Why dump the Cadillac tax?

The Cadillac tax can seem a little counter-intuitive, but it slows down spending on healthcare. Without a replacement, the removal of the cadillac tax will just aid the ever increasing costs of healthcare in America.

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    Affordable Care Act navigators hold an enrollment event at the Fort Worth Public Library in Fort Worth, Texas (Feb 12, 2015).
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Economists love the Affordable Care Act’s Cadillac tax, the excise tax on high-cost employer sponsored health insurance plans. Well, maybe not love. But they do like it a lot.

In contrast, unions, Republicans, and even Hillary Clinton want to dump the tax. Why? Pretty much for the same reason economists support it: By raising the price on expensive employer-based insurance, the tax will encourage firms to offer less costly plans. That, in turn, should drive some costs out of the medical system and slow the overall growth of health spending. Which is a good thing. But unless you are an economist, it all takes a bit of explaining.

The story goes back to World War II wage and price controls. Barred from raising wages as they competed for workers during a period of severe labor shortages, big employers started offering health insurance as a way to increase compensation. In 1954, Congress excluded employer-paid premiums from a worker’s taxable income and clarified that the premiums are a deductible business expense to the employer. Today, the exclusion (from both income and payroll tax) is worth at least $250 billion dollars annually--making it by the far the biggest individual tax expenditure in the revenue code.

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This system creates two big problems. The first is equity. The worker lucky enough to get, say, $10,000 in employer-sponsored insurance gets that benefit tax-free. The worker who gets no insurance at work but instead receives an extra $10,000 in salary must pay both income and payroll tax (up to the statutory caps) on that same $10,000.

The other problem is what this benefit means for medical costs. Today’s health system is plagued by a curious phenomenon—unlike consumers of nearly every other product, many buyers of health care pay only a small fraction of the cost of what they purchase. As a result, they are relatively insensitive to those costs. When the doctor orders the third MRI on a sore knee, the owner of the knee has little incentive to ask why. He just lets the insurance company pay. And the insurance company just passes the cost on to employers, who shift compensation from salaries to the inevitable higher health premiums (If you want to know why wages have been flat for so long, you can start by looking here). As a result medical costs rise for all of us.

The excise tax on high-cost plans should start to change that thinking. Rather than paying the tax, employers are likely to respond in two ways. Some will offer their workers less generous plans with higher deductibles and co-pays or with more tightly controlled managed care (that’s the alternative Clinton and unions hate). Or, they will use their market clout to push down prices from medical providers to keep their health plans below the taxable threshold.

Republicans used to like this idea, at least until Obama endorsed the concept. Unions never did, mostly because in an era where they have little ability to negotiate over salaries, they can still bargain over benefits. I can only assume that Clinton wants to repeal the tax because the unions do.

The debate over the Cadillac tax oozes with classic Washington hypocrisy. On one hand, pols decry the ever-rising costs of medical treatment (even when cost growth moderates as it has in recent years). On the other, they howl in outrage when anybody tries to do something about it.

If lawmakers want to replace the Cadillac tax with a cap on the tax exclusion, or phase in full repeal (and perhaps replace with a tax credit for all buyers), I’m on board. If all they want to do is ditch the levy and replace it with…nothing, I’m not buying.

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