Why Do Employers Provide Health Insurance

The general view of microeconomics is that workers are paid what they are worth. In the jargon of the discipline, workers are paid their "marginal revenue product." This simply means that, when the labor market is in equilibrium, the wage rate is equal to the value of the extra output produced as a result of the worker's effort.

Employee compensation can take many forms, however. It can be money income, vacation time, sick leave, pension benefits, free parking, pleasant working conditions, health insurance, and so on. The key point to appreciate is that, if workers are paid what they are worth, when something is added to the compensation bundle say, free parking then something else must be taken out for example, some money income. If this did not happen, the employer would be paying more than the worker was worth. Economic theory and common sense say that we do not expect many employers to knowingly do this.

The adjustment to the compensation bundle when something is added is called a compensating differential. If a generous health insurance plan is added to the compensation bundle, other things equal, something must be taken out or the employer is not maximizing profits. The compensating differential works both ways. If, for example, the working conditions are particularly hazardous, such as in the mining or lumberjacking industries, then other things equal, the employer would have to add something, such as money income, to the compensation bundle to compensate for the moredangerous working conditions.

Thus, the answer to the question of who pays for employer-sponsored health insurance is straightforward: The employee pays in the form of lower wages, fewer other benefits, or both. Employers often make statements to the effect that they do not offer health insurance "because they can't afford it." Such statements, when translated in the light of compensating differentials, would read something like: "I don't believe my employees are willing to give up enough money income to pay for health insurance."

Notice the phrase "other things equal" in the previous examples. This phrase is important to understanding. It means, for example, that the worker is just as productive before and after the inclusion of, say, vacation time in the compensation bundle. We expect wages to be reduced as a result of the inclusion of the benefit. However, if worker productivity increases as well, this increased value of the worker's effort could be reflected in the vacation time and no decrease in wages. The higher productivity that might have resulted in higher wages is instead spent on more vacation time. To put this in another context, from one year to the next, employees may find that their increased productivity goes to pay for more-expensive health insurance, rather than higher wages.

Consider a second example of "other things equal." Suppose we see two workers with differing productivity. The less-productive one receives only money wages. The more-productive one receives both higher wages and health insurance. This is not an example of failed compensating differentials; it is an example of not comparing apples to apples that is, of not comparing workers of equal productivity.

Why Do Employers Provide Health Insurance?

Once the concept of compensating differentials is understood, we can immediately see the conditions necessary for employers to offer health insurance to their workers. First, employees must value the health insurance. If employees do not value the coverage, they will not consider it a form of compensation and will only see that their wages are lower. Theoretically, these workers would quit and take a similar job offered by employers that provided higher wages and no health insurance.

The second condition necessary for employers to offer health insurance to their workers is that it must be less expensive for an employee to buy health insurance through an employer than to buy it independently. Health health insurance may be less expensive through an employer for three reasons. The first is favorable selection. A worker's ability to hold a job is a very low-cost signal to the insurer that the worker is likely to have low claims experience.

Members of an employed group are likely to have lower claims experience than would a random draw of the population, and certainly lower than a random draw of unemployed people. Moreover, an employer's health insurance plan may have a healthier draw of the population over time as well, if sick employees tend to drop out of the workforce and new healthy employees join.

The tax treatment of employer-sponsored health insurance is the second reason for lower health insurance costs through an employer. Compensation provided in the form of health insurance is not subject to federal income tax, Social Security or Medicare payroll taxes, and state income tax. Suppose you are in the 27% federal income tax bracket, your state imposes a 5% state income tax, and Social Security and Medicare have a combined tax rate of 7.65%.

For every $100 of compensation paid to you by your employer, you take home $60.35. If instead you received that $100 of compensation in the form of health insurance, you would have the full $100 of coverage. In this example, the U.S. tax system effectively reduces the price of health insurance purchased through your employer by almost 40%! If you bought the coverage on your own, under most circumstances you would pay with after-tax dollars, so you would not receive this tax subsidy.

The third reason why health insurance is likely to be cheaper if purchased through an employer has to do with administrative cost savings. This category includes a wide range of potential savings. Some are simply savings that occur because the employer's human resources office performs tasks the insurer would otherwise have to do, such as keeping track of which employees are covered and what plan they have and dealing with open enrollment and employees changing health plans.

Lower insurer marketing costs are another administrative cost savings. It is almost certainly cheaper to enroll people in groups of 25 or 50 or 1,000, rather than trying to sell to individuals and signing them up individually.

Finally, and perhaps of most cost consequence, employers serving as agents for their employees can rationally search longer for a better health insurance value than would individuals. Individuals should search for a better health insurance value until the cost of the extra time spent in search just equals the expected extra savings from continuing to search. In contrast, an employer with 25 or 50 or 1,000 workers can usually afford to search longer because an improvement in the coverage or a reduction in the price will apply to 25 or 50 or 1,000 people.

To summarize: Employees buy health insurance through their employers because [1] they value health insurance, and [2] health insurance is less expensive through an employer than otherwise. If either of these conditions is not met, employers probably will not provide coverage. If they consider themselves invulnerable to injury and disease, their demand for coverage is low. They do not value coverage and are more likely to seek out jobs that offer higher wages and little or no health insurance.

Others may find that family coverage is less expensive through a spouse than is individual coverage through their own employer. They, too, are more likely to seek out jobs that provide higher wages and little or no health insurance. If a public program provides coverage for children for which employed households are eligible, demand for dependent coverage is likely to be more limited and people probably will seek jobs that provide higher wages and no dependent coverage. This last effect is known as "crowd-out" of private health insurance.