Include Employer-Paid Premiums for Income Replacement Insurance in Employees' Taxable Income

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 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2017-2021 2017-2026
Change in Revenues 19.2 36.1 35.6 34.6 33.2 33.7 34.4 35.3 36.3 37.5 158.7 335.9

Source: Staff of the Joint Committee on Taxation.

This option would take effect in January 2017.

To the extent that the option would affect Social Security payroll taxes, a portion of the revenues would be off-budget. In addition, the option would increase outlays for Social Security by a small amount. The estimates do not include those effects on outlays.

Benefits that replace income for the unemployed, injured, or disabled are currently subject to different tax treatments. Whereas unemployment benefits are fully taxable, benefits paid under workers' compensation programs (for work-related injuries or illnesses) are tax-exempt. Disability benefits (for non-work-related injuries) may be taxable, depending on who paid the premiums for the disability insurance. If the employer paid the premiums, the benefits are taxable (although the recipient's tax liability can be offset partly by special income tax credits for the elderly or disabled). If the employee paid the premiums out of after-tax income, the benefits are generally not taxed.

This option would gradually eliminate any tax on income replacement benefits over a five-year period but would immediately include in employees' taxable income the value of several taxes, insurance premiums, and other contributions paid by employers. Specifically, all of the following would be subject to the individual income tax and the payroll taxes for Social Security and Medicare: the taxes that employers pay under the Federal Unemployment Tax Act and to various state unemployment programs; 50 percent of the premiums that employers pay for workers' compensation (excluding the portion covering medical expenses); and the portion of insurance premiums or contributions to pension plans that employers pay to fund disability benefits. Together, those changes would increase revenues by $336 billion over the 2017–2026 period, the staff of the Joint Committee on Taxation estimates. Over the long term, the gain in revenues would result almost entirely from adding workers' compensation premiums to taxable income. Including those various items in employees' taxable earnings, and thus in the wage base from which Social Security benefits are calculated, also would increase federal spending for Social Security. Between 2017 and 2026, the option would increase federal spending very slightly, but the effect on spending would continue to increase after 2026 as more people whose premiums were taxed retired and began collecting Social Security benefits. The estimates shown above do not include any such effects on outlays.

An advantage of this option is that it would treat different kinds of income replacement insurance similarly and thereby eliminate many of the somewhat arbitrary disparities that currently exist. For example, people who are unable to work because of an injury would not be taxed differently on the basis of whether their injury was related to a previous job. Another advantage of the option is that it would spread the tax burden among all workers covered by such insurance rather than placing the burden solely on beneficiaries, as is now the case with unemployment insurance and employer-paid disability insurance. The effect on covered workers would be relatively small: Their after-tax earnings would fall, on average, by less than one-half of one percent. However, the effect would be greatest among low-wage workers, some of whom would be less likely to seek work as a result.

A disadvantage of the option is that it would discourage unemployed individuals from accepting available work because, with unemployment benefits no longer taxable, their disposable income would be higher while they were unemployed than is the case under current law. Research shows that higher after-tax unemployment benefits tend to lengthen periods of unemployment, particularly among those who have no savings and cannot obtain loans after they lose their job. (However, the increase in disposable income would also allow unemployed people more time to find a job that best matches their skill set.)

Another argument against the option is that it would not eliminate all disparities in the way income replacement benefits are treated. For example, the income replacement portion of adjudicated awards and out-of-court settlements for injuries not related to work and not covered by insurance would remain entirely exempt from taxation. Likewise, extended unemployment benefits that the federal government sometimes provides during economic downturns would never be taxed because no amount corresponding to an employer's contribution would ever have been included in the recipients' taxable income.