Tax policy will be front and center next year no matter the outcome of the election as key provisions of the 2017 Tax Cuts and Jobs Act are set to expire in December 2025. Congress can make the challenge of keeping rates as low as possible consistent while also narrowing budget deficits by curtailing wasteful tax breaks, starting with today’s exorbitant and distorting subsidies for job-based health coverage.

The full exclusion of premiums paid for employer-sponsored insurance (ESI) from income and payroll taxation is profligate. The Office of Management and Budget (OMB) estimates it cost the Treasury $0.3 trillion in 2023 and will drain another $5.6 trillion from the government’s receipts over the coming decade. It is far and away the most expensive tax break in federal law.

It is also regressive and distorts both labor and health care markets by encouraging excessively generous and loosely-managed health insurance at the expense of taxable wages and salaries. An annual survey of employers found the average premium for ESI family coverage was nearly $24,000 in 2023, up from $19,600 in 2018. The Treasury Department has estimated that 88 percent of the tax benefits of the ESI exclusion goes to households with above median incomes. The tax benefit goes to everyone enrolled in employer plans, even top executives who can afford health insurance without government support.

Subsidizing health coverage through a tax break was not a carefully considered policy. During World War II, employers attracted workers by offering health insurance to supplement regulated wartime wages. The IRS reacted to this development by clarifying that these benefits would not count as taxable compensation for the affected workers. This favorable ruling enhanced the value of ESI and hastened its rapid take-up. In time, employers began to see offering ESI as necessary to attract the best workers.

ESI is politically resilient because it is the gateway to private insurance coverage for the American middle class, which is its major advantage. Without ESI, the US might gravitate toward full public control of the insurance market, which would risk replicating the struggles of the British National Health Service. New Census data puts ESI enrollment at 54 percent of the total population, or 178 million people, in 2023.

The Affordable Care Act (ACA), approved by Congress in 2010, imposed new rules on ESI but did not end it. Its “Cadillac tax,” a new levy on employers offering ESI plans with costs over an annual threshold, was a somewhat clumsy effort to limit the tax subsidy without admitting that was the objective. It still faced stiff resistance from businesses and labor unions, which led to Congress repealing it in 2019.

It is not necessary to retain the current tax break to prevent ESI erosion. Even with a limit on the subsidy, workers would enjoy valuable tax-preferred insurance that would be a better value in most cases than the alternatives.

A redesigned tax break should adhere to a few simple principles.

• First, it must be limited in some way so that both employers and their workers are encouraged to buy cost-effective plans. Under current law, when an ESI plan costs more, the federal government pays for about one-third of the added costs. A redesigned subsidy should eliminate government financial support when the costs of coverage go beyond an acceptable threshold.
• Second, it should provide the same level of subsidization irrespective of the incomes of the workers. Today’s tax break favors high-wage employees because its value increases in tandem with the income tax system’s progressive rate structure. For instance, the exclusion of a $25,000 ESI premium from taxable compensation is worth $9,250 to workers in the 37 percent income tax bracket and $2,500 for those paying at the 10 percent rate. A fixed tax credit per worker would be fairer.
• Third, the tax subsidy should encourage employers to adopt best practices in their insurance plans. In particular, these plans should incentivize workers to use high-value medical providers by allowing them to share in the savings from more efficient use of services.

A common argument against reforming this tax break is that employers already have strong incentives to economize but are stopped by forces beyond their control. The evidence suggests otherwise. There are known pathways for cutting costs, such as reference pricing, that employers forgo because they are reluctant to get out in front of their competitors with controversial benefit changes.

Congress needs to change the rules so that all employers are incented to cut costs to avoid paying for coverage with after-tax money. A sensible reform could preserve ESI as a valuable fringe benefit but with much less expense to the federal budget and more cost discipline in the provision of medical care.

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