In 2015, Congress voted to delay implementation of the Cadillac tax for two years because repealing it outright would have raised the deficit even more.

Now, with the election of a president who has pledged to repeal all or most elements of the ACA, even delayed implementation is in doubt. We believe that a modified version of the Cadillac tax can still play a valuable role in providing revenues to expand coverage, either in a modified version of the ACA or in an alternative that achieves a similar level of coverage.

What is the Cadillac tax?

The Cadillac tax was originally intended to start in 2018. It’s an excise tax—meaning that it’s embedded in the price of specific purchased products—designed to partially curb the effects of excluding employer-financed health insurance from personal income and payroll taxes.

It applies to high-cost health insurance plans and has the potential to achieve two important goals. First, it reduces the incentive to offer health insurance with features that encourage excessive healthcare spending. Second, it generates revenues that offset the costs of health insurance expansion.

Capping the exclusion of employer-sponsored health insurance from personal income and payroll taxes has long enjoyed bipartisan support among economists. Proponents contend that the unlimited exclusion from personal income and payroll taxes encourages companies to offer, and their employees to select, coverage so generous that people spend more on health care (driven by both quantity and price) than is optimal. Others argue that the tax is regressive, in that it reduces taxes more for high-income households than for low-income households.

The Cadillac tax simultaneously raises revenue progressively and advances the broader objectives of curbing overly generous insurance coverage.

Drawbacks and recommendations

In addition to the two benefits highlighted above, this paper addresses and proposes improvements for the following five criticisms leveled against the Cadillac tax:

• The tax does not sufficiently allow for variation in health insurance costs across employers. We suggest making adjustments based on employer size, geographic differences, and health status variability across employers.
• The indexing rules used to update the threshold at which the tax begins to apply may extend the tax to plans that are not overly generous. We propose that policymakers replace the current indexing plan with an index based on GDP either before the Cadillac tax is implemented or after a limited number of years.
• In trying to avoid the tax, employers may take actions that increase deductibles and other cost-sharing requirements, potentially burdening low- and middle-income households with high medical expenses. We recommend that some of the revenue raised by the Cadillac tax be used to help cover out-of-pocket medical expenses for those with low or middle incomes.
• A cap on the exclusion from personal income and payroll taxes may work better than an excise tax on insurance. We conclude that an exclusion cap is somewhat preferable to the Cadillac tax (or any other excise tax on high-cost plans). The most straightforward way to curb distortions caused by unlimited exclusion of health insurance from personal tax is to limit the exclusion. Either approach is vastly superior to outright repeal or further delay in implementation.
• The tax would discourage flexible spending accounts because such accounts alone may trigger the tax, regardless of total premiums. We recommend using the amendment the Obama administration proposed in its 2017 budget. The proposal let Congress authorize employers to average deposits—amounts deposited by employers in health savings accounts or health reimbursement accounts—over their workforce and add this amount to employer premium costs when computing Cadillac tax liability.

The Cadillac tax has significant positive attributes and fixable flaws. Each of its problems can be solved or mitigated by the modifications we have described. Enactment of our recommendations would preserve the tax as an important revenue source and curb the adverse consequences of the current unlimited tax exclusion of employer-sponsored health insurance.