In Defense of the Cadillac Tax

“What to do? US Sen. John Kerry came up with perfect answer: Preserve the employer exclusion and impose a 40% excise tax on the amount of the premium that exceeded a particular threshold set by the government. Impose the tax on insurers and position it as punishment to insurers . . . for offering high-cost plans.”

William G. (Bill) Stuart

Director of Strategy and Compliance

September 6, 2018

The Cadillac Tax is alive and well.

The levy – formally called the excise tax on high-cost employer sponsored health coverage in Section 9001 of the Patient Protection and Affordable Care Act of 2010  – imposes a 40% tax on the cost of medical coverage in excess of a certain value. It was designed both to control the cost of medical care and to raise tax revenue.

The economic argument in favor of the tax is indisputable: If you tax something, you get less of it. If you subsidize something, you get more of it.

First, a quick history lesson. Employer-sponsored insurance (ESI) coverage exploded during World War II. The federal government imposed wage controls in response to sharp wage increases due to lower supply (young men removed from the workforce and sent to Europe, Africa, and the Pacific to fight the war) and higher demand (need for battleships, tanks, military aircraft, and other war materiels). The result: a shortage of workers, exacerbated somewhat by new entrants (women in the workforce) and job shifts (black Southerners performing low-value work move North and West to factory jobs), but still a shortage.

Employers who wanted to attract workers with higher wages couldn’t do so directly, so they began offering medical insurance to increase overall employee compensation.  The Internal Revenue Service rules that ESI was exempt from federal income taxes. Thus the employer exclusion remains in effect today, with more than 175 million Americans covered by ESI.

Once the war ended, employer-sponsored insurance continued to expand. And why not? The government effectively subsidized the benefit. If a worker today accepts a $100 per month increase in compensation as cash income, somewhere between 20% and 30% of it is taken in federal income and payroll taxes today. (After the war, the figure was over 90% for high-income earners.) In contrast, that same $100 of compensation buys $100 worth of additional coverage.

In 2017, the average employee enrolled in family coverage paid $5,700 toward his insurance, according to a Kaiser Family Foundation survey. His employer paid nearly $19,000. At a tax rate (federal income and payroll taxes) of 25%, the employee saved more than $6,000 in taxes that he otherwise would have paid if his employer had given him $24,700 in additional cash compensation rather than the same amount in the form of medical coverage.

If the average employee suddenly were faced with the loss of $6,000 of net income ($500 per month), he likely would demand that his employer offer a plan with a lower premium. That’s the power of the employer exclusion: Like all government subsidies, it encourages consumers to purchase more of an item than they would without the subsidy.

When Obama administration officials and congressional Democrats were drafting the legislation that became the ACA, they faced several political issues. First, the president was adamant that the legislation not alter the employer exclusion. He knew that he would face the political wrath of more than 160 million Americans and their employers if he tinkered with the exclusion. And he had campaigned to preserve the exclusion against Republican opponent John McCain’s plan to replace the employer exclusion (which is regressive in that it benefits higher income more than lower income workers) with a tax credit that would benefit all taxpayers equally. Second, the president had repeatedly promised on the campaign trail not raise taxes on the middle class.

What to do? US Sen. John Kerry came up with perfect answer: Preserve the employer exclusion and impose a 40% excise tax on the amount of the premium that exceeded a particular threshold set by the government. Impose the tax on insurers and position it as punishment to insurers (who typically poll near the bottom on surveys of consumer confidence and trust) for offering high-cost plans. Of course, insurers would pass the cost of the tax along to employers in the form of higher premiums. This added cost to employers who would raise the cost of employee compensation, which the employer could either pass along to employees, absorbing it from profits or reshuffling the compensation budget to reduce the workforce.

So, instead of, say, capping the employer exclusion at $27,000, the new approach would allow the exclusion for a plan with a premium of $30,000, but the treasury would effectively recover the lost tax revenue that an exclusion would produce by taxing the excess premium at 40%, producing  (in our example) $1,200 of revenue. And best of all, the president could keep his promise of not raising taxes on middle-class Americans. [For a discussion of this topic, see America’s Bitter Pill: Money, Politics, Backroom Deals, and the Fight to Fix Our Broken Healthcare System by Steven Brill, pages 168-9.]

Economists cheered then, and they continue to do so now (see here and here and here).

Their arguments:

1. Employees, to whom employers will shift the burden of the tax, will demand that employers offer lower premium plans to avoid the levy. Lower premium plans usually require more consumer cost-sharing. When patients have more financial responsibility, they have more skin in the game and become more prudent shoppers of care. Individual patient’s seeking better value for a diagnostic service or treatment, multiplied by millions of patients daily, will help curb overconsumption of medical services and spur competition among providers to keep prices down.

2. Employers will respond to these demands by offering lower premium plans and then giving employees the difference in premiums as additional cash compensation, subject to federal income and payroll taxes. This shift will simultaneously provide an antidote to stagnant wages and increase tax revenues.

The former argument is based on sound economic theory. In fact, we’ve seen employers and employees consciously try to reduce premiums when the Cadillac Tax loomed. And we know that patients with more financial responsibility behave differently, consuming fewer units of care and choosing care with lower unit costs.

The latter argument is based on sound economic theory as well since any action short of giving employees the difference in premium – and thus not reducing their gross wages – would violate basic economic theory. But theory and practice often diverge, and typical employers who reduced premiums didn’t compensate employees with higher wages.

Political Considerations

In contrast to economists, politicians rely not on economic theory, but rather votes, to guide their policy preferences. And to Republicans and Democrats alike, the Cadillac Tax is bad politics. Congress hasn’t repealed the Cadillac Tax, but it has delayed the measure four times, so that it won’t go into effect before Jan. 1, 2022.

Democrats have heard an earful from their constituents, particularly organized labor. One key selling point that unions offer to current and prospective members is rich medical benefits. The Cadillac Tax would make this differentiator an economic liability, which in turn would make unions a less attractive option for laborers.

Republicans have heard from their constituents, particularly businesses – and especially businesses located in areas with high medical costs. Many already offer plans with premiums above the thresholds, and others anticipate being subject to the tax in the near future.

But it’s hard to eliminate the tax. The Congressional Budget Office scored the provision to estimate the revenue impact on the federal budget. Because CBO assumed that employers would channel every dollar of premium reduction (exempt from taxes) to employees in the form of higher wages (taxable), the potential revenue loss associated with eliminating the tax is enormous. And since Congress must match projected increases in federal spending or losses in revenue with corresponding decreases in spending or increases in revenue elsewhere in the budget, eliminating the Cadillac Tax requires tough fiscal decisions elsewhere in the budget.

In contrast, continual delays in implementation (and thus revenue from the tax) don’t need to be matched dollar-for-dollar with spending reductions or revenue increases elsewhere.

The Case Against the Tax

There are many arguments against the tax, which is why Congress continues to move the effective date of the tax into the future. More than 300 members of Congress have cosponsored legislation (HR 173 and S 58) to eliminate the tax

Here are the most prominent arguments against the Cadillac Tax:

It’s destabilizing. The ESI market covers 175 million Americans. This is the part of the market that is most stable in terms of continuity of coverage and total coverage. Most ESI plans will be subject to the tax either immediately or within a few years of implementation. Imposing a tax will force rather dramatic changes in benefits, networks, and out-of-pocket responsibility that will leave employees with higher costs and fewer choices, and employers with determining how to rearrange their compensation budgets to address the challenges that the tax imposes.

It’s inflexible. The tax is applied to all premiums above a certain threshold, with inadequate tools to allow variation based on region or the age of the population covered. The tax isn’t a levy on plans with rich benefits.  Instead, it’s a blunt penalty on plans that happen to have high premiums, regardless of the reason for those high prices. Thus, a teacher in Little Rock may end up with a much richer benefit plan than a sales clerk in Boston, but the Boston employee will be subject to the tax and the Little Rock teacher won’t.

It’s too broad. The definition of premium is much broader than the premium paid to an insurer under an insured arrangement or the total cost of claims and administration under a self-insured plan. Included in premiums are the value of a Health Reimbursement Arrangement, employee salary deferrals (contributions) to a Health FSA, and employer and employee contributions to a Health Savings Account. It may – I stress may – make sense to include an HRA (but even then, only the actuarial value rather than the total value) and perhaps even employer contributions to an HSA, since these transactions represent employer contributions toward employees’ expenses.

It’s simply wrong to argue that employees who choose to receive a portion of their pay through a pre-tax reimbursement plan are paying a premium in any sense of the word.

It limits choice. Employers can’t control employee elections to Health FSAs and contributions to HSAs. If the premium alone bumps up against the Cadillac Tax threshold and an employee adds $2,500 through pre-tax payroll contributions to her Health FSA or HSA, her employer has assessed a $1,000 excise tax on that amount. That figure is higher than most participants’ tax savings (depending on their marginal federal and state income tax rates). Faced with this lack of control over employee salary deferrals, an intelligent employer is likely to eliminate this potential tax burden by jettisoning these programs. That action would have the average employee (25% to 30% tax rate) with $2,500 in qualified expenses between $625 and $750 worse off financially with the loss of the tax break when paying those expenses.

Economists might argue (as they do above when discussing medical plans) that Health FSAs and HSAs subsidize overutilization because they effectively reduce the net cost of out-of-pocket expenses. They may be right on a theoretical level, but tell parents with a child’s undergoing cancer treatment or a woman with a husband suffering from diabetes, multiple sclerosis, or emphysema that they’re consuming too much care because they’re receiving a tax break.

It’s more like a Chevy than a Cadillac. It’s impossible to project how many employers will be subject to the tax when it finally goes into effect since the effective date is a moving target without actual ceilings in place. The National Business Group on Health, a coalition of large employers, polled its members in 2017 when the levy was scheduled to go into effect in 2020. Then, 53% of large employers estimated that at least one of their plans would be subject to the tax immediately. That figure jumped to 95% of employers by 2030. Also, 53% of employers anticipated that their most popular plan would be subject to the tax by 2022.

Willis Towers Watson surveyed employers in 2014 and found that nearly half expected to face the tax in 2018 (when that was the effective date of the tax) and 82% five years after implementation.

When more than half of large employers’ plans are expected to be subject to the tax two years after the effective date of the levy and more than four-fifths within a few years after that, we’re not driving a Cadillac anymore.

It’s designed to snare more plans. The annual increases to the threshold premium are calculated based on the rise of the cost of goods and services throughout the economy. That figure rises at half the rate of medical inflation. And a change included in the Tax Cut and Jobs Act of 2017 now ties the increases (and indexing of other coverage figures, like HSA contribution limits) to Chained CPI, a figure that factors in product substitution and rises more slowly than standard CPI (and thus at less than half the rate of medical CPI). If the Cadillac Tax threshold rises at 2% annually and medical inflation increase by 5% annually, more and more companies’ coverage will be subject to the 40% excise tax.

The Outlook

Given the congressional opposition to the actual implementation of the Cadillac Tax, it’s doubtful that the levy will ever be applied. Even if it isn’t, the current bumpy ride – with periodic delays but no permanent solution – is leaving many passengers with motion sickness.

What We’re Reading

What are the four features for which brokers and employers should be looking as they evaluate an HSA administrator or trustee? Learn more here.

Democrats blame the Republican majorities in Congress and the president for failing to take measures to stabilize the ACA. Republicans blame Democrats for passing a law destined to fail and are focused on administrative actions to provide Americans with more choices in coverage. Whom will voters blame in the mid-term elections? The Kaiser Family Foundation offers insight.

What’s the difference between Single Payer and Medicare for All? Learn here.

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4 thoughts on “In Defense of the Cadillac Tax”

  1. Bill, we hear that the House will be taking up this issue again next week.

    1. William G. (Bill) Stuart says:

      This is indeed welcome news. It’s unfortunate that, due to budget policy that you and I know all too well, it’s difficult to eliminate the levy entirely. It’s a much easier lift under current rules to continue to kick the can down the street and delay the tax to even later dates. As long as it continues to hang out there, it represents a threat. And a deadlocked future Congress that can’t get anything done may not continue to pass delays, which will bring the effective date within the planning cycles of benefits managers. It’s time to slay this tax once and for all. I look forward to delivering this message to members of both parties when we visit the Capitol later this month, Marty.

  2. Gerald Belastock says:

    Bill, your “defense” of the Cadillac Tax seems to be limited to a simple endorsement of the fact that taxing something discourages it. I realize you can (and SHOULD) only address ONE topic at a time, but the idea behind the Cadillac Tax fits nicely under the heading of “tax policy and health insurance,” and one of my long-held beliefs is that the tax subsidy of health insurance ought to be phased out. I suppose this really isn’t your “bag” but I thought I’d toss it your way regardless.

    1. William G. (Bill) Stuart says:

      Gerry, from a pure economics perspective, you are right. It can be argued that government shouldn’t be in the business of encouraging consumer spending on one item vs. another. And economic theory would suggest that this subsidy (a dollar of medical coverage costs only 70 cents, while the same dollar spent on a new couch or new windshield wipers costs the consumer the full dollar). The alternative argument is the “horse has left the barn” idea. Do we really want to disrupt the system that provides 175 million Americans with their medical coverage by suddenly (or gradually) increasing the cost so that consumers bear the full brunt of the cost? That action would be destabilizing, even if it fits into the concept of a government that doesn’t use the tax code to favor one form of personal spending over another.

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