Make Employer-Based Insurance Taxable? Surprisingly, the Right Solution

With millions of Americans suffering from Obamacare, the time is right for Republicans to advance a solution that addresses the broken health insurance market.

As things now stand, government policies pigeonhole different categories of people into different health-insurance markets. People who are self-employed, unemployed, employed by large firms, employed by small firms, or over 65 all participate in different health-insurance markets. When you work for somebody else and lose your job, you lose your health insurance. Even if you keep your job, your employer can change your health plan for any reason.

Obamacare made this worse by adding another broken health-insurance market into the mix—exchanges.

Health insurance should be chosen by individuals and families, just as with auto insurance, life insurance, or homeowners insurance. That is the only way to encourage insurers to sell policies designed to meet patients’ needs.

Employer-provided health insurance is excluded from workers’ taxable income. This is a significant benefit. On average, such health benefits are worth about $16,000 per household, of which employers pay about three-quarters of the cost and employees the rest, from pre-tax income. But to allow a real market for health insurance to arise, Congress should amend the tax code so that the entire $16,000 goes to employees as taxable income.

People get upset by the idea of changing a non-taxable benefit to taxable income. They shouldn’t. The tax revenue would immediately be recycled into a tax credit, refundable to each person who buys health insurance.

This means that for each dollar spent on medical insurance, an individual’s income tax bill would be reduced by a dollar. For the average family with employer-based benefits, a tax credit would be worth more than the current tax exclusion, which gives a larger benefit to higher-income households.

According to the Congressional Budget Office, the exclusion of employer-based health benefits from households’ taxable income reduced federal tax revenues by some $248 billion in 2013: the largest “tax expenditure” in the Internal Revenue Code. However, because of our progressive income-tax code, the lion’s share of this goes to those who need it the least. The top 20 percent of earners get 34 percent (more than $84 billion) of the total value; the lowest-earning 20 percent gets only 8 percent (about $20 billion) of the benefit.

If the government converted the exclusion to a tax credit and distributed the revenue equally to all income-tax filers—with upper-income individuals, those at the lowest end of the earning scale, and all those in between receiving the same benefit—each “quintile” would receive $49.6 billion. For the lowest quintile, this would be an increase of 150 percent (almost $30 billion) over the current value of the tax exclusion. For the second lowest, the increase would be 43 percent (around $15 billion). And for the middle quintile—individuals who earn between $38,500 and $55,099; or families of four who earn between $77,000 and $110,200—the increase would be 5 percent (around $2.5 billion).

Now, when individuals lose their jobs, they can maintain coverage via the clumsy and costly mechanism of COBRA. However, COBRA coverage is not available to those whose employers drop coverage entirely or go out of business. Also, COBRA expires after 18 months. Obamacare tries to address such problems, but has succeeded only in making them worse.

Having a policy in the individual market turns out to be a preexisting condition that results in having one’s health insurance canceled. Before the dreaded employer mandate kicks in, legislators can square things by making the individual market the market of first resort.

Reformers should not shrink from this task. Such a reform, based on turning the tax exclusion into the tax credit, would benefit most Americans. Now that Obamacare has shown its flaws, the time is right to advance such reform.