The Obama Administration and congressional Democrats have
recently opened the door to a change in the tax treatment of
employer-sponsored health benefits as part of health care reform.
In doing so, they have joined with a wide range of health
economists across the political spectrum.
Rationale for a Tax Cap
For years health economists have argued that the tax-free status
of employer-sponsored health insurance (ESI) should be limited--or
even ended completely--and replaced with greater tax relief for
lower-income families with ESI and new tax relief for families
buying their own insurance. Economists call for either a tax
deduction or tax credits for these families.
There are two objectives behind proposals to reform the
"exclusion" of ESI benefits from a worker's taxable
- First, it would focus the unlimited special tax break--which,
after all, is a distortion in the underlying tax code--on those who
need help the most. Currently the total value of the tax exclusion
is about $270 billion annually to families at the federal level
(there is also tax relief from state taxes), with most going to
upper-income families who are in higher tax brackets.
- Second, it would achieve efficiencies and cost reductions in
health care over time by making workers more attuned to their
health benefits. Economists generally agree that the tax-free
status of health benefits means their true cost is essentially
hidden: Their value does not even appear in paychecks or year-end
W2s. This discourages workers from questioning value for money in
health insurance or whether they are overusing services. This in
turn pushes up the cost of these benefits and correspondingly
reduces the cash income component of worker compensation. A cap would
focus workers' attention on the total cost of their insurance and
make workers a self-interested partner with employers in seeking
more efficient and less costly plans.
Key Bipartisan Principle: Tax Reform,
Not Tax Hikes
A threshold principle in designing a cap on the tax
exclusion--if bipartisan support for the idea is to be
maintained--is that it must be a tax reform element of
health reform, not a device to raise taxes to pay for new health
spending programs. Thus revenue raised from a tax cap from some
workers should go to other taxpaying workers to help pay for
coverage. The revenue should not go toward, say, expanding Medicaid
or other direct spending. To the extent that health programs or
subsidies to families below the federal tax threshold are to be
financed, that should come from savings elsewhere. The whole
process should result in no net new taxes.
Given that principle, there are several questions about the
nature and design of a tax cap that need to be answered:
Q: Does This Mean Workers Will Just Pay More Taxes on Their
Existing Benefits? Over time it is more likely that workers
will bargain for a change in their compensation to keep health
benefits at or near the cap.
The effect of capping the value of the exclusion would be
similar to limiting tax-free contributions to 401(k) plans or the
tax cap for employer-provided life insurance. In those cases
employees typically elect or bargain to take compensation as cash
income rather than have their contributions and benefits exceed the
Thus while it is true that some employees with health benefits
above the cap might prefer to keep them and pay the tax, most would
likely bargain to have more economical health plans and more of
their compensation in (taxable) cash, meaning bigger paychecks.
Most labor economists and the Congressional Budget Office agree
that changes in non-cash benefits lead to almost dollar-for-dollar
changes in cash earnings in any compensation package.
Q: How Is a Tax Cap Set? The simplest way would be to
specify a dollar amount, similar to the 401(k) limit for individual
and family coverage, with the "excess" identified in a worker's
paycheck as taxable compensation. The cap could be the national
cost of a benchmark plan determined to be a reasonable basic level
of coverage. The cap would apply to actual premiums paid or, in the
case of self-insured forms, to average per-employee health benefits
spending by the firm.
The limit could be held permanently at the same dollar level
until Congress adjusts it, or it could be indexed. That index might
be the Consumer Price Index (CPI). That means the cap would likely
become steadily tighter over time since insurance costs have risen
faster than CPI, so there would be a steady increase in pressure to
trim costs or switch the cash/benefit balance of compensation. Or
the IRS could be instructed to use one of the medical indexes,
which are higher than the CPI.
A simple dollar cap is often challenged as unfair because some
workplace groups or individual insurance purchasers face
significantly higher or lower costs because of such things as their
health status. Adjustments can be made to the cap to reflect these
factors (see below). But it is also important to note that most
health reform proposals also envision regulations or devices such
as rick adjustment to limit premium variations, so the future
variation of premiums would likely be less than today, so there
would be fewer inequitable situations to address.
Q: What About People in Higher-Cost States? Some say that
a dollar cap would unfairly "overtax" families who live in states
where medical costs and insurance premiums are higher while
"undertaxing" families in many other states. While this concern is
understandable, it should be remembered that one of the objectives
of health reform--and the cap itself--is to trigger pressure to
confront and reduce costs in these higher-cost states.
But to the extent that Congress wishes to partially insulate
people in higher cost states--at least temporarily during an
adjustment phase--it could use the local cost of the benchmark plan
for the cap rather than the national average cost. Thus an
adjustment could be made state-by-state. Also within a state there
might be a further "high" and "low" refinement of the cap,
typically to offset rural and urban differences.
Q: Wouldn't Older Workers Often Pay a Higher Cost? Health
costs do rise with age, so a tax cap not adjusted for age would
mean higher taxes for an older individual with the same insurance
coverage. Among the ways to address this would be to include an
adjustment for the worker's age in the federal tax return worksheet
for computing the tax. (Employers make a similar age adjustment in
reporting the taxable value of employer-sponsored life insurance in
a worker's W-2 form.)
Q: But What About Firms with Abnormally High Health
Costs? Workers in some firms still face unusually high costs
for the same broad insurance services, even after the adjustments
to the cap discussed above, and this might be considered unfair.
For instance, people in certain industries tend to have higher
medical costs. One possible solution is to use the "actuarial"
value of the coverage, rather than its actual cost, to compute any
A problem with this general approach is that it is less
effective in encouraging workers to challenge actual benefit costs.
But it could provide a last-resort adjustment for workers in an
abnormally high-cost firm. If a firm, on behalf of its workers,
could demonstrate that a tax cap based on cost meant that the
taxable amount was, say, at least 10 percent higher than the
typical level for a firm with similar demographics in the state,
then the firm could apply for an actuarial value assessment on
behalf of its workers, and this would be used for establishing the
Tax Caps Done Right
The tax exclusion for employer-sponsored insurance has long been
criticized as inequitable, unfocused on those who need help to
afford coverage, and a significant factor fueling insurance costs.
Addressing it with a tax cap in the context of health reform would
distribute existing tax breaks among taxpayers in a more rational
manner while helping to defuse the rapid upward trend in health
costs. And if designed carefully, with no net tax increase, it
could do this in a way that is fair and reasonably adjusts for
existing variations in insurance costs.
Butler, Ph.D., is Vice President for Domestic and Economic
Policy Studies at The Heritage Foundation.
Sherk, "Analyzing Economic Mobility: Compensation Is Keeping Pace
with Rising Productivity," Heritage Foundation Backgrounder
No. 2040, June 11, 2007, at http://www.heritage.org/Research/Labor/bg2040.cfm.
discussion of how changes in employer-sponsored benefits affect
cash compensation and taxes see Douglas Elmendorf, Director,
Congressional Budget Office, letter to Senator Edward Kennedy
(D-MA), June 15, 2009, pp. 5-6, at /static/reportimages/C93FE22B70937661768EACB3326D7138.pdf
(July 1, 2009).
value of a health plan is the total claims cost that actuaries
estimate would occur in a particular plan if it had a nationally
representative population as its enrollees. For the argument that
this method should be used generally for a tax cap, see Stan Dorn,
"Capping the Tax Exclusion of Employer-Sponsored Health Insurance:
Is Equity Feasible?" Urban Institute, June 2009, at http://www.urban.org/publications/411894.html
(July 1, 2009).