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December 6, 2012
The Deliberate Creation of the Most Expensive Tax Preference
Joseph J. Thorndike

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The employer-provided health insurance exclusion is the largest single tax expenditure, with a price tag of $164 billion in fiscal 2014. That's a lot of scratch in cash-starved Washington, and a few brave souls have fingered the preference as a possible revenue raiser in the fiscal cliff negotiations.

Of course, economists love the idea because they hate the preference in the first place. They offer a litany of legitimate complaints, ranging from regressivity to market inefficiency. The preference has nothing to recommend it, they insist.

Worse still, its creation was a historical accident. "It was just a way to allow employers to evade the wage and price controls of World War II," MIT health economist Jonathan Gruber told NPR last week. "And it's sort of grown exponentially since, and there really isn't a single healthcare expert who would design a system from scratch which would include this feature."

The notion of the healthcare exclusion as accidental is popular. It pops up in many discussions of tax and budget reform. And in some respects it's accurate, if by "accidental" we mean "having unintended consequences."

But in history, unintended consequences are the rule, not the exception. Few actions play out exactly as anticipated. And that's certainly the case with the healthcare exclusion. The tax preference itself was not, in fact, accidental. It was a deliberate addition to the law, designed to solve a particular problem at a particular time. Over the years, that solution created its own set of problems. But you could say much the same thing about almost any other tax provision, including the introduction of the income tax itself.

(Imagine this conversation between President Wilson and Rep. Cordell Hull: "I like this income tax and all, but think of all the compliance costs and disincentive effects coming over the next several decades -- I think we should hold out for the efficiency benefits possible under a progressive consumption tax like the one David Bradford is going to propose in half a century or so.")

So before we dismiss the healthcare exclusion as some sort of terrible mistake made by a group of benighted politicians, let's take a look -- with at least a modicum of sympathy -- at why they made the decisions they did. Because at the time it happened, creating the health insurance exclusion wasn't a crazy idea.

Wartime Creation, Sort Of

To some degree, fringe benefits have been treated well by the tax law since 1913. "The U.S. income tax has always excluded some forms of compensation from the individual income tax base, while employers have always been allowed to deduct the cost of fringe benefits as well as wages from their taxable incomes," Robert W. Turner wrote in The Encyclopedia of Taxation and Tax Policy. "Employer contributions for accident and health insurance plans were nontaxable in the original income tax in 1913, although there was some ambiguity about the tax status of fringe benefits until the Internal Revenue Code of 1954."

The Congressional Research Service has reached a similar conclusion about the tax status of health benefits, at least in terms of its ambiguity. "Prior to 1954, there was no statutory provision that explicitly allowed an exclusion for coverage under employer-provided accident and health insurance," according to a 2008 CRS report. "Regulatory rulings shortly after the modern income tax began had conflicting outcomes, first providing that premiums on life, accident and health insurance were considered income to employees but then saying they were not, at least in the case of group life coverage."1

That ambiguity, however, did not impede the dramatic expansion of employer-provided health benefits that came during World War II. Indeed, the war provided a strong incentive for that expansion in the form of wage and price controls. In an effort to constrain inflation, the federal government established strict limits on employment compensation, making raises difficult during a time of acute labor shortages.

As Robert B. Helms, a resident scholar at the American Enterprise Institute, has pointed out, fringe benefits soon emerged as a way to skirt the rules. Convinced that discretion was the better part of valor, the National War Labor Board (NWLB) allowed the workaround, finding that employer-provided pension and health benefits were exempt from wage controls -- a conclusion that echoed the existing tax treatment of those benefits.2 In general terms, this decision mirrored the tax treatment of the benefits in then-current law (although that treatment was still the subject of some debate).

The NWLB decision was not intended to encourage the provision of those health benefits by employers. Its goal was price stability, first and foremost. And in that respect, it was an eminently sensible decision. "The problem though was that we had to keep down inflation," said a member of the NWLB. "So we agreed to allow increases in various benefits that we felt would not be inflationary -- vacations, insurance, and so on."3

Workers and employers, of course, were less concerned about intentions and more focused on opportunities. The NWLB's move "opened the floodgates to the institution of employee benefits programs as unions and management sought wage increases under the guise of 'fringe adjustments,'" according to sociologist Beth Stevens. And later, when the NWLB rethought its decision -- because the new benefits were, in fact, proving inflationary -- both workers and employers successfully resisted any change.4

Stevens has emphasized that the NWLB decision was not a "disguised attempt" to encourage private sector health insurance as a substitute for publicly provided alternatives. Rather, it was a specific policy solution to a specific economic problem. In practice, however, it did help establish employer-provided health insurance as the new normal. By the end of the war, health insurance coverage under group plans had tripled.5

Postwar Consolidation

After the war, the newly ascendant system of employer-provided benefits found a permanent place in the U.S. political economy. Organized labor played a crucial role in the consolidation of this new regime, as unions worked to protect and expand the benefits available to their members. The rise of the mass income tax helped reinforce this effort, because it encouraged unions to focus on tax-exempt benefits, like health insurance and pensions, as an alternative to taxable forms of compensation.6

Meanwhile, federal tax officials were rethinking their generous view of health benefit taxability. In 1953 the IRS issued a revenue ruling that effectively reversed its previous stance, declaring employer contributions to employee health insurance plans to be taxable income for the employee. Congress, however, was having none of it, and lawmakers soon schooled the agency in the new realities of U.S. health policy. The Internal Revenue Code enacted in 1954 included section 106, clearly establishing such contributions as exempt from income taxes (and, in a separate section, exempt from payroll taxes as well).7

And the rest, as they say, is history.

Experiments in the 1930s

The history leaves open a crucial question of causality. Did government policies during the 1940s and 1950s drive the expansion of private sector health insurance, or did the expansion of that insurance drive the change in government policies?8 As the CRS has pointed out, "the historical argument about the importance of tax and regulatory policies may be overstated. Enrollment in group plans expanded steadily from 1939 onwards, starting prior to the tax ruling and regulatory changes."9

The accidental version of the health exclusion story is really a normative judgment dressed up as a historical fact. Politico, for instance, recently described the provision as "a vestige of the World War II era." And that's probably true, in the same sense that the modern income tax is a vestige of the war, too.

And in fact, the war was crucial to the creation of the health insurance preference. But as the CRS has noted, the ascendance of employer-provided health insurance actually began in the 1930s, when Franklin Roosevelt's New Deal changed the way Americans thought about government, business, and economic security.

Yale University historian Jennifer Klein has made that point convincingly in her influential work on private sector employee benefits:

    As a result of New Deal legislation, the national government, for example, would directly intervene in financial, agricultural, housing, energy, and labor markets. The state entered the formerly insular employment realm and compelled employers to pay minimum wages, old-age pensions, and unemployment compensation and to recognize unions and maximum-hours restrictions.10

Those state actions encouraged labor unions and other social groups to pursue health benefits for their members, Klein says. Indeed, those groups were the driving force in the transformation of healthcare then underway. Klein acknowledges that the war was important, but it was not the sole or even the primary factor in shaping this transformation. "It was the New Deal's promotion of security that impelled labor to seek new health benefits for its members -- not the War Labor Board and not wartime tax breaks," she writes.

So the bottom line is this: The war did prove pivotal in the creation of the health insurance tax expenditure. But employer-provided health insurance was already on a roll in the early 1940s, and the NWLB decision and 1954 tax preference just accelerated that process. The United States was moving toward a system of employer-provided benefits for a variety of reasons in the prewar years, not least the wholesale reconceptualization of labor relations that flowed from the New Deal. It seems likely -- or at least very possible -- that the impulse to make those benefits nontaxable might well have carried the day even absent wartime wage and price controls.


1 Bob Lyke, "The Tax Exclusion for Employer-Provided Health Insurance: Policy Issues Regarding the Repeal Debate," RL34767, CRS (Nov. 21, 2008), at 7, Doc 2008-25439 , 2008 TNT 234-18 .

2 Robert B. Helms, "Tax Policy and the History of the Health Insurance Industry," American Enterprise Institute (Feb. 29, 2008), at 7, Doc 2008-4453 , 2008 TNT 42-76 ).

3 Beth Stevens, "Blurring the Boundaries: How the Federal Government Has Influenced Welfare Benefits in the Private Sector," in The Politics of Social Policy in the United States 133 (1988).

4 Id.

5 Id. at 134.

6 Id. at 135.

7 Leonard Burman, "The Tax Treatment of Employment-Based Health Insurance," Congressional Budget Office (Mar. 1994) at 5, Doc 94-3339, 94 TNT 59-4 .

8 Lyke, supra note 1, at 9.

9 Id. at 10.

10 Jennifer Klein, "The Politics of Economic Security: Employee Benefits and the Privatization of New Deal Liberalism," J. Policy History 34 (Jan. 2004).