Explainer Episode 39 – Tax Exclusions for Employer-Sponsored Health Insurance

In this episode, Michael F. Cannon argues that the federal income tax exclusion of employer-sponsored health insurance is an “accident of history,” and has had a significant impact on the American markets for health insurance, medical care, and on the U.S. political system. Read more from Michael Cannon in his article, End the Tax Exclusion for Employer-Sponsored Health Insurance.



Although this transcript is largely accurate, in some cases it could be incomplete or inaccurate due to inaudible passages or transcription errors.

[Music and Narration]


Introduction:  Welcome to the Regulatory Transparency Project’s Fourth Branch podcast series. All expressions of opinion are those of the speaker.


Steven Schaefer:  Welcome to the Regulatory Transparency Project’s podcast. My name is Steven Schaefer, and I am the Director of The Regulatory Transparency Project. Today, we have with us Michael F. Cannon, who is Cato Institute’s Directory of Health Policy Studies. Michael has an MA in economics and a JM in law and economics from George Mason University and BA in American government from the University of Virginia. He is a member of the Board of Advisors of Harvard Health Policy and Review and The Federalist Society’s Regulatory Transparency Project’s FDA and Health Working Group.


Michael, thank you for being with us today.


Michael F. Cannon:  It’s great to be here.


Steven Schaefer:  Michael, you have said, in the past, that the employer tax exclusion for health insurance is the original sin of the US healthcare system. Could you explain that quote?


Michael F. Cannon:  So it’s really the original sin of US health policy. Of all of the bad things that government has done—at least the federal government has done—in health policy, this one is the worst. And the original sin — it’s sort of interesting that the original sin of US health policy is something you wouldn’t think would have anything to do with health policy. It came from not some effort by government to intervene in the health sector of the economy to improve it or anything like that; it happened by chance, by accident, when the government created something that seems totally unrelated, which was the income tax.


If we go all the way back—in the way back machine—to 1913, when Congress created the first income tax — I’m sorry, not the first income tax; the second federal income tax. The first funded the Civil War, and then years later, Congress repealed it. What a wonderful memory to cherish. But then in 1913, Congress created the second federal income tax — and, at about that time, I should mention that the income tax statute didn’t say anything about health care or employer health benefits or anything like that and with good reason. At the time, there really were no—almost no—employee health benefits.


Health insurance, as it exists today, did not exist back then. Where there were health benefits, it was just employers paying for a doctor to make sure their workers were well and, maybe, providing what we call sickness insurance, which meant that if you got sick and couldn’t work anymore, this is a form of insurance that would replace your lost wages because that was the biggest cost of getting sick at the time. There just wasn’t that much that medicine could do for you back then. Medicine was much more primitive then than it is today and much less expensive.


And so, Congress passes the income tax. They don’t mention anything about employer health benefits, and yet, there were some employee health benefits. And so, the Treasury Department bureaucrats who had to implement the exclusion, they had to figure out, “Okay, employers are offering these benefits—some employers are offering these benefits—to workers; that’s compensation. It is, arguably, income. Is that stuff subject to the income tax?” And you might think that in order not to distort the economy, they would just say yes. In order not to distort labor markets, compensation decisions, compensation packages, they would just say, “Yeah, we’re going to tax it all as income.” But they didn’t do that. They didn’t do that because it was actually a lot more complicated to tax health benefits than it might seem at first blush.


One reason is—and there are many, but one big reason is—how do you quantify the value of health benefits on an employee-by-employee basis? Someone who doesn’t use those health benefits over the course of the year have lower compensation than someone who does use those health benefits. Or are you just looking at the insurance value of those benefits and counting whatever the employer pays toward some insurance pool as the compensation for everyone? And if you do that, should you risk rate the payment the employer makes for income tax purposes so that a sicker employee would get higher compensation? It gets pretty complicated pretty fast.


So what the Treasury Department did was they just sort of threw up their hands. They issued some conflicting rulings but, basically, within years of Congress passing the income tax, the Treasury Department just threw up their hands and said, “We’re not going to tax employee health benefits.” Now you would think that that would not be a very big deal, but it, all of a sudden, became a very big deal and had all sorts of downstream effects that nobody could have predicted, including making health care and health insurance more expensive, including steering the health insurance market—once that thing emerged—toward employer provided health insurance—which has this weird feature that it disappears when you change jobs—and away from health insurance that you buy directly from an insurance company that stays with you as you move from job to job and provides a better guarantee that you will have access to health care once you get sick.


And so, these downstream effects, actually, became so pronounced that Congress looked around the health sector as the decades went on and said, “Wow. Our health sector is a mess. We better do something about that. We better intervene in the health sector of the economy even more in order to fix the problems that the exclusion created.” And there’s probably not a single thing that is going wrong in the US health sector or a single way that Congress has intervened in the health sector since 1913 that you can’t trace back to this original sin of US health care, which is the exclusion.


Steven Schaefer:  And how has this system impacted prices for health care?


Michael F. Cannon:  So not directly. It’s not like Congress passed a law saying, “We’re going to require doctors to charge patients more for health care,” or “we’re going to require insurance companies to charge enrollees more for health insurance.” What ended up happening was a little more subtle but maybe even more profound. You see, when Congress taxes a dollar’s worth of cash income that your employer gives you but doesn’t tax that same dollar of compensation if you’re employer gives it to you as health benefits, that creates what we call an after-tax price distortion. If you take that dollar as cash wages, you only get, nowadays on average, 67 cents of that dollar. But if you take that as health benefits, you get a dollar’s worth of health benefits.


So if the choice is between 67 cents of other stuff or a dollar’s worth of health benefits, you’re going to choose more health insurance. You’re going to demand from your employer more health insurance than you would buy if you were making that trade-off yourself on a dollar-for-dollar basis if there were not price distortion like that. On top of that, the money that your employer is paying toward your health insurance doesn’t really seem like your money. It is. The economists agree that that is money that employers take out of cash wages in order to finance health benefits. So it is your money, but it doesn’t seem like your money, and so, workers are probably demanding even more health insurance than they would if they controlled that money because it seems like the cost of an additional dollar’s worth of health benefits falls on their employer and not on them when, in fact, it does fall on them.


So between these two effects, the price distortion and this mirage that it’s the employer’s money, this illusion that it’s the employer’s money and not yours, cause workers to demand more coverage than they would on their own if they were controlling their health care dollars and decisions. And when you insure people more heavily — so that right there, I should say, drives up health insurance premiums because people are demanding more health insurance. But when you insure people more heavily, that means that when they go to the doctor, when they go into the hospital, when they go to the pharmacy, they are paying for less of the health care that they are consuming because their insurance company is paying a larger share of what they’re consuming.


And when you insulate workers from health care prices in this way, that makes them demand more medical goods and services than they would otherwise. It makes them care less about prices than they would otherwise. It makes them resist the insurance companies’ efforts to reduce — negotiate lower prices more than they would otherwise. And so, you can see how encouraging excessive health insurance leads to not just higher health insurance premiums but higher health care prices because almost no one has the incentive and the ability to shop around and negotiate lower prices from pharmaceutical companies and physicians and hospitals and so forth.


And this began very early on in the history of the exclusion. It began insulating workers from the cost of the medical care that they are consuming, which drove up prices and is really one of the main factors in why health insurance is — health care spending rose so rapidly throughout the 20th century, why health insurance prices and health care prices rose so dramatically during that period as well.


Steven Schaefer:  And are there any alternatives to this current system we have with tax exclusion for employer-sponsored health insurance? I mean, that may sound like a very self-evident question. But if there are alternatives, what alternatives are there?


Michael F. Cannon:  So there are alternatives, but we haven’t even come close — and I really want to talk about them, but we haven’t even come close to exhausting all of the downstream effects of the exclusion. We already talked about prices and how the exclusion drove up prices. The exclusion—and we use the term the exclusion—it might make sense just to note where that word comes from. A tax deduction, such as you get for your home mortgage interest payments, is when you tally up your taxable income, and then you deduct your home mortgage interest payments from that. That’s what a deduction is. And then a credit is when you deduct a thousand dollars from your actual tax liability.


An exclusion is a little different because when your employer takes some of your money and pays for your health insurance with that — and, by the way, for the average worker with family coverage that’s about $16,000 of your earnings, so this is not chump change. When your employer does that, that money never goes into the tax base for either your federal income tax base or your federal payroll tax base. The government excludes that amount from the income and payroll tax basis, and that’s why we call it an exclusion.


That’s why when your employer gives you that dollars’ worth of compensation as health benefits rather than cash, you get to keep the full dollars’ worth—or you get the benefit of that full dollars’ worth of health insurance—whereas you only get to take home 67 cents if you took that dollar as cash because the cash wages are subject to income and payroll taxes. And that tax distortion that we call the exclusion doesn’t just drive up prices. It also reduces the quality of health insurance that people get. It reduces the quality of medical care that people receive.


First, let’s look at health insurance. If you get health insurance from your employer, and you stay at that same job until you die, then you’re going to have seamless health insurance from the moment you take that job until your last day. But that doesn’t really describe anyone in the workforce today or even many people in the workforce back in 1913, the 20s, 30s, 40s, when health insurance really began to take off because even workers who did work for the same firm their entire lives retired at age 65. So what the exclusion does is it shepherds people, really penalizes people, unless they enroll in this form of health insurance that disappears when you still need it and often disappears when you desperately need it, after you’ve gotten sick and can’t work anymore or once you’ve turned age 65 and retire and your medical needs skyrocket. The federal government created—again, by accident—this health insurance system in the United States where you get tossed out of your health insurance for no good reason and when you desperately need it.


So two data points about that: In 1965, Congress looked around — Congress created the Medicare program because Congress looked around and said, “All these people over age 65 don’t have health insurance. Only about half of seniors do, so we need to create the Medicare program to cover all these seniors who don’t have health insurance.” But you know what? Why do you suppose all these seniors didn’t have health insurance? It wasn’t because health insurance wasn’t available. There were dozens and dozens of countries that were selling health insurance that was guaranteed renewable until the enrollee died. You know, it would cover you beyond retirement and into death. But the federal government, by then, had spent 40 or more years penalizing that type of health insurance, and the only way to avoid that penalty is if you enrolled in a plan that disappeared when you retire.


So the Medicare program is, itself, an effort by Congress to try to fix the mistakes that Congress made some 50 years earlier, when it created the income tax and created this distortion in the health insurance market. Medicare is not an example of the government succeeding in overcoming the cruelty of unfettered free markets. Medicare is an attempt by government, as I said, to clean up its own mess. It is an attempt by government to fix not a market failure but a government failure.


And the other example that I wanted to use is a study that came out before Congress—right before Congress—passed Obamacare, that looked at people who bought — have that kind of seamless health insurance that comes directly from an insurance company and stays with you from job to job, can stay with you into retirement, and they compared that to health insurance that people buy through employers. This is the kind of — they compared the kind of insurance that Congress penalizes to the kind of insurance that Congress doesn’t penalize—and, maybe, you might even say encourages, but they just don’t tax it—and what the researchers found was that if you buy the kind of insurance that Congress penalizes, you were much less likely to end up uninsured.


So you have what we call the individual market in health insurance, where you buy insurance directly from an insurance company, and once you do that, they guarantee they’re not going to drop you if you get sick and that your premiums won’t go up to reflect your illness. And they do underwrite you. That means they’ll charge you a higher premium if you’re already sick, but if you buy it when you’re healthy and then become sick, you’re much less likely to lose coverage than if you bought coverage through an employer and became sick.


In fact, if you got coverage through a small employer, you were — if you were a 28-year-old male, got coverage through a small employer, and you were in poor health, you were twice as likely to lose your coverage than if you had bought it from the individual market. Forty-four percent was the figure. So almost half of those 28-year-old males in poor health who had small employer coverage would lose it after a year, whereas the individual market, you were much less likely to lose that coverage. You were about half as likely. And so, this was — so for almost 100 years now, this tax exclusion for employer-sponsored insurance has been fueling the problem of pre-existing conditions by tossing people out of their health insurance after they get sick.


And what happened in 2010, when Congress passed Obamacare, well, basically, the same thing that happened in 1965. Congress looked around, saw this problem of pre-existing conditions among the non-elderly, and said, “This is terrible. People are losing their coverage. They can’t get coverage because they’re already sick and insurance companies won’t sell it to them.” So Congress passed Obamacare not because the market had failed but because government had failed and was throwing all these people out of their health insurance plans.


And interestingly, in that comparison I mentioned before—that horse race between the kind of insurance that was more secure and the kind that the government preferred: employer-sponsored insurance—Congress didn’t fix the problem that it created with the exclusion by reforming the exclusion. Instead, what it did was it abolished the type of insurance that was out-performing the government’s horse, that was doing a better job of providing secure coverage to people that employer-sponsored insurance was because now it is, basically — it is almost entirely illegal to offer that kind of health insurance in the United States.


And we haven’t even gotten to how the tax exclusion also degrades the quality of coverage in the United States. It makes it more likely that you are going to — that medical errors will injure patients—things like medication errors or hospital acquired infections—because it penalizes a type of health insurance that forces provider to bear the financial cost of those medical errors, and so we get fewer of those health systems in the United States.


There’s really only one of them that exists in the private sector right now. It’s called Kaiser Permanente, and they operate under a totally different set of incentives than the rest of the health sector, including the Medicare program. But the exclusion in the Medicare program effectively reward unsafe medical practices that injure patients because if you injure a patient and then provide them additional services to bring them back to health, then both the tax exclusion and the Medicare program, effectively, pay providers more in those cases rather than less.


There’s this other model of medical care that Kaiser Permanente represents. They do a better job of avoiding those sorts of medical errors because the providers themselves bear the cost of — the financial cost, at least—of those errors, so they invest in more processes to avoid them and invest in other efficiencies that benefit patients, like preventive care. So the exclusion also penalizes or erodes the quality of care by penalizing innovations that would improve quality, and those same sort of health systems could be providing quality services in the sense of certifying the safety and efficacy of new drugs and medical devices.


But because, since 1913, the exclusion has been punishing those health plans, there were fewer private sector organizations that were doing those kind of reviews in the 1930s, when the elixir sulfanilamide tragedy killed 100 patients, or in the 1950s when thalidomide led to all those babies being born with fetal deformities. And so, Congress — as a result, Congress didn’t say, “Look at what we’ve done to suppress private sector efforts to certify the safety and efficacy of new drugs.” They said, “Oh, the market has failed. We must create the FDA, and we must give the FDA these new powers.” There’s almost nothing, no problem in the US health sector you can point to that doesn’t have its origins in this, seemingly, innocuous decision that Congress and the federal bureaucracy made to exclude employer-sponsored health insurance from federal income and payroll taxes.


Steven Schaefer:  And are there any other health policy effects that people are — that appear to be unrelated but are related to this tax exclusion? I mean…


Michael F. Cannon:  Sure. Sure. So Congress recently passed a law to curb surprise medical bills. This is what happens when you think that you have a doctor who’s in network or go to a hospital that you think is in network, and it turns out the anesthesiologist is not in network. And so, in addition to the bill you get from the hospital—which generally follows your insurance company’s negotiated prices with that hospital—you get this outrageously expensive bill from some ancillary physician or other provider, or maybe the emergency room was in network but the physicians who work there in the emergency room were not, or maybe the ambulance provider was not in network. Patients are getting hit by these sorts of surprise bills all the time.


Congress passed a law to try to curb that. But you know why that is such a problem right now? It’s because the exclusion, for about a hundred years now, has been suppressing the type of health insurance plans and health care delivery systems that would completely eliminate surprise medical bills. Surprise medical bills happen when your health care providers are not part of an integrated whole. There are health care providers out there that are a part of an integrated whole. Again, we call them integrated pre-paid health plans or Kaiser Permanente. Surprise medical bills are much less of a problem when you’re getting all of your health care from this one integrated system, but Congress and the income and payroll taxes have been spending the last hundred years suppressing those types of and penalizing those types of health systems. And as a result, we have this epidemic of surprise medical bills.


Does Congress go back to the original cause or that what it’s doing to contribute to this problem and undo that? No. As it did with health care for retirees in the Medicare program, as it did for pre-existing conditions and Obamacare, instead of undoing the mistakes that it made in the past, it just intervenes in the health sector again, with more regulation or more taxes and mandates, and it really brings to mind the old nursery rhyme about the old woman who swallowed a fly.


What did she do to deal with the fact that she swallowed a fly? “Well, I better send a spider down there after it.” So she swallowed a spider to get the fly, but then she realized, “I swallowed a spider. This is no good. I better swallow a bird to catch the spider that I swallowed to catch the fly.” And when it comes to health policy, we’re, basically — we’re well beyond fly, spider, bird territory. We’re out in goat or horse territory by now because government has done so many things to try to get at that fly that it’s really hard to count them all or to tally all the damage that they’ve done.


Steven Schaefer:  Is there any relationship between the tax exclusion and innovation in health care?


Michael Cannon:  Sure. Now, you might say, well, the tax exclusion encourages some forms of innovation and discourages others. You might say that there are tremendous benefits to the exclusion because when you put your foot on the gas pedal of health spending the way the exclusion does—because it penalizes you if you spend money on non-employer sponsored health insurance and non-medical items but allows you to avoid taxes if you spend on those things—that results in a lot more health spending and a lot more profit opportunities for makers of new drugs and medical devices and so forth. And so, that is probably one of the reasons that the United States leads the world in medical innovations.


So you might say, “Oh, well this is wonderful news. We should keep the exclusion.” Well, not really; for two reasons. One is we may be getting too much medical innovation, including innovations that aren’t making patients healthier or happier or that, if they are, just aren’t worth the additional cost. But patients are still consuming them because someone else is paying because the exclusion insulates them so heavily from the prices of those services.


But the other—and maybe the bigger—reason not to conclude that the exclusion’s impact on innovation justifies its existence, is that the exclusion also penalizes other forms of innovation that could be saving even more lives. These are innovations in health care delivery that emphasize preventive care, that coordinate care, that encourage electronic medical records—and all the efficiencies that they bring—that encourage processes that reduce medical errors including fatal preventable medical errors. The fact that the exclusion has so tilted the playing field in favor of ways of paying health care providers that penalize those innovations means that we are maybe losing more lives for a lack of those quality-enhancing innovations than we are gaining with the additional innovation in new drugs and medical devices that the exclusion brings about.


So even when you look at innovation and how the exclusion may have encouraged some innovations, I don’t think we can conclude that that rescues the exclusion or that we should — that provides any reason why we shouldn’t abandon it.


Steven Schaefer:  What is the largest obstacle to reforming the system as it currently is regarding this tax exclusion as you described it?


Michael F. Cannon:  So the biggest obstacle is about 56 percent of the US population gets their health insurance through an employer, and even if you offer them something better, it’s very easy to demagogue the changes that would result from reform because some of those people on those employer plans do have somewhat secure access to the health care that they need—some of them have very expensive conditions or they have dependents, like spouses, who have very expensive conditions—and when you propose reforming the exclusion to correct these perverse incentives and economic distortions that hurt so many people, it’s very easy for people who make money off the system as it exists right now to demagogue the fears of those workers who, right now, have employer-sponsored insurance and desperately need access to medical care.


This happened in 2008, when John McCain was running for president against Barack Obama, and John McCain proposed to reform the exclusion with what we call a universal tax credit. So you would get rid of the exclusion, which means you would subject employer-sponsored health insurance to income and payroll taxes. So if your employer — if you and your employer together are spending $22,000 on your family coverage—which is about the average. When you include the $16,000 the employer is paying and the portion the employee is paying, it comes to about $22,000—if you eliminate the exclusion, that means that I would have to pay taxes on that $22,000 of compensation that I currently don’t have to pay taxes on. That would increase my tax burden by about $7,300. So right there, you can see why a lot of people wouldn’t like the idea because their taxes are going to go up.


But you could craft a tax credit—and John McCain tried to craft a tax credit—so that most people would then see a reduction in their tax liability that would offset that additional increase. You can never make it perfectly dollar-for-dollar for everybody and, in fact, you wouldn’t want to, you’d just be repeating the same distortions that exist today. But let’s say that John McCain was able to calibrate the tax credits so that the tax incidence was not a political liability to the idea. Actually, that’s not how — and we can conclude that he probably came pretty close to that because that’s not the main ground on which Barack Obama chose to criticize McCain’s tax credit proposal.


He did say that John McCain is going to tax your health insurance, your employer-sponsored health insurance. But Obama’s main line of attack was that you might lose your coverage, and that was very scary to people because if they lost their employer-sponsored coverage back in 2008—remember this is before Obamacare—they would go out into the — they would have really no option but the individual market, where insurers, at that time, could underwrite them and may charge them a higher premium or deny them coverage entirely if they did not — if they had an expensive medical condition.


So that’s the main obstacle to reforming the exclusion, is that opponents of the exclusion—be it Barack Obama who just wants to win a presidential election or insurance companies that make tons of money off the exclusion because it encourages excessive — so much health insurance or health care providers who make so much money off the exclusion for the same reason—they can come at any proposal with that line of attack, and, so far, it has proven very effective.


Now it’s going to be a little less effective since 2014, when Obamacare took full effect because—even though I’m no fan of Obamacare—it does have the characteristic that if you lose your employer-sponsored insurance, you can go into the individual or the Obamacare exchanges and get a health insurance — the insurers have to offer you coverage, and they can’t charge you any more than they charge anyone else just because you’re sick. So now, those premiums — what Obamacare, basically, did was it required everybody to pay exorbitantly high premiums. So that may be cold comfort to a lot of people, but there is that safety net there if reform of the exclusion—that would level the playing field between the individual market and the employer-sponsored market—led to an unraveling of employer-sponsored insurance.


That may not happen — I should add that may not happen. The employer market may not unravel or, at least, not as rapidly as some people think. And there are ways to structure reform so that workers have the resources—have more resources—at their disposal to help them weather those changes. And you can do that without increasing taxes. In fact, you can do it with a tax cut.


Steven Schaefer:  Yeah, you mentioned that there are some ways to structure reform. Could you explain a few of those?


Michael F. Cannon:  Sure. Well, the goal of reforming the exclusion, to my mind, should be eliminating it. There should be no targeted tax preferences in the income tax code or when it comes to payroll taxes for any particular uses of income that ends up — when you have the government using the tax code to pick winners and losers like that, it effectively turns the tax code into a mandate machine, where if you don’t buy the type of health insurance the government wants, you have to pay more to the IRS. That sounds an awful lot like Obamacare’s employer mandate.


But the same is true when it comes to, oh gosh, the deduction for home mortgage interest or even the child tax credit. Any of these targeted tax preferences, effectively, tells taxpayers, either you engage in the kind of activity the government favors or you have to pay an implicit tax penalty—more taxes to the IRS. That violates our individual freedom, our liberty. It creates economic distortions, so that it leaves us a poorer society overall. It creates rent-seeking opportunities for people to come and lobby for more tax preferences that would benefit their industry or their ideology. And so, the goal of reforming the exclusion should be to eliminate the exclusion entirely.


That would probably be a very tough sell to do all in one go, and I mentioned some of the reasons why. The main reason is most people would see their taxes increase. You could reduce marginal tax rates to offset that perfectly, but there would still be — you would never do it exactly perfectly. Some people would see their taxes go up, and there would still be that fear of people with high-cost conditions losing their employer-sponsored insurance and not being able to weather those changes and get the health care that they need.


There is a way, I think, to get there, however, in two steps. The first step being expanding health savings accounts—what are tax-free health savings accounts—and using that as a way to level the playing field between the individual market and the employer market. And here’s what I mean by that. Right now, health savings accounts are tax free accounts that if your employer deposits money in this account for you, it is as with the payments they make toward health insurance on your behalf, it is — the federal government excludes those HSA deposits from both income and payroll taxes—never enters the income or payroll tax basis. So level playing field there between HSA deposits—from your employer anyway—and employer-sponsored insurance.


But there are a lot of rules that they have to comply with in order to have your employer make those deposits. You have to enroll in a qualified high-deductible health plan, which is a health plan defined by Congress. I like to say it’s almost like an individual mandate written by republicans rather than by democrats, where you have to buy the kind of coverage that republicans think you should have. And, lo and behold, a lot of people don’t like that coverage, including many democrats.


And then there are contribution limits on HSAs. You can only put in a certain amount per year, and those contribution limits are too low. And then if you make — if you don’t get an HSA and a high-deductible health plan through your employer, then you can really only deduct — you could get one on your own, but you could then only deduct your HSA deposits from your income taxes. The money you put in your HSA would still be subject to payroll taxes, and so the playing field is not level for those folks.


But HSAs do hold the promise of being a way for Congress to level the playing field between the individual market and the employer market and to overcome that problem that I mentioned before of people with high-cost conditions not having the resources they need to get the care that they need. And they can do it in — and Congress can do that in these ways. The first thing Congress should do is to increase health savings account contribution limits so that workers could deposit in their HSAs the entire amount that their employer had been spending toward their health benefits.


As I mentioned before, for someone with family coverage—the average family plan—that’s $16,000. Right now, HSA contribution limits are less than half of that. And if you increase the contribution limit to, say, $18,000, then most people with employer-sponsored insurance could put the entire $16,000 that their employer pays toward their health benefits into their HSA tax free—no additional taxes as a result. So that’d be the first change, increase those contribution limits.


The second change is that you would let workers purchase insurance from that account, from any source, also tax free. Right now, with HSAs, you can buy qualified medical expenses, so whatever your out-of-pocket medical expenses are, you can purchase those with HSA funds that Congress never taxes. It was tax free going in; it’s tax free going out for qualified medical expenses. If Congress changes the rules so that money that goes out of your HSA to purchase health insurance is also tax free and from any source, that means you can stay in your employer plan; if you want, give that money — give that $16,000 right back to your employer, stay in your employer plan, and nothing has changed. You haven’t changed your health insurance. There’s no tax consequences. But it also would give you the freedom to choose another plan, one that stays with you from job-to-job, one that maybe doesn’t cost as much as your employer’s plan, one that maybe doesn’t cover things that you consider objectionable. If you’re a practicing Catholic, you might not want to purchase health insurance that covers contraceptives or abortion. You would have that choice, and there would be no tax penalty like there is right now. So that’s the second change. You let people purchase insurance from any source.


And the third change is you eliminate the requirement that people purchase insurance at all in order to make these HSA deposits. The reason you do that is that allows maximum flexibility and maximum choice when people are designing and choosing health insurance plans. If you keep the current high deductible health plan requirement or just modify it or add additional types of health plans that would qualify someone to make tax free HSA deposits, then you’re still — you might make that rule a little less rigid, but you’re still going to be restricting choice and innovation in the market for health insurance. And, by god, we need a lot more of that right now. And the government shouldn’t be telling people that you have to buy less coverage than you want to buy.


There’s some people who want to buy coverage not with a high deductible like HSA rules currently require; they want to have a very low deductible. They’re very risk averse. They might want to have first dollar coverage. If they’re the ones paying the premiums, and they’re willing to shell out the higher premiums associated with that type of coverage, we should let them do that. Or the Congress should not penalize them if they want to do that. So eliminating the health insurance requirement that currently exists with HSAs would allow for a lot more choice in the market for health insurance, a lot more innovation in the market for health insurance. That’s the third big change that Congress should make to HSAs as they exist right now.


And these three changes would help solve that problem that I mentioned before. I mentioned two big problems. The first on is, sort of, the budgetary impact and the tax incidence of this, and Congress can calibrate the HSA contribution limits. If Congress uses an exclusion for HSA deposits as a replacement for the current tax exclusion for employer-sponsored insurance premiums, then what will happen is the contribution limits for HSAs—wherever Congress sets them—will act as a cap on the exclusion. Right now, there’s no cap on the exclusion.


There are people whose health benefits — their health premiums are $50,000 per year. Very highly paid executives and others have health insurance through their employer where the premium is $50,000 a year or more. They don’t pay a dime in taxes on that. That’s one of the reasons why the exclusion encourages so much excessive coverage and high prices. Reforming HSAs in the ways I’ve described would, for the first time, put a cap on the exclusion, so that it was not this open-ended distortion of people’s economic decisions that encourages higher prices and so forth.


And what that means is that that executive who has had the $50,000 health benefits, if the exclusion or if we replace the current exclusion with one for HSA deposits, and we cap tax free HSA deposits at $18,000, that means for that executive, $32,000 of previously untaxed compensation would become subject to taxation. That is a revenue source that can offset the revenue loss from expanding HSAs, and somewhere in there there’s sweet spot where when Congress sets the contribution limits, the additional revenue loss exactly equals or comes very close to the revenue gain from taxing those previously untaxed health benefits for highly paid workers. And so, there’s that budgetary issue that expanding HSAs in this way—I call this idea large HSAs—can fix for most people.


Then there’s still this problem, will some people face an increase in their tax liability and hate the idea for that reason? Some people will face an increase in their tax liability. That executive that had the $50,000 health benefits will see $32,000 of their income become newly taxable, subject to income and payroll taxes. On average, they will lose a third of that to taxes. Okay, so a third of $32,000 is about $10,000 and change, okay. So they probably hate this idea, right. Well, maybe not. Because of something else that would be happening at the same time.


When you eliminate the exclusion or replace the exclusion for employer-sponsored health benefits with an exclusion for HSA deposits, what employers are going to have to do is they’re going to have to take that $50,000 they were spending on this executive’s health benefits; they’re going to have to add that to the executive’s salary. That means that the executive who has the $50,000 health benefits and the average worker who spends $22,000 on family coverage, they’re going to gain control over a huge chunk of their earnings that they previously did not control.


The executive is going to gain control over the first 18,000 — first of all, the employer adds that $50,000 to the executive’s salary the executive gets to control $18,000 of that because they put it into their HSA. And then, while they will have to pay $10,000 in taxes to the IRS, they’re still going to gain control over another $22,000, the $22,000 that’s left after tax. So even the executive who has to pay 10,000 additional dollars to the IRS gains control over $40,000 of their income that they didn’t control before. And for the average worker, they’re going to gain control over $18,000 of their income that they didn’t before, which could be — and maybe face no additional tax liability as a result.


So reforming the exclusion with large health savings accounts can be a huge, effective tax cut for so many people that it overcomes that problem that has bedeviled efforts to reform the exclusion in the past, which is people are afraid of the tax incidence, okay. And that also helps overcome the other problem, the one that Barack Obama demagogued so effectively in 2008, which is the fear that people with high-cost conditions will lose their coverage and not be able to get the care that they need. One thing that already helps, as I mentioned, is that Obamacare exists, provides a safety net so that if employers drop coverage, Obamacare is still there for those folks.


We’ve learned from Obamacare that employers may not drop coverage, that employer-sponsored coverage is a lot stickier than we thought it was. But let’s say that an employer decides to drop coverage. What happens to that worker with the average family plan? Well, as I mentioned before, the employer is paying about $16,000 toward that worker’s coverage. And the employer is going to have to add that to the worker’s salary immediately upon this change in the tax law is taking effect or else all of their workers will flee. So no employer is going to mess around with that.


When that worker gains control over $16,000 of their earnings that they previously did not control, as I mentioned, that’s a huge, effective tax cut — but it also means that if the employer does decide to drop coverage, that worker controls $16,000 of their compensation that they previously did not control and that they can use to obtain health insurance from Obamacare or maybe from another source. And that is going to help blunt the demagoguery that’s going to come from the health care industry groups who don’t want to stop the gravy train, who want the government to keep penalizing you and me and more than a hundred million other workers, unless we keep throwing lots of money at the industry for no good return on that investment.


And if Congress did all of these changes, then not only would this be better health policy, but it would also constitute the largest effective tax increase that any of us have ever seen. Because even if these changes, as I’ve described, would be budget neutral so that federal revenues would not change, the fact that employers would be transferring, on average, $16,000 to the salaries of workers with employer-sponsored family coverage—giving workers control over $16,000 of their earnings that they previously did not control—across the entire economy, that would constitute a larger effective tax cut than even the 1981 Reagan tax cuts. The Reagan tax cuts returned 2.9 percent of GDP to the people who earned it, but across all workers, that $16,000 that we’re talking about adds up to a trillion dollars per year. And that constitutes about 4 percent or a third more of the economy that we would be returning to the people who earned it than the Reagan tax cuts did.


So this isn’t why — not only is this good health policy, it’s excellent tax policy and an idea that both tax cutting republicans should be able to get behind as well as democrats who want to see lower health care prices, who want to bring health care within the reach of more people, and who also want to help workers save for their retirement—because HSAs are a good option for that—should also be able to get behind.


Steven Schaefer:  And for our audience, are there any final takeaways that you’d like to share with regards to this topic or finding out more about this topic from your thinking and writing?


Michael F. Cannon:  Sure. Well, earlier this year, I published, through the Cato Institute, a paper that examines the exclusion in a way that I don’t think any other economist policy wonk has by taking different threads of the economics literature and tying them together and really applying those lessons strictly and rigorously to the exclusion in a way that no one has done before. And that’s why, among the conclusions that that paper reaches are, that this is — we call the exclusion a tax cut. It isn’t really a tax cut. If it were, then everybody who’s eligible for it would be taking advantage of it. They’re not. It’s really a weird, sort of, mandate to purchase health insurance that gives employers control over a larger chunk of worker’s earnings than workers would lose to the IRS if they took all of that compensation as cash.


I also conclude that — or one of the things that I stress in that paper is that the economics profession is unanimous or nearly unanimous on the fact that that money that employers are spending on employee health benefits, it doesn’t come from employers, it comes from worker’s wages. And therefore, it is, as I mentioned before, more like a tax than it is like a tax cut because workers lose control over that compensation. And I do discuss the idea of reforming the exclusion with health savings accounts, not before I note that the ideal reform would be to repeal the income tax. But until that’s a live political issue, I think the best politically feasible reform of the exclusion is what I call large HSAs and discuss in that paper and that I will be discussing in a subsequent paper that the Cato Institute will be publishing this year that’s more of a how-to manual on how Congress can reform the exclusion with health savings accounts.


Steven Schaefer:  Well, Michael Cannon, thank you so much for being with us today and sharing your expertise and your insight. For those listeners, thank you for tuning in and if you’d like to find out more content like this, check out www.regproject.org, that’s www.regproject.org. Thank you.




Conclusion:  On behalf of The Federalist Society’s Regulatory Transparency Project, thanks for tuning in to the Fourth Branch podcast. To catch every new episode when it’s released, you can subscribe on Apple Podcasts, Google Play, and Spreaker. For the latest from RTP, please visit our website at www.regproject.org.




This has been a FedSoc audio production.

Michael F. Cannon

Director of Health Policy Studies

Cato Institute

FDA & Health

The Federalist Society and Regulatory Transparency Project take no position on particular legal or public policy matters. All expressions of opinion are those of the speaker(s). To join the debate, please email us at [email protected].

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