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The President's Proposed Standard Deduction for Health Insurance

An Evaluation

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Document date: February 14, 2007
Released online: February 15, 2007

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.


The paper describes the new standard deduction for health insurance, proposed in the FY2008 Budget, and evaluates the extent to which it would meet its stated goals of expanding health insurance coverage and restraining healthcare spending, and its effects on the distribution of tax burdens in the short and long terms. The basic approach would improve the market for health insurance, but inadequate attention was paid to problems in the nongroup market or those facing households with low incomes. In consequence, the plan could actually reduce overall insurance coverage. The paper suggests a variety of ways in which the proposal could be improved so more people would be covered, including those with low incomes or in poor health.

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President Bush's FY 2008 budget proposes major changes in tax incentives for health insurance and health care. His plan would eliminate most current tax exclusions and deductions for health insurance premiums and out-of-pocket costs; for the first time, employer contributions to health insurance would be included in taxable income. In place, the plan creates a separate standard deduction for health insurance in the federal income and payroll taxes for all taxpayers who obtain qualifying health insurance. The plan's intent is to increase the tax incentive to purchase some form of insurance while eliminating the current system's bias in favor of insurance provided through employers and reducing the current tax incentives for over-consumption of health care services and the commensurate under-consumption of other goods and services.

The president's plan also contains several health proposals that lie outside the tax sphere and are not discussed in detail in this analysis. The plan has a vague proposal to allow states greater flexibility to redirect their existing uncompensated care funds to support greater access to affordable health insurance for those with low incomes or chronic health conditions. There are few details on how this would be accomplished. The president also reproposes his Association Health Plan initiative to allow small businesses to purchase health insurance through trade associations and other groups without being subject to state insurance regulations.

The tax proposal is innovative and a step in the right direction, but without substantial expansions and revisions the plan as a whole would weaken existing pooling arrangements and create substantial risks for the current system of health insurance coverage. The proposal implicitly acknowledges that there are no easy answers and spells out some tough choices. It attempts to move forward on the twin problems of the rising number of uninsured and rising health spending without increasing total tax subsidies for health insurance; in fact, as proposed it would even reduce the long-run deficit.

The president's plan effectively turns the existing tax subsidy for health insurance into a kind of voucher. It would increase the amount of tax relief that subsidizes acquisition of some health insurance while eliminating the tax advantages at the margin for increased consumption of health care over all other goods. The proposal will almost certainly encourage some people who currently lack insurance, particularly middle-income families, to get it. And the core of the new proposal is not biased towards the provision of favored forms of insurance (e.g., high deductible policies) over other forms of insurance that could reduce spending (e.g., managed care or plans with higher copayments).

However, as under current law, the subsidy will be more valuable for high-income people than for those with lower incomes who most need help. In fact, low-income households with no income tax liability would get very little help, as is true under the current structure. These limitations could easily be addressed by converting the proposed standard deduction into a flat credit or even a sliding-scale credit that is larger for low-income families.

A more fundamental concern about the plan, as proposed, is that the standard deduction would be available to all who obtained qualifying insurance, whether through an employer or as an individual. That would level the playing field between employer-sponsored insurance and insurance purchased in the individual market. But removing the existing advantage for employment-based plans would lead some employers, especially small and medium-sized businesses, to stop offering health insurance to their employees, exacerbating a trend that is already well underway. Assuming that employers raise wages when they stop offering health insurance, healthy employees will often be able to use their wage boost to purchase inexpensive health insurance in the individual nongroup market, but many who have health problems, especially those with low incomes, will find health insurance unaffordable. Mitigating or remedying these problems would require some combination of expanded public programs, new pooling arrangements, fundamental reform of the individual market, or additional subsidies for targeted groups, such as small employers that offer health insurance, people with chronic health conditions, and low-income households.

The administration proposes to provide states with incentives to address the problems in the nongroup market, but those promises may not be backed by adequate funding. Moreover, the tax changes would go into effect regardless of whether or when states created the complementary programs to expand the nongroup market.

This paper summarizes the proposal and its likely effects on the health insurance market and the level and distribution of tax burdens. We also recommend some modifications that could transform the proposal from a risky change that might destabilize existing insurance into a proposal that would reduce the ranks of the uninsured without collateral costs for vulnerable workers.

The complete paper is available in PDF format.

Topics/Tags: | Economy/Taxes | Retirement and Older Americans

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