Duke 2008 | ASHE | Equity and Efficiency in Health and Healthcare

In 2005, the President's Advisory Panel on Federal Tax Reform recommended setting a cap on the income tax exclusion for employer and employee contributions to health insurance premiums. Currently, employer contributions to premiums are untaxed as are contributions by employees who work at firms with 125 plans. The Panel set the exclusion limit at the average cost of health coverage in 2006, indexed by the CPI-U. This paper estimates how many people would be directly affected by this proposal in the first year and over a 10 year horizon and examines the characteristics of the affected population by features of the establishment where they work.

We use a uniquely informative data set - the Medical Expenditure Panel Survey Insurance Component - to assess the potential impacts on the workforce of capping the federal income tax exclusion. The MEPS-IC provides information on the total premium costs of insurance to the employer and employee, including relevant tax status information (i.e. presence of a 125 plan), as well as establishment characteristics.

Our analysis is based on the illustrative, but unrealistic, assumption that individuals would not change plan characteristics in response to after-tax price increases. Our findings for 2006 indicate that the Tax Reform Panel's cap would directly affect thirty percent of employees with family or plus-one plans at an average of $2,690 over the cap value, while 23% of employees with employee only plans are impacted at an average of $1,279.

The proposed cap amount is indexed to the overall rate of inflation rather than the (larger) inflation in the cost of insurance: consequently, an ever larger proportion of employees is forecasted to face a tax increase on their employer-provided health insurance - a stealth tax. We estimate that in the tenth year over 70% of employees with family plans and 65% of employees with employee only plans would find their premiums subject to income taxes, an average of $6,587 for those with family plans and $2,601 for those with employee only plans.

Restricting our sample to only those employees working in the private sector, we examine the incidence of premiums subject to the tax exclusion cap by various firm characteristics. We find that firms with a greater share of women and a higher percentage of workers over 50 years old are more likely to have workers with premiums subject to the cap. Employees at firms with higher union penetration, higher wages, and those at older firms are more likely to be subject to the cap. This study also finds significant results by industry and geography.

Currently, the tax exclusion of employers' contributions to employee insurance premiums encourages employers to offer health insurance because the exclusion increases employees' after-tax compensation relative to wages. Limiting the tax exclusion would increase the costs of health insurance for employers and/or employees, potentially lowering employees' overall compensation and increasing the number of uninsured. In the final section of the paper, we discuss the potential long run implications of the Tax Reform Panel's recommendation.