Employer-Sponsored Health Insurance and Taxes
Analysis of the demand for health insurance is complicated by the fact that most people in the United States get their insurance through their workplace. The reason for this is twofold. Workers value health insurance, and it is an affordable health insurance when purchased through an employer. Both points are important. Workers do value health insurance. A 1991 Gallup poll indicated that health insurance was the single most valued employment fringe benefit for 64 percent of respondents (Wall Street Journal 1991).
In 2004, MetLife reported that 81 percent of full-time employees ranked medical benefits as most important. Vacations ranked second with 57 percent (Medical Benefits 2005b). Because many people value health insurance, they are willing to trade some of their compensation for health benefits. This willingness to trade wages for benefits is key to understanding employer-sponsored health insurance.
Health insurance also tends to be less expensive when purchased through an employer. There are three reasons for this. The first has to do with “favorable selection,” the flip side of adverse selection. Employed people tend to be healthier, on average, than those who are unemployed. Employment serves as a good signal of lower expected claims costs, and consequently, an employer group can usually purchase coverage at a lower price than can an individual. The second reason for lower costs has to do with the nature of the existing tax laws. Health insurance is not taxed as federal or state income, nor is it subject to Social Security and Medicare taxes. Thus, if an employee values a dollar of health insurance as equivalent to a dollar of take-home pay, an employer need only spend a dollar on health insurance rather than a dollar plus tax on money compensation. Third, there are economies in the marketing and administration of employer group plans, relative to individually purchased insurance.
Tax advantages have provided a significant incentive for employer provision of health insurance. Employer contributions to group health insurance are exempt from federal and state personal income taxes. They are also exempt from federal payroll taxes for Social Security and Medicare. This tax treatment can be viewed as a subsidy for the provision of health insurance. Workers in the 27 percent federal income tax bracket, paying 5 percent state income tax and 7.65 percent in Social Security and Medicare taxes, would find that an extra dollar of employment based health insurance effectively cost them less than 61 cents. If workers are in a higher tax bracket, the tax subsidy for employer-sponsored health insurance is even greater. This is likely to explain why we observe that more-affluent people have more health insurance.
With a progressive tax system as in the United States, higher incomes imply higher tax rates. Higher tax rates reduce the effective price of employer-sponsored health insurance, and at these lower effective prices, people buy more coverage. Thus, the tax subsidy provides an incentive for broader and deeper coverage. In the simple insurance market discussed earlier, someone may not purchase dental coverage because the size of the potential loss is relatively low. The tax subsidy reduces the effective price, encouraging workers to press their employers to include dental coverage in the benefit package. Similarly, the tax subsidy encourages the coverage of events with low expected losses, such as well-baby care.
The purchase of health insurance through the employer is a complex issue. It involves not only the premium charged but also the tax rates of workers and the relative costs across firms.
The tax incentives also complicate the business decision to change the coverage of health benefit plans. Suppose, for example, that a benefits manager discovers the cost-saving implications of implementing greater cost sharing in the form of larger out-of-pocket payments for health services. The firm implements this in a new health insurance plan. As expected, claims costs decline. However, workers correctly view this change in benefits as a diminution of their compensation. To keep the best workers from leaving for other firms, the employer decides to raise wages. Indeed, if full-coverage insurance caused workers to consume units of healthcare that were only of minimal extra value to them, the cost savings from reduced claims should be enough to make the workers whole and have something left to enhance firm profits. That is, the employer has to add something to the compensation basket to make up for the reduced value health insurance coverage, thus “making the worker whole.” As a result, benefits changes have to not only save money, but save enough money to make workers whole—after tax considerations. This is a rather high hurdle to cross.