How this screwy IRS policy kickstarted the American health care crisis | Howard Baetjer

Have you ever wondered why, in the United States, we get our health insurance through our employers, but not our car insurance or home insurance? A 1943 New Deal decision making health benefits tax exempt is the answer.

As a believer in small government, I usually favor anything that reduces taxes. But this tax break has wreaked havoc on American health care. As Congress struggles to fix, or “repeal and replace,” the Affordable Care Act (ACA, or “Obamacare”), probably no single policy change is more important than getting rid of that tax break.

Because the health insurance premiums employers pay on their employees’ behalf are tax exempt, your employer can give you what amounts to extra income without paying the additional Social Security and Medicare taxes it would pay if you got a bigger paycheck instead. And employer-provided health insurance isn’t taxable to you, the employee, either, so you save on income taxes, Social Security taxes, and Medicare taxes.

It sounds innocuous, doesn’t it? It even sounds good!

But it’s not, because taxing people differently, depending simply on whether they or their employers pay for their health insurance, distorts people’s incentives so as to distort the health insurance market in ways that have far-reaching, destructive consequences. The consequence we’ll discuss here is that it causes sick people to lose health insurance.

This article gives a brief history of how and why this tax break came to be, and explains how it leads, ironically, to people losing their health insurance just when they need it most.

From wage controls to widespread employer-provided health insurance

Like so many other government interventions, this tax break resulted in part from a previous intervention.

The original act of government that set the whole sorry process in motion was the wage and price controls implemented in World War II. The New Deal involved government limits on the wages companies could pay employees.

Those wage controls did what all binding price ceilings do: they caused shortages. Companies could not get as many qualified workers as they needed at the wages they were allowed to pay.

So some companies attracted the workers they needed by offering fringe benefits in addition to pay. One such fringe benefit was health insurance.

The question then arose as to whether the health insurance premiums employers paid for their employees, which clearly were a part of the employees’ total compensation, would be treated as income to those employees for tax purposes. In 1943 the IRS ruled that they would not.

That fateful decision made employer-provided insurance less expensive to workers than insurance they could purchase for themselves.

A simple example shows why: Suppose that you want a health insurance policy that costs $200 a month, your employer is willing to spend $1,200 a month for your services, and your income tax rate is 20 percent. If your employer gives you your $1,200 compensation entirely in the form of cash each month, you will have to pay $240 in tax on it, and then you will have to buy your health insurance with your after-tax income of $960. That would leave you, each month, with a $200 health insurance policy and $760 in cash.

But if your employer gives you $1,000 in cash plus a $200 payment for your health insurance, then you only pay $200 in taxes. So you’re left, each month, with the $200 health insurance policy and $800 in cash rather than only $760.

Even after the New Deal wage restrictions were repealed, the differential tax treatment remained, so employers continued to offer health insurance, employees continued to take it, and employer-provided health insurance became widespread. We accept it as a matter of course now: when considering a new job, we ask, “What are the health benefits?” as if it’s natural for employers to offer health insurance.

But absent the tax exemption, it would make no more sense for our employers to buy our health insurance than to buy our home or car insurance.

Employers have no special knowledge about health insurance, and they can offer us fewer options than we could find in an undistorted individual marketplace. But here we are. Like most people, I buy my health insurance through my employer; it is much cheaper that way than buying it for myself. But as we’ll see next, it is riskier in an important way.

Why very sick people lose their employer-provided health insurance

Unfortunately, there’s a dreadful unintended consequence of having so much health insurance provided by employers.

When people get sick and stay sick long enough to lose their jobs, they also lose the health insurance that goes with those jobs. The irony is painful. The main reason we buy health insurance is to protect us if we get really sick. But if we do get really sick, we lose our insurance. It’s crazy.

This craziness is caused, ultimately, by our government’s policy of not taxing pay in the form of health insurance premiums. Absent that wrong-headed policy, people would pay for health insurance themselves, as they do home and car insurance. And most would certainly choose policies that are “guaranteed renewable,” meaning that if the insured person does get sick, the insurer agrees not to cancel the contract as long as the insured keeps paying the premiums.

In short, the problem of people losing their insurance when they get very sick (or get laid off, or change jobs, or for a number of other job-related reasons), is caused by the special tax treatment of employer-provided health insurance. Congress needs to end this. It could eliminate the tax exemption for employer-paid premiums, or exempt the premiums individuals pay, but it must treat them the same.

If Congress were to do that, people would stop buying health insurance through their employers and start buying it individually, as they do their home and car insurance. They would buy guaranteed renewable policies. And they would stop losing their health insurance when they get sick.


Article by Howard Baetjer Jr., Lecturer in the Department of Economics at Towson University. Originally published at www.learnliberty.org.