Sound Tax Policy Proposal in Michigan

A member of the Michigan legislature has proposed taxing the health benefits that employees receive as part of their compensation, thereby making the income tax system more neutral. From the Detroit Free Press:

In a possible first, individuals would pay state income tax on health benefits from their employers under one scenario lawmakers are considering to resolve the state’s budget crisis.
Rep. George Cushingberry Jr., D-Detroit, said extending the income tax to benefits, as well as wages, would allow for a lower income tax rate increase as part of a final budget agreement.

Currently, benefits are not taxed as income.

Cushingberry said raising the income tax from 3.9% to 4.3%, and expanding it to include benefits, would generate about as much revenue as a 4.6% tax on income alone – roughly $1.2 billion in additional revenue. The state faces a $1.75 billion deficit for the new fiscal year that begins Oct. 1.

Senator Ron Jelinek, R-Three Oaks, cautioned that negotiations remained fluid and that the income tax plan was one of several tax issues being discussed.

Cushingberry is right on this one. It is better tax policy to expand the tax base to tax income that is currently untaxed as opposed to raising the tax rate. Calls for this change in policy at the federal level have largely gone unnoticed, and that’s unfortunate because exempting one source of income like employer-provided health insurance from the tax base leads to higher tax rates on everyone, everything else being equal.

One possible downside to Cushingberry’s proposal is that the federal government does not tax health benefits, meaning the transactions costs of implementing this type of reform would be slightly greater than merely raising the tax rate. (Michigan currently just uses federal AGI which excludes health benefits as its starting point, although it does add back some sources of income to its taxable base, which would likely be done if this proposal became law.) However, the savings in transactions costs associated with getting rid of this distortion at the federal level would likely far exceed any additional costs due to the fact that the current system causes huge amounts of complexity in the way the tax code is involved in the health insurance of every employee.