Tax exemption for employer-sponsored health insurance is actually a tax penalty

When is a tax break really a tax penalty? When it comes to the tax exclusion for employer-sponsored health insurance.

This is what Michael Cannon, director of health policy studies at the Cato Institute, convincingly argues in his recent paper, Ending the tax exclusion for employer-sponsored health insurance. His article is a compact lesson in how some supposed tax breaks can actually work as tax penalties, not only distorting markets, but invisibly penalizing people for their choices. And it’s a reminder of how seemingly minor and flippant political decisions, made with little thought about the long-term consequences, can wield haunting influence long after they’re made.

The tax exclusion for employer-sponsored health insurance is exactly what it sounds like: an exclusion for health coverage provided by the workplace.

If an employer were to pay an employee $10,000 in cash, that money would be taxed at an average rate of about 33%, meaning the employee would only see about $6,666. If, on the other hand, the employer were to compensate an employee with $10,000 of employer-purchased health insurance, the value of that plan would be exempt from federal income and payroll taxes. The employee would receive the full value of the plan.

This makes workplace health benefits more valuable, dollar for dollar, than cash compensation, and therefore creates an incentive to buy more of them than if the tax treatment of cash benefits and health benefits were equal. It acts as a grant.

In his article, Cannon admits that “fFrom an accounting perspective, the exclusion is tax relief: it reduces the tax liability of workers who purchase employer-sponsored coverage. »

But he argues that, in practice, this tax relief actually acts as a stealth penalty for workers who want to make their own health insurance choices. Typically, even a generous employer only offers a handful of health plans, and those plans are unlikely to come in the exact form an employee would otherwise choose on their own. However, if an employee wishes to join another plan, they will have to do so with the money first received – and taxed – as cash compensation. Thanks to taxation, it would be worth much less. Thus the tax exclusion acts as a tax malus for any employee who wishes to choose his own health insurance.

The existence of a penalty implies a kind of coercion. Recall that when the Supreme Court upheld Obamacare’s individual mandate to purchase health insurance as constitutional, it was interpreting the mandate as a tax penalty for not purchasing health insurance rather than a direct economic command. This decision highlighted the thin line between tax penalties and coercive mandates; Cannon’s argument takes the logical connection even further: that although the tax exclusion for employer-provided insurance may look like, on paper, tax relief, viewed from an economic , it is functionally similar to a mandate.

And yet, it was never explicitly intended as such. Rather, exclusion stems from a complicated series of bureaucratic decisions dating back more than 100 years. Following the creation of the income tax, Treasury officials had to decide how to deal with health insurance which sometimes included salary payments for sick leave, a minor issue at best since few people had a health coverage at the time.

In 1942, however, as World War II raged, the federal government froze wages as part of the war effort, but ruled that retirement and health benefits were exempt. This meant that employers had to rely heavily on these benefits to attract talent. Unsurprisingly, employer-provided health insurance has become much more common. Just over a decade later, Congress formally codified the exemption. In the 1970s, the vast majority of American workers obtained health insurance through their employers.

So what at first seemed like a minor bureaucratic decision of little consequence eventually became the primary means by which Americans received private health care coverage and, therefore, a huge determinant of American health spending.

According to Cannon’s calculations, the tax exclusion effectively removes control of nearly $1 trillion in workers’ compensation, or the total value of the employer’s share of occupational health coverage. His article is a call to end the coercive politics that created this situation and replace it with a system of large health savings accounts that would allow workers to control this money and be free to make their own choices about ‘Health Insurance.

The tax exclusion for employer-sponsored health insurance is the original sin of the US healthcare system. To mitigate its effects, we must first see it clearly for what it is: not harmless tax relief, but a coercive political mechanism that undermines basic economic freedom.