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Tax Options to Promote the

Purchase of Health Insurance

prepared for State of Maryland prepared by

Elliot K. Wicks, Ph.D.

Stan Dorn, J.D.

Jack A. Meyer, Ph.D.

Economic and Social Research Institute

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Tax Options to Promote the

Purchase of Health Insurance

Executive Summary

Tax incentives for health insurance can take several forms:

 A tax deduction subtracts insurance costs from a

household’s taxable income. The resulting tax savings

depends on the household’s tax bracket. A large majority of the uninsured earn low incomes and owe little or no tax, so deductions would not pro-vide them with much help purchasing coverage.  A refundable tax credit reimburses the taxpayer, dollar

for dollar, for health insurance costs. All eligible

households receive the credit, including those who owe little or no tax.

 A tax penalty increases tax liabilities for individuals

who can afford coverage but fail to get it. Unlike

de-ductions and credits, tax penalties increase state revenue and so do not require offsetting expendi-ture cuts or tax increases. The following analysis focuses on tax penalties.

When those who can afford coverage choose to be uninsured, harm can result:

 Many uninsured can afford coverage. In Maryland, 27 percent of the uninsured have annual incomes above 400 percent of the federal poverty level (nearly $62,700 for a family of three).

 The health of the uninsured frequently suffers because

of reduced access to necessary health care. Moreover, if

a major injury or illness develops, bankruptcy or other major financial loss can result.

 The whole state pays when the uninsured receive

un-compensated care, which is funded in part by higher

hospital rates charged to all payers, including the state. Being uninsured thus raises everyone’s health insurance premiums and taxes.

 Children can suffer when their parents do not buy them

coverage. Uninsured children can lose access to

es-sential care, which can harm their health and im-pair their ability to learn. Like mandates for using child safety seats, requiring health insurance for children enforces parental responsibility.

 Absence of insurance coverage has other spillover

ef-fects. For example, community resources like

trauma care centers can be financially destabilized by high numbers of uninsured patients.

Tax penalties should not apply to those for whom coverage is not affordable:

 Dollar amounts can define the income below which

penalties do not apply. For example, households

earning less than the state median income of $55,900 could be exempted from penalties.

 Percentages of poverty could be used instead. House-holds could be exempted from tax penalties if their income is below a percentage of the federal pov-erty level, such as 400 percent, which is currently about $63,000 for a family of three. While more complex than a single dollar figure, poverty levels take into account costs faced by large families and automatically increase when the federal govern-ment updates the poverty level each year.

Tax penalties could be set in various ways:

 Uninsured taxpayers could be required to pay a defined

dollar amount, which might be some portion of the

cost of coverage. In effect, this amounts to fining people for not getting coverage.

 Uninsured taxpayers could be denied normal tax

bene-fits, such as personal and dependent tax

exemp-tions and deducexemp-tions. Such an approach would not entail heavy penalties. For example, terminating tax exemptions and the standard deduction would increase taxes by (a) $209 for a single tax filer with a $60,000 income; and (b) $646 for a four-person family with $60,000 income and two children.  Households that include both insured and uninsured

members could be assessed partial tax penalties. For

example, if the adults in a family were covered but the children were not, the personal income tax ex-emption for children could be denied.

 It is unclear how high the penalties must be to increase

insurance coverage substantially. Based on purely

fi-nancial calculations, a tax penalty of $600 or so might be too small to induce many people to buy

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coverage, since the cost of coverage is much higher—in the range of $8,000 to $10,000 for a family if they have to pay the full premium. How-ever, many taxpayers might obtain coverage not just to avoid sanctions’ financial impact but also because of a moral commitment to following the law. Given the uncertain behavioral response, tax penalties could be set initially at modest levels but gradually increased over time if necessary.

 In case of job loss, the insurance requirement could be

suspended for a time. The requirement could be

waived for the duration of unemployment. Alter-natively, individuals who were unemployed for more than a defined period (such as four weeks) could have tax penalties waived for the entire year.

 No minimum benefits package should be required, be-yond the definition of a Health Benefits Plan in current state law, which ensures coverage of the most expensive costs. Imposing more specific benefit requirements would make enforcement far more costly and difficult.

Approaches to documenting insurance status:

 Insurers could be required to provide their members

with forms listing the months of coverage for each indi-vidual, which households would file with their

state income tax returns.

 Individuals, not insurers, could be required to provide

proof of insurance coverage, via insurers’ invoices,

pay stubs showing deductions for insurance pre-miums, etc.

 Individuals could affirm their insurance status without

documentation, as happens today with much

in-formation provided on tax forms. Documentation would be needed only in case of an audit.

Policymakers have several options for the money raised by tax penalties:

 These funds could be dedicated to health programs, such as those for uninsured, low-income residents.  Some of the revenue could defray administrative costs of

implementing this law.

 Tax penalty money could simply go to the state general

fund, improving the state’s fiscal position. Recommendations

We recommend that the state of Maryland adopt a tax penalty for high-income people who fail to purchase health insurance coverage. We suggest the following features:*

1. The penalty would apply to any household with federal adjusted gross income in excess of 400 percent of the federal poverty level.

In the first two years after the law goes into effect, the penalty would be calculated on the state income tax forms, but the penalty would be waived. The penalty would be imposed in the third and subse-quent years.

— Rationale. A threshold that varies with family size and is adjusted for inflation—as is the case with the federal poverty level—is more equitable than a threshold that is a single dollar figure. The difficulty with such a threshold is that it is harder for people to understand whether they are subject to it, since it varies with family size. Thus it is appropriate to provide a waiver of the penalty in the first two years: once people have seen, after filing out their tax forms, that they are subject to the penalty, they will understand that in subsequent years they will be required to have coverage. The two year waiver reflects the fact that many people do not fill out their tax forms until April of the next year, at which point, if they did not have coverage, they would already be subject to the penalty for the current year.

2. The penalty for each household subject to the penalty would be 30 percent of the average cost that a household of that size would have to pay for coverage in Maryland. The penalty would be reduced in proportion to the number of household members who are covered.

— Rationale. Although denial of the right to claim the standard deduction and exemptions is often sug-gested as the penalty for failure to buy, our judgment is that this may not be sufficient to induce

*ESRI’s original recommendations were revised after consultation with the Maryland Health Care Coverage Workgroup.

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enough people to buy coverage. We suggest 30 percent of the average cost of coverage because that is approximately the proportion of total premiums contributed by employees enrolled in family cover-age at private-sector establishments in Maryland in 2002.1 For families that have access to

employer-based coverage, the penalty would be roughly equal to the cost they would incur by taking up the employer offer of coverage, which would provide a strong incentive to get coverage. (The average cost of family coverage was $8,809 in Maryland in 2002,2 so the average penalty would have been $2,643.)

3. A family member would be considered uninsured if she or he is without coverage for a period of three months or more during the tax year.

— Rationale. Because it is extremely common for people to be without coverage for brief periods during life transitions, such as marriage, divorce, change of jobs, moving to a new area, etc., it seems unfair to impose a major penalty if a family member is without coverage for a brief period.

4. Coverage would count as acceptable coverage if it meets the definition of a Health Benefits Plan under Section 15-1301 of the Maryland Insurance Article.

— Rationale. Requiring that coverage meet any benefits specifications beyond what is already in law would immensely increase the enforcement burden.

5. A family could demonstrate that they have coverage by signing an affidavit on their tax return indicat-ing that all family members are insured and indicatindicat-ing the source of coverage. Proof of coverage would be required in the case of an audit.

— Rationale. This is proposed because it is simple and does not require insurers to prepare new forms to distribute showing proof of coverage. The prospect of having to show proof in case of audit should help to ensure truthful responses.

6. The requirement would be waived if a principal wage earner in the family loses employment and is subsequently unemployed for a period of four or more weeks during the year.

— Rationale. The provision is to ensure that families that lose substantial income are not required to un-dergo a hardship to meet this requirement. It is especially appropriate since loss of employment often triggers loss of insurance.

7. State revenue collected as a result of payment of penalties should be dedicated to assisting those who remain uninsured and/or should be allocated to the hospital uncompensated care fund to reduce hospi-tal rates.

— Rationale. Since higher-income people represent a minority of uninsured people in the state, a policy that addresses only them leaves most of the problem unsolved. Using the penalty revenues to aid people for whom coverage is unaffordable represents a more balanced approach to addressing the problem of the uninsured. Alternatively, dedicating some of the money to offset the costs of paying for uncompensated care recognizes that all who pay for hospital care bear the burden of covering uncom-pensated hospital bills, part of which is incurred because higher-income people who lack insurance contribute to uncompensated care costs.

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Tax Options to Promote the Purchase of

Health Insurance

One way to promote expansion of health-insurance coverage is to use the state income tax system to create incentives for people to purchase insurance. The incentives can be positive—to encourage the purchase of coverage—or negative—to penalize for not purchasing coverage.

Positive Incentives — Tax Deductions and Tax Credits

Positive incentives are created when people receive tax subsidies to reduce the cost of pur-chasing coverage. Tax subsidies can take the form of either tax deductions or tax credits. The tax deduction approach allows people to subtract a portion of their health insurance costs from their taxable income before they calculate their tax liability, whereas the tax credit approach allows them to subtract an amount directly from their tax liability. The deduction approach is generally considered less equitable than the credit approach because the amount of the subsidy depends on the taxpayer's marginal tax rate. Higher-income people, who have higher marginal tax rates, re-ceive a larger subsidy than lower-income people, who are taxed at a lower rate or who may not owe any income taxes.3

By contrast, because the tax credit is subtracted dollar-for-dollar from a taxpayer’s tax liabil-ity, the benefit does not depend on marginal tax rates. If the tax credit is “refundable”—that is, if taxpayers receive the full credit amount even if the credit exceeds their tax liability or they owe no tax—then the value of the subsidy is equal for low-income and higher-income people. Moreo-ver, since most of the uninsured have low incomes, any credit would need to be refundable to maximize its impact on coverage. In addition, the tax credit approach is probably also superior to the deduction as a way of creating an incentive because the effect of the credit is more obvious to taxpayers.

Although neither tax deductions nor tax credits require new government appropriations, they reduce the amount of revenue that would otherwise be collected, thereby requiring, in times of constrained budgets, either a reduction in other government expenditures or the generation of new revenue from other sources. On the other hand, they have the political advantage that they can be legitimately communicated as a form of tax reduction.

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Tax Penalties

Another way to use the tax system to create incentives for the purchase of health coverage is to impose a tax penalty on people who fail to purchase insurance. One approach would be sim-ply to specify that people who fail to buy health insurance that covers all family members would incur a new tax liability equal to some portion of the costs of coverage. In effect, this amounts to imposing a fine for failing to be insured.

A less strong and perhaps politically more palatable approach is to disallow certain forms of tax relief that would otherwise be available to taxpayers. For example, people who failed to buy coverage could be prevented from taking advantage of the personal income tax exemption or otherwise-allowable tax deductions, such as the standard deduction.

An advantage of tax penalties, in contrast with tax subsidies, is that they do not reduce reve-nue and so require no offsetting expenditure cuts or increases to taxes or fees. If they are effective in inducing people to buy insurance, they increase coverage without any imposition on the state treasury, and if they are ineffective, they add to state revenues.

In the interest of fairness, it would be appropriate to impose tax penalties only on people who could afford to buy coverage. Such people represent a surprisingly large proportion of the unsured: in 2001-2002 in Maryland, 38 percent of the uninsured were in families whose annual in-come exceeded 300 percent of the federal poverty level ($47,000 for a family of three in 2004), and 27 percent were in families with annual incomes above 400 percent of the federal poverty level ($62,700 for a family of three).4

Key Questions About Tax Penalties

The remainder of this paper will focus on tax penalties, discussing some of the key issues that would have to be addressed in implementing this tax incentive approach. We approach this by asking and answering a series of key questions.

1. What is the justification for using tax incentives to require anyone to purchase health in-surance?

Several arguments can be used to justify having the state require individuals and families to buy health insurance. Some would argue that state action is justified because of the extensive evi-dence that shows that uninsured people are much more likely to forego needed care, are less likely to report being in good or excellent health, and are more likely to receive inferior care and more likely to die when hospitalized.5 Others point out that failure to be insured has harmful

consequences for others besides the uninsured themselves. First, if uninsured people, even mod-erately affluent people, suffer a catastrophic injury or illness, the expenses will often be so high that they will not be able to pay for the care from their own resources. In most instances of

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seri-ous illness or injury, uninsured people will still get care (though often lower quality care), but the cost burden of catastrophic cases will be shifted to the rest of the population in one form or an-other. Either the uninsured will be cared for by the safety net system, which is largely supported by public funds, or their bills will become bad debts for providers, and the costs will be shifted to insured populations and the state. (Since Maryland has an all-payer hospital system, an increase in uncompensated hospital care increases costs for both public and private payers). Thus high-income people who have enough resources to purchase coverage but do not do so are not bearing their fair share of the cost burden.

Second, if parents fail to buy coverage for their children, their children’s health may be jeop-ardized because they do not get access to needed services, especially preventive care. Children should not have to suffer for their parents’ failure to insure them, and the state is justified in in-tervening to ensure that children are protected.6

Third, failing to have coverage creates various “spillover” effects, as documented in a series of recent, groundbreaking reports by the Institute of Medicine.7 For example, uninsured individuals

are more likely to develop serious illnesses that undermine productivity, causing broader eco-nomic harm. Moreover, as the number of uninsured people within a geographic area increases, essential community health care resources, like trauma care centers and emergency rooms, can become financially destabilized. They may be forced to reduce the amount of care they provide or even close, harming the insured residents of nearby areas. Finally, children are less likely to get necessary health coverage and health care when their parents are uninsured.8

Fourth, if the state is justified in taxing the whole population to ensure that needy people have access to needed medical services—as the state does in financing Medicaid and the safety net system—it would seem to be justified in providing strong incentives to ensure that people with higher incomes acquire coverage to ensure that they will have adequate access to medical care.

2. To which populations should the penalty be applied? What income cutoffs and other crite-ria should be used?

Presumably, the guiding principle should be that the mandate to purchase coverage should apply only to people who can afford to purchase coverage without financial hardship. The two most important factors in determining affordability of coverage are the amount of household in-come and the cost of health insurance.

It is useful to begin with some income statistics. Median household income for Maryland for the 2000-2002 period averaged $55,912. (This was 30 percent above the U.S. average.) Since most middle-income people do have private coverage, it seems reasonable to assume that most people with incomes in excess of the median income can afford coverage.

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Several basic approaches could be used to set the income level above which people would be penalized if they were uninsured. One approach is to set a single dollar amount that applies to all households regardless of family size. This has the advantage of making the requirement easy to communicate and easy to understand; the disadvantage is that is it not sensitive to family size, which affects both the cost of coverage and the amount a household has available after paying for other essentials. To be sure that the mandate to buy coverage does not impose a hardship, it might be appropriate to apply the requirement initially only to households with incomes above the median for Maryland, perhaps $55,000 or $60,000. Again, the figure could be gradually low-ered (or raised) over time, depending on the initial experience.

A second approach would be to use some multiple of the federal poverty level, since that pro-vides a figure that is adjusted for family size and is thus more sensitive to ability to pay. In effect, this approach incorporates an automatic cost-of-living adjuster, since federal authorities revise the poverty level every year. The disadvantage is that because there would be different threshold income levels depending on family size, it could be more difficult to explain the requirement and for people to understand whether they are subject to the mandate. Since the purpose is to encour-age people to buy coverencour-age, they would need to understand the requirement long before the time they file their state income tax returns, which would otherwise be an obvious point to communi-cate the requirement. If some multiple of the poverty level were used, one sensible, if conserva-tive, approach would be to set the initial cut-off level at 400 percent of the poverty level (ap-proximately $37,000 for a single individual and $63,000 for a family of three in 2004) to ensure that any families subject to the requirement would not bear a financial hardship in paying for coverage. Once there is experience with the mandate, it might be appropriate to lower the cut-off level, perhaps eventually to 300 percent of the poverty level. 9

None of the approaches that link the tax penalty to income levels takes account of the fact that a given income level represents less real purchasing power in some areas of the state (for exam-ple, urban areas) than others. This is a source of inequity, but to try to adjust for that would be very complicated, especially over time. Moreover, most need-based programs and policies, in-cluding Medicaid, do not adjust for geographic differences in the cost of living. One approach to dealing with the problem would be to define the income level at which the penalty would apply statewide based on the cost of coverage in the most expensive area of the state. That would have the effect of exempting some households in less expensive areas who could afford coverage, of course, but imprecision of some sort seems inevitable.

Could there be some people whose income makes them subject to the penalty but from whom coverage would still be unaffordable—for example, a household that includes someone who has a costly medical condition? Most high-income people are likely to be employed and to have ac-cess to employer-sponsored health insurance. This means that even if they have a serious health

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condition, they are likely to be able to get coverage at rates not greatly higher than those available to the average employed person. But some high-risk, high-income people may not have access to an employer-based plan and would thus need to buy coverage in the individual market. They could face very high premiums, since risk-rating is not constrained by law in the individual mar-ket. However, most such people should be able to get coverage through the state’s high-risk pool, the Maryland Health Insurance Plan, at rates that would generally be affordable for higher-income people. Residents are eligible for this coverage if they have no other coverage and if, be-cause of a health condition, “the premium rate [of coverage offered them in the individual mar-ket] exceeds the MHIP premium for similar coverage….10” First operational in mid-2003, MHIP is

unlike most high-risk pools in that any eligible individual can enroll, without the need to spend time on a waiting list until a slot opens. (This may change over time.) Of course, even with this source of coverage, there might be some situations where coverage would still be unafford-able—for example, if there were several people in a family that all had to get coverage through the high-risk pool. To accommodate such unusual hardship cases or other situations such as re-ligious beliefs, it would probably be desirable to have a waiver process available.11

3. How large does the penalty have to be to achieve high take-up rates?

In addressing the relationship between the size of the tax penalty and the likelihood that a taxpayer will choose to purchase coverage, it is useful to recognize that the effect of the tax pen-alty should be much like that of a tax credit. If a taxpayer has a choice between paying a penpen-alty of $500 or buying insurance that costs $3,000, the net cost of coverage is just $2,500: the taxpayer saves $500 (no penalty) by spending $3,000. The effect should be very similar to offering someone a credit of $500, which also lowers to the net cost of a $3,000 policy to $2,500. Thus in assessing the effects of tax penalties on take-up rates, it is appropriate to use the research evidence about people’s reactions to subsidies as a way of gauging how people might respond. Of course, in terms of the psychological effect, a tax penalty may not influence behavior in precisely the same way as a tax credit, even if the financial consequence is the same.

Economic research has generally concluded that in making decisions to purchase health in-surance, people are quite insensitive to price changes. In the jargon of economics, the elasticity of demand is low, which means that it would take a large reduction in the net price of coverage to induce many additional people to buy it. A reduction in insurance cost of, say, 10 percent would likely cause less than a 10 percent increase in the amount of insurance purchased, perhaps more like 5 percent or less. The lesson is that small tax credits or small tax penalties, at least in terms of their effect on economic decisions, are not likely to induce many people to newly acquire cover-age.12 However, a legal requirement to acquire coverage may, by itself, influence behavior

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To gauge the strength of the penalty as an incentive to buy coverage, it is instructive to see what penalties would apply to different family structures. As shown in the table below, a single person earning $60,000 in 2004 in Maryland would pay income tax of $2,589 (assuming he or she took the standard deduction and had no dependents). If that person were to lose the tax benefit of the exemption and the standard deduction, the person would pay tax of $2,798, an increase of $209. A family of four with husband and wife filing jointly and earning $60,000 annually would normally pay a tax of $2,152. Losing the tax benefit of the exclusions and the deductions would cause them to incur a penalty of $646. People who would normally itemize deductions but be-cause of the penalty would be unable to do so would incur a greater tax penalty; but even then, they would lose only $47.50 for every $1,000 of deductions.

Tax Loss from Loss of Personal Exemption and Standard Deduction

Tax with Coverage Tax Without Coverage* Tax Increase Single tax filer, $60,000 income $2,589 $2,798 $209 Family of 4, $60,000 income $2,152 $2,798 $646

*Assumes loss of personal and dependent tax exemption and standard deduction.

This approach, though simple and easy to administer, involves something of an inequity: at a given income level, the penalty is higher for families with more members. On the other hand, any family can avoid the penalty for any member by acquiring coverage for that person.

It is useful to compare these penalties to the price of coverage. In 2002 for Maryland private-sector establishments offering coverage, the average premium for single coverage was $3,164, and for family coverage was $8,808.13 Of course, uninsured people who have chosen to decline

coverage offered by their employer could typically buy coverage for a much lower net cost than these figures, since employers typically pay a substantial portion of the premium, though often less for dependent coverage. Coverage in the individual market is likely to be more expensive, unless the purchaser chooses a plan with substantially less coverage than is typical of employer-sponsored insurance. While the loss of the tax benefits would induce some people who were just on the margin of buying coverage to go ahead with the purchase, tax penalties as small as those in the examples above would probably not, by themselves, cause many people to decide to newly buy coverage. For example, the penalty of $646 cited above for a family of four represents only 7.3 percent of the $8,808 average cost of employer-sponsored family coverage. For a single indi-vidual the comparable figure is only 6.6 percent. If we assume that people pay the full cost of coverage and that the elasticity of demand estimates citied above apply, perhaps about 3 percent to 4 percent of higher-income uninsured people would respond by acquiring coverage. If these

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people could purchase coverage at work to which their employer contributes a significant amount, the take-up rate would be substantially higher.

Even if the size of the penalty is small relative to the cost of coverage, the requirement to pur-chase coverage may still be effective. The mere existence of the law requiring people above some income threshold to buy coverage could be an important reason for people to obey the law. While the inclusion of the tax penalty would be necessary to demonstrate the state’s serious intent, the penalty itself (unless it were quite sizable) would probably not be the main reason most people comply with the law. In general, people obey most laws because they believe that is the right thing to do. In addition, since many people may not have any real idea of how much exemptions and deductions save them, they may overestimate the effect of the penalty and purchase insur-ance to avoid the penalty. But people who are disinclined to obey the law and who calculate the size of the penalties may be just as disinclined with the penalties in place, because the penalties are so small compared to the price of coverage.

If the state wishes to ensure that there is a serious financial consequence for failing to buy coverage, it will probably have to put in place a penalty that goes well beyond denying the tax relief of the standard tax exemption and deduction provisions. A penalty that represents some substantial portion of the typical cost of buying insurance—for example, 30 percent or more—would probably be significantly more effective. One option to consider before taking this stronger approach would be to impose more modest penalties at first and see what the reaction is. If the number of people conforming to the law is insufficient, the penalty could be gradually increased. In fact, it might be advisable to put the requirement to buy coverage in place for one or two years with no penalty to give people time to understand the law. The calculation of the pen-alty would be evident on the tax return, even though the penpen-alty would be waived in the first year or two. People would see that in subsequent years they would pay a penalty if they did not conform to the law’s requirement. Policymakers could also begin with a small penalty that is scheduled to grow substantially over time, as the population becomes more familiar with the new tax rule.

4. Should incentives be targeted to individuals or to families as a whole?

If the objective of the tax incentive policy is to maximize the number of insured people, as it presumably is, the penalties should be linked with the number of people in the family who are uninsured. If the penalty is loss of the ability to claim the standard exemption, the dependent de-duction, and standard or itemized deductions, the solution is straightforward: the tax payer would lose the exemption for each adult not covered and the dependent deduction for each child not covered, and the ability to claim the standard or itemized deduction would be reduced in proportion to the number of family members not covered. Although such a policy would be

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con-ceptually sound, as noted above, even total loss of ability to take advantage of the tax relief provi-sions represents a very small penalty; so loss of just a portion of the tax relief would provide an even weaker incentive to acquire health insurance coverage.

If the potential penalty were larger and not tied to tax relief, a possibility also discussed above, the penalty could be reduced in proportion to the number of people in the family who have coverage.

5. Should the requirement/eligibility be linked to a minimum benefit package?

There are several reasons to support the position that the mandate should not require a mini-mum benefit package. First, any standard health insurance sold in the state already has to con-form to standards of the Maryland Insurance Administration. Thus a plan that meets the defini-tion of a Health Benefits Plan under Secdefini-tion 15-1301 of the Maryland Insurance Article is accept-able coverage for the population in general, so it should be acceptaccept-able for those subject to the mandate. (For example, disease-specific coverage or long-term care insurance would not be ac-ceptable health insurance under this definition.) Second, if there is any group of people for whom a “bare bones” catastrophic benefit package makes sense, it is higher-income people. They have less need than lower-income people for protection against relatively small expenses associated with routine care, as they can pay for such care out of pocket. They do need protection against very high expenses associated with a catastrophic injury or illness. Third, enforcement would be more difficult and the administrative costs would be substantially higher if the mandate included provisions requiring certain minimum benefits. Someone in state government would have to re-view the coverage for each taxpayer to make sure it met the requirement. (How people will show proof of coverage is an issue that is discussed next.)

6. How would taxpayers show proof of coverage? What administrative burdens and compli-cations would be created for employers and insurers?

Ideally, taxpayers would show proof of coverage by including with their tax returns a form from their insurers that showed which family members were covered for which months of the year. For someone who was covered by an employer’s self-insured plan, the employer would provide such information. Of course, insurers, health plans, and employers are not now required to supply such information to the people they insure, and it would not be a trivial matter for them to do so. In effect, the state would have to require both insurers and self-insured employers to provide such a form. They would likely oppose such a requirement, especially since only a portion of the population would need to show such proof.

If it proved impractical to require insurers to provide enrollees with proof of coverage, an-other way to handle this issue would be simply to allow tax filers to declare on their tax returns

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whether they and family members were insured during the year. It would, of course, be illegal to give false information on this as on other issues on the tax return, and the taxpayers’ response would be subject to audit. Under this approach, documentation would be required only in case of audit.

Alternatively, documentation of insurance status could be required to accompany the annual income tax form. Taxpayers could show that premium payments had been deducted from their pay stubs, provide copies of cancelled checks if they paid on their own, or provide copies of health insurance cards, invoices from insurers indicating prior premium payments, or other in-surer forms indicating coverage (such as, “evidence of benefits” forms). This approach becomes more problematic if people have to reveal the precise months during which any family member did not have coverage. People will often forget or may not even know the exact periods of time during which some family member lacked insurance. If this approach to proof of coverage were adopted, it might be necessary to have a simpler reporting requirement. Instead of requiring proof of coverage for every month and invoking a penalty for each month without coverage, it might be advisable to simply require confirmation that no one in the family was without coage for longer than, say, three months out of the year. That would be easier for taxpayers to ver-ify and report with some degree of accuracy and without encouraging people to “stretch” the truth.

7. How should the requirement apply to people who lose coverage during the year because of a job loss or other major changes in their personal circumstances?

Even high-income people, if they suffer a job loss, may find it hard to pay for coverage. Many people in such circumstances have difficulty paying their ongoing obligations during the period without income, even if their annual income for the year exceeds the cut-off point. One simple way to address this issue would be to specify that if an adult in the family is terminated from a job and is without employment, the family would not be expected to have coverage during the period of unemployment. Another approach would be to stipulate that if a wage earner is unem-ployed for some specified period, perhaps four weeks or more, the requirement for coverage would be waived for the year for the household. After all, the purpose of this policy is to encour-age people to get coverencour-age, not to enforce the requirement at all costs. Most people who become unemployed will maintain coverage if they can afford to do so—by taking advantage of COBRA, getting coverage under a spouse’s plan, etc.14

8. How should money raised from the penalty be allocated?

One major justification for collecting penalties is to provide strong incentives for higher-income people to pay their fair share of the costs when uninsured people in this higher-income group

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in-cur catastrophic costs that get shifted to the safety-net system or to other insured people. This logic leads to the conclusion that after covering any administrative costs (including the cost of audits), it would be appropriate to allocate the revenues collected from the penalty revenues to cover what the state must spend to cover uncompensated care. A related use would dedicate these revenues to coverage programs for the uninsured. Another alternative would be to allocate the monies to the uncompensated hospital care fund, based on the logic that this fund pays for care for people who fail to buy insurance. (The amount of revenues needed to support uncom-pensated hospital care should automatically decline as more higher-income people buy coverage in response to the new requirement; they will not incur costs that become uncompensated care. These savings would be passed on to all payers in the form of lower hospital rates.) Although the logic is perhaps less compelling, another option would be to simply use the funds to finance other state health-related costs or to offset the revenue losses resulting from tax credits made available to low-income uninsured people.

However, since funds are fungible, it may be that simply allocating revenue to the general fund may not, in practice, be very different from the other two approaches. Appropriations are made separately from an accounting of particular revenue sources. So if the legislature decides to appropriate a certain amount to the safety-net system or other programs for the uninsured, the decision is likely to be made on the basis of their judgment about the appropriate total allocation. If there is a set-aside revenue source, the legislature may simply reduce the amount of other funds available to make the total match with their judgment about what is the appropriate total funding. To address this concern, policymakers could add a maintenance-of-effort requirement to prevent these new revenues from substituting for previously available state dollars that sup-ported health coverage programs.

Assessment

As far as we know, no state has adopted a tax penalty to encourage purchase of health cover-age. If Maryland passed legislation to establish tax penalties, it would be plowing new ground. Is the experiment worth undertaking? Would it cause substantial numbers of higher-income people who are now uninsured to buy coverage?

Our inclination is to encourage the experiment, on the grounds that the policy appears rea-sonable, has long been recommended in general form by respected health analysts, and would provide useful information to guide other states as well as national policymakers. It would be important to accompany implementation with rigorous and independent evaluation, so that that state could be confident of the lessons learned and would be in a position to share them with oth-ers.

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The tax penalty incentive may have a significant incremental impact on insurance levels. If we assume uninsured people who can afford coverage have made a conscious decision to not ac-quire coverage, many might continue to forego coverage if they were acting entirely as rational consumers and the penalty is small relative to the cost of coverage, as it would be if the penalty is loss of tax exemptions and deductions. On the other hand, many people who are uninsured have probably not made a conscious choice to not buy coverage. Instead, they have simply neglected to do so, not gotten around to it, or not given it much thought. Passage of the law and the conse-quent recognition that they will have to pay a tax penalty if they do not buy coverage may be suf-ficient to cause many of them to overcome such inertia. Many others may be just on the margin of buying, so that the prospect of facing a tax penalty, even if small, would push them to buy cover-age.

The very presence of a state tax penalty law would also be a strong statement of commitment to the proposition that everyone should have coverage and that people who can afford coverage must assume personal responsibility for their medical expenses. Just having such a law on the books, apart from the penalty, might be sufficient to cause many higher-income uninsured peo-ple to take the step to acquire coverage. Most peopeo-ple obey laws most of the time.

Of course, passing such legislation would require making a number of decisions regarding who would be targeted, how large the penalty would be, what waivers might be granted under particular circumstances, how violators would be detected, etc. Because there is virtually no ex-perience with this approach, there is some uncertainty about how these decisions would play out. But the unintended, undesirable consequences are not likely to be major. Apart from the question of political acceptability, the downside risk seems small. Even if the law is not very effective in reducing the number of uninsured, it will raise revenue that can be spent to address the problem in other ways.

Recommendations

We recommend that the state of Maryland adopt a tax penalty for high-income people who fail to purchase health insurance coverage. We suggest the following features:*

1. The penalty would apply to any household with federal adjusted gross income in excess of 400 percent of the federal poverty level.

In the first two years after the law goes into effect, the penalty would be calculated on the state income tax forms, but the penalty would be waived. The penalty would be imposed in the third and subsequent years.

*ESRI’s original recommendations were revised after consultation with the Maryland Health Care Coverage

Workgroup. However, no endorsement by the Workgroup or individual members of the Workgroup should be inferred.

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— Rationale. A threshold that varies with family size and is adjusted for inflation—as is the case with the federal poverty level—is more equitable than a threshold that is a single dollar figure. The difficulty with such a threshold is that it is harder for people to under-stand whether they are subject to it, since it varies with family size. Thus it is appropriate to provide a waiver of the penalty in the first two years: once people have seen, after filling out their tax forms, that they are subject to the penalty, they will understand that in subsequent years they will be required to have coverage. The two year waiver reflects the fact that many people do not fill out their tax forms until April of the next year, at which point, if they did not have coverage, they would already be subject to the penalty for the current year.

2. The penalty for each household subject to the penalty would be 30 percent of the average cost that a household of that size would have to pay for coverage in Maryland. The penalty would be reduced in proportion to the number of household members who are covered.

— Rationale. Although denial of the right to claim the standard deduction and exemptions is often suggested as the penalty for failure to buy, our judgment is that this may not be sufficient to induce enough people to buy coverage. We suggest 30 percent of the average cost of coverage because that is approximately the proportion of total premiums contrib-uted by employees enrolled in family coverage at private-sector establishments in Mary-land in 2002.15 For families that have access to employer-based coverage, the penalty

would be roughly equal to the cost they would incur by taking up the employer offer of coverage, which would provide a strong incentive to get coverage. (The average cost of family coverage was $8,809 in Maryland in 2002,16 so the average penalty would have

been $2,643.)

3. A family member would be considered uninsured if she or he is without coverage for a pe-riod of three months or more during the tax year.

— Rationale. Because it is extremely common for people to be without coverage for brief pe-riods during life transitions, such as marriage, divorce, change of jobs, moving to a new area, etc., it seems unfair to impose a major penalty if a family member is without cover-age for a brief period.

4. Coverage would count as acceptable coverage if it meets the definition of a Health Bene-fits Plan under Section 15-1301 of the Maryland Insurance Article.

— Rationale. Requiring that coverage meet any benefits specifications beyond what is al-ready in law would immensely increase the enforcement burden.

5. A family could demonstrate that they have coverage by signing an affidavit on their tax re-turn indicating that all family members are insured and indicating the source of coverage. Proof of coverage would be required in the case of an audit.

— Rationale. This is proposed because it is simple and does not require insurers to prepare new forms to distribute showing proof of coverage. The prospect of having to show proof in case of audit should help to ensure truthful responses.

6. The requirement would be waived if a principal wage earner in the family loses employ-ment and is subsequently unemployed for a period of four or more weeks during the year.

— Rationale. The provision is to ensure that families that lose substantial income are not re-quired to undergo a hardship to meet this requirement. It is especially appropriate since loss of employment often triggers loss of insurance.

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7. State revenue collected as a result of payment of penalties should be dedicated to assisting those who remain uninsured and/or should be allocated to the hospital uncompensated care fund to reduce hospital rates.

— Rationale. Since higher-income people represent a minority of uninsured people in the state, a policy that addresses only them leaves most of the problem unsolved. Using the penalty revenues to aid people for whom coverage is unaffordable represents a more balanced approach to addressing the problem of the uninsured. Alternatively, dedicating some of the money to offset the costs of paying for uncompensated care recognizes that all who pay for hospital care bear the burden of covering uncompensated hospital bills, part of which is incurred because higher-income people who lack insurance contribute to uncompensated care costs.

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NOTES

1 Medical Expenditure Panel Survey, Agency for Healthcare Research and Quality, www.meps.ahrq.gov/ 2 Medical Expenditure Panel Survey.

3 In Maryland the issue is not very significant because the Maryland income tax is only very slightly

gradu-ated: the tax rate is 2 percent on the first $1,000 of Maryland taxable income, 3 percent on the second $1,000, 4 percent on the third $1,000, and 4.75 percent thereafter.

4 Federal Register, Vol. 69, No. 30, February 13, 2004, pp. 7336-7338.

http://aspe.hhs.gov/poverty/04poverty.shtm.

5 Institute of Medicine, Coverage Matters: Insurance and Health Care, Washington, D.C.: National Academy

Press, 2001; Institute of Medicine, Care Without Coverage: Too Little, Too Late, Washington, D.C.: National Academy Press, 2002.

6 In Maryland, children under 300% of the federal poverty level are eligible for public health care coverage,

so the universe of children not eligible for reasonably priced insurance consists primarily of children from families with moderate and high incomes. These are the very groups that would be targeted by tax penal-ties.

7 Institute of Medicine, A Shared Destiny: Community Effects of Uninsurance. 2003. Institute of Medicine, Hid-den Costs, Value Lost: Uninsurance in America. 2003.

8 If policymakers had a more limited focus and simply wished to ensure that all children received coverage,

parents could be mandated to cover their children without any requirement to cover themselves. However, that would not address the other interpersonal effects noted in this section of the paper.

9 Another approach, halfway between the alternatives discussed, would provide limited variation of

eligi-bility thresholds based on family composition. For example, income-eligieligi-bility for the Earned Income Tax Credit (EITC) varies as follows, according to the IRS: “To qualify for the credit, both the earned income and the adjusted gross income for 2003 must be less than $29,666 for a taxpayer with one qualifying child ($30,666 for married filing jointly), $33,692 for a taxpayer with more than one qualifying child ($34,692 for married filing jointly), and $11,230 for a taxpayer with no qualifying children ($12,230 for married filing jointly).”9 Policymakers seeking to follow a similar approach here could provide, for example, that the tax

penalty applies to uninsured households with adjusted gross income at least twice maximum levels for EITC for a household of the applicable configuration. However, a number of EITC experts believe that a major weakness of the program is that it does not adjust to families of larger sizes, which is not a problem for rules based on the poverty level. See Robert Greenstein, “Should EITC Benefits Be Enlarged for Families with Three or More Children?,” Center on Budget and Policy Priorities, revised July 10, 2001.

10 Quoted from the enrollment form for the Maryland Health Insurance Plan.

11 One possible approach would be to waive the requirement if the cost of coverage would be more than

some percentage of total family income, for example, 10 percent. (This 10 percent figure has some precedent, since premiums for the standard benefit plan in the small-group market are not to exceed 10 percent of the state average wage.) If it were felt desirable to take into account family size, the percentage could be applied to just the portion of family income that exceeds the poverty level income for each family. This approach is based on the idea that only after family income rises above a certain level is there any discretionary income from which a household could reasonably be asked to pay for coverage. For example, a family could be ex-empted if the cost of coverage exceeded 15 percent of the portion of total family income that exceeded the poverty level income level for a family of their size To illustrate, the poverty level income for a family of two in 2004 is about $12,500. Assume a two-person family has income of $32,500 and coverage would cost them $3,500. The difference between their income and the poverty level is $20,000, and 15 percent of $20,000 is $3,000. Since the cost of coverage is above $3,000, this family would not be penalized if they failed to get health coverage.

12 It is worth noting that the elasticity estimates generally apply to the population as a whole. In this context,

we are concerned with high-income people, and it is possible that they are more or less sensitive to price changes than the population in general. One would expect that higher-income people would be less sensi-tive to price changes than lower-income people because the price change is a smaller percentage of their to-tal purchasing capacity and because they have more discretionary income.

13 Medical Expenditure Panel Survey.

14 To reduce the ability of workers to “game” the system, receipt of unemployment insurance could be the

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15 Medical Expenditure Panel Survey.

References

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