The Senate Finance Committee is considering charging an excise tax of 40% on employer-sponsored health insurance premiums that exceed $8,000 for single plans and $21,000 for family plans. In current discussions, these excise tax cut-off values would go into effect in 2013 and be indexed to the growth in the overall rate of inflation plus 1%. As medical costs generally rise much faster than that, an ever-increasing number of plans are likely to be taxed in future years.

The decision to consider an excise tax to partially fund health reform emerged after there was strong opposition to the proposal to cap the current tax exclusion for employer-sponsored health insurance premiums. Capping the currently unlimited exclusion for health insurance would subject workers to new income (and sometimes payroll) taxes.

Under the tax-exclusion cap, premiums in excess of the cap are taxed as wages. The excise tax, however, ostensibly is a tax on insurance companies. In reality, though, this tax is passed on to employers who will almost certainly pass it on to workers in the form of higher premium contributions or lower wages. While it might be appealing to call this a tax of insurance companies, simple economics teaches us that you cannot legislate who will actually bear the cost.

What has been little recognized in the debate is that the excise tax is fraught with all of the problems of the tax-exclusion cap and more.

The excise tax has the same problems as capping the tax exclusion

Like capping the tax exclusion, the excise tax proposal is intended to tax generous health plans. Both policies provide incentives for workers to purchase less-expensive polices. All else equal, less-expensive insurance translates into less-comprehensive coverage, part of the objective of the policy. The hope is that taxing health benefits would help contain the growth of health care costs by encouraging people to buy cheaper, less-comprehensive coverage. The logic is that if patients have to pay a higher share of the costs of visiting the doctor (through higher deductibles or higher co-payments), then they will consume health care services more economically (though, one should note, not necessarily more wisely).

There are, however, three problems with this approach.

1. Research has shown that taxing expensive plans is not the same as taxing generous plans; health insurance plans are expensive for a variety of reasons, including the size of the insurance pool or the health risks of the group. Hence, workers at small firms or firms with an older-than-average workforce can face high premiums for coverage that is actually less generous than the norm.
2. The extra burden placed on families with high medical costs who purchase insurance through work will worsen their health and economic security.
3. While it is likely that workers will indeed purchase fewer medical services if these tax policies were passed, it is not clear that the services they decide to forego are the least valuable. Generally, the research has shown that both high-value and low-value medical care is foregone as people face more cost-sharing.

How an excise tax is worse

So, in regards to being a blunt instrument to target generous plans and squeeze high- and low-value health expenses equally, the excise tax and a cap on the tax exclusion are flawed in many of the same ways. But in some important ways, the excise tax is even worse.

When facing the excise tax, employers have two choices to make: they either retain the expensive plan and pay the excise tax or they cut benefits to their employees to stay under the cap and avoid the tax.

Considering the decision of whether or not to eliminate the more expensive plan, employers will likely do what their workers demand (since the costs are being passed on to them anyhow). Let’s make the (debatable) assumption that lower contributions to health insurance premiums by employers will translate, to some extent, into higher wages. Higher-wage workers are going to be generally indifferent to a tradeoff between expensive benefits and higher wages because their marginal income tax rates are not very different from the excise tax rate. On the other hand, lower-wage workers are going to have a stronger preference to reduce the price of their health care plan to avoid the paying the higher tax rate (40%). Therefore, high-wage firms will generally retain expensive health care plans, while low- and moderate-wage firms will likely drop them.

So, within the same risk pool, workers at firms who decide to move from a more-expensive plan to a less-expensive one will face a loss in plan quality and increasing out-of-pocket exposure. And the problem is compounded by the fact that this increase in out-of-pocket exposure is potentially more harmful for those very people at the lower end of the income spectrum.

If employers instead keep the expensive plan, it is likely because the majority of workers at the firm prefer to retain it. This plan is now taxed above the cap at a 40% tax rate. In all likelihood, all or most of this tax will be passed on to workers. If it is passed on, then each worker winds up paying a 40% excise tax (or close to it) on their health benefits (which exceed the cut-off). Under the tax-exclusion cap scheme, when employers keep the more-expensive plan, workers are subject to paying their marginal tax rate. For low- and middle-income workers, their marginal tax rates are surely lower than 40%. That makes the excise tax doubly regressive.

An excise tax may be a more politically favorable way to reduce the comprehensiveness of health plans and raise money for health reform, but economically it solves none of the problems posed by a cap on the tax exclusion, and in fact introduces substantial new ones.