Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California

Transcription

1 Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California August 2002 Revised March 2003 Prepared for the California HealthCare Foundation by Jonathan Gruber, Ph.D. Massachusetts Institute of Technology and National Bureau of Economic Research

2 Authors 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 can be obtained by calling the California HealthCare Foundation at (510) or by visiting the Web site ( The California HealthCare Foundation is an independent philanthropy committed to improving California s health care delivery and financing systems. Our mission is to expand access to affordable, quality health care for underserved individuals and communities and to promote fundamental improvements in the health status of the people of California. 476 Ninth Street Oakland, CA Tel: Fax:

3 Contents Executive Summary...1 I. Introduction...4 II. Behavioral Modeling...8 III. Estimates of the Impact of Tax Subsidies on Insurance Coverage and Costs...12 IV. Conclusions...27 Notes...28

4 Executive Summary The lack of insurance is a major problem in California. From 1987 through 1998, the number of non-elderly uninsured rose by 43 percent in California, and over 6 million Californians now have no health insurance. One option that is frequently considered for increasing the insurance rate in California is to introduce tax subsidies to private insurance purchase. Tax subsidy proposals come in a variety of forms. Some proposals, such as the one put forward by President George Bush and many leading national legislators, would offer tax credits for the purchase of insurance in the nongroup market only (that is, not from employers). Other proposals, such as those proposed in the past by Assembly Bills 432 and 1734 in California, would offer tax credits to businesses in order to expand employer-based insurance coverage. Still others have proposed bypassing firms and subsidizing employees directly for their share of the costs of employerprovided health insurance. But the tax subsidy approach is not without its flaws. Foremost among these is the potential for poor targeting and inefficient use of public dollars. When a new health insurance subsidy is offered to firms or individuals, that subsidy will immediately be taken by a large share of those who already have insurance; after all, this is essentially a bonus for that group. Moreover, takeup may be much lower among those uninsured who have chosen, in the absence of subsidies, not to purchase insurance. Thus, the net effect could be a very small reduction in the number of uninsured, despite potentially large budgetary costs. Several key issues must be confronted in developing a rigorous analysis of tax subsidy proposals: To what extent will the uninsured take up subsidized private coverage? To what extent will those who already have private coverage in the subsidized form (that is, those with nongroup coverage when a new nongroup insurance subsidy is introduced) take up the new subsidies? To what extent will those who have private insurance in unsubsidized forms (that is, group coverage when there is a new nongroup subsidy) drop that unsubsidized insurance and move to the subsidized form of insurance? Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California 1

5 If subsidies flow to individuals outside the employer-provided insurance system, to what extent will employers reduce their own expenditures on insurance? Likewise, if subsidies flow to employer-provided insurance, to what extent will that promote new insurance offering among employers? This list is representative of issues to be confronted, but a policy analysis requires first developing a behavioral model that incorporates responses to these questions in order to map policy changes into net effects on insurance coverage and public sector costs. This report describes such a model, building on earlier work by this author on the cost and coverage implications of nongroup tax subsidies for the nation as a whole. 1 This research extends that modeling to consider the impacts of tax subsidies for the state of California, and to consider the unique features of the California population and labor market. Two other types of tax policies are also considered: (1) subsidies to employers to offer insurance, and (2) subsidies to employees to take up insurance coverage that they are offered. These alternatives have significant appeal because they have the potential to promote, rather than undermine, the group insurance market. This paper reports several central findings: First, none of the tax policies contemplated is a silver bullet that can solve the problem of lack of insurance in California. Even the most generous policies modeled below are estimated to newly cover, at most, 2 million new people, or only one-third of the uninsured in the state. Additionally, these policies are expensive, with costs ranging from $1.6 billion to almost $15 billion per year. The discussion focuses on one concept of efficiency: the cost to the state per person newly insured. Even the most efficient policies spend roughly $2,500 per person newly insured, but that efficiency varies tremendously, with costs ranging up to $8,300 per newly insured. Second, there is a tradeoff between scale and efficiency. As credits get larger, the reduction in the number of uninsured rises, but the costs to the state government rise even faster so that costs per newly insured increase. The extent of this tradeoff varies by type of tax credit, but it is true for every type of policy considered. Third, targeting is key to policy effectiveness. Credits that target those income groups less likely to be covered by health insurance and that target the types of firms less likely to offer insurance are much more effective than more loosely targeted credits. Moreover, tightly targeted policies can lead to attractive outcomes in terms of distribution. In this report, for example, options are considered whereby the government can target half or more of the spending to those below 200 percent of the poverty line, and relatively little of the spending in the policies considered below usually about one-quarter goes to those above 300 percent of the poverty line. Finally, different types of credits have very different effects. Credits to employers, intended to induce them to offer insurance are the most efficient means of increasing insurance coverage when tightly targeted to the firms that are least likely to offer insurance ex ante. Credits for nongroup insurance are less effective, largely due to the Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California 2

6 high costs of insurance in the nongroup market. Credits for employee purchase of insurance are the least effective of all, particularly when they are very generous in terms of either the credit level or the income ranges made eligible. Since almost everyone who is offered insurance already takes it up, these credits are very poorly targeted. Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California 3

7 I. Introduction The lack of insurance is a serious social problem in the United States that continued to worsen even as the economy improved throughout the 1980s and the 1990s. In 1987, 14.8 percent of non-elderly Americans were without health insurance. Over the next decade, the non-elderly population without insurance coverage grew by nearly 25 percent, to an overall rate of 18 percent, before falling for the first time in two decades last year; however, despite this recent good news, approximately 40 million Americans remain without health insurance. In California, these trends have been even more dramatic. From 1987 through 1998, the number of non-elderly uninsured rose by 43 percent in California. Currently, over 6 million Californians lack health insurance. 2 This represents an enormous potential problem for the state, as it does for the nation as a whole. It has been well documented that lack of health insurance affects an individual s health status. There is a large body of work showing that poor health is also associated with lower earnings and lower participation in the labor market, implying economic costs associated with the lack of insurance as well. 3 Moreover, the fear of losing health insurance coverage has been shown to impede job mobility, a key to success for a dynamic economy such as California s. 4 Thus, there is reason to be concerned about the effects of lack of insurance, both on the health of California s population and on its economy. There are a variety of policy options proposed for addressing the problem of lack of insurance coverage in California and elsewhere. Broadly speaking, these options fall into three categories. 1. Insurance market regulation. Examples include ensuring access and renewability of insurance policies, and limiting the prices that can be charged to sick individuals. California has been at the forefront of state efforts to impose such regulations; however, to date, there has been little evidence that these types of regulatory interventions can make a major dent in the number of uninsured. 2. Public expansions of insurance coverage. There is a substantial body of evidence that suggests public expansions are an effective means of increasing insurance coverage and improving the health of low-income populations, 5 but public expansions are also quite expensive and involve the kind of direct increase in government spending that may prove Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California 4

8 politically difficult when there are competing priorities as there obviously are in California, given the state s current fiscal difficulties. Among opponents of governmental growth, public expansions also raise concerns about increasing encroachment of the public sector on private insurance markets through the crowdout of the privately insured and their move into the public program. 3. Tax subsidies. This alternative is receiving increasing attention. Like public insurance expansions, tax subsidies for health insurance can address affordability problems that plague the uninsured. Unlike public expansions, tax subsidies can be presented as a potentially more palatable tax cut. Additionally, tax subsidies promote, rather than supplant, private insurance markets, which may account for their growing popularity. Tax subsidy proposals come in a variety of forms. Some proposals, like that put forward by President Bush and many leading national legislators, would offer tax credits for the purchase of insurance in the nongroup market only (that is, not from employers). Other proposals, such as those proposed in the past by Assembly Bills 432 and 1734 in California, would offer tax credits to businesses in order to expand employer-based insurance coverage. Others have proposed subsidizing employees, rather than firms, for the share of employer-provided health insurance costs that they bear. The tax subsidy approach is not without its flaws. Foremost among these is the potential for poor targeting and inefficient use of public dollars. Indeed, in their analysis of AB 1734, the Tax Franchise Board suggested that 94 percent of the dollars spent by this program would flow to those firms already offering health insurance. The rationale behind analyses such as this is quite straightforward. When a health insurance subsidy is offered to firms or individuals, that subsidy will immediately be taken by a large share of those who already have insurance; this is, after all, essentially a bonus for that group. Take-up may be much lower among those uninsured who have chosen, in the absence of subsidies, not to purchase insurance. The net result is a very small effect on the number of uninsured despite potentially large budgetary costs. This analysis points out the key issue for analyzing tax subsidy proposals: the behavioral response of individuals and firms to those subsidies. Consider, for example, proposals to subsidize the purchase of nongroup insurance (such as the current Bush plan). To credibly analyze the impact that such proposals would have on insurance coverage and public sector costs, one must consider, minimally, the following set of questions regarding potential behavioral responses: To what extent will the uninsured take up these subsidies? To what extent will those already holding nongroup insurance policies take up the new subsidies (since there is a host of evidence that, in fact, individuals do not always take advantage of these types of offers)? To what extent will those who are employer-insured find nongroup insurance more attractive when it is subsidized and thus drop their employer policies to take the subsidy? Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California 5

9 To what extent will firms now find it less attractive to offer insurance, since there is a subsidized alternative, and stop offering insurance? And to what extent will the resulting dropped workers take advantage of this nongroup credit? To what extent will firms continue to offer insurance but reduce their share of the payment in order to induce their employees to take advantage of this nongroup insurance market subsidy? And to what extent will workers respond to these higher costs by dropping their employer coverage? This list is representative of some of the critical questions to be confronted in developing a rigorous policy analysis. Such an analysis will require first developing a behavioral model that incorporates responses to these questions in order to map policy changes into net effects on insurance coverage and public sector costs. This report describes such a model. It builds on the author s earlier work on the cost and coverage implications of nongroup tax subsidies for the nation as a whole, 6 but extends that work in two directions. First, it focuses on California in particular. As discussed below, differences between the structure of the labor market and the demographic characteristics of residents in California and elsewhere may generate quite different policy impacts in this state from those in the nation as a whole. Thus, for understanding the impacts of tax policies on California, it is critical to pursue California-specific modeling. Second, in addition to nongroup tax credits, two other types of tax policies are modeled: subsidies to employers to offer insurance, and subsidies to employees to take up insurance coverage they are offered. These alternatives have significant appeal because they have the potential to promote, rather than undermine, the group insurance market. This paper reports several central findings: First, none of the tax policies contemplated is a silver bullet that can solve the problem of insurance coverage for Californians. Even the most generous policies modeled below are estimated to newly cover, at most, 2 million new people, or only one-third of the uninsured in the state. These policies are expensive, with costs ranging from $1.6 billion to almost $15 billion per year. The following discussion focuses on one concept of efficiency, that is, the cost to the state per person newly insured. Even the most efficient policies spend roughly $2,500 per person newly insured, but that efficiency varies tremendously, with costs ranging up to $8,300 per newly insured. Second, there is a tradeoff between scale and efficiency. As credits get larger, the reduction in the number of uninsured rises, but the costs to the state government rise even faster so that costs per newly insured increase. The extent of this tradeoff varies by type of tax credit, but it is true for every type of policy considered. Third, targeting is key to policy effectiveness. Targeting credits to the income groups that are less likely to be covered by health insurance and targeting to the types of firms that are less likely to offer insurance are much more effective policies than more loosely targeted credits. Moreover, tightly targeted policies can lead to attractive outcomes in terms of distribution. In this report, for example, options are considered whereby the Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California 6

10 government can target half or more of the spending to those below 200 percent of the poverty line, and relatively little of the spending in the policies considered below usually about one-quarter goes to those above 300 percent of the poverty line. Finally, different types of credits have very different effects. When tightly targeted to the firms that are least likely to offer insurance ex ante, credits to employers to induce them to offer insurance are the most efficient means of increasing insurance coverage. Credits for nongroup insurance are less effective, largely due to the high costs of insurance in the nongroup market. Credits for employee purchase of insurance are the least effective of all. This is particularly true when they are very generous in terms of either the credit level or the income ranges made eligible. These credits are poorly targeted in that almost everyone who is offered insurance already takes it up. This report is organized into three chapters. Chapter 2 provides an overview of the behavioral model used to analyze tax policies for California. It highlights some of the author s previous behavioral health economics research, which is central to developing the current behavioral model. Chapter 3 presents an analysis of the alternative tax policies, comparing the effects in California to the effects in the nation as a whole and contrasting alternative tax policy approaches. Chapter 4 concludes by summarizing the key results of this analysis. For a broader discussion, including related issues such as institutional barriers that might prevent consumers from obtaining health coverage even if tax credits spurred them to seek it, see the companion report by Gruber and Karl Polzer, titled Assessing the Impact of State Tax Credits for Health Insurance Coverage. 7 Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California 7

11 II. Behavioral Modeling The Underlying Model The results reported here are based on a detailed micro-simulation model developed over the past several years. 8 This model uses, as its base, microdata on a nationally representative sample of individuals from the Current Population Surveys (CPS) for February and March The February survey provides information on employer insurance offering, while the March survey gives information on insurance coverage from all sources, income levels, firm characteristics, self-assessed health status, and demographics. Additionally, in recent years, the March CPS has also provided a detailed calculation of taxable income and tax rates for each family in the sample. The CPS information is supplemented by data from the Kaiser-HRET (2001) employer health insurance survey, 9 which provides information by region and firm size on employer premiums, employee premium shares, and whether employee premiums are made on a pretax basis. Additional information was gathered from data from the Community Tracking Survey, as well as quotes from nongroup insurers on the costs of nongroup insurance policies. The model is updated to 2003 dollars. These data are used to simulate the impact of alternative tax policies on insurance coverage. This involves assessing how the policies affect individuals and employers in different circumstances (based on such factors as their insurance status, income, and tax rate) and how those individuals and employers respond. These behavioral responses include, but are not limited to: The extent to which the currently uninsured will purchase newly subsidized insurance coverage, and how that varies by whether or not those uninsured are currently offered health insurance. The extent to which those with existing insurance coverage will take up the bonus of subsidies to their insurance spending (either nongroup insured taking up nongroup subsidies, firms that offer insurance taking up subsidies to employers, or employees who are insured taking up subsidies to employees). Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California 8

12 The extent to which those with one type of existing insurance will switch to another type when it is subsidized (for example, how many of the employer-insured will switch to nongroup insurance when it is subsidized). The extent to which firms that do not currently offer insurance will begin to do so in response to subsidies to employer-provided insurance, and the extent to which firms that do currently offer insurance will stop offering that insurance in response to subsidies to nongroup insurance. The extent to which firms will change the mix of employer and employee premium financing in response to subsidies; for example, when employee premiums are tax subsidized, will employers raise those premiums to have the government bear a larger share of insurance costs? These assumptions are based on academic studies, where available, as well as consultations with economic, actuarial, and policy experts. The particular model used in this report is influenced by the author s previous work, the most central being a paper with Michael Lettau, How Elastic is the Firm s Demand for Health Insurance? 10 That paper develops the best estimates to date of employers responsiveness to tax subsidies in their decisions to offer health insurance. The authors found that while employers in general are fairly price sensitive in their offer decisions, small employers in particular are very price sensitive. This is important, since many of the tax subsidy policies considered in California and elsewhere are focused on small firms. The model used in earlier work has been updated in a number of ways that are critical for the policy analyses conducted in this report. First, information on insurance coverage and costs is the most up-to-date available. In addition, all behavioral responses that were embedded in the old model have been updated based on the current research in health economics. Second, the model has been extended beyond the analysis of nongroup tax credits to consider tax credits for group insurance as well. This is important because, due to dissatisfaction with the nongroup insurance market as a vehicle for insurance coverage expansions, group credits are playing an important role in the policy debate in California and elsewhere. The model is now fully capable of analyzing tax subsidies to both employers (for their spending on insurance), as well as to employees (for their premium shares). The impact of both kinds of subsidy policy is discussed in detail below. Third, and critical for modeling the role of subsidies to group insurance, the newer model allows firm-wide reactions to subsidy policies. A limitation of all current microsimulation models is that they are estimated on individual data, and relatively little is known about a given worker s workplace. This was much less relevant in previous modeling efforts, since they focused on decisions by individuals to purchase nongroup insurance or not; however, it is a critical limitation in considering policies targeted to employee and employer purchase of group insurance, as the reaction to these policies will depend not simply on a given worker, but on the nature of coworkers as well. For example, whether a firm will offer insurance in reaction to a subsidy will depend on the demand for insurance among all workers in that firm, not just the given worker observed in the CPS. Similarly, if subsidies are targeted to low-wage firms, it is critical to measure whether a given CPS worker is part of such a qualifying firm or not. This will Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California 9

13 require looking beyond that worker s own wages to those of the firm as a whole; many low-wage workers are actually working in high-wage firms, and vice versa. A key element of this revised model will be a more realistic model of firm decision making through the construction of synthetic firms. The Bureau of Labor Statistics keeps data that provide information on the wages of all workers within a nationally representative set of firms. These data can be used to correctly assign coworkers to the current CPS sample observations. That is, for a worker of given characteristics (wage, firm size, industry, insurance offering, etc.), the distribution of the characteristics of his or her coworkers can be determined. (For example, for a worker earning $10,000 in the services industry who is not offered insurance, the share of coworkers earning $10,000, $15,000, $20,000, etc., could be determined.) Using this information in conjunction with the CPS data, each CPS observation can be assigned a set of coworkers that matches this distribution. Thus, standard microdata like the CPS can be enhanced by the richness of firm-wide characteristics necessary to fully analyze subsidies for group insurance. California vs. the Nation as a Whole The importance of pursuing California-specific modeling is made apparent by Table 1, which summarizes the key demographic and labor market characteristics of California and the rest of the United States. Californians are younger than those in other states on average, and are less likely to be married. This is important because young and unmarried persons are those most likely to find nongroup credits most attractive, since relative costs for this group are lowest. At the same time, their overall demand for insurance may be lower. Offsetting this is the fact that individuals in California are less likely to report being in excellent health. Table 1. Characteristics of California and the Rest of the United States Characteristics California Rest of United States Average age Married 37.0% 40.6% Excellent health 37.9% 38.7% Very good health 30.3% 33.1% Good health 25.3% 21.6% Fair health 4.8% 4.9% Poor health 1.7% 1.7% Average income $44,000 $46,800 Firm < 100 employees 42.9% 39.3% Firm employees 17.6% 19.7% Firm 1,000+ employees 39.5% 41.0% Employer insured 59.4% 68.4% Nongroup insured 6.9% 6.1% Medicaid insured 12.9% 9.5% Uninsured 20.9% 16.0% Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California 10

14 Californians also have significantly lower incomes, on average, than residents of other states. This is important because it suggests that even tightly targeted (to income) tax credits can have large impacts in the state. Workers in California are also more likely to be employed in small firms. This implies that employer credits targeted to small firms may be effective. It is also important because small firms are much more price sensitive in their insurance offering decisions than are larger firms. 11 The final rows in this table compare the insurance coverage of Californians to the remainder of the United States. Californians are much less likely to be covered by employer-provided insurance, and somewhat more likely to hold nongroup insurance. They are more likely to be on public insurance. Overall, the insurance rate is much lower in California than in other states. Thus, it is clear that the impact of tax credits might be quite different in California than in the nation as a whole. In particular, the lower income levels and lower insurance rates in the state suggest that targeted tax credits might play a more helpful role in this environment than elsewhere. Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California 11

15 III. Estimates of the Impact of Tax Subsidies on Insurance Coverage and Costs Nongroup Tax Credits The first type of tax credit modeled involves credits that are restricted for use to the nongroup insurance market only. This approach is comparable to the most popular tax credit proposals at the federal level, including those put forward during the presidential campaign and in subsequent budget proposals by President Bush. A prototypical nongroup tax credit proposal would have the following details: Individuals can take the credit against their nongroup health insurance expenditures, up to $1,000 per individual and $2,500 per family. The credit is fully refundable; that is, if the family runs out of tax liability against which to offset the credit, they receive the difference as a refund. The credit can only be used for nongroup insurance expenses and not for group insurance purchase. The credit is fully available to those individuals with annual incomes up to $20,000, and phases out as income reaches $40,000. It is fully available to families with incomes up to $40,000, and phases out as income reaches $80,000. The analysis of nongroup credits incorporates a host of assumptions about how individuals, families, and employers will respond to this change in the insurance environment. The key factor that determines this response is the subsidy rate implicit in nongroup credits. This is the amount of the credit divided by the underlying cost of nongroup insurance to the individual or family. It is assumed that those who are uninsured are more likely to take up nongroup credits as the subsidy rate rises. Importantly, the likelihood of take-up will fall as the unsubsidized portion of nongroup insurance costs rise relative to income. That is, a $2,000 credit that leaves the family with $5,000 in insurance costs will have a lower take-up rate for a family with only $30,000 in Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California 12

16 income than for a family with $100,000 in income, since the remaining cost of nongroup insurance is such a high fraction of income for the lower income family. It is also assumed that employers, particularly small employers, react to the availability of nongroup subsidies. As noted above, existing evidence suggests that subsidies to the provision of employer-sponsored insurance (ESI) raises the odds that ESI is offered by firms. By the same logic, subsidies to insurance that is available only outside the firm will lower the odds that firms offer insurance. If their employees have a low-price option to purchase insurance elsewhere, firms, and in particular small firms, will be less likely to offer that insurance through the workplace. Those firms that continue to offer insurance will also react by increasing the premiums that employees pay for ESI in order to provide incentives for their employees to choose nongroup insurance instead, thereby reducing overall firm insurance costs. One key assumption that is important for modeling the impact of nongroup subsidies is the feasibility of advanceable tax credits for nongroup insurance. An important potential limitation of nongroup tax credits, especially for low-income groups, is that the tax refund for a given year is not available until the next spring. Low-income groups that do not have much savings will not be able to advance fund (prepay) their nongroup insurance purchases until that refund is available. For this reason, many plans, such as the current Bush Administration s nongroup tax credit proposal, seek to make these tax credits advanceable so that individuals can access them when they are needed. A sound idea in theory, advanceability has not, unfortunately, worked well in practice. The only experience with this concept in practice is for the Earned Income Tax Credit (EITC), an income supplement available to low-income wage earners. A given year s EITC is typically paid as a refund the next spring, but individuals do have the option of getting their EITC payments during the year, which would raise their value for the vast majority of recipients. Yet less than one percent of EITC recipients use this option. Presumably, this is due to fear among potential recipients that their income will end up higher than expected, so that they will have to pay back some or all of this credit if they claim it in advance. Advanceability is likely to work better in the context of nongroup credits. For example, the Bush proposal would base eligibility for an advanceable credit on taxable income in the previous year, so that there is no potential for costly reconciliation when taxes are due in April. However, even this approach has its limitations, such as difficulties in qualifying individuals whose incomes suddenly decrease. Given our inability to set up a working advanceability model in other contexts, the model assumes that advanceability mechanisms will only be effective for one-half of the low-income consumers who face funding problems in buying their nongroup health insurance. For the other half, the problem of mismatch between the time premiums are due and the time refunds are received will reduce their take-up of the credit. The results of estimating the model for California, using these assumptions, are shown in Table 2. As the first section of that table shows, this tax subsidy is taken up by 2.01 million people, or 7 percent of the state population. Two-fifths of those who take up the subsidy are uninsured, onethird have nongroup insurance, and about one-sixth have employer-provided insurance. Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California 13

17 Table 2 shows the net changes in insurance status as a result of this subsidy. Most importantly, there is a net reduction in the uninsured of 640,000, or 10.3 percent of the existing number of uninsured. This figure is smaller than the number of uninsured who Table 2. Nongroup Credit Base Case* No. of Persons (millions) Percent of Insurance Category Net Cost (millions) Total cost ,631 Total take-up of subsidy Previously employer insured Previously nongroup insured Previously Medicaid Previously uninsured Not offered and uninsured Offered and uninsured Total change in population size Nongroup Medicaid Uninsured Employer insured Firm dropped to nongroup Firm dropped to uninsured Switch to nongroup Uninsured due to increased employee contributions Change in federal tax revenue (millions) 708 Cost per newly insured 2,564 * $1,000/$2,500 refundable credit; $20,000 $40,000 / $40,000 $80,000 income range Calculated in 2003 dollars. take up the credit because the 830,000 who take up is offset by some increase in the number of uninsured resulting from employer dropping. As the table shows, there is an overall reduction of 580,000 in the number of persons with employer-sponsored insurance, or 3.1 percent of the existing number of ESI holders. This reduction in ESI applies to four groups. The first consists of those to whom firms no longer offer insurance because of the availability of nongroup insurance, and who, when dropped, take up the nongroup credit (220,000). The second consists of those who are dropped and who decide not to take up the credit, becoming uninsured (160,000). The third group is made up of those who switch from group insurance to nongroup insurance because they are very healthy and subsidized nongroup insurance proves to be less expensive (140,000). The fourth group consists of those who become uninsured because their firm increases employee premium contributions in response to the nongroup credit, and the employee chooses not to continue purchasing the group health insurance (30,000). Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California 14

18 Table 2 also shows the costs associated with this credit. The total cost of this credit to the state is $1.63 billion per year. It is important to note, however, that this estimate does not include federal (income and payroll) tax revenue increases that result from individuals moving out of taxsubsidized ESI. As the next to last row shows in the Table, there is a federal income tax increase of $708 million, which is quite large relative to the net costs to the state. Therefore, if the state could somehow recapture these federal tax gains, it would lower costs by roughly 40 percent. The net cost of this credit per newly insured is approximately $2,550. This very large number results from the fact that only about 40 percent of program dollars are spent on the uninsured. Thus, this is a fairly poorly targeted approach to increasing health insurance coverage. But, once again, the poor targeting here would be greatly mitigated if federal tax savings were taken into account. Table 3 shows the distributional implications of this tax credit. It shows the spending and insurance coverage changes for those below the poverty line, between 100 and 200 percent of the poverty line, between 200 and 300 percent of the poverty line, between 300 and 400 percent of the poverty line, and above 400 percent of the poverty line. Most of the net reduction in the uninsured is among those below 200 percent of poverty; there is even some increase above 400 percent of poverty, due to firm dropping. The credit is fairly well targeted in terms of distribution, with 80 percent of spending going to those below 200 percent of the poverty line. Table 3. Nongroup Credit Base Case: Distributional Analysis* Group (by Percent of FPL) Net Cost (Millions) Percent of Costs Subsidy Take-up (Millions) Percent of Group Change in Uninsured (Millions) Percent of Uninsured Cost per Newly Insured <100% $ $2, % $ $2, % $ $3, % $ $3,483 >400% -$ $4,652 * $1,000 / $2,500 refundable credit; $1,000 $2,500 / $20,000 $40,000 / 40,000 $80,000 income range Calculated in 2003 dollars. Table 4 summarizes the key results of varying the parameters of the nongroup credit in various ways. It first shows the base case from Tables 2 and 3 for comparison. The second and third rows present the effect of expanding the generosity of the credit by raising it by 50 percent, and then by doubling it. This increased generosity results in a larger net reduction in the uninsured, but an even larger rise in net costs, so that the cost per newly insured increases. When the subsidy amount is increased by 50 percent, the reduction in the uninsured rises by nearly 65 percent, to 1.04 million. But costs more than double to more than $3.3 billion per year, so the cost per newly insured increases to $3,200. Similarly, doubling the credit more than doubles the reduction in uninsured but triples the costs, so that the cost per newly insured rises to almost $3,700. Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California 15

19 Table 4. Alternative Approaches to Nongroup Credit Base case $1,500/$3,750 credit $2,000/$5,000 credit Double income phaseouts Nonrefundable Total Take-Up Total Cost Change in Uninsured Change in Nongroup Insured Change in Employer Insured Cost per Newly Insured Percent of Benefits for <200% FPL , , , , , , These results illustrate a general principle that is common to all of the types of tax subsidies considered here: Increases in generosity reduce the efficiency of the policy, in terms of cost per newly insured. This happens for two reasons. First, each person who is subsidized is getting a larger amount of subsidy. Second, the larger subsidies increase take-up by all persons, whether previously insured or uninsured. On net, this makes the credit more inefficient since for every credit considered, the majority of those who take up already had private insurance. The fourth row in Table 4 shows the impact of making the credit available to a broader range of incomes by increasing the phaseout ranges to $40,000 $80,000 for singles, and $80,000 $160,000 for families. This change has essentially no impact on the number of newly insured resulting from the nongroup credit; a slight increase in take-up by the existing uninsured is offset by increased firm dropping. In this case, costs rise to just over $2.5 billion per year, so that the cost per newly insured rises to over $4,000. This finding has very important implications that are echoed throughout this report: the more tightly targeted the credit, the more cost efficient it is. In this case, loosening the targeting has no benefits, only costs. Moreover, as the distributional columns in this table show, the credit is now much less well targeted, with 65 percent of spending going to those below 200 percent of the poverty line. The final row of the table shows the results of a nonrefundable tax credit. This is an important case to consider because of the frequent political opposition to refundable credits as a form of welfare, but a state tax credit has very limited effect if it is not refundable, since state tax liabilities are limited relative to the size of the credit. This is shown very clearly by the results: the credit does essentially nothing if it is not refundable. Only 400,000 California residents take up the credit, and this is offset by a net increase in the number of uninsured (200,000). The credit is cheap at $53 million per year, but since the number of uninsured actually increases, this is not money well spent. Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California 16

20 This finding highlights the key limitations of state income tax policy as a vehicle for insurance reform. It is absolutely critical that credits be fully refundable, or they will essentially have no effect given relatively small state tax liabilities. Employer Tax Credits The second type of tax credit option modeled is a tax credit that can be used by employers to offset their costs for providing health insurance. These credits have two distinct advantages relative to nongroup tax credits. First, they promote, rather than supplant, the group insurance market. This is advantageous because it preserves the pooling mechanisms that work well in the group market, and also because it benefits from the lower prices in group markets. Moreover, group insurance coverage provides, in general, more comprehensive insurance than nongroup coverage; thus, broader coverage through the group market results in people being more fully insured than they would be by expansion of nongroup coverage. Second, these credits largely avoid the issue of advanceability because firms are much more likely to have the funds to pay for health insurance through directly lowering wage payments or other sources of firm capital until tax credits are available. Additionally, governments interact with employers on a more frequent basis (for example, quarterly payroll tax or unemployment insurance tax collections) so that it would be easy to have a more frequent subsidy payment. There are three key potential limitations of employer subsidies. The first is targeting. Since the subsidies go to employers and not individuals, they are necessarily tied to characteristics of that workplace. Workplaces are generally heterogeneous places, with continuous mixing of low- and high-income workers. This has one key advantage and one key disadvantage in terms of targeting. The advantage is that the lack of insurance in the United States is largely tied to firm offering; roughly two-thirds of the uninsured are employed but not offered health insurance. Therefore, targeting firms will target the source of the problem. Those firms that do not offer health insurance are tightly grouped into a set of small and lowwage firms. This is illustrated in Table 5, 12 which shows insurance offering rates by firm size and average firm earnings level (in 1997). In all firms of more than 100 employees, and in firms of more than 50 employees with moderately high average wage levels, rates of offering are very high. Only in the very smallest firms, or in those small-to-medium firms that are very low wage, is the offering rate very far from 100 percent. This makes it feasible, in theory, to fairly tightly target offering subsidies to those small firms that are most likely to be uninsured. The disadvantage is that many of the dollars flow to firms that have a nontrivial number of higher income workers. Some small, low-wage firms have one or several high-wage employees. Moreover, the targeting at the firm level is by necessity based on earnings and not total family income. So an apparently low-wage firm may be a high-income firm if it employs the spouses of higher income workers. By examining the effects of these subsidies along the income distribution, one can assess how much of a problem this is relative to nongroup subsidies. Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California 17

21 Table 5. Insurance Offer Rates by Firm Size and Average Earnings Categories Average Earning 1 9 Employees Employees Employees Employees 100+ Employees <$10, $10 15, $15 20, $20 25, $25 30, >$30, The second potential limitation of employer subsidies is that they are limited to those who have access to employer-sponsored insurance. This can be viewed as unfair to the unemployed, to the employed but uninsured whose employers are not eligible for subsidies, or to those uninsured whose employers do not respond to this subsidy by offering insurance. The final potential limitation is that, by subsidizing employer spending on insurance, the government encourages employers to offer more generous insurance plans, and this further erodes the tax base, since employer-sponsored insurance premiums are tax excluded. Earlier work by Gruber and Lettau 13 finds that employer spending on health insurance is very sensitive with respect to tax subsidies. This suggests that open-ended percentage subsidies to employer spending (for example, subsidies of a share of premium regardless of the richness of the benefits offered) can be quite costly. On the other hand, flat dollar subsidies will increase spending somewhat, as firms have more resources, but much less than an open-ended percentage subsidy. As a result, this paper considers a flat dollar subsidy that is equivalent to roughly 50 percent of the average spending of employers on health insurance. The current analysis considers an employer credit with the following characteristics: The maximum credit rate is $1,500 per employee taking up individual insurance coverage, and $3,500 per employee taking up family coverage. This maximum credit rate applies to firms with fewer than ten employees and with an average earnings level of less than $20,000 per year. This credit rate is reduced both as firm size increases and as average wages increase. 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 50 employees. The reduction with average earnings is a function of firm size. For firms of fewer than ten 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. In this way, the credit structure mimics Table 5, with the largest credits for small and low-wage, medium-size firms. Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California 18

22 While this structure appears quite complicated, in practice it is fairly straightforward to implement a credit of this nature. Firms collect their earnings data regularly for paying other forms of payroll taxes. One important question is whether any employee should be counted in computing firm size, or only (for example) full-time employees. This is a difficult issue: on the one hand, part-time employees are unlikely to be eligible for insurance; on the other hand, if firm size is computed based only on full-time employees, there is an incentive to relabel employees as part-time. On balance, it seems that a sensible approach would be to count only full-time employees, but to define full-time fairly liberally (for example, 20 hours per week or more). Once again, the model used to analyze employer credits has embedded within it a number of important behavioral assumptions. In this case, larger subsidies will lead to a larger number of firms, particularly small firms, offering ESI. Firms will also share these subsidies with their employees by bearing a larger share of the cost of insurance, lowering employee premium shares. The results of simulating this credit are shown in Table 6. The total take-up of this subsidy is 3.1 million persons, about 25 percent of whom are uninsured, and 60 percent of whom are employerinsured. There is a net reduction in the number of uninsured of 780,000; 80 percent of this decrease is from new insurance offering, and the remaining 20 percent is from increased take-up of employer insurance among those already offered (since employers are lowering employee premium shares). There is a net increase in the number of employer insured of 1.2 million, incorporating both the reduction in the uninsured and new ESI take-up among some of those who had nongroup or Medicaid coverage. The total cost of this subsidy is $1.9 billion per year. About 45 percent of the spending on this credit is on those who were previously uninsured. The cost per newly insured is $2450. This is a lower cost than the nongroup credit, for a credit that 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 nongroup credit, a larger percentage of the dollars are spent on those who were previously uninsured. Rather it is the much lower cost of insurance in the group market, relative to the nongroup market, which makes this a much more efficient arena for promoting coverage. For the nongroup credit, federal tax savings would potentially offset much of the costs. This is not true for the employer credit; there is a negative impact on federal tax revenues. This is because the federal tax losses from firms newly offering insurance (thereby replacing taxable wages with non-taxable health insurance premiums) is only partially offset by the federal tax gains from firms passing these credits on to workers in the form of higher wages. Thus, if one were to net out federal tax revenues, the nongroup and employer credits would be much more comparable. But, at the state level, not accounting for federal tax changes, employer credits are more attractive. The distributional impacts of the employer credit are considered in Table 7. It is somewhat difficult to compare the distributional impacts of employer credits with nongroup credits (or the employee credits below) since the credit dollars go to employers, and not directly to workers. Thus, to assess distributional impacts, it is necessary to make some assumption about the incidence of the payments to employers; that is, who will benefit from subsidies to employers? Following a large literature in economics, this analysis assumes that the subsidy dollars that Cost Modeling for Tax Subsidies to Increase Health Insurance Coverage in California 19