A Sick Policy on Health Insurance

The right of workers to obtain, tax free, an unlimited amount of health insurance at work gives buckets of tax savings for executives but only spoonfuls of savings for low and moderate-income workers. It also excessively drives up the cost of health insurance and health care in general.

Question 5. Ask the Candidate:

Shouldn’t Congress initially limit this tax break to the premium for a basic policy? And shouldn’t Congress eventually replace this tax break with a tax credit to help all Americans buy a basic policy, without regard to employment?

If Olympic medals were awarded to countries for the most poorly targeted, most expensive, and most economically unjustifiable health care policy, the United States surely would win gold because of the tax break it provides for employer-based health insurance. We cannot afford to be so wrong.   

The Tax Break for Employer-Based Health Insurance

Some background. Any thoughtful lawmaker recognizes the benefits of a healthy society. Healthy children are more likely to have better school attendance and be better students. Healthy adults are more likely to work productively and be able to support themselves and their families. And the entire family is less likely to become a burden on government.

See comments on the Affordable Care Act (or “Obamacare”) under “What Congress Should Do.”

We can understand, therefore, why Congress might adopt a tax break that encourages workers to acquire health insurance. Congress should have a hard time explaining, however, why, since World War II,  it has preserved the most expensive tax break of all—an employee’s right not to count as income the premiums for an unlimited amount of health insurance acquired at work.

Why the Exclusion is a “Tax Break.”  The exclusion of employer-based health insurance premiums from the employee’s income tax return is considered a “tax break” because it departs from the general rule that all compensation is taxable income. In general, if your employer pays your personal expenses, such as for food and housing or your summer rental at the beach, the payments count as wages and are added to your W-2 form. A major exception is for employer-based health insurance premiums. Whether the employer actually pays the premium from its own resources, or deducts money from your wages and makes the payment on your behalf, the money involved is exempt from income and payroll taxes.

The Income Tax Savings (and Government Revenue Loss).  In 2013, according to White House estimates, the income tax savings for workers from the tax break for employer-based health insurance will be a staggering $181 billion.[1]Yet, as always has been the case, the greatest income tax savings will be for the most highly paid workers, those who could pay for a policy without government assistance. The least savings will be for low-income workers.

Social Security and Medicare taxes also don’t apply to employer-paid health insurance; these tax savings are likely to exceed $100 billion in 2013.

Congress also knows these demographics: (i) higher-income workers are much more likely to be covered by an employer-based health insurance policy than are lower-income workers, (ii) full-time, full-year workers are much more likely to be covered than are part-time or part-year workers, and (iii) workers at large firms are much more likely to be covered than are workers at small firms.

Primo Subsidies for Primo Premiums

Many of the 47 million uninsured Americans work but have no employer-based health insurance because they’re deemed ineligible, their employers don’t offer it, or they can’t afford to contribute toward it.

Over  60% of workers and their families obtain their insurance at work, but the people helped most by the exclusion, as in the case of all exclusions, are people who otherwise would be taxed at the highest “marginal” tax brackets if the premiums were taxable. Your marginal tax bracket is the top tax bracket applicable to your taxable income.  You may owe 10% (the lowest bracket) on some of your income, but if you pay the 15% rate on your top $1 of taxable income, then 15% is your “marginal” tax bracket.

See Common Myths and Misunderstandings #1 for how our progressive tax rates work.

For example, each $1,000 excluded saves $350 for someone who, without this exclusion, would pay the top 35% marginal tax rate on it. For the majority of households whose top tax bracket is only 15%, each $1,000 excluded saves only $150. And the exclusion has no value for millions of households whose taxable income is so low that they wouldn’t pay a tax on the premium even if it counted as income.

Basic math also tells us that the tax benefits widen further because employers typically provide much more expensive policies for a manager or top executive that include extensive coverage and few co-payments and deductibles, while paying only the cost of a basic policy for an ordinary worker that covers only her. If she wants a family policy, she must pay the difference herself. No wonder this tax break produces such upside-down subsidies.

You may recall that the Introduction discussed the lopsided tax savings for Mr. CEO vs. Ms. Secretary resulting from the tax exclusion for employer-based disability income insurance premiums. That’s exactly what happens with the exclusion for health insurance premiums.

Let’s say Mr. CEO and Ms. Secretary are both married with young children, and that ABC, Inc. pays $12,000 for a basic family health insurance policy for each.  The $12,000 is excluded from their respective tax returns.  Mr. CEO, who earns $500,000, saves $4,200 in income taxes, because without the exclusion, he would have been taxed on the $12,000 at the highest 35% tax bracket (35% x $12,000 = $4,200). That makes his net out-of pocket cost only $7,800 for the premium. Ms. Secretary, who earns $30,000, saves only $1,800at her 15% tax bracket.That makes her net cost $10,200 for the premium.

And if ABCbuys the deluxe $25,000 policy for Mr. CEO (with low deductibles and littlel co-insurance), while buying the basic policy for Ms. Secretary, his income tax savings are ramped up to $8,750(35% x $25,000), over 5 times the savings for Ms. Secretary.

The Affordable Care Act uses just the opposite formula to help the uninsured. It calls for refundable tax credits[2] to be issued to the uninsured for the purchase of health insurance; the poorest people are to receive the largest credits.

If Congress eliminated the tax break but authorized the Department of Health and Human Services to issue checks to help Americans buy health insurance, could you imagine an HHS program that authorized a check to Mr. CEO nearly five times larger than the check to Ms. Secretary?

As experts from the nonpartisan Tax Policy Center have written about the exclusion of employer-based health insurance premiums, “Putting all…factors together, the picture is of a tax subsidy that overwhelmingly favors middle- and upper-income households.”[3]

Health Care Economics. Here’s something else to think about: Economists tell us that the unlimited exclusion for employer-based health insurance premiums excessively drives up the price of health insurance and health care generally. An expert from the non-partisan Center on Budget and Policy Priorities explains, “Like any subsidy, it encourages more spending on the item that is subsidized, particularly for those with high incomes who derive the greatest benefit from the exclusion. By reducing the after-tax price of health insurance, the exclusion provides an incentive for employers and individuals to select more generous or costly coverage than they otherwise would purchase. That, in turn, leads to an increase in the demand for health care services, pushes up prices in the health care sector, and ultimately makes health care and health coverage less affordable.”[4]

What Congress Should Do

As long as Congress refuses to adopt universal coverage for all Americans (see discussion at end of this question), it should address the tax exclusion for health insurance premiums as soon as possible.

Limit Exclusion to a Basic Policy. Congress eventually should replace the exclusion with a tax credit. But the employer-based insurance program is too extensive to be replaced without adequate planning time. In the interim, Congress should limit the exclusion to premiums for a basic policy that would take into account the size of the household. What is “basic” will need defining, but I’m hardly the first person to suggest this. As far back as 1984, the Treasury Department—under Ronald Reagan--made this exact recommendation, and went on to specify the maximum monthly amount.[5]

The Affordable Care Act adopted a compromise: It preserves the exclusion until 2018, and then imposes a 40% tax on premiums that would be deemed excessive[6] But the Act has an uncertain future. Moreover, we can’t afford to wait until 2018. From 2013 through 2017, the unlimited exclusion is estimated to cost the government over $1 trillion in total tax revenue![7]

Deny Exclusion for Policies Favoring Managers. Congress also should deny the exclusion to highly-compensated workers if other workers for the same employer are not entitled to comparable policies. No stranger to this idea, Congress already has adopted similar rules when employees pay for their own health insurance under an employer’s “cafeteria plan.”

Cafeteria plans allow an employer, if authorized by an employee, to pay various personal expenses of the employee and his family by subtracting the amounts from his salary. All payments allowed by the cafeteria plan—such as for health insurance, disability income, life insurance, and child care--are tax free, with one exception:  Highly-compensated employees are taxed on the entire premium unless (i) a minimum percentage of other workers participate, and (ii) other workers’ policies are comparable to those of highly-compensated workers. Typically, when rank-and-file workers choose to participate, they choose only a basic health insurance plan because that’s all they can afford.

It doesn’t make sense for Congress to impose such reasonable limitations for cafeteria plans but not for other premium-payment plans that employers commonly adopt. One thing is clear: The government would gain a great deal of tax revenue by capping the exclusion to premiums for a basic plan. For example, the Congressional Budget Office estimated that if, in 2008, Congress had limited the exclusion for employer-based health insurance to $910 per month (10,920 per year) for family coverage and $340 a month ($4,080 per year) for individual coverage, the government could have collected an additional $290 billion of income and payroll taxes from 2008 through 2012 and nearly $1 trillion from 2008 through 2017.[8]

Tax Credits. In the long run (short of adopting universal health care), Congress should replace the exclusion with a tax credit for everyone, employed or not, to be applied to the purchase of a basic insurance policy. The credit should be refundable—people who don’t owe income taxes would receive a check in the amount of the credit--and it should be large enough to make a basic policy affordable.[9]

If Congress chose to reduce the credit for higher-income taxpayers, it would be adopting a policy that provided the maximum health insurance coverage at the minimum possible cost to the government. But a diminishing credit also would complicate the tax laws and would be very difficult politically.

A final note. Some experts argue that replacing the exclusion with a universal tax credit would have the effect of reducing, rather than increasing, the number of people insured. Employers, the argument goes, would stop contributing to the costs of their employees’ health insurance and simply pay the difference to the employees, who would struggle to find an affordable policy. For that reason, many proposals retain the exclusion but limit it to a basic policy.  

We cannot resolve this debate here. What we should expect, however, from every candidate is agreement that tax subsidies for health insurance should help people with limited income at least as much as they help high-income people. Let’s find out what the candidates believe, what legislation they would favor, and why.   

[1] Executive Office of the President, Office of Management and Budget, Analytical Perspectives, Budget of the United States Government, Fiscal Year 2013, Tax Expenditures.

[2] Each $1 of tax credit offsets $1 of tax liability. If the credit exceeds the person’s tax liability, a check is issued to that  person for the difference. This is referred to as a “refundable credit.”

[3] Leonard Burman, Bowen Garrett, and Surachai Khitatrakun, “The Tax Code, Health Insurance Coverage, and Utilization,” a paper for presentation at a meeting at the Brookings Institution, Washington, D.C., February 29, 2008.

[4] Paul N. Van de Water, “Limiting the Exclusion for Employer-Sponsored Insurance Can Help Pay for Health Reform; Universal Coverage May Be Out of Reach otherwise,” Center on Budget and Policy Priorities, June 4, 2009.

[5] Department of the Treasury. Tax Reform for Fairness, Simplicity, and Economic Growth: The Treasury Department Report to the President, Vol. II, November 1984, 17. President Bush’s “Advisory Panel on Federal Tax Reform” also recommended a cap on the exclusion.

[6] In 2018, the Act imposes a 40% tax on the value of premiums that exceed about $10,200 for individuals and $27,500 for families. But this still allows much larger tax savings for high income employees with larger policies than for lower income employees with smaller policies.

[7] Seth Hanlon, “Tax Expenditure of the Week: Tax-Free Health Insurance,” Center for American Progress, January 12, 2011.

[8] Congressional Budget Office. Budget Options. Washington, D.C.: Government Printing Office, February 2007, 279. CBO’s premium figures do not adjust for cost-of-living adjustments, which presumably would be included in any legislation. Their figures include eliminating the exclusion for health cost reimbursements through a cafeteria plan, flexible savings accounts (FSAs), and health savings accounts (HSAs] but the great bulk of the tax savings comes from limiting the exclusion for health insurance premiums. CBO notes that the additional Social Security taxes that would be paid because a portion of premiums previously exempt would count as wages also would permit additional Social Security benefits over the long run.

[9] In order that people not have to wait until the end of the year to know the size of their credit, the credit should be based on a taxpayer’s income for the prior year.  Rules also would have to be developed to assure that the credit is in fact used to acquire insurance.  For example, the credit could be assigned directly to the insurance company.

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