The Biggest Tax Break in America Hides in Your Paycheck Stub

Pull out your pay stub. Look for the largest tax break the federal government gives you. You will not find it, because it never appears. It is the money your employer spends on your health insurance, which never shows up in your wages and therefore never gets taxed.

The budget scorekeepers count that break among the biggest in the whole code. It is so large and so old that most people treat it as the weather. I want to argue that it is not the weather. It is a policy, it has consequences, and it deserves the same scrutiny that conservatives bring to any other subsidy. The thesis is simple: the unlimited exclusion of employer-paid health coverage from income and payroll tax favors the best-paid workers, hides the real price of care, and locks people into their jobs. The conservative answer is equal treatment for every family, however it buys coverage.

The terms

Before the argument, the definitions.

An exclusion is income the tax code says does not count. Under Section 106 of the Internal Revenue Code, the amount an employer spends on an employee's health coverage is excluded from the employee's gross income. The exclusion also keeps the amount out of the payroll tax base, which funds Social Security and Medicare. There is no dollar cap on it.

A tax expenditure is the technical name for a break delivered through the tax code rather than through a spending program. The effect is the same as a check: the government collects less than it otherwise would, and the person with the break is better off. Economists count tax expenditures because they cost the Treasury real money.

Equal treatment means a rule that gives every family the same tax advantage for buying health coverage, whatever its source: an employer, an individual purchase, a spouse's plan.

How the exclusion came to be

The exclusion is an accident, and I have told its story elsewhere, in How World War II Wage Controls Tied Your Health Insurance to Your Job. In brief: during World War II, wages were frozen, employers competed for workers by offering insurance, a 1943 administrative ruling declared the employer's premium payments not to be income, and the Internal Revenue Code of 1954 wrote the principle into the statute. Nobody voted for the system we have. A wartime stopgap hardened into a permanent feature, and that is a poor reason to keep it.

The argument

I will give the argument in numbered premises, so you can find the one you want to challenge.

Premise one: the exclusion favors the best-paid workers

A tax exclusion is worth more to a person in a higher bracket than to a person in a lower one. This is arithmetic, and a worked example shows it. Take a hypothetical, labelled as such: an employer pays $10,000 toward an employee's coverage. The rates below are illustrative, and the brackets change, so check the IRS's tables for the real ones.

• A worker in the 12 percent income tax bracket avoids 12 percent of $10,000 in income tax, which is $1,200. He also avoids the employee's share of payroll tax, 7.65 percent of $10,000, which is $765. His total benefit is $1,200 plus $765, or $1,965.
• A worker in the 24 percent bracket whose wages are below the Social Security wage base avoids 24 percent of $10,000, which is $2,400, plus the same $765, for a total of $3,165.

Same plan, same premium, same worker's need. One gets $1,965 from the government and the other gets $3,165, a difference of $1,200. And the benefit is zero for the family that has no employer coverage at all, the cashier, the freelancer and the small-business owner who buys a plan himself. A subsidy that rises with income and disappears for the person without a big employer is not a subsidy a conservative should have designed.

It is also unlimited. A plan costing twice as much gets twice the break. The Congress that gave the exclusion no ceiling gave the most expensive plans the biggest subsidy, which is the opposite of what anyone who cares about cost control would do.

Premise two: premiums are wages

When an employer pays a health premium, it does not do so out of charity. It pays because the worker's work is worth a certain total amount to the firm, and the firm splits that amount between cash wages and benefits. That is the standard economic view, and it matches common sense: a company has a budget for each employee, and every dollar that goes to the insurer is a dollar that does not go to the paycheck.

If that is so, then the premium is the worker's money. The employer is simply sending part of it to the insurer on the worker's behalf. When premiums rise, as they have year after year, the firm has less to give in raises. Workers feel stuck in stagnant wages and blame the company or the economy. They do not blame the arrangement that hides one half of their pay from them.

The claim is not that workers are foolish. It is that the structure hides the information they need. A worker who sees $10,000 appear on his stub as wages, and then writes a check to an insurer for the same amount, would know what coverage costs and could decide whether the plan is worth it. A worker who never sees the money cannot.

Premise three: it hides the real price of care

A family that buys coverage through an employer sees a deduction from its paycheck and a copay at the doctor's office. It does not see the price of the plan or the price of the care. The insurer negotiates in secret, and the family sees a fraction of the cost, which means the family has no reason to ask what anything costs. The consequences are described in Hospitals Went to Court to Keep Their Prices Secret, and They Lost: a market in which the buyer learns the price after the sale is no market at all.

The tax exclusion feeds the problem. Because the benefit rises with the plan's richness, an employer and a worker both prefer a first-dollar plan with low deductibles, which is the plan that hides prices the most. The tax code pays people to avoid the very information that would lower costs. A high-deductible plan with a health savings account, discussed in Eleven Questions About Health Savings Accounts, Answered for Working Families, restores that information, and it has to climb a tax hill to do it.

Premise four: it locks people into jobs

Because the best tax treatment attaches to employer coverage, a worker who leaves his job loses it. The family loses the plan, the network and the deductible progress, and it must buy a replacement on worse tax terms. That is job lock. It does not appear in an unemployment rate, but it shows up in the businesses that were not started and the better jobs that were not taken because a family could not afford the risk of a coverage gap.

Conservatives should be moved by this, because it concerns freedom and opportunity. The American promise is that a person can move to where his talent is most valued. A tax code that ties health coverage to a particular employer puts a thumb on the scale against that freedom.

The other side's best case

The strongest objection is that any change would raise taxes on the middle class. If the exclusion were limited or ended, the argument runs, millions of workers would see the value of their health benefits become taxable income, and their tax bills would go up. Politicians who said they would do that would lose their jobs.

The objection is serious and I do not want to dodge it. If you remove the exclusion and do nothing else, taxes go up, and workers with generous coverage see the biggest jump. That is a fact, and a reform that ignored it would be a tax increase wearing a policy costume.

But the objection assumes the only reform is to repeal the exclusion and keep the money. That is not what the reform proposals say.

The proposals that answered it

Two Republican proposals, a year apart, took the objection head on.

In his State of the Union address on January 23, 2007, President George W. Bush proposed a standard deduction for health insurance: $15,000 for a family and $7,500 for an individual, available whether the coverage came from an employer or was bought individually, and applying to both income and payroll taxes. The idea was to trade a break that scaled with the price of the plan for a flat deduction that every family received. The White House projected that about 80 percent of employer-provided policies would see lower taxes, while the most generous plans would get no cut. The principle was equal treatment.

In 2008, Senator John McCain proposed a refundable tax credit, $2,500 for an individual and $5,000 for a family, to be paid to anyone who bought coverage, along with ending the exclusion for employer-paid premiums. The credit was refundable, which means a family that owed no tax received it in full. Critics of the plan argued that taxing employer-paid benefits would hurt workers, and the proposal was a flashpoint in the campaign. Supporters said the credit would more than offset the change for most families. I will not quote the estimates, which varied, and I recommend that you read the analyses of the time.

Both plans share the same answer to the objection: pair the end of the unlimited exclusion with a replacement benefit that every family can claim. Done correctly, the middle-class family does not pay more. It receives the same help, and the help is portable. That design was the bargain, and the voters never got to consider it fairly because both proposals were buried in the larger fights of their campaigns.

The Cadillac tax, and why it was the wrong tool

The 2010 health law took a different path. It created a 40 percent excise tax on the cost of employer-sponsored coverage above a threshold, the so-called Cadillac tax. It was meant to discourage lavish plans and to raise revenue. The effective date was pushed back repeatedly, and Congress repealed it in a December 2019 spending law before it ever took effect.

The Cadillac tax shows what happens when a reform is designed to raise revenue and not to reform. It targeted the most expensive plans, which is a sound instinct, but it did nothing for the worker who does not have employer coverage, and it left the structural inequity untouched. It was a surcharge on a bad policy, not a replacement for it, like fining people for driving the car the dealer was paid to push. Its repeal does not make the underlying problem go away. It means the problem is waiting for a better solution.

A conservative reform in outline

A reform that tracks the Bush and McCain ideas might be written like this, as a sketch and not a statute.

1. Give every family, including those with employer coverage, a standard deduction or a refundable credit for health coverage, in the same amount whatever its source.
2. Phase out the unlimited exclusion for employer-paid premiums, so that the exclusion and the new benefit work together and do not stack.
3. Let the benefit go into a health savings account or toward a plan the family chooses, so that the family owns the money.
4. Scale the transition over years, so that no worker is hit all at once.
5. Make the whole package revenue neutral, or better, so that no family is told it is a tax cut when it is a tax increase.

Reasonable conservatives will argue about the details. The point is the principle: a policy that gives the biggest subsidy to the biggest plan held by the best-paid worker is not conservative, and the burden is on its defenders to explain why it should continue.

The Founding connection

The Constitution makes tax policy the business of the House of Representatives. Article I, Section 7 says that "All Bills for raising Revenue shall originate in the House of Representatives." The Framers wanted taxes to begin with the members closest to the voters, who would answer for them every two years. A tax break buried in an administrative ruling in 1943, and in a code revision in 1954, is the opposite of what they had in mind. It is a subsidy the voters never debated.

There is a second Founding point. The framers feared favors that gave some citizens advantages over others without a public reason. A tax code that treats the same coverage differently depending on who writes the check is such a favor. It is not a conspiracy. It is an accident that has become a privilege, and the Founders' answer to a privilege is to put it on the table and ask whether it can be justified. For the exclusion as it stands, I do not think it can.

The case in brief

1. The unlimited exclusion of employer-paid health coverage from income and payroll tax is among the largest tax breaks in the code, and it came about through wartime accident, not design.
2. It favors the best-paid workers: in a labelled example, a $10,000 premium is worth $1,965 to a worker in the 12 percent bracket and $3,165 to one in the 24 percent bracket, and nothing to a worker with no employer plan.
3. Premiums are really wages, and the arrangement hides their cost, blinds patients to prices and ties workers to their jobs.
4. The objection that change would raise middle-class taxes is answered by pairing the end of the exclusion with a standard deduction, as President Bush proposed in January 2007, or a refundable credit, as Senator McCain proposed in 2008.
5. The 2010 Cadillac tax, repealed in December 2019, was a surcharge on the problem and not a cure; equal treatment for every family is the cure.

What you can do: ask your employer's benefits office to show you in writing what it pays toward your health plan each year, and then write to your representative and ask whether he or she supports equal tax treatment for health coverage however a family buys it.