Estimating the Impact of Eliminating the Employer Sponsored Health Insurance Tax Exemption on Macroeconomic Growth

The Affordable Care Act levies a 40% “Cadillac” tax on health insurance premiums above certain thresholds.  As a means of eliminating the tax distortion in the employer sponsored health insurance market, the Cadillac tax fails on many dimensions:  (1) it depends upon total premiums, hence blurring the extent of coverage with regional differences in the cost of health care; (2) it has no effect on coverage decisions for most people covered by employer paid health insurance; and (3) the incidence of the tax is difficult to analyze.  Politicians of many political viewpoints are ready to repeal the tax, but cannot agree on a mechanism to replace the foregone revenue.

We estimate the effect of repealing the Cadillac tax and replacing it with a comprehensive policy:  complete elimination of the favored tax treatment for employer paid health insurance premiums, coupled with proportionate across-the-board reductions in the marginal income tax structure for personal income taxes, Social Security taxes and Medicare taxes paid by all US workers and their employers.  

Unlike the Cadillac tax, this policy affects every decision about health insurance choices for workers using employer-paid mechanisms for their coverage.  We discuss the most important market responses: (1) coverage generosity will fall, thereby also reducing the size and rate of growth of the health sector.  (2) Employers will continue to offer health insurance to employees and their families, but workers will face the true price of such coverage when making their choices.  The market for individual life insurance (which does not have meaningful favored tax treatment) offers a good template for the future health insurance market.  (3) Labor discord relating to health coverage will end.  (4) Job lock and entrepreneurial lock will end.  (5) Health insurance markets will become more competitive as the subsidized advantage of the employer group market ends.

Removing the favored tax treatment for employer-based insurance would add over $600 billion to the taxable income base, representing approximately a 7 percent increase in taxable income.  We would thus reduce all marginal payroll and income taxes by a comparable amount, offsetting the revenue gains arising from the increased tax base. 

The economy and hence total tax revenue will surely grow in response to the reduced marginal taxes on labor, since the basic proposal assures revenue neutrality before considering any expansion in labor supply.  We discuss three separate estimates of the growth in GDP arising from our proposal, centering on a steady-state increase in the equilibrium size of the economy – and hence income and payroll tax receipts – of approximately 0.5 percent. 

We also discuss two other important policy issues: (1) potential deterioration of individuals’ health as their insurance generosity declines.  Three separate sources of evidence suggest that health effects, if any, would be minimal.  (2) Winners and losers under our proposed policy.  In summary, individuals who take higher-than-average fractions of their total compensation as employer paid health insurance would lose, most notably labor union members and governmental employees.