The release last month of the blueprint for a Republican alternative to the ACA has brought renewed—and welcome—attention to the tax exclusion for employer-sponsored health coverage. On that point (and others), the blueprint hints at some common ground between Republicans and Democrats. Once the midterm elections have passed, it may even suggest an opportunity for compromise.
Because employees pay taxes on their wages but not on their health benefits, the tax exclusion gives workers incentives to accept lower wages and more health coverage than they would in the absence of the exclusion. The result is excess spending on health care. This is not especially controversial: as the Republican blueprint explains, “economists across the political spectrum largely agree that the current distortion in the tax code helps to artificially inflate the growth in health care costs.”
Reducing that distortion is what the ACA’s “Cadillac tax” is all about. The Cadillac tax imposes a 40% excise tax on the costs of employer-sponsored coverage that exceed a threshold amount, effectively capping the exclusion at that threshold. When the tax goes into effect in 2018, the threshold will be $10,200 for individual coverage and $27,500 for family coverage. The threshold will increase over time, but, after 2020, only with the rate of inflation, not with increases in medical inflation, which have historically been considerably higher.
Although relatively few plans will approach the threshold at first, linking the threshold to overall inflation means that, over time, more and more plans will brush up against it. Eroding the tax exclusion for high-cost plans increases the pressure on employers and insurers to keep health spending in check.
The Republican blueprint pursues the same goal, only much more aggressively: it would cap the exclusion at 65% of the costs of an average plan. That’s a Cadillac tax on steroids. According to one analysis of the plan, the blueprint would cap the exclusion at about $5,400 for individual coverage and $11,250 for family coverage—significantly less than the $10,200 and $27,500 figures for the Cadillac tax. (Although the authors of the blueprint have since retreated from those low thresholds, they still endorse capping the exclusion.)
But here’s the trick. Neither the Cadillac tax nor the Republican blueprint addresses another big problem with the tax exclusion for employer-sponsored benefits. As it stands, the exclusion is worth more to individuals in higher tax brackets than those in lower tax brackets. That means the exclusion disproportionately benefits the wealthy.
Capping the exclusion based on the costs of an employee’s health plan would make the exclusion somewhat less regressive—high earners tend to have expensive health plans. But not all workers with expensive health plans have high incomes. Unions in particular worry that the Cadillac tax may harm their members. Many unions, especially those representing public employees, have negotiated generous benefits packages for their members. Because of the Cadillac tax, unions are coming under tremendous pressure to accept cuts to those benefits.
This discontent from some of the Democrats’ most ardent supporters presents an opportunity. What about tax reform that both reduces economic distortion and is more progressive? The exclusion, for example, could be replaced with a tax credit for employer-sponsored insurance—a fixed amount that each taxpayer could subtract from her overall tax liability. Less radically (and probably less effectively), the tax exclusion, instead of being capped at a set amount of a health plan’s cost, could phase out with income.
Either reform would encourage employers and insurers to cut their spending on health care, whether by pressing for systemic changes, negotiating lower prices, or shifting costs to consumers. Unions won’t be thrilled about that, but the changes could be delayed for unions in current contracts until they renegotiate against the backdrop of the new tax rules. In any event, tax reform that limits an unhealthy market distortion should make Republicans (and some Democrats) happy.
At the same time, a reformed exclusion would assure that the federal government devotes its forgone tax revenue to those who need it the most—not to those in the highest tax brackets. Improving the fairness of the tax treatment of health insurance, and easing union members’ tax burdens, should make Democrats (and some Republicans) happy.
So maybe there’s room for a deal. I don’t want to be Pollyannaish about this: the politics of health care in general, and the tax exclusion in particular, are miserable. But if the ACA does stick, as seems increasingly likely, both parties should be on the lookout for policies that could attract bipartisan support. Reforming the tax exclusion could—perhaps—be one such policy.