Given its sheer size, it's not surprising that the Obama administration's $3.8 billion spending plan contains a mix of good and bad ideas. But one potentially obscure component of the budget, a tax provision with a name that ought to cause many eyes to glaze over — deduction disallowance for excess non-taxed reinsurance premiums paid to affiliates (yawn) — may rank as the budget's worst idea of all.

Explaining what the new tax proposal does and how it impacts consumers requires a little background in how insurance and reinsurance work. To begin with, all companies that sell "primary" insurance to consumers (Allstate) and businesses (CNA) buy insurance of their own — reinsurance — to diversify the risks they face and cover them against extreme losses like hurricanes and billion-dollar liability payouts. All sizeable insurers buy reinsurance from both entirely separate corporations and "affiliated" insurance from parent or sister companies that they can trust with sensitive information and that they know won't abandon them after a major catastrophe.

Most reinsurance in the US comes from companies with headquarters in other countries like Bermuda, Switzerland, Germany, the United Kingdom and Japan. Because these companies often insure risks (say, Tokyo earthquakes and United Kingdom floods) that are unlikely to happen at the same time as disasters in the United States, the process reduces overall insurance costs since companies can make profits off of one type of coverage when they lose it on another.

To make up for the transfer of some profits to other jurisdictions, offshore companies pay federal excise taxes roughly equivalent to the corporate income tax.

While all reinsurers engage in strategies to minimise tax liabilities, neither US nor offshore companies have a permanent tax advantage on US operations. The proposal in the administration's budget, a protectionist tariff for all intents and purposes, would give US-domiciled companies a big upper hand by imposing an enormous, burdensome tax on supposedly excessive offshore affiliated reinsurance transactions that are an intrinsic part of just about every large insurers' business. Although US-based reinsurers would sell more reinsurance, much reinsurance would simply vanish. Primary insurers would have to raise rates and reduce coverage in order to rebuild the financial cushion they now get from offshore transactions.

US-based companies, furthermore, wouldn't simply fill in the gap with new products or capital. The company that's pushed hardest for legislation like the Obama administration's proposal (Connecticut's WR Berkeley) is a specialty insurer that recently attributed its record profits to its unwillingness to write the sort of catastrophic risk business that the offshore companies thrive on. And, because other countries' overall tax laws give more favourable treatment to reserves against catastrophes there's good reason to think that most of this business would stay outside of the US borders whatever happened. If offshore companies can't operate as easily in the US, much insurance will disappear and prices will rise.

And consumers would pay the bills. The actuarial firm The Brattle Group estimated that a similar, slightly more sweeping proposal (the Neal bill) would cost American consumers somewhere around $10 billion to $12 billion in higher premiums and destroy about a fifth of all reinsurance.

In fact, however, there's good reason to think that simply higher insurance premiums may understate what would happen. If the administration's plan becomes law, Americans living in particularly risky areas of the country like South Florida and Northern California might find themselves unable to get conventional insurance at any price. In most states where significant price shocks have happened, politicians have rushed in to try to force rates down and driven out private companies as a result. In Florida, nearly one homeowner in five gets homeowners' insurance through a government agency.

To make matters worse for proponents of the tax increase, the proposal could well spark a trade war: when Congress considered similar legislation last year, the European Commission sent letters to the Senate Finance Committee that strongly hinted at trade sanctions against the United States. For all this trouble, the President's budget proposal says the new tax would only bring in a little over $50 million a year, a figure that might well decline as offshore insurers gave up on the US market.

The Obama administration's proposal for a new insurance tariff has enormous downsides and no real upside. It just won't work.

This article was originally published in the Frum Forum. Eli Lehrer is a senior fellow of The Heartland Institute.