Taxes and Health Insurance Chapter 14

2 Overview Taxes and health insurance incentives Taxes and health insurance incentives Tax expenditures Tax expenditures Tax savings from employer-sponsored health insurance (ESHI) Tax savings from employer-sponsored health insurance (ESHI) Effects of tax law changes on coverage Effects of tax law changes on coverage Taxes and employee premium contributions Taxes and employee premium contributions

3 Taxes and Incentives Ad valorum tax on money wages Ad valorum tax on money wages Work less Work less Substitute untaxed compensation Substitute untaxed compensation Health insurance Health insurance Working conditions Working conditions

4 Single individual claiming one exemption and the standard deduction Total IncomeMarginal Income Tax Rate Marginal Social Security Tax Rate Marginal Medicare Tax Rate Combined Marginal Tax Rate $0–$8,4500%6.2%1.45%7.65% $8,451–$16,00010%6.2%1.45%17.65% $16,001–$39,10015%6.2%1.45%22.65% $39,101–$82,65025%6.2%1.45%32.65% $82,651–$94,20028%6.2%1.45%35.65% $94,201–$163,25028%0.0%1.45%30.45% $163,251–$345,00033%0.0%1.45%34.45% $345,001 or More35%0.0%1.45%36.45% Table 14-1: Federal Tax Rates—2006

5 Full Marginal Tax Rate Single individual earning $45,000 Single individual earning $45,000 Marginal federal income tax rate25.00 percent Marginal federal income tax rate25.00 percent Employee share of payroll taxes 7.65 Employee share of payroll taxes 7.65 Employer share of payroll taxes 7.65 Employer share of payroll taxes 7.65 State income tax rate 5.00 State income tax rate 5.00 Full marginal rate42 percent Full marginal rate42 percent ( )/( )

6 Effects of Taxes Consider a single woman earning $45,000 with no ESHI and a marginal tax rate of percent Consider a single woman earning $45,000 with no ESHI and a marginal tax rate of percent She pays $32.65 on each additional $100 of earnings She pays $32.65 on each additional $100 of earnings Suppose ESHI costs $3,696 per year (2004 average) Suppose ESHI costs $3,696 per year (2004 average) With $41,304 in wages and $3,696 in untaxed health insurance, her tax liability will be reduced by $1,207 With $41,304 in wages and $3,696 in untaxed health insurance, her tax liability will be reduced by $1,207 ($3,696 × = $1,207) ($3,696 × = $1,207) Effectively, the cost of the health insurance will be reduced by $1,207 Effectively, the cost of the health insurance will be reduced by $1,207

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9 How Elastic Is the Firm’s Demand for Health Insurance? 1983–1993 Bureau of Labor Statistics (BLS) Employment Cost Index data 1983–1993 Bureau of Labor Statistics (BLS) Employment Cost Index data Survey of jobs in establishments Survey of jobs in establishments four or six or eight jobs per establishment four or six or eight jobs per establishment 10,000 to 20,000 jobs per year 10,000 to 20,000 jobs per year Current Population Survey Current Population Survey Characteristics of workers Characteristics of workers Tax rate for: Tax rate for: Married and single itemizers and nonitemizers Married and single itemizers and nonitemizers Compute median (or mean) marginal tax rate for each establishment, state, year Compute median (or mean) marginal tax rate for each establishment, state, year Source: Gruber and Lettau, MIT Economics Department working paper (March 2000)

10 “Tax Price” TP = (1 – tf – ts – tss – tmc) (1 + tss + tmc) (1 + tss + tmc) INS = f (tax price, firm char., state, year) Source: Gruber and Lettau (2000)

11 Findings Basic Results: Basic Results: For the decision to offer coverage: For the decision to offer coverage: Elasticity = Elasticity = For extent of insurance spending: For extent of insurance spending: Elasticity = -1.3 to -2.5 Elasticity = -1.3 to -2.5 Small Firms: Small Firms: Offer elasticity = Offer elasticity = Medium and Large Firms: Medium and Large Firms: Spending elasticity = -1.5 Spending elasticity = -1.5 Source: Gruber and Lettau (2000)

12 Policy Simulation Remove tax exclusion for health insurance: Remove tax exclusion for health insurance: 10 percent of firms drop coverage 10 percent of firms drop coverage 37 percent drop in spending for those that continue to offer coverage 37 percent drop in spending for those that continue to offer coverage 43 percent overall drop in spending on health insurance 43 percent overall drop in spending on health insurance Source: Gruber & Lettau (2000)

13 So, marginal tax rates affect whether or not a firm offers coverage, and particularly the generosity of the health plan offered.

14 Why Are There Employee Premium Contributions? Tax incentives argue for no out-of-pocket premium contributions Tax incentives argue for no out-of-pocket premium contributions

15 Suppose Premium Contributions Were Untaxed Suppose worker out-of-pocket contributions to employer-sponsored health insurance were exempt from taxes. Suppose worker out-of-pocket contributions to employer-sponsored health insurance were exempt from taxes. What would that imply about the magnitude of worker premium contributions? What would that imply about the magnitude of worker premium contributions? How would compensating wage differentials work in this context? How would compensating wage differentials work in this context?

16 IRS Section 125 Provisions Flexible Spending Account (FSA) Flexible Spending Account (FSA) An employee may choose to set aside up to an employer- established maximum in pretax income to pay for allowable healthcare expenses. An employee may choose to set aside up to an employer- established maximum in pretax income to pay for allowable healthcare expenses. Premium-only FSA Plans Premium-only FSA Plans Only the out-of-pocket premium is paid out of the FSA Only the out-of-pocket premium is paid out of the FSA Health Reimbursement Arrangement (HRA) Health Reimbursement Arrangement (HRA) Employer-funded account to reimburse for health-related expenses. Employer-funded account to reimburse for health-related expenses.

17 Prevalence of FSAs 1998 KPMG Survey of Employers 1998 KPMG Survey of Employers 53 percent of private-sector firms with 200+ employees offer FSAs 53 percent of private-sector firms with 200+ employees offer FSAs 2001 BLS National Compensation Survey 2001 BLS National Compensation Survey 19 to 25 percent of firms with 100+ employees offer an FSA 19 to 25 percent of firms with 100+ employees offer an FSA 4 to 8 percent offer premium-only plans 4 to 8 percent offer premium-only plans 2003 NFIB Employer Survey 2003 NFIB Employer Survey 9 percent of firms with fewer than 250 employees offer an FSA 9 percent of firms with fewer than 250 employees offer an FSA

18 Effects of FSAs Eliminate the tax difference between pre- and posttax worker contributions Eliminate the tax difference between pre- and posttax worker contributions Perhaps serve as a vehicle for compensating wage differentials in that workers clearly pay for their insurance with pretax dollars and have given up wages for benefits Perhaps serve as a vehicle for compensating wage differentials in that workers clearly pay for their insurance with pretax dollars and have given up wages for benefits Should all of the premium be paid through an FSA? Should all of the premium be paid through an FSA?

19 Discussion Questions The Social Security and Medicare programs are predicted to face financial crisis before One way of dealing with this problem would be to raise payroll taxes. What effects would this have on the market for employer- sponsored health insurance? The Social Security and Medicare programs are predicted to face financial crisis before One way of dealing with this problem would be to raise payroll taxes. What effects would this have on the market for employer- sponsored health insurance?

20 Discussion Questions You are a consultant specializing in employee benefit programs. Suppose there is a relatively large and permanent reduction in the federal personal income tax rate. What sort of changes to their health insurance offerings would you encourage your clients to consider as a result of this congressional action? You are a consultant specializing in employee benefit programs. Suppose there is a relatively large and permanent reduction in the federal personal income tax rate. What sort of changes to their health insurance offerings would you encourage your clients to consider as a result of this congressional action?

21 Discussion Questions Some policy advocates have called for the taxation of employer-sponsored health insurance (ESHI) as just another form of employee compensation. At least one study has suggested that expenditures on ESHI would decrease by as much as 45 percent. Would you anticipate that spending on medical care would be reduced by 45 percent as well? Would you anticipate any change in medical care spending? Some policy advocates have called for the taxation of employer-sponsored health insurance (ESHI) as just another form of employee compensation. At least one study has suggested that expenditures on ESHI would decrease by as much as 45 percent. Would you anticipate that spending on medical care would be reduced by 45 percent as well? Would you anticipate any change in medical care spending?