fb tracking

Health Reform

Where Will the Money Come From?

November 2009

Public Citizen Health Letter

As different health reform bills wend their way through assorted congressional committees, policy-makers of every ilk are looking into possible sources of monies. Ideally, the mechanisms used to finance the health care system should meet the following criteria:

  1. Collectively, they should be sufficient to cover costs for the foreseeable future. Strategies that yield one-time savings may make the package more politically attractive, but cannot be relied upon as a continuing source of support if the system is to be sustainable.
  2. They should follow principles of basic justice, those with greater incomes contributing proportionately more than those with lesser resources. This means that the financing should be progressive rather than regressive. It would then have a redistributive effect, narrowing the prevailing income inequalities that have widened over time.
  3. They should encourage efficient and effective delivery of care.
  4. They should promote appropriate health-seeking behaviors. This means avoiding noxious practices and encouraging prevention and prompt care.

There are several options, but none is able to meet all the above requirements. In addition, each one affects different groups in various ways. This differential impact on key stakeholders means that there will always be winners and losers. Many interests have therefore mobilized to insure that they will not bear the brunt of paying for care. These are therefore intent on defeating any measure that is not kind to their particular interests. Not surprisingly, many of the discussions to date are more memorable for their level of decibels than for the clarity and quality of the dialogue.

The possible sources of funds are finite. We therefore summarize what some of the possibilities are, as well as what they mean for different groups and for health reform in general.


This is the most easily-understood source of funds, involving people paying out-of-pocket for the care they get. This usually takes the form of co-payments or deductibles.

Those who advocate the use of cost-sharing argue that it promotes responsible consumption of health care: because individuals see the connection between what they pay and what they get, they avoid over-utilizing services. “Cost consciousness” is also seen as a way for people to value the health care services they receive.

There is no evidence, however, that the medical market necessarily promotes desirable health behaviors. While it is true that cost-sharing tends to constrain consumption, patients often lack a way to distinguish essential from unnecessary care. When RAND did an experiment on this topic in the early 1970s, the researchers found that cost-sharing reduced the use of both highly effective and less effective services in roughly equal proportions. While cost-sharing had no adverse effects on participant health overall, free care led to improvements in the areas of hypertension, dental health, vision, and selected serious symptoms, particularly among sicker, poorer patients. Extrapolating the findings of this study to the current health reform debate, RAND researchers indicate that cost-sharing should be minimal of nonexistent for the poor, especially those with chronic disease.

Cost-sharing is regressive in its effect: its burden is heavier for those with low incomes who have limited resources and tend to have greater health needs. A standard co-pay (say, $10 a visit) that may seem marginal to a middle-income person may be a major barrier to someone who is poor and/or needs a lot of care.

Taxing health insurance benefits to pay for extending coverage

This measure is one of the most hotly debated strategies. It emerged as a contentious issue during the presidential campaign, with McCain suggesting it as a way to raise revenues and Obama opposing it. But both the broader political discussion and the estimated price tag for enhanced coverage have re-opened the topic, and taxing benefits has not been discarded as a possibility.

At present, employers’ contributions to employee health benefits are treated as tax-free to both employers and employees. This benefit represents a major source of foregone revenue to the government; indeed, it is estimated by the joint Congressional committee on taxation that in 2008 alone the government gave up $226 billion as result of the tax exemption. And this figure is expected to reach $300 billion by 2012, which is more than would be needed to cover everyone’s health care.

Like many features of our quirky health care system, this tax break has a unique history. It came about in 1943, when wage controls were in effect. Because employers could not attract workers on the basis of higher salaries, they relied on benefits as a way to retain their competitive advantage in recruiting labor. Circumstances changed, and the labor market changed with it. Nevertheless, in 1954 the Internal Revenue Act exempted employee benefits (e.g., pensions, health care) from income taxes. Once embedded in the tax code, the exemption was difficult to eliminate or even modify: entrepreneurs factored it into their business plans, workers expected it, and unions have fought hard to retain it.

Most economists agree that the tax exemption is regressive: avoiding taxes is worth more in absolute dollars to those with higher salaries that have higher marginal income tax rates. In addition, those with higher wages are more likely to get health insurance benefits through their employers and are therefore more likely to benefit from the tax break.

Backing down from their original opposition to phasing out the tax exemption, some are advocating that the exemption not be eliminated altogether, but rather capped. This is similar to a 2005 proposal that called for limiting the tax exclusion for health benefits to $5000 for individual coverage and to $11,500 for family coverage. More expensive policies would be taxed for the amount exceeding the cap (see “Taxing Cadillac plans” below). The rationale for this is that it would encourage both employers and employees to choose lower-priced policies; correct some of the regressive effects of the tax exemption; and allow the government to recoup some of the revenues that it now foregoes. At the same time, any cap could lead employers to lower their contributions to match the cap level, limit the scope of benefits, and/or increase cost-sharing, all of which may have negative societal effects. The full effects of this measure would greatly depend on the cap levels and how much of the bill they are likely to cover. Also unknown is how insurers would react to the cap.

Another question mark concerns the effect of the tax reform on technological innovation. The U.S. justifiably prides itself in being a leader in the area of research and development (R&D) in health care, and some economists have argued that even the threat of cost-containment related to tax reform could dampen efforts to develop new technologies: manufacturers could shift their investments from health care technologies to innovations in non-health fields, and thus affect the types of R&D undertaken.

The viability of this measure is fraught with political uncertainty because of the many interests involved. Moreover, inertia is important in decision-making, with many stakeholders fearing anything that may change their current position and profitability. But the option of taxing health benefits cannot be dismissed because it represents the most significant potential source of revenues to provide universal health care for the U.S. population.

Taxing ‘Cadillac’ plans

During the presidential campaign John McCain proposed taxing high-end insurance plans as a way to raise revenues for health care. One rationale for this is that it would have a redistributive effect, taking money from the “over-insured” to enable those of modest means to afford insurance. In addition, the measure could slow the rate of growth of health insurance and health care costs by discouraging insurers from offering (and employers from purchasing) extremely generous coverage that encourages excessive health care utilization.

The proposed tax would be applied only to premiums payments above a given threshold, which ranges between $8,000 and $10,000 for an individual and $21,000 to $25,000 for a family policy.

Referring to these more-generous policies as “Cadillac” plans suggests that they are excessive and include “frills” such as massages and cosmetic treatments. While such plans exist, they are very rare. Goldman Sachs executives had a plan with family premiums of $40,453; these covered expensive, seldom-used procedures, including sex reassignment surgery. More often, the higher-priced plans include a broader array of more often-used health services, such as prescriptions and vision and dental care. They also have low or no co-payments and deductibles. And it is not a select group of “fat cats” that tend to have these plans, but union members who have forgone wage increases in exchange for more generous medical benefits. Interestingly, both unions and the U.S. Chamber of Commerce are strongly against the tax on these benefits. Their cause has been championed by Sen. Jay Rockefeller, who argues that the miners he represents are high-risk and therefore need the broadest possible coverage.

Taxing health-related industries

This mechanism, included in the proposal submitted by the Senate Finance Committee, would impose a 10-year fee on certain drugs and medical devices. The pharmaceutical industry would pay $2.3 billion per year, while medical device manufacturers would pay $4 billion. The rationale for this is that both industries stand to benefit from health reform, which would increase the market for their products. The fees would be apportioned by a company’s market share, with those with the most business paying the highest fees. The pharmaceutical industry currently has a high profit margin, and has been relatively acquiescent concerning the imposed fees. Device manufacturers, however, have protested the measure. To a large extent, the effect on these industries will depend on whether or not they can pass on these increases to consumers, and on whether or not buyers can leverage their purchasing power to press for lower prices.

“Sin” taxes

Taxing products that are hazardous to health is a hardy perennial in all discussions of revenue sources. Over 230 years ago, Adam Smith, father of economics, wrote the following in his famous opus, The Wealth of Nations (1776): “Sugar, rum, and tobacco are commodities which are nowhere necessaries of life… and which are therefore extremely proper subjects of taxation.” The idea of “sin” taxes therefore has a long history, although its rationale and targets have changed over time. While Adam Smith stressed the fact that the targeted commodities were “frills,” current proponents of “sin” taxes argue that these are activities or products that cause damage and inflict costs, and should therefore be discouraged or penalized in some way. These taxes are therefore seen as a way to reduce the objectionable behavior.

Because of the connection between smoking and health, cigarettes are currently taxed. Both the anti-smoking lobby and public health advocates tend to favor a further tax increase on tobacco products, and devoting these revenues to health expenses, including smoking-prevention measures. Because the consumption of tobacco products is sensitive to price, the tobacco tax is therefore seen as a “two-fer”: it would raise revenues while also curtailing tobacco use. In addition, it would enhance overall health status by reducing the number 1 cause of preventable death in the U.S.

Two researchers and health practitioners, Yale professor Dr. Kelly Brownell and Dr. Thomas Frieden, director of the Centers for Disease Control and Prevention (CDC), have argued for a soda tax as a way to help pay for expanded health insurance. This would apply to sugar-sweetened beverages, the idea being to reduce obesity, which is associated with several chronic diseases. The targets would include Coke, Pepsi, Gatorade and Red Bull, among other beverages. Proponents of the soda tax point out that the average person now consumes 190 calories a day from sugary drinks, up from 70 calories 30 years ago. Moreover, as Brownell has indicated, of all foods and beverages, “the science is most robust and most convincing on the link between soft drinks and negative health outcomes.” While this alone does not account for the rise in obesity, it does contribute to it. A soda tax would therefore promote healthier eating while contributing revenues that could be earmarked for health coverage.

Alcoholic beverages are also a likely target for additional taxes. These are already taxed, but alcohol taxes have fallen, relative to inflation, since the early 1990s. This is because alcohol taxes are based on volume rather than price. As a result, the tax does not automatically rise with the price of the product. Because Congress has adjusted liquor taxes only twice in the past 55 years, the tax on distilled spirits has shrunk by 84 percent since 1951. The Congressional Budget Office has calculated that setting alcohol taxes at a uniform $16 per proof gallon would raise $60 billion over 10 years. For the average drinker, this tax increase would represent a nickel-and-dime raise in the price of liquor: an additional 9 cents on a bottle of beer, 10 cents on a glass of wine.

While these taxes may seem eminently logical, they have a number of effects that lessen their attractiveness. First, such taxes are regressive: they affect those with lower incomes more than the affluent. In addition, to the extent that they reduce the “sinful” behavior (which is an explicit, desirable goal), they also reduce generated revenues. The government would therefore be facing a dwindling source of revenues, on which it would not be able to count over time. Moreover, these taxes place government in the anomalous situation of having two conflicting interests: desiring to curtail certain behaviors while reaping the financial benefits that accrue from those same behaviors. Finally, some libertarians object to any public “police” that would monitor what they eat, drink, and smoke. This latter argument, however, seems to overlook the fact that there already are a number of private interests that do just that, although their object is to promote rather than control the consumption of certain products.

Taxing flexible spending accounts

A flexible spending account (FSA) is an employer-sponsored benefit that allows employees to set aside a fixed amount of pre-tax wages for a particular purpose (in this case, health care). The money is deducted from the employee’s paycheck and is exempt from federal income taxes. There is an annual maximum that can be contributed for health care (e.g., $4000- $5000); this is set aside to cover health care expenses that are not covered by employer-sponsored insurance. As the beneficiary spends down from this total, he or she is reimbursed by the account. These reimbursements remain tax-free when they are paid out.

A holder of an FSA needs to calculate how much he or she expects to spend out-of-pocket and budget according. Because of the tax benefit that an FSA provides, the IRS has guidelines on how the money can be used and requires the beneficiary to forfeit any money that is not used in the course of the year. The plan is thus a “use or lose” proposition and may therefore stimulate overutilization of certain elective health services, especially at the end of the year. (Beneficiaries may therefore have an incentive to schedule elective services or stock up on eligible health supplies in order to spend down their allotted benefit.) Unused funds go into the plan and may be used to cover the plan’s administrative costs. The FSA covers expenses incurred for medical, dental and vision care. In some cases, proof of medical necessity may be required.

Taxing these benefits is likely to make FSAs a lot less attractive and will therefore reduce both the number of employers offering them and the employees opting for them. Revenues from this source will therefore tend to taper off over time.

VAT taxes

The VAT tax is an indirect tax applied to the value added to an item in each stage of its production, and functions much like the sales tax paid in the United States. It is used in 130 countries (including the European Union, Japan, and some South American countries) and varies between 5 and 25 percent. Canada and New Zealand have a variation on this tax: Canada assesses a 7 percent Goods and Services Tax (GST) on most goods and services provided in the country; New Zealand has a GST of 12.5 percent.

Supporters for the method of raising revenues like it because it would make every consumer a direct stakeholder in health care, since the VAT could be earmarked for health services. Presumably, this would make the resulting increase in goods and services more politically palatable and give everyone much-vaunted “skin in the game” in the delivery and payment of health care. Moreover, a VAT is flexible and has the potential to generate much revenue: it is estimated that a VAT of 10 percent would cover every American in a health plan with no deductibles and minimal co-payments.

But the VAT is highly regressive, affecting practically all prices and therefore making the “crunch” evident to all. And because wages are unlikely to increase at the same rate as the VAT, everyone except the very wealthy would feel poorer as a result. Retailers object to the tax because it would be costly to administer and potentially burdensome to businesses. In addition, they argue that this type of taxation would fuel inflation, discourage consumption, and dampen economic growth. The VAT is therefore a tough sell, and would have to be accompanied by other measures to offset its harshest effects.

As the table summarizing the potential sources of revenues indicates, there is no ideal way to achieve all the key objectives laid out at the beginning of this article. Moreover, the full impact of these measures depends on the level at which they are set, what services people receive in return, and how the link between the two is made. Any revenue-producing strategy will involve definite trade-offs, affect different persons in different ways, and have varying effects on the economy as a whole. As with all policy decisions, the key question is cui bono? – to whose benefit? Whatever strategies we use to pay for services should create a satisfactory health system, whose essence, in the words of Aneurin Bevan, “is that the rich and the poor are treated alike, that poverty is not a disability, and wealth is not advantaged.”

Comparison of Proposed Measures to Finance Health Reform


Proposed measure


Effect on Income Distribution

Impact on Delivery of Care

Effect on Health-seeking behavior

Other effects


Contingent on levels of co-pays, deductibles


Tends to curtail services; may increase administrative costs

Discourages prevention and early care unless some services are exempted

Increases cost-consciousness on part of consumer

Taxing health-insurance benefits

Could represent major source of funds


May lead employers to reduce contributions

Could lead to less comprehensive care

May dampen investment in technological innovation

Taxing ‘Cadillac’ plans

Revenues likely to dwindle as plans become less attractive


May reduce higher-end plans with comprehensive benefits; insurers would have incentive to offer lower-priced plans

Could lead to reduced benefits, and therefore to greater cost-sharing and lower utilization

May rein in costs if buyers shop around for lower-priced plans; could have differential impact on businesses with older employees or in higher-cost regions

Taxing health-related industries

Depends on level of tax, consumption of goods and services, and length of application


Likely to raise prices, decrease consumption

Would discourage use of products affected

May have inflationary effect on health care overall

‘Sin’ taxes

Revenues likely to taper off over time


No direct effect

Tends to discourage unhealthful behaviors

Seen as ‘policing’ of individual behaviors

Taxing FSAs

Revenues will decrease over time as fewer employers offer the option

Regressive now, so anything to curtail FSAs may be somewhat progressive

May reduce payments for providers who currently benefit

Will decrease consumption of elective services

Lower administrative costs


Potentially high, with much flexibility

Highly regressive

No direct effect

No direct effect

May link overall consumption and health care; may be cumbersome to administer