Everyone claims to despise tax "loopholes" – especially when they benefit someone else. But the largest tax loophole (or "tax expenditure," as they are officially called) is claimed by a majority of Americans. Roughly two-thirds receive health insurance as part of their employment compensation, and for them the exclusion is a huge benefit.
Americans would be much better served, however, if the government taxed their health insurance (by treating it as income) and simultaneously lowered tax rates to offset the increase in their taxable income. The economy as a whole would be better served as well, with improvements in the health insurance and labor markets, as well as increased job creation and economic growth.
In a recent paper published by the Mercatus Center, Harrison Searles and I used the example of a family of four earning the median annual income of $75,000, and assumed they receive the national average of $12,000 in health insurance benefits from their employer. If they take only the standard deduction, this family would pay nearly $10,000 in combined federal taxes (income and payroll).
While treating health insurance as taxable income would initially be a massive tax hike for this family – raising its annual tax bill by more than $2,700 – the family would still be better off in the long run if Congress simultaneously lowered tax rates. By lowering marginal tax rates by 3 percentage points, and the payroll tax rate by 1 percentage point, the family's tax bill would be roughly equivalent to what it was before. The lower tax rate would also reduce the current disincentive for additional work.
True, this tax policy change would likely spur some employers to no longer provide health insurance. Would this mean that workers would effectively take a pay cut? No. Both wages and insurance are a cost to the employer, and employers are indifferent about providing one or the other. In a competitive labor market, we need not depend on the benevolence of the employer to increase wages. If employees chose to purchase the same health insurance package their employer had purchased for them in the past, they are no worse off than before.
Under this policy change, employees could instead use the additional income to purchase a more affordable insurance policy that better suits their needs. Eliminating the tax exemption for employer-provided health insurance would also eliminate the threat to workers of simultaneously losing their job and their health care benefits. Brigitte Madrian in a 1994 article in the Quarterly Journal of Economics estimated that the current employer-provided health insurance system reduces voluntary job changes by around 25 percent. This makes the labor market much less efficient and "locks in" many workers to their current employer.
Divorcing health insurance from work benefits would improve the labor market in other ways, as well. A recent study by the Tax Foundation estimated that treating health insurance as taxable income – while simultaneously lowering rates – would lead to the creation of more than 800,000 new full-time jobs. This model suggests that income tax rates would need to be cut by 14.6 percent across the board to be revenue-neutral in the short run. Over time, this revenue-neutral cut would actually increase federal revenue by about $30 billion due to new jobs and increased economic activity.
It is important to note, however, that the study also found closing the loophole without simultaneously reducing tax rates would destroy more than a half million jobs.
Whether through a "blank-slate" approach, or through piece-meal reform, closing the biggest tax loophole will be not easy. When National Journal recently asked Americans to rate the importance of keeping this tax break, 59 percent said it was very important; another 29 percent said it was somewhat important.
But this issue should not be framed as simply a choice between keeping or losing this widely utilized tax deduction. Instead, Americans should be offered the opportunity for trading this deduction – and its many negative effects – for lower rates, portable health insurance and a stronger, more efficient labor market.
Jeremy Horpedahl is an economics professor at Buena Vista University and the co-author of the Mercatus Center at George Mason University research paper "The Tax Exemption of Employer-Provided Health Insurance."