Tuesday, January 23, 2007; A16

THIS TIME last year, President Bush's main health policy proposal was to expand tax-sheltered health savings accounts. In the days leading up to tonight's State of the Union address, he has signaled a welcome shift in policy. Expanded tax shelters for health savings accounts would have drained billions of dollars from the budget, and the shelters would have mainly benefited the affluent. Their legitimate goals -- to correct the tax bias against people who don't work for big companies and to discipline health costs -- would be far better advanced by Mr. Bush's new initiative, which is budget-neutral and progressive.

At present, people who get health insurance from employers pay no tax on the value of the benefit. Someone with a marginal tax rate of 35 percent and a generous insurance policy worth $20,000 a year gets a $7,000 tax break. But people who buy insurance on the individual market must usually do so with post-tax dollars, so their tax break is normally zero. The administration proposes to eliminate that unfairness by giving salaried workers and freelancers the same tax deduction.

The reform would also remove the tax incentive to buy excessive insurance. Currently, the more generous your health plan, the more tax subsidies you capture; the person in the example above would get a tax break worth only $3,500 if he chose a more restricted insurance plan worth $10,000 annually. Generous insurance plans, which impose few restrictions on visits to specialists or on possibly redundant tests, inflate demand for medical services and push up prices for everyone; they help explain why the United States spends almost twice as large a share of its economy on health care as do most rich economies. By giving all insurance buyers a standard deduction, irrespective of the type of health coverage they choose, Mr. Bush would restrain medical costs and promote fairness. Because richer people tend to have more expensive insurance, the reform would slightly increase tax rates for people in the top fifth of the income distribution while slightly reducing tax rates for others, according to the White House.

There are weaknesses in the president's proposal. Rather than embracing tax deductions, which are most valuable to people in high tax brackets, Mr. Bush could have made his proposal even more progressive by recommending a refundable tax credit that would be worth the same to everyone. Moreover, there's a danger that ending the tax privilege for employer-provided insurance will cause companies to discontinue coverage, driving more buyers into the individual market, where it's hard to buy insurance at a reasonable price, especially if you already have a medical problem. The administration promises to support state efforts to redeploy federal Medicaid dollars in ways that would make the individual insurance market work better. But success here will depend on the states, and the details are sketchy.

Despite these caveats, the president is right to go after the existing system of tax subsidies for health care. Like the deductions for mortgage interest, these subsidies are regressive and have perverse consequences. Mr. Bush has kicked off a needed discussion.