Qualitative Section
Since 1954, employer-provided health insurance (EPI) has been exempt from the personal income tax
system. As a fringe benefit, EPI is deductible in the corporate tax system, but unlike wages, it is also
exempt from personal income tax. This exemption acts as a subsidy from the federal government and
creates an employee preference for being compensated in the form of health insurance relative to wage
by making EPI cheaper than privately purchased health insurance. The magnitude of the subsidy
depends on employees’ marginal income and payroll tax rates, but in general, the value of $1 in EPI is
greater than $1 in wages, given the tax exemption. As a result of this shift in relative “prices,” a number
of distortions occur.
First, because the marginal cost to employees of EPI declines, the exemption results in an increase in the
quantity demanded of EPI. The increased quantity of EPI may come in the form of both (1) new
insurance policies and (2) more generous coverage in existing policies, which may include lower
deductibles, lower coinsurance rates, and/or a broader scope of coverage (Pauly, 1974 and Manning,
1987). A study that examined household level health insurance data from 1953 and 1958 found that the
1954 tax exemption of EPI resulted in a 9.5% increase of group coverage (Thomasson, 2003).
Second, an increase in the number of insurance policies and/or the generosity of coverage results in an
over-consumption of health care. This is because having health insurance or having more generous
health insurance reduces an individual’s marginal cost of consuming health care due to coinsurance
rates being less than 100%. This creates moral hazard in that individuals are able to consume units of
health care for which the marginal cost is greater than the marginal benefit. Not only does
overconsumption of health care cause deadweight loss, but it ultimately leads to higher prices and
increased health insurance premiums, which further induce demand for insurance.
Third, the exemption of EPI perpetuates the link between employment and health insurance, resulting in
labor market distortions. Such distortions include (1) employees choosing an employer or job based on
the availability and/or coverage of EPI, (2) employees not changing jobs even when more productive for
fear of losing health benefits (“job lock”), or (3) employees not retiring because of health benefits
(Buchmuelle, 1996). These distortions are expected to be more severe for employees that are high
health risks or have pre-existing conditions.
Potential Justification of the Exemption
A common justification for the tax exemption of EPI is that it solves the problem of adverse selection.
That is, by drawing a larger and more diverse group of people into the risk-pool, the tax exemption
facilitates risk-sharing in employer-provided risk pools, which insulates against the impact of adverse
selection. However, there are several reasons why this justification is not entirely satisfying. First,
employers are not ideal risk-pools and do not represent random samples from the population. This is
particularly true in small firms as well as types of industries and jobs that are correlated with health
status.1 Second, increasing insurance coverage by subsidizing EPI results in deadweight loss because
doing so reduces the marginal cost of EPI to employees and, therefore, distorts their behavior. Lastly,
the tax exemption of EPI creates strong incentives to continue health insurance risk-pooling at the
employer level, a pooling mechanism that is certainly not ideal.
Results of Removing Exemption
As a result of removing the exemption, we expect the following to occur:

Decreased demand for EPI, in the form of reduced policies and decreased generosity of
coverage (higher deductibles, higher coinsurance rates, and more narrow scopes of coverage)

Increased cash compensation. Removing the exemption reduces employee preference for
compensation in the form of EPI as opposed to cash.2 The amount of the cash compensation
increase will depend on the amount of the subsidy and price elasticities of demand and supply
for EPI.

Decreased demand for health care. As the generosity of health insurance coverage declines, the
private marginal cost of health care for those insured will increase, resulting in reduced
consumption.3

Reduction in labor market distortions, to the extent the link between employment and health
insurance is reduced. This effect may be small in short-run because of sticky wages and
contracts, but would likely increase in the long-run.
Limitations of our Analysis (GOES SOMEWHERE IN QUANTITATIVE SECTION)
The following is a list of relevant issues that were not excluded from our analysis. All of the following
are likely to result from removing the tax exemption of EPI, but were not quantified in our analysis:

1
Reduce revenue
o Possible increases in AMT tax burdens due to increased taxable income.
For example, coal miners are not able to risk-pool in the same manner as, say, general office workers.
EPI will still exist in the short-run and in the long-run to the extent that there are advantages to EPI over privately
purchased health insurance, such as reduced administrative costs, improved risk-pooling, superior ability of
employers to choose plans and negotiate premiums, avoidance of significant search costs for employees, etc.
3
There will also likely be a related effect on R&D for medical procedures and technologies. To the extent that
people are no longer consuming health care services and technologies with low cost-effectiveness, incentives to
research and develop such technologies will be reduced.
2
o

Increases in section 213 deductions of health expenditures greater than 7.5% of
expenditures.
o Increased usage of FSA, HSA, and HRA’s as tax shelters for medical expenditures.
o Increased EITC refunds as adjusted gross income increases for qualified individuals who
also receive EPI.
o Shifting of employed individuals into self-employment in order to take advantage of EPI
tax deductibility for self-insured individuals.
o Increased state and local tax liabilities due to increased taxable income at the federal
level could result in a greater number of individuals itemizing.
Increase revenue
Buchmeuller, Thomas C. and Robert G. Valletta. “The Effects of Employer-Provided Health Insurance on
Worker Mobility.” Industrial and Labor Relations Review, Vol. 49, NO. 3 (Apr., 1996), pp. 439-455.
Manning, Willard G., et al. “Health Insurance and the Demand for Medical Care: Evidence from a
Randomized Experiment.” American Economic Review, June 1987, 77(3), pp. 251-77.
Pauly, Mark V. “Overinsurance and Public Provision of Insurance: The Roles of Moral Hazard and
Adverse Selection.” Quarterly Journal of Economics, February 1974, 88(1), pp. 44-62.
Thomasson, Melissa A. “The Importance of Group Coverage: How Tax Policy Shaped U.S. Health
Insurance.” The American Economic Review, Vol. 93, No. 4 (Nov., 2003), pp. 1373-1384.