September 9, 2013

A Health Care Loophole Worth Closing

Jeremy Horpedahl

Summary

Everyone claims to despise tax "loopholes" – especially when they benefit someone else. But the largest tax loophole (or "tax expenditure," as they are officially called) is claimed by a majority of Americans. Roughly two-thirds receive health insurance as part of their employment compensation, and for them the exclusion is a huge benefit.

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Everyone claims to despise tax "loopholes" – especially when they benefit someone else. But the largest tax loophole (or "tax expenditure," as they are officially called) is claimed by a majority of Americans. Roughly two-thirds receive health insurance as part of their employment compensation, and for them the exclusion is a huge benefit.

Americans would be much better served, however, if the government taxed their health insurance (by treating it as income) and simultaneously lowered tax rates to offset the increase in their taxable income. The economy as a whole would be better served as well, with improvements in the health insurance and labor markets, as well as increased job creation and economic growth.

In a recent paper published by the Mercatus Center, Harrison Searles and I used the example of a family of four earning the median annual income of $75,000, and assumed they receive the national average of $12,000 in health insurance benefits from their employer. If they take only the standard deduction, this family would pay nearly $10,000 in combined federal taxes (income and payroll).

While treating health insurance as taxable income would initially be a massive tax hike for this family – raising its annual tax bill by more than $2,700 – the family would still be better off in the long run if Congress simultaneously lowered tax rates. By lowering marginal tax rates by 3 percentage points, and the payroll tax rate by 1 percentage point, the family's tax bill would be roughly equivalent to what it was before. The lower tax rate would also reduce the current disincentive for additional work.

True, this tax policy change would likely spur some employers to no longer provide health insurance. Would this mean that workers would effectively take a pay cut? No. Both wages and insurance are a cost to the employer, and employers are indifferent about providing one or the other. In a competitive labor market, we need not depend on the benevolence of the employer to increase wages. If employees chose to purchase the same health insurance package their employer had purchased for them in the past, they are no worse off than before.

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