Assessing the Impact of State Tax Credits for Health Insurance Coverage

Transcription

1 Assessing the Impact of State Tax Credits for Health Insurance Coverage June 2003 Prepared for the California HealthCare Foundation by Karl Polzer and Jonathan Gruber

2 About the Authors Karl Polzer, M.P.A., is an independent health policy analyst based in Washington, D.C. Jonathan Gruber, Ph.D., is Professor of Economics at the Massachusetts Institute of Technology and a Research Associate at the National Bureau of Economic Research, where he directs their Program on Children s Economic Issues. Opportunities for Further Analysis Professor Gruber is available, through support from the California HealthCare Foundation, to analyze tax credit proposals introduced during California s 2003 legislative session. For more information contact Marian Mulkey at or mmulkey@chcf.org. Copyright 2003 California HealthCare Foundation ISBN Additional copies of this and other publications may be obtained by calling the CHCF publications line toll-free at CHCF (2423) or by visiting us online ( The California HealthCare Foundation, based in Oakland, is an independent philanthropy committed to improving California s health care delivery and financing systems. Formed in 1996, our goal is to ensure that all Californians have access to affordable, quality health care. CHCF s work focuses on informing health policy decisions, advancing efficient business practices, improving the quality and efficiency of care delivery, and promoting informed health care and coverage decisions. CHCF commissions research and analysis, publishes and disseminates information, convenes stakeholders, and funds development of programs and models aimed at improving the health care delivery and financing systems. For more information, visit us online ( 476 Ninth Street Oakland, CA Tel: Fax:

3 Introduction In recent years, amidst continuing concern about the many people without health insurance, some state and federal policymakers have advocated providing tax credits to stimulate the purchase of health coverage. The Bush Administration has proposed $89 billion over ten years in new refundable tax credits to help lower-income families buy health coverage for the most part in the individual insurance market and many Democrats have supported the idea. 1 Last year, Congress passed much more limited legislation, which became effective in December, offering advanceable tax credits to subsidize health coverage for a narrowly defined group of workers displaced by international trade and retirees receiving federal pension guaranty payments. 2 Though many implementation hurdles must be overcome before this new law takes full effect, tax credit proponents see it as a testing ground for broader legislation. Other proposals, such as Assembly Bill 39 (Thomson), introduced in California in 2002, would offer tax credits to businesses in order to expand employer-sponsored insurance (ESI). Others have proposed subsidizing the employees rather than firms for the share of the costs of employer-sponsored health insurance that they bear. And yet other proposals have suggested combined approaches, such as tax subsidies that could be used in either the individual or group markets. This report analyzes the potential impact of providing tax credits at the state level, focusing particularly on the effects that several proposals would have in California. The first section provides some context for why policymakers are concerned about expanding coverage. Next, it presents the findings of a study by one author (Gruber) estimating the impact of three approaches to tax credits in California. Finally, the report discusses related issues, such as institutional barriers that might prevent consumers from obtaining health coverage even if new tax subsidies spurred them to seek it. (See textbox for additional background on the tax treatment of health insurance premiums under existing law.) A more detailed discussion of Gruber s findings and assumptions can be found in an accompanying report, titled Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California. 3 Assessing the Impact of State Tax Credits for Health Insurance Coverage 1

4 The Bigger Tax Picture: Tax Subsidies in the Current System Increased tax subsidies currently being considered by policymakers would overlay much larger tax subsidies already built into the health care system. These arise in large part from the exclusion of employer-provided benefits from federal and state taxation and have a silent but important impact on the financing and distribution of health care services in the United States. A major advantage of receiving employment-based coverage is that workers are not subject to income and payroll taxes on their employer s contributions to employee health benefits. Individually purchased coverage, in contrast, does not receive such preferential tax treatment. In recent years, there has been renewed interest in reforming the tax treatment of employee health benefits and individually purchased health insurance. Various proposals have been put forth, some motivated primarily by attempts to expand coverage levels and others by concerns over perceived inequities and inefficiencies resulting from the current tax system.* According to an official estimate, the exclusion of employer contributions for health care, health insurance premiums, and long-term care insurance premiums from federal taxation alone will amount to about $80 billion in federal tax expenditures (i.e., in forgone government revenue) in fiscal year This is roughly ten times more than amounts the Bush Administration has recently proposed for covering more of the uninsured through new tax credits. The current tax exclusion of employer-provided health benefits favors higher-wage workers over lower-wage workers who pay little or no income taxes. A recent study estimated that, for workers with incomes too low to pay income taxes (roughly one-quarter of the workforce), the subsidy created by excluding employee health benefits from income and payroll taxes lowers the effective price of health coverage to about 86 percent of premiums. As income rises, the effective price of employee coverage drops. For people in the 15 percent tax bracket, the tax exclusion of employee health benefits was estimated to lower the price of health coverage to about 72 percent of premium. And for people in the 28 percent bracket and above, the effective price dropped under 60 percent. New tax subsidies targeted at lower-income workers would tend to make the effective prices more level across income groups. Under current law, there is no upper limit on the exclusion from taxation of employer-provided health benefits. Some analysts see the open-ended nature of these tax subsidies as a key factor in driving up the consumption and cost of health care services. That is, under the current tax system, employers and employees may have an incentive to provide and receive compensation in the form of tax-favored benefits as opposed to cash. If consumers then obtain very comprehensive coverage with little cost-sharing at the time service, they may make decisions regarding the consumption of care less prudently than they would if they were paying a greater share of the bill. * Polzer, Karl, Retooling Tax Subsidies for Health Coverage: Old Ideas, New Politics, National Health Policy Forum Issue Brief Number 728. National Health Policy Forum, George Washington University: Washington, DC. November 12, Estimates of Federal Tax Expenditures for Fiscal Years , Prepared for the Committee on Ways and Means and the Committee on Finance by the staff of the Joint Committee on Taxation, U.S. Congress. December 19, U.S. Government Printing Office: Washington, DC Burman, Leonard, and Amelia Gruber. First, Do No Harm: Designing Tax Incentives for Health Insurance, National Tax Journal, vol. 54, no. 3 (September 2001) pp Assessing the Impact of State Tax Credits for Health Insurance Coverage 2

5 Covering the Uninsured Widespread lack of insurance is a major and growing social problem in the United States, and in California in particular. In 2001, some 6.7 million Californians more than 21 percent of the state s nonelderly population had no health coverage. 4 On a national level, 16.5 percent of the nonelderly population was uninsured in 2001, up from the previous year, mainly due to the effects of the weak economy and rising health care costs. With the exception of a brief downturn in the number of uninsured after the economic boom years of the 1990s, the number of Americans without insurance has been growing over the past 15 years, despite expansions of public programs for lower-income people. 5 And rapidly rising health care costs, a lagging economy, and deepening state budget deficits promise to significantly increase the number of uninsured. California policymakers face a budget shortfall among the nation s largest and they are considering deep cuts in the Medi-Cal program. 6 There is strong evidence that expanding coverage to a greater number of people, which provides financial access to health care services, would increase the level of health and life expectancy, especially for those in poorest health and at greatest disadvantage in the current health care system. 7 Although increasing the number of insured would improve the health and productivity of many individuals, health coverage also entails economic costs. As policymakers develop proposals to expand coverage (or, given budgetary pressures, simply attempt to maintain existing levels of coverage), they also must consider, among other factors, the impact on individuals (both insured and uninsured), employers (which sponsor coverage for about 58 percent of nonelderly Californians 8 ), and taxpayers. Evaluating Options: Tax Subsidies for Individuals, Employers, or Employees To help policymakers and others better understand the potential impacts of increasing tax subsidies for health coverage at the state level, the California HealthCare Foundation commissioned one author (Jonathan Gruber, Ph.D.) to estimate the impact of three approaches: 1. Subsidizing the individual purchase of health insurance; 2. Subsidizing employer offering of health coverage; and 3. Subsidizing employee take up of employer coverage. Gruber begins his analysis by examining a state tax subsidy approach similar in magnitude and design to what the Bush Administration has proposed at the federal level. After estimating the total number of Californians that would be newly insured if this policy were enacted, he develops specifications for an employer tax credit option and employee tax credit option that would expand the state s insured population by a roughly similar number of people The individual tax credit option. Under this option, low- to modest-income individuals could take a fully refundable tax credit 10 of up to $1,000 per individual and $2,500 per family but only use it in the individual (nongroup) market. (In this exercise, the credit is fully available to those individuals with incomes up to $20,000, and phases out when their incomes reach $40,000. It is fully available to families with incomes up to $40,000, and phases out when their incomes reach $80,000.) Assessing the Impact of State Tax Credits for Health Insurance Coverage 3

6 2. The employer tax subsidy option. For the employer tax subsidy approach, the maximum credit available would be $1,500 per employee taking up individual coverage and $3,500 per employee taking up family coverage (or about half the average amount employers spend on health insurance). This maximum credit rate would apply to firms with fewer than ten employees and whose employees earn on average less than $20,000 per year. This credit rate would be reduced both as firm size increases and as average wages increase; 11 thus, the largest credits would go to small and low-wage firms that are most likely to have uninsured workers. 3. The employee tax credit option. The third type of tax credit considered would subsidize employees to help pay their share of employer-provided coverage. Here, a credit of up to $350 per single person and $800 per family is proposed, with income limits the same as for the individual insurance tax credit. To simulate the impact of these three options, Gruber uses an econometric model (updated to 2003 dollars) that makes a series of assumptions based on academic studies and consultations with economic, actuarial, and policy experts about marketplace conditions and individuals in different circumstances in terms of their insurance status, income, and tax rate. The model simulates how individuals and employers might behave in response to the subsidies. These behavioral responses include, but are not limited to: Take-up rates among the uninsured. The extent to which the currently uninsured would purchase newly subsidized health coverage, and how that might differ depending on whether those uninsured are currently offered ESI. Take-up rates among the previously insured. The extent to which those with existing insurance coverage would take up new subsidies for their insurance spending (either nongroup insured taking up individual subsidies, firms that already offer insurance taking up subsidies to employers, or employees who are already insured taking up subsidies). Shifts in type of coverage. The extent to which people with one type of coverage would switch to another type when it is subsidized; for example, how many of the employerinsured would switch to individual insurance if it were subsidized? Shifts in employer offer rates. The extent to which firms that do not currently offer insurance would begin to do so in response to subsidies to employer-provided insurance, and the extent to which firms that currently offer insurance would stop offering that insurance in response to subsidies to individual insurance. Changes in employer contributions. The extent to which firms would change the mix of employer and employee premium financing in response to subsidies; for example, when employee premiums are tax subsidized, would employers increase the employee s premium share so that the government would bear a larger share of insurance costs? Assessing the Impact of State Tax Credits for Health Insurance Coverage 4

7 The Model s Findings The results of the simulation are summarized in Tables 1 and 2. Table 1. Estimated Impacts of the Three Tax Subsidy Options* Individual Tax Credit Employer Tax Credit Employee Tax Credit California fiscal cost $1.6 billion $1.9 billion $1.6 billion Total number of people taking up subsidy 2.01 million 3.07 million 8.52 million Previously employer insured 350, million 7.8 million Previously individually insured 690, ,000 70,000 Previously Medicaid 130, , ,000 Previously uninsured 830, , ,000 Not offered and uninsured 700, , ,000 Offered and uninsured 120, , ,000 Total change in population size Individual market 1.32 million -190,000-70,000 Medicaid -100, , ,000 Uninsured -640, , ,000 Employer insured -580, million 680,000 Change in federal tax revenue $708 million -$124 million -$391 million Annual cost to state per newly insured $2,564 $2,448 $4,014 Note: Data might not total exactly due to rounding. * All costs calculated in 2003 dollars. Table 2. Distributional Impacts: Percentage of Credit Dollars to Each Income Group Group Individual Credit Employer Credit Employee Credit 100% of FPL* % of FPL % of FPL % of FPL >400% of FPL * FPL = Federal Poverty Level. The calculation of state government costs here includes both the direct costs of the new tax credits as well as the impact on state spending resulting from behavioral responses to the new tax credits. As a result of implementing the individual tax credit option, government expenditures would actually drop for the highest income group. This is because some employers would stop offering coverage and employees they formerly covered would end up either with individual coverage or uninsured (since the individual tax credit phases out with income, and is completely phased out by $80,000 of income). In either case, these employees would lose the advantage of having their employers contribution to coverage be tax-exempt. This would raise government revenues, so that the total cost of the policy for this group is negative. Assessing the Impact of State Tax Credits for Health Insurance Coverage 5

8 Perhaps the simulation s most striking finding is that in relation to the public expenditures needed to fund any of these tax subsidy approaches, the total number of newly insured is relatively modest. For the employer tax credit, which is particularly targeted toward small, lower-wage firms, the state s uninsured would decrease by 780,000, or roughly 13 percent. The individual (nongroup) tax credit would lower the uninsured population by 640,000 (slightly more than 10 percent). And the employee tax credit would reduce the number of uninsured by 390,000 or about 6 percent. Depending on the option chosen, the annual cost to the state would range from about $1.6 billion (for the individual and employee subsidy options) to about $1.9 billion (for the employer tax credit). While the overall number of newly insured might be modest, the three options have distinctly different impacts on the type of institutional setting in which many people would receive coverage. The options also differ in how many people would receive new subsidies, the cost to state taxpayers per newly insured, and the percent of new state spending going toward lowerincome citizens. Under the individual subsidy option, for example, California s individual market would grow by about 1.32 million covered lives, while employer-sponsored coverage would shrink by about 580,000, according to the model. In contrast, under the employer subsidy option, employment-based coverage would grow by about 1.2 million covered lives. Under the employee subsidy option, employment-based coverage would grow by 680,000. The largest number of people 8.5 million would take up the employee tax credit, in contrast with about 3 million who would opt for the employer subsidy and 2 million who would choose the individual subsidy. The employer and individual tax credit options, however, would cost the state much less per newly insured citizen than the employee subsidy option roughly $2,500 compared with about $4,000. Under the individual tax credit option, a greater percentage of new subsidies would go toward the lowest-income people (see Table 2). Of the three options, tax credits aimed at inducing employers to offer coverage, when targeted to firms that are least likely to offer coverage, are the most efficient means of increasing coverage. 12 Credits to individuals are somewhat less efficient, largely due to the high costs of insurance in the individual market. Also, as noted below, consumers have fewer regulatory protections in the individual market than in the group market. Credits for employee purchase are the least effective particularly when the credits are large or eligibility extends to higher income ranges because the vast majority of those taking the credits would already have coverage. The Individual (Nongroup) Tax Credit Option According to the simulation, two million people would take a tax credit to buy their own insurance policies in the individual market (see Table 3). Previously, 41 percent of these people would have been uninsured; 34 percent already would have had individual insurance; and 17 percent would have opted to switch from employer-provided insurance. Under the individual option: The number of people with ESI would fall by 580,000, or about 3 percent, mostly due to employers dropping their health plans (because tax subsidies for use in the individual market would now be available for at least some of their employees); about half of the dropped employees would enroll in individual insurance, but about half would end up uninsured. Assessing the Impact of State Tax Credits for Health Insurance Coverage 6

9 There would be a net reduction of 640,000, or 10.3 percent, in the number of uninsured. The total cost to the state would be $1.63 billion per year. The net cost to the state per newly insured of this type of credit would be about $2,550. Only about 40 percent of the tax credit dollars would go toward reducing the current number of uninsured. Most of the tax credit would go toward reducing already-insured lower-income people s tax liabilities or increasing their incomes. More than four-fifths of new tax spending would go to those below 200 percent of the Federal Poverty Level (FPL). Should the credit be expanded in size, its effects would increase, but the cost per newly insured would rise as well. Table 3. Individual Tax Credit Option: Impact on Cost and Coverage* Percent of Number of People Insurance Category Net Cost California fiscal cost $1.6 billion Total number of people taking up subsidy 2.01 million Previously employer insured 350, $274 million Previously individually insured 690, $503 million Previously Medicaid 130, $43 million Previously uninsured 830, $897 million Not offered and uninsured 700, $736 million Offered and uninsured 120, $133 million Total change in population size Individual market 1.32 million Medicaid -100, Uninsured -640, Employer insured -580, Employees buying individual -220, coverage after firm stops offering Employees become uninsured after -160, firm stops offering Employees switch to individual -140, insurance even though firm still offers Employees become uninsured due to -30, increased employee contributions Change in federal tax revenue (millions) $708 million Annual cost to state per newly insured $2,564 Note: Data might not total exactly due to rounding. * The approach modeled involves a refundable credit of up to $1,000 per individual and up to $2,500 per family. The credit would be fully available to those individuals with incomes up to $20,000, and would phase out as incomes reached $40,000. It would be fully available to families with incomes up to $40,000, and would phase out as their incomes reached $80,000. All costs calculated in 2003 dollars. Assessing the Impact of State Tax Credits for Health Insurance Coverage 7

10 Making the credit available to higher-income families would raise state costs, with essentially no impact on the reduction in the uninsured. Nonrefundable tax credits would have no effect, since state tax liabilities are too small to offset much of the cost of insurance. The Employer Tax Credit Option The idea behind this type of credit is to increase the likelihood that employers will offer coverage by paying them to do so. Unlike individual tax credits, employer credits promote, rather than supplant, the group insurance market, which typically provides more generous insurance coverage at a lower price than in the individual market. On the other hand, such credits provide no benefits to those who are not working, have no employer, or are not eligible for their employers plans. And such credits would do no good for someone whose employer still did not offer a plan. According to the simulation: The total take-up of this type of subsidy would be 3.1 million people, about 25 percent of whom previously would have been uninsured, and 60 percent of whom would have been employer insured (see Table 4). The net reduction in the number of uninsured would be 780,000, or 12.6 percent. The net increase in the number of employer insured would be 1.2 million. This figure incorporates both the reduction in uninsured and the new ESI take-up among some of those who previously had individual or Medi-Cal coverage. The total cost of this subsidy to the state would be $1.9 billion per year. About 45 percent of the spending would be on those who were previously uninsured. The cost per newly insured would be about $2,450. This is slightly less than the cost for the individual credit, but the employer credit covers more people and serves to promote, rather than displace, the group market. The reason for this lower cost is not better targeting; in fact, with the individual credit, a larger percentage of the dollars are spent on those who were previously uninsured. Rather it is a reflection of the much lower cost of insurance in the group market relative to the individual market. The employer tax credit is less targeted toward lower-income citizens than the individual credit; still, it is fairly well targeted, with more than half the benefits flowing to those below 200 percent of FPL (see Table 2). Once again, as the credit is made larger, it would have more impact, but at a steeper cost per newly insured person. Assessing the Impact of State Tax Credits for Health Insurance Coverage 8

11 Table 4: Employer Tax Credit Option: Impact on Cost and Coverage* Number of People Percent of Insurance Category Net Cost California fiscal cost $1.9 billion Total number of people taking up subsidy 3.07 million Previously employer insured 1.9 million 10.0 $1.04 billion Previously individually insured 190, $146 million Previously Medicaid 230, $158 million Previously uninsured 780, $895 million Not offered and uninsured 630, $777 million Offered and uninsured 150, $118 million Total change in population size Individual market -190, Medicaid -230, Uninsured -780, Employer-insured 1.2 million Switched from individual insurance 190, Newly insured through new offering 630, Newly insured due to reduced employee 150, contributions Change in federal tax revenue -$124 million Annual cost to state per newly insured $2,448 Note: Data might not total exactly due to rounding. * The approach modeled involves a credit of up to $1,500 per employee or $3,500 per family covered with a phase out by firm size (from 10 to 50 employees) and average earnings of a firm s workers. All costs calculated in 2003 dollars. The Employee Tax Credit Option Roughly one-quarter of the uninsured are offered, but do not take up, health insurance. It would seem relatively easy to increase insurance coverage among this population. Most employers already pay the majority of health insurance costs; thus, in theory, the government, paying only a minority of costs, significantly reduces the out-of-pocket cost to the employee. In practice, however, there are several problems with employee credits. First, today only about 7 percent of those who are offered employer insurance are uninsured. 13 This makes it difficult to effectively target public spending aimed at this group. Second, existing research suggests that the decision to take up employer-provided health insurance is not particularly price sensitive that is, it would take quite a bit of subsidy to prompt many employees now declining to decide to take up coverage. 14 This suggests that it may be hard to reach people with price subsidies who have opted not to take up coverage offered to them by their employers. Third, if the government offers generous subsidies for the employee portion of insurance expenditures, employers may respond by shifting more of the cost of insurance on to their employees, mitigating the potential gains in terms of employee take-up. According to the simulation: Assessing the Impact of State Tax Credits for Health Insurance Coverage 9

12 The take-up of this type of subsidy would be the largest of any of the three approaches, with 8.5 million people, or more than one-quarter of the population of California, taking the credit (see Table 5). But more than 90 percent of those who would take this credit would already have employer-provided health insurance and would use the credit to finance premiums for existing plans thereby increasing their disposable incomes but not changing their insurance status. As a result, the net reduction in the uninsured would be only 390,000, or about 6 percent. The total cost to the state of this option would be $1.6 billion per year. The cost per newly insured would be slightly more than $4,000, much greater than for the nongroup and employer credits. Table 5: Employee Tax Credit Option: Impact on Cost and Coverage* Percent of Number of People Insurance Category Net Cost California fiscal cost $1.6 billion Total number of people taking up subsidy 8.52 million Previously employer insured 7.8 million 41.6 $1.8 billion Previously individually insured 70, $4 million Previously Medicaid 220, $302 million Previously uninsured 430, $92 million Not offered and uninsured 180, $55 million Offered and uninsured 250, $38 million Total change in population size Individual market -70, Medicaid -220, Uninsured -390, Employer-Insured 680, Switched from individual insurance 70, Newly insured through new offering 180, Newly insured due to decreased employee contributions Uninsured due to increased employee contributions Change in federal tax revenue 250, , $391 million Annual cost to state per newly insured $4,014 Note: Data might not total exactly due to rounding. * The approach modeled involves a refundable credit of up to $350 per employee and $800 per family. The credit would be fully available to those individuals with incomes up to $20,000, and would phase out as incomes reached $40,000. It would be fully available to families with incomes up to $40,000, and would phase out as their incomes reached $80,000. All costs calculated in 2003 dollars. Assessing the Impact of State Tax Credits for Health Insurance Coverage 10

13 This type of credit is the least targeted to lower-income people, with only 33 percent of dollars going to those below 200 percent of the poverty line. (But the largest concentration of new state spending would be on the group between 200 percent and 300 percent of FPL, which would receive 38 percent of the subsidy dollars; less than 30 percent of the spending would be on those above 300 percent of the poverty line.) A Cautionary Note about Econometric Modeling Models that generate estimates such as these are intended to help policymakers and others think through policy options, but they should be used with caution. For one thing, differing assumptions about behavior based on available research can lead to wide variation in results, even in models developed by the most capable researchers and analysts. 15 It also should be noted that this particular model does not specify the source of funds for the new tax subsidies. Different types of funding sources (such as progressive or regressive taxes, or with government program cuts) could significantly alter the overall impact of a tax subsidy approach on different income groups and might even have behavioral ramifications affecting health coverage. The analysis produced by this model also emphasizes the cost to the state per newly insured. As has been pointed out, however, offering tax credits to purchase health insurance would have the effect of raising income for many already insured people and for many firms. Some analysts argue against focusing too much on the cost to the government per newly insured, although this undoubtedly will be a major concern to policymakers, especially under current fiscal conditions. Furthermore, some have argued that providing tax credits to relatively lowincome people who already have health insurance may promote responsible behavior and basic fairness, as well as increase tax equity. 16 Finally, due to lack of available data, it is difficult to model many potential structural and technical barriers that could slow or impede implementation of a tax credit program. For example, it is important in estimating the impact of individual subsidies to understand the feasibility of advancing tax credits to individuals, especially for those with low incomes who cannot wait for next year s tax refund to pay insurance premiums. Because advancing tax credits has not worked well in practice, Gruber s model assumes that such mechanisms will be effective for only one-half of low-income consumers. Key Challenges to Expanding Coverage Those working toward policy changes that would expand the number of people with health insurance face two basic challenges: (1) providing people with an institutional setting in which to buy or gain access to affordable coverage; and (2) providing people with sufficient funds to afford coverage. Currently, most nonelderly Americans receive health coverage through plans that are sponsored either by employers (65.6 percent) 17 or by government agencies (15.3 percent). 18 A few (6.6 percent) buy their own health insurance policies. Providing new tax subsidies may address financial barriers in full or in part, but such subsidies do not address the many institutional barriers that people may face in obtaining coverage. Assessing the Impact of State Tax Credits for Health Insurance Coverage 11

14 Institutional Barriers The individual insurance market. As the simulation shows, providing individual tax credits would cause employment-based health coverage to shrink and individual insurance to grow. Yet consumer protections and access to coverage are relatively weak in the individual market. Rules in the individual market allow many individuals to be excluded from or priced out of purchasing coverage. Several studies have documented how market practices can make it difficult for consumers to buy individual policies, particularly if they have pre-existing medical conditions. 19 California, like most other states, places few limits on what insurers may charge in the individual market. Except for certain circumstances, such as when people are transitioning from group coverage, insurers are not prevented from denying, modifying, or pricing individual coverage based on a person s health risk status, age, or other factors. For people rejected for coverage in the individual market, California offers a high-risk pool, called the Major Risk Medical Insurance Program. But this program has several limitations, including a long waiting list, benefit restrictions, and relatively expensive premiums. 20 For more information on the limits of consumer protections, see a forthcoming issue brief by Deborah Kelch about the rules that govern California s individual health insurance market to be published on the California HealthCare Foundation Web site ( The group market. Providing tax subsidies for ESI either to stimulate employer offering or employee take-up would not necessarily eliminate institutional barriers, primarily because employment-based coverage is typically provided and taken up on a voluntary basis. Some small employers will probably never offer health benefits, regardless of the size of the subsidy. 21 While many employers offer generous benefits and some require all employees to be covered, most employers do not make all employees eligible for health benefits (particularly part-time, temporary, contract, or seasonal workers). 22 Some employers do not contribute much toward premiums. For example, in 2002, 7 percent of small firms (3 to 199 workers) paid less than 50 percent of the premiums for employee-only coverage, up from 4 percent the previous year, 23 while in that same year 44 percent of small employers paid 100 percent of premiums for employee-only coverage, down from 57 percent in Employers on average contribute less toward family coverage than they do toward single coverage. Employers offer health benefits primarily as a function of their competition for labor that is, to attract and retain the most qualified workers and to increase productivity. They generally are not motivated by, nor do they focus on, larger societal concerns such as expanding health coverage. 24 Yet, as the simulation demonstrates, for many small employers, new tax subsidies may be sufficient incentive to begin offering health benefits. Under current law, those covered by plans sponsored by small employers enjoy more consumer protections than individuals buying policies on their own. Under federal law, for example, individuals may not be excluded from employee health plans, nor by insurers contracting with employee health plans, on the basis of their health status. Similarly, the benefits provided, premiums charged, and employer contributions may not vary within similarly situated groups of employees based on their health status. Both federal and California law require insurance carriers to guarantee to issue products to small groups (those with 50 or fewer employees). California also limits the extent to which rates for small groups may vary based on a group s health status. More information Assessing the Impact of State Tax Credits for Health Insurance Coverage 12

15 on the rules that govern California s small group health insurance market are provided in a forthcoming issue brief by Debra Roth, to be published on the California HealthCare Foundation Web site ( ERISA preemption a potential barrier for states. State policymakers considering a tax subsidy approach might also consider market or institutional reforms to increase the likelihood that people can actually use these subsidies to obtain needed coverage. For example, they might want to further regulate insurance prices, the content of benefit plans, insurer underwriting practices, or employer contribution amounts, or require employers to offer coverage. However, the federal law regulating private-sector employee benefits, the Employee Retirement Income Security Act of 1974 (ERISA), bars states from enforcing laws relating to private-sector employee benefit plans. Under ERISA, states can tax employers, but they cannot force employers to offer health benefits, 25 nor can they dictate what benefits are offered (unless an employer buys a state-regulated, fully insured product) nor how employee benefit plans might be administered. ERISA does allow states to regulate insurance carriers contracting with employee benefit plans. 26 But most large employers, and even some smaller ones, self-insure their employee health plans, thereby escaping state insurance regulation. 27 Because large employers are less likely to offer fully insured health plans, it would be particularly difficult for states to impose regulations affecting this part of the market. Most small employers offering coverage buy fully insured products licensed and regulated by the state. Because of the barriers posed by ERISA, states have more latitude to make regulatory changes affecting the individual insurance market than they have with regard to employment-based coverage. On the other hand, as described above, barriers to access in the individual market tend to be greater. Financial Barriers Providing tax credits in the amounts currently being discussed by many policymakers may simply not be enough to make coverage affordable for many people. As shown above, all three of the coverage options simulated would reduce California s uninsured population by only about 6 to 13 percent. Individual tax credits set at the amounts proposed by the Bush Administration (and analyzed by Gruber) have been criticized as being too small to help many people afford coverage. For example, a recent study of market conditions in 25 cities across the country concluded that such subsidies would not be enough to give many low-income women the ability to purchase individual policies, even those in excellent health. 28 And in many cities, at proposed subsidy levels, it would be hard to find a plan at all. In general, the cost of health coverage increases as the group purchasing coverage becomes smaller. Large groups face lower administrative costs than small groups. Administrative and risk costs are highest in the individual market, which is the most prone to adverse selection. 29 If tax credits are set at flat amounts, an additional issue arises with respect to differences in insurance prices based on where a person lives. Tax credits such as those proposed by the Bush Administration would provide more purchasing power in lower-cost regions than in higher-cost regions, such as many major metropolitan areas. This could be remedied by providing tax credits Assessing the Impact of State Tax Credits for Health Insurance Coverage 13

16 covering a percentage of health insurance costs. The Trade Act of 2002, for example, offers tax credits covering 65 percent of coverage costs. Coordinating with Federal Policy California policymakers contemplating new state tax credits should consider the relationship between proposed state policy and current and potential federal policy. For example, if Congress does decide to offer new tax credits, the federal government would develop processes to identify those eligible and to distribute the subsidies. To avoid confusion, states with existing tax credit programs would have an incentive to coordinate their eligibility and distribution rules with the federal program. This might mean substantially changing an existing state tax credit program in order to coordinate with the new federal tax program. Also, considering policy options in a broader context, California policymakers may wish to compare a state tax credit approach with an option involving the expansion or maintenance of coverage through Medi-Cal. The Medi-Cal program is heavily subsidized by federal dollars, while a state tax credit approach would receive no federal match at all. Conclusion Tax credits can be offered in a variety of ways to provide incentives to expand coverage. However, tax credits at the amounts currently being discussed by policymakers may make only modest inroads in reducing the number of uninsured, at considerable cost to taxpayers. Such proposals also may not address the many institutional barriers facing consumers seeking affordable coverage. Offering tax credits to individuals, employers, and employees may result in markedly different outcomes. For example, under the individual subsidy option the individual market would grow substantially, while employer-sponsored coverage would shrink. In contrast, under either the employer or employee subsidy options, employment-based coverage would grow. Of the three options, tax credits aimed at inducing employers to offer coverage are the most efficient means of increasing coverage when the targeted firms are those least likely to offer coverage. Credits to individuals are somewhat less efficient, largely due to the high costs of insurance in the individual market. Under the individual tax credit option, however, a greater percentage of new subsidies would go toward the lowest-income people. Credits for employee purchase are the least effective option in terms of increasing coverage. This is particularly true when credits are large or eligibility is extended to include higher income levels, because the vast majority of those taking the credits would already have coverage. Tax credits by themselves fail to address the many institutional barriers facing consumers seeking health coverage. Furthermore, offering tax credits to individuals may increase the number of people facing such barriers by causing a significant shift from employment-based coverage to the individual market, where consumers with medical conditions may have trouble finding affordable coverage or any coverage at all. Consumers also face barriers in the group market. But, because of ERISA, the federal employee benefit law, state policymakers have more Assessing the Impact of State Tax Credits for Health Insurance Coverage 14

17 latitude to make reforms in the individual insurance market to help increase access to coverage than they do in the group market. State policymakers should consider tax credit options in the context of other approaches to expanding or maintaining levels of health insurance coverage. Expanding government insurance programs such as Medi-Cal can address both financial and institutional issues by providing heavily subsidized coverage through a sponsored plan. Yet many low-income people are not eligible for Medi-Cal. Finally, state policymakers have several reasons to pause before committing state funds to a tax credit program. For one thing, the current budget crisis has led California to consider making cuts to Medi-Cal, which is heavily subsidized with federal dollars. State tax credits, of course, would not be. The likelihood of new federal tax credits being enacted appears to have diminished, given competing budget priorities such as the Bush Administration s proposed tax cuts and spending increases for national defense. But in the longer run, increased federal tax subsidies for the purchase of health insurance will remain under discussion. Should the federal government enact broad tax credits, California policymakers might consider how to coordinate a state tax credit approach with what the federal government establishes. Assessing the Impact of State Tax Credits for Health Insurance Coverage 15

18 Notes 1. Fuchs, Beth, Mark Merlis, and Julie James. Expanding Health Coverage for the Uninsured: Fundamentals of the Tax Credit Option, Background Paper, National Health Policy Forum. George Washington University, Washington, DC. August 28, For a description of the tax credit proposal contained in the Administration s fiscal year 2004 budget, see General Explanations of the Administration s Fiscal Year 2004 Revenue Proposals, U.S. Department of Treasury, February pp The Trade Act of 2002, which expanded trade adjustment assistance (TAA) benefits available to workers dislocated by import competition or shifts of production to other countries, amended the Internal Revenue Code to create a tax credit for up to 65 percent of the premiums paid by eligible individuals for certain types of medical coverage (including COBRA medical coverage) for eligible individuals and their qualifying family members. Those eligible for the tax credit include individuals who are receiving TAA benefits and individuals who are at least 55 years old and who are receiving pension benefits paid by the federal Pension Benefit Guaranty Corporation. 3. See Jonathan Gruber, Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California, California HealthCare Foundation, June 2003 ( 4. Fronstin, Paul. Sources of Health Insurance and Characteristics of the Uninsured: Analysis of the March 2002 Current Population Survey, EBRI Issue Brief No. 252, December Employee Benefit Research Institute: Washington, DC. 5. In 1987, 14.8 percent of the nonelderly population had no coverage. 6. Impact of Proposed Budget for on Medi-Cal and Other Health Programs, California HealthCare Foundation/Medi-Cal Policy Institute, January 2003 ( 7. Care Without Coverage: Too Little, Too Late. Institute of Medicine. National Academy Press. Washington, DC p See Fronstin. 9. As can be seen from Table 1, the net number of newly insured is not exactly the same but rather of the same order of magnitude. 10. The credit is fully refundable; that is, if the family runs out of tax liability against which to offset the credit, they could receive the difference as a refund. 11. The reduction with firm size is at a rate of percentage points per additional employee beyond ten employees, so that the credit reaches zero at fifty employees. The reduction with average earnings is a function of firm size. For firms of fewer than ten Assessing the Impact of State Tax Credits for Health Insurance Coverage 16

19 employees, the credit phases out fully by an average earnings level of $40,000. As firm size grows, the credit phases out faster with average earnings. 12. By most efficient here, we mean that the government s cost for covering an additional uninsured person is lowest. 13. Estimate based on Jonathan Gruber s analysis of Current Population Survey data. A worker declining his or her own employer s offer of coverage may be covered under the plan of a spouse or other family member. 14. Gruber, Jonathan, and Ebonya Washington, Subsidies to Employee Health Insurance and the Health Insurance Market, mimeo, Massachusetts Institute of Technology. 15. See Individual Tax Credits and Employer Coverage: Assessing and Reducing the Downside Risks. (Report based on an Expert Forum convened by the Institute for Health Policy Solutions.) Institute for Health Policy Solutions: Washington, DC. August p. iii. 16. Pauly, Mark, and John Hoff, Responsible Tax Credits for Health Insurance, The AEI Press: Washington, DC p See Fronstin. 18. Sponsors, such as the government or employers, take on the legal responsibility of providing health benefits for individuals under specific terms. Under federal law, privatesector employers generally are free to discontinue such promises at any time. 19. For example, see Karen Pollitz, Richard Sorian, and Kathy Thomas, How Accessible Is Individual Health Insurance for People in Less-than-perfect Health? The Henry J. Kaiser Family Foundation, June 2001; and Sara Collins, Stephanie Berkson, and Deirdre Downey, Health Insurance Tax Credits: Will They Work for Women? The Commonwealth Fund, December Butler, Patricia and Karl Polzer, Regulation of ERISA Plans: the Interplay of ERISA and California Law, California HealthCare Foundation. June 2002; p. 57 ( 21. Nationally, only 40 percent of private-sector business establishments with fewer than 10 workers offered coverage in 2000, compared to 70 percent with workers, and 99 percent with 1,000 or more workers. Source: U.S. Agency for Healthcare Research and Quality Medical Expenditure Panel Survey Insurance Component. 22. See Rachel Christensen, Paul Fronstin, Karl Polzer, and Ray Werntz, Employer Attitudes and Practices Affecting Health Benefits and the Uninsured, EBRI Issue Brief No. 250, October Employee Benefit Research Institute: Washington, DC. Assessing the Impact of State Tax Credits for Health Insurance Coverage 17

20 23. Employer Health Benefits: 2002 Annual Survey, Kaiser Family Foundation and Health Research and Educational Trust, p Christensen, et al. 25. After a lengthy court battle, Hawaii, the only state requiring private-sector employers to offer coverage, needed to obtain an exemption from ERISA from Congress in order to enforce the state mandate. 26. Under ERISA, employee benefit plans are distinct legal entities and different from insurers, managed care companies, and third-party administrators contracting with them. 27. For more information on how ERISA preempts state law and how it impacts the regulation of employee benefits and health insurance, see Butler and Polzer. Also see Patricia Butler, ERISA Preemption Manual for State Health Policy Makers, the Alpha Center and the National Academy for State Health Policy, January 2000 ( 28. Collins, et al. 29. Adverse selection is a term used by insurers to describe the phenomenon that people with pre-existing medical conditions will have a greater incentive to seek health insurance than those in good health. If a commercial insurer attracts a disproportionate number of less healthy subscribers, it will have to raise its premiums, which may cause the more healthy to seek coverage elsewhere at a relatively lower cost. This type of behavioral pattern can lead to a death spiral of higher and higher premiums. Insurers underwriting and pricing practices must take adverse selection into account. Assessing the Impact of State Tax Credits for Health Insurance Coverage 18