Kill the Tax Exclusion for Health Insurance
The employer exclusion turned 60 this week — it's time to replace it with a single discount for all.



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 agree 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.