Congress Could Improve Both the Tax Code And Health Coverage By Redesigning The Tax Subsidy For Employer-Sponsored Insurance

Taxes

When Congress voted in December to repeal the Affordable Care Act’s “Cadillac tax” on high-cost employer-sponsored health insurance plans (ESI), it took health policy in exactly the wrong direction. Rather than fully preserving the exclusion from taxable income of these insurance benefits, Congress should have further scaled it back, or even repealed it.

That step could have helped slow the growth in health care costs and generated new revenue that could have been used, in part, to expand access to health coverage for low- and moderate-income people.

How to reform the ESI exclusion

A new report by my Tax Policy Center colleague Gordon Mermin and co-authors from the Urban Institute’s Health Policy Center describes the flaws of the ESI exclusion and shows how cutting it back or even enacting a well-designed repeal could improve the nation’s health policy.

Excluding employer-sponsored health insurance from workers’ taxable income will cost the US Treasury nearly $300 billion this year—almost 10 percent of all federal revenue. In effect, instead of paying taxable wages, employers compensate their workers with tax-free, subsidized health insurance. This reduces their taxable income and both their income and payroll taxes.

As a share of after-tax income, middle- and upper-middle income households get an outsized benefit from the tax subsidy, almost three times that of the lowest income households, according to TPC estimates.

In dollar terms, the lowest income households will get an average benefit of about $160 this year, while the highest income taxpayers will receive an average of $4,700.

Reducing medical costs

The ESI exclusion not only does little for the low-income families, it may also contribute to higher health costs—a major concern of lawmakers of both political parties. The reason: Because the tax code creates a 29 percent average subsidy, employers may offer their workers insurance that is more generous than they’d buy if they had to pay the full, unsubsidized cost.

As a result, ESI may cover more services, pay providers more, or require lower out-of-pocket costs. All these features may be popular, but they also contribute to higher health care costs.

So what could be done about it? Gordon and his coauthors suggest three alternatives:

  • Repeal the exclusion.
  • Tax ESI premiums like wages if they exceed $7,150 for singles and $18,500 for couples.
  • Replace the exclusion with a refundable tax credit that would start at $2,275 for singles and $5,700 for family coverage in 2020. The credit and the thresholds would increase at the rate of health cost growth. The flat credit would be equal to the average value of the exclusion, but would be more progressive and decouple the size of the tax break from the cost of insurance.

Two of these changes would lower the number of people covered by health insurance. Fully repealing the exclusion would increase the number of uninsured by about 8 million since fewer workers would buy health insurance with after-tax dollars. Capping the exclusion would add about 4 million people to the rolls of the uninsured. The tax credit would result in no net change since about the same number of workers would add or drop coverage.

How to use the revenue

However, Congress could choose to use some of the revenue savings from repealing or scaling back the exclusion to, for example, increase subsidies for insurance purchased on the individual market exchanges or expand Medicaid coverage. The net effect could be fewer uninsured, slower growth in health care costs, and some federal budget savings.

Repealing—but not replacing–the exclusion would result in a significant average tax increase for middle- and upper-middle income households. However, if Congress uses some of the new revenue to increase subsidies for those who purchase in the non-group market, the changes could reduce net after-tax insurance costs for millions of people.

Replacing the exclusion with the credit would modestly cut taxes for most households, on average. Only higher income households would pay more, and not by much.

Today, Congress is unwilling to take any steps to reform the ESI exclusion. After all, it just voted to repeal an even more modest effort. But by not fixing ESI, it is missing an opportunity to make the tax code more progressive, perhaps slow the growth of health costs, and generate funds that could boost individual insurance coverage. 

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