• 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.

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    • Love this post – it makes the argument very real. But I think there is a policy fallacy buried in your analysis, at the “20% federal/5% state tax rate.” That simply isn’t very representative.

      Try this: a small table that shows the outcomes at $40k, $80k, $150k and $300k of AGI for a family of four (extra credit for adding single filers:-)), rather than assuming a 20% marginal tax rate and calculating based on marginal dollars of income.

      Two reasons: first, since the employer health benefit really applies from dollar one of the employee’s income, it is more reasonable to apply it to the tax burden averaged across the entire annual income, not the highest marginal rate of the taxpayer; and second, it is important to understand the regressiveness of this kind of tax benefit. Very few people (<10% of families of four) have an average tax rate of 37%. The benefit is indeed nearly 40% for AGIs above $150k, but there are very few of those. For an SEIU member in Texas (no state income tax, $50k annual income), that benefit looks much more like 12-15%.

    • Wikipedia tells me that only 6.24% of taxpayers have AGI above $100k.

      So to complete the thought: the “Cadillac Tax” might be a “bargain” if your AGI is above $100k. But if your AGI is below $60k (most union workers), then not only is it no bargain from a tax benefit analysis, it is an income tax increase on a person who is very poorly positioned to absorb it.

    • I lean toward Mr. Frakt, as far as he goes. In fact, on a dollar-weighted basis I’d be inclined to use 25% as typical marginal income tax rate, for a combined marginal rate of 40% federal, and perhaps 50% in states with high state income tax rates.

      But Frakt also misses an important part of the picture. Employer-sponsored insurance is by law community rated, and guaranteed issue subject to a waiting period for people without prior creditable coverage. This means that there is a secondary transfer going on: healthy employees are subsidizing the less-healthy.

      The employer tax exclusion roughly compensates healthy employees for the added cost of community rating. The tax subsidy merely cancels out the negative cross-subsidy. Of course, for high risk employees, both subsidies are positive.

      For me the biggest problems with the tax exclusion are:

      1) The amount of tax subsidy is probably too high for the purpose, leading to overconsumption. This is because the subsidy is an accident of the individual tax rates, rather than a deliberately chosen rate.

      2) The employer exclusion is regressive, again because the subsidy is based on marginal tax rates.

      3) It discriminates against those who purchase equivalent community-rated insurance with after-tax dollars (e.g. COBRA or HIPAA continuation coverage).

    • @Bart – It is my understanding that one of the points of negotiation is modifying the Cadillac tax so it is sensitive to employer risk profile, as well as geographic variation in medical costs.

    • Austin- That doesn’t surprise me. The whole bill is full of similar tweaks. Why not a few more?

    • The fatal flaw of this whole realm of discussion, is the notion of a link between over consumption and plans with good benefits. I’ve yet to see any data even referenced. It’s just assumed as truth that “consumers” (that is to say “patients”) drive health care consumption.

      First, what is “overconsumption?” I am sure there are people who make more trips to the doctor than are absolutely neccessary, but most people I know are like me. They go to the doctor when it gets to a point that they suspect it is probably irresponsible not to. My office visit rate was the same when my copay was $2 and when it was $20. I admit that now, with no insurance, a $200 dollar office visit is more than I am willing to do under most circumstances, but honestly, do we want to use economic demand curves to drive health care “use”?

      In reality most people have practically no say in the cost of their health care as they lack the expertise to reasonably (safely) do so. They do health care the same way they do car care. They trust their specialist and do what they recommend. So while cost can be shifted to the individual with ever increasing deductibles and copays the cost of health care will not be impacted. Morbidity and mortality will go up, giving us even worse health care results for the money spent.

      Real change in health care costs, will require changes in physician practice either by incentive or requirement.

      One way to do this is to change away from fee for procedure pay that economically rewards increased use of the system. Perhaps forbid doctors from using facilities in which they have financial stakes, from laboratories to surgery centers.

      The even more controversial bit is evidence based medicine. People get up in arms about being told no to getting care, even care that is demonstrably harmful. One economic reality is that unlimited demand does collide with limited resources. Some day we have to have a conversation about who will get what care when. Currently we have given up earlier more basic care for all, for Extraordinary measures at (and arguably beyond) the end of life for all. Few would argue that this is a good thing, but inertia is allowed to dictate.

      • @David – Over-consumption is use that yields little to no benefit. Low out-of-pocket costs facilitate it. The idea of overuse due to generosity of insurance is the notion of moral hazard. There is a vast literature on it. The most famous study of it is the RAND Health Insurance Experiment (HIE). Quoting from the HIE Wikipedia entry, “An early paper with interim results from the RAND HIE concluded that health insurance without coinsurance “leads to more people using services and to more services per user,” referring to both outpatient and inpatient services. … The experiment also demonstrated that cost sharing reduced “appropriate or needed” medical care as well as “inappropriate or unnecessary” medical care.” One would like to encourage the appropriate care while discouraging unnecessary care. I’ll have a post next week on insurance designs aimed at doing just that.

    • You’ve not even added in the substantial discount of buying these products as an institution, as opposed to an individual. The Feds tax us as if we buy the benefits as an individual, so I happen to get a little report showing what they’re assuming the benefits would cost – not what they actually do cost. And they seem to think the benefits cost to be 2-3x what we actually spend on them. Much like buying a flat of soda I can get them a 25¢ a can but if I buy a single can I’m pay $1.

      But there’s no overconsumption of healthcare. How could you make a ridiculous argument such as that? Overconsumption would mean better results, not poorer. Americans see doctors less than nearly any advanced country and we have poorer results for it. That’s not a result of overconsumption of healthcare. Miss-consumption, sure, but not overconsumption.