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The Incredible Shrinking Cadillac Tax

Josh Barro
Medical Progress Today
January 20, 2010

In October, when Max Baucus unveiled the Senate Finance Committee's version of Health Care Reform legislation, it was the first bill to include the "Cadillac Tax" on high-end insurance plans. Since then, the Senate watered down the provision twice, and last week it reached tentative agreement to do so a third time. Originally expected to raise $201 billion over ten years, this latest iteration would likely raise just $90 billion, according to the New Republic.

The Cadillac Tax is intended to serve a dual purpose—it raises money to finance insurance subsidies provided in the health bill, and it "bends the cost curve" by discouraging overly generous health plans. With each revision, it has become less suited to both aims. That means that health reform, if enacted, will be more economically costly and less effective at controlling costs than it could have otherwise been.

First, let's recap the shrinking frame of the Cadillac Tax. As originally proposed, the 40% tax would have applied (starting in 2014) to most family health plans costing more than $21,000. Twice, the Senate watered down the tax by raising the exclusion and creating additional exemptions. But major unions still threatened to oppose the bill unless it was weakened further.

Last week, the Administration and Congressional negotiators cut a deal with unions that raises the initial exclusion level to $24,000, and excludes dental and vision benefits from taxation entirely. Most importantly, collectively bargained plans will be exempt from the tax entirely until 2018, four years after other plans become taxable.

Officially, this sop to the unions is designed to avoid taxation on plans that were bargained before the tax was passed. But, because nobody will be subject to the tax until four years from now, the "not enough lead time" justification is thin. The real reason is that unions don’t want their health care cost curve bent. (For a more detailed discussion on why the tax bends the cost curve, see here.)

So, what are the consequences of weakening the tax? One is that the lost revenue (a $58 billion drop from the bill the Senate passed in December) will inevitably be replaced with some other tax increase that is more economically damaging. Another is that fewer health plans will be hit by the tax, reducing incentives to cut health care costs.

Replacement revenue will most likely come from boosting the Medicare Tax hike on high-income people already included in the bill. But to raise an additional $60 billion in this manner would require upping the rate from 0.9% in the Senate bill (and 0.5% in the original version of the Senate bill) to over 1.5%, meaning this "little" tax hike won't look so little anymore.

While the Cadillac Tax could be expected to raise revenues at little economic cost, raising marginal tax rates on high-income people is one of the most expensive ways to raise additional government revenue.

The Tax Foundation's Robert Carroll estimates that the reinstatement of 36% and 39.6% tax rates on earned income for top earners (a policy with similar economic incidence to the Medicare Tax surcharge) will result in 67 cents of lost economic activity (or "excess burden") for every new dollar of revenue. By contrast, the income tax as it stands today only imposes about 11.5 cents of excess burden per dollar of revenue.

The Cadillac Tax is an unusual policy creature—a way to raise government revenue that has ancillary economic benefits. Replacing it with an economically costly income tax benefits certain recipients of high-end health plans, but it’s not good for the economy or the country as a whole.

The union exclusion may be less of a concern. The $24,000 initial threshold is very high (the average family health plan premium is just $13,300) so few plans will be impacted in the tax's early years. But because the tax is indexed to the Consumer Price Index plus 1%, it will affect more plans over time, as insurance premiums tend to rise significantly faster than inflation.

Union members are disproportionately likely to have "Cadillac" style plans, so taxing them is important if the tax is to help control costs. But the special treatment runs only for the first three years, when the tax is least important anyway.

The greatest concern is that Congress might extend the union exclusion past 2017, a frequent occurrence with supposedly "temporary" tax provisions. They could even do this through the budget reconciliation process, meaning that only 51 votes would be needed in the Senate. So, we won't know how much the provision has been defanged until we start seeing union plans taxed in 2018.

Josh Barro is the Walter B. Wriston Fellow at the Manhattan Institute.

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