How World War II Wage Controls Tied Your Health Insurance to Your Job

Nobody sat down and designed it. That is the first thing to understand about the way most Americans get their health insurance. No commission studied the options, no great statesman proposed it in a speech, and no voter approved it at the ballot box. It happened because a government that was trying to fight a war also decided to control wages, and a clever personnel manager found a loophole.

I find that wonderful and appalling in equal measure. It is wonderful because it shows how ingenious people are when a rule gets in their way. It is appalling because eighty years later, a worker who wants to change jobs still has to ask whether his family's doctor goes with him, all because of a patch on a patch from 1942. Let me tell you the story, because once you know how it began, the notion that it is the natural order of things falls apart.

The setting: a war economy

By 1942, the United States was at war and the economy was being turned toward the war effort. Factories were converting to tanks and aircraft, millions of men were in uniform, and the civilian workforce was shrinking at exactly the moment the demand for labor was exploding. Economists will tell you what happens when you chase more jobs with fewer workers: wages rise as employers bid against each other. Washington worried that rising wages would set off inflation, and it decided to stop the market from doing what markets do.

Congress passed the Stabilization Act, which became law on October 2, 1942. It gave the President authority to stabilize prices, wages and salaries, and the President acted through an executive order that created an Office of Economic Stabilization. A National War Labor Board, which had been set up earlier that year to settle disputes between employers and unions, now had the job of approving wage increases. The board applied a rule, known as the Little Steel formula after a case it had decided in July 1942, that tied permitted raises to an earlier cost-of-living benchmark. In plain terms, the government told employers they could not raise pay, and in practice it told the workers whom they wanted to hire that the wage was the wage.

Now here is the problem every central planner meets. You can freeze a price, but you cannot freeze the thing the price is a stand-in for. An employer who wanted workers still wanted workers. A worker who could not be offered a higher wage could be offered something else.

The loophole

The National War Labor Board drew a distinction between wages and what we now call fringe benefits. A raise in pay was frozen. Certain other kinds of compensation, including insurance and pension contributions within limits, were treated differently. The board allowed employers to offer such benefits without breaking the freeze.

So employers did what employers do. They could not give a raise, but they could pay for the worker's hospital insurance. A firm that offered a good insurance plan could hire the welder that the next firm could not. Nobody was cheating. The system had a gap, the gap was legal, and the labor shortage made the gap valuable. Health insurance, which had been a minor feature of the working life of most Americans, became a competitive weapon in the hunt for workers.

It helped that the insurance already existed. Hospital insurance of the modern kind traces its start to Dallas in 1929, when a group of schoolteachers arranged with Baylor University Hospital to prepay for hospital care. That experiment grew into Blue Cross plans, which spread across the country in the following years. The product was waiting. The war economy gave employers a reason to buy it for their workers.

The tax ruling

A second piece fell into place in 1943. The Bureau of Internal Revenue, the ancestor of the Internal Revenue Service, ruled that when an employer paid the premiums for a group health plan, the payment was not taxable income to the employee. That ruling made the arrangement far more valuable. A dollar of wages was taxed. A dollar of employer-paid insurance premium was not.

Think about what that does to a worker's calculation. Suppose, as a labelled hypothetical, a worker is offered either a dollar of additional pay or a dollar of additional insurance from his employer. The pay arrives after taxes. The insurance arrives whole. The insurance is the better deal even if the worker would have preferred the cash, because the government has put its thumb on the scale.

That ruling was not a law passed by Congress after a debate. It was an administrative decision, which Congress later endorsed. The Internal Revenue Code of 1954 wrote the principle into statute. Section 106 of the code excludes from an employee's gross income the employer's contribution to an accident or health plan, and it has no dollar cap. The 1954 code did not create the practice. It certified an accident and made it permanent.

The unions finish the job

If the war and the tax ruling lit the fire, the unions fed it. After the war, wage controls ended, but the habit did not. Industrial unions, who had learned that benefits were a way to win gains during the freeze, kept bargaining for them.

A court decision helped. In the late 1940s, the National Labor Relations Board ruled, and the courts upheld, in the case known as Inland Steel Co. v. NLRB, that pensions and similar benefits were part of "wages" or "conditions of employment" under the labor law and so were subjects an employer had to bargain over. The Court of Appeals decided the case in 1948, and the Supreme Court declined to review it in 1949. Once benefits were a mandatory subject of bargaining, unions put health coverage at the top of their lists, and employers who did not unionize often matched what the unionized firms offered to keep the union out.

The numbers tell the story, if you will check them for yourself in the historical tables of the Census Bureau and the Department of Labor: private health coverage, which had been a small fraction of the population before the war, became the norm for working families within a decade or two. A habit that began as a wartime loophole became, by the 1950s, the way Americans bought health care.

What nobody decided

Now look at what did not happen. At no point did anyone ask whether this was the best way to organize health insurance. The war planners wanted to hold down inflation. The employers wanted to hire workers. The tax authorities made a ruling about what counted as income. The unions wanted gains for their members. The Congress of 1954 wrote a technical code revision. Each actor was solving a small, local problem. The result was a national system that none of them intended and that no one had voted for.

The Declaration of Independence has a line for this situation, written by men who understood the weight of an old arrangement. It says: "Prudence, indeed, will dictate that Governments long established should not be changed for light and transient causes." That line is usually quoted in defense of stability, and it is a fair defense. But it cuts the other way too. An arrangement that was never established by deliberate choice, and that began as a wartime stopgap, has no special claim to the respect we give to institutions that were designed. It is long established, but it was not wisely established, and a free people can ask whether it deserves to continue.

What the accident still costs

Here are four costs, stated as numbered points so you can check each one.

1. Job lock. A worker thinking about leaving for a better job, a new city or his own business must weigh the loss of his family's coverage. A change of employer usually means a change of plan, a new network and a deductible reset to zero. The worker who stays in a job he would otherwise leave is paying a tax that does not appear on any form. Congress has tried to ease the problem: the 1985 COBRA law allows a departing worker to keep the old coverage for a limited time by paying the full premium, and the 1996 HIPAA law limits the use of preexisting-condition exclusions for people who keep continuous coverage. Those are patches on the accident.
2. Invisible compensation. Because the employer pays the premium, most workers never see its price. A premium is part of what the worker earns, but it does not appear on the paycheck. Workers think they are receiving a benefit, when they are receiving a share of their own wages in a form they cannot choose. When premiums climb, wages stagnate, and the worker never learns why. The tax angle is explored in The Biggest Tax Break in America Hides in Your Paycheck Stub.
3. Weak price discipline. When a third party pays, the person who consumes care does not shop for it. The effect is explained in Hospitals Went to Court to Keep Their Prices Secret, and They Lost, and it follows directly from an arrangement where the buyer, the payer and the patient are three different people.
4. Unfairness between workers and the self-employed. The tax advantage went to people who got coverage through an employer. The self-employed and people who bought coverage on their own did not receive it in the same way for decades, which made the individual market a poor relation.

Compare the arrangement with car insurance. Imagine if the law had tied auto insurance to your employer. Your boss would pick your carrier, your collision deductible would be a topic in the job interview, and a promotion in another city would begin with the question of whether your new company's insurer would cover your car there. You would call the idea absurd. Yet that is how we buy something far more important.

The other side's best case

A fair defender of the system will say: employer-based coverage works for most people who have it. Employers pool risk across a workforce, which means a large group of workers can be insured without the medical underwriting that an individual faces. Employers have bargaining power that a single buyer lacks. Many workers like their coverage and fear what might replace it. And the arrangement is not entirely an accident, since it has been reinforced by seventy years of decisions in Congress, and the legislatures that kept it were responding to voters who wanted it.

That is a strong case, and part of it is right. Pooling is valuable, and some employers do negotiate well. I would not abolish employer coverage, and I do not know any serious conservative who would.

The answer is that the issue is not whether employers may offer coverage. They may, and should. The issue is whether the tax code should push people into getting coverage only through an employer, while treating the same coverage bought another way less favorably. Equal treatment, which means a credit or deduction available to every family whichever way it buys coverage, would let employers keep doing what they do well, and would let workers keep their coverage when they leave. That is a reform of the tax code, not an attack on anyone's benefits.

What follows

If the system is an accident, then there is no sacred duty to preserve it, and no shame in asking what a designed system would look like. Conservatives have answers, and they are compared in Four Conservative Health Plans Side by Side, From Tax Credits to Block Grants: a refundable credit the family owns, health savings accounts the family controls, Eleven Questions About Health Savings Accounts, Answered for Working Families has the details, and protection for the sick that does not depend on where you work.

The principle underneath is that your compensation is yours. The Stabilization Act of 1942 forced employers to find a way around a wage freeze, and the way they found has been shaping your life ever since. A free people can look at the origin of an arrangement and say plainly: this was a workaround, and we have kept it long enough to know what it costs.

I would like to end on the upbeat note I believe in. Americans are practical. They built a system out of a loophole, and made it work for tens of millions of families. A people that can do that can build something better on purpose.

The case in brief

1. The Stabilization Act of October 2, 1942, and the National War Labor Board froze wages but allowed fringe benefits, so employers competed for scarce workers by offering health insurance.
2. A 1943 ruling that employer-paid premiums were not taxable income made insurance cheaper than wages, and the Internal Revenue Code of 1954 wrote that exclusion into law with no cap.
3. Unions, aided by the Inland Steel decision of 1948, made health benefits a subject of bargaining, and employer coverage became the American norm after the war.
4. The accident still costs workers through job lock, hidden compensation, weak price discipline and unequal treatment of those who buy coverage on their own.
5. Equal tax treatment for every family, whatever the source of coverage, would keep what works in employer plans and free the worker who wants to move.

What you can do: look at your last pay stub and your benefits statement, find out what your employer pays toward your health plan each month, and ask your human resources office to show you the total in writing.