Federal Tax Policy: Its Effect on Health Care Costs, Coverage and the Uninsured

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1 Federal Tax Policy: Its Effect on Health Care Costs, Coverage and the Uninsured Victoria C. Craig Director of Research October, 1992

2 Executive Summary The United States currently has two classes of citizens-those who are fortunate enough to work for prosperous employers and receive tax-free health benefits on the job, and those who are self-employed or purchase insurance on their own and must pay for coverage with after-tax dollars. This preferential treatment of employer-based health insurance can be ataibuted to the evolution of our nations s tax policy, beginning in the 1940s. In recent years, the tax laws have been changed to tilt more in favor of large corporations and further from those who need help the most. More specifically, tax law has been changing in exactly the wrong direction. Starting in 1982, the Congress has madeit increasingly difficult for individuals to deduct their medical expenses and health insurance premiums. This has contributed to the alarming rise in the numbers of Americans with no health insurance coverage. Providing an unlimited tax exclusion for employer-provided health benefits has also caused an explosion in the amount of money spent on health care in the United States. This same tax policy has encouraged excessive coverage for some, which in turn has resulted in over utilization of health care services and an increase in medical costs. At the same time, it has discouraged individuals from sharing in their own health care expenses. Federal tax policy should be modified to treat coverage that is paid directly by individuals in the same way that employer-purchased health insurance is currently treated. Thischangein taxpolicy woulddirectly addresstheproblemofthe uninsured. Lower income families could be provided with vouchers to buy health insurance, while middle income taxpayers would be permitted to deduct the full out-of-pocket costs of health care, both for health insurance as well as for medical expenses. Some studies estimate that this change alone could increase the number of insured people by 10 million, reducing the numbers of uninsured by one-third, at little cost to the government or the public. If the tax policy remains unchanged, medical costs will keep rising and the number of uninsured will increase. 1

3 Introduction Current tax policy permits businesses to deduct the full cost of health care for employees, but provides only limited deductibility to individuals for their own expenses. This policy has resulted in a health care system that provides generous subsidies to those individuals who work for large employers, but very limited help for the self-employed, unemployed, and people who work for businesses that do not provide health coverage on the job. Ironically, this latter group - the self-employed, the unemployed, and the uninsured, most of whom work for small businesses, are the people who are most in need of the kind of tax assistance that is currently available and unlimited for the nation s largest employers. Over the years, federal tax policy has cruelly tilted ever more in favor of the large corporations, and away from people who must pay for their own health care expenses. This paper reviews the history of this changing tax policy and the consequences that have resulted.

4 The History of Tax Policy and Health Care There have been three major revisions of the Internal Revenue Code, occurring in 1939, 1954, and 1986, with each revision amended over time. (Cumulative Changes in the Internal Revenue Code of ) The following provides an historical look at the evolution of the health expense deduction in the context ofchanges in the health care system over the years. During the depression years of the 193Os, few employers provided health insurance benefits and spending on health services was marginal. The nation spent$3.6billionin 1929,$2.8 billionin 1935;and$3.8 billionin These sums amounted to 3.6%, 4.1%. and 4.9% of the GNP, respectively. By 1940, with a total population of 132 million, the United States had 12 million people covered by some form of private health insurance. The Health Insurance Association of America (HIAA) breaks this number into6 million covered by Blue Cross Blue Shield Plans, 3.7 million covered by commercial insurers (including 2.5 million in group plans and 1.2 million with individual insurance policies), and 2.3 million in other plans (HMOs, and health cooperatives). (HIAA,l In 1939, the United States first compiled all taxregulations into a single code,withenactmentoftheintemalrevenuecodeof Section23ofthe Code laidthefoundationforhealthcaredeductions6-omgrossincomeforindividuals. During the Second World War, a wartime wage connol was enacted to prevent employers from raising salaries to attract workers. To get around the wage control and with some encouragement from the government, employers offered noncash ( fringe ) benefits such as health insurance to employees. The employer s payments for medical insurance were considered a normal business expense deduction under Section 162 of the Internal Revenue Code. Section 23 of the Internal Revenue Code of 1939 was amended several times in the 1940s to clarify how the medical expense deduction for individuals could be claimed on individual tax returns. In 1942, Section 23 was amended to allow a medical expense deduction of up to $2,500 for a family and $1,2,50 for an individual to the extent those expenses exceeded 5% of net income. In 1943, the Internal Revenue Service ruled that employer contributions toward premiums for group health insurance plans were not taxable to the employee. 3

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6 In 1944, Section 23 was amended with the Individual Income Tax Act of 1944 (and again in 1945) to specify that the maximum deduction for the taxpayer, with only one surtax exemption, could not exceed $1,250. If more than one surtax exemption, the maximum deduction could not be in excess of $2,500. Section 23 was amended again in 1948 to specify that medical expenses exceeding 5% of adjusted gross income could be deducted, but not more than $1,250 multiplied by the number of exemptions allowed under 25 (b), with a maximum deduction of $2,500. For married couples filing jointly, the maximum deduction was increased to $5,000. These tax benefits encouraged the growth of health insurance and spending on health care. From 1940 to 1950, health care spending more than tripled - from $3.8 billion to $12.7 billion. As a percentage of the GNP, it rose from 4.0% to 4.4%. Private health insurance grew even faster. Blue Cross Blue Shield enrollment grew by more than 600%, from 6 million to 38.8 million, and enrollment in commercial insurance companies grew tenfold, from 3.7 million in 1940 to 37 million in 1950 (individual insurance policies from 1.2 million to 17.3 million and group plans from 2.5 million to 22.3 million), and another 4.4 million were enrolled in other health plans. When duplicate coverage was eliminated, 76.6 million people had coverage in just over one-half of the total population of million people (HIAA) In 1954, Congress updated and reorganized the Internal Revenue Code of l939. Section 23, pertaining to medical expense deductions, became Section 213, which was amended to allow a deduction for medical expenses for the taxpayer, spouse, anddependents if the expenses exceeded 3% of the adjusted gross income. Section 106 outlined the tax neatment of employer-paid health insurance premiums for both individual and group policies. The period from 1950 to 1965 was marked by continued growth of health care financing and costs as the policies of the post-war years played themselves out. Hospitalconstruction,newresearchandaainingprograms,andcontinued growth in private health insurance all fed the growing appetite for health services of the American people. By 1965,72.5% of the population was covered by private health insurance (138.7 million out of a population of approximately million). Enrollment in Blue Cross Plans continued to grow, from 38.8 million in 1950 to 58.1 million in 1960, and 63.3 million in Commercial insurers grew even faster, from 37 million in 1950 to 60.2 million in 1960, and 77.6 million in (Individual insurance policies growing from 17.3 million to 22.2 million and group plans from 22.3 million to 54.4 million from , and by 1965, 24.4 million for individual plans and 65.4 million for group 5

7 plans). Health care spending grew from $12.1 billion (4.6% of GNP) in 1960, to $38.9 billion (5.9% of GNP) in (HIAA) In 1965, the Internal Revenue Code was amended to continue the deduction for medical expenses in excess of 3% of adjusted gross income, and added a deduction of $150 for one-half of expenses paid during the taxable year for insurance premiums. While nearly three-quarters of the population had gained coverage through private insurance by 1965, there still were a large number who were without coverage, particularly the elderly and the poor. The enactment of Medicare and Medicaid would prove to be a revolution in American health care financing, although when first enacted they were thought to be modest steps to reduce the number of the uninsured. In 1960, close to 50% of total national health expenditures were paid out-ofpocket. The balance was split almost evenly between private, third-party payers and various levels of government. After 1965, this ratio would change radically with the enactment of Medicare and Medicaid. In 1965, the yearthe two programs were enacted, out-of-pocket expenditures approximated 45% of the total, private third-party payers were at 30%, and the government paid 25%. By 1967, third-party payers dropped to approximately 27%, and outof-pocket to 36% of the whole, while government spendingrose to 37% of the total. (L&n) During this time, most of the increase in government payments came from the federal government. In 1965, state and local spendingforpersonal health care exceeded federal spending by $4.3 billion to $2.9 billion. In 1967, state and / i r:;;i 10 5 i Distribution of National Health Expenditures (by source of financinp: ~ \\<~//x Y=--s.s&-C TT1--,SO,CS. ievrr,, OL i i i i *-- I 6

8 local spending increased to $5.5 billion, but federal spending increased to $9.7 billion-an increase of 234% in just two years. (HIAA) By 1970, state expenditures would rise to $9.9 billion, while federal expenditures would increase to $17.7 billion. (levirr) The enactment of Medicare and Medicaid prompted an enormous run-up of health care costs. Health care spending grew at a 65.5% greater annual rate during the 20 years following the passage of Medicare than in the 15 years leading up to its passage. Before the enactment of Medicare and Medicaid (from ) there was an average annual growth of 7.75% in health care spending. After the enactment of Medicare and Medicaid ( ) annual growth averaged 12.67%. By 1970, the nation was spending $67.2 billion, or 7% of its total GNP on health care. By 1975, total expenditures for health services exceeded $118 billionor 8.3% ofgnp. By theendofthe 197Os, theus. spent $214.7 billion on health care or 8.6% of its GNP. Since 1965, the country had endured cost increases exceeding 10% each year, with 1974 and 1975 as high as 14.5%. 14 I 1 12 Jo 10 8 Health Care Spending as % of GNP ;i-/ ,sourcs: "IA.4 So"rcsbook of Health,"S"ra"c* Data. t991, 1976 was the first year that commercial insurers listed a drop of enrollment, followed by the first ever drop in Blue Cross Blue Shield enrollment in 1977.(HIAA) By 1979, 27.9 million individuals were enrolled in Medicare and 21.5 million in Medicaid and private insurers covered 183 million. National health care expenditures grew by another 14.9% in 1980 and 15.9% in In 1982, the Tax Equity and Fiscal Responsibility Act of 1982 (PL97-248) changed in the medical expense deduction. First, the separate $150deduction for one-half of health insurance premiums was eliminated (health insurance premiums continued to be counted as medical expenses that could be 7

9 deducted subject to the adjusted gross income floor). Second, the floor for deductible medical expenses was raised from 3% to 5% of adjusted gross income. This was effective January 1, (General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of I PL97-248) National Health Expenditures (in billions) I / / 400 -~ ,so"res: HlAA SO",CS Book of "eelrh,"sum"ce D&m,,991, In the 1980s employers, alarmed at the uncontrolled increases in health costs, pushed for programs such as managed care, prospective payment, and increased coverage for outpatient care. At the same time, the federal govemment turned to prospective payment through Medicare DRGs. For a while these programs were remarkably successful. The rafe of health care inflation dropped every year for six years in a row from Health care inflation in 1981 reached the highest level ever %, but steadily decreased until 1986 when it reached the lowest level since %. WAN Annual Rate of Growth, National Health Expenditures vs Gross National Product lsource:,a,4 Sourcsbook of eahh,nsormcs Data NHE ~-,---o-gnp

10 The Tax Reform Act of 1986 updated the Internal Revenue Code of 1954 to be theintemalrevenuecodeof Section 213 remainedthe sameexcept the floor under the itemized medical expense deduction increased from 5 to 7.5% of the taxpayer s adjusted gross income. This was effective January 1, 1987 and still is in effect. (General Explanation of the Tax Reform Act of 198WL99-514) The reduction in tax benefits for individually-paid premiums has brought a concomitant drop in the number of people insured through individual health insurance. These numbers peaked in 1978 at 36.1 million and have dropped steadily through the 1980s until reaching 19.7 million in This is the fewest covered by individual health insurance policies since (HIAAI EBRI) I Millions with Individual Health insurance Policies I C%urce: HUM Soorcs Book of Healrh hurencs Dare, 1991/ I While an employer s contribution to a plan providing health insurance was excludable from an employee s income (Section 106 of theincernalrevenue Code), no equivalent exclusion was provided for self-employed individuals. The Tax Reform Act of 1986 enacted a temporary partial deduction for selfemployed individuals of 25% of the amounts paid for health insurance for taxable years beginning before January 1, 1990, under Section 162 of the Internal Revenue Code. Extension of this partial deduction has become an annual ritual in Congress with the following extensions: * Technical and Miscellaneous Revenue Act of Omnibus Budget Reconciliation Act of 1989 (OBRA 89) Omnibus Budget Reconciliation Act of 1990 (OBRA 90). * Tax Extension Act of 1991, * Congress passed H.R. 11, the Revenue Act of 1992, which would extend this provision retroactively up to 12 months since it expired on June 30,

11 Tax Policy and Health Care Today Federal tax ueatment of health care expenses has been a major contributor to the problems in the health care system. It has encouraged excessive coverage for people employed by large corporations. These employees have been exempt from the economic consequences of their health care decisions, and have driven the alarming increases in the price and utilization of health care services. At the same time, the erosion of tax benefits for individually-paid premiums has raised the number of people who can no longer afford to pay for their own coverage. These includes workers whose employers have cut back on or eliminated payment for dependent coverage. In the 197Os, workers whose employers did not cover them or their dependents could purchase individual health insurance policies, and deduct a large amount of those premiums from their gross income. Today, most of the uninsured are full-time, year-round workers or their dependents. Of the 35.7 million uninsured in 1990, 85% lived in families headed by a worker. Nearly 50% of these workers were self-employed or worked in firms with fewer than 25 employees. The rate of noninsurance is particularly high in certain industries such as agriculture (39%), conshuction (31%), and retail trade (24%). Uninsured Workers by Firm Size m q loo-499 Employees Employees R Employees 13.60% q Under 25 Employees,.so rcs: EBRI spscia/ Report llr23, 10 The uninsured are low income. Of the workers without health insurance ( 19.9 million), 55% have family incomes below $20,000. The uninsured are young. Nearly 60% or20.8 million of the total 35.7 million are under age 30. (EBRIJ

12 35.7 Million Uninsured -- Work Status of Family Head 14.50% 8% r Nonworker n Part Year % 7.70% 15.80% ISource: CBRI Specie/ Report X 1231 q Full Year, Some Unemployment 0 Full Year, Part Time Full Year, Full Time The uninsured are not chronically without coverage. Half of the uninsured regain coverage within four months and 70% are covered within a year. Only 15% remain without coverage for two or more years. (Swurfz andmcbride) Current tax policy permits business to deduct the full cost of health care for their employees, but provides only limited deductibility for individuals who pay for their own care. This policy has resulted in a health care system that provides generous subsidies to those individuals who work for large employers, but very limited help for the self-employed, the unemployed, and people who work for companies that do not provide coverage on the job. T % of Uninsured Workers by industry Retail Trade ConstnKtion Aghhre Government Self-Employed ls*wce: EN?/ Specid Report X 723) honically, this latter group are the very people who are most in need of the kind of assistance currently available and unlimited for those who are fortunate enough to work for the nations largest and wealthiest employers t 11

13 % Uninsured by Family Income (In Thousands) n Less than $10 $ $ $ R $40 and Over I,sowce: EBRl Specid Report 1.23, Over the years, federal tax policy has cruelly tilted ever more in favor of the large corporations and away from the people who must pay for their own health care expenses. Under current tax law, individuals may deduct health insurance Fremiums only if they exceed 7.5% of adjusted gross income. Most taxpayers who purchase individual health insurance receive no benefit from the medical expense deduction either because they don t itemize, or if they do itemize, they are unable to reach the floor of 7.5% of adjusted gross income except in years of unusually large medical expenses. (CRS Report-Tax Issues Related to Health Insurance Reform) In 1989, only 5 million returns claimed the medical expense deduction. This represented 15.9% of all itemized returns and 4.5% of all tax returns filed. This reflects a substantial decrease from tax year 1986, when the floor was at 5% of adjusted gross income. In 1986, 10.5 million returns claimed the 1 Time Spent Without Insurance 5.2 Million less than 4 months 0 4 to 12 months 17.5 Million n 12 to 24 months q more than 24 months,.%u,cs: Swarlz and McBride

14 medical expense deduction, representing 25.9% of all itemized returns and 10.2% of all tax returns filed. (CRS Report-Tax Issues Related to Health Insurance Reform) Corporations may treat health care as a business expense, thereby avoiding not only personal income taxes on the benefit, but Social Security (FICA), MedicarePartA (SECA).and stateincometaxesaswell.estimatesofthecost to the federal government of this tax-free treatment of corporate health care benefits in FY 1992 have been set at $33.5 billion by the Treasury Department and $37.7 billion by the Joint Committee on Taxation. Meanwhile, the self-employed individual must pay both the Social Security (FICA) and Medicare Part A (SECA) tax and may only deduct up to 25% of the cost of providing health insurance from personal income. Part-time workers, students, the unemployed, and everyone not receiving employerprovided health insurance receive no tax deduction at all. They must pay for all their health insurance with after-tax dollars, doubling the effective cost of the coverage. (Health Solutions for America) Finally, the tax subsidy of employer-based insurance is not equally distributed across all workers. Those with higher incomes and morejob security are more likely to receive employer-provided health insurance than those in lower-paid and less permanent jobs. Also, the exclusion is more valuable to higher-income workersbecause taxes increase as income rises. For every 10 dollars in health insurance paid by an employer, the employee in the 15% bracketsaves 15dollarsintaxes, whereas theemployeein the28% tax bracket saves 28 dollarswhen state and local taxes are added, the health care tax savings can reach 35% of the total cost of coverage. (CRS Taxation of&nplayer-provided Health Benefits) I 13

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