Obamacare’s “Cadillac Tax” – A Poor Patch for a Hole in the Income Tax

The “Cadillac Tax” provision of the Affordable Care Act, which levies a 40 percent marginal tax rate on expensive employer-provided insurance, is unpopular in some circles. The Cadillac Tax is not ideal, but Cadillac plans – and other health care plans, too, for that matter – should be part of the tax base.

Health benefits are known as “in-kind” compensation. Firms give health benefits to workers in exchange for labor, just like a salary. In-kind compensation should, in general, be taxed at the same marginal rate as salary. Otherwise, firms can change your tax liability by shuffling your compensation between salary and benefits, which is silly and wasteful. The tax code’s purpose is to raise revenue, not to direct the means by which people are paid for their work.

Employer-provided health insurance has historically been untaxed – a poor policy likely to encourage overspending on health insurance. While the effects of tax policy are often hard to measure empirically, there is certainly a broad consensus that Americans pay too much for their health care.

The Cadillac Tax helps equalize the treatment of health benefits and other sorts of compensation, but it is still a poor substitute for simply including health insurance in the tax base and lowering rates. As it is designed now, there is a massive spike from a zero marginal tax rate on family plans below $27,500 to 40 percent for plans above that amount.

It’s as if the Obama administration is absolutely certain that the optimal amount of employer-provided health insurance for everyone – no matter what the rest of their budget looks like – is exactly $27,499. I, personally, am not so sure; some epistemological modesty from the architects of the ACA would have been welcome.