the self-employed could be created by increasing the portion of the cost of a policy that is deductible when it covers children (or all dependents). But because there are only 12.0 million self-employed workers (9.2 percent of the total labor force), and only 2.6 million self-employed people who take the health insurance deduction, this provision would have only a limited effect on insurance coverage for children.30
More children could be affected if an expanded deduction for the cost of health insurance were made available to individual taxpayers regardless of their employment status. This type of tax subsidy would be advantageous to any person purchasing an individual policy directly from an insurance company or any worker whose employer does not provide health insurance or does not cover dependents.
Any amount of deduction from taxable income would lower the net cost of the insurance to the purchaser, but because the deduction lowers a person's taxable income, the amount of the reduction in taxes is determined by the person's marginal tax rate. For example, if a single parent with one child made $20,000 in 1996, her tax would be $1,639. If a $1,000 deduction had been allowed for health insurance, the tax would only go down $150 to $1,489, a reduction that is only 15 percent of the $1,000 deduction because that person is in the 15 percent tax bracket.
In addition, a major disadvantage of using deductibles as a positive incentive is that it is difficult to target this type of tax subsidy to lower-income workers. Under present law, it is usually advantageous for a low income worker to take the standard deduction ($4,000 for a single taxpayer or $6,700 for a couple filing jointly in 1996) rather than itemize deductions. Therefore, to take advantage of the tax deduction, a person must first have an income high enough to require him or her to pay taxes. And even if the person pays income taxes, he or she would have to itemize deductions unless a change in tax law would allow him or her to take the health insurance deduction in addition to the standard deduction. These difficulties making tax deductions effective for low income taxpayers are why most tax subsidy proposals use some form of tax credit as a way to induce a change in behavior.
The use of tax credits is a more efficient way to subsidize the purchase of health insurance for low-income taxpayers. In addition, by making tax credits refundable, it is possible to use the tax system to subsidize those people who do not currently pay income taxes.
A tax credit is a direct reduction of taxes owed and does not require a taxpayer to itemize deductions in order to qualify for the credit. This is especially important because those who are most likely to qualify for the tax credit and to need it to purchase health insurance are likely to be among those least likely to itemize their deductions.
To illustrate, consider again the single parent with one child earning $20,000 per year and facing a tax bill of $1,639 under current law. If she were allowed a $1,000 tax credit for the purchase of health insurance for herself and her child, her taxes would be reduced by the full amount of the $1,000 tax credit, to $639. The amount of the tax credit could be set to cover most or all of the cost of a defined health insurance benefit for the parent and the child or just for the child.
A tax credit has three other advantages over direct subsidies or tax deductions. First, the amount of the tax credit can be based on an actuarial calculation to cover either a portion of or all of the cost of the desired level of benefits for the people that are to be subsidized. The IRS would still have to assure that the taxpayer actually purchased health insurance, but the federal government would not face the difficult task of defining a complicated benefit package and determining that each person's policy contained those benefits. The purchase of health insurance could be left to the individual consumer, who could choose among alternative plans offered by competing health insurance companies. Insurance