Where Tax and Health Reform Meet

Where Tax and Health Reform Meet
AP Photo/Jacquelyn Martin

The Trump administration and Republican leaders in Congress are pledging to turn their attention toward tax reform after their failure to pass a repeal and replacement of the Affordable Care Act. But Republicans can still improve health care and lower costs if they change the treatment of employer-sponsored health insurance plans in tax reform.

The goal of tax reform is to lower individual and corporate rates, paid for with a broadening of the tax base. Republicans are struggling to find consensus on what popular tax breaks should be curbed. There is no better target than job-based health insurance. Over the next decade, the exclusion of employer-paid premiums from income and payroll taxes will reduce federal revenue by $4.6 trillion, making it by far the largest tax expenditure in the budget.

The tax break for employer-paid health insurance premiums is an accident of history. During World War II, employers competed for labor by offering health benefits to evade wage controls. The IRS later ruled that employer-paid premiums wouldn’t be included in taxable compensation; job-based coverage soon became the most common source of private insurance.

Republicans shouldn’t seek to upend employer-based health care, which works well for most people in these plans. In 2015, 164 million people below age 65 got insurance coverage from employers, and most of them were satisfied with what they received. Innovative employers have led the way on managed care and health savings accounts to cut costs.

But the current tax break is still too costly and inequitable to ignore.

Higher-wage workers gain the most from the exclusion. According to the Tax Policy Center, in 2016 the average tax break for job-based insurance was $3,120 for households in the top fifth of the income distribution and only $980 for households in the middle quintile. Lower-income households get very little from the tax break.

The tax break also encourages overly generous insurance because there is no limit on the amount of premiums that can be excluded from taxation. The more expensive the coverage, the greater the tax subsidy. By favoring high-premium plans with lower deductibles and co-payments, the tax exclusion has undermined the effectiveness of cost-sharing measures that discourage the use of less valuable services. The result? Higher use of testing and procedures, not higher-value care. Economists estimate the federal tax break for job-based insurance pushes up spending in employer-sponsored plans by about 35 percent.

Excluding employer-paid premiums from taxation has also encouraged the substitution of health benefits for cash wages. Between 1999 and 2016, the annual premium for employer plans covering families rose at an average annual rate of 6.9 percent; average weekly wages only went up by an average of 3.8 percent per year. 

President Obama did not put a limit on the tax break for job-based insurance. Instead, he imposed a new 40 percent excise tax on employers who sponsor “high-cost” insurance plans with premiums exceeding specified thresholds, projected to be $10,900 for individuals and $29,100 for families.  The “Cadillac” tax rate of 40 percent is the same regardless of the wage of the worker, hitting employees paid by the hour equally with company CEOs. Although Congress delayed implementing the Cadillac tax until 2020, it remains on the books.

Congress should scrap the Cadillac tax and replace it with an immediate limitation on the existing tax break so that premium payments above a threshold would count as taxable income to workers. This would have a number of salutary consequences. 

Companies would still offer coverage, and most of the plans would be entirely tax-free. But firms sponsoring expensive plans — and their employees — would have strong incentives to embrace intensified efforts to cut costs to avoid the tax. More workers would enroll in high-deductible plans paired with HSAs that are proven to cut costs. Many others would sign up with more tightly run managed-care plans to keep their premiums below the threshold for taxation.  Finally, firms would add to workers’ salaries and wages what is not spent on health benefits.

The CBO estimates a proposal to scrap the Cadillac tax and limit the tax preference for only the most expensive 25 percent of employer plans would generate $193 billion in additional income and payroll tax revenue over a decade. Only premium payments above about $20,000 annually for family coverage would be subject to taxation. The added revenue could be used to lower tax rates for the entire middle class. That would mean more progressive taxation and lower health-care costs.

The Cadillac tax makes taxes more regressive and fuels the relentless increase in health-care costs. Earlier this year, as part of the health-care debate, the GOP embraced replacing the tax with a limit on the current preference for job-based health care. But the party walked away from the idea. That was a mistake party leaders can correct now in their tax reform plan.

Dr. Antos is the Wilson H. Taylor scholar in retirement and health policy at the American Enterprise Institute. Mr. Capretta is a resident fellow and holds the Milton Friedman chair at AEI.

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