U.S. Tax Policy and Health Insurance Demand: Can a Regressive Policy Improve Welfare?

Karsten Jeske and Sagiri Kitao
Working Paper 2007-13
July 2007

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The U.S. tax policy on health insurance is regressive because it favors only those offered group insurance through their employers, who tend to have a relatively high income. Moreover, the subsidy takes the form of deductions from the progressive income tax system, giving high-income earners a larger subsidy. To understand the effects of the policy, we construct a dynamic general equilibrium model with heterogenous agents and an endogenous demand for health insurance. We use the Medical Expenditure Panel Survey to calibrate the process for income, health expenditures, and health insurance offer status through employers and succeed in matching the pattern of insurance demand as observed in the data. We find that despite the regressiveness of the current policy, a complete removal of the subsidy would result in a partial collapse of the group insurance market, a significant reduction in the insurance coverage, and a reduction in welfare coverage. There is, however, room for raising the coverage and significantly improving welfare by extending a refundable credit to the individual insurance market.

JEL classification: E21, E62, I10

Key words: health insurance, risk sharing, tax policy, adverse selection

The authors thank Thomas Sargent, Gianluca Violante, and seminar participants at the Atlanta Fed, the Chicago Fed, Columbia Business School, Duke University, the European Central Bank, the German Macro Workshop, the University of Illinois at Urbana-Champaign, the University of Michigan, the University of Maryland, New York University, New York University’s Stern School of Business, the University of Pennsylvania, the 2006 Society for Economic Dynamics meetings, the University of Tokyo, the University of Southern California’s Marshall School of Business, and the University of Western Ontario for helpful comments. They also thank Katie Hsieh for research assistance. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.

Please address questions regarding content to Karsten Jeske, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, GA 30309-4470, 404-498-8825, jeske100@gmail.com, or Sagiri Kitao, Department of Economics, New York University, 19 West Fourth Street, New York, NY 10012, 212-998-8900, sagiri.kitao@gmail.com.

For further information, contact the Public Affairs Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309-4470, 404-498-8020.