Tax Reform III: Tax Employer Health Care Benefits; Offer a Tax Credit to Health Insurance Purchasers

In an earlier blog post I suggested eliminating all personal tax deductions, with a possible exception related to health care.  One of the well-publicized problems with the American health care system is that employer-provided health insurance is not taxed, pushing us to a system in which people get health insurance from their employers.  A better option would be to allow a competitive market in which people shop for their own health insurance, as they do with homeowner insurance, auto insurance, life insurance, and really, all insurance except for health insurance.

One way to change the system is to make employer-provided health insurance a taxable benefit, taking away the tax advantage of buying health insurance through one’s employer.  That would impose a tax cost on those receiving the benefit, which could be offset by allowing everyone to deduct the cost of their health insurance from their taxable income.

One problem with the deduction is that those with higher incomes would benefit more from it than those with lower incomes whose tax liabilities may be less than what they would have to pay for health insurance.  So, provide everyone with a refundable tax credit up to some limit, or maybe as a percentage of their premium cost.  For example, the credit could be 85% of the cost of their premiums.  This is not that original an idea, in that it is similar to one of the proposals John McCain made when he was running for president.

This policy would have a huge beneficial effect on the market for health care, although it would not be optimal for tax policy.  Simply looking at the tax system, the best option would be just to tax employer-provided health insurance and use the extra revenues to lower tax rates for everyone.  The problem is that politically, it would be very difficult to tax health insurance benefits without some offset.  The tax credit provides a mechanism that would not impose a cost on those who now receive the benefit, would invigorate the market for health care and health insurance, and would encourage everyone to buy health insurance.

It is not a perfect policy, but it is a politically feasible way to improve on what we have now.

Randall G. Holcombe is Research Fellow at the Independent Institute and DeVoe Moore Professor of Economics at Florida State University. His Independent books include Housing America: Building Out of a Crisis (edited with Benjamin Powell); and Writing Off Ideas: Taxation, Foundations, and Philanthropy in America .
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