Remembering the Cadillac Tax

When employers pay the health insurance premiums for their employees, these payments are exempt from income tax. If health insurance payments by employers were taxed as income, the government would collect about $200 billion in additional income taxes, and another $130 billion in payroll taxes for supporting Social Security and Medicare (according to the Analytical Perspectives volume of the US budget for 2020, Table 16-1).

The notion that the US would finance its private-sector health insurance system in this way is an historical accident going back to World War II. As Melissa Thomasson explains at the website of the Economic History Association:

During World War II, wage and price controls prevented employers from using wages to compete for scarce labor. Under the 1942 Stabilization Act, Congress limited the wage increases that could be offered by firms, but permitted the adoption of employee insurance plans. In this way, health benefit packages offered one means of securing workers. ... Perhaps the most influential aspect of government intervention that shaped the employer-based system of health insurance was the tax treatment of employer-provided contributions to employee health insurance plans. First, employers did not have to pay payroll tax on their contributions to employee health plans. Further, under certain circumstances, employees did not have to pay income tax on their employer’s contributions to their health insurance plans.

The idea that US employers will often pay for health insurance, and that this will be an important element of what most Americans mean by a "good job," is embedded in how most of think about the US healthcare system. But it's worth being clear on its distributional effects and economic incentives it provided. When employers provide a benefit with the value exempt from income tax, it will naturally offer greater benefit to those with high incomes, who otherwise would have paid higher income taxes. In addition, when employer-provided health insurance is tax-free, people will have an incentive to receive compensation in this tax-free form, rather than in a taxed form.

Katherine Baicker describes these dynamics in her recent 2019 Martin Feldstein Lecture at the National Bureau of Economic Research, "Economic Analysis forEvidence-Based Health Policy:Progress and Pitfalls" (NBER Reporter, September 2019). She says:

On the private side, the dominance of the employer-sponsored insurance market is driven in large part by the tax preference for health insurance benefits relative to wage compensation, which also drives down cost-sharing, since care covered through insurance plan premiums is often tax-preferred to out-of-pocket spending. This aspect of the tax code is thus both inefficient (driving inefficient utilization through moral hazard) and regressive (favoring people with higher incomes and more generous benefits)—a rare opportunity to improve both efficiency and distribution through reform.

This is a prime example of the challenge of translating economic insights into policy: Even though economists on both sides of the aisle agreed, proposing the taxation of employer-sponsored insurance to policymakers and the public was not popular. The “Cadillac tax” on expensive plans came into existence largely because it was nominally levied on insurers rather than taxpayers. This made it more politically palatable, even though it does not mean that the ultimate incidence falls on insurers, and it constrains the degree to which it can undo the regressivity of the tax treatment of employer-sponsored insurance. Earlier this year, the House voted to repeal the Cadillac tax; whether it will ever take effect remains an open question.

What is this "Cadillac tax" she is talking about? As part of the Patient Protection and Affordable Care Act of 2010, there was a provision that if someone was receiving very high-cost health insurance from an employer, there would be a tax equal to 40% of the value of the health insurance benefits above a certain level. The bill was careful to specify that this tax would be paid by employers--but of course, it would be reflected the design of health insurance plans and in overall compensation received by workers.  

In a standard example of the elegant dance moves that make up the budgeting process, the 2010 legislation bravely postponed the imposition of the Cadillac tax until 2018, which would be two years after President Obama left office even if he served a second term. Thus, the revenues from collecting the Cadillac tax could be counted in the long-run budget projections for the legislation--to show it wouldn't cost too much over time--but the actual tax was comfortably off in the future. 

Quite predictably, the Cadillac tax was then postponed from 2018 to 2020, and then to 2022. It its latest version: "This `Cadillac tax' will equal 40 percent of the value of health benefits exceeding thresholds projected to be $11,200 for single coverage and $30,150 for family coverage in 2022." 

In July, the Democrat-controlled House of Representatives voted to repeal the Cadillac tax altogether. It's not yet clear whether the Republican-controlled Senate will go along. Perhaps the repeal of the Cadillac tax will get stuck in the gears of politics for a little longer. But at this point there's no reason to believe that it will ever actually go into effect. 

I have my doubts about how the 2010 Cadillac tax was designed. For example, various health care analysts have argued that such a law might set certain thresholds, and then just have any health insurance benefits above that level taxed as regular income. I also have my cynical doubts about whether politicians back in 2010 intended that the Cadillac tax would ever go into effect. But whatever the details of the design or the underling motivations, the Cadillac tax was a modest effort. If allowed to take effect, it would raise about $8 billion in 2022, rising to $38 billion by 2028 (according to the Congressional Budget Office, see discussion starting on p. 231). It was the only meaningful effort to reduce the tax exemption for employer-provided health insurance, and to use that money to make health insurance more affordable for others. And it seems to be politically impossible.  

A version of this article first appeared on Conversable Economist.