A tax break that many workers don't even realize they have has become a pawn in the chess game of health care overhaul as lawmakers look for ways to pay for a reform that would reduce costs, boost quality and extend coverage to more Americans.
The tax exclusion for the value of workers' health benefits represents one of the most substantial sources of funding for comprehensive health overhaul efforts, many economists say.
As legislators scramble to come up with ways to finance the upfront cost, which is projected at around $1 trillion over 10 years, they are increasingly considering options for imposing a dollar limit on the amount of premiums for employer-sponsored coverage that can be excluded from taxable income.
When it comes to raising money for an overhaul, no other strategy comes close. The tax exclusion for employer-sponsored health benefits is set to reduce federal tax revenues by an estimated $3.5 trillion between 2010 and 2019, according to the Urban Institute.
No draft legislation calls for raising that whopping sum through total elimination of the tax exclusion. But capping it above a certain threshold to shore up a fraction of its potential value has bipartisan support, even though any kind of tax increase remains politically sensitive.
"Historically, this has been a sacred cow," said Michael Thompson, a principal with PricewaterhouseCoopers in New York. "But with the momentum we're seeing in Washington around health reform, I wouldn't be surprised if something moves forward that will dramatically change the way people think of the tax-related nature of health benefits."
Workers with job-based health insurance have enjoyed a tax exclusion for the full value of those benefits. The value of the tax exclusion is greater for higher-income workers, who tend to have richer employer benefits compared with lower-income workers, who are much less likely to have job-based health insurance, according to an analysis from the Urban Institute.
Capping benefits would present a dilemma for President Barack Obama, who promised he wouldn't raise taxes on workers earning less than $250,000 a year. On the campaign trail, he attacked Sen. John McCain's proposal to end the tax exclusion for employer-provided health benefits. But Obama also has said a health care overhaul must not increase the federal deficit, which puts the issue back into play.
Striking a balance between generating enough funds and keeping the tax bite manageable for workers while still being fair to workplaces with different characteristics is a tough job, said Paul Fronstin, director of the health research program for the Employee Benefit Research Institute in Washington.
"Taxing (benefits) will raise money, but it's a blunt instrument that won't necessarily only tax Cadillac plans," Fronstin said. "You're being taxed on price rather than being taxed on comprehensiveness. There are ways to make adjustments for it, but that affects how much money they can raise."
In the first year of having a cap on the tax exclusion, the impact would be minimal across three of the policy options being discussed on Capitol Hill, said Lisa Clemans-Cope, lead author of the Urban Institute report.
"The bite is very small in the first year," Clemans-Cope said. "In 2010, the change in after-tax income for those who have an increase is less than 1%."
But over time, the cap would affect a growing share of the premium for a growing number of taxpayers. Even so, some of the tax bite may be offset by wage gains.
Under a moderate scenario that would raise an estimated $224 billion in income tax by indexing the cap to growth in the gross domestic product, about 38% of taxpayer households would face a tax increase in 2019, according to the Urban Institute's projections. The average tax increase would be 1.6%, equal to $1,260 in income and payroll tax. This example preserves 90% of the tax subsidies.
Tying the cap to growth in the consumer price index would raise twice as much money, an estimated $456 billion, but would take a bigger bite out of workers' earnings. It would affect about the same amount of taxpayer households, but the average tax hit would be $2,220, a nearly 3% change in after-tax income, according to the study. This scenario would preserve 80% of the subsidies.
Adjusting the cap to keep up with the rapid rise in medical expenses would generate the least revenue of the three options and would affect taxpayer households the least in the next decade. After-tax income would dip 0.7% on average, equal to $570 in income and payroll taxes, and only slightly more than 14% of taxpayer households would be affected. This example would raise $62 billion.
The study used a benchmark of how various options would affect taxpayer households in the 75th percentile, where a quarter of them had premiums that exceeded the cap and three-quarters fell below the cap, set at $5,642 for single coverage.
Capping the tax exclusion may create headaches for administrators trying to ensure that workers in high-cost areas and those whose colleagues are older and sicker aren't penalized disproportionately, said Henry Aaron, senior fellow at the Brookings Institution in Washington.
"The question is whether it's done in a way that's administratively feasible and fair and equitable across the country and across different population groups," Aaron said. "On the latter score, it's not so clear it passes that test."
Combining a cap on the tax exclusion with policies that promote risk-sharing and health plan competition, such as the proposed health insurance exchange, is a "better approach" than making actuarial adjustments, Clemans-Cope said. The Urban Institute study didn't account for behavioral changes that may result from other proposed elements of a health overhaul.
Though it won't likely be considered, Aaron said he favors creating a value-added tax that is earmarked for health care and has to be balanced over the long term.
"As in the case of the Social Security Trust Fund, you have an annual report that says whether it's in balance or not," he said. "That's actually quite a conservative mechanism of fiscal discipline acting on our pension system. There's nothing else in government quite like it."
Americans appear mixed on how they would react to a cap on the tax exclusion of employer-based health benefits. Nearly half, or 47%, said they would switch to a lower-cost plan if they faced a cap. That is compared with 38% who said they would stay with their current health plan and pay the added tax, according to a recent survey from EBRI. Nine percent said they didn't know what they would do. The remaining 6% said the question wasn't applicable.
"I think it will lead to some buy-down if people want to avoid the tax," Fronstin said. "But then you have to start to ask how do people view the buy-down? More catastrophic coverage is also a tax, in some sense. Then people start to weigh do I want to pay more in taxes or pay more in cost-sharing?"
In the first years when the tax bite is low, workers may choose to "go with the certainty of the tax rather than the uncertainty of cost-sharing," costs such as deductibles, co-payments and co-insurance, Fronstin said.
"At some point what may have been viewed as preferable to pay a certain tax as opposed to uncertain cost-sharing may flip as taxes get higher and higher, assuming it does nothing to control health care costs," he said.
Many employers don't want their workers to face a tax on the value of their job-based health benefits. In a recent poll, 82% want to maintain the current exclusion, according to a survey of 213 employers from Miller & Chevalier and the American Benefits Council.
If the tax exclusion were capped as part of a comprehensive overhaul, health insurance may go the way of life insurance, said Thompson of PricewaterhouseCoopers. With group life insurance, workers whose policies are worth $50,000 or less get it tax-free, with anything beyond that ceiling calculated as imputed income, Thompson said.
"Today you might have an employer that provides one or two times up to $50,000, but you might have the option to buy three or four times earnings if you need the insurance and get it on a group basis," Thompson said.
"In health care, you might find an employer might seek to offer at least one plan that wouldn't generate imputed income for you and then offer richer plans where you would pay for the difference."