The tax treatment of employer sponsored health insurance

The tax treatment of employer-sponsored health insurance is a key factor in the structure of U.S. health insurance markets. In this article, we explore the cost to taxpayers of the exclusion of employer-provided health insurance from the income and payroll tax base.

We demonstrate the effects of the tax exclusion on employers' provision of health insurance, and we examine the effects of tax law changes on the extent to which coverage is provided and the generosity of that coverage. In addition, we introduce the role that tax policy plays in determining the size of the employee's premium contribution.

The Tax Treatment of Health Insurance

Approximately 62% of the under-age-65 population in the United States had health insurance provided to them through the workplace in 2005 [Fronstin 2006]. Income provided to employees in the form of health insurance is not subject to federal or state income tax or to Social Security and Medicare payroll taxes. As a consequence, this tax treatment provides a substantial subsidy for the purchase of health insurance through an employer.

Tax Rates on Money Wages

To understand the interplay of income, taxes, and health insurance, begin with the demand and supply. These reflect the market for labor. Employers are willing to hire hours of labor as shown in the downward-sloping demand curve. Workers are willing to supply hours of labor along the upward-sloping supply curve. In a competitive labor market with no taxes, equilibrium would be at quantity QE of hours provided at price [wage] PE per hour. Suppose a 10% tax is imposed on the wage rate per hour worked.

Since the original supply curve reflects the minimum wage that people would accept to provide the labor, the tax pivots the supply curve upward, indicating that people have to get a wage that reflects both their minimum acceptable wage and the tax.

Estimates of the Effects of Tax Rates on Health Insurance

Estimating the effects of tax rates on the health insurance decisions within the firm is a daunting challenge. We would need variation in tax rates across individuals, time, and/or political boundaries. If we had data on individuals, there would be concern about the nature of spousal and other nonearned income in the household, which would affect tax rates. If we had data over time, we would need to take into consideration other factors that might have changed along with the tax rates. If we had data across political tax boundaries states, for example we would have to worry about why these tax differences exist and what else of relevance differed across the states.

A number of studies, however, have attempted to estimate the effect of tax rates on an employer's decision to offer health insurance coverage and on the proportion of workers with coverage in a firm. Exploiting differences in state income tax rates has been the most popular approach. The results vary substantially, however.

Taxes and Employee Premium Contributions

Our discussion of taxes and health insurance may have raised at least two issues with thoughtful readers. Both are related to the tax treatment of employee premium contributions for health insurance obtained through an employer. The first is that many employers offer flexible spending accounts [FSAs]. These plans cover the employee premium contribution, effectively making the employee's contribution pretax.

What effect does this have on employersponsored health insurance? The second is that, in the absence of an FSA, the tax laws seem to imply that employee premium contributions should not exist; the entire premium should be paid "by the employer" with the employee's pretax earnings. However, tax policy issues of relevance to both questions are briefly highlighted here.

• Federal and state personal incomes taxes, together with Social Security and Medicare payroll taxes, are major factors underlying the employer provision of health insurance in the United States.
• Employer-sponsored health insurance is not subject to these taxes, and this exclusion provides an incentive for employers and their employees to shift compensation from taxed money wages to untaxed health health insurance.
• Higher tax rates lower the "tax price" of health insurance and increase both the probability that a firm will offer coverage and the generosity of the coverage provided.
• A recent study found that a 10%age point decrease in the tax price [an increase in tax rates] would lead to a 3.6% increase in the probability that a firm would offer coverage and an 11% increase in health insurance spending among firms offering coverage. Smaller firms were found to be the most responsive to tax law changes.
• Tax policy also affects the size of the employee premium contribution. When tax rates are higher, the size of the out-of-pocket premium will be smaller.
• Flexible spending accounts [FSAs], among other advantages, extend the pretax treatment of employer-sponsored health insurance to the employee premium contribution. The effect is to reduce employees' price sensitivity to different plans offered by employers.