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Some policymakers propose capping the amount of employer-sponsored insurance that is exempt from federal income and payroll taxes. If such a cap is based on employer premiums, inequities will result. Workers could pay higher taxes if their employer is located in a high-cost area, if many co-workers are in their 50s and 60s, or if a few employees have a major illness or accident. To avoid such inequities, the cap could be based on benefit generosity, measured by actuarial value, which is the cost of expected claims if a nationally representative population received the covered benefits.
Employer payments for health insurance are exempt from income and payroll taxes. Some policymakers propose limiting the amount of such payments that receive favorable tax treatment, arguing that capping the employer exclusion would both reduce companies' incentive to offer very generous coverage and raise revenue to finance subsidies for the uninsured.
However, if the application of such a cap is determined by the premiums paid for employer-sponsored insurance (ESI), the generosity of coverage will not be the only factor that determines whether benefits are taxed as income. Because of geographic differences in health care costs, premiums for the same benefits can more than double when an individual crosses state lines. Workers' age, company size, and the categorization of dependent coverage can likewise change premiums, even if benefits remain fixed. Here are examples of the resulting inequities under a leading 2005 proposal, from the President's Advisory Panel on Federal Tax Reform, which would count as taxable income ESI premiums to the extent they exceed the national average for single or family coverage:
- At firms where at least 60 percent of workers are age 50 or older, 41.2 percent of employees would be taxed on their health benefits. Where fewer than 20 percent of employees are 50 or older, only 16.0 percent of workers would be taxed.
- At small firms with fewer than 10 employees, 29.7 percent of workers would see their benefits taxed, compared with 17.4 percent at companies with 1,000 or more employees.
- 41.3 percent of workers with family coverage would pay taxes on their health insurance. By contrast, only 19.5 percent of enrollees in worker-only ESI would be subject to taxation.
This paper explores a way to cap the tax exclusion that avoids these inequities. Benefits would be taxed based on their generosity, not on premiums. Such generosity would be measured by actuarial value, which is the claims costs that actuaries estimate would result if a nationally representative population received the covered benefits. Utterly irrelevant would be geographic variation in health care costs, the age of workers at a particular firm, the company's size, and whether workers have family or individual coverage.
Actuarial value already plays a major role in defining covered benefits for the Comprehensive Omnibus Budget Reconciliation Act of 1986 (COBRA), the Children's Health Insurance Program, and prescription drug coverage under Medicare Part D. In addition, employer-sponsored group life insurance is excluded from taxation only up to a capped level, and the taxable value of a given employee's benefits is determined by imputation, rather than employer cost.
If an actuarial value cap for ESI had the Internal Revenue Service (IRS) develop comprehensive and detailed guidelines for actuarial valuation using a nationally representative enrollee population, the ability of employers to "game" the system would be greatly limited. At the same time, employers' administrative burdens would be kept to a minimum. Insurers could calculate the actuarial value of each product they sell to firms, since that value would be the same for all purchasing employers. Further, for typical benefits, actuarial value could be calculated, without any need to hire an actuary, based on decision rules published by IRS.
A disadvantage of this approach is that employers would not receive any tax advantages from lowering costs through methods other than reducing benefits. Such methods could include using restrictive provider networks, bargaining effectively with insurers, or improving workers' health by encouraging exercise on the job.
Of course, employers have powerful incentives to lower health care spending under current law, even though such reductions yield no tax advantages. Those same incentives would continue under an actuarial value cap. But it could be seen as inequitable to tax workers at the same level, based purely on covered benefits, without reducing tax burdens when their employers apply effective methods of cost control.
Another approach to avoiding the inequitable application of a tax cap would adjust employer premiums to compensate for objective factors like firm size, industry of employment, and each covered worker's age, gender, and area of residence. However, these adjustments would not fully account for health status, which has a major impact on health care spending. As a result, if a company's covered workers, dependents, and retirees tend to be disproportionately unhealthy, the employees of that company would be more likely to pay taxes on covered benefits. This effect could be particularly troublesome if, at a particular company, a small number of enrollees happened to experience major accidents or costly illnesses, substantially increasing premiums and average health care costs at the firm. This could subject all covered employees to higher tax liability.
Neither actuarial value caps nor premium adjustments would be easy to explain (though the actuarial value approach would probably be more difficult). Each approach would require administrative agencies to develop complex formulas but could be structured to avoid major new administrative burdens on employers.
Put simply, if policymakers wish to cap the amount of the employer exclusion without creating serious inequities, no perfect solution is available. But reasonable solutions appear feasible.
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