Revised April 22, 2003 

ADMINISTRATION’S PROPOSED TAX CREDIT FOR THE PURCHASE OF HEALTH INSURANCE
COULD WEAKEN EMPLOYER-BASED HEALTH INSURANCE
by Edwin Park

 Executive Summary

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As part of its fiscal year 2004 budget, the Administration has proposed to provide a refundable tax credit to individuals and families for the purchase of health insurance in the individual health insurance market.  This proposal is the chief component of a series of budget proposals related to the uninsured.

The tax credit would be available for the purchase of health insurance in the individual market for individuals and families who do not participate in employer-based coverage or public health insurance programs.  The credit would equal up to $1,000 for individuals and up to $3,000 for families with children, with the full credit being available to individuals with incomes of less than $15,000 per year and families with incomes below $25,000.  The tax credit would phase down as income rose above these levels and would phase out entirely when income reached $30,000 for individuals and $60,000 for a two-parent family of four.  According to the Joint Committee on Taxation, the proposal would cost $64 billion over 10 years (the Administration estimates the cost at $89 billion).  The proposal accounts for a large percentage of the new federal resources the Administration is proposing for the uninsured.

While the tax credit would result in some currently uninsured individuals gaining insurance, the proposal is highly controversial.  It poses substantial risks.  In particular, the tax credit could materially weaken the employer-based health system through which the vast majority of insured Americans obtain their health insurance coverage and could cause some currently insured people — particularly people who are older or are in poorer health — to lose insurance altogether or to have to pay exorbitant amounts to retain insurance.

This analysis examines the Administration’s tax credit proposal.  It considers how the credit would affect the two pillars of group health insurance in the United States — employer-based average and public coverage through programs such a Medicaid and SCHIP.  The analysis finds that the tax credit proposal would pose significant risks, including the following:

• The availability of the tax credit could lead some employers to cease providing coverage to their workers and could induce many new employers not to offer coverage.  Analysts from M.I.T., the Kaiser Family Foundation, and the Urban Institute have found that enactment of a tax credit of this nature would encourage some firms not to offer health insurance coverage to their employees because the firms would know their workers could now get a tax credit to purchase coverage in the individual market.  Substituting the purchase of health insurance in the individual market for group coverage through an employer, however, would seriously disadvantage older and less healthy workers.  In most states, insurers can vary premiums for health insurance policies offered in the individual market on the basis of age and medical history and can refuse to cover people entirely.  Many older and less healthy workers would generally have to pay far more than the amount that the tax credit would provide to secure coverage in the individual market or would not be able to obtain coverage at all because of their health status.

• The tax credit could institute an “adverse selection” cycle that substantially increases the costs of employer-based coverage.  Aggravating this problem is the fact that under the Administration’s proposal, workers whose employers do offer coverage and require their employees to pay a share of the premium would be able to opt out of employer-based coverage and instead use their tax credits to purchase insurance in the individual market.  Such a move could be attractive to young, healthy employees; they may be able to purchase individual policies for which the tax credit could cover up to 90 percent of the cost, which often would be a larger percentage of the cost than their employer would cover.  But if these young and healthy workers opt out of employer coverage, the pool of workers remaining in employer plans would become older and sicker, on average, which in turn would drive up the costs of employer-based insurance and further raise the amounts that both employers and the employees remaining in these plans must pay for insurance.

This phenomenon — known as “adverse selection” — could then induce additional younger, healthier workers to abandon employer-based coverage and use their tax credits instead, because the departure of the first wave of younger, healthier employees would have caused premiums for employer-based coverage to rise.  In this way, a vicious cycle could be set in motion.  The increase in premiums for employer-based coverage that ultimately could occur could induce many employers either to cease offering health insurance or to increase substantially the amounts their employees must pay for insurance.  The end result would likely be that many older and less healthy individuals would eventually lose their employer-based coverage and become uninsured or underinsured or have to pay exorbitant amounts for decent coverage.

Intensifying the risk that many firms might not offer coverage is the recent return of a high rate of inflation in health care costs, which are now rising at double-digit rates.  As a result, fewer firms, especially those of smaller size, are offering health insurance coverage to their employees.  Institution of the tax credit could provide a further incentive for some employers seeking to cut costs to drop or not to institute coverage for their workforce.

• Older and sicker individuals likely would be unable to secure adequate health insurance in the individual market without paying exorbitant amounts.  The individual market is generally unregulated.  Under the Administration’s proposal, a family containing older or sick members could find itself excluded from coverage in the individual market or charged premiums that are unaffordable, even with a $3,000 tax credit.  Alternatively, such a family could be offered a plan that is affordable but does not provide coverage for a variety of significant medical conditions.  Many plans in the individual market do not offer comprehensive coverage.  They may require high deductibles, impose significant cost-sharing, and provide minimal benefits.

The Administration says its proposal responds to this concern by allowing tax-credit recipients to buy coverage through high-risk pools and private purchasing pools.  The success and scope of these mechanisms, however, has been quite limited.  Even with some federal and state funding, participation is often low, premium costs are substantial, and the health insurance benefits provided can be restricted to a fairly narrow range of services.  Moreover, policies available through high-risk pools often impose high deductibles and cost-sharing or exclude coverage of pre-existing conditions for a lengthy period of time.

The Administration’s proposal would permit states to allow certain individuals also to use their tax credits to buy into comprehensive public coverage.  It is uncertain, however, how many states would elect this option and open their Medicaid and SCHIP managed care plans to tax-credit recipients.  Because the people most in need of buys-in to public coverage tend to be sicker, high-risk individuals unable to obtain coverage in the individual market, adding these individuals to the current Medicaid and SCHIP managed care pools (which primarily enroll relatively healthy families and children) could increase Medicaid and SCHIP costs.

• The tax credit would be of inadequate size to make health insurance affordable for many low- and moderate-income families.  Health insurance can be expensive.  According to the General Accounting Office, the mid-range premium for family insurance in the non-group market exceeded $7,300 in 1998.  Even without factoring in the increases in health insurance premium costs since 1998, a family with income of $25,000 that receives a $3,000 tax credit would have to expend 15 percent or more of its gross income to purchase insurance at this price.  Furthermore, more recent studies have found that with a $1,000 tax credit for individuals, older individuals may have to spend one-third of their income to purchase comprehensive health insurance in the individual market.  In some higher-cost geographic areas, premiums could consume still-greater percentages of an individual’s or family’s income.  Studies indicate that such expenditure levels are substantially beyond what most low- and moderate-income families can afford.  In addition, the value of the tax credit is likely to erode over time.  The Administration’s proposal would index the full credit amount annually by inflation, not by increases in health costs.  As a result, in some years, insurance premiums could increase by more than two and a half times faster than increases in the value of the tax credit.

• The tax credit would not be a cost-effective and well-targeted approach to reduce the ranks of the uninsured, since the large majority of those who would use the credit already have insurance.  Analysts from M.I.T. and the Kaiser Family Foundation have estimated that under this or similar tax credit proposals, more than two-thirds of those using the tax credit would be people who already are insured.  As a result, relatively little of the benefit of the credit would go to reducing the ranks of the uninsured.  Instead, a large share of the credit’s substantial cost would go either to provide people who already are insured with another tax cut or to shift people from their current insurance arrangements (primarily through employer-sponsored coverage) to different insurance arrangements.

• Establishment of the tax credit could encourage states to scale back Medicaid and SCHIP coverage for families with children.  Facing severe budget deficits, some states have begun cutting eligibility for working parents and children under Medicaid and the State Children’s Health Insurance Program.  Because the tax credit is targeted in part at the same low- and moderate-income adults and children served by these public programs, states may have another inducement to reduce Medicaid and SCHIP coverage.  States could decide that beneficiaries could instead go out and use the tax credits to purchase health insurance in the individual market.  After all, unlike public programs that require states to contribute a portion of the costs, the tax credit would be fully funded by the federal government.  As a result, beneficiaries who now have access to affordable and comprehensive public coverage through Medicaid or SCHIP could be placed into the individual market and become uninsured or face much higher out-of-pocket costs and significantly reduced benefits. 

• Some individuals and families may be unable to take advantage of the tax credit because of timing problems for “advance payment” of the credit.  To ensure that people can take advantage of the tax credit, the Administration proposal allows the credit to be available at the time that insurance premium payments are due, rather than at the end of the year when income tax returns are filed.  Insurers would discount premiums paid by tax-credit recipients and be reimbursed for the discount by the federal government.  Eligibility would be based on the taxpayer’s prior-year tax return.  However, the incomes of low- and moderate-income fluctuate substantially during the course of a year.  As a result, some taxpayers may be presumed to be ineligible because their prior-year income was too high to qualify for the credit, even though they may have since lost their jobs or had their work hours reduced.

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