Saturday, June 13, 2009

Funky tax issue: taxing employer health insurance

In the US, employer-sponsored health insurance is excluded from taxable income. This is an artifact of World War II. Wage controls were in place, but the Internal Revenue Service ruled that health insurance wasn't wages. As a result, employers offered health insurance to attract workers. The system became institutionalized.

It is inherently regressive. Most countries have progressive tax systems, where there are multiple tiers of tax brackets. In any such system, any sort of tax exclusion or deduction gives more benefits to those in higher tax brackets. Let's say I'm earning $15,000 and I'm paying 10% of my income in tax. If my employer pays $500 for my health insurance, and that amount isn't counted in my income, that's worth $50 to me. If I'm earning $150,000 and paying 33% of my income in tax, the same $500 in health insurance would be worth $165 to me.

The tax exclusion does make it cheaper for employers to provide health benefits to their workers. Employers have an inherent interest in a healthy workforce - sick people aren't productive. Due to economies of scale, especially with large employers, health insurance is considerably cheaper for large businesses than for individuals or employees of small businesses. Larger employers also find it easier to promote wellness initiatives and use onsite clinics, because they have the size to do so. Many smaller employers (not to mention individual buyers) have found themselves priced out of the market, meaning that their workers don't get any tax advantage when they purchase insurance on the individual market. This is inherently unfair also.

Lastly, having the true cost of health insurance excluded from taxable income makes workers less sensitive to the price of health care. If workers demanded cheaper health insurance en masse, providers and insurers would be more diligent about saving them money.

Sen. John McCain proposed to repeal the tax exclusion outright in his campaign. He would give workers a flat tax credit. This is inherently progressive. However, his other health proposals would have done nothing to reform healthcare or to cover the uninsured. Repealing the exclusion outright would be very disruptive to the system - not to mention that his tax credit was insufficient for many people to buy health insurance.

There are proposals to put a cap on the value of health insurance that can be excluded from income. For example, if we set the tax exclusion at $13,000 for an individual, and I was in a firm that spent $16,000 on my health insurance, my taxable income would rise by $3,000.

The tax exclusion costs the US a lot of money in foregone revenue every year. It is very unlikely that the US will be able to pay for health reform without touching the exclusion. In addition, capping it would make people more sensitive to the price of healthcare - this is not the only factor driving up healthcare costs, as the Republicans seem to think, but it does play some role. Other good tax measures have been proposed, but many of them are not being considered or are drops in the bucket. For example, a value added tax could generate significant revenue; VATs are inherently regressive, as the poor must spend more of their income on necessities, but doing a VAT in the context of health reform with subsidies to the poor to buy insurance would be a net progressive move. Taxing soda is a great idea, if we can get past the ^*&#ing soda lobby, would generate $4-5 billion a year - a lot of money to you and me but not much in the context of the Federal government.

Some have argued that capping the exclusion will harm children. An improperly designed cap might not account for the difference in value between individual, individual plus one and family plans. Employers are likely to reduce children's benefits first, rather than workers'. Those arguments are nothing that cannot be solved by a properly designed cap and a minimum benefit standard applying to all insurance that includes pediatric benefits. In addition, health reform itself will benefit children. Holding up health reform over one tax issue will harm them. This comes from the Economic Policy Institute.

Unions have argued against capping the exclusion as well. There are some indications that union-negotiated plans are expensive (caution, article is from the Wall Street Journal) because they have low deductibles and co-payments. If this is so, I would advise union folks to suck it up. Health care is expensive for everybody. Like I said to the folks at EPI, if you hold up health reform over one tax issue, you will harm everybody.

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