Journal Issue: Health Care Reform Volume 3 Number 2 Summer/Fall 1993
Applying Principles of Fairness to Possible Financing Sources
In analyzing who will bear the burdens of making health care more affordable for children, attention should focus not on how taxes are initially levied but on the relative incidence of these taxes. Public finance economists who study burdens of taxation distinguish between who is initially required to pay a particular tax and who ultimately pays. The latter burden is referred to as the incidence of the tax and is of most interest here.19,20 For example, a payroll tax will be initially levied on employers who must legally collect the receipts for the government. Advocates of such a tax frequently assume that employers bear the cost of this tax themselves. But most economists agree that the actual burden of the tax rests on employees in the form of lower wages or benefits;21 a few argue that it is passed on to consumers in the form of higher prices for goods and services. The incidence of the income tax, on the other hand, tends to fall where it is initially levied; little of the initial burden is shifted to others.20Taxes for Financing Care
The income tax is, at least in theory, a fair tax in that it is progressive and applies to the broadest possible range of citizens.22 Because the income tax is not shifted, its progressivity can be directly manipulated and predicted. The tax reform of 1986 continued the trend of reducing the rates that apply to income, but the elimination of a number of deductions and exemptions helped to maintain the progressivity of the tax. Effective tax rates fell for those with the highest incomes in 1986, but have changed little for others since 1975.21 Moreover, because the income tax applies to all Americans, it is a particularly relevant tax when fairness demands that everyone contribute.
A simple surtax on the current income tax structure would yield progressive tax revenues consistent with the overall distribution of revenues obtained by the income tax. (Table 4 indicates the average tax rates by income class for the individual income tax.) A 5% surtax would simply increase revenue burdens in proportion to the tax liabilities that each family or individual now pays. Such a tax increase can be isolated from the rest of the tax structure because it is calculated at the very end of the process.
The income tax could be made more progressive by raising rates only on upper income categories or by broadening the tax base in ways that primarily target higher-income taxpayers. For example, President Bill Clinton's February 1993 proposal to add a new top income bracket would only affect married couples filing jointly with taxable incomes above $140,000 and single people with taxable incomes of more than $115,000.23 Elimination of mortgage deductibility on second homes or on mortgages above a certain amount also would raise taxes mainly on higher-income families and individuals.24 This is referred to as base broadening because it increases the amount of income subject to the tax. The disadvantage of such progressive changes is that they have only a limited capacity to raise revenues. Restricting tax increases to the top 5% or 10% of households limits the dollars that can be raised to fund programs.
One base-broadening tax change that is directly related to health reform would be to alter the treatment of employer-subsidized health insurance premiums.25 These benefits are received in before-tax dollars, giving individuals the incentive to take more of their total compensation from employers in health benefits rather than wages. And the advantage of this tax treatment increases with the incomes of the employees. Health care analysts often argue that this tax treatment encourages excessive purchase of health insurance; if so, a change in the tax treatment of employer-subsidized health premiums would not only raise revenues, but might also help to contain health care costs.26 Many proponents of fostering price competition as a means for controlling health care costs depend heavily on this device to make Americans more conscious of health care costs.27 It remains a controversial proposal, however, particularly opposed by labor and other consumer groups because they believe these are benefits they bargained for precisely on the grounds that they were exempt from tax. Further, these groups oppose treating as taxable income benefits that are received in kind.28
Payroll taxes have traditionally been associated with social insurance programs run by the federal government. These are generally flat-rate taxes, usually with an upper limit on the total amount of wages subject to the tax. And wages are more important to income for lower- and middle-class families than for those with higher incomes. The combination of these three factors makes the payroll tax regressive. It comprises a lower share of income for high-income households than the share paid by low-income households on average. Indeed, for many moderate-income families, the payroll tax constitutes a substantially greater burden than the income tax. Table 4 also indicates the average burden of the federal payroll taxes.29
There are, of course, ways to reduce the regressivity of the payroll tax.30 If there is no upper limit on wages subject to the tax or if the limit is set at a very high level (such as the current $135,000 limit for the Medicare portion of FICA), the tax will remain more proportional. And if payroll taxes were combined with an increase in income taxes on those in the top brackets, the overall effect would be a proportional tax. Alternatively, the regressivity of the payroll tax could also be mitigated by offering income tax credits or exemptions from the tax for lowerincome individuals.31
The payroll tax is sometimes suggested as one way to finance a Canadian-style public health care program.32 Employers who now offer insurance to their workers would save substantial sums under a shift to publicly provided health care. Replacing current employer contributions with a payroll tax may be a reasonable trade-off, and one that would reduce the redistributional effects. This approach would also be reasonable for a children-only public program because such a change would relieve employers of the burden of providing dependent coverage. It would still have a redistributional impact, however, because not all employers currently provide insurance to their workers.
Excise and Sales Taxes
Excise taxes on specific products such as alcohol or tobacco are often included in health care reform proposals32 because there is a widespread perception that use of these products raises health care costs. Revenues that can be raised from these "sin taxes" are, however, relatively limited and probably would not be sufficient as the major source of funding for anything other than a limited program such as a children-only plan. Because the base of these taxes is small, the rates would have to be very high to raise large revenues. Excessive tax rates even for sin may be considered oppressive. They can lead to the development of black markets and problems with compliance. If rates get to be very high, use will fall and revenues will not rise further. There will simply be less sin to tax.
Another excise tax that can be linked to benefits is a tax on medical care providers or insurers. Indeed, if various cost containment efforts succeed in reducing expenses in the private sector, provider or insurance taxes can be billed as a means for recapturing some of those savings to expand coverage. For example, a 2% tax on the revenues of health providers is one of the specific excise taxes that will support the new Minnesota health care plan.33 Many states also tax health insurance, but they are currently able to tax only part of that insurance.34 Little is known about who actually bears the burden of these taxes, but it is likely that at least a part of the impact is felt by consumers. If so, these become taxes on the sick, who are not necessarily the most desirable payers for health care reform. Again, this source will probably yield only limited revenues.35
One alternative to specific excise taxes is a broader sales tax that encompasses all or nearly all purchases. Most states and some localities rely heavily on sales taxes. At the federal level, proposed sales taxes often take the form of a valueadded tax (VAT), a sales tax that is assessed at each stage of the production of a good or service and accumulates over the production and distribution cycle. While the VAT is relatively invisible to the consumer, it has the same impact as a general sales tax.
Both excise and sales taxes are widely criticized for their regressivity. Because higher-income persons spend a lower percentage of their income on goods than do those with low incomes, broad sales taxes hit lower- and moderate-income families harder. Table 5 summarizes the average tax burdens by income from existing alcohol and tobacco taxes and from one possible version of a value-added tax. The specific percentages differ because varying amounts of revenue are raised by each. What is important is the relationship across the income quintiles for a particular tax. For the tobacco tax, the share steadily declines with income.36 The same trend occurs for the VAT, although to a somewhat lesser degree.37 The alcohol tax is largely proportional.36
When the tax is on specific goods like alcohol or tobacco, regressivity is less important because one goal of such a tax is to discourage use. In particular, a VAT as a broad-based tax will raise more in revenue. But when the tax is levied on necessities or takes the form of a general sales tax, it does impose greater burdens on those with low income. One way to avoid this problem is to exempt basic purchases—food and utilities, for example. Some states have tried to broaden their tax base by also taxing services, although a tax of this kind is difficult to enforce. But even with these efforts, the sales tax will still be regressive.38
Magnitude of Revenues
The sources discussed here would raise varying amounts of revenue each year. Some of the more popular options raise little, while other, more controversial options could increase federal revenues substantially. A recent study by the Joint Committee on Taxation of the U.S. Congress helps to put some of these changes in perspective (see Table 6).39 While variations on these options would result in different relative revenues, the ones listed here are within the normal range of those proposed. From the table, it becomes clear that cigarette and alcohol taxes and increases in tax rates for persons in the top income bracket raise relatively little new revenue, certainly as compared with the costs of health care reform. Perhaps precisely because fewer people would have to pay these taxes, they are more popular with the general public. The two largest amounts shown on the table, taxation of employer-paid health insurance and a VAT, would mean major changes in taxation but could raise substantial revenues. The ultimate revenue potential of a VAT is actually understated in this table. In making these estimates, it was assumed that implementation of a VAT would take longer than the other changes because of the need to create a new administrative structure. Moreover, it makes little sense to set up a whole new tax structure for a small VAT; for this reason, it is presented here as a substantially larger revenue source than the others. A larger payroll tax could also be introduced to raise substantial new revenues, but many opponents of such an expansion would point out that, with an existing combined payroll tax of more than 15%, it may be difficult to enact large increases in the rates.Employer Mandates
Requiring that employers provide health insurance implicitly creates the same types of burdens as a payroll tax levied on employers. Because an employer mandate will be experienced mainly as lower wages, the relative incidence of such a requirement will probably be similar to the incidence of a payroll tax.40,41
A strict mandate that employers provide and pay for much of the cost of insurance to employees would result in the greatest changes for firms with low-wage workers.42 Moreover, the expense of a mandate would constitute a larger percentage of payroll in these firms. For example, if the costs of the mandate were to average about $2,000 per worker, that is a larger proportion of wages for employees making $15,000 per year than for those making $50,000 per year. Further, like the payroll tax, the burden would be borne largely by workers in terms of lower growth in wages or other benefits. These burdens will be a higher percentage of the incomes of workers in firms with low wages and, hence, will be regressive.
This regressivity is likely to be even more serious when we look at the net impact of such a mandate—that is, the new costs over and above those that are now borne by employers. Because high-wage workers (especially if they work for large firms) are now more likely to have employer-subsidized insurance, the net new costs of an employer mandate will be largely concentrated on employers with low-wage workers who are not now offering such benefits. Further, some of the "winners" from an employer mandate are employees in firms that currently offer generous benefits not only to their workers but also to spouses employed by firms not making available such coverage. Burdens on those firms that now provide coverage—and on their higher-wage employees—would likely decline. Consequently, the net new costs of the system will be even more regressive than if we were adding mandated benefits that no employers now cover.43
The regressivity of the requirement that employers provide insurance to their employees can be mitigated in a number of ways. One of the most common is to give employers the option of offering insurance or of paying a tax—usually a payroll tax—that effectively enrolls their employees in a publicly sponsored insurance plan. The payroll tax operates as an upper bound on the share of payroll that would have to be devoted to health insurance premiums. (This is usually referred to as a pay-or-play system, where the employer chooses whether to play by offering health insurance or to pay a payroll tax.) Consider an example where an employer could pay an 8% payroll tax instead of $2,000 per employee. If the firm's payroll averages less than $25,000, it would be less expensive for the employer to pay the tax rather than buy the insurance. And the resulting burdens on employees in the form of lower wages or reductions in other fringe benefits would thus be less as well. Implicit in this type of approach, however, is the assumption that additional tax revenues would need to be raised outside the mandate system to pay for the subsidies offered to those enrolling in the publicly sponsored plan. And the greater the relief offered to low-wage employers, the higher those additional revenue subsidies must be.
Other methods of offering relief to low-wage or small employers include direct or indirect subsidies to make insurance more affordable. Offering tax credits against other taxes owed by the firm is one alternative that was proposed by President Clinton during his campaign. These credits could be against the profits of the firm or against payroll taxes owed for Social Security, for example. While these variations on mandates technically reduce burdens on the employer, the incidence of such relief will probably be felt by the employees and/or consumers of the goods and services provided by these small firms.
If a mandate were imposed solely to cover the children of workers, the burdens on employers and employees would be considerably less. Moreover, because the costs would probably be shifted to all workers and not just to those with children (in lower wages or benefits across the board), this tax would actually be less regressive. Instead, there would be some redistribution from families without children, who tend to have higher incomes on average, to those with children, whose incomes are lower than their childless counterparts.