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-tFtStSStMC of a dollar. Hence, for the marginal dollar of employer cost, you actually receive post-tax

TP = (1-tFtStSStMC)/(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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