Health care policy debates can be frustrating because they seem at times to assume the health sector operates without regard to financial incentives.

For instance, proponents of an expanded governmental role in cost control seldom acknowledge the obvious: economic theory, with abundant empirical evidence from around the world backing it up, indicates that such cost controls will invariably lead to waiting lists and reduced access to care — in other words, some form of rationing by the government. This should not be surprising. Price controls and other regulations aimed at holding down costs are effective only to the extent that they suppress supply. Consumer demand, which isn’t altered by such policies, cannot be fully satisfied because there aren’t enough willing suppliers. The predictable result is non-price rationing of services.

Financial incentives, driven by tax policy, play a particularly important role in the organization of private health insurance in today’s marketplace, as highlighted in a recent and interesting academic study. Today, when an employer pays health insurance premiums on behalf of a worker, the premiums are not counted as income to the employee, no matter how much the employer contributes. This open-ended exclusion applies both to income and payroll taxes.

Economists have long argued that this favorable tax treatment has important implications for private health insurance and health spending. First, current tax policy creates a bias toward employer-sponsored coverage, as opposed to individually-owned and -selected insurance. Second, it encourages compensation in the form of health insurance as opposed to cash wages. Employees tend to opt for low deductible and low cost-sharing health coverage because their employers pay the higher premiums associated with such plans, and the premiums are tax-free to them. Third, with expansive insurance, workers tend to over-consume health services, as each additional test or visit to a physician costs them very little.

A new study by economists John F. Cogan, R. Glenn Hubbard, and Daniel P. Kessler —available online here — makes it clear just how important this open-ended tax subsidy is in today’s marketplace.

The authors approached the question from a novel perspective. Employer-paid premiums are excluded from income and payroll taxes, but some workers earn above the maximum amount subject to the Social Security payroll tax. (In 2008, earnings above $102,000 are not subject to the payroll tax rate of 12.4 percent. See this press release from the Social Security Administration.) The authors tested the hypotheses that workers with incomes just above this threshold would consume less health insurance, and less health services, than those just below it because workers just above the threshold do not enjoy the tax break associated with the exclusion of health insurance from the payroll tax.

The data presented by the authors are striking. Households with incomes just below the Social Security tax threshold consumed, on average, $2,406 of health care per year, in constant 2004 dollars. All other things being equal, one would assume that health spending would rise with income. But, as the authors predicted, households with annual incomes of between 100% and 110% of the Social Security threshold spent only $1,836 per year in 2004 dollars, or 24% less than those with incomes just under the threshold. The conclusion here is simple: the exclusion of employer-paid premiums from taxes provides a powerful incentive for more expensive insurance and higher health care spending.

This study is just one more piece in a long line of evidence that fixing health care will require getting the financial incentives right. As matters stand, federal tax law is slowing the move toward more efficient systems for delivering health care services. That needs to change.

Of course, good health care policy needs to weigh more than financial considerations. Public policy must assure that services are widely accessible too, including by households unable to pay for coverage and services on their own. What’s needed is a policy framework within which financial incentives encourage high quality care, innovation, and medical breakthroughs, even as access to care is equitable and based on health need, not income.