Changes to the Tax Exclusion of Employer-Sponsored Health Insurance Premiums: A Potential Source of Financing for Health Reform

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Abstract

Many have suggested that reducing or eliminating the tax exclusion of employer-sponsored health insurance (ESI) could generate significant additional tax revenue to fund expansions in health insurance coverage. In this paper, we focus on two specific policy design elements: (1) a cap, or dollar limit, on the amount of employer-sponsored health insurance premiums excluded from taxable income; and (2) an index that determines how this cap might grow over time. Our analysis shows that limiting the tax exclusion would provide substantial funding for health reform and mitigate the huge inequities built into the current treatment of employer premiums.

Introduction

One of the challenges that Congress will face as it considers major health reform legislation this year will be identifying the necessary financing. Many have suggested that reducing or eliminating the tax exclusion of employer-sponsored health insurance (ESI) could generate significant additional tax revenue to fund expansions in health insurance coverage. In this paper, we discuss the revenue and distributional consequences of several policy options that would alter the ESI tax exclusion. We focus on two specific policy design elements: (1) a cap, or dollar limit, on the amount of employer-sponsored health insurance premiums excluded from taxable income; and (2) an index that determines how this cap might grow over time. We present first year (2010) and 10-year (2010-2019) revenue estimates for all options and distributional impacts in 2019 for selected options. The distributional impacts include income and payroll taxes even though payroll tax revenue would not be available to fund health reform, because any decreases in benefits resulting from the tax changes would eventually return to workers as higher wages that would be subject to both types of taxes.

Even the policy option generating the least estimated revenue—capping the ESI premium exclusion at the 75th percentile of premiums and indexing by medical expenses—would generate $62 billion in new income tax revenue over 10 years relative to current law, but maintain the vast majority (97 percent) of the tax subsidy from the current ESI exclusion. This policy change would increase taxes for only 14 percent of tax units in 2019. Alternatively, indexing a 75th percentile cap more slowly over time would generate considerably more income tax revenue—$224 billion using a GDP index—but would increase taxes for almost 40 percent of tax units in 2019. Because high-income households are more likely to have ESI, each of the policies modeled would increase taxes for relatively fewer lower-and middle-income tax units compared with those in the top two income quintiles.

Setting the cap on the exclusion at the median of ESI premiums would generate about twice as much tax revenue in the first year as applying a cap set at the 75th percentile of premiums. Over time, however, the relative revenue gains would depend on how the cap is indexed. If the cap is indexed to grow more slowly than medical expenditures, a 75th percentile cap would increase revenues by only between 16 percent and 34 percent less over 10 years than a median cap.

In 2010, under every policy option examined, affected tax units in each income quintile would see their after-tax income fall less than 1 percent. However, the burden would increase over time because projected ESI premiums grow faster than the caps. Some reform options would increase average federal taxes substantially by 2019, but the average percentage changes in after-tax income would be relatively modest for most income quintiles and most index options. For example, imposing a 75th percentile cap indexed by GDP growth would increase federal taxes by an average of $550 in 2019 for affected tax units in the lowest income quintile—reducing after-tax income by an average of 3.9 percent. Those in the top income quintile would experience an average reduction in after-tax income of 0.7 percent—about $1,920 in 2019. Much of the additional tax paid by lower-and middle-income tax units would come from payroll taxes. Retaining the exclusion for payroll taxes would make the reform more progressive but would forgo substantial additional funding for Social Security and Medicare.

Our analysis shows that limiting the ESI tax exclusion could be an important component of financing health reform. The extent of the impact on overall health care costs depends, in part, on whether this causes employees to demand plans that are less expensive in order to keep their premium under a cap, or whether employees are likely to accept a plan with a higher premium even if some portion of the premium is taxed. Any effects on cost growth would likely be modest, given that the vast majority of the current tax exclusion would remain in place. In any case, limiting the tax exclusion would not only provide funding for health reform but would also mitigate the huge inequities built into the current treatment of employer contributions to premiums.

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