What If Obama Caps the Tax Exclusion for Health Coverage?

The exclusion, without limit, of employer-based health coverage from employees' taxable income is one of the pillars of the U.S. healthcare system. But it's far from sacrosanct. From time to time lawmakers on both sides of the House have proposed tinkering with it, either by imposing a cap or substituting tax credits. A limit on tax-preferred coverage will likely loom large in the upcoming debates around the incoming administration's health-care agenda, according to a report published Wednesday by the nonpartisan, nonprofit Employee Benefit Research Institute (EBRI).

Given the popularity of the exclusion, a cap might seem like a long shot. And President-elect Obama's comprehensive tax plan makes no mention of such a policy. But the measure has been proposed by Sen. Max Baucus (D-MT), chairman of the Senate Finance Committee, who played a central role in crafting Mr. Obama's tax reform program. "That's why it has legs," Paul Fronstin, senior research associate with EBRI and author of the report, told Business Finance. "That puts it on the table -- and there's a lot of interest."

It's not hard to see why, given the perennial need to rein in health-care inflation. Critics of the tax break say that it encourages employees to over-insure and to use more health-care services than they otherwise would. In November 2005, a presidential advisory panel suggested that limiting the amount of coverage that an employee can receive on a tax-preferred basis could result in lower overall private-sector health spending.

A cap on the exclusion would also harmonize with Mr. Obama's stated tax-relief priorities. "One of the ways you could design this is by means testing, so that essentially only upper-income people lose the exclusion," says Fronstin. "So it's a statement about taxes: 'We are not going to raise taxes on the middle class, but we might on the upper income groups.' "

Would capping the exclusion add to companies' tax compliance burden? That depends on the details of any legislation, according to Fronstin. Determining the value of the benefit and adding that to the annual W-2 statements might not be a big deal for companies that purchase health insurance for their employees from an insurer. But for organizations with self-insured plans, valuing the coverage would be a much more complex process, unless the legislation allowed them to base the calculation on the premiums which they already calculate for COBRA (the Consolidated Omnibus Budget Reconciliation Act of 1986).

Any move by Congress to establish a cap would need to address a host of other questions: How would the employer's reporting reflect health incentives, such as payments to workers who take smoking cessation classes? What would happen to health savings accounts? What about flexible spending accounts? Lawmakers would need to prepare the ground carefully, notes Fronstin. Otherwise any legislation could meet the same fate as Section 89 of the Tax Reform Act of 1986, which aimed at reducing tax-favored benefits for higher-paid employees. Undermined by far-reaching and complex compliance burdens, the law was scrapped in 1989.

The EBRI brief is available here.