The following analysis reflects the authors’ concern that Senator Obama’s failure to address the perverse incentives in the U.S. health system will exacerbate the cost problem he has argued must be solved if we are to achieve anything close to universal coverage. Tax subsidies that promote first-dollar coverage have led consumers, health care providers, and suppliers to act as if any service that might yield some value, no matter how small, should be covered. Subsidized third-party payment has helped drive up health spending and, as demonstrated by the Dartmouth Atlas, sometimes has even led to poorer health outcomes. Realistic expectations about cost, value, and the outcomes that health care is likely to provide must be better understood by all parties.

An upshot of recent health-care cost-shifting between employers and employees is that “first-dollar” coverage is now rare. I’ve had true first-dollar coverage in the distant past, ain’t got it now, and couldn’t have it for a premium that would keep my small employer-sponsored group together. A main idea behind copayments and coinsurance is to avoid some obvious free-as-in-beer-goods problems by not covering the first dollar.

Moreover, they totally beg a central economic efficiency question: given the disconnection between health care prices and marginal costs, it’s far obvious that allocative efficiency is better served by exposing consumers to something like the list prices of routine services as opposed to the co-payments or co-insurance. (Exercises: What’s the marginal cost of a $150-list-price office visit where you spend 5 minutes with a nurse and 5 minutes with the doctor? Of a $1000 CT scan? The $200 month’s supply of an on-patent drug?) Explanation of benefits forms provide routine evidence that much or most of the price of various health-care services is markup.**

Of course, dynamic efficiency considerations mean that incremental cost constraints must be satisfied somehow — marginal cost prices wouldn’t be compensatory for the doctors, clinics, and hospitals. But efficiency-improving pricing arrangments that better align prices with marginal costs such as “two-part tariffs” (where customers pay a fixed charge plus variable usage-based charges; see e.g. your electric, gas, or [limited-usage] phone bill) can look a lot more like traditional insurance with what Antos et al. characterize as “modest” cost sharing than a high-deductible health plan plus an HSA. On this front, the conservative reform approach involves an unforgivable conflation of price and cost.***

Nor do some of the “perversions” sound all that perverse as features of private or social insurance. On Obama’s proposal to establish a federal reinsurance pool, Antos et al. write:

Even though employers would welcome the subsidy, the reinsurance does not reduce health care use or cost. Instead, the policy just shifts some of the cost to the federal budget and could even increase health care spending. Insurers and providers might be encouraged to provide more services to patients who were above the catastrophic threshold since the federal government was sharing in the cost.

The proposal could also lead to anomalous results. One neonatal intensive care stay could lead to federal catastrophic payments for an employer with younger employees (and lower health costs per employee), while an employer with older workers and much higher per employee costs might receive no subsidy for the costs of managing chronic conditions.

This is just about 180-degrees backwards. True, risk-spreading does not in itself reduce the cost of health care, but it does reduce the cost of health insurance, and reducing the cost of insurance helps promote efficient (multi-part) pricing of health care. Moreover, million-dollar NICU trips and the like are exactly the sort of losses for which reinsurance is appropriate. In the absence of adequate reinsurance, catastrophic losses are a death-spiral trigger, since especially small groups end up with huge premium increases leading to collapse of the plans one way or another. As for covering chronic conditions such as aging, the factoid that most of us would like to grow old and healthy, and be well-cared-for in the alternative, suggests a role for intergenerational transfer mechanisms for equitable distribution of the costs.

It might be argued that the reinsurance services could be provided privately, but what I’ve heard from people involved with such matters at local health insurers is that health care reinsurance isn’t a candidate for Marginal Revolution’s ‘markets in everything’ series.

Hoisted from our archives, here’s Kash from 2004 addressing the question of whether the reinsurance pool (also a Kerry proposal) would increase costs:

How would this national reinsurance pool help our nation’s health care problem? In a couple of ways. First and most obviously, it would simply reduce the cost to health insurers of providing health insurance, resulting in lower premiums. Part of this cost would be shifted to taxpayers, but as we shall see, the cost to taxpayers will be less than the savings reaped by people buying health insurance…

Think of it this way. Since the claims for one seriously ill person can easily reach $100,000 or more in a year (while most people’s claims are probably just in the hundreds of dollars), it’s much harder for an insurance company to predict what the aggregate health care costs will be of a group of 10 people compared to a group of 1,000 people. The law of large numbers means that you can pretty much rely on population averages when trying to guess how much health care the large group will need over the year; but for the small group, you either have to spend a lot of time and energy evaluating each of the 10 individuals to estimate each one’s likely health care needs for the coming year, or else you have to just take a chance. And insurance companies hate just taking chances.

The best estimates that I have seen by an economist of the effects of this reinsurance proposal are those by Kenneth Thorpe, professor at Emory’s school of public health. He estimates that the Kerry plan would reduce the variance of firms’ insurance claims by about 50 percent. This in turn will have two effects. It means that it will become dramatically cheaper for small firms to provide health insurance to their employees. Combined with the plan’s requirement that all participating firms offer health insurance to all employees, Thorpe estimates that about 3 million currently uninsured people will start receiving health insurance. This in turn will help to reduce the country’s overall health care costs by allowing more preventative care and early detection of health problems.

That is, since insurance costs depend on the variance of the losses, insufficient reinsurance implies higher risk premia paid to insurers, and those premia are big.

So McCain policies would raise taxes on lots of middle-class workers and dramatically increase marginal tax rates on some middle-class earnings regardless of the net benefits (something conservatives wring their hands over in other contexts), not obviously in service of aligning health care prices and marginal costs and without features that promote efficient risk-sharing. That’s changiness we shouldn’t believe in, my friends.


* For a family; individuals would get $2500. Observe that there’s a family insurance penalty in the plan, as family plan premiums are commonly more than double individual premiums.

** E.g., the negotiated price between my health plan and the UW hospital for my son’s emergency appendectomy last year was roughly 1/3 of list.

*** Yes, people use “cost” when they mean “price” colloquially all the time; the problem is not considering price/cost ratios carefully when arguing that one price promotes economic efficiency better than another.