Replacing Employer-Monopoly Health Benefits: Tax Deduction or Tax Credit?

Key Points

The government forces most Americans to take health “benefits” chosen by HR managers who work for their employers. This leads to fragmentation, frustration and bureaucracy.

Giving individuals ownership of their health dollars relies on reforming the federal tax code to give the tax benefits of health insurance to individuals instead of employers.

This tax benefit can be either a tax credit or a tax deduction. Each has positive and negative consequences, which proponents of consumer-driven health reform need to appreciate.

Last month’s Health Policy Prescription developed an extremely simple model to explain that while the legal struggle against Obamacare’s unconstitutional individual mandate is admirable and will hopefully be successful, it is economically absurd. As long as the penalty for complying with an individual mandate is a fine (as opposed to imprisonment), it is really no different than a tax. The real difference is between the government giving the tax preference for a qualifying health plan to an individual or to the individual’s employer.1 The latter, where the employer has monopoly control over her employees’ health dollars, is the status quo in the United States. Bizarrely, we refer to this as a “benefit” of employment, instead of a liability.

While it would be unthinkable that Americans would tolerate our employers’ HR departments deciding whathome we occupy, what car we drive, or where we shop for groceries, we are irrationally enthusiastic about the “perk” of allowing these corporate functionaries total control over which health plan we use. In return, we suffer artificially reduced wages, because our employers confiscate more than $10,000 of the average family’s income to pay for employer-monopoly health “benefits.”

What is needed is a reform to the tax code such that the tax benefit for having a health plan goes to the individual and not his employer. What has never been well settled is whether this tax benefit should be a tax deduction or a tax credit. This article discusses the consequences of both reforms.

First, let’s look at a simple society with four people under different scenarios. We’ll use a series of tables, drawn from a spreadsheet publicly available on the Internet.(2) Table 1 depicts the current employer-monopoly system. Alice and Barry are equally productive. Alice earns $50,000 and receives non-taxable employer-based health benefits worth $4,500 for total compensation of $54,500. Barry earns cash wages of $54,500, but receives no health benefits. They pay a 10 percent flat rate of income tax. We don’t know why Barry has forgone health benefits in exchange for more cash wages, but we know that the flexibility of cash is worth at least $450, because that’s how much extra tax he pays as a consequence.

Charles and Diane are much more productive than Alice and Barry, and therefore earn significantly higher incomes. This society imposes a progressive income tax regime, with a 20 percent rate kicking in at incomes above $54,500. Charles and Diane provide equally valuable labor to their firms, so their employers pay them the same. However, Diane has also forgone health benefits. Because she takes all her income in cash wages, she pays $900 more in tax than Charles. The government’s total tax revenue is $40,450. Although oversimplified, scenario A is the status quo in U.S. health care…