Explaining the excise tax

If a new tax is passed and no one actually pays it, can it fund health-care reform?

It sounds like a zen koan for public policy students. But the Senate Finance Committee is banking on it. The excise tax on employer-provided, high-value health insurance is something of an odd bird: It's a new tax that raises money even, and perhaps especially, if people manage to avoid paying it.

On a superficial level, the policy is simple enough: Health-care premiums above $21,000 for families, and $8,000 for individuals, are hit with a 40 percent surtax. So if your family's insurance plan costs $23,000 a year, then $2,000 of it will be taxed at 40 percent. The tax will be levied on the insurer, who will in turn pass it onto your employer, who will in turn pass it onto you. But that's only if it doesn't work.

If it does work, your insurer will design more affordable plans that don't run afoul of the tax because your employer will refuse to purchase plans that do run afoul of the tax. That's the point of the policy: to give employers an incentive to become more value-conscious purchasers of health-care insurance. "Employers are not shopping very well," says MIT economist Jonathan Gruber. "They're signing up with Blue Cross or whichever insurer they know, because what do they care? They just pass it onto wages." But employers don't like wasting their money and workers don't like big jumps in health-care costs.

According to the Joint Committee on Taxation, the tax will raise a shade over $200 billion over the first 10 years, and more after that. But not because people will pay the tax. Rather, the bulk of the money -- $142 billion, according to the JCT -- will come because people won't pay the tax. Employers are expected to choose cheaper plans, and redirect some of that money into paychecks. That means more of a worker's compensation will be in wages, and wages, unlike health-care benefits, count as taxable income. That's how the tax raises money even if it's not being paid.

The excise tax was not the first choice for most policymakers. Health economists think the primary distortion in the health insurance market is that insurance provided by employers is tax deductible. That means a dollar paid in health benefits is worth more to a worker than a dollar paid in wages. Originally, Sen. Max Baucus sought to fund health-care reform by capping the employer deduction. But unions and employers howled, and the Senate Finance Committee quickly backed off.

The excise tax was a compromise thought up in Sen. John Kerry's office. Actually, "thought up" isn't quite the right term: It was unearthed by a clever staffer combing old ideas from the 1994 reform effort.
The appeal of the proposal is that it has the same effect as capping the deduction, but with very different politics: It taxes "insurers" rather than "employers," which sounds a lot better. The tax, however, is passed down to employers, so the impact is virtually identical. If anything, the rhetorical populism obscures a policy that's actually a bit less progressive. The excise tax hits all qualifying insurance plans at 40 percent, regardless of the worker's income. Capping the deduction would mimic whatever tax rate the worker was already paying, which would mean lower-income workers would face a smaller burden. "The irony," says the New America Foundation's Len Nichols, "is that they made it more friendly to the unions, but they made it less friendly to the union’s workers."

They also made it more friendly to the deficit. Early on, the tax will hit relatively few people. The average cost of a family health insurance policy in 2009 was $13,375. In most cases, it takes a strikingly generous plan to pass that $21,000 threshold (there are a few exceptions, like workers in dangerous jobs who have health insurance premiums reflecting the risks of their occupation). But the trick of the excise tax is that the cap grows at the same rate as the consumer price index, plus one percentage point. That's a lot slower than health-care spending, which means that more and workers will see their policies bumping up against the tax. What begins as a tax on generous policies could quickly become a tax on average policies.

When a policy bumps up against the tax, a couple of different things could happen. One is that the employer just passes along the tax, either increasing premiums for the employee or taking it out of wages. The other is that the employer chooses a plan that's beneath the threshold. That plan might have a higher deductible, or more co-pays, or tighter networks, or less coverage for brand-name drugs. It will, in other words, be more like the managed care of the 1990s, which brought down spending and didn't hurt health outcomes, but which people really didn't like. "Managed care worked," says Gruber, "but workers didn’t know it. They didn’t see the benefit. We've got to make them feel the pain of not reforming and enjoy the benefits of reforming." In this case, the pain will be the excise tax. The benefit will be the higher wages they get, and the lower tax burden their children face, when their employers begin choosing higher-value policies. The question is whether they'll ever realize there's a connection between the two.

The other hope is that the rest of the bill -- in particular, the delivery system innovations and the modernizations of the health-care system's infrastructure -- will also work to push down costs, and so growth in the system will slow and the excise tax won't move down the income ladder. "It's an implicit bet on reform working," explains Harvard's David Cutler. "If we can't figure out how to make the cost savings work, the thing will blow up." That's true not just for the excise tax, but also for the subsidies, and for Medicare, and for everything else. If spending doesn't slow, then the system collapses. In that scenario, the excise tax isn't so much a tax as it is a cost-control measure. "The underlying goal is to provide a strong-enough incentive for reducing premiums that nobody has to pay it," says OMB director Peter Orszag. If we don't become a nation of tax evaders, in other words, the policy will have failed.