Options For Modifying The Exclusion Of Employer-Provided Health Coverage

The AP is reporting that during his meeting with the President, Sen. Max Baucus (D-MT) will make the case for taxing employer-sponsored health care benefits as a way to finance reform:

Baucus says the tax-free benefit packages Americans now enjoy are a big factor in the high costs of the country’s health care system, because they provide workers free or low-cost access to too many health care services.

Indeed, the exclusion of employer-based health insurance from income or payroll taxes has contributed to rising health care costs. Since compensating an employee with cash is taxed, but compensating with health care benefits is not, the employer has an incentive to shift compensation toward health insurance (or another kind of benefit). Under this arrangement employees are desensitized to the true cost of health care coverage and higher-income Americans — those who need the least help paying for health coverage — benefit most. Workers in a lower tax bracket “receive a smaller tax benefit from the exclusion.” From the Center on Budget and Policy Priorities’ new report:


Democrats don’t want to get rid of the exclusion all together — as Sen. John McCain had proposed during the campaign — but some are considering limiting or capping the subsidy to raise some of the revenue needed to pay for health care reform and make the tax system more progressive. Below are some of the options currently under consideration:

Limit based on the actuarial value of the plan: The employee will have to pay taxes for health care plans that exceed the actuarial value (i.e. the entire value of the plan) of a certain benchmark plan (the Senate Finance Committee suggests that initially, the standard option in the Federal Employee Health Benefit Program could be used as the benchmark). The taxes would only be paid on the difference, not the entire value of the expensive plan.

Limit based on the income of the insured: Employees who earn a gross-adjusted income in excess of a certain amount (i.e. $200,000) would no longer be able to exclude their health care benefits from income and payroll taxes.

Limit based on both the value of the plan and the income of the insured: An employee who earns in excess of $200,000 and has a plan that is above the value of a standard package would have to pay taxes on the difference of the value of the expensive plan and the benchmark plan.

Limiting the tax exclusion rather than abandoning it entirely (as McCain tried to do) has the benefit of preserving the employer-based system. Employers, after all, are fairly good at pooling risk — they have a good mix of healthy and sick people — and most employees like the coverage they currently receive. Maintaining the employer’s role also preserves the employer contribution to health care benefits, protecting the government or the individual from suddenly paying far more for coverage.

Most of the media reports have characterized modifying the tax treatment of employer-provided coverage as politically problematic for the administration, which harshly criticized McCain for taxing the full value of employer-sponsored benefits. But while McCain proposed eliminating the exclusion entirely, and thus blowing-up the employer market, Obama is proposing changes at the margin. McCain would have ended the employer’s role; Democrats are considering improving it.