Have you ever wondered about the origins of the tax deduction for employer-provided health insurance? Here's a little gem from Micha Gisser in the WSJ letters section ($ ?) that explains this, along with a quick application of price theory to the problem. Professor Gisser is as skilled in the art of price theory as any economist who has walked the earth.
Gisser's concern is the recent essay by Cogan, Hubbard, and Kessler, which proposed making all health care expenditures tax deductible for anyone with at least catastrophic insurance coverage. Micha and I both endorse this proposal, given that tax deductibility of employer provided insurance is written in stone. Extending the deduction to purchases made by individuals would induce people to pare back insurance coverage towards catastrophic events only; i.e. what insurance is designed for in the first place. In an odd way, extending a tax distortion in this market is likely to produce salutary efficiency gains.
Here is the core of Micha's letter:
The tax deductibility of health insurance started during World War II when the federal government capped wages at a relatively low level that created labor shortages. Employers could not raise the frozen wages to compete for scarce labor, so they exploited a loophole in the tax law and covered workers' medical insurance with pre-tax money. Getting around wage controls during the war became a tax-advantaged benefit after the war, and now it is viewed as an entitlement of employment. Medical-care tax advantages are not a free lunch; they are financed by higher federal taxes. Revamping this huge tax distortion is politically unfeasible.
The economic problem lies in the fact that traditional medical insurance covers two dissimilar events, catastrophic and minor illnesses. Consumers' demand for catastrophic medical incidents is inelastic: a consumer will not use more of the heart-surgeon's services just because his out-of-pocket spending is zero. Consumers' demand for care for minor illnesses is elastic: it is inversely related to price. At the true high price a consumer would consult the medical encyclopedia and use over-the-counter drugs. At a low price (zero if her insurance pays the entire cost) a person would consume much more freely, mainly by making appointments with her doctor for every sniffle and headache. The problem with the prevailing health insurance is that the third-party payment of health-care bills insulates the consumers from the real costs of medical care services for non-catastrophic incidents.
The new Health Saving Accounts (HSA) law basically allows a consumer to set aside an account, say of $1,000, that is tax exempt, and can be used in the marketplace for sniffles and headaches at her discretion. If this year she spent only $300, she can use the remaining $700 for next year's sniffles, or save it for retirement. HSAs thus eliminate "moral hazard" by separating catastrophic from minor illnesses and injuries.
Reducing excess treatment of sniffles won't cure all of the problems with health markets, but it's a start.