BRIEF: Reform the Tax Treatment of Health Insurance

Background: With the outbreak of World War II, the federal government imposed wage and price controls on employers to prevent them from raising wages to attract a shrinking available workforce. To address this compensation problem, the Internal Revenue Service (IRS) issued a major rule that health benefits would be treated as compensation just like wages, but with a crucial stipulation: This form of employee compensation, unlike wages, would be tax free for both employers and employees. The result: health insurance at work enjoyed an enormous tax advantage compared to any other type of insurance, and employer-sponsored health insurance became the prevalent form of health insurance coverage.

After the war in 1954, Congress formalized the IRS ruling and enacted major revisions to the federal tax code that exempted job-based health insurance from federal income and payroll (Social Security and Medicare) taxes. Congress set no limit on the amount of income that could be spent on employer-sponsored health insurance tax free and as a result, employer provided health insurance quickly became the dominant form of health coverage for working families. By 1980, over 71 percent of all non-elderly U.S. citizens were covered by employer-sponsored health insurance.

Problems: The tax treatment of health insurance, while advantageous at the time, set the stage for the explosion in health care costs we’ve witnessed for the past few decades. First, by exempting money spent on health insurance from any taxation, Congress eliminated any normal incentive to control the costs of health insurance, either on the part of employers or employees; business health benefit expansions, whatever their cost to businesses, became a large chunk of tax free compensation for employees. Federal tax policy encourages systemic over-insurance, to the point that even routine, predictable medical services are covered by insurance.

Second, the current tax policy distorts the health insurance market. The federal government officially favors employer-provided health insurance over all types of insurance, particularly individual health insurance. If a worker is unable to get health insurance through the place of work, that person must buy coverage on the individual market without a compatible tax break, raising that worker’s premium costs. This policy directly injures employees of small businesses, where coverage is unavailable, the self-employed, and individuals between jobs or unemployed. In other words, the current tax policy is incompatible with the widely held goal of fully portable and affordable health insurance.

Third, the current tax policy undermines consumer choice and competition. Individuals exercise little or no control over the terms and conditions of their coverage, their health benefits, their network of physicians and health care providers, their premiums, co-payments and deductibles. Because health care financing is confusing, under this third party payment system, employees are unaware of the true costs and value of medical care. They have no incentives to tailor health plans more toward meeting their personal and family needs. Government bureaucrats, employers and insurance executives make all of the key decisions.

Finally, every employer dollar spent on health benefits is roughly a dollar less for wages and other compensation. This tax policy contributes to sluggish wage growth and prevents individuals from using their own money to pay for medical care outside of insurance or non-health related expenses.

Solution: Ideally, Congress should replace current tax policy with individual tax relief, and that tax relief would be neutral in terms of the types of health coverage individuals would select, whether group or individual insurance, whether conventional insurance or health savings account plans. This could be accomplished by capping the tax exclusion of employer-sponsored insurance and replacing all health care tax breaks with an alternative health care tax relief option available to all taxpayers and employees if they so choose.

There can be no true market for health insurance outside of a level playing field, with no government favoritism or bias for particular kinds of health coverage. With a level playing field and a genuine free market, consumers would pick and choose the kind of coverage that best serves their personal needs, and insurers would compete to provide value for consumer dollars.  This would reduce run-away health care spending and restore direct patient control over healthcare dollars. With individual tax relief, individuals would be able to secure affordable coverage at competitive premiums, policies would be personally owned and fully portable from job to job, and in making rational transactions over the levels of coverage they want, individuals would be able to keep more of their hard-earned wages.

Another way to accomplish this goal would be for Congress to pass legislation transitioning health savings accounts (HSA) into a free-standing optional tax relief mechanism. In order for this to happen, Congress would need to cap the amount of tax relief applied to employer sponsored health insurance, raise HSA contribution limits, repeal the mandate requiring HSA holders buy health insurance, and allow HSA funds to be used to pay for health insurance premiums.

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