Tax Exclusions for Health Insurance: Let Me Count the Ways

Copyright, The New York Times Company

The magnitude and distributional effects of the tax exclusion for health insurance look quite different when viewed from the perspective of the entire safety net.

Expenditures on health services, especially those made through employer-sponsored health-insurance plans, are largely excluded from a host of taxes. The tax exclusions affect both the size of the health-services sector and society’s distribution of disposable income.

By excluding health services from tax, governments in effect redirect money toward health care and away from other activities that might be subsidized or prevent government from reducing overall tax rates, or both. The tax exclusions therefore have a lot in common with direct government spending on health, and for this reason are often described as “tax expenditures.”

A typical approach to estimating the size of the health subsidy implicit in the tax exclusions is to estimate the amount of federal personal income tax revenue that is lost because of the income that escapes tax. It’s important to know the amount of the implicit subsidy, because it is directly related to the amount by which the health sector is enlarged by public policy.

However, the income-tax approach underestimates the amount of the exclusion, because health services are often excluded from many other taxes. The payroll tax is an important instance: employer-provided health-insurance premiums are exempt from payroll and state personal income taxes, too, regardless of whether the employer or employee pays them.

Health-insurance premiums paid by employers on behalf of their employees will escape pretty much anything that taxes an employee’s wages and salaries, because those premiums are not officially considered part of employee wages or salaries. For example, the food-stamp program and Section 8 housing subsidy programs implicitly tax wages and salaries by withholding benefits according to how much a person earns, but for that purpose they ignore employee fringe benefits like health insurance.

Health goods and services often escape state sales taxes, depending on the type of good or service delivered or the type of organization delivering it. Many health services are delivered by nonprofit institutions that escape corporate income and property taxes, too. Just as with the housing industry, we vastly underestimate the government’s effect on the health industry if we focus only on the income tax.

A good summary statistic for the overall effect of tax exclusions on the health industry would be a measure of the marginal tax rate on earned income that included all the relevant taxes. When an employee accepts a $1 pay cut so that his employer can add that dollar to his health insurance contribution, that overall marginal tax rate would tell us how much of that dollar comes back to the employee in the form of the various tax reductions.

I am not aware of a marginal tax-rate measure comprehensive enough for this purpose (it would also need to pay special attention to the Medicaid program and its different treatment of adults and children), but previous studies have taken some useful steps in this direction. The studies find marginal tax rates greater than 50 percent for families above but near the poverty line, which means most of the money they might devote to employer-provided health insurance would come back to them in terms of reduced taxes and enhanced benefits.

More study is needed to quantify accurately the government’s effect on the health market. But we can be sure that public policy has served to enlarge the health industry at the expense of others and that previous estimates do not fully appreciate the magnitude of the distortion.