Commentary

US House Got One Right, Agreed to Repeal So-Called ‘Cadillac Tax’

Chris Pope
By Chris Pope | August 14, 2019 | 11:46 AM EDT

(Photo by Joe Raedle/Getty Images)

While millions of Americans were vacationing this summer, the seemingly impossible happened in Washington: On July 17, Alexandria Ocasio-Cortez (D-NY), Nancy Pelosi (D-CA), Kevin McCarthy (R-CA), and Steve King (R-IA) all voted in favor of the same healthcare legislation. The bill in question, H.R. 748, sought to repeal the so-called “Cadillac Tax” imposed by the Affordable Care Act on costly employer-sponsored health insurance (ESI) plans, and passed the House of Representatives by a landslide vote of 419-6.

Nevertheless, almost 100 public-policy experts voiced strong opposition to the bill, sending a letter to Senate leaders warning that repeal of the Cadillac Tax would “increase health spending, slow wage growth, and expand the budget deficit.”

I think the House has this one right. While the scholars are correct in saying that the Cadillac Tax would increase federal revenues, it is ultimately a regressive tax increase that would make employer-sponsored insurance (ESI) coverage worse while doing nothing to improve alternatives.

What exactly is the Cadillac Tax? It’s a 40 percent excise tax on the value of employer-sponsored health insurance above $11,200 for individuals and $30,150 for families, due to take effect from 2022. As such, it is seen as roughly achieving the objective of capping the exclusion of employer-sponsored health insurance from taxable incomes.

Scholars supportive of the Cadillac Tax argue that “the unlimited exclusion of employer-financed health insurance from income and payroll taxes is inflationary, inefficient, and regressive.” They say the Cadillac Tax will “discourage the provision of insurance that covers such a large proportion of health care spending that consumers have little incentive to insist on cost-effective care.” And they suggest that as “employers redesign health insurance plans to hold costs within the tax-free amount, cash wages or other fringe benefits will increase,” while the tax will generate $197 billion over 10 years for the federal treasury.

To assess these arguments, it is helpful to break down the effects of the ESI tax exemption. The exemption distorts economic behavior in three main ways: by encouraging employers to provide health-insurance benefits instead of wages, by encouraging healthcare to be purchased through insurance rather than out-of-pocket, and by putting employers instead of individuals in charge of purchasing health insurance.

First, far from being an unintended distortion, expanding health insurance coverage by prodding employers to dedicate a part of workers’ incomes to health insurance is a deliberate policy objective. Indeed, the ESI tax exemption does so in a way that strengthens incentives to work, rather than increasing the tax burden on economic output.

Second, the tax skew toward the purchase of medical services by insurers, to the extent which might reasonably have been purchased out-of-pocket, has been greatly mitigated by the establishment of Health Savings Accounts. But one of the first consequences of the Cadillac Tax would likely be for employers to reduce their contributions to HSAs.

Third, the skew toward the purchase of health insurance by employers remains problematic, as high prices are intrinsic to the nature of employer-sponsored insurance and increased cost-sharing can do little to reduce them. Employers would surely love to pay less for healthcare if they could, but are constrained by the nature of their situation in procuring costly medical care, for reasons that are largely unrelated to the tax code.

Insurers, rather than individuals, negotiate fees with providers. When employers purchase insurance for dozens of staff spread across a metro area, they must have most of the region’s hospitals in their network to ensure that employees are each able to access care at their local facilities. This prevents insurers from excluding relatively expensive providers and greatly hinders their ability to negotiate good rates. As a result, individually-purchased insurance plans are able to negotiate rates an average of 35 percent lower than employer-sponsored plans.

But, as nearly all insurance plans cost less than the $11,200 level at which the Cadillac Tax kicks in, it will do little to undo the tax skew toward employer-sponsored insurance vis-à-vis insurance purchased by individuals. The Trump administration’s recent HRA rule, which allows employers to provide all pre-tax funds for individuals to purchase plans for themselves, is a far better remedy for the problem.

Rather than making the individual market for health insurance function better, the Cadillac Tax would therefore serve only to make employer-sponsored insurance worse. It would prod employers to reduce the share of medical costs that their plans cover or push them to stop providing coverage altogether.

The share of businesses offering health insurance has already fallen from 66 percent in 1999 to 57 percent in 2018. Employers are very sensitive to taxes in the decision to offer employer-sponsored insurance. Jonathan Gruber of MIT has estimated that “each percentage point rise in the tax price leads to a fall of −0.69 in the percent of workers covered by employer-provided insurance.” From this, one might expect the elimination of the ESI tax exclusion to reduce the number of Americans with employer-sponsored health insurance by 18 million.

Although the Cadillac Tax would not have so radical an effect, its impact would grow over time as the level at which it phases in is indexed below the rate of growth of medical costs. CBO has estimated that the share of employees likely to be hit by the Cadillac Tax would rise from 15 percent in 2022 to 25 percent in 2028. At some point, employers are likely to be trapped between being penalized by employer mandate if they don’t offer health coverage, and the Cadillac Tax if they do – resulting in increasingly thin insurance coverage.

While some cost-sharing can discourage needless spending associated with the third-party purchase of medical services under health insurance, the benefit of this is subject to diminishing returns and may reduce the consumption of valuable care as much as wasteful services. Deductibles for workers covered by employer-sponsored plans have already soared from an average of $584 in 2006 to $1,573 in 2018. As the bulk of healthcare spending is associated with costly chronic conditions (77% of U.S. healthcare spending in 2015 was on privately insured individuals who had already spent more than $2,000), so increasing relatively low deductibles will likely do little to reduce overall costs. Indeed, we may already have gone too far in this direction: 51 percent of those enrolled in employer-sponsored plans in 2018 said they had postponed needed care over the past year due to cost.

It is wrong to suggest that the ESI tax exclusion is an open-ended subsidy. It increases incentives for economic output, doesn’t extend beyond letting people keep money that they have earned, is limited to spending on medically necessary services, and is also constrained by the requirement that employers make the same benefit terms equally available to all staff. The name “Cadillac plans” is also misleading. Plans may become subject to the Cadillac Tax because they operate in expensive parts of the country or cover a pool of relatively older and sicker employees, but not by covering medically unnecessary services such as cosmetic surgery.

So, the justification for the Cadillac Tax rests largely on the fact that it would generate more revenue for the federal government. CBO estimates that it would raise $15 billion in 2023, rising to $44 billion in 2029. As a tax, is it a good one?

In absolute terms, the value of employer-sponsored insurance is fairly flat across the income distribution, as employers must provide the same benefits to all staff, and so the value of the ESI tax exemption is only slightly greater for individuals in higher marginal tax brackets. But, as a share of income, the value of the exemption is much greater for lower-income individuals, and the Cadillac Tax would therefore be regressive – hitting those in third and fourth income quartiles the hardest, while having the least impact on incomes of the wealthiest Americans.

But, as an excise tax, the most significant distributive impact of the Cadillac Tax relates to consumption rather than income. Given that the value of health insurance to individuals varies according to their medical needs, the burden of the tax increase would obviously fall heaviest of all on the very ill.

By reducing the adequacy of privately-financed health insurance coverage, the Cadillac Tax might therefore drive more people into public entitlements, or strengthen political pressure for them to be expanded. If that is the case, over the long-run, it may not even serve to reduce the federal budget deficit either.

Chris Pope is a senior fellow at the Manhattan Institute. Follow him on Twitter here.

Editor’s Note: This piece was originally published by Economics21 at the Manhattan Institute.

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