Market Insurance Versus Self Insurance: The Tax-Differential Treatment and Its Social Cost

Considerable resources have been expended over the years debating the business tax treatment of market-purchased insurance versus self insurance. Following a long tradition, the U.S. Internal Revenue Service treats only the latter as acceptable evidence of risk shifting and therefore worthy of tax deductibility. We explore the background of this policy and the social cost attached to the implicit subsidy of market insurance as opposed to its substitutes, competing forms of pre-loss risk financing. The scope of economic inefficiency attached to this policy suggests a large potential social gain from equal tax treatment of all forms of business insurance.