President Bush's proposal to replace the current employer-based
tax exclusion for employer-provided health coverage with a standard
tax deduction of $15,000 a year for family coverage would lead to
higher cash income for many Americans. This is because the change
would eliminate the incentive for companies to earmark an often
excessive proportion of workers' compensation for tax-free health
benefits. Instead, they would compensate workers with higher
Companies that today purchase health insurance for their
employees often do so because neither employers nor employees have
to pay income taxes or payroll taxes on it, unlike for wage and
salary income. By limiting the amount of this compensation not
subject to taxes, the President's proposal would cause both
employers and employees to reconsider how compensation is paid.
Rather than devoting a high proportion of their compensation to
tax-free health coverage, many workers would decide that a more
economical plan made sense and take compensation in other forms.
Some might decide to add more compensation to tax-advantaged
savings plans, such as 401(k) retirement plans or 529 education
savings plans. Other workers would choose to take their income in
the form of a pay raise to increase their paychecks.
Wages Versus Benefits
Companies have adjusted to the rapidly rising cost of health
insurance in recent years by reducing the amount of compensation
they pay as cash wages. For the employer, the most important
consideration is the cost of the combined compensation package. So
when health care costs rise at slower rates, companies pay their
workers more in cash. When health costs rise faster, employers slow
the growth of cash earnings.
But a wrinkle in this equation is the tax treatment of
benefits-especially health care. Workers do not owe income or
payroll taxes on compensation paid in the form of benefits-this is
known as the "tax exclusion." The tax break for health benefits is
particularly generous because the government also exempts employers
from their share of the payroll tax on health benefits. So the
government provides a strong tax incentive for employers to give
compensation in the form of health benefits. The result is that
many workers receive more benefits and lower cash wages than they
would prefer in the absence of the tax exclusion.
The effects of the artificial incentive to pay workers in health
benefits rather than cash compensation and the impact of rising
health costs squeezing cash earnings is evident in recent
compensation data. The average employee's total compensation rose 7
percent between 2001 and 2006. Total benefit packages, however, grew much
more rapidly than wages and salaries. Almost two-thirds of workers'
increased earnings over the past five years have come in the form
of increased spending on benefits, with only a third going into
Of those benefits, the greatest increase has come in what
employers spend to provide their workers with health care. While
wages have risen 3 percent since 2001, employer spending on health
benefits has risen 34 percent. Consequently, the share of compensation
taken up by employer-provided health care is rising. These health
benefits are now worth 11 percent of the average worker's paycheck,
up from 8 percent in 2001. Companies are using money that would have
gone towards higher wages to pay for health care.
What the Research Shows
Many economists have examined the data and found that employers'
spending on benefits is essentially interchangeable with spending
on wages and salaries. In states where rising medical malpractice
costs drove up the costs of health insurance, workers paid for the
higher premiums almost dollar-for-dollar with lower wages. In
states where medical malpractice insurance costs have remained low,
and thus health insurance less expensive, workers received the
savings in the form of higher wages.
Similarly, many states have passed laws mandating that health
insurance plans cover childbirth costs. This makes providing health
insurance to women of childbearing age and their husbands more
expensive. Research has shown that companies respond to these laws
by reducing the wages of their female and married male employees by
the same amount that the health insurance premiums for their
employees' coverage rose. Workers, not employers, ultimately bear the
cost when health care becomes more expensive.
Giving Workers Control
The Bush plan would require companies to disclose the cost of
their group coverage and then would limit the value of coverage
that could be shielded from taxation. The tax-free maximum would be
$7,500 for individuals and $15,000 for families. This limit would
encourage workers to review the structure of their taxable and
non-taxable compensation. Workers who now have coverage that costs
more than this limit would face a strong incentive to consider
whether to negotiate for the now-taxable health compensation in
some other form, such as cash or tax-free savings for retirement.
In many instances, employers and employees would agree to cut back
on "gold-plated" health coverage in favor of higher wages that
would make up the difference.
An increasing number of firms offer flexible benefit "cafeteria"
plans in which employees choose their own wage and benefits
packages, spending as much of their earnings on health coverage as
they see fit.
When the cost of health care rises, many workers with cafeteria
coverage opt for more economical health coverage and devote
compensation to other priorities, such as education or retirement
A detailed National Bureau of Economic Research analysis of
workers at one company that offered a cafeteria plan found that for
each dollar that the cost of health care rose, workers chose to
increase the amount of compensation they devoted to health care by
only 52 cents. They paid for that by reducing their wages 37 cents
and reducing spending on their other benefits by 15 cents. These workers
made a conscious decision about how they wanted to spend their
money and were able to do it in the way that they, not their
employer, saw fit.
By limiting the tax relief for company-sponsored health
coverage, the President's health plan would encourage workers and
their employers to review the structure of compensation. Today that
structure is effectively hidden from most employees, and the tax
system encourages companies to pay compensation as tax-free health
benefits rather than cash. The President's plan would encourage
workers to tailor compensation to meet their unique needs, and many
would choose to receive more compensation as cash wages.
Sherk is Bradley Fellow in Labor Policy in the Center
for Data Analysis, and Nina
Owcharenko is Senior Policy Analyst for Health Care in the
Center for Health Policy Studies, at The Heritage