Capping the Health Exclusion: May a Thousand Flowers Bloom

Until now, unions have been among the strongest critics of paying for health reform by limiting the tax exclusion for employer sponsored insurance. But on Monday, a well-connected labor lobbyist told me a deal could be done. “It all depends,” he said, “on what the cap looks like.”

Remarkably, in just a few weeks, lawmakers seem to have moved beyond the argument over whether the exclusion should be capped. Now, they are debating how. It is not easy. There are caps based on employee income, the value of the insurance, or both. There are caps tied to the actuarial value of coverage, or linked to geography. Then, there is the issue about how to index a cap.

First, a bit of boilerplate: Today, workers can get tax-free health coverage from their employer. Because this subsidy is excluded from taxable income, it is worth more to high-bracket workers than to those earning less. And the exclusion is very costly. In 2007, it reduced federal revenues by nearly $250 billion—about $145 billion in income taxes and $101 billion in payroll taxes.

With that kind of dough on the table, even a cap on the exclusion is a tempting way to help pay for a health reform. But what should it look like? 

If the goal is to raise cash, the simplest option may be to put a ceiling on the value of tax-free insurance. President Bush’s Tax Reform panel, for instance, would have limited the exclusion to $5,000 for single coverage and $11,500 for families, and indexed the cap to the Consumer Price Index. Because health premiums rise so much faster than the CPI, this design rapidly erodes the value of the tax break and raises lots for the Treasury.

But the commission's job was to reform taxes, not health policy. The Urban Institute’s Stan Dorn, seeking a more equitable exclusion, would tie the cap to the actuarial value of policies, not their price. In other words, benefits more generous than average would be taxed. Paul Van de Water, however, argues that such a structure would be too complicated to administer and might discourage employers from offering higher-quality plans.

While Stan would look to the value of benefits to measure “fairness,” others have different benchmarks. For instance, lawmakers from states where health costs (and, thus insurance premiums) are higher than average favor some geographic adjustment to the cap. Paul Fronstin found typical premiums for the same type of policy can vary by nearly 60 percent among states. Small business premiums can vary by more than 100 percent from state to state.

A regional adjustment may be politically attractive in the Senate, but it will also soak up a lot of potential revenue. Rather than scaling back the subsidy from a national average in lower-cost states, Congress is instead likely to just sweeten it for high-cost jurisdictions.     

Finally, some unions to prefer to base a subsidy cap on worker income rather than the value (however measured) of the insurance. Labor’s interest in this matter is no surprise since unionized workers are far more likely to have coverage that exceeds the Tax Panel’s limit than employees of non-union shops, according to a Tax Notes article by Eliza Gould and Alexandra Minicozzi. At the same time, union wages may well fall below an income cap.

Lots of really interesting policy questions to chew over, and no obvious answers. TaxVox will look more closely at each of these ideas over the next few weeks.