Congressional Republicans are hoping to pass a temporary funding bill that would keep the government open until mid-February, thus allowing negotiations to continue on immigration and other matters. To attract more support for the stop-gap bill, Republican leaders have proposed combining it with other unrelated and more popular provisions, including a two-year delay of the so-called “Cadillac tax.” Delaying the “Cadillac tax” again — it was already pushed back once — is a bad idea. It would set back the cause of market-driven health care rather than advance it.
The “Cadillac tax” is an imperfect answer to a long-standing and fundamental problem. Employer-paid premiums for health insurance are excluded from the calculation of the taxable compensation of workers. Workers pay income and payroll taxes on their cash wages but not on the value of the health insurance their employers provide for them.
The exclusion of employer-paid premiums from taxation is the largest tax expenditure in the federal budget, reducing federal revenue by $356 billion in 2017. But that’s not the primary reason to worry about it. The bigger problem with excluding employer-paid premiums from taxation is that it undermines the incentive for cost-control in employer-sponsored insurance — the dominant form of private insurance coverage in the United States. (The Census Bureau estimates there were 178 million people enrolled in employer-sponsored insurance in 2016.)
The unlimited exclusion of employer-paid premiums from taxation encourages overly-generous job-based insurance. All premiums paid by employers are excluded from taxation, no matter the expense. This leads employers to offer expansive insurance coverage, which then leads to more consumer demand for services and higher prices. Employer plans cost 35 percent more than they would if there were no federal tax break attached to them.
The large, current tax break for job-based is also regressive. The Tax Policy Center estimates that it was worth $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 it.
It will not be possible to build a functioning, efficient marketplace for health care if the federal government continues to subsidize all employer-paid insurance premiums without limitation. The current subsidy sends the wrong signals to employers and workers. A sizeable portion of every extra dollar spent on job-based insurance comes from the federal treasury instead of from the firms sponsoring the insurance plans or their employees. That’s not free-market health care.
While economists have been urging both parties to cap this tax break for years, it has been mainly Republican politicians who have taken up the cause. President Ronald Reagan proposed capping the amount of the tax break in 1983, and President George W. Bush proposed a similar plan in 2007. These efforts failed in large part because of unified opposition from businesses and labor unions.
President Obama campaigned against “taxing health benefits” in 2008. But when it came time to consider what should be done to bring more discipline to the health system, his advisors proposed capping the tax break for employer-paid premiums. To avoid looking like he flip-flopped, the president endorsed a plan to impose a 40 percent excise tax on employers who sponsor plans with premiums exceeding certain dollar thresholds. The Democratic majority in Congress reluctantly went along with this idea, despite adamant opposition from labor groups.
Originally, the Cadillac tax was supposed to go into effect in 2018 — four years after the rest of the ACA was operational — with thresholds of $10,200 for plans covering individuals and $27,500 for plans covering families. But legislation passed in 2015 and signed by President Obama delayed its implementation for two more years and allowed the initial thresholds to rise with inflation over the period 2018 to 2020. The thresholds are now expected to be $10,800 for individual coverage and $29,050 for family coverage in 2020 (with those amounts indexed to the CPI in subsequent years).
President Obama wanted to create the impression that the Cadillac tax was punishing employers, not workers, with the excise tax. But that isn’t how it would work in practice. As the Congressional Budget Office (CBO) has confirmed, the Cadillac tax would lead most employers to adjust what they offer workers to keep the premiums for their insurance plans below the thresholds that trigger the tax. Employers would raise the deductibles workers face, contract with narrower networks of physicians and hospitals to deliver services to them, and make other adjustments to cut costs. This is also what would happen if the GOP successfully replaced the Cadillac tax with an upper limit on the tax break for employer coverage. Though these two taxes look different in design, their effects would be very similar.
The Cadillac is the inferior approach because it imposes a uniform 40 percent tax on all plans with high premiums, regardless of the wage levels of the workers. In some cases, this could mean excessively punishing low-wage workers. It would be more equitable to place a limit on the current tax exclusion, thus including in the taxable income of workers any premiums paid by employers in excess of the limitations. Why? Because higher-income workers fall into higher marginal tax brackets and thus would face higher taxes than low-wage workers if employers actually paid premiums above the thresholds.
This is largely a theoretical point, however, because both approaches — the Cadillac tax and an upper limit on the tax break for employer coverage — would have more or less the same effects. Businesses do not want to pay taxes on health benefits, and neither do workers. Under both forms of the tax, most employers would make adjustments to their insurance plans to keep their premiums below the thresholds that would trigger the taxes. The incidence of both taxes, then, would fall mainly on workers in the form of reductions in the value of their health benefits.
Perhaps some Republicans think they can oppose the Cadillac tax now and then later replace it with a traditional limitation on the current tax preference. That’s very unlikely to happen. If Congress delays and then kills the Cadillac tax, there will be no appetite anytime soon to reimpose a different version of the same policy, even if the new version is more rationally designed.
Some Republicans may also think that reforming the tax treatment of employer-based health insurance is not central to building a market-driven health system. They’re mistaken about that. It is impossible to rid the system of inefficiency and waste when so much private insurance is financed by open-ended federal tax subsidies.
If Republicans don’t like the Cadillac tax, they should offer a plan to replace it with a more sensible approach to limiting the current tax break. And if they don’t have the votes to pass an alternative version of the tax, they should leave the current one in place and accept it as a second-best solution. After all, despite its flaws, the Cadillac tax can help remove a long-standing impediment to a well-functioning health-care marketplace.
James C. Capretta is a RealClearPolicy Contributor and holds the Milton Friedman chair at the American Enterprise Institute.
