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Tax My Health Benefits. Please.

How a little hypocrisy could make health reform possible.

During the presidential campaign, Barack Obama famously and effectively attacked John McCain for threatening to eliminate the tax exclusion for group health insurance. “For the first time in American history, he wants to tax your health benefits,” Obama said in a typical flourish. “Apparently, Senator McCain doesn’t think it’s enough that your health premiums have doubled. He thinks you should have to pay taxes on them too.”

But one of the worst kept secrets in Washington these days is that Obama and his advisers are willing to consider the idea of, you guessed it, taxing your health benefits. At least some of the time. For some of the people.

To be clear, such a move would happen in the context of an entirely different health reform proposal than McCain was suggesting. McCain’s plan would have undermined employer-sponsored insurance and forced large numbers of people to purchase insurance as individuals through an unregulated market, where it can be incredibly tough to buy decent coverage. Obama’s reforms, if executed properly, would make good coverage available to everybody. And they’d still leave in place most employer-sponsored insurance. Changing the tax treatment of health benefits would simply provide a nice way of financing these reforms.

So if you voted for Obama because you preferred his health care agenda to McCain’s, you needn’t have second thoughts. You did the right thing.

Still, the notion of altering the tax exclusion even under these conditions is already proving controversial. Sunday’s New York Times carries a quote from Alan Reuther, legislative director of the United Auto Workers, saying “These proposals would represent a tax increase on working families. They would undermine good health care coverage.” And while the UAW these days should probably be a lot more worried about holding onto jobs than preserving generous health benefits, strategists believe the public isn’t too keen on the idea, either--a sentiment, surely, Obama’s campaign rhetoric did nothing to change.

And this could be a big problem for reformers. Making insurance available to everybody will likely require at least a trillion dollars in net revenue over ten years--and quite possibly a lot more. Obama’s budget proposal puts forward about half that amount--and, in this political environment, there may be only one other place to find the rest of the money. That place is the tax exclusion. Eliminating even a portion of the existing tax break would be enough to make up the difference between what Obama has already proposed to set aside and what’s necessary to bring insurance to every American.

Fortunately, fiddling with the tax exclusion in this way turns out to be a good idea on the merits. Not only would it raise the money we need for universal coverage. It would also open the door to making other changes in our health care system--the kind that are necessary if, over the long run, we want to give people better, less costly medical care.

Let’s start with the basics of how the tax break works. When your employer pays you wages, the government subjects that money to the income and payroll taxes. But if your employer also gives you health insurance and kicks in some of the premiums, the government doesn’t apply taxes to that amount.

The distinction goes back to the 1940s, just after World War II, when government regulators decided linking health insurance to the workplace would help spread insurance coverage to the working population. It turns out they were more or less right. Since a dollar of health insurance became more valuable than a dollar of income, workers pressed for more benefits--and employers happily obliged. Enrollment in employer-sponsored insurance swelled over the next decades, finally peaking in the 1970s. Most economists will tell you that the tax exclusion is a major reason why.

But most economists will tell you something else: The exclusion distorts the market. It tilts the incentives for purchasing insurance; people tend to buy more than they really value, which in turn can foster over-consumption of medical services. And while sometimes this is a good thing--some people underestimate their risk of illness and financial catastrophe--the tax break also skews its benefits in a way that reinforces inequality. As a break on personal income taxes, its value is relatively higher for people in higher tax brackets. Throw in the fact that richer people tend to have more generous benefits anyway, and what you have is a really nice tax break for people who are well-off and have the most generous health benefits--generally speaking, the people who need help from government and society the least.

Most conservatives hear all of this and say, “Well, let’s just get rid of the exclusion altogether.” That’s basically what McCain was proposing during the presidential campaign. Trouble is, without the exclusion, lots of people will stop taking their employer’s health coverage and buy individual coverage instead. And since individual policies don’t work well for people with pre-existing, chronic medical conditions--the policies aren’t as available and, when they are, the benefits tend to be less complete--the people fleeing group policies will primarily be the healthy. The only ones left taking group policies from their employers will be the sick, whose rates will skyrocket--until they can’t afford insurance at all (or their employers stop offering it).

Some liberals have taken the conservative insight and gone a few steps further. They’ve proposed to eliminate the exclusion but to enact a bunch of other reforms, too, so that individuals can get affordable, comprehensive plans on their own. The best example of this right now is probably the bipartisan plan that Senator Ron Wyden has been pushing. Under his plan, everybody would get what is, in effect, a voucher to buy insurance on his or her own; the coverage would have generous benefits and be available to anybody, regardless of medical condition, at the same price. To finance this transformation--that is, to pay for the vouchers--Wyden would (indirectly) get rid of the employer exclusion.

In the aggregate, Wyden's plan would redistribute money, from wealthy to poor and from healthy to sick. It would also re-align some of the poor incentives in the status quo. In these respects, his plan has a lot to recommend it. And it's a point Wyden has tried to press whenever he could. Twice in the last few weeks, Budget Director Peter Orszag--one of the key architects of health care policy in the Obama Administration--has appeared before committees on which Wyden sits. Both times, Wyden asked a leading question about whether tapping the employer exclusion would be a smart way to finance health insurance expansions. Both times, Orszag hinted strongly that the administration thought it might be.

Still, like other Obama officials, Orszag wouldn't endorse the proposition explicitly. Nor will the administration propose such an initiative on its own. Congress will have to take the initiative. And many congressional Democrats have their own reservations, thanks in no small part to organized labor. Unions like the UAW and the Teamsters strongly oppose such a reform because their members bargained for generous health benefits over the years and have held onto them.

Lurking beneath this opposition is a legitimate substantive point. A sudden, total removal of the exclusion would mean a tax increase for at least some lower-income and middle-income individuals with employer-sponsored insurance. You can argue these people would still be better off, since they’d have something they don’t have now (guaranteed health insurance). And you can argue that, in a well-functioning economy, they’d eventually get that money back as higher wages. But the short-term effect would still be a tax increase people would feel right away. That makes the proposals tough to sell politically.

But there’s a way to split the difference. And it’s actually pretty elegant. Instead of getting rid of the entire exclusion, you could limit it--and do so, perhaps, only for wealthier taxpayers.

For example, in order to protect lower- and middle-income workers, you could maintain the exclusion for individual tax filers making under $62,000 and families making under $125,000 a year. Three-quarters of the population would be no worse off than now. For individuals making between $62,000 and $125,000 a year, or families making between $125,000 and $250,000 a year, you could then reduce the exclusion’s value. Instead of providing a tax break that covered the full value of all group health insurance premiums, you could exclude only the amount equal to the value of median priced insurance policies. (These people could still opt for richer benefits, but they will pay taxes on any premiums above median level.) Finally, for everybody else--that is, the richest 4 to 5 percent of the population with employer health benefits--you could eliminate the deduction altogether.

As you may have guessed by now, these amounts are not purely hypothetical. I got them from Jonathan Gruber, an economist at the Massachusetts Institute of Technology who consults widely with elected officials on health reform issues. At the request of various parties in Washington, he’s been running simulations on multiple varieties of exclusion reform--eliminate it, cap it, cap it only for certain income groups, and so on. In the example I cited above--one version of what Gruber calls a “progressive cap”--the effects are impressive. According to the simulations, such a reform would generate more than $700 billion over ten years. That’s in the general vicinity of what we need, on top of Obama’s budget proposal, to achieve universal coverage. And the effect would be highly progressive, far more than the existing exclusion. (Note: Gruber's projections assume reform of the income tax exclusion only; they'd leave in place the exclusion for payroll taxes.)

Of course, you could choose to reform the exclusion in any number of other ways. You could reduce the tax break for everybody, rather than reducing it only for the rich. You could also let the tax break’s value change over time, rising in conjunction with economic growth, inflation, or the cost of health care. As you narrow the reform--by applying it to fewer people, or to smaller fractions of health insurance premiums--you generate less money for underwriting the cost of coverage expansions. But Gruber’s calculations suggest that even some of the less sweeping tax changes could generate around half a trillion dollars over ten years--thereby closing much if not most of the gap between what Obama has set aside in his budget and what universal coverage would require.

And making this sort of change would do more than generate revenue. The government could declare, for instance, that in order to qualify for the tax exclusion, an insurance plan must meet certain standards for benefits, electronic record-keeping, chronic disease management, preventative care, consumer satisfaction, and so on. In other words, the government could use its leverage over the new exclusion to realign the incentives of our medical care system, in order to encourage better quality care.


On paper, this is the kind of proposal around which people from both parties, and both ideological extremes, could rally. Conservatives would get to eliminate a distortion of the free market; liberals would get to eliminate a regressive tax cut and, along the way, raise the money necessary for universal health insurance. And that’s one reason why the idea has proven attractive to elected officials who know a thing or two about health care reform. Hillary Clinton actually called for a (milder) progressive cap during her presidential campaign, although almost nobody seemed to have noticed. More recently, Senate Finance Chairman Max Baucus has indicated that changing the exclusion may be the best way to finance health care reform (although, curiously, he’s proposed it as an alternative to Obama’s budget proposal, rather than a supplement).

Alas, the fact that the idea makes political sense in the abstract doesn’t mean it will prove popular. It’s easy to demagogue, as Obama himself demonstrated during the presidential campaign. And the interest groups out to protect existing employer benefits--a category that also includes many employers, who fear any disruption to current arrangements--are sure to make noise. But that is precisely why would-be health care reformers should be careful before rejecting the idea out of hand.

The most likely obstacle to achieving universal health insurance this year is not the relatively narrow controversies over whether to require that people buy insurance or whether to create a public insurance plan, although both are very important. The biggest obstacle will be the struggle to pay for a plan. Ruling out a method for overcoming that obstacle, particularly when that method seems both progressive and sensible, just doesn’t make sense.

Jonathan Cohn is a senior editor of The New Republic.

Correction: The original version of this article suggested that, during congressional testimony, Budget Director Peter Orszag agreed that tapping the exclusion was a smart way to finance reform. But he actually hedged his answers a bit more carefully than that. During his confirmation hearings before the Senate Budget Committee, Orszag agreed that, in theory, changing the tax rules of health care could finance Obama's reform plans. And during his more recent testimony before Senate Finance, he stated that "tax rules" should be among the options "firmly on the table."