This is the first in a new CAP series called the “Tax Expenditure of the Week.” The series aims to explain the often-confusing constellation of tax breaks in a way the average taxpayer can understand. Every Wednesday we will focus on one tax expenditure, explaining what it is, what purpose it is intended to serve, and whether it is effective toward that purpose. We will also review any applicable reform proposals.
Subjecting these dozens of tax breaks to greater scrutiny is part of our broader focus on making government work better and achieving better results for the American people, which is the goal of CAP’s “Doing What Works” project.
Tax-free health insurance is the single largest tax break in the United States, estimated to cost the federal government more than $1 trillion over the next five years in foregone revenue.
CAP has argued that tax expenditures are essentially spending programs that are administered by the IRS. They therefore should be evaluated alongside direct spending programs that serve similar purposes.
The tax exemption for employer-sponsored health insurance is a rare example of a tax expenditure that was considered in the context of overall health care reform. The Patient Protection and Affordable Care Act of 2010 makes important changes to the tax treatment of health care as part of more comprehensive changes to expand affordable health coverage and slow the growth of health care costs. Below, we will consider the role and effectiveness of the tax exclusion for employer-sponsored health insurance in promoting health coverage, as well the effects of the recent reforms.
What is the exclusion for employer-sponsored health insurance and why is it a “tax expenditure?”
The federal government generally takes a cut of all employee compensation whether it comes in the form of salaries, wages, bonuses, or valuable perks. But Uncle Sam doesn’t tax health benefits employees receive at their employers’ expense. Employer-provided health insurance is exempted from income and payroll taxes thanks to a specific provision in the tax code. Such special rules are considered “tax expenditures” if they are departures from the general tax rules and result in lower revenues.
Certain fundamental aspects of the tax code, for example the progressive structure of tax rates, are not considered tax expenditures. They are considered to be a normal part of the tax system. Provisions that favor or encourage specific activities, like employer-sponsored health insurance, are tax expenditures, however.
What is its purpose?
The tax exclusion is a subsidy for employer-sponsored health care, intended to encourage employers to provide health care coverage and make that coverage more affordable. Some tax expenditures serve unclear purposes, but broader health insurance coverage is surely a worthy goal. The tax exclusion should be evaluated based on how effectively it achieves that goal.
How much does it cost?
The exclusion of employer-provided health care benefits is the single largest tax expenditure. It is estimated to cost the government more than $1 trillion over the next five years.
Is the health insurance exclusion effective?
The health insurance exclusion encourages employer-sponsored coverage.
About 60 percent of Americans under the age of 65 are covered by an employer-provided plan. The tax break for employer-sponsored health insurance is undoubtedly a major reason why most American workers (and their families) receive their health care coverage through their jobs. And tens of millions of Americans pay substantially lower federal income taxes than they would if health benefits were taxed in the same manner as cash wages.
Workplaces are logical settings for people to pool together to share risks, and the tax exemption has been described as the “glue” that holds employer pools together. Insurance pools benefit workers by allowing them to spread risks, combine their purchasing power, and save on administrative costs. But there are also some downsides to employment-based health coverage: It might tie workers to their existing jobs even if, all things being equal, they have better job opportunities elsewhere.
The exclusion is not very effective in targeting the subsidy where it is most needed.
The health insurance exclusion benefits most American workers, including millions of middle-class families. But the tax benefits are distributed unevenly. The health insurance exclusion tends to provide larger tax savings to high-income workers. Most subsidies for socially beneficial things are targeted toward those who are least likely to afford them. For this reason, the health insurance exclusion has been called an “upside-down” subsidy.
High-income workers get more of a tax benefit for several reasons. First, workers in higher tax brackets save more in taxes because their health benefits would otherwise be taxed at higher rates. If an employer pays for $10,000 in family health premiums for an executive in the 35 percent tax bracket, for instance, the tax exclusion saves the executive $3,500. A security guard in the 15 percent bracket with the same health plan only saves $1,500.
What’s more, the executive’s health plan is likely to be more valuable than the security guard’s, magnifying the upside-down effect. “Highly paid employees tend to receive more generous employer-paid health insurance coverage than their lowly paid counterparts,” according to the Congressional Research Service. The more expensive a health plan is, the more valuable the tax exclusion for it becomes.
Finally, the exclusion by definition favors those with employer-provided health insurance, who tend to have higher incomes than people who are uninsured or who have to buy their own insurance. The tax benefits of the health insurance exclusion are not as skewed toward wealthy taxpayers as many other tax expenditures, however, as future installments in this series will explain.
The Patient Protection and Affordable Care Act of 2010 takes a number of important steps to target health insurance subsidies where they are needed the most.
First, starting in 2014, low- and moderate-income families who purchase health insurance through newly created insurance exchanges will be able to claim refundable tax credits that cover a percentage of the cost.
These refundable credits will be “right-side-up” subsidies that provide greater assistance on premiums for families closest to the poverty level. The new health care credits, like all tax credits, do not create the “upside-down” effect that occurs with exemptions and deductions. That’s because unlike exclusions, credits provide dollar-for-dollar reductions in taxes owed, so that a $1,000 tax credit is worth $1,000 for all households—no matter what tax bracket they are in. The new credits are also refundable, which allows them to benefit even low-income households that owe no federal income taxes at the end of the year.
Second, the tax subsidy enjoyed by people with more generous health plans will effectively be capped starting in 2018. The new health care law levies a 40 percent tax on the value of health insurance that exceeds certain amounts (about $10,200 for individuals and $27,500 for families). The provision is expected to raise revenue to help pay for the extension of affordable care to more families.
The health care exclusion impacts health care costs.
The tax-free status of employer health insurance is often identified as one of the causes of overall rising health care costs. Employers and employees have an incentive to agree to structure compensation in the form of health benefits rather than in cash because health insurance is tax free. Economists generally believe that health plans are more generous than they would be if all compensation were taxed in the same manner.
More expansive health insurance, in turn, means that workers pay lower out-of-pocket costs for health care. And when they are paying less out of pocket they are more likely to consume more health care. Of course the decision to seek medical care is often beyond people’s control. But at the margins the tax exemption likely encourages greater demand for health care.
More demand for health care means higher health care costs. Health care costs in the United States are among the highest in the world. To be sure, the tax subsidy for health care is only one reason for high health care costs. Other significant causes include payment incentives that reward more care and more intensive care, new technologies, demographic changes, unchecked administrative costs, and inefficiencies in health care delivery.
The Patient Protection and Affordable Care Act makes a number of important changes to rein in the growth in health care costs. The tax on high-premium plans is one of those changes. It is generally expected to help slow the growth of health care costs, though there is uncertainty about how big an effect it will have.
The tax exclusion for employer-sponsored health care benefits is the largest tax expenditure and one of the most important. The Patient Protection and Affordable Care Act takes steps to make it more targeted and cost effective in the context of overall health care reform. Other tax expenditures should be similarly evaluated and considered in the context of the policy goals they serve.
Seth Hanlon is Director of Fiscal Reform for CAP’s Doing What Works project. We hope you’ll find this series useful, and we encourage your feedback. Please write to Seth directly with any questions, comments, or suggestions.
Next week: A closer look at the second-largest tax expenditure: tax breaks for retirement saving.
Articles in this series: