Exclusions also apply to federal employment taxes (Social Security, Medicare, and unemployment taxes) and to state income and payroll taxes as well. Because employment-based health insurance covers more than three-fifths of the population under the age of 65, the exclusions also result in considerable revenue loss to the government. Ending the exclusions could raise several hundred billion dollars a year, depending on exactly what would be repealed and how workers and employers adjust. The federal income tax exclusion—the focus of this report—has been targeted for other reasons as well. These attributes contribute to what many economists argue is a welfare (or efficiency) loss from excess health insurance for those with coverage. In addition, the federal income tax exclusion often is criticized as unfair because the workers' tax savings depend on their marginal tax rate. These three assertions about the income tax exclusion—that the revenues could help to reduce the deficit, that it contributes to inefficiency and rising health care costs, and that higher-income taxpayers unfairly get greater tax savings—are the principal arguments put forth for repeal. The income tax exclusion has been in the tax code for more than 50 years, and its repeal could have unintended consequences unless policy makers understand what transactions it covers and what role it has had in the development of employment-based insurance. Coverage of former employees is also included. To some observers, these tax changes and regulatory decisions largely explain the predominance of employment-based insurance in the United States. There is something to be said for this argument. The future of employment-based insurance was one of the most important issues in health care reform. Excess Insurance

One criticism of the exclusion for employer-provided health insurance is that it reduces the after-tax cost of insurance to workers in ways that are not transparent, likely resulting in their obtaining more coverage than they otherwise would. Not being explicitly capped or limited in some other manner, it does little to restrict the generosity of the insurance or annual premium increases. How repealing the exclusion would affect this welfare loss is a complicated question, however, depending on how consumers react to higher cost-sharing. It could be challenging to determine alternative tax benefits to replace the exclusion without adversely affecting people with high costs. There are other issues with potentially ending the exclusion that merit attention. For example, some might think that income should be taken into consideration. To some extent, the tax savings shown above might not be an inequitable subsidy but only a consequence of the proper treatment of losses under a progressive income tax.
Employer-provided health insurance is excluded from the determination of employees' federal income taxes, resulting in significant tax savings for many workers. Comparable exclusions apply to federal employment taxes and to state income and employment taxes. Because employment-based health insurance covers three-fifths of the population under the age of 65, the exclusions also result in considerable revenue loss to the government. Ending them could raise several hundred billion dollars a year, depending on exactly what is repealed and how workers and employers adjust. Some see this revenue as a source for financing health care reform without explicitly raising taxes.
The federal income tax exclusion—the focus of this report—is criticized for several reasons. Because it reduces the after-tax cost of insurance in ways that are not transparent, it likely results in people with insurance obtaining more coverage than they otherwise would. Not being explicitly capped or limited, it does little to restrict the generosity of the insurance or annual premium increases. These attributes contribute to what some economists argue is a welfare (or efficiency) loss from excess health insurance for those with coverage and also contribute to rising health care costs and spending. In addition, the income tax exclusion often is criticized because it gives greater tax savings to higher income individuals and families, an outcome that strikes many observers as wasteful and inequitable.
These arguments about the exclusion merit careful consideration, as President Obama's Commission on Fiscal Responsibility and Reform include the tax exclusion as a recommendation for reducing the deficit. However, the arguments involve complex issues, and other points and perspectives might be taken into account. The welfare loss may be difficult to gauge considering how consumers react to higher cost-sharing. Determining alternative tax benefits that would not adversely affect people with high costs to replace the exclusion could be challenging. The larger tax savings to higher-income people might not be an inequitable subsidy, but only a consequence of the proper treatment of losses under a progressive income tax.
The income tax exclusion has been in the tax code more than 50 years, and its repeal could have unintended consequences. For example, unless exceptions were made, repeal would also terminate the exclusion for employer-paid disability insurance, health care flexible spending accounts, and other benefits some consider useful.
The exclusion and regulatory decisions in the 1940s sometimes are said to be the reason why employer-paid coverage is the predominant form of private health insurance in the United States. There is something to this argument, but there are other reasons why employment-based insurance arose and why it remains attractive. These reasons make it difficult to predict the effect of ending the exclusion on the future of employment-based insurance, a major policy issue.