The Effect of Rising Health Care Costs on U.S. Tax Rates

Health care spending in the U.S. now accounts for 17.6 percent of GDP, a figure that could grow to 26 percent by 2035 if current trends continue. Public expenditures on health care, including Medicare, Medicaid, and other insurance and direct care programs, account for nearly half of all health care spending. If health care costs continue to rise, taxes will need to be raised to fund these programs. Indeed, the recent health reform law raised Medicare taxes on high-income workers to keep that program solvent for an additional decade or so.

How high might tax rates on different groups have to go in the future to fund government health care pro-grams? How large would the efficiency costs associated with these higher taxes be (that is, how much GDP may be lost due to tax-motivated changes in labor supply and savings behavior)? These questions are the focus of a new working paper by NBER researchers Katherine Baicker and Jonathan Skinner, Health Care Spending Growth and the Future of U.S. Tax Rates (NBER Working Paper 16772).

The authors first develop a macroeconomic model based on choices about working, consumption, and saving. The model includes a government sector that levies taxes and uses part of the revenue to pay for lon-gevity-enhancing health care. Based on forecasts by the Congressional Budget Office, the authors assume that new tax revenues equal to 8 percent of baseline GDP will be needed to fund health care costs in 2060.

The authors then use their model to simulate several scenarios for raising this additional revenue. In the first, marginal income tax rates are raised so as to maintain the shares of taxes paid by high-income taxpayers, middle-income taxpayers, and low-income taxpayers . In this scenario, marginal tax rates rise from 18 to 21.8 percent for the lowest income group and from 42 to 70 percent for the very highest income group (those now in the 33 or 35 percent bracket). These tax increases slow GDP growth, so that in 2060 per-household GDP is 11 percent lower than it would have been otherwise, or $133,900 instead of $149,400. The average loss in utility is roughly $2.48 for every additional dollar of tax revenue raised, yielding a net cost to society (or efficiency cost) of $1.48.

In the second scenario, payroll taxes are increased by 12.4 percent across the board. The resulting tax system is much less progressive than in the first scenario, as the marginal tax rates for the lowest and highest income groups are 30.4 percent and 54.4 percent, respectively. However, the efficiency cost is much lower too, at $0.41 per dollar of revenue raised, and GDP declines by only 5.2 percent relative to baseline.

In a third scenario, the after-tax-income Gini coefficient is held constant rather than the tax shares. This generates a similar top marginal tax rate to that in the second scenario, 52.8 percent. This approach is less progressive than the first scenario because when taxes rise faster than income, holding tax shares constant implies that the share of income devoted to taxes rises more for high-income groups.

Finally, the authors repeat their first scenario but assume that the new revenues needed would be only 4 percent of GDP rather than 8 percent. They find that even with the tax structure of the first scenario, the top marginal rate (56.2 percent) is similar to that in the second and third scenarios, as is the loss in GDP (5.1 per-cent), highlighting the important role that potential improvements in health care productivity play.

These findings illustrate the trade-off between equity and efficiency that often arises in tax policy. To raise the same amount of revenue, there is only half as much loss in economic activity under the flat payroll tax hike as under the tax-share-preserving policy (scenario 2 vs. 1). The simulations also demonstrate the value of cut-ting back on waste in health care, as this avoids distortionary taxes that can reduce economic activity quite significantly. Nonetheless, the authors find that no matter how the revenue is raised, the value of the health improvements funded by taxes is greater than the efficiency cost arising from reduced economic activity.

To explore whether policy makers respond to the efficiency cost of providing additional resources to the health care sector, the authors examine data for OECD countries in which they estimate the link between a country's tax-to-GDP ratio in 1979 and the subsequent rise in its health care spending. They find that those countries with high initial ratios (who would have faced greater efficiency costs from raising taxes) experienced slower growth in health spending over the next three decades.

While most observers of the U.S. health care system conclude that there must be a break in the trend of rising real health care costs at some point, it is not clear what policy or condition would effect that change. This study suggests "strains on the revenue-raising system may exert a natural brake on health care spending, and thus may be a key (albeit inefficient) mechanism for constraining overall health care spending growth."

The authors gratefully acknowledge funding support from the National Institute on Aging (P01-AG-19783) and from the U.S. Social Security Administration through a grant to the NBER as part of the Retirement Research Consortium (RRC08098400-03-00).