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Small Business Employee Benefits and HR Blog

The Biggest Tax Exclusion - Employer Paid Health Insurance

One of the biggest tax exclusions in the U.S. is the exclusion that allows workers who get job-based (or "employer paid") health insurance coverage not to pay taxes on the value of those policies and employers to deduct the cost as a business expense. The exclusion costs the Treasury an estimated $246 billion annually, according to Congress’ Joint Committee on Taxation, dwarfing the second-largest break, the mortgage interest deduction, which costs an estimated $98 billion.Sources of Health Insurance CBO

How the Tax Exclusion for Employer Paid Health Insurance Affects the Federal Budget

The effects of the exclusion on the federal budget are large, exceeding federal spending on Medicaid. The Joint Committee on Taxation has estimated that the total federal tax expenditure associated with the exclusion for employment-based health insurance was $246 billion in 2007, consisting of $145 billion in individual income taxes and $101 billion in payroll taxes. By comparison, the federal government spent over $195 billion on Medicaid in 2007. In addition, the federal government incurs an additional tax expenditure of about $5 billion annually by allowing self-employed individuals to deduct the costs of health insurance from their taxable income. 

History of the Tax Exclusion for Employer Paid Health Insurance

The history of employers providing workers with health insurance goes back for decades. In the early 1940s, the federal government changed the tax laws to allow businesses to provide health insurance coverage as part of an employee's compensation package 100% tax-free.

During World War II, workers demanded wage increases that were prohibited by wartime wage and price controls. To grant a concession to labor without violating wage and price controls, Congress exempted employer-sponsored health insurance from wage controls and income taxation—in effect allowing off-the-books raises for employees in the form of non-taxable health benefits. This created an enormous tax advantage for employer-sponsored health benefits over health insurance purchased by employees with after-tax dollars (e.g., auto insurance). By the mid-1960s employer paid health benefits were almost universal.

The Tax Exclusion for Employer Paid Health Insurance Has Caused Concerns

The current tax treatment of health insurance premiums encourages employers to offer health insurance to their employees and encourages employees to enroll in those plans, but it has also raised several concerns because the exclusion does not provide benefits for health insurance evenly. Specifically:

  1. Individuals with the same income and similar family responsibilities can receive very different tax benefits for medical costs.

  2. Employees who can exclude premiums for employment-based insurance from payroll taxation, as well as from individual income taxes, typically receive more generous tax subsidies than do self employed individuals.

  3. Employees who work for firms that do not offer insurance do not benefit from the exclusion.

Should We Eliminate the Tax Exclusion for Employer Paid Health Insurance?

Some economists think that reducing or eliminating the tax exclusion would slow spending on health care because it would prompt employers to choose less generous insurance plans that cost less. However, eliminating the tax exclusion would eliminate the primary reason most employers offer health insurance, which might cause many firms to drop health insurance coverage altogether.

Starting in 2018, the Affordable Care Act (ACA) attempts to address this issue by imposing a 40 percent excise tax on health plans that cost more than $10,200 for individuals, or more than $27,500 for a family.

What do you think? Should we remove the tax exclusion for employer paid health insurance?

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