The Question of Taxing Employer-Provided Health Insurance


Bruce Bartlett held senior policy roles in the Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Paul. He is the author of the forthcoming book “The Benefit and the Burden: Tax Reform – Why We Need It and What It Will Take.”

The Senate Finance Committee recently committed itself to a zero-based approach to tax reform. All tax expenditures – special provisions that reduce taxes – will be deemed expendable unless senators speak up in support of them.

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I am dubious about the value of this approach but nevertheless think it is useful to re-examine the origins and operation of major tax expenditures, many of which were adopted on the fly, with little thought to their long-run implications. Today I want to begin a series of posts on major tax expenditures, starting with the largest one.

The exclusion for employer-provided health insurance is far and away the largest tax expenditure. In part this is because it, like all such exclusions, reduces payroll taxes as well as income taxes; it is as if the worker never received the income it represents, although employers may deduct the cost of health insurance as a business expense. In contrast to exclusions, individuals’ tax deductions, exemptions and credits reduce only income taxes.

According to the Congressional Budget Office, the health insurance exclusion will reduce federal revenue by $248 billion this year, including lost income and payroll taxes. That is equal to 1.5 percent of the gross domestic product – more than the federal government spends for interest on the public debt.

Section 213(6) of the Revenue Act of 1918 provided that benefits received from health insurance were not considered to be part of gross income for tax purposes. This tax provision was not significant at the time, however, because health insurance was rare, in part because the cost of medicine was low.

According to the Miami University economist Melissa Thomasson, before the 1920s, medical technology was primitive, few drugs were available and hospitalization was rare. The main cost of illness was the income lost from not being able to work.

On the eve of World War II, just 1.3 million people had hospital insurance in a population of 130 million people. During the war, the federal government established wage and price controls to contain inflation. But the demand for war materiel and the military draft created a labor shortage, and businesses looked for ways to compete for the limited supply of workers without being able to raise wages.

President Franklin D. Roosevelt’s Oct. 3, 1942, executive order freezing wages provided an exception for insurance and pension benefits. Employers began offering such benefits as a de facto way of paying higher wages without violating the controls. In 1943, the Internal Revenue Service ruled that employer-provided health insurance was not taxable to the employee.

This ruling was significant, because on the eve of the war only about 3 percent of the population paid federal income taxes; by the end of the war, this percentage had risen to 30 percent. There were fewer than four million taxable returns filed in 1939; by 1943, there were 40 million. Consequently, average Americans were suddenly in need of tax shelters and the exclusion for health insurance was very popular, leading to an expansion of health insurance coverage. By 1945, 32 million people had such benefits, according to Professor Thomasson.

In 1953, the I.R.S. briefly reversed itself and ruled that health insurance benefits were in fact taxable. The following year, however, Congress made the exclusion for health insurance part of the law. This and the continuation of wartime tax rates throughout the 1950s led to a further expansion of health insurance. By 1960, more than two-thirds of the population was covered: 122 million Americans in a population of 179 million.

In the 1970s, many economists such as Martin Feldstein of Harvard became concerned that the unlimited exclusion for health insurance was causing workers to demand excessive health benefits. Instead of providing protection for unforeseen events, analogous to fires in the case of homeowners’ insurance or accidents in the case of auto insurance, health insurance covered normal doctors’ visits, drugs and other predictable medical expenses.

In effect, people were paying for ordinary consumption with before-tax dollars. It was as if one’s auto insurance covered not only accidents but routine maintenance and gasoline as well.

Economists contended that overbuying health insurance fueled medical cost inflation, which raised health insurance premiums, which drove up the cost of employee compensation while pushing down cash wages.

In 1985, the Reagan administration proposed requiring workers to pay taxes on some health insurance benefits as part of tax reform. But the idea went nowhere in Congress.

In 2008, the Republican presidential nominee, Senator John McCain of Arizona, put forward an intriguing proposal to abolish the exclusion for health insurance and use the revenue to finance a $5,000 tax credit for families to buy their own health insurance.

One highly desirable result would have been to delink health insurance from employment, which would improve labor mobility and aid small businesses that are less likely to be able to afford health insurance than large companies, as well as aiding part-time workers and others who tend to lack employer-provided health insurance. The proposal would also have improved fairness because the tax benefits would be the same regardless of one’s income or tax bracket.

Unfortunately, Congress took the idea of abolishing the health insurance exclusion off the table early in the health reform debate in 2009. Also, Republicans made a partisan political decision to abandon the McCain plan, not offer any alternative to the Affordable Care Act and simply oppose whatever Democrats supported.

While it would be a good idea to revisit the exclusion for employer-provided health insurance in the context of tax reform, the likelihood that Congress will do so is small. Democrats have no appetite for reopening debate on the Affordable Care Act and Republicans still have nothing to replace it with.

More importantly, the exclusion remains highly popular. A July 22 United Technologies/National Journal poll found that 59 percent of Americans believe it is very important to keep it and another 29 percent say it is somewhat important; just 9 percent of people say it is not important.