Kill the tax exclusion for health insurance

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Article Highlights

  • Tax exclusion created unintended problems for the structure, cost, and availability of both private health insurance and health care.

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  • Tax reform that aims to do too many things at once will inevitably fall to accomplish most of them very effectively.

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  • Tax policy should aim to be as neutral as possible regarding how one chooses to purchase health care.

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  • Radical changes in the tax treatment of health care are not only politically unwise but simply hard to implement

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Last Saturday, August 16, marked the 60th anniversary of the enactment of the Internal Revenue Code of 1954, which permanently established in federal law generous tax advantages for employer-paid health-insurance premiums. Those group health benefits are excluded from employees’ taxable wages and thereby are not subject to income and payroll taxes. This tax break has been praised as a pillar of our employer-based private health-insurance system, but its age is showing. A growing list of critics agrees that the tax exclusion needs to be changed. The key questions are when and how. We should expect a significant overhaul, but not a full retirement party, within the next five to ten years.

The simplified history of the tax exclusion for health care usually begins with a 1942 ruling by the War Labor Board that allowed employers to bypass wartime wage controls by providing fringe benefits to workers. In 1943, the Internal Revenue Service issued a special ruling that confirmed employees were not required to pay tax on the dollar value of group health-insurance premiums paid on their behalf by their corporate employers. Over the next decade, a number of IRS rulings and court decisions created additional uncertainty over the full scope of the tax exclusion. When Congress codified this area of tax policy in 1954, it provided many employers and unions with even stronger incentives to sponsor group health-insurance plans.

However, the tax exclusion also created unintended problems for the structure, cost, and availability of both private health insurance and health care, and these problems continue today. It has been criticized for raising — and hiding — the overall costs of health insurance and health care. It limits choices for individuals who are seeking other forms of coverage, and it can disrupt insurance arrangements of workers who are changing or losing their jobs. The tax exclusion dispenses its rewards disproportionately to higher-income workers in larger companies with better-paying jobs.

The Affordable Care Act tries to walk in several different directions at the same time on this issue. It provided extremely generous, income-based, premium-assistance tax credits to lower-income individuals who purchase insurance outside the employer-based system. But it did not want to destabilize (at least not immediately) the current employer-sponsored coverage that the vast majority of non-elderly workers and their families still rely on. Nevertheless, it plans to impose an excise tax on the most expensive, “Cadillac” employer plans, beginning in 2018.

Whether or not the poorly structured Cadillac tax ends up being watered down for political purposes later this decade, most private employers are beginning to take preliminary steps to avoid paying it — primarily by lowering the expected future premium costs of any group plans they continue to sponsor and finance. Health-policy reformers of various political persuasions are also hungrily eyeing the hundreds of billions of dollars in federal tax expenditures (forgone revenue from employees’ not paying taxes on the value of their group health-insurance benefits) now devoted to the tax exclusion; they want to redirect it toward other types of health-insurance subsidies.

When Republican legislators and other conservative health-policy analysts focus on developing viable replacement alternatives to Obamacare, they usually start with changing how the tax code subsidizes purchases of health-insurance coverage. The two main proposals would expand the benefits of the current tax exclusion to other insurance purchasers — either through tax deductions or through tax credits — and then limit its maximum amount per insured person. But neither approach by itself strikes the right balance between efficiency, equity, and sustainability.

Most tax-reform proposals for health policy mistakenly try to achieve several conflicting policy goals all at the same time, without accounting for tradeoffs, or they choose the wrong order of priorities. Tax reform that aims to do too many things at once will inevitably fall to accomplish most of them (or any of them) very effectively.

Many sketchy proposals overpromise by trying to more fairly redistribute current tax subsidies for health care, provide more financial assistance to lower-income Americans, encourage a rapid transition from employer-based insurance to individually owned and controlled insurance, cap tax advantages for the most expensive and comprehensive types of coverage, and steer health plans toward high-deductible catastrophic insurance. Yet at the same time, they hope to minimize disruption of existing employer plans for currently insured workers and to avoid creating larger budget deficits.

Moreover, for many conservative Republican incumbents and their allies, treating the tax code as a vending machine that dispenses public benefits to favored political groups remains a more appealing approach than directly expanding on-budget entitlement-spending programs. We need a more principled but less disruptive phased transition away from today’s familiar arrangements and expectations.

Tax policy should aim to be as neutral as possible regarding how one chooses to purchase health care. We need to make the tax code needs simpler, rather than more complicated than it already is.

  • The economic problems facing lower-income Americans are much greater than just whether they can afford better health-insurance coverage. Improved macroeconomic and social policies, as well as other better-targeted interventions, will do much more to assist poor individuals and their families.
  • Broad-based tax subsidies for health-insurance premiums do not actually lower their overall costs. They simply transfer — and arguably increase — them through additional sets of indirect payers. Making the real price of health insurance more transparent, rather than hiding it in tax expenditures and regulatory cross-subsidies, will help lower future health-care costs.
  • Reducing inefficient distortions and inequities in health-care spending under the current tax code should not require net income-tax increases on millions of working Americans who have more generous employer-based coverage.
  • Sudden, radical changes in the tax treatment of health care are not only politically unwise but simply hard to implement in practical terms.


Nevertheless, we can start moving in the right direction by combining the best elements of the tax-deduction and tax-credit approaches in a manner that overcomes their respective weaknesses. Fixed-dollar tax credits, even when partly adjusted for age groups, remain politically arbitrary and disconnected from the wide variation in health-insurance costs in different markets and for different types of health risks. Expanded tax deductions within the “progressive” tax-rate structure of the current federal income tax remain inherently regressive in their distributional effects. Wealthier individuals receive larger tax subsidies for the same amount of premium costs.

Hence, we might consider instead moving toward a fixed-percentage tax credit, which would eventually provide the same level of tax code “discount” for health-insurance-premium costs for anyone purchasing coverage — whether as individuals or through group-purchasing arrangements. That would effectively subsidize low-income Americans more, and high-income ones less, compared with the current tax exclusion for workers who receive job-based coverage. It also would allow tax subsidies to adjust in proportion to the actual premium costs that insured individuals face.

The move toward a single tax-discount rate (that mirrors the equivalent of a flat federal-income and payroll-tax rate for everyone) should be phased in over a number of years, rather than imposed overnight, to limit sudden disruption to current employer-based health-benefits arrangements. An accompanying cap on the maximum amount of premiums per household from which tax subsidies are based may well be necessary, too. But we should justify it as a way to reduce the distorted incentives currently created by the unlimited tax exclusion (until the ACA’s Cadillac tax kicks in during 2018), rather than as a revenue-generating mechanism to finance expanded health-insurance subsidies for low-income individuals or others not benefitting from the employer-based tax exclusion. Roughly equivalent adjustments in marginal rates for federal income taxes can offset any potential net hikes in federal income taxes for upper-income workers or those who have more costly insurance plans. The fiscal need to finance any additional tax subsidies for new beneficiaries should be addressed through other federal spending reductions, or after a broader review of overall tax and budget policy.

Then turn out the lights. The tax party is almost over.

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Thomas P.
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