Today The Washington Post reported that President Obama’s budget proposal to “tax the rich” to pay for health care, including reduced deductions for charitable donations, is “facing deep skepticism on Capitol Hill”. According to the Post, as an alternative, top lawmakers are pondering a change to the federal tax treatment of health insurance—a relic of the WWII era—as an alternative way to financing health reform.

If there is one item where there is a powerful consensus among serious health policy analysts, conservative and liberal alike, it is the need to change the existing tax treatment of health insurance. It distorts the health insurance markets, undercuts consumer choice and competition and fuels higher health care costs. For two decades, the Heritage Foundation has been at the forefront in championing such reform. Tax reform should be the number one component of any major health reform worthy of the name. Without such reform, there would be no serious reform of the insurance markets or health care financing, just more of the same.

Under current law, compensation in the form of health insurance is excluded without limit from the employee’s taxable income: that is, workers pay no income or payroll tax on their employer-sponsored health insurance. The Joint Committee on Taxation estimated this tax expenditure for employer-sponsored health care was $246.1 billion in 2007—the federal income tax and payroll tax components were $145.3 billion and $100.7 billion, respectively. This represents the largest federal tax expenditure and the third largest federal health care expenditure after Medicare and Medicaid.

The current tax break is tied exclusively to employer based coverage, and workers without employer coverage get nothing. Worse, by driving up health care costs and undermining personal ownership and portability of coverage, it directly contributes to the growth of the uninsured. It is not only unfair and inequitable, it is also counterproductive. For these reasons, health economists of all political stripes – including some of President Obama’s top advisers – have long considered tax reform the fundamental component of real health care reform– to stem the rising tide of uninsured and contain rapidly growing health care costs. They would do this by replacing the existing tax exclusion on the value of health benefits with a national tax credit system, as originally proposed by Heritage analysts, or at least capping that exclusion, and creating an alternative system of health care tax credits.

Although President Obama has not included such a tax reform in his health reform proposal, it is not too late. Senator Max Baucus (D-MT) has surfaced the case for change in his recent white paper, suggesting a cap on the current tax exclusion. Recent talks on Capitol Hill indicate there is still a possibility for a compromise on this vital issue. If President Obama and leaders in Congress are sincere about enacting, and responsibly financing, comprehensive health care reform legislation, and do so with broad bipartisan support, reform of the tax treatment might be the key ingredient for a far reaching improvement in the system. A proposal that gradually phases out the income tax exclusion– while phasing in a new system of tax relief– could be a promising addition to any serious health reform proposal.

A crucial issue to be resolved is how the health care tax reform is to be implemented. Two key principles are essential. First, any revenue raised by taxing the value of health insurance benefits received through employers must be entirely used in new tax relief for taxpayers—in the form of a tax credits for individuals and families. The tax credits should only be available for people actually paying income tax and should apply to a large portion of a health plan’s premium, but not all of it. The credit must be designed in such a way that consumers have “skin” in the game, and thus advance, not retard, the cause of cost control. Second, for low-income Americans with no tax liability, or tax liability less than the value of the credit, there should be a “voucher” component. That direct health care subsidy for coverage can and should be paid for by reductions in other government spending in the budget; there are plenty of options. The health care voucher would then be available, either in full or in part, to low-to-middle income individuals and families who lack the resources to afford insurance but have little or no tax liability to offset.

The convergence of the health care and tax reform offers a rare opportunity for serious bipartisan cooperation. It does not come about very often. Hopefully, the Obama Administration and the Congressional leadership on both sides of the aisle will not blow it this time.