The President’s Health Care Tax Deduction initiative proposed during the State of the Union was designed to produce two main results: (1) limit the economic distortions currently present in the tax code with respect to health care, and (2) reduce the number of uninsured in America.
How Does It Work?
The President is seeking to accomplish these two goals by eliminating the exclusion of employer-provided health insurance from income and replace it with a standard tax deduction – $15,000 for family and $7,500 for individual – available to anyone who has health insurance, regardless of the price.
Such a change in the tax code would largely accomplish the first goal. However, introducing a deduction in the income tax system alone would not affect a large fraction of the uninsured who already pay no federal income taxes. Therefore, the President was forced to look at what federal taxes those uninsured actually pay if he wanted to lure them to purchase health insurance from his plan.
All workers do pay payroll taxes – i.e. Social Security and Medicare taxes – even those who have no federal income tax liability. Therefore, the President’s plan takes the standard deduction against both payroll taxes and adjusted gross income (AGI), which enables those who pay no income taxes to benefit through a reduction in their payroll taxes.
Tax Cut or Tax Hike?
Whether a family sees its tax bill increase or fall as a result of this change depends upon the value of its current employer-provided contribution. Those with employer-provided plans that exceed the proposed standard health deduction will end up paying more in both federal income taxes and payroll taxes. Those who do not have such high-valued plans, which the Treasury Department estimates to be 80 percent of families, will get a tax cut.
For example, a family of four with two children that earns $80,000 per year in wage and salary income and receives $10,000 in employer-provided health insurance would see $1,500 in tax savings. However, the same family with $20,000 in employer-provided health insurance would see a tax increase of $1,500. (For more examples of how the plan works on different types of families, see the charts here.)
Hitting the Third Rail?
Since Social Security benefits are tied to payroll tax payments, it is unclear at this time what long-term net benefits the President’s plan will have. Payroll tax payments are still linked to Social Security benefits by law through a complex formula, and a calculation of how such potential reductions would compare to the benefit people receive from the new health insurance deduction is not possible until more detailed analysis from government agencies is available.
(For further discussion on this issue, this week the Tax Foundation will release its latest Tax Policy Podcast featuring Katherine Baicker of the President’s Council on Economic Advisors.)
More Non-Payers, Less Tax Reform
Ultimately, this may be a death blow for serious tax reform. In 2006, Tax Foundation economists estimated that roughly 43.4 million tax returns, representing 91 million individuals, paid no federal income taxes or received money back as a result of a negative tax liability. That's out of a total of 136 million federal tax returns filed. Adding to this figure the 15 million households and individuals who file no tax return at all, roughly 121 million Americans—or 41 percent of the U.S. population—were completely outside the federal income tax system in 2006. The President’s plan will only increase this trend.
The pressure to fix an insanely complicated and unfair tax code will continue to dwindle as fewer and fewer Americans pay into the system. More non-payers mean a higher tax burden for those who already pay the vast majority of federal taxes. Major challenges ahead, such as reforming entitlement spending, are made increasingly difficult as lawmakers continue to use the tax code to "solve" social problems.