Taxing Employer-Provided Benefits

On this page: Taxation

Background

Employer-provided benefits, such as pensions, health insurance, group term life insurance, etc., are excluded from both taxable income (for the income tax) and taxable wages (for the payroll taxes). Employee contributions to retirement savings, such as 401(k) plans, are excluded from the income tax, but subject to the payroll tax.

This tax break may encourage an undesirable “overuse” of the benefits by reducing their after-tax price. For example, many argued that the unlimited exclusion for employer-provided health insurance created an incentive to obtain more expensive coverage, offered no incentive for health cost containment, and provided greater benefits to more affluent taxpayers. It violated the neutrality and equity principles by creating disparities between different forms of compensation and distorting relative after-tax prices.

To address this problem, the Patient Protection and Affordable Care Act imposed a 40 percent excise tax on “Cadillac” (overly generous) health insurance plans exceeding certain cost thresholds. The tax is scheduled to go into effect in 2018 and apply to health plans per se, as well as to various tax-preferred accounts such as health-savings or flexible-spending accounts that are used to pay for health care.

 

TAX EXPENDITURES AND INCENTIVES: Policy

Taxing Employer-Provided Benefits: Policy

Pensions

In this policy: FederalStateTaxationincome taxpensions

Lawmakers should maintain the tax-deferred status of employer-provided pensions as a critical way of promoting retirement savings.

Health insurance

Eligibility for the exclusion for employer-provided health insurance should be determined based on the employer’s coverage rules.

When structured correctly, the exclusion for employer-sponsored health insurance may be an important method of encouraging health insurance coverage. Limiting the health insurance exclusion to amounts below some threshold, and using the revenue thus derived to finance health insurance for low-income or uninsured families and individuals, makes the tax system more neutral and equitable and may be a factor in slowing the growth of health care costs. (For discussion on implementation challenges, see Chapter 7, Health—Individual- and Employment-Based Group Plans; and Chapter 7, Health—Retiree Health Coverage.)

Other benefits

In this policy: FederalStateTaxationemployment benefits

Additional new limitations on the exclusions for other employer-provided benefits, such as life insurance, tuition, and parking, are a desirable method of broadening the tax base and making the income tax more progressive.