The Deductibility of Employer Provided Health Care

Brad DeLong and Andrew Samwick have both been having some discussion of the vague outlines of Bush’s health care proposal. You know, the one that involves dumping all employer provided health care plans and tossing everyone out into the free market on their own to purchase catastrophic health insurance while paying the up-front costs of care out of their own pocket?

When we last looked at this issue, Bush was proposing to finance tax cuts for investment income by eliminating the deduction for employer provided health insurance. Right now, many of us collect health benefits from employers that can be worth up to $10,000, without paying a dime of tax on what is essentially income (compensation for our labor). In technical terms, this income is excluded from taxes rather than being deductible (as Samwick points out).

It’s always a hoot when economists first turn their attention to a policy issue. Samwick writes, "The deduction exists because there is a notion that the government ought to encourage people to get health treatments that they need."

This is typical of a functionalist way of thinking about policy. But it makes sense from an economist’s point of view. If people are presumed to be optimizing and maximizing all the time, then they are doing so instantaneously every second of the day. The second a policy ceases to be desirable, one changes it. So the original reasons a policy passes are irrelevant. If a policy is still in existence today it must be explainable in terms of today’s policy objectives. I guess the idea that policies, not just wages, might get sticky got thrown out with the whole "rational expectations" thing. Typical of a macro-economist.

In point of fact, if we take a historical-institutionalist approach, we can trace the excludability of health premiums from income taxes to World War II. During that time, price and wage controls limited how much and how fast employers could raise employee incomes. So unions negotiated health benefits for their workers which fell under the radar of the wage ceilings. And Washington looked the other way to keep people happy. This policy then became institutionalized (the whole subject would make a great research paper about how social policy becomes institutionalized but Jacob Hacker and Paul Pierson probably have already written it) so that changes have pretty much been seen to be off the table. You think Social Security is the Third Rail of American politics? That would make the tax excludability of health benefits and home mortgage interest payments (which have survived every tax reform effort since 1945) the Black Hole of American politics. But who knows, maybe after the election, the Bushies are feeling lucky.

That said, tax deductibility is a major policy problem for a number of reasons. For one thing, it’s economically inefficient. Always better to give people cash over in-kind benefits. It’s also pretty unfair since employer provided health insurance is compensation that is fully deductible but people who get health insurance on their own have to do so with after tax dollars and only a portion of their premiums are deductible. And of course, there is that fact that tax deductions are regressive because they are worth more to those in the higher tax brackets. But most importantly from the perspective of this humble progressive, tax deductibility blinds people to how much they are already paying for health care.

One of the things Democrats used to spin around on their heads over in the 1990s was how to protect themselves against charges that a national health insurance plan would represent a tax increase. But they generally missed that such a policy might actually represent an overall economic saving for most people. Howard Dean used to talk about this kind of thing pretty well in the campaign. It’s one thing to cut taxes, but if your other policies are taking money out of people’s pockets, they are actually worse off. The idea that a person could be financially better off with a tax increase that also results in a substantial income increase escapes most people.

But in the early 1990s when I was working on the issue, we estimated that a 7% payroll tax could probably raise the money needed for some kind of a national health plan (after another decade of health cost inflation I have no idea what that rate would be now). If a family of four making $100,000 were to have to pay this tax it would come to $7,000. Ouch you say! But if the employer is currently paying $10,000 for a family plan for the employee and no longer has to do that, the money would get returned (in economic theory) to the worker in the form of a higher wage. It is almost certainly true that blue collar wages have been so flat for so long because rising health care costs annually eat a large chunk out of what could otherwise go to a wage increase. Of course, in the short run, most employers would see the foregone cost of health insurance as a cost-savings and a profit increase. But most economists look at the money paid for health benefits as money that would other go towards employees since it is part of the overall costs of employing workers. So in the longer short-run (or the shorter long-run - Keynes’ admonition about the long run being truer than ever these days) this money would come back to workers in the form of higher wages. That’s a net savings of $3,000.

But most Americans might not see it this way because most never see what employers pay for health care. My own employer is kind enough to tell me that the University’s current contribution is about $320 a month and I pay the rest (about $450) out of my salary. But if you asked most people how much their employer pays for their health insurance they would look at you like you asked them who won the War of the Roses. And most people don’t think of this money as their money, as their income. The hypothetical worker we described above wouldn’t say that his income is $110,000. If you asked him how much he makes, he would say, $100,000. He would forget to add in how much his employer pays for health insurance, for dental insurance, for disability insurance, for life insurance, for contributions to a pension plan or 401K, all money that represents the costs of employing him.

Addressing the tax deductibility of these things might help people to realize a number of things. Just how much these things cost. Just how much money they actually make. And perhaps people might realize that when a company defaults on it’s pension obligations, it is essentially stealing money from workers that they had been promised under a contractual agreement and which many of them have worked a lifetime to accumulate. One works for a company and one gets compensation in return. But the divergence between actual, economic compensation and what people think is their level of compensation allows for all kinds of shenanigans that typically end up costing working people real money. But asking for a rational American tax policy is like asking for peace on earth.