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:

  1. It gives more tax relief to those who get health insurance through their job, penalizing people who buy it on their own; and
  2. 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.