Tax Prep Rant
I’m a believer in do-it-yourself tax prep for situations that are fairly simple, as is mine (even with my wife’s small business to contend with). Following my own advice, I just did our taxes in about three hours. Consequently, I am now experiencing my annual post-tax-prep irritation at the complexity of our tax system and the amount of work required to comply. This year, for the first time, I’ll vent it on a blog, any blog. Oh, OK, this one will do.
Actually, with modern software (TurboTax, and the like) it is far easier than ever to prepare tax returns, but still not as easy as it should be. Because I use tax prep software the focus of my ire has shifted from the tax code to the software implementation (the existence of which facilitates tax code complexity, but that’s a different post). I’m rarely 100% satisfied with my software tax prep experience. There always seems to be little things that aren’t explained or don’t feel quite right.
This year, TurboTax nearly tripped me up by not offering to import my mutual fund data until after I had entered it by hand (which wasn’t hard). But when it finally got around to offering importation, which I accepted, I found my taxable events had been doubled, one set hand entered and another imported. Oops! Easy to fix, but sheesh! How many folks are going to catch that one?
I had a few other minor irritations in my encounter with TurboTax this year, but nothing easy to describe in words. So, let’s move on to my second source of annual tax frustration: the IRS withholding calculator and the use of allowances to index withholding.
Look, I have a very simple request to the IRS or Congress: give me the freedom to do withholding my way and in return you’ll get what I owe you with far less error. I know with better accuracy than anyone else in the world what my taxable income will be in the next tax year. I can look at my 1040 from the prior year, make a few adjustments for things I can predict, and voila, out pops a reasonable estimate of my taxable income. Next, I can look up the tax rates and, presto, I know fairly well what my tax will be next year. Call it X. Now, all I want to do is tell my employer how much to withhold from each of my 26 paychecks. This isn’t hard. It’s X/26.
But wait! I can’t just give that number to my employer. I have to convert it into some integer called “allowances.” The method of converting to allowances is complicated and, um, STUPID!!! To make it easier one can use the IRS withholding calculator. Except, that’s stupid too because it is not based on the entries in my prior year’s 1040. It seems as if it is, but it isn’t. For example, they ask you for your expected wages and your 401(k) contributions. That’s, must I say it again, STUPID. It takes far more work to figure that out than to just look up your taxable wages on your prior year’s 1040 (and then inflate that a little if you really want to).
Also, the withholding calculator has no way of handling self-employment income and the sundry deductions one gets for a small business. Guess where all that information is? ON MY LAST YEAR’S 1040!!! So, thank you very much IRS, but you’ve found a way to make a very simple thing–something I can do in my head–nearly impossible to do half as well and for no good reason.
I know I’m going to get a lot of advice on how to do this in a less frustrating way. Good, give it to me. I want it. And Uncle Sam should want me to have it because the biggest source of error in my tax withholding is due to the cockamamie ways the IRS offers to help me calculate it. And somebody please tell me why withholding allowances make sense. Can’t do it? How about just tell me the formula that converts allowances to dollars. Now that would be helpful!
Gruber’s Latest Paper on Employer-Sponsored Health Insurance
Today NBER released a paper by Jon Gruber on the tax exclusion (a.k.a tax subsidy) for employer-sponsored health insurance (ESI). Since its content relates to that of many of my prior posts I will draw out a few points I haven’t already raised or that answer some questions I’ve had.
Gruber claims, without citation, that about 80% of those with ESI have access to Section 125 (cafeteria) plans. I wondered about something like this before. Because employee contributions to non-cafeteria plans are taxed the tax exclusion does not apply to every dollar of ESI premiums. Note that the word “access,” in bold above, is his. He is not saying that 80% are enrolled in a Section 125 plan. So this doesn’t exactly answer my question about what proportion of workers are in such plans. A citation would have been helpful.
Gruber correctly points out that a significant benefit of the ESI tax exclusion: it supports the risk-pooling benefits of the employer-based system. One concern is that employers will cease offers of insurance if the tax subsidy were to vanish. Based on his own work (the extensive margin is relatively low) Gruber writes that if the tax exclusion were repealed “there is no reason to think that there will be a wholesale exit of medium and large firms from ESI.” Perhaps a gradual erosion is more likely.
On the other hand, the tax exclusion also promotes purchase of too much insurance (the intensive margin is relatively high). Gruber briefly surveys some of the literature on this point. He also notes the well-known labor market distortions due to an employer-based system that include “limited job to job mobility and distorted retirement decisions.”
Gruber then turns to a brief summary of his microsimulation model that he uses to estimate the effects of changes to the ESI tax exclusion. The model is based on data from the Current Population Survey and the Medical Expenditure Panel Survey and relies on parameters available in the literature. That is, estimates are incorporated from empirical research on employer and individual responses to variations in degree of tax exclusion.
Based on empirical evidence, Gruber makes some assumptions about the insurance-wage trade-off (how saved premium dollars translate into increased wages).
Any firm-wide reaction, such as dropping insurance or lowering employee contributions, is directly reflected in wages. Yet any individual’s decision, such as switching from group to non-group insurance, is not reflected in that individual’s wages; rather, the savings to the firm (or the cost to the firm) is passed along on average to all workers in the firm. (© 2010 by Jonathan Gruber.)
Before turning to the implications of reform options, Gruber notes the limitations of his approach. One is worth highlighting:
If [the] tax subsidy is removed (or mitigated), then healthy workers may find better prices in a more closely experience-rated non-group market, and to some extent abandon the cross-subsidized employer pools. This will raise the price of ESI, which could exert further pressure on healthy workers to exit. This potentially important spiral of rising premiums is not included in the analysis. This effect could be reinforced through the reduced influence of non-discrimination rules that are enforced indirectly through the tax exclusion.
The concluding section of the paper summarizes simulation results for a variety of changes to tax exclusion policy. Included among them are exclusion cap policies, akin to though not equal to the proposed Cadillac tax. I won’t review the results much here as there are too many and they are summarized well in tables at the end of the paper, one of which is excerpted below.
Why Call It a “Tax Subsidy”?
A reader was confused as to why the special tax treatment of employer based health insurance premiums is considered a “tax subsidy.” I appreciate the question. It isn’t obvious that this is the right terminology. But it is standard, as is “tax expenditure.”
The confusion may stem from the fact that the subsidy isn’t explicit. It’s not as if Uncle Sam sends you a check for purchasing employer based insurance. Instead, what Uncle Sam does is cut you a tax break. If you declined employer based coverage and took the premium as wage it would be taxed. Then if you were to use those dollars to buy non-group coverage you would not get a break on your taxes.
So, relative to taking the compensation as wage and relative buying coverage in the non-group market, employer based coverage is treated differently. All other things equal, it is cheaper thanks to the tax rules. The difference in what it would cost without those favorable rules and what it does cost is the tax subsidy.
Some may object to the terminology on the grounds that it has a bias toward taxation. That is, if one is inclined to think that employer health insurance is “getting a break” then one is led to wonder how that can be justified. On the other hand, if one views the lack of taxation of compensation in the form of health insurance as appropriate government restraint from meddling, then the notion that lack of taxation is a subsidy might be offensive.
I contend that if one thinks government should not tax health insurance then one should think it ought to exempt non-group coverage too. It’s not necessarily a crazy idea. But to put it on sound intellectual footing one ought to tell a good story as to how encouraging compensation in the form of insurance as opposed to wage is welfare improving. That’s a hard story to tell, as I’ll illustrate next week.
Quick Follow-Up: 26% of What?
I’ve been trying to find a way to convert into an annual dollar amount the 26% figure calculated in my prior post, the amount of employer based health spending due to the tax subsidy. To do so I’d need to know total health spending by employer-insured individuals who are beneficiaries of the tax subsidy. I haven’t found that yet. Anybody know it?
The closest I’ve found is the NHE figure for annual private health spending. It’s in the $700-$800 billion range. Even the low end of that is probably high because there is some private health spending outside the employer-based system. Also, not every dollar of employer-based insurance premiums avoids taxation. Employee contributions to non-Section 125 (non-cafeteria) plans are taxed. (Good luck trying to find a figure for what proportion of employees are in or out of Section 125 plans and what proportion of the premiums they pay. Some colleagues and I have been looking for the former for a while. I recall seeing figures that half of firms offer Section 125 plans. They’re probably the bigger firms so the majority of workers are probably in such plans.)
So, it’s 26% of X where X is probably in the ~$400 billion range, but that’s a bit of a WAG. If right, that would make the additional spending due to the tax subsidy ~$100 billion per year or ~$1 trillion over 10 years. And that’s the price tag of health reform.
I think someone can only believe the tax subsidy is not a big deal if they don’t understand it.
Understanding the Employer Based Insurance Tax Subsidy, Part II
It is not my intention to pile on James Kwak. (Can one blogger really constitute a pile on anyway?) I’m a fan of his blogging and he knows far more than I do about many things. But the employer based health insurance tax subsidy may not be one of them. So, with all due respect to Kwak, here goes …
I’ve already raised one problem with Kwak’s calculation of how much the employer based insurance tax subsidy is to blame for high U.S. health care costs. By e-mail several economists have communicated to me another issue. Actually, I pointed it out in my comments to Kwak’s post as well as to Tyler Cowen’s that quotes the key passage:
[T]he exclusion gives the median family a discount of 20%. Only about 60% of people get health insurance through an employer plan, so the average discount across the population is only 12%. Given that the price elasticity of health care is almost certainly a lot less than one (if you double the price, demand won’t fall in half), the overconsumption due to the tax exclusion must be less than 12%.
We now know that the assumption of a tax subsidy at a 20% rate is far too low. The other issue is that the elasticity of health care is not as far below one in magnitude as one might assume. The reason rests on the difference between intensive and extensive margins. Kwak will know what I mean but the uninitiated will not. So I’ll explain.
When health insurance (or most anything) is made cheaper, more people buy it. The rate of increase of the insured (or, more generally, in purchase of a good) due to price is known as the extensive margin. As health insurance is made cheaper by the tax subsidy, more people buy coverage. But, as Kwak correctly notes, far less than one percent buy coverage when price falls by one percent (elasticity is relatively low). Fine.
But something else happens when health insurance is made cheaper. People who buy it buy more of it. That is, even if none of the uninsured buy insurance when the price is lower, those who are already insured buy more generous coverage. That’s the intensive margin. Think using a resource that’s already in use more intensively. Another example is when gas is cheaper you drive more. That’s more intensive use of your vehicle (and the roads, and gas). Some people switch from biking to driving a gas-powered vehicle as well, but that effect is the extensive margin.
As it turns out, for health insurance, the intensive margin is a bigger deal than the extensive one. According to a 2004 paper by Gruber and Lettau that relates the employer tax subsidy to firm insurance offers and insurance spending,
[T]here is a moderately sized elasticity of insurance offering with respect to after-tax prices (−0.25), and a larger elasticity of insurance spending (−0.7). … Our simulation results suggest that major tax reform could lead to an enormous reduction in employer-provided health insurance spending.
As the authors point out, the difference between extensive and intensive margin elasticities means that reduction in the tax subsidy would have a greater impact on reducing insurance spending (which is what we want to bring down) than it would on reducing coverage (which we don’t want to bring down). To be sure, there would still be a reduction in employer offers if the tax subsidy were reduced. But the problems that raises can be mitigated or addressed with other elements of reform, like employer penalties and non-group insurance exchanges.
As I and many economists have said before, the employer based insurance tax subsidy really is a very big deal. I agree with Kwak that it isn’t the entire reason for high U.S. health costs. But it is a bigger reason than he and others might have thought.
Understanding the Employer Based Insurance Tax Subsidy
The economist’s knock on employer based insurance is that it is paid with pre-tax dollars. That means that each dollar of worker compensation in the form of health insurance is worth more than a dollar in compensation in the form of wages. One consequence is over consumption of health insurance and health care. The tax subsidy also contributes to job lock and other labor market distortions because it makes employer based insurance more valuable than non-group health insurance.
So, the decks are tilted toward employer based insurance but by how much? What is the tax subsidy per dollar of insurance? It is tempting to say that it is the worker’s federal marginal income tax rate. But that’s not right. It is not even close. The key is to the right answer is to ask, for each additional dollar an employer pays toward its wage bill, how much does the employee receive in after-tax compensation? That is, your employer paid a dollar toward covering your wage. What portion of that dollar showed up on your net paycheck?
Let’s start with the additional cost to the employer due to the Social Security payroll tax rate (tSS) and the Medicare payroll tax rate (tMC), ignoring the high-income cutoff of the Social Security tax. Each dollar of gross wage costs your employer (1+tSS+tMC) dollars. Or, put another way, for each dollar your employer pays toward its wage bill on your behalf you only receive 1/(1+tSS+tMC) dollars. But that’s before you pay your taxes. So, let’s do those next.
The final dollar of gross wage is taxed at your federal marginal income tax rate (tF), your state marginal income tax rate (tS), and is also hit with Social Security (tSS) and Medicare payroll taxes (tMC). Therefore, what you actually receive post-tax from that dollar of wage is 1-tF-tS-tSS-tMC of a dollar. Hence, for the marginal dollar of employer cost, you actually receive post-tax
TP = (1-tF-tS-tSS-tMC)/(1+tSS+tMC).
The quantity TP in the foregoing expression is known as the tax price and has played an important role in theoretical and applied economic analysis of employer based health insurance. (See the fifth page (marked 297) of The Impact of the Tax System on Health Insurance Coverage by Jon Gruber.) The amount by which TP differs from one is the cost avoided when the marginal dollar of compensation is provided in the form of health insurance instead of wage. Thus 1-TP is the amount in taxes lost to government. Already we can begin to sense that this is quite a different animal than the federal marginal tax rate.
Let’s plug in some numbers. Suppose your federal marginal income tax rate is 20% (selected to correspond to James Kwak’s calculation), your state marginal income tax rate is 5%. The employer and employee Social Security payroll tax rate is 6.2%. And the employer and employee Medicare payroll tax rate is 1.45%. Plugging these in (as decimals, not percentages) to the tax price equation above we find that
TP = (1-0.2-0.05-0.062-0.0145)/(1+0.062+0.0145) = 0.63.
Thus 1-TP is 0.37. Even though your federal marginal income tax rate is only 20% government (federal and state combined) loses 37 cents of tax revenue for each dollar paid in health insurance as opposed to wage.
This is why the tax subsidization of employer based health insurance is a big deal. It goes way beyond the federal marginal tax rate. Assuming that’s all there is to is a mistake (h/t Tyler Cowen; note also Henry Aaron’s correction). Finally, a Cadillac tax of 40% is pretty close to what would be required to recover the lost tax revenue for the example above. But it wouldn’t be enough for individuals with a federal marginal income tax rate above 20%. In this sense, the Cadillac tax is a bargain.
Later: See also my follow-up post on another important fact about the employer based tax subsidy.
Taxing Financial Transactions
The Obama Administration is looking for ideas in the area of taxing financial transactions. Ezra Klein asked for thoughts. Even though I haven’t read deeply into this area (*) I have an idea to share. I would not be at all surprised if it has already been proposed or considered by those more knowledgeable in this area than I am. Nevertheless, here goes:
We already tax financial transactions in a way via short- and long-term capital gains, the cutoff between the two being one year. If a policy goal is to reduce high-frequency trading I have two ideas that build on the current tax framework: (1) Include a “very short” category with, say, a cutoff of a quarter year, or month (or whatever makes sense to the folks who really know this stuff). This very short category could have, though need not have, an even higher capital gain tax rate than the current short-term one does; (2) Eliminate the ability to write off short-term (or very short-term) capital losses. Ideas (1) and (2) need not be combined.
A third idea is to remove the taxation exemption from otherwise tax preferred accounts (401(k)s, IRAs, 529s, etc.) but only for very short-term trades. I can already hear the howls on this one as it might be characterized as the first step down the slippery slope toward elimination of tax advantaged vehicles. Still, if we want to provide an incentive for buy-and-hold, we can’t ignore tax advantaged accounts, can we? High-frequency trading can be done under those vehicles so why should they be exempt?
The point here is not to penalize everybody who wishes to participate in the market, but to make some (perhaps crude) distinction between types of market behavior. We already do this, as I said, so why not build on it?
What do readers who know finance better than I do think? (TFB, Mike, others?)
(*) This disclaimer serves as notice that this is a deviation from my M.O. You’ve been warned!
Note: I added the paragraph about tax advantaged accounts in a later update to this post.
Gruber, the Excise Tax, and the Politics of Policy
A lot of well-meaning people and good ideas can get tarnished when they enter the realm of politics. Take Jon Gruber, who’s been in Krugman’s words, the “go-to guy on modeling reform” and a “top micro-modeling expert”. Due in small part to the fact that he didn’t disclose his contract with HHS to all people all the time, and in large part to bloggers at firedoglake he’s been accused of harboring conflicts of interest.
Sometimes a kerfuffle is just a kerfuffle and not worthy of a lot of worry. Again, Krugman:
The truth is that this is no big deal. Gruber’s grant is from HHS, not the West Wing; it’s basically the same kind of thing as, say, an epidemiologist receiving a grant from the National Institutes of Health. You wouldn’t ordinarily say that this tarnishes the epidemiologist’s credentials as an independent analyst on infectious diseases…
The only reasons you might see this differently would be if Gruber were either receiving a sweetheart deal, or seemed to have changed his views to accommodate his sponsors. Neither is remotely true.
Speaking of Gruber and small kerfuffles, he’s one of the several individuals called to task by Larry Mishel in his piece on the historical trends in health care costs and wages. But in Gruber’s case, I think this is making a mountain out of a molehill. Though Mishel has a narrow point I agree with, that wage changes aren’t entirely explained by those of health care costs, I don’t think Gruber’s words in his 28 December 2009 Washington Post Op-Ed explicitly contradict that point (though one could read his implication that way).
Moreover, the debate over the extent to which changes in wages can be related to premiums is silly, because we know the answer. In the long-run it is one-to-one. Workers pay the premiums even if employers appear to and even if those payments aren’t the main or only cause of wage changes over the last two decades. It misses the point of the excise (Cadillac plan) tax to in any way obscure or avoid that fact. So, in my view, it is the fact worth emphasizing: workers pay the premiums.
Workers will also pay the excise tax on premiums. That fact is receiving not one, but two levels of obfuscation in the policy debate. John Kerry is characterizing the excise tax as one that won’t harm workers because it is levied on insurers (h/t Ezra Klein). But insurers will bill their costs to employers who pay the premiums (at least in part). Employers will pass that cost along to employees, through–that’s right–lower wages. Workers pay the premiums.
Of course the whole point of the excise tax is to raise revenue in a way that also promotes efficiency in the health care system. It will certainly do the former but it is a very imprecise and flawed way to do the latter. It’s regressive relative to removing the premium tax exemption. In the form publicly proposed to date it makes no accommodation for geographic variation in health care costs or in the risk profile upon which the premium is based. Put simply, in implementation it’s a stinker (though that could be fixed) with its main redeeming quality its intent (which is good).
Nevertheless, it is being defended as a way to begin to remove the special status that employer-based health care premiums receive by the tax system. Again, this is a defensible and laudable goal but the excise tax would replace one flawed system for another. And I have to believe that the smart people defending it know all this. So why is it being defended so strongly? The only plausible answer I can come up with is that it is, somehow, good politics. Or, at least, it is less bad than alternative ways to raise revenue for health reform.
When good people (like Jon Gruber) and good ideas (like eliminating the special tax treatment of health care premiums) meet politics their intent and image can get distorted. It’s a sad fact that the surest way to stay pure is to stay away and to keep your good ideas quiet. But that doesn’t help anybody but yourself.
What “I” Really Think of the Cadillac Tax
It would be easy if I just agreed with Paul Krugman about everything. But I don’t always.
Yet, sometimes I do. And he writes well. So instead of writing my own post about what I really think about the Cadillac tax I’ll just state (now for “the record”) that I think what he wrote makes a lot of sense. In brief, the tax’s general aim is good, but the specific way it is currently proposed is bad and should be fixed. (In truth this isn’t too different from what I’ve already strongly implied. Maybe Krugman is agreeing with me. He doesn’t always.)
The other thing I agree with Krugman about today is in his other post. Click through to find out. That’s the point.
Marginal Versus Average Tax Rate Figures
I don’t need to write a post on the difference between marginal and average income tax rates. There are already perfectly good explanations available elsewhere (see list at the end of this post). In brief, your marginal tax rate is the tax paid on the last dollar earned. Often this is what people mean when referencing their “tax bracket.” Your average tax rate is simply your tax paid divided by your taxable income.
The purpose of this post is to show off graphs that illustrate the difference between marginal and average federal income tax rates (state and payroll taxes excluded). A while back I wanted graphs like this but couldn’t find any online. So I made them myself. They’re included below and also in an online Excel spreadsheet that has the data on which they’re based. All figures and data are for federal income tax for the 2009 tax year.
For more on marginal versus average tax rates see any of:
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