This Urban Institute report examines the possible equity of caps on the tax exemptions for health insurance that are currently under debate in Congress.  The report finds that, if the application of the employer-exclusion cap is based on premiums alone, factors other than the level of benefits provided will affect the benefits taxation.  Under such a plan, workers in more expensive geographic areas, those with many coworkers in their 50s and 60s, and those with coworkers with serious illnesses would pay higher health benefit taxes than those with equivalent benefits.  The report suggests that the cap should be based on benefit generosity alone, measured by an actuarial value accounting for a nationally representative population, to avoid such inequality. 

From the report:

Employer payments for health insurance are exempt from income and payroll taxes. Some policymakers propose limiting the amount of such payments that receive favorable tax treatment, arguing that capping the employer exclusion would both reduce companies’ incentive to offer very generous coverage and raise revenue to finance subsidies for the uninsured. However, if the application of such a cap is determined by the premiums paid for employer-sponsored insurance (ESI), the generosity of coverage will not be the only factor that determines whether benefits are taxed as income. Because of geographic differences in health care costs, premiums for the same benefits can more than double when an individual crosses state lines. Workers’ age, company size, and the categorization of dependent coverage can likewise change premiums, even if benefits remain fixed. Here are examples of the resulting inequities under a leading 2005 proposal, from the President’s Advisory Panel on Federal Tax Reform, which would count as taxable income ESI premiums to the extent they exceed the national average for single or family coverage:

• At firms where at least 60 percent of workers are age 50 or older, 41.2 percent of employees would be taxed on their health benefits. Where fewer than 20 percent of employees are 50 or older, only 16.0 percent of workers would be taxed.
• At small firms with fewer than 10 employees, 29.7 percent of workers would see their benefits taxed, compared with 17.4 percent at companies with 1,000 or more employees.
• 41.3 percent of workers with family coverage would pay taxes on their health insurance. By contrast, only 19.5 percent of enrollees in worker-only ESI would be subject to taxation.

This paper explores a way to cap the tax exclusion that avoids these inequities. Benefits would be taxed based on their generosity, not on premiums. Such generosity would be measured by actuarial value, which is the claims costs that actuaries estimate would result if a nationally representative population received the covered benefits. Utterly irrelevant would be geographic variation in health care costs, the age of workers at a particular firm, the company’s size, and whether workers have family or individual coverage.

Full report: Capping the Tax Exclusion for Employer-Sponsored Health Insurance: Is Equity Feasible? (PDF | 203.98 KB)  

The Urban Institute. (2009). Capping the tax exclusion for employer-sponsored health insurance: is equity feasible? Dorn, S.