Better Ways to Pay For Health Care: Taxing Health Benefits

By Conor Clarke

Matt Yglesias says that CBO director Doug Elmendorf's testimony yesterday morning (in which he said the House is not proposing "the sort of fundamental changes that would be necessary to reduce the trajectory of federal health spending by a significant amount") is going to change the health-care debate. In particular, Matt says that "Elmendorf’s words will now help [Senator Max] Baucus, the [Senate] Finance Committee, and taxing health benefits all get back in the game."

I hope that's true! The idea of taxing health benefits was floated by Baucus a couple of weeks ago, but torpedoed before you could say "complicated tax loophole." But it really should come back in fashion. Capping the health-care tax exclusion is a fantastic idea -- one we should be pursuing even in the absence of the current health care debate. A little background: The employer-sponsored insurance (ESI) exclusion means that when your workplace supplies you with health care, or pays part of the cost of health insurance, it' is not considered income and you pay no tax on it. This has been described (accurately I think) as the single largest subsidy in the tax code: The government forgoes $250 billion a year to keep it around. That's a lot of money. It's also a lot of money going to a bad cause.

Why is it a bad cause? Four reasons:

First, the ESI exclusion is unfair. If your employer doesn’t offer health care, or you don’t have an employer, you have to pay for your health insurance with after-tax dollars. If you are self-employed, you can deduct your insurance premium from the federal income tax, but not the federal payroll (Social Security and Medicare) tax. Unless there is some reason we wish to encourage people to work for big companies with lavish fringe benefits -- and there isn’t -- this discrimination makes no sense.

Second, the exclusion is unlimited. Even the most lavish and expensive health care plans are fully tax-free. That means the benefit of the exclusion goes disproportionately to better-off employees -- the ones who need help the least.

Third, the exclusion traps people in their current jobs, usually when their current employer offers better insurance than a potential one, or especially if an employee or family member has a “pre-existing condition” which will be excluded from coverage in the new job. This also is unfair and inefficient.

Fourth, when one product or service gets special tax treatment that most others don’t, it artificially encourages people to consume more of that product or service than they otherwise would. And it is easier for suppliers of that product to raise prices. Because of the exclusion for employer-paid medical care, employees consume more health care and suppliers charge more for it. This is inefficient and especially unfair to those who don’t have employer-supplied insurance, since they get no subsidy but are stuck with the higher prices anyway. (And of course it is the last thing we need as we try to moderate health care costs.)

In my opinion, getting rid of the ESI exclusion is a no-brainer, at least when we'd be using the additional revenue to fund comprehensive reform. If only the unions, the rest of the Senate and President Obama would agree!