Congress Shouldn’t Repeal the Cadillac Tax Without Replacing It

There are many provisions in the Affordable Care Act (ACA) that are ill advised and should be repealed immediately, but the “Cadillac” tax isn’t one of them. In fact, absent a better alternative, it shouldn’t be repealed at all. It’s likely to be the provision of the ACA that does the most to encourage higher-value and lower-cost health care, despite its flaws.

For decades, economists have complained that the open-ended tax break for employer-paid health insurance premiums is a major distortion in the marketplace. Unlike cash wages, employer-paid premiums are excluded from the taxable compensation of workers. This exclusion from taxation has encouraged employers to offer, and employees to value, insurance plans that are more expensive than would be the case if health benefits were taxed like salaries. The tax preference for employer coverage has led many firms to offer coverage with little cost-sharing that has encouraged the over-consumption of health services by employees and their families.

The “Cadillac” tax would, for the first time, penalize expensive employer-sponsored plans by imposing a 40 percent excise tax on the premiums for those plans above specified thresholds — estimated to be $10,200 for individual policies and $27,500 for family coverage in 2020.

The tax’s design — an assessment on the employers offering the expensive plans — was purposeful. The authors wanted to create the impression that it would be firms, not the workers, who would bear the added cost.

But that’s a political deception. The Congressional Budget Office (CBO) and other analysts have concluded, rightly, that the tax will, in most cases, lead employers to adjust what kinds of insurance plans they offer their workers in order to avoid paying the tax. The result will be insurance plans with higher deductibles, more co-payments paid by the plan’s enrollees, and more tightly managed networks of participating physicians and hospitals. These are the kinds of steps that will bring more cost discipline to health care by forcing consumers to be more cost-conscious in their use of services. CBO projects that these adjustments will lead employers to provide more compensation in the form of taxable wages, and less in the form of untaxed health benefits, thus increasing both income and payroll tax revenue.

The “Cadillac” tax is on a deathwatch because both parties in Congress dislike it. Businesses groups and labor unions have joined together to push for its repeal; last year, they succeeded in getting Congress to push back initial implementation of the tax from 2018 to 2020. President Obama signed the legislation because he had little choice in the matter.

Part of the problem is the tax’s checkered political history. In 2008, Sen. John McCain, during his campaign for president, proposed to replace the tax preference for employer-paid premiums with a uniform, refundable tax credit payable directly to individuals to subsidize their enrollment in health insurance. This proposal would have made the tax code more progressive by giving substantial new support to millions of lower income households. And yet, his opponent in the campaign, then-Sen. Obama, attacked him for proposing to tax health benefits “for the first time in history.” This attack proved highly effective and helped propel Sen. Obama to the presidency.

Once in office, President Obama’s advisors strongly urged him to adopt some kind of limitation on the tax preference for employer plans because of the importance of the tax break in driving up costs. The administration settled on the “Cadillac” tax as a way of imposing some discipline without admitting the president was supporting the same policy he had just attacked McCain for endorsing.

Embracing the “Cadillac” tax instead of a more straightforward limitation on the existing tax break may have helped President Obama avoid a politically embarrassing admission that he had been wrong in 2008, but it didn’t fool the labor unions. They know who will pay the “Cadillac” tax, which is why repealing it is among their highest priorities.

Many Republicans in Congress remember this history too, which is another reason they feel no need to come to the tax’s defense. Moreover, they played no part in passing the ACA and so they see no reason to take political heat for one its least popular provisions.

The “Cadillac” tax is also a far-from-ideal solution. While it is true that the effect of the tax will be similar to a more straightforward limitation on the tax preference for employer coverage, they are not entirely interchangeable. The “Cadillac” tax applies a uniform 40 percent excise tax on all premiums above the threshold. Some employers will not adjust what they offer and will therefore pay the tax and pass on the cost of it to their workers, perhaps in the form of lower wages. If that is the case, the tax would be felt in the form of a fixed, per worker cost, which means it would be regressive. By contrast, a limitation on the tax preference for employer-paid premiums would lead to higher taxable compensation for workers, which would impose higher costs on higher paid workers and lower costs on the lowest paid employees.

The “Cadillac” tax is also written to affect increasing numbers of employer plans as the years pass. The thresholds for applying the tax are indexed to consumer inflation, not health-care cost growth, so more and more plans will bump up against as health spending rises more quickly than prices for other goods and services. The result is a projection of massive revenue growth for the government that is unrealistic and helped pave the way for more spending in the ACA than is really affordable.

And, yet, despite these problems, the “Cadillac” tax is far better than the alternative, which is open-ended subsidization of employer coverage and thus less discipline in the health sector.

It would be best if Congress were to replace the “Cadillac” tax with a simple and clear limitation on the tax preference for employer-paid premiums, as is called for the House GOP’s “Better Way” health plan. That approach is fairer and more transparent. The limits can also be set to raise a more realistic level of revenue over time.

But until Congress is ready to replace the “Cadillac” tax with something better, they should leave it in place. No, it’s not ideal. Yes, it was passed as part of the ACA, with all of the problems that come with that. But it is close enough to what would be ideal that it would be foolish to get rid of it without replacing it, despite the unpleasant way it was conceived and enacted by Congress.

James C. Capretta is a resident fellow and holds the Milton Friedman chair at the American Enterprise Institute.