The Right Health Care Fix Could Help Save Social Security

With the nation’s health care system on the operating table this year, Washington’s policy surgeons have focused so intently on their outsized patient that they seem not to have noticed that Social Security is attached at the hip. That’s unfortunate, because a clearer recognition of the interconnectedness of the two policy challenges could make it easier to solve both.

On top of Social Security’s demographic challenges that will leave fewer workers contributing payroll taxes per retiree, spiraling health costs mean that a bigger portion of worker pay will be devoted to non-taxable health benefits. Social Security’s actuaries project that as rising health insurance costs outpace economic growth, untaxed compensation will increase from less than 19% of total pay to nearly 31% over the next 75 years.

Changing this trajectory – by changing the tax-free status of employer-provided health insurance – could have a measureable impact on Social Security’s finances by bringing in more payroll tax dollars, along with more income tax and Medicare payroll tax dollars to help pay for a broad expansion of health care coverage. Yet unlike other approaches to raising tax revenue, limiting the tax exclusion for employer-sponsored insurance offers a big side benefit: It could help to restrain out-of-control health care costs that pose a major threat to the nation’s fiscal and economic future.

Economists point to the tax-free status accorded to health insurance acquired through the workplace as among the reasons that the U.S. spends much more per-capita on health care than other developed nations, though without deriving better outcomes. Making employer-provided health insurance tax-free distorts economic behavior by creating an incentive for more expensive policies with low deductibles and co-pays that limit a worker’s taxable out-of-pocket health costs. This, in turn, has the effect of putting distance between consumers and the consequences of their health care spending – namely, the bills.

Intuitively, this would seem to create the conditions for people to consume more health services than they need, while greasing the skids for the health care industry to raise prices. And closer analysis bears this out. A paper by economist Jason Furman published in the spring of 2008 – before he became the Obama campaign’s economic policy director and a White House economic adviser – cited studies suggesting that ending the tax-free status of employer-provided insurance could lead to a 9%-38% drop in health spending by the privately insured, with “little if any worsening in health outcomes.”

Thus, unlike the surtax on the wealthy that Democratic leaders in the House have proposed to pay for health care reform, curbing or phasing out the tax benefits for employer-provided care could help to ensure that health care reform doesn’t just offer short-term pain relief – subsidies to make insurance attainable for the tens of millions without it – but contributes to a cure that keeps coverage affordable over the long term. Despite this logic, and with centrist Democrats apparently cool to the House’s surtax on the wealthy, there is much doubt as to whether Washington can come up with the $1 trillion-plus realistically needed to pay for health care reform.

One of the principal reasons many Democrats have resisted the idea of taxing employer-provided health insurance is that doing so could raise the tax bills of middle-class households, contrary to President Obama’s pledge to shield households earning less than $250,000 from tax hikes. Yet broadening the focus to include not just health care reform but Social Security as well could help to inform this debate.

A review of the three proposals on the table that might provide a starting point for a Democratic-led Social Security fix – including the two co-authored by current White House advisers Peter Orszag and Jeffrey Liebman and one by former Social Security commissioner Robert Ball (scored by the actuaries in 2005) – reveals that each prescribes payroll tax increases on all wage earners. This isn’t surprising because any realistic path to closing Social Security’s shortfall without a broad-based tax increase would be likely to weaken the safety net for both the disabled and the very old.

So the real question isn’t whether the middle class will face a bigger tax bill, but what kind of tax increases are most likely to produce constructive economic outcomes and the highest standard of living. In this context, limiting the tax exclusion on employer-provided health care appears much more attractive.

If economists are correct that taxing employer-provided coverage can help restrain health care costs by removing counterproductive incentives and making health spending more transparent, then the result wouldn’t just be increased tax revenues; slowing the growth of worker compensation devoted to health spending would also produce higher wage growth.

In the context of Social Security reform, there’s another reason that closing a portion of the financing gap by taxing employer-provided health coverage should appeal to those who wish to preserve a strong retirement safety net. Any extra portion of compensation that would be taxed as wages would raise a worker’s career earnings level and result in a bigger monthly benefit check relative to other means of closing that gap. By contrast, while raising the payroll-tax rate would reduce the need for benefit cuts, the extra tax dollars wouldn’t yield additional benefits under Social Security’s formula.

Just how far could taxing employer-provided care go toward closing Social Security’s deficits? At least on paper, eliminating the tax exclusion starting in 2014 could erase 48 percent of Social Security’s full 75-year cash-flow gap, or nearly 70% of the narrower problem that treats the $2.4 trillion trust fund as money in the bank. But the extent to which Social Security’s financial improvement would flow through to the overall budget would depend on how much of the extra Social Security payroll-tax dollars – nearly $6.5 trillion in present value over 75 years – are counted on to pay for universal health care. At least initially, the health care plans on the table that tax all employer-provided care as wage income would rely on most of the extra payroll-tax dollars to expand coverage, yet Social Security would owe extra benefits worth $2.7 trillion in present value on these additional payroll-tax contributions.

A far less abrupt and perhaps more politically realistic approach than eliminating the tax exclusion for employer-provided coverage would target the savings that would come from slowing the growth of payroll-tax-exempt health spending to the overall growth rate of the economy. My analysis shows that this would still close about one-fourth of Social Security’s official trust fund gap.

Initially, this tax change could be designed to impact those with the richest benefits packages, while keeping more affordable coverage options tax-free and without penalizing employees of companies whose policies cost more because their workforces are older. Over time, limiting the growth of non-taxable compensation to the growth rate of the economy could act as a restraining influence on even relatively moderate-priced plans.

Few options for raising taxes have such a clear rationale. When rising health costs are among the biggest threats facing both government and household finances, it simply makes little sense to provide tax incentives that facilitate those price increases, put health insurance out of reach for more Americans and undermine Social Security’s future.

Jed Graham is author of A Well-Tailored Safety Net: The Only Fair and Sensible Way to Save Social Security due out from Praeger in late 2009. He writes about economic policy for Investor’s Business Daily, but the views here don’t represent the opinion of IBD.