The taxation of medical costs in perspective

Proposed changes to the taxation of contributions to medical schemes were announced in the 2009 Budget. As John Stuart Mill pointed out, in the absence of definite principles, many false notions of taxation gain credibility.

To place the changes to the taxation of contributions to medical schemes into perspective, they should be interpreted in terms of the fundamental principles of taxation.

The fundamental principles of taxation are both simple and well-known. These were laid down by Adam Smith over 200 years ago and are today known as the canons of taxation. The first principle requires that amounts required to cover the necessities of life are not to be taxed and beyond the limit of the necessities of life, the burden of taxation increases gradually until the final rate of taxation is reached.

2009 Budget changes

In terms of the 2009 Budget, the first R54 200 per annum is the exempt amount, a figure far below that which is needed to support the necessities of life. In an article published in the South African Journal of Economics in 2006, I estimated that the cost of the necessities of life was in the order of R120 000 per annum.

It is thus clear that this basic exemption is not sufficient to cover the taxpayer's medical expenses and accordingly that the total contributions to medical schemes should be tax deductible. If this is not done, then in addition to paying the medical costs, the taxpayer must also pay income tax on the amounts devoted to medical expenses.

This places the government in a most fortunate situation. Firstly it has no obligation to pay any medical expenses and secondly it receives some considerable income from poor persons who are attempting to pay for their own medical expenses. The table below indicates the budget proposals.

Year                             2008/09              2009/10

Principal member           R570                  R625+9.65%
Dependant                     R345                  R380+10.14%

                                              Table 1: Tax allowances

No tax relief

The increase in the tax allowance from R570 to R625 per month was greeted with exclamations of great joy as representing a ‘dose of tax relief' (Personal Finance February 14, 2009). The reason for the joy is not clear at all, since no tax relief was granted. Discovery Health had announced an increase in contributions of 12.4% and the Government Employee's Medical Scheme an increase of 11.18%.

The increase in the tax allowance is thus below both of these increases. It is therefore clear that the increase of 9.65% means that the tax burden will increase, not decrease. There is no tax relief in the Budget.

Government gains

Now let us look at the gains the government will make form the taxpayer's contribution to medical schemes, as indicated in Table 2.

Take an example where the principle member's monthly contribution to a medical scheme is R2 000, the contributions of the taxpayer's dependant is R1 400 per month and the taxpayer pays income tax at an average tax rate of 35%.

Item                                                     Per month              Per annum
Principal member                                  R2 000                  R24 000
Dependant                                            R1 400                  R16 800
Total medical scheme contribution         R3 400                  R40 800
less: Tax deduction                                R1 005                  R12 060
Cost in excess of the deduction              R2 395                  R28 740

Portion of gross income needed to pay for the cost in excess of the deduction to the medical scheme                                                  R3 685                  R44 215
Income tax harvested by the government on these contributions to medical schemes
                                                             R1 290                  R15 475

                        Table 2: Income tax payable on contributions to a medical scheme

In addition to income tax, the government also harvests income on medical contributions in terms of other forms of tax such as VAT.

Changes in context

The universal problem of taxation, from the beginning of all time, has been government expenditure. It does not matter how much taxpayers pay, it will never be enough. Government expenditure quickly rises to exceed its income. This is known as Wagner's Law. The question is how to spread this ever increasing burden of taxation.

The only correct way is Adam Smith's canons of taxation. But this has not been happening. When income tax was re-introduced in Britain it started at a figure which was three times the cost of the necessities of life. In order to avoid any possibility of shifting the burden between the classes of society there was only one tax rate.

By 1900 government expenditure had risen to wipe-out the great surplus which has been generated by the introduction of income tax and it was decided to introduce a progressive tax system.

Shifting the tax burden

The idea was that wealthy would pay more tax than others. The top rates both in England and USA soon reached 90%. It was then decided to reduce the top rates, but not government expenditure.

In the US the top rate has declined to 28%. Reducing the top rates and increasing government expenditure could only be achieved by shifting the burden to the poor and especially the middle income wage earner. This was achieved firstly by starting taxes at well below the necessities of life. In England it started at below the poverty datum line and in South Africa it is about 50% of what it should be.

Secondly, it was achieved by abolishing specific necessities of life deductions. The decline in the tax deductions for medical scheme contributions is simply a continuation of this second trend. Taxes now fall on those who cannot afford to pay these at all.

From bad to worse

Thus, considered in proper perspective against the fundamentals of taxation, the changes to the tax deductibility of contributions to medical schemes are not an improvement on last year. It is simply a continuation of the shifting of the tax burden onto the middle income wage earner with the government harvesting increasing tax revenues from contributions to medical schemes.

It should be clear that there are many taxpayers who will not be able to afford the R15 475 per annum in additional income tax payments. These, given a choice, will not be in a position to purchase medical cover.

In the long run one can anticipate a falling off of membership to medical schemes where members are free to make this choice. It is thus not surprising to note that membership to open medical schemes recently increased by a mere 0.7% and the number of dependants covered by these declined by nearly 4%. With an increasing population, declining membership should not occur.

It is clear that increasingly taxpayers are unable to afford medical cover, let alone paying an additional R15 000 in income tax.