Revised May 20, 1998
Are Health Insurance Tax Deductions a
Wise Use of Tobacco Tax Revenues?
by Iris J. Lav and Cindy Mann
A number of policymakers recently have called for devoting a substantial proportion of funds raised as a result of federal tobacco legislation to financing new tax cuts. For example, an amendment introduced by Senator William Roth proposed two new or expanded tax deductions for the purchase of health insurance that would cost $18 billion over five years and $47 billion over 10 years. While this amendment was defeated in the Senate Finance Committee, similar amendments may be offered during the Senate floor debate or as the legislation moves through the House of Representatives.
The deductions proposed by Mr. Roth ostensibly are intended to reduce the ranks of the uninsured. Lowering the proportion of the population that is uninsured is a worthy goal and potentially a reasonable use for funds obtained through tobacco legislation. It is highly unlikely, however, that this goal would be advanced much through these types of tax incentives. The families that can benefit from tax deductions are, by and large, a very different population from the families that are uninsured.
The uninsured are heavily concentrated at low- and moderate-income levels. The federal income tax system, on the other hand, exempts many low- and moderate-income families from taxation and taxes the remainder at relatively low rates. Health insurance deductions can provide these families with at most a subsidy equal to 15 percent of the cost of purchasing insurance, which in most cases is not enough to make coverage affordable. As a result, tax deductions are inefficient and largely ineffective as a tool to promote health insurance coverage. The bulk of the cost of the proposed deductions especially the proposal for a costly new deduction for the purchase of individual coverage would go to relieve the taxes of already-insured, higher-income taxpayers.
Tax deductions for health insurance, like other elements of the tobacco bill that have a cost, would be financed by the proceeds of higher tobacco taxes or payments by tobacco companies. The funds raised by tobacco taxes or company payments that are passed through to consumers in the form of higher prices will come disproportionately from lower income families. Since, as explained below, the benefits of the proposed health insurance tax deductions will largely benefit higher-income families, this would represent to a significant degree a transfer of income from lower-income families many of whom are uninsured to families at higher income levels most of whom are already insured.
If one of the goals of the legislation is to expand health coverage, a portion of the proceeds of the tobacco tax paid by lower-income families should be returned in the form of targeted measures that can expand coverage for the low- and moderate-income families that remain uninsured.
Health Insurance Tax Breaks are Expensive and Inefficient
Senator Roth's amendment included two specific tax breaks. The smaller of the two provision would accelerate a provision already in the law by allowing self-employed persons to deduct from their taxable income the full cost of purchasing health insurance. Self-employed persons currently may deduct 45 percent of the cost of insurance, with the deductible portion scheduled under current law to rise to 100 percent by 2007. The amendment also would have created an expensive new provision allowing employees whose employers do not provide health insurance to deduct the full cost of purchasing an individual health insurance policy. Together, these provisions are said to cost $18 billion over five years and $47 billion over 10 years, with the overwhelming majority of the cost attributable to the deduction for employees whose employers do not provide insurance. Much of this revenue loss would subsidize higher-income individuals and families who already are covered by health insurance.
- Most uninsured people live in low-income families. Nearly 45 percent of all uninsured people live in families with annual income under $20,000 and 64 percent live in families with annual income below $30,000, according to the Employee Benefit Research Institute. Similarly, the Congressional Budget Office estimates that nearly three-fourths of all uninsured children live in families with incomes below 200 percent of the poverty line.
- Many of these families have no federal income tax liability that could be offset by a new tax deduction. A family of four with two children that has child care expenses of $400 a month, for example, has no tax liability if its income is below $31,000. A family of three with two children and child care expenses of $200 a month has no tax liability if its income is below $24,500. For these and many other types of families, a tax deduction would provide no subsidy at all and would do nothing to make health insurance more affordable.
- For moderate- and middle-income families that do have some income tax liability, the proposed tax incentives would not provide a sufficient subsidy to make health insurance affordable. A deduction would subsidize a maximum of 15 percent of the health insurance costs of these families, leaving 85 percent of the costs uncovered. The average cost of a family health insurance policy purchased in the individual market is $6,226, according to a recent study by KPMG Peat Marwick. So the deduction would provide a low- or moderate-income family with a maximum subsidy of $934, leaving the family with $5,292 in costs. Families earning $25,000 to $50,000 who have foregone insurance because they cannot afford the $6,200 premium are likely to be equally unable to afford the net $5,200 cost of the premium after the tax break.
- The largest subsidies would go to higher-income families. Like all federal income tax deductions, the health insurance deductions are worth more than twice as much to affluent individuals in the 31 percent, 36 percent, and 39.6 percent tax brackets than to moderate- and middle-income families in the 15 percent tax bracket. The family with income of $150,000 that pays taxes at a 31 percent marginal rate, for example, would receive a subsidy of $1,930 toward the average cost of the individual-market family insurance coverage. The net cost of purchasing the coverage for the family with income of $150,000 would thus be less than the net cost faced by the family in the 15 percent bracket.
- Few of the higher-income families that would capture a disproportionate share of the tax benefits from the proposed deductions are uninsured. According to the Employee Benefit Research Institute, only 7.4 percent of families and individuals with incomes in excess of $50,000 are uninsured, as compared to nearly 18 percent of the total population and 36 percent of those with incomes under $30,000. High-income people who remain uninsured may do so for reasons other than because they cannot afford the premiums.
- Most of the tax benefits thus will go to families and individuals that already are purchasing insurance outside of employer coverage. Some 8.3 million families with incomes exceeding $30,000 already purchase their own insurance in the private market. All such families already purchasing their own insurance will have their taxes lowered; thus the deduction will carry a substantial cost even if no additional families purchase insurance. As a result, the amount of federal revenue lost for each newly insured family will be very high. The tax deduction will be extremely inefficient.
- Finally, the availability of tax deductions for employees whose employers do not provide health insurance could induce some employers to drop coverage. This could result in replacement of private health insurance coverage with public funds. In addition, this could be an acute problem for moderate-income workers. If an employer of a moderate-income worker that has been subsidizing 50 percent of family coverage decides to discontinue that subsidy because of the availability of the new deduction, the worker would be much worse off. Instead of the 50 percent subsidy from his or her employer, the tax deduction would provide a subsidy of only 15 percent.
Regressive Taxes Will Finance Tax Breaks for Higher-Income Households
While the benefits of the proposed health insurance tax deductions will largely benefit higher-income families that already are insured, the proceeds of the tobacco taxes that will finance those tax breaks will come disproportionately from lower-income families. Increasing the cost of cigarettes, whether through a tax or other means, is inherently regressive that is, it will absorb a greater percentage of the income of lower-income households than of those with higher incomes.
- An analysis by the Joint Committee on Taxation shows that 45 percent of a tobacco tax increase would be paid by families with incomes below $30,000. Only 10 percent would be paid by families with incomes exceeding $75,000.
- The Joint Committee on Taxation estimate of the Commerce Committee bill shows that a $1.20 per-pack increase in the price of cigarettes would by the year 2003 take an average of 3.1 percent of income from families with incomes below $10,000 and 0.9 percent of income from families with income between $10,000 and $20,000. But the increase would absorb less than one-tenth of one percent of income from families with incomes above $100,000.
In general, consumption taxes are more burdensome for lower-income households than for those at higher income levels. This is particularly true for tobacco taxes, since a higher proportion of lower-income than higher-income people smoke. This does not mean such taxes should not be imposed to reduce the number of people, especially young people, who smoke. But the distribution of the burden of taxes levied on tobacco products strongly argues for using a portion of the proceeds of the tobacco tax for targeted measures that will expand health insurance coverage for the low- and moderate-income families that disproportionately make up the ranks of the uninsured.
Alternative Uses of Funds Could Help Cover Low-Income Uninsured
Efforts to improve access to health care coverage by those who cannot secure employer-based coverage represent an appropriate use of funds raised by tobacco legislation. Although the proposed health insurance tax deductions would do little to reduce the ranks of the uninsured, other approaches are available that would be both more effective and more efficient.
Approaches that combine targeted subsidies that can help individuals purchase coverage with strategies such as rate reform, group purchasing options, or high risk pools that can help bring the cost of individual private insurance coverage within reach of more low- and moderate-income families could address this need much more efficiently than the proposed tax deduction. Another viable approach is to grant states an option to cover low-income working parents under Medicaid and to allow low- and moderate-income individuals to buy into the Medicaid program, as Minnesota has done through its MinnesotaCare program. That would allow states to target available resources to low- and moderate-income uninsured individuals who lack employer-based coverage.
Two much more modest steps also would help reduce the number of uninsured children and warrant consideration by Congress. These proposals build on last year's bipartisan child health initiatives and are included in the Administrations budget proposal for fiscal year 1999.
- Expand the state "presumptive eligibility" option under Medicaid to allow states to develop more effective strategies to identify and enroll working poor and near-poor children who already are eligible for Medicaid but are uninsured.
Census data show that 4.4 million uninsured children, the vast majority of whom are from working families, are eligible for Medicaid but not enrolled. To help states reach these children, last year's Balanced Budget Act created a new state option under which states can allow health care providers and a limited group of community-based organizations to "presumptively" enroll in Medicaid children who appear to be eligible based on their age and family income.(1) A proposal included in the Administration's 1999 budget, as well as in the Conrad tobacco bill, would provide states greater flexibility under this option by allowing states to use schools, child support enforcement agencies, and other organizations that have regular contact with low-income working families to enroll presumptively eligible children in Medicaid on a temporary basis.
- Allow states the option to cover lawfully present immigrant children under Medicaid and the new child health block grant.
The child health initiatives included in the Balanced Budget Act left out one group of children. Under current law, states are prohibited from providing either Medicaid or coverage under a separate state child health program to most legal immigrant children who enter the United States on or after August 22, 1996 and are in their first five years in the country. These restrictions leave low-income children who are lawfully present without coverage for primary and preventive care unless states are willing and able to cover these children fully at state cost.
Neither of these initiatives would create new mandates or require coverage of any new groups of children. They would simply expand the options available to states under Medicaid and the new child health block grant to help states meet the goal of providing coverage to the millions of low-income children who continue to lack health insurance.
Credits Instead of Deductions Can Better Target Health Care Tax Incentives
If tax breaks for health insurance purchases are included in the tobacco legislation, using credits rather than deductions can better target the tax relief to moderate-income families. A credit equal to 30 percent of health insurance premiums, for example, is worth the same amount to all taxpayers with equal expenditures. So long as the taxpayer has sufficient tax liability to utilize the entire credit, the value does not vary with the income level of the taxpayer. This is in sharp contrast to a deduction, which as noted above is worth more than twice as much to affluent taxpayers in the 31 percent, 36 percent, and 39.6 percent tax brackets than to moderate- and middle-income families in the 15 percent bracket.
To be able to help the large proportion of uninsured families that have little or no tax liability, however, a health insurance tax credit would have to be refundable. With a refundable credit, a family would receive a check for the amount by which the credit for which the family is eligible exceeds its tax liability. Even with a refundable credit, a number of issues of the extent to which the tax break could help lower-income families would remain. For example, it is unclear whether a check received a year after a family paid health insurance premiums would render the purchase affordable.
1. The children then have a limited period of time during which they must submit a formal application to the state Medicaid agency to secure regular coverage on an ongoing basis.