On the Cadillac tax: ‘Dare Greatly’

Democrats and Republicans finally agree on something – repealing the Cadillac tax on high-cost health plans.  Good news?  Not exactly.  Both the Cadillac tax and the bipartisan calls to repeal it illustrate what is wrong with our tax system and our healthcare system.

The Cadillac tax is a hefty 40 percent excise tax on any employer’s health plan – the value of the health insurance premiums paid by the employer – that exceeds $10,200 for individuals or $27,500 for families.  It was a well-intentioned but bad idea.  It was well-intentioned because it was designed to bring down health care costs and to raise revenue needed to pay for Obamacare.  But it was still a bad idea because when the government tries to pick the “right” amount that should be spent on healthcare, it frustrates market forces that would otherwise push towards efficient pricing and consumption decisions.  It is also a blunt instrument:  it may force employers to pay less to health insurers, but that may just result in cheaper plans with worse coverage.  And like other contraptions in our Rube Goldberg tax code, it creates complexity and opacity instead of simplicity and transparency:  this makes it harder for the public to judge whether our system is progressive or regressive, fair or unfair.

The bipartisan calls to repeal the Cadillac tax are just as lamentable, for different reasons.  Democrats want to get rid of the tax because they want the maximum government subsidy for health benefits provided to workers.  Republicans want to get rid of the tax because they hate taxes and Obamacare.  But a bipartisan repeal will ultimately be just another example of how we end up with (a) an $18 trillion dollar public debt that no one wants to talk seriously about fixing, and (b) a health care system with massively increasing costs because consumers of health care have no incentive to push suppliers for rational pricing or rational cost-benefit decisions on what services are really needed.  Repealing the Cadillac tax pours gasoline on both of those two fires.

Instead of repealing the Cadillac tax, Congress should repeal the entire tax exemption for health insurance.  Right now, when employers compensate their employees by giving them health insurance, that compensation is tax-free.  That is the largest “tax expenditure” in the federal budget.  According to the OMB, this tax break will cost $206 billion in income tax revenue in 2015 and nearly $2.7 trillion over the next ten years – and that does not count the $1.6 trillion of foregone payroll tax revenue.  The reason for the tax break is (as always) well-intentioned:  the government wants to encourage employers to provide health insurance, and doesn’t want to tax people on money spent paying for health care.  But the end result is a system in which health care costs spiral out of control because the consumers aren’t incentivized to push for cost-efficient pricing, and the national debt spirals out of control because the Government locks itself into back-door subsidies that neither political party has the courage to remove.

If this back-door subsidy were repealed, then employers could simply pay their employees the cash currently spent on health insurance.  That additional income would be taxed, but the harsh effects of that could be offset by lowering tax rates—at least on low-income workers, perhaps on all.  That would allow for a more transparent and effective way to implement tax progressivity than through a back-door subsidy.  If done right, it could also raise as much (or more) revenue as the Cadillac tax, but without risking regressive tax burdens or disrupting market forces. 

Employees could use their additional income to buy whatever health plan they want:  one offered by their employer; one offered by some other group (a new industry of group purchasing would likely arise to negotiate better prices); or one from an exchange.  Obamacare would require them to buy some form of insurance, but they would have more freedom to choose which one.  That means tens of millions of additional consumers would be incentivized to make rational and well-priced health care decisions, putting pressure on the system to deliver better care at lower cost. 

This de-coupling of health care from employment might then result in the de-coupling of the market for routine annual health care (not really “insurance” at all) from the market for true insurance that covers catastrophic or non-routine health problems.  A small tax credit would incentivize individuals to make cost-effective decisions for the former (including by buying preventive care).  A large risk-pool, together with direct and transparent subsidies to targeted individuals in need, would ensure the humane availability of the latter.  Both would benefit from repealing a system that irrationally links health care to employment through an opaque subsidy.  Replacing that subsidy with something simpler and more transparent would result in more competition, better pricing, and a more rational healthcare system.

Most politicians will say such a repeal is politically impossible.  That’s a good way to fail before trying to succeed.  Instead, they should borrow from the Cadillac slogan:  “Dare Greatly.”

Hume is a partner with Boies, Schiller & Flexner LLP in DC .