As the standoff in Congress over the future of Affordable Care Act tax credits continues, here’s a look at a different approach to reforming tax treatment of health insurance – taking on the exclusion for employer-sponsored health insurance (ESI) premiums.
The ACA marketplace premium tax credits have been the focus as the government shutdown enters week three. Democrat leaders contend a failure to extend COVID-era enhancements to the credits will cause “tens of millions of people” to “experience dramatically increased premiums, co-pays and deductibles.” Meanwhile, many Republicans argue the credits allow for “waste and fraud.”
But while the ACA premium tax credits are claimed by millions, they aren’t the largest Tax Code “preference” for health care, according to the Tax Foundation’s William McBride and Alex Durante. “[F]ar and away the largest is the exclusion for employer-sponsored health insurance (ESI) premiums,” say McBride and Durante.
The Bipartisan Policy Center’s Andrew Lautz and Andrew Patzman go even further, calling the ESI exclusion “the third largest expenditure in the sprawling federal tax code, behind only retirement tax advantages and reduced capital gains tax rates.”
McBride and Durante contend the ESI exclusion could reduce federal tax revenue by $5.9 trillion over the next decade, when accounting for reduced income tax revenue and reduced payroll taxes.
But ESI is also widely taken up. It’s “the largest source of health coverage for non-elderly U.S. residents,” according to KFF’s Gary Claxton, Matthew Rae, and Aubrey Winger. In 2023, “60% of people under age 65, or about 164.7 million people” had ESI, they add.
History of the Employer-Sponsored Insurance Exclusion
The ESI exclusion dates back to over 100 years ago, when “[e]mployer payments for individual health coverage were deductible as a cost of doing business,” explains the Congressional Research Service. The exclusion was “significantly expanded during and after World War II by administrative decisions and policies that froze wages, but not employer-sponsored fringe benefits during wartime” – before being enacted into law in 1954.
Presently, IRC § 106 provides that “gross income of an employee does not include employer-provided coverage under an accident or health plan.” In addition, IRC § 105(b) sets forth an exclusion for benefits employees receive through ESI.
The Case for Limiting the Exclusion
The Tax Foundation’s McBride and Durante say the ESI exclusion incentivizes employers to “shift pay packages toward untaxable ESI benefits.” The result of this, they contend, is “increasingly generous ESI benefits that boost demand for healthcare and put upward pressure on healthcare prices.”
The Cato Institute’s Michael F. Cannon supports simply ending the ESI exclusion. One of his key arguments is that the exclusion, in effect, allows employers to make health decisions for workers. “To take advantage of the exclusion,” says Cannon, “a worker must let her employer control a sizable share of her earnings (typically more than twice the amount the exclusion saves her in taxes), enroll in a health plan that is likely not her first choice (or even her second choice), and pay any remaining share of the premium out of pocket.”
However, the Tax Foundation authors caution that “[f]ully eliminating the exclusion for ESI” would “result in a major tax increase on workers.” McBride and Durante offer a more measured approach – limiting the ESI exclusion.
They modeled limiting the exclusion for premiums above the 80th and 90th percentile, with and without indexing the ESI cap to inflation. While all four options would increase tax revenue, limiting the ESI exclusion to the 80th percentile and indexing for inflation could raise nearly $389 billion over 10 years.
Lautz and Patzman also advocate for an ESI cap at the 80th percentile. They contend the current exclusion “encourages higher spending on health insurance than is necessary to achieve good health outcomes.” Limiting the exclusion could “put downward pressure on premium increases,” they explain.
Support for the ESI Exclusion
Ending, or even capping the ESI exclusion is controversial. KFF’s Claxton, Rae, and Winger argue that “providing health insurance through the workplace is efficient, with advantages relating both to risk management and to the costs of administration.”
The KFF authors explain that if health insurance purchasing decisions are made at the individual level, those who are in poorer health will naturally be more inclined to purchase insurance and pay more for it – leading to a risk pool “dominated by a relatively small share of people with the highest needs.” Conversely, “providing coverage through workplaces provides insurers with a fairly normal mix of healthy and less healthy enrollees.”
And there are administrative advantages to ESI as well, say the KFF authors. Employers take the lead in enrolling employees and collecting their share of premiums, they explain, “dramatically reducing the number of transactions and reducing the amount of unpaid premiums.”
Nomi Health CEO Mark Newman also stressed the importance of the ESI market, noting that “if you’re on an individual plan, you do not have an employer or a broker or a consultant or anybody that’s acting as your advocate when something bad happens.”
Transparency and accountability over spending and claims data is key for Newman – and he warns of difficulty in accessing this data for both the individual and small group insurance markets.
Employers have “a better opportunity” to approach “the real cost of health care because they have tools and data to kind of justify their case,” he told Checkpoint. Meanwhile, those on individual plans are just “price takers.”
And Newman’s view is that the vast majority of employers offering benefits advocate for better health insurance options. These employers’ take is, “we want you to do your best work and have your best life while you work here.” And employers don’t want to pass along to employees “the mental load” of trying to figure out their own insurance, Newman added.
Newman takes issue with the argument that the ESI exclusion has led to overly generous insurance, boosting health care demand and driving up prices. He attributes overutilization, instead, largely to high-deductible policies – which he says spur a “manic response” for beneficiaries once a deductible is met. “When you eliminate deductibles or co-pays, or make them minimal, it has a moderating effect on utilization,” he contends.
Newman is also skeptical about whether capping the ESI exclusion will actually be helpful. With a 90th percentile cap, he predicts “the base will just go up, and every plan will become an 89% plan.” He argues, “it’s all fake benchmarking.”
“Until we get to a data-driven, open-accountability market,” said Newman, “we’re not going to address the overall health care costs.”
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