Note: The Value of Health and Wealth: Economic Theory, Administration, and Valuation methods for Capping the Employer Sponsored Insurance Tax Exemption

Abstract

The recent passage of health reform introduces a tax that many policy wonks love but much of the public hates. This initiative is the so-called Cadillac Tax on high-value health insurance plans. For years, economists have argued that the exclusion of employment sponsored insurance (“ESI”) from taxable income represents a major distortion in the tax code that incentivizes overinsurance, which in turn causes overutilization of medical ser- vices and rising health costs. They tout the tax as a tool to help control costs and end inefficient distortions. They also claim that the tax is beneficial for lower- and middle-income individuals because the ESI exclusion in the Internal Revenue Code (“I.R.C.”) § 106 disproportionately benefits the wealthy.

However, there are problems with the Cadillac Tax. Since the inception of ESI, the Internal Revenue Service (“IRS”) and the Department of the Treasury (“Treasury”) have excluded it from income to avoid the complex matter of valuing health insurance. There are numerous other concerns involving the administration and proper drafting of the I.R.C. provisions pertaining to the ESI tax, since § 106—the section of the code which excludes ESI—links to many other parts of the fractured Code. While most of the policy debate focused on the economic gains and revenue raising power of the Cadillac Tax, few considered these problems. Yet, ease of administration is another important factor that one must consider in any tax debate, especially one involving an uncharted area like this one.

The provisions in the recently enacted Patient Protection and Affordable Care Act (“PPACA”)1 and the Reconciliation legislation2 embrace the benefits of taxing ESI. However, the PPACA uses a flat excise tax with few adjustments across the board. While this approach is easy to administer, it fails to push as effectively toward equity and efficiency gains that a cap on the § 106 exclusion could provide, another tool for reforming ESI taxation that will be discussed throughout this Note. Thus, the so-called Cadillac Tax is a good idea that has been poorly legislated.

This Note seeks to outline the key points in the debate involving the PPACA Cadillac Tax and attempts to establish a framework for analyzing valuation methods. While the Note finds the PPACA’s approach administratively simple, it finds the tax lacking in that it veers too far from the goals of efficiency and equity that an ESI cap might achieve. Two ESI cap proposals are analyzed: one based on premium value adjustments and the other based on actuarial values. Both are difficult to administer, but each seeks to achieve more equitable outcomes than those provided by the Cadillac Tax. Of the two proposals outlined, actuarial valuation holds the greatest promise at succeeding in the balancing act between efficiency, equity, and administration.

Keywords: taxation, health insurance

JEL Classification: k34, i13