The end-of-year budget deal passed by the House and Senate repealed the so-called “Cadillac Tax.” While never implemented, the Cadillac Tax would have placed a 40 percent excise tax on employer-sponsored health insurance with especially broad coverage—plans valued at $11,200 for individuals and $30,150 for families. While an imperfect policy, if the Cadillac Tax had been allowed to go into effect, it would have helped reduce a major bias in the tax code: the exclusion for employer-sponsored health insurance.
Under current law, health insurance provided by an employer as a form of compensation is not subject to the income tax, while normal, cash-based compensation is. This asymmetry creates an incentive for employees to prefer more expansive health insurance plans and lower monetary compensation relative to more basic health insurance and more cash.
In a recent paper from the Mercatus Center, researchers Yevgeniy Feyman and Charles Blahous explained the history of the tax exclusion and its negative consequences.
This policy originated in a World War II-era labor market, which was heavily regulated with controls on wages and prices. As companies weren’t able to attract workers with higher wages, they had to get creative, and one of the things they did was offer broad non-cash benefits, such as health insurance. After the war, Congress strengthened the link between health insurance and employment by exempting health insurance received through their employers from taxation.
This imbalance has numerous deleterious effects on the healthcare system in the United States. The American healthcare system relies heavily on comprehensive insurance, or insurance that covers a broad set of procedures and features a low deductible. However, comprehensive insurance obscures the original purpose of insurance in any role: as a way to manage risk for extreme, catastrophic scenarios.
Making employer-sponsored insurance exempt from taxes leads people to favor more comprehensive plans. This increase in demand leads to higher prices of health insurance and overconsumption of healthcare. Furthermore, higher healthcare prices lead to slower real wage growth, as total compensation has grown, but more of that compensation is coming in the form of non-cash benefits like health insurance and less in the form of cash wages.
Additionally, connecting health insurance to employment leads to something called job lock. If a worker would like to move to a better job or start their own business, they might be dissuaded from doing so because it would lead to a lapse in health insurance coverage. Workers are therefore incentivized not to shift jobs or start their own businesses, leading to slower wage growth (thanks to a less competitive labor market) and fewer new businesses.
Lastly, the tax exclusion costs a lot of government revenue. The Treasury Department projects that the tax exclusion will reduce federal revenue by $2.786 trillion over the next decade. For comparison, the Congressional Budget Office found that all itemized deductions will reduce federal revenue by only $1.3 trillion over the next decade.
The Obama administration, along with economists on both the left and right, saw some of these problems, and included the so-called “Cadillac Tax” as a revenue provision in the Affordable Care Act in 2009.
The Cadillac Tax would not have been a full solution to this problem. It only targeted the most expansive health insurance plans, so it would only have addressed the tax bias for a small percentage of employer-based plans. As the Wall Street Journal noted, only about twenty percent of workplaces provide health insurance plans valued above the Cadillac Tax threshold ($11,200 and $30,150 for individuals and families, respectively). And as the nonpartisan Tax Foundation argued, a simple cap on the value of health insurance that can be excluded would be a better way to reform the exclusion than imposing an excise tax.
However, for its faults, the Cadillac tax would have helped bring down a politically popular, yet economically foolhardy, tax break. As such, it’s unfortunate that Congress chose to repeal it without finding a different way to address the tax bias against normal compensation. Additionally, Congress repealed the tax without any corresponding revenue increases or spending cuts: axing the Cadillac tax costs the federal government $200 billion in revenue over the next decade.
Policymakers shouldn’t give up on fixing the tax treatment of employer-sponsored health insurance. Instead of just repealing the Cadillac Tax, they should further cap the exclusion, or in an ideal world, eliminate it entirely.
