Unbiased Analysis of Today's Healthcare Issues

McCain and the Tax Deductibility of Health Insurance

Written By: Jason Shafrin - Oct• 24•08

What are the tax implications of John McCain’s health care proposal?  The key components are that health insurance will no longer be tax deductible but individuals will receive a $5000 credit of purchasing health insurance.  Let’s work out some simple math to see how this will impact the life of a typical American.

Example with Max, Rob and Rich

Currently, the deductibility of employer provided health insurance is highly regressive.  Let’s look at 3 individuals.  One is middle class and his name is Max; the other two are rich and their names are Rob and Rich.  Middle class Max has a 25% tax rate, while Rob and Rich pay a 40% income tax rate. Rob has the same $12,000 health insurance package as Max, but Rich has a more generous $16,000 plan.  Let’s see how this affects their tax bills.

Max Rob Rich
Tax Rate 25% 40% 40%
Health Ins. Cost $12,000 $12,000 $16,000
Health ins. tax liability
$3,000 $4,800 $6,400
Tax liability if ins. tax-deductible
$0 $0 $0
Net taxes w/ $5000 credit -$2,000 -$200 $1,400

The tax system as it currently stands is very regressive.  Max, Rich and Robert pay the same $0 taxes on their health care benefit regardless of their income and regardless of the size of their health insurance benefit. If health insurance was taxed, then middle class Max will pay less taxes on his health insurance than rich Rob and rich Rich because Max has a lower marginal tax rate.  On the other hand, individuals with more generous health insurance packages get a larger tax benefit when health insurance benefits are tax deductible.  Even though Rob and Rich are in the same tax bracket, Rich saves more money than Rob when health insurance is tax deductible, since Rich has a more generous health insurance plan.  Tax deductibility encourages people to buy more generous health insurance packages at the expense of the taxpayer.

The McCain plan.

Will the McCain plan lead to higher net taxes?  In my example, Max and Rob save money under the McCain plan. Only Rich owes more taxes since he is in a higher tax bracket and has a more generous health insurance plan.  Of course, health insurance costs will increase over time, so McCain may want to index his health insurance credit to inflation.

Individuals are also worried that if they pay for health insurance themselves, this is a pure transfer of cost.  If I support McCain, will my health insurance costs go up by $12,000?  or $7000?   In reality, if employers stop paying for health insurance and transfer the burden to employees, in a competitive market employers will increase wages to compensate for the loss of the health insurance benefit. Most economic research has found that the cost incidence of employer-provided health insurance appears almost 100% through lower employee wages.

We do have to worry that as individuals start to pay for individual health insurance plans, the problems of adverse selection may worsen.  Further, non-group plans are more expensive to administer than group plans.  Thus, the shift in the type of plans individuals select may affect the cost, but the direct tax effect of the McCain plan will lead to a reduction or small increase in tax liability from health insurance benefits.

Effect on Employers

Some individual believe that the McCain plan would increase taxes for business.  This is incorrect.  If health insurance businesses were taxed, individuals would pay the tax.  For businesses, health insurance still counts as a labor cost and would reduce their profit and thus tax liability.  If individuals would receive a $12,000 health insurance package from work, currently they do not owe any taxes on this benefit.  If individuals were taxed on  this benefit, then an individual in a 25% tax bracket would owe $3000 in additional taxes.  If you are in the 40% tax bracket, you will owe $4800.  This means on net, the McCain plan would decrease your taxes by $2000 for the 25% tax bracket and $200 in the 40% tax bracket.

Also, even if the employer paid for health insurance for a group, each individual would be taxed according to the average cost of the health insurance plan per worker (likely weighted by whether it was a family or single plan).

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  1. Noah says:

    I propose that we use the consumerism model being employed by most health insurance companies as a basis for real universal healthcare. We can use this model to institute a true single payer national healthcare system without losing the benefits of a competitive free market. All preventative healthcare such as physicals etc. would be covered 100% as well as all families under the poverty level would be 100% covered. All families above the poverty line would be required to meet a yearly deductible via the proliferation of HSA’s (we could potentially explore the possibility of letting people access their 401k’s to either fund the HSA’s or pay for medical expenses). The deductible would be directly linked to the family size and income level. Larger families have a larger deductible as do wealthier families up to a cap. After meeting the deductible the single payer system takes over similar to a high deductible health plan. The national healthcare system will provide payment for standard prescribed services beyond the consumer’s deductible. Where I would differ is the consumer would still retain the option of using any additional funding in their HSA to pay for additional services, such as private service rather than public, advanced treatments etc. using tax free HSA money.

    This strategy has multiple benefits including:

    Everyone is covered and no one is forced to buy anything.
    Regardless of income level all citizens are covered and able to receive the medical care they need. No one is unfairly burdened by being forced to pay for insurance they cannot afford. Medical costs will not be inflated to cover the costs associated with treating the un-insured.
    Consumers become more engaged in their healthcare decisions. Lowered healthcare costs.
    By voting with their dollars consumers will be better positioned to drive innovation and control medical costs. Similar to shopping for an auto mechanic or construction contractor the consumer will be allowed to research and seek out the best services for the greatest value.
    The public will have a financial incentive to maintain their health.
    The healthier you are the less you will spend on healthcare. Un-used HSA funds can be used to supplement retirement income should the consumers health and financial situation warrant it. Consumers who maintain a healthy lifestyle will be rewarded with a healthy, tax free, supplemental retirement income thanks to their careful planning and proper choices.
    Consumerism creates open market entrepreneurial opportunities.
    The competition for consumer dollars will create businesses and drive innovation. Along with the new businesses will come jobs and new opportunities for high quality low cost healthcare solutions.
    Alleviates many of the known pitfalls associated with other national healthcare systems.
    Through the melding of consumerism with national healthcare we can limit or remove many of the common complaints associated with other national healthcare systems. Long wait times for service will be limited by the competition for the consumer’s dollars. Stagnant medical innovation would also be eliminated via increased competition brought about via consumerism. By allowing those with the desire and means to do so to use HSA dollars to fund out of pocket expenses for advanced or un-orthodox treatments we can encourage and drive innovation that may eventually become the standard in the future providing an ever better quality of healthcare for all.

    Obviously this is a very high level outline and does not get down deep in the weeds. I do feel however that this can be a very workable solution. The health insurance companies are clearly staking a lot in the success of this methodology to maintain profitability going into the future. If they can use this to be profitable, a not-for-profit single payer system should easily be able to break even without costing more to the consumer. Even if it is government run! J

    I’m all for using profitability as a driving force where it makes sense to do so. In my opinion, health insurance simply doesn’t fit the mold. One of the easiest and most common ways for a health insurer to make a profit is to deny claims. With the need to make a profit, denying a claim is reduced to simply a way to make a buck. Remove the need to make a profit and the playing field changes. No longer is the person who needs an expensive transplant on the other end of the phone simply an income drain. Suddenly they are a person, a mom, a dad, a brother or sister and they need help. Life is too precious to be left to profitability.

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