Since the beginnings of employer-sponsored health insurance (ESI), employer contributions have been excluded from both income and payroll taxes, without limit (“the exclusion”). The Affordable Care Act’s (ACA) so-called “Cadillac Tax”—a nickname chosen to suggest luxury and extravagance—is a 40 percent excise tax on the insurer on the excess of aggregate cost of coverage over $10,200 per individual and $27,500 per family in 2018.
The Cadillac Tax was intended to help correct some of the perverse incentives created by the exclusion, as well as to help pay for subsidies for health insurance purchases. Some employers and unions are now lobbying for its repeal.
Costs Of The ESI Tax Exclusion
In 2015, the exclusion will cost the federal budget $250 billion. The exclusion has created powerful incentives to drive up health care costs; it has led to over-insurance as employees and employers take maximum advantage of an available tax break. Beyond insurance for high-cost, unpredictable expenses, employers have included coverage for routine care, dental care, eye care including prescription glasses, podiatry, hearing aids, and more.
Deductibles, copayments, and coinsurance rates have been reduced as employers sought to include as much as possible in tax-favored premiums and flexible spending accounts. Because of the exclusion, an additional dollar of benefits costs, for many, roughly 60 cents, net of income and payroll taxes.
Tax-free ESI has been the subject of many labor disputes, especially over post-retirement benefits. Public employees have been promised overly generous post-retirement health insurance on top of unsustainable pensions by elected officials whose campaigns were financed in large part by public employee unions. Post-retirement liabilities have contributed to the bankruptcies of cities and towns and companies.
When using their own money on exchanges, few employees choose the most comprehensive coverage. The exclusion biases choices in favor of more costly plans, therefore undermining the market for cost-effective organized systems of care.
In the 1940s and 1950s, nearly all employers adopted open-ended—meaning no budget set in advance—fee-for-service because that was practically all there was in the market. Even as that model of health care finance came to be recognized as wasteful and conducive to overuse, employers have been very slow to change. The tax law has weakened their incentive for cost-reducing innovation.
Through Medicare and Medicaid, the government is in the market for provider services. Through the exclusion, the government is subsidizing its competition for the same resources, driving up the amount Medicare and Medicaid must pay for physician and hospital services.
Under tax-free ESI, few people have a clear understanding of what their insurance costs, and even fewer know what individual services cost. Providers of health care services have been able to make it hard for a patient to find out, except after the fact, when he gets his bill. Thus, the exclusion has created a culture of complete cost unconsciousness. As employers have raised deductibles, exposing consumers to more cost, entrepreneurial startups like Castlight have become needed to inform patients how much providers charge.
Alternatives To The ESI Tax Exclusion
What are the alternatives to the open-ended exclusion? For decades, economists and others have recommended a “tax cap.” This would be a limit on the amount of employer contribution that can be excluded, preferably at the level of an efficient plan, for example, $300-$500 per month, depending on regional costs and age-sex adjustment. The law should allow employers to adjust this for the age and gender of the employee group and for regional health care input costs. Above the adjusted cap, all employer contributions would be subject to income and payroll taxes.
This would leave unresolved the problem that the exclusion would be worth more to high-income than to low-income taxpayers. This argues for replacing the exclusion with universal refundable tax credits, not dependent on employment or income, as proposed by Senator McCain in 2008. Then, everyone could buy insurance through public or private exchanges.
Another alternative would be to abolish the exclusion and refund the $250 billion to taxpayers in the form of lower tax rates (tax reform) or use the money to reduce the debt and deficit.
The Role Of The Cadillac Tax
The Cadillac Tax was included in the Affordable Care Act to offset the tax exclusion, and to help pay for the ACA subsidies. One important beneficial effect of the tax is that anticipation of it has set in motion serious work by many employers to reduce the premiums enough to escape it. The simplest way is by raising deductibles. The tax has also encouraged delivery systems to restructure to achieve efficiencies, as in the case of hospitals and their medical staffs joining forces to create accountable care organizations to serve the commercial population.
The greatest deficiency of the Affordable Care Act was its failure to address the problem of excessive health care costs. The most effective, and probably the only effective, way to reduce costs is through a fundamental change in incentives. We need a health care system in which practically everybody has a choice of health plan and an opportunity to keep the savings by choosing economically — that is, a regime of defined contributions and responsible consumer choice.
Provider interests were too powerful to permit a serious cost containment component in the ACA. An outright repeal of the Cadillac Tax would not only undermine the cost containment efforts now underway, but it would be an unmistakable signal that our democracy is not capable of reining in excessive health care costs.
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