Problem: Under the current system, the ability to exclude health insurance from taxable income is unlimited, encouraging some employees to "purchase" too much insurance.

Solution: The ability to exclude payments for health insurance from taxable income (or the opportunity to receive a tax credit for premiums) should be limited to a premium sufficient to allow the purchase of a no-frills, catastrophic health insurance policy. Individuals who pay higher premiums for additional coverage should do so without tax subsidy.

Discussion: As noted above, the tax subsidies for health insurance are quite large. For a higher-paid employee (facing a 6 percent state and local income tax rate), $1.97 of wages is equivalent to $1.00 of health insurance. This encourages employees to prefer overly generous (and wasteful) health insurance coverage – coverage that they would not buy out-of-pocket without tax subsidies. For a highly-paid employee, $1.97 spent on health insurance need only be worth $1.01 to be preferable to $1.97 of wages. If paid in wages the employee will be left with just $1.00 of take-home pay. Moreover, since higher-paid workers tend to dictate the contents of employee benefits plans, their choices tend to be imposed on all other workers.

The tax law encourages over-insurance in yet another way. One of the strange features of the tax code is that a physician's fee paid by an employer (or an employer's insurance carrier) is paid with pretax dollars, whereas fees paid out-of-pocket by employees must be paid with after-tax dollars. As a result, the tax law encourages (subsidizes) 100 percent health insurance coverage (with no deductibles and no copayments) for all medical expenses. Unfortunately, insurance for small medical bills is the most wasteful type of health insurance. For one thing, it usually costs an insurance company more than $50 to administer and monitor a claim for a $50 physician's fee, effectively doubling the cost of health care. For another thing, people are far less prudent in purchasing health care if the bills are paid by someone else. [16]

Under the current system, tax deductible health insurance expenditures range from a high of $3,055 under the generous health care plans provided by the automobile manufacturers to as little as $793 – the average for workers in retail trade. Although this system may appear to benefit large companies with highly-paid employees, in many cases these companies are trapped in benefit plans that are eating into company profits and raising production costs. The current system not only encourages and subsidizes rising health care costs, it is causing harm to the very industries and companies which are subsidized the most.

To correct this abuse, it should be national policy to encourage individuals to purchase health insurance for catastrophic medical expenses and to save to pay small medical expenses with their own funds. Accordingly, the tax credit for health insurance should be limited to a premium amount sufficient to purchase a policy, say, with a $1,000 deductible and a 20 percent copayment up to an additional $1,000. [17] At the same time, people should be encouraged to save for small medical expenses in the manner described below.