Presumptive Republican presidential nominee Senator John McCain has proposed a radical reform for the tax treatment of health insurance. He would eliminate the current employer tax exclusion (i.e., employees do not count as income the money employers spend on employee health insurance; it is “excluded” from income) and replace it with a refundable tax credit: $2,500 for an individual and $5,000 for a family.
Critics of the McCain proposal—and they are legion—say that a $5,000 tax credit for a family doesn’t come near covering the cost of the average family policy, about $12,000 a year.
But to make that claim is to display a woeful ignorance of how the current tax exclusion affects a family’s income tax bill.
Consider, for example, a family making $60,000, a year which has an employer-provided policy that costs $12,000 a year.
The first thing to realize is that most employers, including the federal government, don’t cover the entire cost of a family policy. Employers will generally pay between half and three quarters of the cost.
So the comparison probably wouldn't be between a $5,000 tax credit and a $12,000 tax exclusion, but the $6,000 to $9,000 the employer actually spends. The employees already pay the balance of the cost (albeit some tax shelter that difference through a Flexible Spending Account).
Now, under the current system, the family is actually making $69,000 (basic income plus a $9,000 employer health insurance contribution), but only paying taxes on $60,000. If after eliminating the tax exclusion the family had to pay taxes on the full $69,000, it’s tax bill would likely rise by $1,000 to $1,500, depending on other factors such as deductions, etc.
So the real tax break for this family is around $1,000 to $1,500.
Under the McCain plan, the family would take $5,000 directly off its actual tax bill, not its income. That’s a $5,000 tax reduction compared to, say, $1,000 to $1,500 under the current system.
In terms of value, for most taxpayers McCain’s plan wins easily.
Of course, there are other questions that arise:
• Would a standard tax deduction, like the one President Bush has proposed, be a better deal?
• Should we just eliminate all tax breaks for health insurance as economist Milton Friedman proposed?
• And would a McCain plan encourage employers to drop coverage over time?
All of these questions should become part of the debate. But what should be clear is that under McCain’s proposal, most Americans would get a better tax deal than they get today.