Fixing the Premium Tax Credit

Reducing De Facto Marginal Tax Rates Through Public Reinsurance and Continuous Premium Subsidy Phase-Outs

Abstract: The Affordable Care Act has substantially expanded health insurance coverage, but its reliance on income-based premium tax credits creates affordability problems and can impose large de facto marginal tax rates on households whose subsidies decline rapidly as income increases. This paper proposes an alternative framework that combines publicly financed catastrophic reinsurance with a continuous household premium contribution schedule. Public reinsurance lowers underlying insurance costs before subsidies are calculated, while a smooth contribution schedule replaces abrupt subsidy cliffs with a gradual phase-out of assistance. Illustrative examples suggest that this approach can improve affordability, reduce work disincentives, and lessen insurer incentives to avoid high-cost enrollees without relying exclusively on larger premium tax credits. The proposal shifts the focus from expanding subsidies to restructuring their delivery, arguing that a more efficient allocation of public resources can produce a more transparent and economically coherent system of health insurance support.

Introduction

The Affordable Care Act has substantially reduced the number of uninsured Americans, but its reliance on income-based premium subsidies creates three persistent challenges. Premiums remain unaffordable for many middle-income households, implicit marginal tax rates discourage additional work and income, and federal health care assistance increasingly relies on back-end tax credits -- a design that fails to tackle the root causes of high insurance costs.

Previous research on this blog and at SSRN has shown that the interaction of multiple Adjusted Gross Income (AGI)-based taxes and benefit programs can create de facto marginal tax rates that substantially exceed statutory income tax rates. (An improved and updated version of the SSRN paper is under review and will be available shortly.) The Affordable Care Act premium subsidy structure is one important contributor to these distortions, particularly for households whose eligibility for assistance changes rapidly as income increases.

This paper proposes shifting a portion of federal support from back-end premium tax credits to front-end catastrophic reinsurance while replacing the existing subsidy schedule with a smooth quadratic contribution formula. The objective is not necessarily to reduce government spending, but to allocate public resources in a manner that improves affordability, reduces labor-market distortions, and creates a more stable and transparent health insurance market.

The Proposal

The proposal supplements the existing Affordable Care Act framework with two complementary policy instruments: publicly financed catastrophic reinsurance and a continuous household premium contribution schedule. Rather than relying primarily on premium tax credits to make coverage affordable, the proposal seeks to reduce the underlying cost of insurance while allowing household premium obligations to increase gradually with income.

The first component is an upstream reinsurance program under which the federal government would reimburse 50 percent of commercial insurance claims exceeding $50,000. Rather than requiring insurers to price the full cost of catastrophic medical events into every policy, a portion of these low-frequency, high-cost risks would be shared across taxpayers. The expected result is a structural reduction in retail insurance premiums for all marketplace participants.

The second component replaces the existing stepwise subsidy schedule with a continuous household contribution formula. Household premium responsibility would increase gradually with income, beginning at a low contribution rate for lower-income households and rising smoothly as income increases. Because public reinsurance reduces the underlying benchmark premium, the premium tax credit would often phase out naturally once the household’s calculated contribution equals the reduced market premium. At that point, no additional subsidy would be needed. The proposal therefore does not require an arbitrary subsidy cliff at 400 percent or 600 percent of the Federal Poverty Level. Instead, assistance would decline continuously and disappear only when the household contribution formula exceeds the reinsurance-reduced premium.

For many households, this framework is more generous than the baseline Affordable Care Act subsidy structure. That outcome is intentional rather than accidental. The current system limits explicit government expenditures but often does so by exposing middle-income households to rapidly rising premiums and large effective tax rates on additional income. The proposed framework instead allocates a greater share of public resources toward lowering underlying insurance costs and providing a smoother transition from subsidized to unsubsidized coverage.

The proposal therefore should not be evaluated solely by comparing federal expenditures with current law. Public resources are finite. Additional spending on health care ultimately requires either higher taxes, reductions in other government programs, or higher budget deficits. This proposal does not claim otherwise. Instead, it argues that improving the efficiency and affordability of health insurance should rank among the highest priorities for public investment because health care affects labor-market participation, household financial stability, entrepreneurship, and economic mobility. The relevant policy question is therefore not whether public resources are scarce, but whether allocating additional resources to a more efficient health insurance system generates greater social benefits than available alternatives.

Whether this approach justifies somewhat higher public expenditures is ultimately a policy judgment. The central hypothesis of this paper is that a system built on lower retail premiums and gradual subsidy withdrawal will produce superior economic outcomes by expanding insurance affordability, reducing labor-market distortions, improving household financial stability, and creating a more predictable insurance marketplace.

Illustrative Example

The interaction between catastrophic reinsurance and a continuous contribution schedule is best illustrated through a representative marketplace participant. The example below is intended to demonstrate the mechanics of the proposal rather than provide a comprehensive simulation of all household types.

Consider a 45-year-old single individual purchasing the benchmark silver plan in the Affordable Care Act marketplace. Under the baseline system, the benchmark premium is assumed to be approximately $551 per month. At 400 percent of the Federal Poverty Level (FPL), the household pays approximately $427 per month while the federal government provides a premium tax credit of approximately $124 per month. A modest increase in income beyond the statutory threshold causes the subsidy to disappear immediately, increasing the household premium from $427 to $551 per month—an annualized increase of approximately $1,488 resulting from only a minimal increase in earnings.

Under the proposed framework, publicly financed catastrophic reinsurance reduces the benchmark premium to approximately $358 per month. At 400 percent FPL, the household contribution is approximately $283 per month, and the remaining federal subsidy is approximately $75 per month. Unlike the current system, however, that subsidy does not disappear at 400 percent FPL. Instead, as income rises, the required household contribution increases gradually while the subsidy correspondingly declines.

Eventually the required household contribution equals the compressed retail premium of $358 per month, at which point the subsidy naturally phases out to zero.

A second example illustrates the marginal tax-rate effect more directly. Suppose the same individual receives a $10,000 raise after reaching 400 percent of the Federal Poverty Level. Under the baseline system, the raise causes the remaining premium tax credit to disappear. Monthly premiums rise from approximately $427 to $551, an increase of $124 per month, or $1,488 per year. The loss of premium assistance therefore absorbs nearly 15 percent of the raise before considering income taxes, payroll taxes, or other income-tested benefits.

Under the proposed framework, the same raise has a smaller and smoother effect. Because public reinsurance has already reduced the benchmark premium to approximately $358 per month, the maximum additional premium exposure is limited. The household’s monthly premium rises from approximately $283 to $358, an increase of $75 per month, or $900 per year. The effective marginal burden from premium changes alone is therefore approximately 9 percent of the raise rather than nearly 15 percent.

This comparison shows why the structure of the subsidy matters. The proposal does not eliminate income-related premium increases, but it reduces their size and prevents a household from facing a large discontinuous loss of assistance after a modest increase in earnings.

The proposal therefore does not eliminate subsidy phase-outs; rather, it changes both their size and their shape. Public reinsurance substantially reduces the amount that must be subsidized, while the continuous contribution formula replaces an abrupt statutory cliff with a gradual reduction in assistance over a limited income range.

This interaction between the two components is central to the proposal. Reinsurance lowers the underlying cost of insurance for all marketplace participants, reducing reliance on premium tax credits. The continuous contribution schedule then allows the remaining subsidy to taper smoothly as household income rises, substantially reducing the de facto marginal tax rates created by the current system without requiring a simple across-the-board expansion of premium subsidies.

Although this example focuses on a single individual, the same economic principles apply more broadly. Premium reductions and subsidy phase-outs will vary with age, household composition, and benchmark premiums, but the underlying design remains the same: catastrophic medical risk is addressed through public reinsurance, while affordability is addressed through a continuous income-based contribution schedule rather than abrupt eligibility thresholds.

Discussion

The combination of public catastrophic reinsurance and a continuous premium contribution schedule create three principal benefits: improved affordability, lower de facto marginal tax rates, and reduced distortions in insurer behavior arising from low-frequency, high-cost medical claims..

Improved Affordability

The proposal improves affordability through a mechanism that differs from a conventional expansion of premium tax credits. Public reinsurance reduces the underlying retail cost of marketplace coverage before income-based subsidies are calculated, allowing many households to benefit from lower premiums regardless of their subsidy eligibility. Middle-income households that currently face rapidly increasing premiums may therefore experience meaningful reductions in out-of-pocket costs while maintaining a stronger connection between premium obligations and ability to pay.

Reduced De Facto Marginal Tax Rates

The Affordable Care Act subsidy structure illustrates a broader public finance problem in which multiple AGI-linked taxes and benefit programs interact to create de facto marginal tax rates substantially above statutory income tax rates. Abrupt subsidy withdrawal can discourage additional work, career advancement, entrepreneurship, and self-employment by imposing large financial penalties on relatively small increases in earnings.

The proposed contribution schedule addresses these distortions by replacing abrupt eligibility thresholds with a continuous phase-out of assistance. Rather than facing a sudden increase in premium obligations, households experience a gradual and predictable increase that more closely reflects their economic capacity. The resulting reduction in de facto marginal tax rates may improve labor-market efficiency while reducing the financial uncertainty associated with income-tested benefits.

Reduced distortions in Insurer Behavior

Public reinsurance addresses distortions in insurer behavior caused by the insurance firms desire to avoid or mitigate the impact of low-frequency, high-cost medical events. The reinsurance subsidy reduces the incentive for insurers to design policies that discourage enrollment by people with chronic health conditions, reduce the incentive for insurers to deny claims and reduce the need for strict time consuming and costly prior authorization procedures. In fact, some of the claim denial and prior authorization procedural decisions might be handled by standards created by economists and doctors hired by the reinsurance agency instead of the private health insurance company.

Conclusions and Limitations

The examples presented in this paper are illustrative rather than comprehensive and are intended to demonstrate the mechanics of the proposed framework rather than estimate its aggregate fiscal effects. The assumed reduction in retail premiums depends on the design and effectiveness of the reinsurance program and would require empirical validation through actuarial modeling and microsimulation.

The examples in this paper use one continuous contribution schedule to illustrate the proposed framework rather than to prescribe a unique mathematical solution. Alternative functional forms could achieve many of the same objectives while preserving the central principle of smooth subsidy phase-outs and lower de facto marginal tax rates. Future research should examine aggregate budgetary effects, insurance market participation, labor supply responses, and interactions with other AGI-linked federal benefit programs.

Public reinsurance lowers the underlying cost of insurance, reducing the amount that must be financed through premium tax credits, while a continuous contribution schedule allows the remaining subsidy to phase out gradually rather than disappear at an arbitrary statutory threshold. The combination of these two complementary policy instruments seeks to improve affordability, reduce de facto marginal tax rates, strengthen labor-market incentives, and create a more coherent system of health insurance support. Whether these benefits justify somewhat higher public expenditures is ultimately a policy judgment, but the proposal demonstrates that alternative subsidy designs may achieve superior economic outcomes without relying exclusively on ever-larger premium tax credits.

Author’s Note: This paper is part of a broader research agenda on reducing economic distortions created by AGI-linked taxes and benefit programs including the paper A Third-Party Tax Reconciliation Approach to Health Care. Planned projects include pediatric reinsurance, alternative methods for smoothing income-based subsidies and loan repayments, and detailed estimates of the fiscal costs and economic effects of these proposals. Paid subscriptions directly support the purchase of data, statistical software, computational tools, and the time required to produce independent policy research.