Standard Health Care Deduction

A Critical Analysis of the Standard Deduction for Health Insurance

Introduction

President Bush's plan to amend the tax code to help provide health coverage for more Americans is drawing mixed reviews from health experts who say it moves in the right direction but could one day undermine the nation's employer-based health insurance system.

The president's plan would, for the first time, give a flat, standard deduction of $7,500 for individuals and $15,000 for a family. Those whose coverage costs more - an estimated 35 million people - would pay taxes on the difference. Those paying less for insurance would still get the full deduction and the resulting break in taxes. (www.usatoday.com)

The standard deduction proposal that the President has put forward in the State of the Union levels the playing field between insurance coverage purchased inside the employer market and outside the employer market, and does it in a fairly innovative and creative way.

Most tax-policy analysts agree that differences in individuals' tax liabilities (and thus in their shares of the costs of government) should reflect those individuals' differing abilities to pay. That is, of course, the beginning rather than the end of tax-policy arguments, because it is often debatable how differences in individuals' situations affect their abilities to pay tax. On one point, however, there is widespread agreement: no one has any ability to pay tax on the amount of income necessary to support life at a level of basic decency. Ability to pay is generated only by "clear income"--the amount of income a person has in excess of subsistence needs. If the poverty threshold is, say, $15,000, then no one--not even Bill Gates or Warren Buffett--should be required to pay tax on his first $15,000 of income. Historically, Congress has agreed with this view. The combination of the standard deduction and the personal and dependency exemptions is designed to approximate the official poverty threshold, thus excluding the cost of subsistence from the tax bases of taxpayers at all income levels. Although in recent years Congress has denied the benefit of personal and dependency exemptions to taxpayers near the top of the income distribution, this appears to have been a matter of political expediency--a technique for disguising a marginal tax-rate increase for affluent taxpayers--rather than of changed principles.

Clear-income analysis provides a non-subsidy justification for excluding the individualized cost of basic medical care from each person's tax base.

Critical Analysis and Discussion

The costs of basic medical care--both basic health-insurance coverage and necessary care not covered by insurance--obviously are costs of subsistence. Thus, just as the costs of basic food, clothing, shelter, and transportation should be excluded from the tax base, so should the cost of basic medical care. In the same way that personal and dependency exemptions make the tax system sensitive to differences in the cost of subsistence attributable to differences in family size, a tax allowance for the cost of basic health insurance should be sensitive to age- and sex-based differences in the cost of such insurance. Such differences in the cost of basic health insurance coverage are significant: the cost of insurance for persons in some age-and-sex categories can be several times the cost for persons in other categories. If the cost of basic health insurance for a twenty-five-year-old man is a small fraction of the cost of basic coverage for a woman of childbearing age, or for a sixty-five-year-old of either sex, then a universal allowance of a fixed dollar amount, akin to the standard deduction, must be too generous to the young man or inadequate for the others. To the extent that the income-tax exclusion of employer-provided health insurance removes the age- and sex-adjusted cost of basic medical care from the tax base, it is--like the standard deduction and the personal and dependency exemptions--part of the definition of the ideal income tax base. Thus, if a "subsidy" is a provision included in the Internal Revenue Code to accomplish some goal other than adjusting tax liability to reflect ability to pay (such as encouraging particular types of consumption behavior), then because the health insurance exclusion is justified by ability-to-pay concerns internal to the tax system, it should not be understood as a "subsidy." (Zelenak, 104)

Although the "clear income" approach provides a non-subsidy justification for the exclusion of basic employer-provided health insurance, in some respects current tax treatment of health insurance and other medical costs differs significantly from the dictates of clear-income analysis. The implications of clear-income analysis are that all costs of basic health care should be excluded from the tax base and that no costs of more-than-basic care should be excluded. Current tax treatment is insufficiently generous on the first count and overly generous on the second.

On the first count, current law is insufficiently generous because most costs of basic health care not covered by employer-provided insurance are not excluded from the tax base. People who purchase health insurance outside of the employment context may, in theory, deduct their premiums as medical expenses under section 213, but the deduction is allowed only to the extent total medical expenses exceed 7.5% of adjusted gross income (AGI), and even that excess is deductible only if the taxpayer itemizes rather than claiming the standard deduction. In addition, the 7.5%-of-AGI floor applies to basic medical expenses not covered by insurance (co-payments, deductibles, expenses for treatments not covered by a taxpayer's insurance, and all expenses of uninsured taxpayers). Under an ideal income tax implementing the clear-income concept, however, all such expenses should be deductible in full. Although clear-income analysis suggests that the tax favoritism for employer-provided health insurance (that is, favoritism relative to other health insurance and health costs not covered by insurance) is inappropriate, it does not follow that the exclusion is a subsidy. Rather, the failure to provide equivalent treatment for other health care costs is a sort of penalty, or anti-subsidy.

On the second count, however, current law is overly generous because it extends the exclusion for employer-provided health insurance beyond the value of basic insurance. Under current law, the entire value of employer-provided health insurance is excluded from income, even if the insurance covers, for example, the excess cost of a single-bed hospital room over a two-bed hospital room, longer-than-medically-necessary