Third party payment in health care (part 2)

Yesterday I explained that there is a tradeoff between employer-provided health insurance and wages, and that health insurance provided by an employer looks less expensive to the employee than it is. Today I want to focus on the second element of the “third party payment” problem, the tax treatment of employer-provided health insurance.

The tax system is biased in two ways:

  1. It gives more tax relief to those who get health insurance through their job, penalizing people who buy it on their own; and
  2. It gives more tax relief for more expensive health insurance policies, penalizing people who choose to purchase inexpensive policies, pay for routine care out-of-pocket, and take higher wages instead.

Let’s return to the Thompson family from yesterday. They had a combined income of $80,000, and got a $12,000 family health insurance policy through Kelly’s job. Kelly’s employer paid $9,000 of the premium, and the Thompsons paid the other $3,000. Now we’re going to introduce taxes into the discussion.

Remember from yesterday that in 2008 Kelly’s total compensation looked like this. We were ignoring taxes at the time:

Total amount Kelly’s employer can afford to employ her $69,000
minus 3/4 of Kelly’s $12,000 health insurance premium – $9,000
equals Kelly’s salary = $60,000

Kelly and her husband Chet will pay income taxes on the $60K of wages — they’re in the 25% income tax bracket. Kelly will also pay 7.65% of $60K ($4,590) in payroll taxes. Her employer will pay the same amount on her behalf. As in the discussion yesterday about health benefits, those employer-side payroll taxes are actually a part of Kelly’s compensation, but invisible to her. So, from her employer’s perspective, Kelly’s compensation actually looks like this:

Total amount I can afford to employ Kelly $73,590
minus payroll taxes I pay on Kelly’s $60K of wages – $4,590
equals Kelly’s post-employer-side payroll tax compensation =$69,000
minus 3/4 of Kelly’s $12,000 health insurance premium – $9,000
equals Kelly’s salary = $60,000

Notice that Kelly’s employer pays payroll taxes on her $60K of wages, but not on the $9K he pays of her health insurance premium. The amount of the premiums paid by her employer is exempt from payroll taxes.

The same is true for the payroll taxes and income taxes that Kelly pays. She calculates these based on $60K of wages, not on $69K of compensation.

This is called a tax exclusion for employer-provided health insurance. A deduction is when you pay no income taxes. An […]