Proposed Change in the Tax Treatment of Health Coverage

Under current law, the value of health coverage provided by an employer-sponsored plan, including a multiemployer plan, is exempt from income and Social Security and other payroll taxes. The Bush Administration proposes amending the Internal Revenue Code to eliminate that exclusion and treat employer-sponsored health coverage as taxable income to the covered employees (and retirees) and to add a standard income and payroll-tax deduction for those with health coverage. Those with health coverage would deduct $15,000 ($7,500 for those with single coverage) from their income in determining the amount that is subject to federal income and payroll taxes. The deduction would operate much like the personal exemption for individuals and dependents, which can be used whether or not the taxpayer otherwise itemizes deductions. It would be available for people who get coverage either on their own or through an employer-sponsored plan.

Taxpayers could claim the entire standard deduction, even if their health insurance costs less than $15,000 for family coverage or $7,500 for self-only coverage. However, the deduction would only be of value to individuals who have a comparable amount of taxable income; it would not be refundable as a cash payment to people who cannot use the full tax benefit.

The details of how this would work are still sketchy. It appears that the employer would calculate the value of health coverage and include it as compensation on the employees’ W-2s, and would take the exemption into account in withholding the employees’ FICA taxes. Employers would still be allowed to deduct the cost of health insurance provided to their employees as a business expense, without regard to the limit.

Currently, employees can pay their share of premiums and out of pocket expenses on a pre-tax basis, through Section 125 cafeteria plans and Flexible Spending Arrangements (FSAs). The proposal would eliminate these type of arrangements. Health Savings Accounts (HSAs) would continue to be available with the current tax treatment, so contributions to them would be deductible in addition to the new standard exemption.

The proposal would go into effect in 2009. The standard-deduction dollar amounts would be indexed for general inflation (the consumer price index). The cost of medical care and health coverage typically rises significantly faster than that.

Proposal to Shift Federal Dollars to States for Coverage of Vulnerable Groups

The President also proposed to take existing federal funds from Medicaid, Medicare and health care provider payments made on behalf of vulnerable individuals and instead redirect those funds in grants to the states for “Affordable Choices” programs they might create. In particular, the expectation is that this would draw on funds now used to support inner-city and rural hospitals that serve a “disproportionate share” of needy and uninsured patients. The state programs could include such initiatives as offering premium assistance, high-risk pools, or other subsidies or approaches to promote coverage for the uninsured.

Observations on These Health Policy Initiatives

The Bush Administration believes that taxing individuals on the cost of health coverage above the standard deduction amounts will generate pressure to keep health insurance premiums within those bounds, which will lead more people to purchase health insurance, including high-deductible health plans. In addition, the Administration estimates that the proposal would result in lower taxes for about 80 percent of the people with employer-funded coverage, and those who currently have costlier coverage will press for benefit cuts to avoid the taxes, with higher wages to compensate. It claims that the average tax bill for those families who purchase their own insurance would decrease by more than $3,650 in 2009, when the proposal is first implemented.

Because the tax deduction is not refundable, it would provide little help to those with no taxable income, such as couples making less than roughly $20,000. While working people in very low-income tax brackets would save on FICA taxes, their future Social Security benefits would be correspondingly lower. There is also the prospect of splintering groups with employer-based coverage, if younger, lower-cost employees object to receiving expensive coverage on which they might now be taxed. A rollback of workplace coverage would thrust more people onto the individual coverage market, which could have unintended consequences such as higher administrative costs. The Administration proposal would not regulate or provide incentives for insurers to offer low-cost coverage in the individual market so it is unclear whether that market would meet the expanded needs and whether it can pool risks as effectively as the employer market, or whether individuals with substandard risks will get adequate coverage.

It is also worth noting that the flat dollar amount of the proposed deduction does not take into account geographic differences in the cost of health care.

Most states are looking at insurance market reforms to cover those who are uninsured, low-income, or sick, as well as tools such as an individual mandate, but the federal proposal would not mandate these reforms.

The impact of the proposal will be different for employers or multiemployer plans depending on whether they have a high-cost population, the family size of the population and the ease of valuing the coverage provided to their participants and beneficiaries.

Evaluating these and Other Health Reform Proposals

The President’s proposals are the opening salvo in what promises to be an intense debate over the future of health care financing and administration. Other ideas are being floated for modifying the tax code, creating employer assessments or individual mandates, expanding federal health care programs, or reforming state insurance programs, and many are pointing to the new Massachusetts health care reform law³ as a harbinger of the future. In addition, health care will have visibility in this Congress, because the State Children’s Health Insurance Program (SCHIP), which is popular with all parties, expires this year, unless it is reauthorized.

When reviewing health reform proposals, it is important to keep the following key issues in mind:

• Access Does the proposal increase availability of meaningful health care coverage to the poor and workers without employer-sponsored coverage?
• Affordability How would the proposal curb the high rate of medical inflation, and would it affect specific coverage or populations differently? Employer groups and multiemployer plans have significantly greater bargaining power than individuals in terms of purchasing health care and making it more cost-effective.
• Quality Does the proposal provide incentives to increase the quality of care, take into consideration evidence-based medicine, and provide wellness incentives to moderate the need for acute care after serious problems emerge?
• Administration Will the proposal provide significant economies to result in decreased administrative costs, or will it increase administrative burdens on employers and health care providers?

Outlook for Action

Plan sponsors should not expect quick legislative action on the Bush Administration’s health reform agenda. Plans should continue their aggressive strategies to control health care costs, and should not wait on the passage of any particular law.

As the debate continues, Segal will provide information on significant developments.

1	To see the full text of the State of the Union address, click here. (To return to the Capital Checkup text, click here.)
2	To see the White House’s background information, click here. (To return to the Capital Checkup text, click here.)
3	For more information on the Massachusetts law, see Segal’s Bulletin for employers or for sponsors of multiemployer plans. (To return to the Capital Checkup text, click here.)