Politics & Policy

Time to Trade In the ‘Cadillac Tax’ on Health Insurance

How conservatives can replace the tax on high-end health-care plans and offer middle-class Americans a tax cut

The 5 percent want their tax cut, and they want it now. But this isn’t the 5 percent you might imagine. When Hilary Clinton went to Nevada two weeks ago, she wasn’t trying to win hearts and minds on Wall Street; she was courting the unions that had opposed her in 2008. And cutting high taxes for their members is one of their top priorities.

Labor unions, whose members make up about 5 percent of the American population, have a big problem with Obamacare: The law’s 40 percent excise tax on high-cost health-insurance plans, better known as the “Cadillac tax,” is set to take effect in 2018. Since union health plans tend to be significantly more expensive than non-union plans, it’s a key issue for them heading into election season. (In December 2014, health insurance for unionized workers was more than twice as expensive as it was for non-unionized workers.)

Unions want to repeal the tax, or at least modify it so that it doesn’t hit their members. This presents a golden opportunity for conservative reformers to offer the middle class a tax break while making health care more efficient and affordable.

If you subsidize something, you get more of it. That’s what we’ve done with employer-provided health insurance. By allowing employers to offer insurance on a tax-free basis (as opposed to wages, which are subject to taxation), a dollar of wages is worth less than a dollar of health insurance. This phenomenon offers a particularly convincing explanation for the U.S.’s high health-care costs: Employers have overinvested in health insurance, making workers less sensitive to health-care prices and giving providers more leeway to raise them.  

Public-employee-union plans in particular have overinvested in insurance. In New York in 2014, the average deductible for single coverage in New York’s employer market hit a little over $1,200; a silver plan (the most popular) on the state’s exchange came with a deductible of $2,000 (and in some cases, even higher). Meanwhile, a plan offered to NYC unionized transit employees (over 60,000 of them) has no deductible to speak of. NYC employees typically make no premium contributions for their plans either. In the private sector, members of Detroit’s autoworkers’ union pay 6 to 8 percent premium contributions, compared to an average of about 23 percent for non-unionized plans.

Bottom line: The tax subsidy for employer-based health plans winds up benefiting unions much more than non-unionized workers and taxpayers generally.

The basic flaw is this: The Cadillac tax imposes applies the tax rate for the top 1 percent to all employees above the threshold, regardless of income.

The Cadillac tax was a second-best (or third-best) alternative to limiting this subsidy. Plans that cost more than $10,200 ($27,500 for families) in 2018 will have to pay a 40 percent tax on the value over that threshold. Because the threshold increases with consumer inflation, which grows more slowly than medical inflation, more plans are expected to be hit by the tax each year. In 2018, 26 percent of employers are expected to be hit — growing to 42 percent 10 years down the line. A more straightforward approach, which is popular among economists, would be to eliminate the tax exemption for employer health-care plans altogether, but this is politically impossible. Finding a middle ground between the Cadillac tax and eliminating the exemption, then, is the next best choice.

The basic flaw is this: The Cadillac tax imposes the highest income-tax rate in America on all employees above the threshold – applying the tax rate for the top 1 percent to the other 99 percent. Jettisoning the Cadillac tax (with no replacement) would make Obamacare even more expensive for taxpayers and reduce pressure on unions to “right-size” their health benefits. So instead of penalizing lower-income workers, the deduction for employer-sponsored coverage should simply be capped. That way, workers who pay taxes on the excess amount will do so at their own marginal rate, not a punitively high maximum rate. John McCain proposed this in his 2008 health-care plan, and the Patient Care Act, along with Senator Rubio’s health-care proposal, would do the same thing.

Here’s how it could work, assuming a cap of $9,000 per year for a worker in the 15 percent tax bracket (someone earning, say, $26,000 a year). Under the Cadillac tax, if this worker’s plan was valued at $11,200 ($1,000 over the threshold) he would be responsible for paying $400 extra in taxes. But under a $9,000 cap (meaning the plan is now $2,200 over the threshold), the same worker pays only $330. Higher-income workers would end up paying more under a cap, and would pay a larger share of total costs, because they face higher marginal tax rates. (This assumes that health insurance above the cap is still not subject to payroll taxes.) The actual cap could be adjusted up or down, but the progressivity of the cap relative to the Cadillac tax is a critical advantage.

Even so, unions’ opposition to the Cadillac tax remains short-sighted. In the long run, runaway health-care inflation erodes employees’ take-home pay and reduces incentives for health-care providers to compete on cost and quality. Shifting more employee compensation into wages would be a win-win.

Reform-minded conservatives have been advocating abolition of the employer health-care tax exclusion for decades. President Obama, however, was the one who taxed employee benefits “for the first time.” We should seize the opportunity to reform the tax, right-size union health plans, and give the vast majority of working Americans an Obamacare tax cut.

— Paul Howard is a senior fellow at the Manhattan Institute and director of the Institute’s Center for Medical Progress. Yevgeniy Feyman is a fellow with and deputy director of the Center for Medical Progress.

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