Healthcare and the Tax Code

Tyler is puzzled by the usual economic argument against the tax treatment of health insurance. In a nutshell, the current system allows health insurance to be bought with pre-tax dollars, but direct purchases of healthcare products and services must be made with post-tax dollars. The usual economic argument, as stated by Glenn Hubbard, is that this system encourages a system of third-party payment in which consumers are rarely confronted with the true cost of their choices at the point of sale.

Tyler raises some tough questions about this line of argument. I’ll try to respond, while admitting that I (like Tyler) am not an expert in this field.

If the argument is that tax deductibility leads to too much health care, I can see the logic. But then the problem is in the pretzels and beer markets; health care should be doing fine, albeit in bloated form.

A bloated healthcare market is indeed part of the problem. It seems likely that many Americans do purchase more healthcare services than they really need. But the bigger issue is that greater expenditures don’t necessarily translate into more health services. The fact that consumers cannot use untaxed dollars to buy healthcare directly creates a strong incentive to have as much of our healthcare as possible purchased through middlemen (the insurance companies), which at a minimum drives up administrative costs. Instead of you just handing a check to your doctor, your employer has to pay an insurance company, you and/or your doctor have to fill out reimbursement forms, and bureaucrats at the insurance company have to process the claims and payments. (Lest it seem like I’m arguing against insurance in general, I’m not – for low-risk high-consequence health events, insurance makes perfect sense for purposes of risk-spreading, despite the administrative costs. But for small and routine expenses, out-of-pocket payment is more sensible.)

In addition, there is an incentive problem created by third-party payment. Patients have no incentive to economize on their health purchases when someone else is paying at the point of sale. They tend to purchase more doctor visits, more hospital days, more name-brand medicines, more pain medication in the hospital, more physical therapy, etc., and they have no reason to ask if the price is right. More on this below.

Alternatively, it might be argued that buying health insurance involves a negative externality on others. Maybe insurance companies are intrinsically bad monitors, and more insurance corrupts the system as a whole.

Tyler’s point, I think, is that the problem of uneconomical health purchases, brought on by third-party payments, could be solved through better cost monitoring. That’s true, but it creates problems of its own. First, the enforcement itself is costly, because it involves having insurance companies regularly reviewing and sometimes overruling the decisions of doctors and patients. Second, it engenders the animosity of doctors and patients, who don’t like having their decisions second-guessed. The essential purpose of an HMO is to ration healthcare by means of lines and bureaucracy instead of by price; hence the recent vilification of HMOs. Facing such resistance, the insurance companies can either (a) continue their monitoring and face the public’s wrath, (b) raise premiums, or (c) a little of both, which is what we’ve in fact observed.

Grant this premise, but where do we end up?
1. We would have a good argument for taxing insurance purchases. Yet the insurance point is rarely raised with this conclusion in mind. We might have (yikes!) an argument for greater government involvement in health care.

Actually, the argument is for equalizing the tax treatment of health insurance and direct healthcare expenditures. One way to do this is to tax health insurance; the other is to remove the taxes on direct health expenditures. The latter approach would continue to subsidize healthcare relative to other goods and services, but it would get rid of the perverse incentive to get all healthcare through insurance companies. Either approach would be preferably to the status quo.

2. If insurance companies are such poor cost monitors, why doesn't this raise premia accordingly? The poor monitoring of the company would be reflected in policy price and thus would be internalized by the people or institutions who buy the policies. The externality should vanish or at least significantly diminish.

See above points about cost monitoring. The bottom line is that even if there is substantial competition among insurance companies for institutional customers, the competitive price is still higher than it would be otherwise. Even the most efficient health insurance company can’t eliminate the administrative and enforcement costs entirely.

3. Why should insurance subsidies lead to "low copayments and deductibles"? Insurance with high copayments and deductibles is favored by the tax system as well. That being the case, why do we blame the tax system for how insurance is (perhaps) poorly structured?

It’s not exactly true that the tax system favors high-copayment/low-deductible policies as well, because in general, such copayments and deductibles must by paid out of consumers after-tax dollars. Recent change in the tax code have made it possible to have limited Medical Savings Accounts (MSAs), which allow you to put aside some pre-tax dollars for copayments and deductibles. This is a move in the right direction. But my understanding – again, limited by lack of expertise – is that such MSAs have been hobbled by a variety of restrictions. For them to create the proper incentives, it must be possible to “roll over” any unused dollars into your general income, which to my knowledge is not possible in the status quo. The patient’s incentive is to use the dollars before they disappear.

All these points collapse into a more simple query: how can a simple relative price, whether a distortion or not, corrupt the cost control practices of an entire industry?

The issue is not the distorted relative price between healthcare and other products and services. It’s the distorted relative price between health insurance and directly purchased healthcare. That, as outlined above, leads to higher administrative and enforcement costs.

And if government provision of health care is ineffective and costly, isn't there a positive externality from the purchase of private health insurance?

Certainly, private insurance is better than government provision. But what would be even better is a combination of private insurance and private direct payment.

For more commentary on healthcare, much of it inspired by Gephardt’s plan, see my previous posts here, here, and here.