Third party payment in health care (part 2)
14 May
Yesterday I explained that there is a tradeoff between employer-provided health insurance and wages, and that health insurance provided by an employer looks less expensive to the employee than it is. Today I want to focus on the second element of the “third party payment” problem, the tax treatment of employer-provided health insurance.
The tax system is biased in two ways:
- It gives more tax relief to those who get health insurance through their job, penalizing people who buy it on their own; and
- It gives more tax relief for more expensive health insurance policies, penalizing people who choose to purchase inexpensive policies, pay for routine care out-of-pocket, and take higher wages instead.
Let’s return to the Thompson family from yesterday. They had a combined income of $80,000, and got a $12,000 family health insurance policy through Kelly’s job. Kelly’s employer paid $9,000 of the premium, and the Thompsons paid the other $3,000. Now we’re going to introduce taxes into the discussion.
Remember from yesterday that in 2008 Kelly’s total compensation looked like this. We were ignoring taxes at the time:
| 2008 | |
| Total amount Kelly’s employer can afford to employ her | $69,000 |
| minus 3/4 of Kelly’s $12,000 health insurance premium | - $9,000 |
| equals Kelly’s salary | = $60,000 |
Kelly and her husband Chet will pay income taxes on the $60K of wages — they’re in the 25% income tax bracket. Kelly will also pay 7.65% of $60K ($4,590) in payroll taxes. Her employer will pay the same amount on her behalf. As in the discussion yesterday about health benefits, those employer-side payroll taxes are actually a part of Kelly’s compensation, but invisible to her. So, from her employer’s perspective, Kelly’s compensation actually looks like this:
| 2008 | |
| Total amount I can afford to employ Kelly | $73,590 |
| minus payroll taxes I pay on Kelly’s $60K of wages | - $4,590 |
| equals Kelly’s post-employer-side payroll tax compensation | =$69,000 |
| minus 3/4 of Kelly’s $12,000 health insurance premium | - $9,000 |
| equals Kelly’s salary | = $60,000 |
Notice that Kelly’s employer pays payroll taxes on her $60K of wages, but not on the $9K he pays of her health insurance premium. The amount of the premiums paid by her employer is exempt from payroll taxes.
The same is true for the payroll taxes and income taxes that Kelly pays. She calculates these based on $60K of wages, not on $69K of compensation.
This is called a tax exclusion for employer-provided health insurance. A deduction is when you pay no income taxes. An exclusion is when you pay neither income taxes nor payroll taxes (employer or employee). For most taxpayers an exclusion is worth more to a taxpayer than a deduction.
Let’s look at how this tax preference is unfair to those without employer-provided health insurance. Kelly’s twin sister Sarah is in exactly the same situation as Kelly, except that her employer pays her higher wages and does not offer health insurance. Let’s compare Kelly and Sarah’s situations:
| Kelly | Sarah | |
| Total amount employer can afford to employ Kelly or Sarah | $73,590 | $73,590 |
| minus payroll taxes paid by employer on wages | - $4,590 | - $5,230 |
| equals post-employer-side payroll tax compensation | = $69,000 | = $68,360 |
| minus health insurance premium (if any) | - $9,000 | - 0 |
| equals salary | = $60,000 | = $68,360 |
| minus Sarah’s additional 25% income taxes on higher wages | - $2,090 | |
| minus Sarah’s additional 7.65% payroll taxes on higher wages | - $640 | |
| equals comparable salary (they’ll pay the same taxes on these amounts) | = $60,000 | = $65,630 |
| Memo: Has health insurance? | YES | NO |
Kelly and Sarah each cost their employee $73,590. Kelly has $60,000 of wages and her employer paid $9,000 of her health insurance premium. Sarah has $65,630 of wages and no health insurance. They will pay the same taxes, because I included Sarah’s incremental taxes in the table above. Kelly got something worth $9,000, and Sarah got something worth $5,630. The tax code treats the two differently (Kelly better), even though they have the same total compensation.
Now suppose, because of an improvement in productivity, Kelly’s employer will give her $100 more in compensation. $100 in additional compensation cost to the employer will buy Kelly $100 more health benefits, or $60 more in after-tax wages. The tax code tilts the playing field toward taking the marginal dollar of your compensation in the form of better and more expensive health insurance, rather than as wages.
There is a broad and bipartisan policy consensus that the tax treatment of employer-provided health insurance is both unfair to those who choose higher wages and less expensive health insurance policies, and unfair to those who are not fortunate enough to get health insurance through their job. It is also inefficient, in that it subsidizes more costly health insurance plans at the expense of higher wages.
Health insurance provided by an employer looks less expensive to the employee than it is. This lack of transparency distorts compensation toward higher health insurance premiums, since employees are not aware of how much of their compensation is being spent on their behalf to buy more expensive health insurance. In addition, even if an employee is aware of these costs that appear to be borne by the employer, the tax code subsidizes taking the marginal dollar of compensation in the form of more generous health insurance benefits, rather than as higher wages.
Both factors contribute to price insensitivity in the purchase of health insurance, and both are key contributors to the out-of-control growth of health insurance premiums.
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Thank you, Keith, for this detailed explanation of the tax exclusion for employment-based health insurance and how it impacts two employees in identical situations except for whether they get health insurance at work. It is hard for employees and employers to understand this flow of funds, making it all too easy to confuse the political debate over this issue. It’s time to end the confusion by making the full costs of health insurance visible to employers and employees and making the tax break fairer and portable, as President Bush had proposed.
I think there might be a mistake. At the end you state in the “MEMO” that Kelly has Health Insurance and $60,000. I believe that is not entirely accurate, as Kelly would still need to pay the additional $3,000 (tax deductible) for her co-pay of the employer provided health insurance premium to have fully covered health insurance.
Therefore, Kelly’s bottom line would be $57,000 and fully insured vs Sarah at $65,630 and no health insurance.
WJ – Good catch in noticing that when Kelly has $60,000 in disposable income she in health insurance limbo, her employer has paid $9,000 of the $12,000 health insurance premium but she Kelly has not paid her mandatory $3,000.
We should really be comparing Kelly and Sarah after they have both paid their health insurance premiums: Kelly would have $57,000 and Sarah would have $53,630 ($65,630-$12,000). This means that Kelly is able to get her desired health insurance and has $3,370 extra in disposable income.
Also, Keith can you clarify why Kelly pays $640 less in wages? I would assume that it is because Kelly pays out $9,000 in wages to health insurance as an exclusion, but it would be nice to see in the income statement for Kelly vs. Sarah.
There is another subtle issue with this analysis, I think. Imperfect knowledge on the part of the employer and the inability for ‘fully’ compensate for the savings of not selecting HC as a benefit will also drive wages down for those choosing not to participate.
The employer cannot know whether Sarah will choose to have HC. So they cannot announce a pay level(60,000) that would include it or not(68,360). Instead, they often have to estimate what share of employees will choose one or the other and fix pay accordingly. This would further distort the benefits of choosing to have HC coverage.
There are some more tweaks that need to be done.
First, to answer your question about the $640, Sarah’s W-2 will show total wages of $68,360. She needs to pay 1.45% medicare + 6.20% social security tax on that entire amount. Keith is saying that Kelly’s W-2 will show total wages of $60,000. She needs to pay 1.45% + 6.20% in payroll taxes on that amount, which will be 7.65%*($68,360-$60,000) = $640 less than what Sarah pays.
Now, here’s an extra tweak on WJ’s correction. Kelly has to pay $3,000 in health care premiums out of her paycheck, but that $3,000 comes out before payroll taxes (and certainly before income taxes) are applied. So Kelly’s W-2 will actually show total wages of $57,000, and her payroll tax burden will be $869 less than Sarah’s.
So the true bottom line is this:
After health care is paid for, Kelly takes home $38,390 after tax (both the 7.65% payroll tax and the 25% income tax).
Sarah takes home $34,040 after tax ($68,360*(1-7.65%-25%) – $12,000).
This is a difference of $4,350, which is even larger than what Keith came up with. Although my calculations assume an average income tax rate of 25% (which is not realistic), the difference ends up the same for a marginal income tax rate of 25% (which is realistic).