Reduce Tax Preferences for Employment-Based Health Insurance
CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.
|(Billions of dollars)||2014||2015||2016||2017||2018||2019||2020||2021||2022||2023||2014-2018||2014-2023|
|Accelerate and Expand the Excise Tax on High-Cost Plans|
|Change in Outlays||0||*||1||3||3||3||3||4||4||4||8||26|
|Change in Revenues||0||11||20||25||24||25||31||37||43||50||79||266|
|Net Effect on the Deficit||0||-10||-19||-21||-21||-22||-28||-34||-39||-46||-72||-240|
|Replace the Excise Tax With a Limit on the Tax Exclusions for Employment-Based Health Insurance|
|Change in Outlays||0||2||6||8||9||10||10||10||11||11||25||77|
|Change in Revenues||0||21||42||51||58||66||76||88||100||112||173||613|
|Net Effect on the Deficit||0||-19||-36||-44||-49||-55||-66||-78||-89||-101||-147||-537|
Sources: Staff of the Joint Committee on Taxation; Congressional Budget Office.
Notes: This option would take effect in January 2015.
* = between zero and $500 million.
Overview of the Issue
The federal tax system provides preferential treatment for health insurance that people buy through their employer. Employers’ payments for health insurance are a form of compensation, but unlike cash compensation, those payments are exempt from income and payroll taxes. In most cases, the amounts that workers pay for their own share of health insurance premiums are also excluded from income and payroll taxes. In all, that favorable tax treatment costs the federal government about $250 billion in forgone revenues each year.
The subsidies provided by those tax preferences encourage firms to offer employment-based health insurance and encourage workers to enroll in such insurance. By pooling risks within groups of workers and their families, and by reducing the administrative costs of marketing insurance policies and collecting premiums, employment-based health insurance is a relatively efficient way to provide coverage—even apart from the tax preferences. Those preferences, however, give employment-based insurance an additional advantage. As a result, in 2012, 85 percent of private-sector employees worked for an employer that offered health insurance coverage; 78 percent of those employees were eligible for their employer’s coverage (the rest were ineligible for various reasons, such as working only part time); and 76 percent of the eligible workers chose to enroll.
At the same time, the open-ended nature of the tax exclusions has increased health care spending by encouraging the provision of more comprehensive health insurance than would be the case if there were no tax preferences. In addition, the value of the tax exclusions is generally larger for workers with higher income, even though such workers are more likely to purchase coverage anyway.
A new excise tax that will reduce the tax subsidy for employment-based health insurance is scheduled to begin in 2018. It will be levied on employment-based health benefits whose value exceeds certain thresholds, curtailing the open-ended nature of the current tax exclusions. Even when the new excise tax is in effect, however, employment-based health insurance will still receive a significant tax subsidy, and that subsidy will still be larger for higher-income people.
Reducing the tax subsidy for employment-based health insurance would raise federal revenues and would also affect people’s sources of health insurance coverage—decreasing the number of people with employment-based coverage, boosting enrollment in the new health insurance exchanges, and increasing the number of people without insurance. In addition, policies to reduce the tax subsidy would lower total spending on health care relative to what it would be otherwise.
Current Law. The federal tax system subsidizes employment-based health insurance both by exempting employers’ premium payments from income and payroll taxes and by letting employees at firms that offer “cafeteria plans” (which allow workers to choose between taxable cash wages and nontaxable fringe benefits) pay their share of premiums with pretax earnings. The tax system also subsidizes health care costs not covered by insurance by exempting from income and payroll taxes the contributions made to other types of employee accounts that can be used to pay for those costs. Examples include employers’ contributions to health reimbursement arrangements (HRAs), employees’ contributions to flexible spending arrangements (FSAs), and both employers’ and employees’ contributions to health savings accounts (HSAs).
The favorable tax treatment of employment-based health insurance is the largest single tax expenditure by the federal government. (Tax expenditures are exclusions, deductions, preferential rates, and credits in the tax system that resemble federal spending by providing financial assistance to specific activities, entities, or groups of people.) Excluding employment-based health insurance from both income and payroll taxes will cost the government $248 billion in 2013, CBO estimates. In addition, the federal government incurs a tax expenditure of about $6 billion a year by allowing self-employed people to deduct the costs of health insurance from their taxable income for the individual income tax (though not for payroll taxes).
The excise tax due to start in 2018 will be imposed on employment-based health benefits whose total value—including employers’ and employees’ tax-excluded contributions for health insurance premiums and contributions made through HRAs, FSAs, or HSAs for other health care costs—is greater than specified thresholds. The staff of the Joint Committee on Taxation (JCT) and CBO project that those thresholds will be $10,200 for single coverage and $27,500 for family coverage in 2018 (with slightly higher thresholds for retirees ages 55 to 64 and for workers in certain high-risk professions, and with further adjustments for the age, sex, and other characteristics of an employer’s workforce). The excise tax will be equal to 40 percent of the difference between the total value of tax-excluded contributions and the applicable threshold. If employers and workers did not change their coverage in response to the tax, roughly one out of every five people enrolled in an employment-based health plan in 2018 would have some tax-excluded contributions in excess of the thresholds, JCT and CBO estimate. (However, JCT and CBO expect people’s responses to the tax to reduce that share, as discussed below.)
In 2019, the thresholds for the excise tax will be indexed to the growth rate of the consumer price index for all urban consumers (CPI-U) plus 1 percentage point. In subsequent years, the thresholds will be indexed solely to the growth of the CPI-U. Because health insurance premiums will probably continue to rise faster than inflation, the excise tax will probably affect a growing number of people over time. As a result, revenues stemming from the tax are projected by JCT and CBO to rise from $5 billion in 2018 to $22 billion in 2023.
Effects of the Current Tax Treatment. The tax subsidy for employment-based health insurance reduces the problem of “adverse selection,” in which less healthy people are more likely to buy health insurance (or to buy specific types of plans) than healthier people are. Adverse selection can cause health insurance markets to break down or to operate inefficiently. Most people would be willing to pay an insurance premium that was somewhat higher than their expected costs for health care in order to avoid the financial risks from unexpected and costly health problems. However, it is difficult and expensive for insurers to determine, and tailor their premiums to, an individual’s expected health care costs.
In markets where everyone pays the same premium, health insurance tends to attract enrollees with above-average costs, for whom insurance provides more benefit, and to be less attractive to people with below-average costs, for whom insurance provides less benefit. Thus, in the absence of subsidies or a mandate to purchase coverage, markets for health insurance usually end up offering limited coverage (which less healthy people do not find as appealing), denying coverage to people with high expected costs (to the extent that insurers can determine them), charging high premiums (to cover the costs of less healthy enrollees), or some combination of those outcomes. That situation tends to occur today in markets for individually purchased health insurance, although states’ regulations matter crucially for those markets.
Employment-based health insurance limits those market problems in several ways. Employers generally select a workforce on the basis of criteria other than health care costs, so most workforces consist of a mix of healthier and less healthy people. Therefore, pooling risks across a workforce (and its family members) reduces the variability of average health care spending for the group. The current tax exclusions encourage employers to offer health insurance; in turn, when employers pay a large share of premiums, employees’ share tends to be small relative to their expected health care costs, which encourages them to buy insurance and thereby reduces adverse selection. The tax exclusions also mitigate increases in premiums that might occur because of adverse selection by directly reducing the after-subsidy price of insurance.
The Affordable Care Act made several changes to health insurance markets that, together, will substantially reduce the traditional problems in individual markets discussed above, thus weakening the rationale for subsidizing employment-based insurance:
- The new insurance exchanges will enable individuals and families to buy insurance if they lack other sources of coverage that are deemed affordable. Depending on their income, people may receive refundable tax credits to limit the amount they pay for that coverage. (With a refundable tax credit, if the amount of the credit exceeds the amount of income tax owed before the credit is applied, the taxpayer receives the excess as a payment.)
- Most legal U.S. residents will be required to obtain insurance coverage or potentially be liable for a penalty tax.
- Insurance purchased individually (through the exchanges or directly from insurers) will be available on a guaranteed-issue basis—meaning that policies will be offered to all applicants regardless of their health status—and premiums will not be allowed to vary according to policyholders’ health status or sex. In addition, variation in premiums by age will be limited. (Without the subsidies and the requirement to obtain insurance, those provisions alone would increase adverse selection in the market for individually purchased insurance.)
Although the current tax preferences for employment-based health insurance reduce adverse selection, those preferences also encourage workers to favor health care over other goods and services they could purchase and thus contribute to the growth of health care spending. That outcome occurs because the tax exclusions encourage employers to compensate their workers with a combination of health insurance coverage and cash wages rather than entirely with cash wages. And because the value of the tax subsidy increases with an insurance plan’s premium (up to the threshold for the excise tax in 2018 and beyond), enrollment is especially encouraged in plans that cover a greater number of services, cover more expensive services, or require enrollees to pay a smaller share of the costs of the services they receive. As a result, people use more health care—and health care spending is higher—than would otherwise be the case.
Concern about that effect has lessened somewhat in recent years because employment-based health insurance has shifted toward plans that require workers to pay a higher share of health costs (notwithstanding the incentive created by the exclusions for premium payments). For example, almost one-third of people under age 65 with employment-based coverage reported enrolling in a high-deductible health plan in 2013, up from about one-sixth in 2008.
Another concern about the tax exclusions arises from how their subsidy is distributed among workers at different income levels. The value of the exclusions is generally larger for workers with higher income, partly because those workers face higher income tax rates (although they may face lower rates of payroll taxation) and partly because they are more likely to work for an employer that offers coverage. Because larger subsidies go to higher-income workers, who are more likely to buy insurance even without the tax exclusions, and smaller subsidies go to lower-income workers, who are less likely to purchase coverage, the exclusions do not yield the maximum gains in insurance coverage for the tax dollars forgone. Thus, the tax exclusions are an inefficient means of increasing the number of people who have health insurance, and they are regressive in the sense of giving larger benefits to people with higher income.
The forthcoming excise tax will be levied on insurers and on self-insured employers, but economic theory and empirical evidence suggest that it will be passed on to employers who purchase or provide insurance that is subject to the tax—and then ultimately passed on to workers. JCT and CBO expect that many employers and workers will shift to health plans with premiums below the thresholds to avoid paying the tax, resulting in higher taxable wages for affected workers or higher taxable profits for employers. Workers will pay income and payroll taxes on any additional wages they receive, and because workers with higher income will pay higher marginal tax rates on those wages, the regressive nature of the tax exclusions will be somewhat lessened.
For employers and workers who do not shift to lower-cost health plans to avoid the excise tax, the costs of the tax will be spread equally among workers, JCT and CBO expect. However, workers with higher income are more likely to be enrolled in high-cost plans and thus are more likely to have their subsidy reduced (either by being subject to the tax or by changing to a lower-cost plan).
Thus, the new excise tax will decrease the net tax subsidy for workers with health benefits whose value exceeds the thresholds—with the reduction slightly greater for higher-income workers, on average. However, the majority of workers will have health benefits whose value is below the thresholds and therefore will be largely unaffected by the excise tax. Consequently, the net impact of the existing tax preferences and the new excise tax will be to continue subsidizing employment-based health insurance and providing larger subsidies to higher-income people, who would be more apt to purchase coverage even without the subsidy.
Key Design Choices That Would Affect Savings
Lawmakers who wanted to reduce the tax subsidy for employment-based health insurance could take several approaches, which would have differing effects on federal revenues, on the amount of taxes owed by people at various income levels, and on employers’ and employees’ choices about health insurance plans and their resulting health care costs. Two broad approaches would involve modifying the excise tax on high-cost plans that is due to begin in 2018 and modifying the current tax exclusions. The parameters of both the new tax and the current exclusions could be adjusted to yield larger or smaller amounts of additional revenues or to alter the impact on different types of people, employers, and health insurance plans. A third approach would be to replace the current tax exclusions with an income tax credit for employment-based health insurance, which could also be designed to generate specific amounts of revenues or to have other specific effects.
In general, reducing the tax subsidy for employment-based health insurance would tend to lower the number of people with such insurance and increase cost sharing, which in turn would decrease spending on health care and increase the financial burden on people with substantial health problems. The precise impact, however, would depend on the specific features of any policy change.
Timing and Scope of the Excise Tax on High-Cost Plans. While keeping the current design of the excise tax, lawmakers could increase its impact by moving up the starting date or by slowing the indexing of the threshold amounts. For example, the tax could take effect as soon as 2015, or the specified thresholds could be frozen in nominal terms (that is, not indexed to rise with inflation) so that a larger share of health insurance plans would become subject to the tax over time than would be the case under current law. Lowering the amounts of the thresholds at which contributions begin to be taxed or raising the 40 percent tax rate would also increase the impact of the tax.
In addition, the design of the excise tax could be modified in various ways. Current law allows for different thresholds based on characteristics of an employer’s workforce but does not explicitly vary the thresholds by the extent to which an insurance plan encourages health care spending. One alternative to setting a threshold value for premium contributions would be to apply the excise tax to certain types of health insurance plans and exempt others. For example, lawmakers could exempt plans whose actuarial value (the percentage of health care spending for a given population that the plan would pay for) was below a certain amount. Such exemptions, however, would require additional reporting of information by insurers and employers and would be difficult to administer. Moreover, the relationship between a health plan’s actuarial value and the extent to which it encourages health spending is not direct. For instance, plans offered by health maintenance organizations often have higher actuarial values than other types of insurance plans, but they may have lower overall costs and result in less health care spending because they manage the use of care more tightly or contract with lower-cost doctors and hospitals.
Scope of the Tax Exclusions. Alternatively, lawmakers could remove the excise tax scheduled to take effect under current law and instead subject contributions for health insurance premiums that are currently tax-preferred to income taxes, payroll taxes, or both. On average, enrollees in employment-based plans face slightly higher federal income tax rates than payroll tax rates. Specifically, JCT and CBO estimate that the average marginal income tax rate (the rate that applies to the last dollar of someone’s earnings) for workers with employment-based coverage is about 16 percent, whereas the average marginal payroll tax rate (including both the employer’s and employee’s shares of payroll taxes) is about 14 percent. Thus (if everything else stayed the same), including contributions to health insurance premiums in taxable income for income tax purposes would raise slightly more revenue than including them in taxable income for payroll tax purposes, and doing both would raise the most revenue.
Whether to include only some, rather than all, of those contributions in employees’ taxable income would be a key design issue. For example, the exclusions could be capped for all taxpayers, or they could be phased out for higher-income people. Such caps or thresholds could also be allowed to vary according to other characteristics of employees, such as age, sex, or occupation. The forthcoming excise tax includes several adjustments of that sort, including assigning higher thresholds to some groups of people with higher average health care costs.
Tax Credit Versus Tax Exclusions. Yet another approach to reducing the tax subsidy for employment-based health insurance would be to replace the current income tax exclusion (or income and payroll tax exclusions) with an income tax credit. If the credit was a fixed dollar amount and was refundable—so that people for whom the credit exceeded the amount of federal income tax owed could receive money back from the government—all workers would receive the same value from the credit, regardless of their tax bracket or their health care costs. If the credit was a fixed dollar amount but was nonrefundable, low-income workers, who have little or no income tax liability, would benefit much less. As an alternative to fixing the dollar amount of the credit, its size could be phased down for people at higher income levels. With any of those designs, the credit would have a set dollar value for a given worker, so that person could not increase his or her tax subsidy by purchasing more extensive or more costly insurance.
In setting the value or rate schedule for a tax credit, lawmakers would face various trade-offs. For example, a larger credit would increase the number of people who obtained health insurance but would reduce the amount of tax revenues collected. As another example, phasing down the credit for people at higher income levels would focus the tax preference on people who would be less likely to obtain insurance in the absence of a tax subsidy, but that approach would also raise effective tax rates on income in the phase-out range.
Specific Alternatives and Estimates
CBO and JCT analyzed two alternatives for reducing the tax subsidy for employment-based health insurance: accelerating and expanding the excise tax on high-cost plans or replacing that tax with a limit on the current tax exclusions. Both of those policy changes would increase the tax liability and affect the behavior of people with large before-tax contributions for employment-based health plans, but the specific increases in taxes and changes in behavior would be different under the two approaches.
In the first alternative, implementation of the excise tax would be sped up by three years, to 2015, and the thresholds at which contributions would become subject to the tax would be lower in 2018 and beyond than they would be under current law. Specifically, the thresholds in 2015 would be set at $7,970 for individual coverage and $19,910 for family coverage—which represent JCT and CBO’s estimate of the 75th percentile for health insurance premiums to be paid by or through employers in that year. After 2015, the thresholds would be indexed for inflation as measured by the CPI-U. In 2019, they would be $8,700 for individual coverage and $21,750 for family coverage, compared with $10,550 and $28,400, respectively, under current law. As in current law, the tax would equal 40 percent of the difference between total tax-excluded contributions and the applicable threshold. Similar to the provisions of current law, the thresholds would be 10 percent higher for retirees ages 55 to 64 and for workers in designated high-risk professions, but other adjustments provided under current law (such as those for age and sex) would be eliminated to simplify administration.
That alternative would reduce federal deficits by $240 billion between 2015 and 2023, JCT and CBO estimate. Like the excise tax in current law, the modified tax would generate revenues in two ways. First, it would produce additional excise tax revenues for employment-based plans whose premiums remained above the thresholds. Second, it would generate additional income and payroll tax revenues because of people’s responses to the tax: Many employers and workers would probably change to lower-cost insurance plans, and some employers would be discouraged from offering health insurance to their workers. The resulting reduction in payments of health insurance premiums would lead to higher taxable wages for those employees or higher taxable profits for their employers.
The increase in excise tax collections and the tax’s indirect effects on tax receipts would boost revenues by $266 billion from 2015 to 2023. However, outlays would also rise over that period, by $26 billion, primarily because more people would receive subsidies for insurance coverage purchased through the exchanges (as discussed below). Although premium subsidies for exchange plans are structured as refundable tax credits, in most cases the amounts of those credits will exceed the amount of federal income tax that recipients owe, and the amounts above the tax owed by recipients are classified as outlays. Cost-sharing subsidies for enrollees in exchange plans are also categorized as outlays.
By decreasing the tax subsidy for employment-based health insurance, that alternative would result in about 2 million fewer people with employment-based insurance in 2019 than the number projected under current law. In that year, roughly one and a half million more people would buy coverage through the exchanges, and about half a million more people would be uninsured. After 2019, the tax subsidy for employment-based insurance would decline further, so fewer people would have such insurance. By 2023, about 3 million fewer people would have employment-based coverage, and about 1 million more people would be uninsured, than under current law.
The second alternative would eliminate the excise tax and instead impose a limit on the extent to which employer-paid health insurance premiums and contributions to FSAs, HRAs, and HSAs could be excluded from income and payroll taxation. Specifically, starting in 2015, any contributions that employers or workers made for health insurance and for health care costs (through FSAs, HRAs, and HSAs) that together exceeded $6,420 a year for individual coverage and $15,620 for family coverage would be included in employees’ taxable income for both income and payroll taxes. Those limits, which are based on the estimated 50th percentile for health insurance premiums paid by or through employers in 2015, would be indexed in subsequent years for inflation using the CPI-U. The same limits would apply to the deduction for health insurance available to self-employed people. Capping the tax exclusions at lower thresholds than the ones scheduled to take effect for the excise tax would reduce federal tax subsidies. For example, in 2019, the caps for individual and family coverage under that alternative would be $7,000 and $17,000, respectively, whereas the current-law thresholds for the excise tax would be $10,550 and $28,400, respectively, in that year.
That alternative would decrease federal deficits by $537 billion between 2015 and 2023, JCT and CBO estimate. The reduction in the tax subsidy for employment-based health insurance would cause about 6 million fewer people to have employment-based coverage in 2019 than under current law. In that year, about 4 million more people would buy coverage through the exchanges, about half a million more people would enroll in Medicaid or the Children’s Health Insurance Program (CHIP), and an additional one and a half million people would be uninsured.
The reduction in the deficit from that alternative stems from several, partly offsetting, changes in revenues and outlays. Income and payroll tax revenues would rise by $681 billion through 2023 because the number of people with employment-based coverage would decline and because many of those who kept such coverage would receive a smaller tax subsidy. (For example, the capped tax exclusions would reduce the combined federal income and payroll tax liability of people with individual coverage by an average of $1,827 in 2019, compared with an average reduction of $2,330 for such people under the current exclusions.) However, other effects of that alternative would also affect revenues. Additional tax credits for coverage purchased through the exchanges and the repeal of the excise tax would reduce revenues, whereas additional penalty payments by certain employers and individuals resulting from changes in health insurance coverage would increase revenues by a small amount. In all, revenues would be $613 billion higher through 2023 than under current law. The policy changes would boost federal outlays by $77 billion through 2023, primarily because of increased spending on exchange subsidies and Medicaid.
Reducing the tax subsidy for employment-based health insurance would affect many aspects of the U.S. health care sector, including the growth of health care costs, the health of the population, the coverage choices of employers and workers, and the number of people without health insurance.
Effects on Health Care Costs. Expanding the forthcoming excise tax on high-cost insurance plans or replacing that tax with a limit on the current tax exclusions would reduce health care spending relative to what it will be under current law. As discussed above, the current tax preferences for employment-based insurance encourage overconsumption of health care relative to other goods and services. Those tax preferences give health insurance plans an incentive to cover a greater number of services, cover more expensive services, and require enrollees to pay a smaller share of the costs of the services they receive. The excise tax will effectively scale back those tax preferences to some degree. Under both of the alternatives examined here, the tax increases would start sooner and would apply to a larger share of employment-based plans than the excise tax will under current law. As a result, employers and their workers would have less incentive to buy expensive health insurance, which would reduce upward pressure on the price of health care and use of health care services and would encourage greater use of cost-effective types of care. The effects on health care spending would be larger in areas with higher health care costs.
Effects on People’s Health. By reducing the incentive to purchase expensive health insurance coverage, both of the policy alternatives analyzed here would probably limit some people’s access to health care and cause them to forgo some care. In a health insurance experiment conducted by the RAND Corporation from 1974 to 1982, nonelderly participants were randomly assigned to health insurance plans. The experiment found that greater cost sharing—which is a key mechanism through which insurance plans can lower their premiums—reduced the use of effective care and less effective care (as defined by a team of physicians) by roughly equal amounts. Although the study found that cost sharing had no effect on health in general, among the poorest and sickest participants, those with no cost sharing were healthier by some measures than those who faced some cost sharing. Thus, the reduction in health care spending prompted by these alternatives could be accompanied by worse health for some people.
Effects on Employers and Workers. By raising the tax liability of people enrolled in high-cost employment-based plans, the alternatives considered here would probably increase the financial burden on some people with substantial health problems. In particular, some employers and workers would avoid the new taxes by shifting to plans with lower premiums and higher cost-sharing requirements, which would increase out-of-pocket costs the most for those workers (and their dependents) who used the most services.
Under both alternatives, employees of firms that had a less healthy workforce or that operated in an area with above-average health care costs would be more likely to see their tax liability increase. In higher-cost areas, those increases in people’s tax liability might exert pressure on health care providers and insurers to reduce prices or decrease unnecessary care. In addition, because the alternative to expand the excise tax would not adjust the thresholds for workers’ age, firms would be more likely to face the tax if they had an older workforce. That situation might decrease employers’ willingness to hire older workers or cause employers to reduce other forms of compensation for older workers, such as cash wages or contributions to pension plans.
Effects on the Number of Uninsured People. The tax increases envisioned in this option would lead fewer employers to offer health insurance, thus increasing the number of uninsured workers. Most people whose employers stopped offering health insurance coverage would purchase it in the individual market, including in the health insurance exchanges. The federal subsidies available through the exchanges would give many low-income people an affordable alternative to employment-based coverage, and the tax penalty for lacking insurance would give many high-income people who lost employment-based coverage an incentive to buy insurance in the exchanges even without a subsidy. Nevertheless, some workers whose employers ceased to offer health insurance under this option would forgo coverage, CBO and JCT expect.