Statement on Modern Families; Outdated Laws

Testimony by John C. Goodman, Ph.D.

President, National Center for Policy Analysis

Before the Committee on Ways and Means, U.S. House of Representatives

January 31, 2007

Mr. Chairman and members of the committee, good afternoon. I am John Goodman, President and CEO of the National Center for Policy Analysis, a nonprofit, nonpartisan public policy research organization dedicated to developing and promoting private alternatives to government regulation and control, solving problems by relying on the strength of the competitive, entrepreneurial private sector.

The most important problems faced by middle-income working families today are not problems that arise from the nature of our economic system. Instead they are problems caused by outdated public policies. The basic structure of tax law, labor law, employee benefits law and a host of other institutions was formulated 50 or 60 years ago by policymakers who made assumptions about how life would be lived. From top to bottom, key public policies were based on the assumption that:

Workers would work for the same employer throughout their work lives.
Men and women would marry and stay married; and throughout their working years the husband would be a full-time worker and the wife would be a full-time homemaker.
Workable social insurance (e.g., for unemployment, disability, illness etc.) could be managed by bureaucratic agencies because the consequences of individual choices are largely irrelevant, regardless of how perverse the incentives are.

Clearly, these assumptions no longer describe the world in which we live. Accordingly, institutions designed for the 20th century are unworkable and inadequate for the 21st century. Among the reforms that are needed: Employee benefits need to be personally owned and portable – traveling with the worker from job to job. In this respect, IRAs, 401(k) plans and Health Savings Accounts (HSAs) are all steps in the right direction.

More needs to be done.

Adjusting to a Mobile Labor Market

One of the remarkable changes in the workforce over the past several decades is the rise in labor force mobility. Today, workers have held an average of 10.5 different jobs by the time they reach age 40.¹ Traditional employee pension and health benefits are ill-suited for this environment.

Mobile Workers, Immobile Retirement Savings. Opportunities to save for retirement are very dependent on where people work – and whether they work.

Defined Benefit Pension Plans. Since World War II, the dominant form of retirement plan provided by employers has been the defined benefit pension. Employees acquire pension benefits based on their wages and years of service to the company. These plans work well for people who stay with the same employer, but they do not work well for employees who switch jobs. The reason: Under typical benefit formulas, workers sacrifice substantial benefits if they switch employers frequently throughout their career, even though they remain fully employed for their entire work lives and fully vested in every plan they enroll in.

Defined Contribution Plans. Unlike defined benefit plans, defined contribution plans such as 401(k)s and 403(b)s promise no specific benefit at retirement. The employee has ownership rights over the assets in a specific account and is entitled to the full accumulation. Unlike defined benefit pensions, these accounts are portable: They follow the worker from job to job.

Some complain that employees are ill-prepared to make the type of investment decisions made under the old system by professional managers. One answer is for workers to copy the investment choices of the defined benefit plans. Another criticism is that 401(k) holders are subject to stock market risk not encountered by defined benefit plan beneficiaries. However, the risk of defined benefit pension losses generated by job changes can be greater than the stock market risk assumed by 401(k) holders.²

There are a number of ways to make 401(k) plans work better. These reforms – initially developed and proposed by the National Center for Policy Analysis and the Brookings Institution and passed by Congress in 2006 – include automatic enrollment of new employees in 401(k) plans, automatic escalation of contributions and diversified portfolios.³

Individual Retirement Accounts. Workers who do not have access to a 401(k) plan may make contributions to an Individual Retirement Account (IRA). However, the contribution limits are lower and there are also income limits. Participants in an employer-sponsored 401(k) plan can contribute up to $15,000, while nonparticipants can contribute only $4,000 ($5,000 if age 50 or older) to a tax-advantaged IRA (both Roth and traditional IRAs).

Mobile Workers, Immobile Health Plans. Like the tax subsidies for retirement saving, tax relief for the purchase of health insurance also depends on where we work and whether we work. The federal government subsidizes employer-provided health insurance through the tax system. The employees avoid federal, state and local income taxes as well as payroll taxes. In some places, the government is effectively paying half the cost of the insurance.

The tax law is far less generous to people who must purchase insurance on their own, however. For this reason, more than 90 percent of people who have private insurance get it though an employer. The downside is that the health plan most of us have is not a plan that we chose; rather, it was selected by our employer. Even if we like our health plan, we could easily lose coverage because of the loss of a job, a change in employment or a decision by our employer.

Problem 1: Lack of Continuity of Insurance. Virtually all employer health insurance contracts last only 12 months. At the end of the year, the employer – in search of ways to reduce costs – may choose a different health plan or cease providing health insurance altogether.

Problem 2: Lack of Continuity of Care. Employees who switch jobs must also switch health plans. All too often that means changing doctors as well, since each health plan tends to have its own network.

Problem 3: Perverse Incentives for Employers and Employees. Some individuals have a family member (often a spouse or child) who has very high health care costs. When these workers compare job opportunities, they are primarily comparing health plans. To protect themselves from such potential hires, employers are increasingly altering their health plans to attract the healthy and avoid the sick.

Problem 4: Younger Spouses of Retirees on Medicare. When a husband retires and enrolls in Medicare, a younger wife may be left without coverage because underage spouses cannot enroll in Medicare. Until the wife qualifies for Medicare at age 65, the couple will have to purchase her insurance with after-tax dollars.

Problem 5: Federal Laws Designed to Encourage Portability Have Actually Outlawed It. Under the current system, employers cannot buy individually-owned insurance for their employees. Specifically, lawyers interpret the Health Insurance Portability and Accountability Act of 1996 (HIPAA) to say that the only employee health insurance employers can purchase with pretax dollars is group insurance.

Exception: Health Savings Accounts (HSAs). An interesting exception to these generalizations is the HSA. These accounts represent individual self-insurance and they are an alternative to third-party insurance. Unlike third-party insurance, HSAs are fully portable, traveling with the employee through the labor market. Moreover, they are a model of how the rest of the insurance arrangement may also become portable.

Solution: Tax Fairness. Health insurance and retirement savings choices have been distorted by a byzantine tax code that has long since lost its rational. In an ideal system, people would receive the same tax relief whether they save at home or at work, and whether they work or do not work.

Solution: Personal and Portable Benefits.⁴ Just because employers pay all or most of the premium does not mean health insurance must necessarily be employer-specific. As an alternative, why can't employees enroll in health plans that meet their needs, and then be allowed to stay in those plans as they travel from job to job? Portable health insurance promises a continuing relationship with an insurer and, therefore, a continuing relationship with doctors and health facilities. It also means that people who are in a health plan they like can stay in it, without worrying whether they will be forced out of the plan by an employer's decision or by a change in employment.

Pension benefits should also be personal and portable. While the creation of 401(k)s has been a liberating development in this respect, vesting periods are still too long. Although Congress has made progress on lowering vesting requirements, beyond a nominal period (to accommodate administrative costs) there should be no such thing as unvested, tax-advantaged 401(k) contributions.⁵ The principle should be: If there is a tax advantage, the benefit should belong to the worker.

Adjusting to the Entry of Women

Into the Workforce⁶

The most significant economic and social change in the past half-century has been the movement of women into the labor market. Since the 1950s, the labor participation rate of women ages 25 to 55 years has increased more than 75 percent. Today, more than 60 percent of mothers with children under the age of six are working.⁷ Families with both spouses in the labor market now constitute almost two-thirds of all married couples.⁸ Yet the tax law, pension law, social insurance policies and laws governing employee benefits assume women never left the home.

Income and Payroll Taxes. Income taxes and payroll taxes favor families with a homemaker spouse over families with two working spouses. Consider what happens when a married woman enters the labor market:

Even if she earns minimum wage, she is taxed at her husband's income tax rate; and even if her husband reaches the cap on Social Security taxes, she must still pay Social Security taxes on every dollar she earns up to the same maximum.
Since she is entitled to half of her husband's Social Security benefit (and gets 100 percent after his death) whether she works or not, odds are that she will get little if any benefit from the payroll taxes she pays.
Further, when all taxes and costs are considered (including the cost of child care and other services she was previously providing as a homemaker), a woman in a middle-income family can expect to keep only about 35 cents out of each dollar she earns.⁹

Pensions and Health Care. In contrast to most other developed countries, the United States encourages employers rather than government to provide such benefits as health insurance and pensions. Federal policies also encourage employers to provide life insurance, disability insurance and even day care for children. Not everyone is treated the same, however. The employer-sponsored benefit system has been structured from top to bottom to accommodate the single-earner family with a spouse and dependents at home:

Because they are more likely to work part time, women are less likely to qualify for employer-provided benefits.
Because they move from job to job and in and out of the labor market more frequently than men, women are more likely to be burdened by employee benefit programs that penalize job switching (such as lack of vesting in a pension plan).
And when people acquire health insurance or save for retirement outside the workplace, the tax system is far less generous.

Because of federal policies, this system favors workers over nonworkers, full-time workers over part-time workers and long-term employment over job-switching and intermittent employment.

Child Care. Federal policies have resulted in a patchwork system of child care credits and exemptions that are arbitrary and unfair:

While the tax law has a credit for child care expenses, the maximum credit for 2006 was only $1,050 – well below most families' actual expenses. Further, there is no tax relief for uncompensated care provided by a relative, friend or family member.
Parents lucky enough to work for an employer who provides a flexible spending account may set aside up to $5,000 of annual pretax wages to purchase child care services.
Employers can provide an unlimited amount of day care on-site – all tax free; however, if the employer provides additional compensation to the employee to purchase day care services, the benefit is taxable.

Clearly this is not a system designed to accommodate the needs of a 21st century workforce.

Labor Market Rigidities. Our institutions were not only designed for the full-time worker with a stay-at-home spouse, employers and employees find it difficult to make any other arrangement.

Because of rigid tax laws and employee benefits laws, if both spouses work full time they will likely receive duplicate, unnecessary sets of benefits. The wife will be unable to acquire higher wages in return for forgoing health and pension benefits she acquires through her husband's employer.
In a free labor market, one would expect to find a wide variety of work arrangements. Not every two-earner couple will want to work 40 hour weeks. Some might opt for 25 to 30 hour weeks so they can spend more time with each other or raising children. But rigid tax and employee benefits laws make such arrangements largely impossible for people who need health insurance, pensions and other benefits.
Women raising children or caring for an ailing parent have other reasons to want flexibility in working hours. However, rigid labor laws may deny them the opportunity to attend a child's soccer game or take a parent to the doctor one week and make up the hours the following week.

Antiquated Social Insurance. Among its other shortcomings (see below), the unemployment insurance system makes few allowances for women who leave work to have a baby, care for a relative or relocate because of a change in their husband's job. For example, suppose a woman has been working for years, paying taxes into the system, but decides to leave her job to have a baby. In most states, she would receive no benefits during her time away from the workforce and she would also be denied benefits when she searches for a new job. If she does find a job, works for a month and then is laid off, she still won't qualify for benefits because all but nine states ignore the most recent three to six months of work when calculating eligibility for unemployment compensation.¹⁰

Solutions. Many changes are needed to bring aging institutions into sync with the way people are living their lives in the 21st century. Here are a few suggestions:

All employee benefits should be personal and portable; they should be individually owned and travel with the worker as he or she moves from job to job.
There should be a level playing field under the tax law, so that people who save for retirement or purchase health insurance, long-term care insurance, day care, etc., receive just as much tax relief as people who obtain these benefits at work.
The tax system should not penalize two-earner couples; at a minimum, both spouses should be able to file completely separate tax returns.
The employee benefit system should be flexible, making it easier for dual-earner couples to obtain higher wages rather than unneeded, duplicate benefits, and for part-time workers to accept lower wages in return for more valuable health and retirement benefits.
Labor law should be flexible, making it easier for workers (especially parents with young children and caregivers for elderly parents) to choose alternatives to the traditional 40-hour work week.

Making Social Insurance Meet Individual Needs

Social insurance schemes managed by large, impersonal bureaucracies inevitably create perverse incentives for the individual beneficiaries. Sixty years ago there were only a limited number of options open to individuals, even if the incentives were perverse. For example, there were only a limited number of ways to spend health care dollars, even if someone else paid all the bills.

Today we potentially can spend the entire gross domestic product on diagnostic tests alone. As a result, individuals left unchecked to pursue their own interests can bankrupt a health insurance plan. Similar principles apply to the workers' compensation and unemployment insurance systems.

Dysfunctional Workers' Compensation Insurance.¹¹ State workers' compensation systems do not allow employers and employees to reap the rewards or bear the full financial costs of their individual behavior. Premiums are not fully adjusted for claims experience, and employers are not allowed to integrate employee health plans and workers' compensation medical coverage.

Most employer-sponsored health plans do not have first-dollar coverage or allow a completely free choice of physicians and facilities. The reason: There are significant savings from other types of plans. For companies that offer health benefits, the health plan presumably reflects the employees' implicit trade-off between wages and health insurance, since employers compete for labor by making their overall compensation package as attractive as possible. There should be no barrier to using the same health plans for workers' compensation claims. The failure to give employers and employees this option forces employees to take too much workers' compensation coverage and too little in wages and other benefits.

Employers should also be allowed to integrate wage-replacement benefits with their regular disability plans. Having the same waiting periods could provide direct financial incentives to workers for safe behavior and impose financial penalties for unsafe behavior. With their premium savings from selecting more limited conventional coverage, employers could establish Workers' Compensation Accounts (WCAs) for employees; individually-owned WCAs would be a form of self-insurance.

As a step in the right direction, employers should also be allowed to "opt out" of the statutory workers' compensation system. In Texas, firms employing almost one-fourth of the state's workers have chosen this option. These firms have fewer injuries, lower treatment costs and fewer sick days.

Dysfunctional Unemployment Insurance.¹² The unemployment insurance system encourages employers to lay off employees and discourages workers from seeking new jobs until their benefits are nearly exhausted. Part-time workers and those who change jobs frequently are taxed, but often are ineligible for benefits. Those who never make a claim receive no benefit in exchange for the taxes they pay.

The system encourages layoffs by shielding employers and workers from the true cost of such layoffs, since the tax rate paid by the employer is not fully adjusted for the cost to the system resulting from layoffs. Furthermore, because benefits for low-wage workers replace 50 percent or more of their previous pay, the loss of benefits upon reemployment acts as a 50 percent tax, acting as a powerful disincentive to find a new job.

The simplest solution is replacing unemployment insurance with personal employment accounts that are individually owned, totally portable and benefit workers even if they are never involuntarily unemployed. A portion of the payroll taxes paid would be put into investment accounts that workers own and control. People could withdraw funds from their accounts during periods of unemployment, and any unused funds would add to their retirement incomes.

Chile has implemented such a personal account system.¹³ The accounts are funded by payroll taxes. Workers own their accounts, but prior to retirement they only withdraw funds when they are unemployed. Unlike the U.S. unemployment system, Chileans can draw the funds out even if they quit or were fired from their last jobs. This allows workers more flexibility in changing employment. Any unused funds in their accounts are their own money. Also, employers have incentives to provide steady, year-round employment since seasonal work is not artificially subsidized.

Antiquated Health Insurance for the Poor, Elderly and Disabled. The basic structure of Medicare and Medicaid closely resembles the Blue Cross plan it was modeled on more than 40 years ago. In the years since, private insurance has changed considerably. Our public insurance programs have changed little, or not at all.

Medicare enrollees are the only citizens in our society who must buy a second health plan (medigap) to fill the holes in the first. Many go on to buy a third plan (Medicare Part D) to fill the gaps in the first two. Paying three premiums to three plans is wasteful and inefficient. In fact, Medicare Part D would never have been necessary if Medicare and medigap had been combined efficiently into the type of comprehensive plans available to other Americans.¹⁴ Medicaid is also replete with inefficiencies.¹⁵ Although these programs do not directly affect the middle class, they serve as safety nets in case of loss of earning power, disability or old age.

These programs are not only inefficient, they are on an unsustainable growth path. If the trend of the past 30 years is continued indefinitely into the future, spending on health care will crowd out every other government program at the federal, state and local level by the time today's college students reach the retirement age.¹⁶

We cannot get off this unsustainable path unless someone is forced to choose between health care and other uses of money. The only question is: Who will that someone be? Government? Employers? Insurers? Or patients and their families? The system is likely to work better for people if they make their own choices rather than relegating the power to choose to an impersonal bureaucracy. Moreover, if seniors, the poor and the disabled are to have access to the same care as the rest of the country, they must be part of the same health care system.

"Number of Jobs Held, Labor Market Activity, and Earnings Growth among the Youngest Baby Boomers: Results from a Longitudinal Survey Summary," U.S. Department of Labor, Bureau of Labor Statistics, Press Release, August 25, 2006.
James Poterba, Joshua Rauh, Steven Venti and David Wise, "Defined Contribution Plans, Defined Benefit Plans, and the Accumulation of Retirement Wealth," National Bureau of Economic Research, Working Paper No. 12597, October 2006.
For more information, see John C. Goodman and Peter R. Orszag, "Retirement Savings Reforms on which the Left and the Right Can Agree," National Center for Policy Analysis, Brief Analysis No. 495, December 1, 2004.
See John C. Goodman, "Employer Sponsored, Personal and Portable Health Insurance," Health Affairs, Vol. 25, No. 6, November/December 2006, pages 1,556-66.
The Pension Protect Act of 2006 reduced the vesting period to three years for employer contributions to defined contribution plans, down from five years before the change.
This section is largely based on Kimberley A. Strassel, Celeste Colgan and John C. Goodman, Leaving Women Behind: Modern Families. Outdated Laws (Lanham, Md.: Rowman and Littlefield, 2006).
"Women in the Labor Force: A Databook," U.S. Department of Labor, Bureau of Labor Statistics, Report 985, May 2005, Table 7.
"Women in the Labor Force: A Databook," U.S. Department of Labor, Bureau of Labor Statistics, Report 985, May 2005, Table 23.
Assumes a 25 percent federal income tax, plus a 7.65 percent payroll tax, 7 percent state tax and 25 percent for "replacement services."
"Women, Low-Wage Workers and the Unemployment Compensation System: State Legislative Models for Change," 2003 revised edition, National Employment Law Project, October 1997, pages 3-4, 9.
See N. Michael Helvacian, "Workers' Compensation: RX for Policy Reform," National Center for Policy Analysis, Policy Report No. 287, September 13, 2006.
See William B. Conerly, "Unemployment Insurance in a Free Society," National Center for Policy Analysis, Policy Report No. 274, March 29, 2005.
William B. Conerly, "Chile Leads the Way with Individual Unemployment Accounts," National Center for Policy Analysis, Brief Analysis No. 424, November 12, 2002.
Mark E. Litow (Milliman & Robertson, Inc.), "Defined Contributions as an Option in Medicare," National Center for Policy Analysis, February 4, 2000.>
John C. Goodman, Michael Bond, Devon M. Herrick and Pamela Villarreal, "Opportunities for State Medicaid Reform," NCPA Policy Report No. 288, September 2006.
Laurence Kotlikoff and Christian Hagist, "Health Care Spending: What the Future Will Look Like," National Center for Policy Analysis, Policy Report No. 286, June 2006.