The Once and Future Cadillac Tax

Over the last few weeks, health economists have been defending the often politically friendless “Cadillac Tax.” This policy, as part of the Affordable Care Act, will begin taxing certain generous health insurance plans starting in 2018. Since World War II, the IRS has held that employer-sponsored health insurance should not been taxed, costing the federal government $329 billion in lost federal revenue. But, the most pivotal decision in the tax exemption status of employer-sponsored health insurance took place in 1954, not during World War II.

In 1954, when Congress extended the World War II provisions into permanent tax law, Congress decided to do away with the limits imposed on the tax-free status of health insurance. In essence, Congress has already repealed the Cadillac tax back when you could buy a new Cadillac for $5,000.

The Introduction of the Tax:

As part of the World War II price and wage controls, President Roosevelt’s National War Labor Board first put limits on wage increases and would not allow wages to increase greater than 15 percent of 1941 rates. Enterprising employers began offering health insurance coverage to recruit workers, because enticing workers with higher wages was not permitted. This forced the hand of the Board to address the tax status of health insurance.

Until this point, the tax treatment of employer provided health insurance had not been defined. In 1943, the Labor Board made the decision to allow employers to provide health insurance tax-free. They did this because their primary concern was that wage increases would cause inflation and they believed that health insurance was a negligible cost. They had evidence to show that this was true. In 1940, premiums accounted for 0.4 percent of disposable income and only 20.6 million people had private health insurance coverage. Their action, however, caused the number of people with employer-sponsored health insurance to skyrocket. Today, about 150 million people have their health insurance provided by their employer.

Reasonability provision

The National War Labor Board was still cautious of this benefit becoming unreasonable and put a limit on the amount of health insurance that could be tax-free in their 1943 decision. The Board ruled that tax-free health insurance expenditures must be less than five percent of annual salary.

This limit on the amount of money that an employer can spend on health insurance was not present in the 1954 law that cemented the tax treatment of health insurance. As noted earlier, the share of health insurance as a percent of income was much less than five percent. The policy makers of the time did not have a reason to believe that medical costs would rise to what they are today. Except they should have. The federal investment in medical technology has been had been growing at 10 times the rate of wage growth for the previous two decades.

Imagine a world where the “reasonability provision” had remained in law today, this would have held the tax-free benefit at 5% of income. The average annual premium for an employer-sponsored plan was nearly $17,000 with the employee paying $5,000 of that cost. This would be tax-free and “reasonable” in World War II if the average person were making $336,000 a year. Of course, this tax policy favors more generous benefits for higher earners and may have caused an even more inequitable health insurance system.

In today’s political climate, it is politically nearly impossible for lawmakers to impose taxes on large sections of Americans. The Cadillac tax is perceived – albeit wrongly – as a policy which could impact all people with health insurance through their employer, or half the population. In reality, first it would impact a smaller portion of the population and second, we had an upper limit to the taxing threshold before. The public and policy makers have neglected the history of this policy and the necessity to update our laws due advancements in health care and insurance.