Another Look at Reforming the Health Insurance Exclusion

June 27, 2018

Health policy expert Avik Roy recently announced a new proposal to repeal and replace the Affordable Care Act. According to Roy, the framework of this new proposal bears some similarities to the Graham-Cassidy bill that failed in the fall of 2017. One area that this new framework does not address (likely for political reasons) is the exclusion for employer-sponsored health insurance. Under current law, health insurance provided by employers is not included as taxable income, which leads employees to favor health insurance over regular wages as compensation. This distortion leads to more spending on overly comprehensive insurance plans than would otherwise occur, and lower tax revenue.

There are a few different approaches to addressing the health insurance exclusion. The Affordable Care Act sought to curb the distortionary nature of the exclusion by creating the “Cadillac Tax,” a 40 percent excise tax on high-end employer-sponsored health plans, specifically plans valued above $10,200 for individuals and $27,500 for families. The benefit of this proposal is that it discourages employers from purchasing expensive, tax-excluded health insurance plans and encourages employers to compensate workers with normal wages. On the other hand, the point at which the Cadillac Tax begins is arbitrary, and furthermore, the Cadillac Tax has been postponed until 2022 thanks to political opposition.

Instead of using an excise levy like the Cadillac Tax, a better way to curb the exclusion would be to place a cap on the value of health insurance that can be excluded. For example, instead of subjecting plans that exceed a certain threshold to a new tax, it would be better to simply cap the value of the exclusion. Anything in excess of the cap would be counted and taxed as ordinary income. Directly curbing the exclusion of employer-sponsored health insurance in the context of the income tax code, instead of trying to achieve the same ends with a new excise tax, is more sound tax policy.

The most ambitious solution to this distortion is to eliminate the exclusion for employer-sponsored health insurance entirely. This way, the entirety of health insurance in-kind compensation would be treated exactly the same as monetary compensation. This option could significantly raise revenue: according to the Joint Committee on Taxation, ending the exclusion would lead to $157.2 billion in new revenue in 2018 alone. Furthermore, ending the exclusion and subsequently lowering tax rates in a revenue-neutral way could lead to economic growth. The benefits of making the tax code more neutral and allowing for lower tax rates aside, getting rid of this exclusion would also stop incentivizing overconsumption of health care.

Despite the policy benefits that capping or ending the exclusion would bring, it remains politically perilous. Organizations that tend to offer large health-care benefits, in addition to the public, tend to strongly support the exclusion. For that reason, it’s understandable that the health policy working group avoided this issue while trying to draft a new repeal and replace bill. Nonetheless, it remains good tax policy to rein in this exclusion.


 

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