The Senate Finance Committee proposes to substantially raise
taxes on middle- and low-income taxpayers through a misguided
excise tax on insurance plans in order to pay for a portion of its
massive health care bill. The Congressional Budget Office (CBO)
estimates that this steep tax hike would cost taxpayers more than
$200 billion over 10 years, about a quarter of the bill's $829
billion cost.[1]
Despite the intention to hit only high-priced "Cadillac" health
insurance plans, the excise tax would fall mostly on low- and
middle-income workers in the near future.
A better tax policy solution would be to cap the exclusion for
employer-provided health care benefits for individuals and use the
revenue to provide offsetting tax reductions. This solution would
also restructure incentives facing health insurance consumers and
ultimately reduce health care costs without growing government
further.
Hidden Tax on Workers
Under the Senate Finance plan, providers of health insurance
plans that cost more than $8,000 a year for individuals ($21,000
for families) would pay a 40 percent tax on their value above that
threshold. For instance, a plan that costs $10,000 a year for an
individual would face this 40 percent tax on the $2,000 over the
$8,000 threshold. The health insurer would have to pay $800 (40
percent of $2,000).
Although the insurance companies would technically make the tax
payment, they would undoubtedly pass this cost along to employers
purchasing the plans for their workers in the form of higher
premiums. Employers, in turn, would pass that cost on to their
workers by lowering other forms of compensation like wages. Once
the excise tax is passed on to workers, the result is no different
than an increase in their income taxes.
Passing the tax on to workers would result in an effective tax
rate that is even higher than the specified 40 percent. When the
insurance companies embed the cost of the excise tax in premiums,
the prices of plans will rise. A higher price means the excise tax
would be higher, too.
For instance, using the example above, if a $10,000 plan rises
to $10,800 because insurers embed the excise tax in the price,
insurers would then calculate the excise tax on top of the $10,800.
This adds an extra $320 on to the price of the plan. When insurers
embed that additional cost in to the plan, its total cost rises to
$11,120 and the cycle would start again. If insurers are able to
push the full cost of the tax on to purchasers, this cascading
effect could raise the effective rate for the excise tax to 67
percent according to one estimate--considerably higher than the 40
percent specified in the bill.[2]
This series of events highlights the first great flaw with the
health plan excise tax, a flaw regarded ironically by its
proponents as one of its finest features: The tax itself is
invisible to those on whom it will fall. It fails miserably the
test of transparency on which the President has put so much
emphasis.
No Way to Avoid Higher Taxes
Faced with the possibility of paying substantially higher taxes,
many workers would logically look for ways to avoid the tax. The
first way they could avoid it would be by reducing the value of
their health benefits below the threshold. If workers take less
expensive health care coverage, they would want higher wages so as
not to experience a reduction in total compensation. But this would
not allow them to escape higher taxes completely, since higher
wages would also be taxed.
Choosing lower coverage is a better tax option since the top
marginal income tax rate today is 35 percent. Even under Obama and
Congress's stated plans to hike the top income tax rate to 39.6
percent, most workers would still pay income tax rates far less
than the top rate. Faced with a 40 percent excise tax rate (before
cascading) on the value of their health care plan above the
threshold, workers would likely trade off health benefits for
higher wages and pay a lower marginal income tax rate.
Workers could also agree to plans that have higher co-pays and
deductibles to avoid the excise tax. This would lower the price of
their plans without reducing their benefits, but they would pay
more out of pocket for their health expenses. They would then
receive the money saved by their employers because of reduced
premiums in the form of higher wages.
The additional wages in both scenarios were previously untaxed
income, because they were devoted to paying for employer-provided
health care. Those additional wages would be subject to tax at the
worker's highest marginal rate--not at the 40 percent rate plus
cascading. Regardless if they pay the excise tax or choose less
expensive health insurance coverage, workers would still pay higher
taxes because of the excise tax.
Excise Tax Breaks President Obama's
Pledge
President Obama has repeatedly pledged that no one making under
$250,000 a year will see their taxes increase. The excise tax would
break this pledge. It would soon fall on low- and middle-income
workers that make considerably less than $250,000 a year, since the
tax would be indexed to inflation rather than the higher health
inflation rate.[3]
Changing the indexing formula is an important feature of many
health and entitlement reform proposals. But taxpayers should not
be fooled into thinking they will not bear the substantial
additional costs of the excise tax. Given the problematic features
of the excise tax, this tax increase would be far in excess of the
income tax rates most Americans pay today.
For example, a worker who earns $34,000 in taxable income today
pays a top income tax rate of 15 percent. But the effect of the 40
percent excise tax on this worker's wages is the equivalent of a
top marginal hike of 167 percent (assuming he or she does not
accept lower health care benefits to avoid the excise tax). And
this does not even account for the cascading effect.
AMT Flashback
The squeezing of the middle class by the excise tax is
reminiscent of another tax that was not supposed to hit
middle-income taxpayers. Congress created the alternative minimum
tax (AMT) to ensure that high-income taxpayers paid a minimum
amount of taxes after taking advantage of the various deductions,
credits, and exemptions allowed through the income tax code.
When Congress passed the AMT, it failed to index the minimum
income threshold for inflation. As time passed and the threshold's
value declined relative to current incomes, more and more
middle-income taxpayers were subject to the AMT. In response,
Congress passes a temporary "patch" each year to prevent most
middle-income taxpayers from paying the AMT, but many taxpayers
that were never originally intended to pay it still do. The same
thing will happen with the health insurance excise tax over
time.
Cap on Exclusion a Better Way to
Go
In place of this misguided and problematic excise tax, the
Senate should seriously consider capping the exclusion on
employer-provided health insurance. Currently, employer-sponsored
health insurance is an untaxed benefit for workers--a benefit
excluded from taxable income. The cap would work much like the cap
on a 401(k), limiting the amount of the benefit that is excluded
from taxable income.[4] Economists on both the right and the left
agree that the exclusion is a major distortion in the tax code and
that capping it is necessary to slow the rapid increase in health
care costs.[5]
Capping the exclusion would change the incentives facing the
recipients of employer-sponsored health insurance because they, for
the first time, would bear some of the cost of their coverage. When
the full costs are transparent--unlike the excise tax--consumers
will make better decisions about their health care insurance and
services.
Capping the exclusion would likely increase the amount of income
subject to taxation for many low- and middle-income taxpayers. But
unlike the excise tax, a cap would not increase the marginal tax
rate of those taxpayers. Taxpayers would pay the same top marginal
tax rate on the cost of their health insurance premium above the
cap as they pay on their wage income--instead of a much higher,
cascading rate. So a taxpayer who pays a top rate of 28 percent
today would pay only 28 percent on the premiums above the cap.
This reform would also generate additional tax revenue. But
rather than growing government's share of the health sector, any
additional revenues should be used toward a credit for individuals
to purchase insurance on their own.
Reform That Does Not Grow
Government
The health insurance excise tax is not a free ride that
insurance companies alone would bear. American taxpayers should not
be fooled into thinking they will not have to bear costs of this
poorly structured tax.
The better option is to equalize the tax treatment of health
insurance by capping the exclusion on employer-sponsored health
insurance and using the revenues to create a credit for individuals
to purchase insurance on their own--without growing the
government.
Curtis S.
Dubay is a Senior Analyst in Tax Policy in the Thomas A. Roe
Institute for Economic Policy Studies at The Heritage
Foundation.