Health Insurance Tax Exemptions Create Market Distortion

August 8, 2013

The federal government currently does not tax health insurance when employers provide it to their employees as part of the employee's compensation package. The income tax revenue forgone due to this practice is the single largest "tax expenditure" in the federal income tax code. A major unintended consequence of this policy is to drastically distort both the labor market and the health insurance market. While changing the tax code to tax employer-provided health insurance would mean a major tax increase on all working Americans, if it were coupled with a reduction in marginal tax rates many of the distortions to the health insurance market would be eliminated without a net increase in taxes, say Jeremy Horpedahl and Harrison Searles of the Mercatus Center.

The exclusion of employer-provided health insurance from taxation lowers federal tax revenue significantly. According to the Office of Management and Budget, the federal government missed out on over $170 billion in income tax revenue and another $108 billion in payroll tax revenue in fiscal year 2012 due to the exclusion.

  • Over the next five fiscal years, the federal government would collect around $1 trillion in income tax revenue if employer-provided health benefits were taxed, plus another $600 billion in payroll tax revenue.
  • Given the large deficits that the federal government continues to accumulate, this exclusion is a tempting source of new revenue.
  • But closing this loophole would also mean a significant tax increase on all working Americans that currently receive health insurance from their employer.

A related cost of the current tax treatment of health insurance may be a bias against small firms. Small firms are less likely to provide health insurance than large firms, putting them at a competitive disadvantage in recruiting labor. There is some evidence that this fact is due to the higher cost of providing insurance for small firms, potentially leading to a bias toward larger firms.

In the end, employer-provided health insurance is currently tax-exempt by the federal government in order to encourage its provision by employers. Not only does this have the result of reducing federal revenue by $278 billion in fiscal year 2012 alone, it also creates distortions within the economy that introduce concerns about efficiency and justice.

Source: Jeremy Horpedahl and Harrison Searles, "The Tax Exemption of Employer-Provided Health Insurance," Mercatus Center, July 23, 2013.

 

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