Question

Imagine that the U.S. Congress, recognizing the importance of being well dressed, started giveing preferential tax treatment to "clothing insurance." Under this new type of insurance, you would pay the insurance company an annual premium, the insurance company would than pay for 80 percent of your clothing expenses (you pay the remaining 20 percent), and the tax laws would partly subsidize your insurance premiums.

a. How would the existence of such insurance affect the amount of clothing that people buy? How would you evaluate this change in behavior from the standpoint of economic efficiency?
b. Who would choose to buy clothing insurance?
c. Suppose that the average person now spends $2,000 a year on clothes. Would clothing insurance cost more or less than $2,000? Explain.
d. In your view, is this congressional action a good idea? How would you compare this idea with the current tax treatment of health insurance?

Answer 1

Part a.

If the Congress of country U to clothing insurance gives a preferential tax treatment, and the insurance company agrees to pay 80% of the clothing expenses and the tax subsidizes the insurance premium, it will result in increase in the consumption of clothes, because people will buy clothes as if they were free.

With this change in behavior there will be decline in economic efficiency because purchasing of formal and expensive clothing is not done on a regular basis, with clothing insurance people will buy less costly daily wear clothes at subsidized rates or for free and the price of clothes will decrease.

Part b.

People who can pay for the 20% remaining cost of clothes will buy insurance clothing and those who can pay the premium. Moreover, the rich will over consume than the poor because they are the ones who will give more importance to good clothing.

Part c.

If a person spends $2000 on clothing the clothing, insurance cost will be more than $2000 because higher the probability of claim higher will be the premium charged by the insurance company.

Part d.

This is not a good idea by the Congress of country U because good clothing is something every person would like to have. Like in health insurance, people should be insured for big life threatening health issues and for minor health issues people should pay out of their pockets, because people take health insurance benefits for minor health issues since health is more or less free in the COUNTRY U. The high premium costs and high prices are completely ignored.