Implications of Compensating Differentials in health insurance

Compensating differentials have a remarkably broad set of policy and management implications. Consider some management implications. Suppose employers decide to cut "their" health insurance costs by substantially raising the copays associated with the use of all covered ambulatory services. Other things equal, this makes the health insurance plan less generous. As a result, we would expect that money wages or some other form of compensation would be increased "to make the employees whole."

Thus, it is not at all unusual to see an employer's health insurance plan combine changes, perhaps raising the copay while at the same time increasing the lifetime maximum benefits. This can be viewed as compensating employees for the increased copays. One of the reasons that employers have been relatively conservative in their adjustments to health benefits is that reductions in benefits have to save enough money to make workers "whole" and add something to profits. A change like switching from experience rating to being self-insured probably requires little, if any, compensating differential, but a change like eliminating the dental plan probably does require compensation.

Employers often complain that their health insurance costs are making their products uncompetitive in the global economy. The theory of compensating differentials undercuts this argument, however, since if employers were not paying health insurance premiums, the theory says they would be paying higher wages or more of other benefits. The real issue is not health insurance; it is labor productivity and total compensation.

Given compensating differentials, we would expect to see employers trying to cater to their employees' preferences for coverage and for coveragewage tradeoffs. In an era of rising health insurance premiums, for example, we would expect employers to try to reduce lesser-valued health benefits, pare back other nonhealth programs, and reduce wage increases as they attempt to make the wide range of tradeoffs that their employees would.

Compensating differentials have a number of implications for public policy. Many states are currently debating whether to require employers to extend health insurance coverage to dependents up to age 26. Some states and more private health insurance contracts currently provide for dependent coverage through age 18 or age 22 if the dependent is a full-time student. Compensating differentials imply that workers will pay for this new coverage in the form of lower wages or reductions in other benefits.

Similarly, requiring firms that do not offer health insurance to provide coverage means that workers who currently do not have employer-sponsored health insurance will now have coverage and lower wages or reductions in other benefits. Thus, an employer mandate has much the same effect on uninsured workers as does an individual mandate. In the former, the employer buys health insurance and effectively passes the cost on to workers through compensating differentials.

In the latter, the worker pays directly by being required to own an health insurance policy. It is worth noting that the theory of compensating differentials also suggests that employment should be little affected by an employer health insurance mandate; wages and benefits will adjust, not jobs. There are two exceptions to this: The first is if wages are not free to adjust. For low-income persons affected by minimum-wage laws, wages cannot adjust downward to accommodate the required health insurance coverage. The theory of compensating differentials predicts that many of these individuals would lose their jobs.

The second exception is when workers do not value the coverage in which case, the lower wages and the near worthless health insurance may lead these individuals to drop out of the labor market. Compensating differentials also have implications with regard to the effect that tax policy has on the provision of employer-sponsored health health insurance. If Social Security and/or Medicare taxes were raised to help pay for the cost of the retiring baby boomers, the implication is that these higher taxes would lead workers and their employers to substitute away from money income into more health insurance to avoid some of the net income consequences of the higher taxes.