Page images
PDF
EPUB

LIMITING FAVORED TAX TREATMENT FOR EMPLOYEE HEALTH INSURANCE

Marilyn Moon, Ph.D.*

Proposals to expand health care coverage to the uninsured often suggest as a source of revenue a reduction in the tax preferences given to those who have employer-paid coverage. Current tax law allows employers to deduct their contributions to health insurance for employees as a cost of doing business, and employees are not required to declare this benefit as taxable income. Consequently, such benefits are not taken into account for either personal income or payroll (Social Security) taxes. The total revenue loss for both the employer and employee exclusions is projected to be about $35 billion in 1989.

All or a part of the health insurance premium paid by the employer could be treated as income and subjected to the personal income tax. The most popular proposal for taxation of health insurance is the "tax cap" approach. This approach would, for example, allow the continued exclusion from income of a portion of the health insurance premium, say $250 per month for family coverage, and tax only amounts above that level. In that way, many employees would continue to receive a tax free subsidy toward their insurance costs, while very expensive policies would be partially taxed.

Tax preferences for health insurance coverage have helped to stimulate employer participation and hence avoid the necessity for more public sector activity. In addition, because insurance represents an “in-kind" benefit, taxing it would ask individuals to pay in cash for a benefit that came in a restricted form (as insurance, not cash). The principle of not taxing such inkind benefits has been long-standing, although options for taxing various in-kind benefits are increasingly being proposed as a means for further raising revenues. Opposition to taxing health benefits thus also arises from the precedent that would be set for taxing

• This report prepared by Marilyn Moon, Ph.D., Senior Research Association, the Urban Institute.

other in-kind benefits such as private pension contributions.

Proponents and opponents of changing the tax status of health insurance benefits both argue about fairness-the subject of this memo. Proponents fault the disproportionate benefits that go to upper income workers who are more likely to have generous coverage-and who benefit more because of the progressive nature of the income tax-as compared to less well off workers. Opponents of a change, on the other hand, cite many of the difficulties in fairly setting appropriate tax caps. The following discussion explores both sets of arguments.

THE BASIC INEQUITIES OF THE CURRENT SYSTEM

The major inequities of the current system cited by proponents of taxing insurance benefits relate to the share of the benefits that flow to a relatively small number of high income taxpayers. High-wage workers are more likely to be covered by their employers, and when they are, the value of the benefits they receive is likely to be higher. In addition, if these benefits were to be taxed, they would be subject to higher marginal rates than the rates faced by noncovered workers. Thus, the tax benefits for each dollar's worth of insurance are larger for those with high incomes. For example, exempting $1,000 worth of premiums saves a low income family only $150 in potential income taxes, but the same premiums result in $280 or $330 in tax savings to those with higher incomes. And for a very low-wage worker who pays no federal income tax, there is no tax subsidy whatsoever.

The concept of base broadening suggests that all employer benefits ought to be subject to tax. Con

sider, for example, the case of workers who can bargain either for higher wages or more health insurance. They are explicitly trading off one for the other, so why shouldn't they pay taxes equally on both types of benefits? Bargaining units correctly recognize that insurance benefits, which are not taxed, may actually be a better deal for employees who can give up one dollar of taxable income for one dollar of insurance that is not subject to tax.

Many tax experts and health economists have recognized that the exclusion encourages individuals to seek more health insurance coverage than is desirable from the standpoint of economic efficiency. That is, because the benefits cost them little or nothing, individuals are inclined to seek more coverage than they would be willing to pay for if they had to bear the full cost. Moreover, individuals whose earnings come solely in cash (and who have no choice) effectively pay higher tax rates than other workers with nontaxed benefits in their total compensation package. Further, some would argue that the resulting lower revenues to the federal government from these tax exclusions mean a lower ability to fund public programs to meet the needs of persons who cannot afford to buy insurance, creating even further inequities. Thus, on both equity and efficiency grounds a good case can be made for taxing health insurance benefits.

EQUITY PROBLEMS IN TAXING HEALTH INSURANCE

The very fact that health insurance is an in-kind benefit creates some inherent inequities. The costs of such insurance vary widely even for similar policies, yet the recipient of insurance coverage may not consider that he or she is better off than a fellow worker just because the policy costs more. If services covered are the same, why should one individual be subject to more tax?

If employer paid insurance premiums were subjected to the federal personal income tax, persons whose health insurance premiums were expensiveeven if for no reason under their own control-would pay higher taxes. And the problem remains even under the tax cap approach. The intention of a tax cap is to discourage excessive coverage, while still allowing a tax break on the basic insurance premium. But, a single cap does not allow a distinction between excessive coverage and expensive coverage. Although the goal of taxing the insurance benefits is not to create a tax that varies by health status, the results could move in that direction if the inequities are

severe.

Another consequence of taxation of insurance benefits may be to discourage coverage of benefits such as preventive services. While some would argue that coverage beyond a minimum package should not be subsidized, other health analysts would argue that additional benefits ought to be encouraged. Choosing what represents excessive coverage (and hence setting a tax cap) would not be an easy task.

Variance in insurance costs stems from a number of factors, some more difficult to deal with than others. First, levels of insurance premiums differ within a given region depending upon the size of the group being offered insurance. Large employers generally face lower costs per worker since the pool of individuals covered by insurance is very large. Employers with only a few workers find insurance costs to be particularly high-a trend that is increasing over time. These represent cost differences beyond the control of the employee who will be penalized if insurance premiums are taxed or taxed above some simple cap.

Second, age and other demographic characteristics of workers in a particular employment setting may result in different insurance premiums. An employer with a large supply of older workers, for example, might face much larger insurance costs-and that could be further exacerbated if the business is a small one. All workers for that employer regardless of age would face higher than average tax liabilities for the benefits they receive. (Or, if differential premiums were to be applied, then older workers or women of child bearing ages might be singled out for heavy tax burdens.)

Basic health care costs and patterns of actual use of services also show great differences by geographic location. Thus, someone in the northeast or north central United States experiences higher premiums— and thus potentially higher taxes-than someone in similar circumstances in the west or the south. Should individuals be taxed differently because the rates that providers charge vary? If they receive the same coverage, individuals may be able to argue appropriately that they should not be held accountable for differences in hospital costs and doctors fees, for example. On the other hand, higher doctors fees tend to occur in high wage areas where workers are also likely to be paid more than, for example, their rural counterparts.

Differences in premiums resulting from varying patterns of use of services pose an even more difficult problem since more care is received by those for whom higher premiums are charged. On the other hand, patterns of use may be more attributable to doctors' decisions than to patient demand. We know, for

example, that practice patterns differ around the country-in some areas many more procedures are performed than in other areas. If so, individuals could again argue that they should not be penalized through the tax system for differences in premiums that are largely beyond their control.

Some proponents of a tax cap argue that the whole purpose of the cap is to put pressure on providers to deal with each of these potential problems. When individuals are faced with having to pay higher taxes, they will presumably demand reforms in the insurance market. This competitive approach assumes that individuals and their employers will be able to have enough purchasing power to force improvements in the market.

SOME SOLUTIONS TO THE INEQUITIES

Several options exist to reduce the inequities created by taxing insurance premiums. Differential caps could be specified depending upon region of residence. But other differences discussed above will vary by firm, so some further adjustment might be needed. For example, an index might be assigned to each individual's reported insurance amount to adjust for differences in the premiums that reflect factors other than scope of coverage. Such an index might be calculated by insurers to reflect differences in the actuarial costs to firms as compared to a national average for some standard policy. That index could then be used, for example, to lower the reported taxable value of unusually high premiums.

Employees of large firms are already likely to be relatively well protected from arbitrary variations in the cost of premiums if a firm-wide average is used to calculate the premium. That is, if the pool of em

ployees is large enough and covers many areas of the country, average premiums are likely to wash out arbitrary differences. Similarly, small firms could be better insulated if their insurance costs were modified by creating large risk pools that would also implicitly weight all the various reasons for insurance premium differences and average them out. Such averaging would likely help small firms with high costs, but if confined to a particular region would not address the issue of geographic variation in insurance costs.

When combined with other health care proposals, a tax cap could also avoid most of the equity issues raised here. Consider, for example, the tax cap in combination with an employer mandate. If the cap is set at or above the amount needed to buy the mandated package, covered individuals would only pay tax when their insurance was more comprehensive than the standard package. And since many mandated insurance proposals would include options for small employers to have access to affordable insurance, premiums should show less variation as compared to the current insurance market. In fact, any reform that improves the private market for insurance could help. For example, if improved risk pooling enabled small firms to buy less expensive insurance, employees would not face taxes on unnecessarily high insurance premiums.

In that sense, combining tax cap financing with health care proposals that result in more reasonably priced insurance complement each other well and reduce one of the major objections to taxing a portion of employer-paid health insurance premiums. On the other hand, proposals such as expanding Medicaid coverage to more of the uninsured would do little to improve the private insurance market; financing such a proposal with a tax cap could be criticized on equity grounds unless some of the modifications described above were also made to the tax cap.

123

« PreviousContinue »