• The economic theory of premium-wage tradeoffs

    The following is cross-posted at the HealthCare Markets and Regulation (HMR) Lab, Department of Health Care Policy, Harvard Medical School and is by Jeannie Biniek, a PhD candidate in the economics track of the Health Policy Program at Harvard University. From 2009 to 2013 she worked as professional staff for the Senate Budget Committee where she advised Chairmen Murray (D-WA) and Conrad (D-ND) on health, tax, and economic policy issues. Prior to that she worked as a consultant to companies in the health care industry on transfer pricing matters and intellectual property litigation. She holds a BA from the University of California, Los Angeles and a MA from Johns Hopkins University.

    The Affordable Care Act included an excise tax on high-cost health plans (the Cadillac tax). The objective of the tax is to curb overutilization of health care services by reducing the tax-subsidy for the most expensive employer-sponsored coverage (which is currently provided as tax-exempt compensation). Estimates of the effect of the Cadillac tax on federal tax revenues assume employers will increase wage compensation to offset reductions in health insurance benefits made to avoid triggering the tax (CBO and JCT estimate that three-quarters of new revenue from the tax will come from taxes on higher wages). The extent of this premium-wage tradeoff is important, but poorly understood by non-economists.

    In December I discussed why we might not expect every dollar reduction in health insurance premiums to lead to a dollar increase in wages — a 1:1 premium-wage tradeoff — in the public sector. In this post, I take a step back and discuss the economic theory underpinning the conceptual framework researchers use to empirically examine premium-wage tradeoffs in the literature.

    Economists expect employers try to offer the most appealing combination of wages and benefits, such as health insurance, for any given level of total compensation. In a competitive labor market, this strategy is necessary to attract workers. Because workers have different preferences for health insurance, and because employers face different costs for providing coverage, the particular wage/benefits package deemed most appealing will vary. Note that in theory workers could buy benefits directly (as opposed to taking advantage of employer provision of benefits). Yet because they would have to pay a higher premium for similar coverage purchased on the individual market (where administrative costs are higher and the beneficiaries across which risk is pooled may be less favorable), workers are motivated to seek employer sponsored coverage (which is why individual mandates could increase employer provided coverage).

    In a very simple world, with homogeneous workers, economic theory predicts that if workers value benefits more than their cost to the employer, the employer will offer more of the benefit and lower the workers’ wages accordingly. Thus in equilibrium, the compensation package will reflect the point where workers value benefits at exactly the cost to employers to provide them. This calibration is predicted to occur both across employers — with workers sorting based on the wage-health insurance combination they find most attractive — and over time as the cost and characteristics (such as extent of services covered) of health insurance changes.

    In practice workers are not homogeneous, and the ability to precisely target the benefit package to each worker is limited. Health insurance by design requires individuals to pool risk by joining together in a finite set of plans. Even if it were allowed under the law, employers cannot, therefore, offer each worker a plan and corresponding premium tailored specifically to their preferences.

    It may also be difficult for employers to reconfigure compensation packages for existing workers when the costs or characteristics of health insurance coverage changes. For example, when provider prices increase or new technology raises the costs of treating a particular covered condition. In addition to the challenge of precisely targeting the benefit package, wages exhibit a stickiness — workers don’t like to see their wages cut — that may prevent employers from adjusting this margin of compensation (Sommers explores this in more depth).

    As a result, the premium-wage tradeoffs may be “lumpy”, operating for groups of workers, rather than individuals. For example, certain groups who have higher expected medical costs may be offered and accept lower wages when, as part of their compensation, an employer provides health insurance covering medical services the group expects to use.

    It could also lead to employers not fully passing through changes in the cost of health insurance coverage. In particular, if changes in the cost of providing benefits are driven by things workers do not value equally, employers may bear some of the burden of the cost change.

    In the context of the Cadillac tax (since that was the motivation for this review of the literature), two sets of questions emerge: 1) Do employees at firms providing health insurance that will trigger the Cadillac tax value the generosity of the benefits at their cost? And, 2) What other options for health insurance, such as from a spouse or the individual market, do these employees have?

    In my next post I will turn to the literature examining the premium-wage tradeoff in the private sector and interpret the implications of these studies for understanding how the Cadillac tax (when and if it goes into effect) will affect wages, and as a result, federal income tax revenue.

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