Why Obamacare’s “Cadillac Tax” is so Contentious

President Obama’s signature health care law is called the Affordable Care Act, but just how affordable remains an open question even this long after its enactment. One of its provisions that aimed at chipping away health care’s high costs is a tax that attempts to remove a hidden subsidy for the most expensive employer-paid health insurance plans.

The highly controversial 40 percent surcharge on these plans quickly became known as the “Cadillac tax,” but its implementation has been anything but quick: Congress has delayed its effective date from 2018 to 2020, given the misgivings many lawmakers have about its wisdom — and possible effects. Indeed, it’s not at all clear that the provision will ever become effective.

The Republican opposition is based upon the party’s overwhelming aversion to everything about Obamacare, and the Democrats’ resistance arises from concerns over how the tax will affect employee benefits. Unions are also concerned that health insurance benefit increases they’ve bargained for in lieu of wage increases will be lost.

Of course, economists have opinions on this topic as well, with a recent poll of economists finding strong support for the Cadillac tax on high-price employer-provided health plans.

The tax was intended to raise revenues to help fund Obamacare and, because it provides an incentive for employers to reduce their spending on health care, function as a cost-control measure.

The high marks the Cadillac tax receives from economists are based on the differential tax treatment of employer spending on wages and health benefits. Unlike wages, when a firm helps to pay for an employee’s health plan, the spending is exempt from taxes. This means if a firm pays an extra dollar in wages, employees will only take home, on average, around 65 cents. But if the firm pays an extra dollar for health care, the worker gets to keep it all.

Thus, in terms of the aftertax value workers receive, it costs the firm less to compensate workers with health insurance dollars than with wages.

The result is a shift in compensation toward health care and away from wages relative to the case where all employee compensation is taxed the same. By imposing a tax of 40 percent on high-price health plans, the hope is that balance can be restored by shifting employer spending from health care to wages. As this happens, spending on health care will fall.

How much would this change wages? Jason Furman, chair of the Council of Economic Advisors, estimates that the tax will increase take-home pay by $45 billion per year by 2025. For comparison, that wage gain is about double the Congressional Budget Office’s estimate of the wage increase for low- and middle-income families from increasing the minimum wage from $7.25 per hour to $10.10 per hour.

If economists are so enamored with the Cadillac tax, why is there so much opposition? Setting aside the political motivation of Republicans to deny Democrats any success, the ideological opposition from the political right is based on the idea that free markets work best when government steps out of the way.

However, health insurance is rife with market failures, and Republicans have supported plans very similar to Obamacare in the past as a way to overcome the inherent faults in health insurance markets.

Two additional objections involve what are known as the indexing and adaptation problems. The indexing problem arises from the fact that the threshold for the tax (around $10,900 for single coverage and $29,400 for families when it takes effect in 2020) is set to increase at the rate of inflation plus 1 percent (based on the CPI), but health care costs are projected to rise faster than the threshold.

Thus, if health care costs rise as projected over time, more and more plans will be subject to the tax, causing it to extend beyond the high-cost plans it is aimed at.

The adaptation problem is related to uncertainties about how employers will respond to the tax. The hope is that the tax will lead to more efficient health care delivery, for example, through employers finding ways to direct patients to lower-cost facilities that provide the same quality of care.

But employers could also implement strategies such as raising deductibles or increasing co-pay amounts that would cause people to avoid seeking the care they need, especially lower-income households. The result would be much higher costs down the road due to insufficient preventative care and the escalation of serious medical conditions.

Last are the concerns about geographical distortions because the cost of health care, and hence insurance coverage, varies by region. However, in February the White House proposed that the tax be adjusted to account for regional differences in costs in an attempt to win more support for it.

I hope the tax works out as planned, and there’s a good chance that it will. However, there’s no certainty. My worry is that employers will substitute lower-cost plans or make other changes to decrease health insurance costs, but wages won’t rise as much as promised.

When multiple distortions exist (including those beyond the health insurance tax break the Cadillac tax addresses) as there are in both health and labor markets, it’s difficult to predict the consequences of reducing one of the distortions while the others remain in place.

When dealing with a single distortion, economic models give us a pretty good idea of what to expect when the distortion is removed. But in this case, quite a bit of uncertainty remains about how the Cadillac tax will change health care plans and the take-home pay of workers.

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