Recently unveiled health care reform legislation known as the "Pelosi plan" would impose new costs on small businesses. This legislation would create an employer penalty system that would apply to small firms--even those with 25 or fewer workers. Businesses expanding total annual payroll to $500,000 would face a $10,000 marginal penalty; this penalty rises to $19,200 for small firms expanding total wages to $750,000. This additional cost would create a strong disincentive for small firms to increase compensation or hire additional employees.

Increasing Costs on Small Businesses

The Pelosi plan, H.R. 3962, outlines a detailed employer mandate that would affect small firms with 25 or fewer employees (see Table 1 below). This legislation includes an assessment penalty on businesses with total annual payroll of $500,000 or more that decide not to provide health insurance coverage to their workers.[1] This penalty would effectively impose a new tax on many small businesses.

The plan imposes new costs on businesses, regardless of whether they decide to offer health insurance coverage or pay the assessment penalty.[2] It explicitly states that these additional payments for health insurance cannot be directly taken out of an employee's wages, and any employer-based coverage must meet the Pelosi plan's minimum coverage requirements.[3]

Small firms with $500,000 of total annual payroll would have to absorb a $10,000 marginal penalty, which increases to $19,200 on small firms with total annual payroll of $750,000 (see table below). If, for example, a firm with $499,999 in total payroll moves to $500,000 in total payroll, it would suddenly incur a $10,000 marginal penalty. The marginal impact on a firm expanding total payroll from $749,999 to $750,000 would be $19,200. This marginal impact holds at each specified threshold under the Pelosi employer penalty structure.

How Many Small Businesses Would Be Impacted?

The Pelosi plan's employer mandate system is a substantial change from S. 1796, the "Baucus plan," in which firms with 25 or fewer workers would not only be exempt from any type of tax penalty for not offering health insurance coverage but would also qualify for the specified small firm tax credit. The Pelosi plan eliminates the exemption for firms with 25-49 workers created in the Baucus plan, and a significant number of these firms would face an 8 percent payroll tax.

Moreover, the Pelosi plan imposes a new cost on a majority of small firms with 25-49 workers. A significant number of small businesses could now face the full 8 percent penalty if they elect not to provide health care coverage. According to estimates by Mark Wilson of Applied Economic Strategies, there are approximately 330,839 businesses with fewer than 25 workers per firm that would face employer mandate penalties if they elect not to offer coverage--and 32,425 could face the full 8 percent penalty.[4] Moreover, these estimates suggest that the total employer mandate penalties for these firms could reach approximately $9,256,891,925.[5]

Businesses Would React to Costs

This 2-8 percent mandate cost would affect small businesses' bottom-line, and subsequently, businesses facing new marginal penalties could determine that it is too costly to expand their labor force.[6] Companies would have a strong incentive to:

• Outmaneuver the government in reaction to these penalties; and
• Find a way to absorb these costs.

These changes do not have to exactly take the form of firing some of their labor force or changing their labor force mix to weigh more heavily on part-time or contract workers. Firms would likely have a strong incentive to change both the level and distribution of compensation.

For example, companies would likely reconsider any bonus and raise that would move the firm above a specified total payroll threshold so that they will not have to incur a higher marginal assessment penalty. Where the marginal cost of expanding compensation is too high, many firms would determine that it is easier to contain wages.[7] Thus, firms with a high composition of low-income, low-skilled workers would likely reduce wages in order to offset the additional costs.[8]

Leave Small Businesses Alone

Health care reform cannot ignore how such legislation's employer coverage mandates would negatively impact small businesses. The Pelosi plan eliminates the exemption for businesses with 25-49 workers created in the Baucus plan, and it would also impose new marginal penalties on small firms with 25 or fewer workers. This creates a punitive cost for firms, which significantly raises the costs for businesses on the margin.

Establishing disincentives for small firms to grow would lead to a slower, less robust economy--and labor market. Altering these incentive structures is harmful to small businesses and the way they allocate labor. Federal health care reform legislation, therefore, should avoid creating steep new marginal costs relating to business growth--particularly in terms of wages and worker compensation.

John L. Ligon is a Research Assistant in the Center for Data Analysis at The Heritage Foundation.