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The Cato Weekly Podcast
Host: Rikki Schlott Guest: Michael F. Cannon, Director of Health Policy Studies, Cato Institute
Cold Open
Rikki Schlott: In these polarizing times, there seems to be one thing that most Americans can agree on. Our health care is too expensive. It comes as health insurance costs are rising significantly. A recent KFF survey found that the average annual premium for a family with workplace insurance reached nearly $27,000 in 2025.
[Audio clip]: I was paying last year $57 a month premium, and then it jumped up this year to $16.90 a month. And getting insurance to pay for it is just too complicated.
[Audio clip]: No family should have to go through having to fight to get treatment as recommended by their physician covered while fighting for their lives.
[Audio clip]: I’ve said it before and I’ll say it again. In order for me to care for patients in the United States, I have to care about insurance. If I don’t navigate insurance and I don’t get approval for surgeries and patients are stuck with huge bills, I’m not helping them.
Rikki Schlott: Politicians on both sides keep proposing legislation and programs to fix this.
[Audio clip]: Every single one of us, joined by 17 Republicans, have partnered in a bipartisan way to protect the health care of the American people.
Rikki Schlott: But what if the root cause of our health care problems started more than a century ago and nobody wants to face up to that fact? Today’s guest argues that the original sin of U.S. health policy is the federal tax code itself. How did tax policy decisions become the foundation of the modern health care system? And why have decades of reform with programs like Medicare and Medicaid failed to solve the problems that they were meant to fix? I’m Rikki Schlott, and this is the Cato Weekly Podcast. I’m here with Michael F. Cannon, Director of Health Policy Studies here at Cato.
Interview
Rikki Schlott: Michael, before we get into the giant mess of our health care system, can we just start at the beginning with what your argument is here? How exactly would the federal tax code, of all things, represent the original sin in health care?
Michael F. Cannon: So Congress passed the second federal income tax in 1913. And when it did that, it didn’t say anything about employer-sponsored health insurance, because that really didn’t exist in 1913. Modern health insurance didn’t come on the scene until 1929. But some employers were providing doctor, physician services to their workers, and they went to the IRS and they said, “Hey, this stuff we’re doing for our workers, does that count as income? Do our workers have to count that as income when they’re paying their income taxes?” And the Treasury Department bureaucrats said, “Wow, this is a really complex question. We don’t know. We’re just going to punt. We’re going to say that, no, it doesn’t count toward your taxable income, and so you can provide those things to your workers tax-free.” And then when employers began offering health insurance, that was tax-free as well.
But when you think about it, what that ended up doing was creating a situation where, since employers pay for those benefits with money they would otherwise give to their workers as cash, workers had a choice. They could either control their income themselves, control that compensation themselves, in which case they’d have to pay taxes on it, or they could let their employer control it and use it to choose and purchase their health insurance. And there’s a big difference between the two, because if you wanted to control that money yourself, right now you lose on average about a third of it to federal taxes. So that’s really like a penalty on controlling your own health insurance dollars and your health insurance decisions, and exercising your right to choose a health plan that stays with you from job to job. Because that penalty was so steep, that’s why we have an employer-based health insurance system where more than half of the U.S. population gets their coverage through an employer, and it’s all because Congress did this thing.
Rikki Schlott: It created an income tax without being able to foresee all the ways that that might distort people’s economic decision-making, and as you say, we have not been able to get rid of that, even though it has made health care more expensive and expanded the gaps in our health sector, because so many people have become so dependent on that system that it created. And the fact that this is not taxable, who actually stood initially to benefit from that? Was it better for employers at the time?
Michael F. Cannon: Really, it was better for the Treasury bureaucrats, because their basis for deciding “this is too complex, we’re not going to tax these benefits” was that it’s hard to put a number on the value of the health benefits that any one worker is receiving, and so they punted. So this is really a decision that made life easier for them. But then you can see how others benefited from it. If you are a doctor or a health insurance company and the federal government is penalizing workers 33 cents on the dollar for every dollar they don’t spend on health care, that’s really good for the health sector, because it distorts (we economists say it distorts) the after-tax prices that people face when they’re trying to decide between health care and other uses of income. They purchase more health insurance, which encourages them to purchase more health care, which is good for doctors and hospitals and pharmaceutical companies and so forth. It’s also really good for large employers, because of the economics of employer-sponsored health insurance, they can offer it at a lower cost than smaller employers and take the savings and put that into higher salaries, so that they have a competitive advantage in the labor market. All of these things happened, all these distortions in the health sector and the labor market, because Congress ventured into this area and didn’t know enough about taxing incomes, and all sorts of negative, harmful economic consequences followed from that.
Rikki Schlott: And so what sort of timeframe are we talking about when we are exploring the proliferation of these employer-sponsored plans? When did they become basically the standard, as they are today?
Michael F. Cannon: So modern health insurance didn’t really start until 1929. Employers started offering it then, but the usual story we hear about how employer-sponsored insurance took off is that during World War II, Congress imposed wage caps that said, “You can’t compete for workers by offering higher wages,” but Congress also said, “We’re not going to include the health benefits in the wage caps.” So employers said, “Oh, well then we’ll offer more comprehensive health benefits, we’ll offer them more often, we’ll make them more comprehensive to attract workers.” That’s the usual story we get. But it wasn’t until those wage caps disappeared in the mid-1950s, and Congress codified what we call the tax preference, or tax exclusion, for employer-sponsored health insurance into statute (up until then, it had just been regulation), that it really took off. Both of those things happened in the mid-1950s, and that’s when employer-sponsored insurance came to be the dominant form. I mean, it was already sort of the dominant form of health insurance, but it just left everything else in the dust starting in the 1950s. And now, 70 years later, we’re still in a situation where more than half of the U.S. population has this source of health insurance.
Rikki Schlott: And so I think for a lot of people, it’s just a number coming out of their paycheck and they’re not even fully sure how this entire system functions. They just file claims and their employer does something and they hopefully have health care. Oftentimes it’s more complicated than I think a lot of us would appreciate it being. Unfortunately, we don’t have open pricing in our health care system. In my opinion, it’s a failing of our health care system. It’s all hidden behind layers of bureaucracy and relationships between insurance companies and providers, which I don’t believe are beneficial to the consumer, largely. But how actually does this employer-sponsored system work, and who is controlling how money is spent?
Michael F. Cannon: This is a $1.6 trillion chunk of the economy. We’re talking about the money that employers and workers together spend on employer-sponsored health insurance, and that is larger than the federal Medicare program. That’s larger than the federal-state Medicaid program. So you could call it the largest government health care program in the United States, but individual employers administer it. What they do is the employer picks a plan, offers it to their workers as an employee benefit, and the employer pays part of the premium, typically only part, and then the employee pays another part. On average, if you have family coverage, the employer is paying $20,000 and the employee is paying $7,000 toward a $27,000 premium. And you multiply that across all workers with all sorts of coverage, and you get that $1.6 trillion chunk of the economy.
So the important thing to understand here, though, is that the $20,000 that the employer is paying comes out of the workers’ wages. When you mentioned something comes out of our paychecks, yeah, that $7,000 part of the premium, that’s the part that goes into your salary and then comes out to go toward the premium. But that other $20,000, that’s also your money, but it never even enters your salary. It’s money that your employer would have to give you if they weren’t giving you health insurance. They couldn’t not give you that money if they tried; the labor market would require them, or the next employer, you would get that money. So it’s your $20,000, but you don’t get to control it. If you want to control it, you could work for an employer that doesn’t offer health insurance, but you’d have to pay taxes on all $27,000, so you’d lose $9,000 of that to taxes. So the government’s penalizing you if you want to control that $20,000 yourself, so workers have to let employers control it. And that is a $1.2 trillion chunk of the economy that, if we could return that money to the workers who earned it, would be a larger effective tax cut than the 1981 tax cuts that Ronald Reagan signed into law. But there’s been a lot of resistance to reforming what economists universally regard as the original sin of U.S. health policy.
Rikki Schlott: And so the fact that Congress can tax wages but not these benefits, I’m sure, has a ton of distortionary effects on the market, whether it’s actual care being provided or different health plans. How is this actually impacting the way that we understand the landscape of health care in this country?
Michael F. Cannon: Yeah, Congress could tax the employee health benefits, but it’s not, and I don’t want to say the lack of taxes is the problem. That’s not the problem. I’d rather get rid of the entire income tax. But the way it distorts people’s economic decisions is like this. First of all, you lose control of $20,000, or maybe $27,000, of your earnings, depending on how you count. You lose control of your choice of health plan to your employer. You lose the ability to purchase a health plan that would provide cradle-to-grave coverage, a health plan that stays with you between jobs, so that if you get sick and can’t work anymore, you don’t necessarily lose your health insurance. And studies have shown that people, including sick people, are more likely to end up uninsured if they have employer-sponsored insurance than if they bought it directly from an insurance company, in which case it stays with them between jobs. So employer-sponsored insurance also creates gaps in the health sector, because when you change jobs, you lose your health insurance. And if you lose your job because you get sick and can’t work anymore, then you’re out of luck. Now you have an uninsured and uninsurable preexisting condition.
And just in case that wasn’t bad enough, this tax provision encourages people to purchase more health insurance than they would otherwise, and makes them less price-sensitive as a result of all that extra insurance. When they go to consume medical care, medical prices are higher, a lot higher, because of this provision of tax law. So your insurance is riddled with gaps. Once you fall through one of those gaps and end up with an uninsured and uninsurable preexisting condition, you also have to face much higher prices because of this same tax provision. So just about everything that Americans hate about health care in the United States is a result of this tax preference for employer-sponsored insurance. If it didn’t cause that problem, it made that problem much worse.
Rikki Schlott: So do we, effectively through our employers as an intermediary, have a somewhat free market of policies being sold, and someone else is just doing the picking for us? Or has this distorted the types of policies that are available to people, and are these corporations actually operating in a free market system?
Michael F. Cannon: What we have is very, very far from a free market. The OECD, the Organisation for Economic Co-operation and Development, collects data about different countries, and one of the data points that they collect is what share of health spending in every advanced country is compulsory versus voluntary. Voluntary means free market. It means you can choose this or that, you can choose health or non-health items, and there are going to be no consequences from the government, no tax penalties, no anything. But compulsory means the government controls how that health spending happens, whether it’s through the private sector or the government sector. In the United States, you would think, people say the United States is a free market in health care, but in the United States, the government controls 84% of the health spending. That’s closer to Cuba, which is a communist nation, at 89%, than it is to the average OECD nation, which is at 76%. So we are very far from a free market, and the biggest category of compulsory health spending in the United States is that $1.6 trillion of employer-sponsored insurance.
And you can see how unfree we are in the fact that the government is distorting the relative prices, it’s forcing people into insurance that they wouldn’t buy on their own. I mean, if you controlled that money yourself and the government wasn’t distorting the playing field, there’s no way you or I would choose a form of health insurance that just disappears when your job disappears. That doesn’t make any sense. We would want seamless health insurance. We would want it to stay with us through those life changes. And so the higher prices that we see and the huge gaps in coverage are just two of the ways that our very unfree market distorts our health decisions, our health insurance decisions, and leaves us with worse health insurance and medical care.
Rikki Schlott: And what about from the provider side? How is this employer-sponsored insurance, where we often don’t even know the bill walking into a certain procedure or even just a checkup… I was at the hospital not long ago and the bill was almost $6,000, and then even when the insurance paid for some of it, I was still stuck with almost $3,000. So, very expensive. I know for a fact that there are families who skip services just because things are so expensive. How is this distorting how much providers can actually charge you for medical services?
Michael F. Cannon: Driving up the prices dramatically, in part because it encourages consolidation on both the provider side (these are hospitals, doctors, and so forth) and the insurer side. When the tax code encourages people to demand more comprehensive health insurance, we’re buying more of our medical care through insurance than we would otherwise, and we’re less price-sensitive. But the insurance companies are buying more of our health care from these providers, and they each have an incentive to just grow and grow and grow so that they’re in a better negotiating position when they’re negotiating those prices. And so it drives up prices through all of these mechanisms. Whereas if the tax code weren’t distorting our decisions and we were paying for more things directly ourselves, the consumer would be much more willing to avoid this hospital that is overcharging them and drive an extra 10 miles, 20 miles to a lower-price hospital, because I would get to see the savings. And there have been experiments that have shown that when the patient gets to see the savings, they break the monopoly power of hospitals that had been overcharging them in a way that the insurance companies couldn’t.
Rikki Schlott: And so let’s get to the actual human impact for typical Americans. Who is most adversely impacted by this employer-sponsored system? Are there particular groups that really get the short end of the stick?
Michael F. Cannon: There are. So raising prices for goods and services is like a tax on the entire populace that falls hardest on low-income people. The hidden taxes that are a result of this policy are extremely regressive, and they price a lot of low-income people out of health insurance and medical care. Also, anyone who falls into those gaps that we’ve been discussing. People like gig workers, or the unemployed, or retirees: these are people whom the government forced into a very insecure form of health insurance, and then when that job ended, they didn’t have health insurance anymore. It’s no accident that 40 years after the federal government creates this tax preference for a form of health insurance that disappears when you retire, Congress looked around and said, “Why do all these retirees lack health insurance?” They created a new government program, Medicare, to deal with that problem, and Medicare has driven up the prices of medical care. It has reduced the quality of care. So seniors are suffering as a result of this tax preference. But at the same time that Congress created Medicare, they also created Medicaid for low-income people, which itself reduces the quality of care and drives up health care prices further. And all of these things have been a burden on taxpayers. So there’s lots of misery that the tax preference for employer-sponsored insurance is spreading far and wide.
Rikki Schlott: And how about one group that I don’t think anyone would say is particularly disadvantaged in the health care system in general, which is just young, healthy people. Are they in any way less able to shop the market freely or get the sort of plans that might actually be reflective of their age or health status?
Michael F. Cannon: Absolutely. So these are folks who value health insurance less because they’re healthier and less likely to need health insurance. Markets encourage them to buy health insurance by lowering the premiums, because your risk is lower, so you’re going to face lower premiums. That creates incentives for you to insure before you get sick and really start contributing to the medical bills of complete strangers. It’s a wonderful thing that markets are able to accomplish. But employer-sponsored insurance, because it encourages more comprehensive insurance, will often encourage insurance so expensive that young people don’t value it, so they will opt out of that market. And then when Congress passed the Affordable Care Act in 2010, that was an attempt to raise premiums on healthy people, typically younger people, in order to bring them down for older and sicker people. So right now we have a situation where Obamacare is doubling or tripling premiums for healthy, younger people in sort of a hidden tax to subsidize premiums for people who are older and sicker and have more money. And so there is a bit of regressivity involved in that aspect of this as well.
Rikki Schlott: And so I think that there might be some people who would say, “Okay, fine, this employer-sponsored system is bad, but, you know, Medicare and Medicaid are an alternative that the government provides, and that’s fixing the landscape in the end.” Why is that not actually accurate?
Michael F. Cannon: The only reason anyone thinks we need Medicare or Medicaid is because of all of the damage that this provision of the tax code has done to our health sector, and our health insurance market specifically. If it weren’t for this part of the tax code, we wouldn’t have had as many uninsured seniors in 1965. There wouldn’t have been the political pressure for Medicare, because people would have been able to purchase freely with their own money insurance that stayed with them from cradle to grave. So right now there are lots of people who are dependent on Medicare and Medicaid, but that doesn’t mean that they’re a solution. They are an attempt by government to address a problem that government created: not market failure, but government failure. And the most important thing we can do for current Medicare and Medicaid enrollees, for people with employer-sponsored health insurance right now, is eliminate or reduce as much as possible these tax distortions that are hurting people, compelling people to enroll in a very insecure form of health insurance that drives up health care prices and makes access to both health insurance and health care less secure.
Rikki Schlott: So now I want to talk about what sort of solutions you might propose, and I want to do that at two levels. I’ll ultimately give you the magic wand and let you do whatever you want to the system, but first, what are just some low-hanging fruit, practical, feasible solutions that could potentially actually happen in the short term?
Michael F. Cannon: So one form of low-hanging fruit, I call it a short putt, would be if Congress were just to codify some rules that President Trump put in place in his first term that allowed people to save 60% or more on their health insurance just by avoiding a lot of federal regulations that Obamacare imposes on health insurance. We had an experiment with this. It lasted six years. It didn’t disrupt Obamacare. Everything was fine. And the Trump administration is looking at reissuing those regulations, which President Biden rescinded after six years. That would be great, but insurers won’t invest in long-term health insurance products that people need to provide them real protection unless it’s a statutory change. So Congress could just change the statute. That should be very easy. It should be a bipartisan initiative, because President Trump did something similar in his first term, and President Obama did something similar with U.S. territories: he exempted U.S. territories from Obamacare’s most expensive health insurance regulations. So that’s one thing that Congress could do.
There’s a lot of low-hanging fruit at the state level as well: removing a lot of regulatory obstacles to lower-cost, higher-quality health care in the form of clinician licensing regulation, and also removing barriers to lower-cost, higher-quality health insurance by letting their residents purchase some of those Obamacare-exempt plans from U.S. territories. States have the power to do that.
Rikki Schlott: And that just makes me curious: are there any states that are either particularly good or particularly bad in that regard?
Michael F. Cannon: So when it comes to clinician licensing, the Western states tend to be better and the Southern states tend to be worse, meaning that the Western states tend to respect your right to choose your provider more than the Southern states do. The Southern states have more regulations that restrict that right. When it comes to health insurance, all the states are in a bind, because the federal government layers a thick layer of federal health insurance regulation over all the states. And only recently have states been looking into alternatives, like letting their consumers and employers purchase health insurance from U.S. territories that doesn’t carry all the same expensive regulations. Legislation to that effect has appeared in Florida. It is currently live in Kentucky, but no state has passed that reform yet. Hopefully some will soon.
Rikki Schlott: And what about your sort of unilateral control over the health care system? You get to redesign it. How would that actually function in the optimal way, in your eyes?
Michael F. Cannon: So there are two types of changes that policymakers need to make if they want to make health insurance of ever-increasing quality available to an ever-increasing number of people, or make health care more universal. The first one is to change who controls the money. We’re spending in this country about $6 trillion on health care, but the wrong people are controlling that money. The OECD says the government, federal and state, controls about $5 trillion of that $6 trillion. We need to let consumers control all of it. We need to leave that money with the people who earned it, to the extent possible. And where we can’t do that, where the government is going to subsidize people like Medicare enrollees, it should just give them cash.
So changing the money in the private sector means changing the tax code so that workers can control that $20,000, really all $27,000, and choose their health plan without penalty. If they want to buy directly from an insurance company or stay with their employer, that should be a free choice. That would be, as I mentioned before, a massive effective tax cut, larger than the Reagan tax cuts, which were 3% of GDP. This would be an effective tax cut of 5% of GDP. With regard to the Medicare program and the 60 or 70 million people who get health care subsidies there, Congress should just give them that money as cash, the way Social Security does, and trust them to spend it the way Social Security does. We will get a much higher-performing health system if we do that.
The other bucket, if you will, is that there’s a whole host of federal and state regulations that are blocking higher-quality, lower-cost health insurance and medical care, and Congress and the states just need to start getting rid of those regulations. Those include health insurance regulations at the federal level, regulation of drugs and medical devices at the federal level, and state regulation of clinicians (here we’re talking about licensing). States also have health insurance regulations. All of these things are taking away my right and yours to make our own health insurance and medical decisions. And it would be one thing if they were improving health care for us, if they were making health insurance more affordable, making medical services more affordable or higher quality. They’re doing neither of those things. They’re having the opposite effects, because they’re blocking innovations that would make health care more universal. So the second bucket is we need to get rid of those things. I’ve already mentioned some of the steps that policymakers could take, like letting people purchase insurance from territories or otherwise purchase Obamacare-exempt plans. States can also let their residents choose clinicians in other states, so that each state’s regulations won’t be as much of a barrier to competition and to exercising your right to make your own health decisions as they are right now.
Rikki Schlott: And so I want to end the conversation by just zooming all the way out. If you’re a typical libertarian who’s interested in maximizing freedom and individual liberty, why should you care about the health care component of Americans’ lives? What is the moral principle underlying your argument on a libertarian level?
Michael F. Cannon: So we have a right to make our health decisions. That’s the most important right we have when it comes to our health care. Protecting that right is important in itself, just as a matter of human dignity. It’s also important because when government violates that right, it makes a mess of health care, and it leaves people with less health care. It reduces access. It reduces the quality of health care. So if we want our lives to be better, we have to defend, uphold, and restore that right.
But we also need to restore those rights for the sake of the rest of our lives as well, because if you look at health policy, what you notice is it’s driving everything else. The federal government has a $30 trillion debt right now. That is equal in size to U.S. GDP, the size of the entire annual output of this country. We’re adding another 6% of GDP to that debt every year, because Congress keeps spending more than it brings in in revenue. The single largest driver of the federal debt is health care spending. That is the single largest category of federal spending, and it is the largest one that’s growing faster than GDP is growing. So unless we get this under control, we could be in for a very wrenching economic recession where Congress hits a wall and can’t borrow anymore because of the federal debt. We’re going to see people losing lots of jobs, losing subsidies they are depending on for their health care access, and that could make the financial crash of 2008 look minor by comparison. So there are many, many reasons why we have to get our [house] back on track.
Closing
Rikki Schlott: [That’s all for] today’s episode of the Cato Weekly Podcast. If you enjoyed today’s discussion, please subscribe and leave a review wherever you get your podcasts. To learn more about the ideas and research discussed in this episode, visit cato.org.
