A simple fix can bring revolutionary change to health spending

Prices for health services in the U.S. are high relative to the rest of the world. For example, a simple MRI scan that costs $1,430 in the U.S. costs around $450 in the United Kingdom, $750 in New Zealand, and $310 in Switzerland. High U.S. prices have been the primary cause of high health insurance premiums in the U.S. for several years. Ultimately, the burden of high prices and premiums are borne by American workers in the form of high employee contributions, lower wages, and less generous benefits.   

A simple change to federal tax policy can bring high health care prices down, while at the same time increasing government revenues and reducing inequality: Make insurance coverage of high-priced health care providers a taxable employee benefit. 

To see this requires a little bit of history. In 1954, the IRS made employer-sponsored health insurance deductible to the employer, but non-taxable to the employee. Research by myself and others shows that one effect of the tax exemption has been to dampen employers’ and employees’ sensitivity to increases in health insurance premiums. This makes sense: Employers’ and employees’ response to an increase in premiums that is tax exempt will be less than the response to an increase that must be paid with (more valuable) taxable dollars.   

Insensitivity to health insurance premiums, however, creates a big problem: It weakens the ability of competition among providers to keep prices low. This too makes sense. Why should doctors or hospitals compete vigorously when they know that their high prices can be passed on by insurers without much pushback? 

Problems with the tax exemption don’t stop there. The tax exemption is the largest single “tax expenditure” — revenue loss attributable to a special exclusion, exemption, or deduction from gross income. According to the U.S. Treasury’s Office of Tax Analysis, in 2020 the health benefits exemption cost the federal treasury $215 billion. By comparison, all retirement savings exemptions (including those for Individual Retirement Accounts) cost $210 billion, lower rates on capital gains cost $99 billion, and the deductibility of home mortgage interest cost $30 billion. 

Finally, the tax exemption is regressive: High-income taxpayers benefit more from it than low-income taxpayers. High-income taxpayers face higher marginal tax rates than low-income taxpayers, so the value of a $1 exemption increases with income. In addition, high-income taxpayers tend to spend more on health insurance than low-income taxpayers, so the exemption benefits high-income taxpayers more independent of their tax rate. 

Presidents George W. Bush and Barack Obama both tried to cap the unlimited tax exemption.  President Bush proposed replacing it with a fixed amount available to anyone with employer-sponsored health benefits; President Obama, as part of the Affordable Care Act, sought to impose an excise tax on high-premium health insurance plans that would effectively undo the exemption for those plans. Neither succeeded. President Bush’s proposal never passed; President Obama’s proposal was adopted into law, but later repealed with bipartisan agreement. 

The best solution, of course, would be to abolish the tax exemption entirely, putting health insurance spending on a par with all other goods. However, as the experiences of Presidents Bush and Obama showed, abolishing the tax exemption is highly politically unpopular — given that it would raise taxes on a vast swath of the middle class, especially those with generous benefit packages. 

A compromise position would abolish the tax exemption only for spending on high-priced providers, perhaps those priced at more than a specified multiple of Medicare rates. Employers who wished to preserve access to high-priced providers could still do so, but they would have to pay for it with premium dollars that would be taxable to their employees. Spending on high-priced providers would become a taxable benefit. 

This solution has several merits. It directly targets high prices due to tax-policy-induced failures of competition. It is flexible: Congress could set the cutoff at a very high level (affecting relatively few providers) and gradually phase it down. It avoids the dangers of direct government price regulation: Some proposals would make it illegal to charge health plans more than a specified multiple of Medicare. Although this might seem satisfying at first, it runs the risk of inadvertently banning a product or service that people value. 

Other proposals (like those of Presidents Bush and Obama) increased taxes on plans with high insurance premiums, which pulled in plans not only with high prices per unit of service but also plans with high volumes of services. Although plans that deliver high volumes of services can also be cost-ineffective, the evidence that consumers are getting poor value from services with high unit prices is stronger than the evidence that consumers are getting poor value from services with high volumes. 

Finally, abolishing the exemption for high-priced providers is implementable: Health plans could keep track of the share of payments to high-priced providers on a plan-level basis, and then report it to individuals, employers, and the IRS on existing Form 1095.  

As with most changes in tax policy, there will be losers and winners. Losers will be the high-priced providers, such as academic medical centers, who will need to deliver a clearer value proposition in order to justify their rates. High-income people, union members and others with plans that do not differentiate between providers on the basis of price will also see effective premium increases. The winners will be the rest of us, who will enjoy the fruits of enhanced competition in markets for health services, some extra tax revenue, and a modest increase in the progressiveness of the tax system.   

If this sounds too good to be true, it isn’t. The tax exemption is an historical accident that no one ever intended to become so large and destructive. Who knows? It might even have grown into a big enough problem to attract a bipartisan coalition for its reform. 

Daniel Kessler is the Keith and Jan Hurlbut Senior Fellow and Director of Research at the Hoover Institution and a professor at the Graduate School of Business and Law School at Stanford University.