A few days ago, I tweeted the following: “So much of what’s wrong in American policy could be summarized this way: Stop using tax deductions and start using tax credits.”
As debate rages over President Obama’s proposal to tax capital gains in 529 savings accounts, health care has lessons for higher education, students, families, and our nation on this point. The message above is one of the most important lessons. The need for the lesson is clear even from what our Penn State students write, as the recent op-ed in The Daily Collegian showed.
Since World War II, health care operated under a system where health benefits were provided by employers, and both employers and employees received a tax deduction for those benefits. In other words, compensation paid to employees as health benefits, unlike compensation paid as wages or salaries, was effectively untaxed.
As a little Econ 102 will tell you, a tax advantage like that will skew compensation toward benefits and away from wages and salaries. Not surprisingly, over the the past 70 years, the share of compensation paid as benefits has steadily climbed. This highlights one of the negative consequences of tax deductions, and contributes to explaining why wages and salaries, especially for lower income workers, have stagnated.
But, the effects are even more pernicious. In our current federal income tax system, as we learned during the last Presidential campaign, nearly half of Americans pay no federal income tax (I’ll note that this ignores that these individuals pay many other taxes, so it misrepresents their real tax burden, but that’s another story). So, what that means is that for those Americans, a federal income tax deduction offers NO benefits at all. Yes, that’s right, close to half of Americans–most of the poor and middle class–get no benefit from this policy.
So, who does benefit? Well, the higher your income tax rate, the larger a benefit like this is for you. In health policy what that means is that for close to 70 years America provided an incredibly generous subsidy to help high income individuals purchase health insurance, while providing little to no subsidy to those above poverty and in the middle class. Read that again. It’s the stupidest, most ineffective, completely inefficient, inequitable, unfair and brain dead policy you can imagine.
The policy has even worse effects. Because the benefit is largely provided to higher income people, who generally have most of their basic health care needs covered, it drives the typical health insurance policy to become overly generous in important ways–services that are less effective are covered; prices are driven higher; incidental costs like check-ups, eyeglass frames and more are insured. This, of course, creates a double whammy for lower income and middle class Americans. They don’t get the tax benefit of the deduction AND they face the higher prices driven by the consumer demand of the higher income people who do get the subsidy.
Thankfully, the Affordable Care Act is ending this; unfortunately, for political reasons, it’s happening in a convoluted and less than ideal way. Nevertheless, in another decade, if we do not undo what is in the law, we will have a system that helps those who need help the most, and has those who make more shoulder more of their own costs (as well as some of those of lower income and middle class Americans).
Yet, now people in higher education are vehemently defending this exact same approach. If you want a financing system for higher education that benefits wealthy people, is ineffective, inefficient, inequitable, unfair, and stupid, then by all means shout your support of 529 savings plans. If you want a policy that just adds further encouragement to colleges and universities to focus on incidentals like rock walls and wave pools, then federal income tax advantaged 529 savings accounts are the perfect route. SEVENTY percent of the dollars in these accounts are held by families with incomes greater than $200,000 per year. If you want to make life easier for them and give them greater buying power than they already have in the higher education market, then join the chorus opposing the changes proposed by Obama.
On the other hand, if you’d like a policy that benefits lower income and middle class Americans, a policy that directs precious government dollars to those that need it most, a policy that encourages economic and social mobility, a policy that is more effective, more efficient and more equitable, then come to the tax credit side. Don’t defend 529 plans. Encourage state governments to return to their commitment to support higher education. Push university administrators to address efficiency and lower costs. And use income related tax credits to help families. Tax deductions are the enemy of good policy.