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The Cadillac Tax Is a Poor Solution to a Real Problem

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The Cadillac Tax Is a Poor Solution to a Real Problem

October 1, 2015

A presidential candidate wants to repeal part of the Affordable Care Act. Normally this would not be news, but the candidate in question is Democratic frontrunner Hillary Clinton, and the ACA provision is the Cadillac Tax, a levy on expensive employer-sponsored health insurance plans. The tax is deeply unpopular—it has been delayed to 2018—and with Democratic members of Congress under heavy pressure from labor unions who oppose the tax, it could be repealed altogether. While the tax is certainly a poorly-designed policy, it does have a real purpose, and lawmakers should have an alternative solution ready before they repeal it.

The Cadillac Tax seeks to address the unlimited tax deduction for employer-sponsored health insurance. Since there is no comparable deduction for insurance purchased individually, employers have a massive incentive to provide their employees with insurance rather than letting them purchase it on their own. Currently, 90 percent of privately insured individuals get coverage through their employers.

The deduction is problematic for many reasons. Most obviously, it costs $250 billion per year—a figure subsidized by poorer individuals whose employers do not offer health insurance. It also encourages employers to give workers raises in the form of more-expensive health insurance plans rather than cash wages, since wages are taxable and health insurance is not. These employer-sponsored health insurance plans reduce competition through “insurance lock:” since employed individuals are disincentivized from shopping for their own health coverage, insurance companies are less likely to maintain both low prices and high quality. If you want a better plan, you might have to leave your job.

Finally, since the employer deduction is open-ended—there is no limit to how expensive a tax-exempt health plan can be—it encourages unnecessarily pricey plans, leading to inefficiency. Of all the problems with the employer deduction, this is the only one which the Cadillac Tax addresses.

The Cadillac Tax is a levy of 40 percent on employer-provided plans above a certain threshold, indexed to inflation. It would discourage the growth of employer-sponsored insurance beyond this threshold, channeling rising health costs into deductibles, which economists view as more efficient (if more unpopular).

But the benefits of the tax largely stop there. The Cadillac Tax is expected to raise $91 billion over the next ten years, according to the Joint Committee on Taxation. This is a fraction of a fraction of the full cost of the employer deduction.

Moreover, the tax does very little to equalize the treatment of employer-sponsored and individually-purchased health insurance, since individually purchased insurance is still taxable at all levels. As described above, this imbalance reduces wages and hinders competition. In fact, the Affordable Care Act cements the imbalance by mandating that employers of more than 50 workers provide health insurance as a benefit. The ACA rightly limited an inefficient tax deduction but sealed off the most promising alternative route to efficiency.

Unions despise the Cadillac Tax, as it reduces their ability to negotiate gold-plated health plans for their membership, which diminishes their value in the eyes of workers. Moving toward equalization of employer- and individual-sponsored health insurance would only further reduce their standing. Pressure from labor unions on the Democratic members of Congress who crafted Obamacare is likely one of the reasons the law’s attempt to address these problems was so miniscule in the first place.

The Cadillac Tax has other inefficiencies. There are tons of exemptions to the tax, which could limit its effectiveness in many industries. Additionally, since health costs tend to grow faster than inflation, more moderately-priced insurance plans may become subject to the tax in coming years, despite its intended purpose to only hit expensive plans (hence the name). Without other forms of tax relief, such as a similar deduction for individually-purchased insurance or an overall lowering of tax rates, workers and businesses will face a much greater tax burden as the years pass.

A better solution to the inefficient employer deduction would be to create a single tax credit for the purchase of health insurance that could be applied to plans purchased either by individuals or employers. Consistent with the goals of the Cadillac Tax, this credit should be capped at a reasonable amount to make it revenue-neutral with the current system. This would take government out of a decision that should be between employer and employee on how to ensure that individuals get the insurance coverage which best suits them.

The Cadillac Tax addresses a small part of a much larger problem, and Congress should not repeal it simply because the political winds are growing stronger. Rather, it should seize the opportunity to come up with a better alternative.


Preston Cooper is a Policy Analyst at Economics21. You can follow him on Twitter here.

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