Is the Cadillac Tax Pigovian?

It seems plausible that most people think health is good, both at the individual and population level. Healthy people are happier, more productive, and more self-sufficient. Good population health obviates public expenditure battling outbreak of disease. Thus, good health is good economics. That is, health has positive externalities. It has social value beyond that which is paid for by and conferred upon the individual.

Economist Arthur Pigou (1877–1959) is credited as the first in the profession to recognize the significance of the difference between private and social value of a good or service. When externalities are (social value is) positive, decreasing the private cost can increase overall welfare. Therefore, decreasing individuals’ cost of health would seem to be welfare enhancing. In contrast, when externalities are negative (think pollution from manufacturing processes), welfare might increase if private costs rise (think carbon tax).

Enter Pigovian taxes or subsidies, named in honor Pigou. A Pigovian tax (subsidy) changes the private cost so that individuals pay (are compensated) for the social cost (benefit). The notion of using the tax system to transfer costs (benefits) of externalites to individuals (also called “internalizing externalities”) is supported by many economists, policymakers, and pundits from across the political spectrum. Many are members of the Pigou Club. Naturally, Pigovian taxes are not universally embraced, and there is also a NoPigou Club.

Given a constant level of taxation, a Pigovian tax system makes sense to me. After all, every tax changes behavior. Holding the overall tax level constant, it is hard to see why it might be undesirable (aside from self-interest) to use taxes to internalize more of the social cost of private behavior. So, count me as a member of the Pigou Club.

Let’s return to health care and health insurance. Under current law, employer contributions to health insurance avoid income and payroll taxation (employee contributions to certain types of plans are also tax exempt). Relative to wages, which are taxed, this is considered a tax subsidy. That’s akin to a Pigovian subsidy for insurance relative to wage and is what one would naively think reasonable given the positive externalities of health. Though if it is reasonable on those grounds why isn’t the tax benefit extended to all types health insurance?

But, health insurance is not health. Nor are health care services. Each may contribute to health but far from efficiently. There are a lot of gears and pulleys between health insurance and health. They don’t run frictionlessly. Not all the ones we pay for connect to health at all. And some of the right levers on health (like good nutrition and exercise) are outside the reach of most health insurance plans. Health insurance is generally poorly designed to promote good health without a lot of waste. (That’s not an argument against insurance. That’s an argument for changing the incentives within the health care system, of which insurance is a part.)

This leads to the question, if the employer based insurance tax subsidy is not a Pigovian one with respect to health, is the Cadillac tax a Pigovian one with respect to insurance? It can only be so if its effect is to cause individuals to internalize some negative externality. What negative externality does tax preferred employer based insurance impose on society?

I confess I can’t think of a slam dunk negative externality. However, it is the case that the relatively rich benefits of tax subsidized employer based insurance promote a climate of excess, unnecessary care and an expectation of access to the latest technology, which in some cases may cost more than the value it provides. In doing so, employer based insurance likely influences medical practice with some spillover effects on Medicare and Medicaid, which are largely taxpayer funded. The cost of overuse of unnecessary care in those programs might be viewed, at least in part, as a negative externality of comprehensive employer based coverage. From this point of view, the Cadillac tax can be seen as a Pigovian one, designed to push some of the social cost of relatively rich coverage back on the individuals who purchase it.

Even if one disagrees with my example of an externality and that the Cadillac tax is Pigovian, there’s reason to support it on other grounds. Reduction of the incentive for provision of economically inefficient services would be one. Equity, considering the size of the uninsured population, would be another. (Aside: I’m not going to rehash all the ways in which the Cadillac tax is poorly designed and could be better. See my prior posts on it for that.)

What is clear is that a Pigovian subsidy on health would make a degree of sense. But it can’t be easily achieved via a subsidy on health insurance for working individuals. There’s just too much play in the connection between insurance and health. If Pigou had a vision for health his gaze probably didn’t settle on taxes or subsidies for employer based insurance. It did, however, focus favorably on the individual mandate.

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