The Problem. The treatment of lower-income workers and families eligible for employer coverage is a difficult challenge for health reform. Many of these workers struggle to afford their rising contribution requirements. Recent survey findings indicate that 38 percent of workers eligible for employer coverage and with incomes under 200% of the federal poverty level (FPL) decline to participate, and over 20 percent remain uninsured.

But subsidy policies that would invite a shift from employer- to federally financed coverage would be very costly. According to the Census Bureau, of all non-elderly people with employer coverage, 47 percent have incomes under 400% FPL,  the income threshold for premium-credit subsidies available through the Exchange under the Senate HELP and House Energy and Commerce Committee bills. Almost 30% have incomes under 300% FPL, the subsidy level reportedly being considered by the Senate Finance Committee.

Of people in the Committees’ core (common) Exchange subsidy eligibility range of 150% to 300% FPL, 38 million had employer coverage—2.5 times the 15 million who were uninsured.

To avoid a costly shift from employer to public financing, Committee-approved plans establish a “firewall” blocking subsidized coverage in the Exchange unless the worker’s share of employer plan premiums exceeds 12.5% (Senate HELP Committee) or 12% (House) of family income. But those amounts would deny access to reasonably affordable coverage to many lower-income workers.

The Solution. A progressive sliding-scale tax credit toward modest-income workers’ contribution costs could address this problem. Changes in existing tax policies regarding  worker contributions could (more than) pay for the new credit. For example, a sliding-scale tax credit for low-income workers would cost less than revenue that could be recaptured from employer tax savings on workers’ contributions.

These policies could be implemented earlier than other health reforms, because they do not rely on individual market reforms, individual mandates, Exchanges, or other subsidies. They would provide needed relief to millions of workers and families who are not assisted under Committee-approved plans to date.

Subsidy Structure in Current Proposals. Current proposals address the affordability question primarily by making sliding-scale subsidies available to people whose income falls below a specified threshold (noted above) and who purchase coverage through an authorized “Exchange” (called a “Gateway” in the Senate HELP Committee bill).

But, due to the “firewalls,” more affordable access would not be extended to many modest-income workers who are eligible for employer coverage. They would receive only current tax benefits that apply to all employment-based coverage, including the ability to shelter their premium costs from income and FICA (payroll) taxes by using an employer “Section 125 plan.” About 90% of worker contribution dollars are so sheltered.

The value of this tax sheltering is less for lower- income workers, who have lower income tax rates. And a given premium amount by definition constitutes a higher percentage of their lower income.

As Exhibit 1 shows, out-of-pocket premium costs for low-income workers, net of tax benefits and premium subsidies, are often considerably higher for employer coverage than for subsidized Exchange coverage under current proposals. (And this comparison understates the problem, given the wage concessions often made for employer contributions.) [All exhibits can be enlarged by clicking on them.]

Thus, the proposed “firewalls” in the Committee-approved bills would leave many lower-income workers with unfair cost burdens. Although intended to avoid shifts from employer to public financing, they would create strong incentives for such workers and their employers to alter employment arrangements (e.g., convert to part-time or out-sourced positions with higher wages) in order to qualify for subsidized coverage in the Exchange.

Firewalls have not caused such “crowd-out” to date in Massachusetts, where very few workers on employer coverage have incomes low enough to qualify for subsidies.  Employer groups are far more likely to respond to incentives to reduce costs for the substantial share such workers represent nationally.

A Targeted Affordability Credit. At present, workers facing unaffordable premiums can decline coverage. To fairly achieve coverage of these workers under health reform, they need to have access to coverage they can afford. Exhibit 1 shows that, even if provisions regarding employer-contribution minimums are enacted, many lower-income workers could still not afford coverage.

An affordability tax credit to offset lower-income workers’ contribution costs for employer coverage could both make such coverage more affordable for these workers and reduce federal costs by discouraging crowd-out of employer contributions. The credit could be used in lieu of Section 125 tax exclusions, which are of limited value to lower-income workers.

An illustrative credit could slide down from 80% of the worker-paid premium for those under 100% FPL to 35% for workers up to 250% FPL. Higher-income workers would receive savings equal to those under current Section 125 plans. This “Low-Income Credit” schedule is shown in column 1 of Exhibit 2, which also displays other alternatives referenced below, as well as current tax rates applicable to Section 125 plans.

The credits could be administered through employers in the same manner as COBRA premium subsidies under the stimulus packag, i.e., the employer would reduce its payroll tax payments to the federal government by the amount of the credits. Workers would submit a federal tax form to the employer indicating the percentage credit to be applied (as informed by a federal schedule given the worker). Details regarding applicable income periods, income tax reconciliation, and other factors would need to be determined.

The impact of alternative credit approaches on workers’ net out-of-pocket premium costs relative to income is illustrated in Exhibit 3. The illustration is for a family of four purchasing employment-based family coverage at average premiums and typical employer contribution rates in 2009 (projected based on the Kaiser/HRET Survey of Employer-Sponsored Health Benefits, 2008).

Costs. The total federal revenue loss due to use of Section 125 for worker-paid health insurance premiums was about $45.2 billion in 2008.  (Using data from the 2004 MEPS employer survey, we determined that about 20% of the tax expenditures associated with employer coverage are due to use of Section 125 plans to tax-shelter the employee share of premium.) We estimate that, if the Low-Income Credit had been in place in 2008, if Section 125 remained available to higher-income workers, and if there had been no change in enrollment in employer plans, then the total federal revenue loss would have been $50.7 billion in 2008, or about $5.5 billion more than under current law.

We believe employers would not change contribution levels in response to the proposed credits for several reasons. Since only 7% of all persons with employer coverage have incomes under 150% FPL this low, the high credit percentages for such workers should not cause employers to drop their contribution share—given that employers would be prohibited from contributing less to lower- than to higher-wage workers. Also, the 35% tax credit for incomes between 200% and 250% FPL is no higher than the combined federal and state tax subsidies often realized under Section 125 plans for the majority of workers on employer coverage. Further, the financing source described next should reduce employer incentives to shift premium costs to the worker.

Offsetting Savings. The additional cost of the Low-Income Credit could be more than offset by making changes so that employers no longer realize tax savings for workers’ contributions under Section 125. Under current law, when a Section 125 plan is in use, the amount of premium payments withheld from workers’ pay is completely excluded from the worker’s income for both income-tax and FICA payroll-tax purposes. Workers thus pay neither income taxes nor Social Security (6.2%) and Medicare (1.45%) payroll taxes on earnings deducted from their paychecks to pay health insurance premiums.

Importantly, this also means that the worker’s employer does not pay payroll taxes (total 7.65%) on the amount of income the worker pays for premiums through a Section 125 plan. (This curious policy derives from the rationale underlying Section 125 tax sheltering of premium payments withheld from workers’ pay—the “legal fiction” that these worker contributions are employer contributions.

We estimate federal spending on this employer tax shelter to be about $9.4 billion in 2008 (or well over $100 billion over 10 years!). Part of this tax spending ($1.8 billion) is automatically recaptured by the basic design of the Low-Income Credit, because low-income workers using the credit are not using Section 125. Recapturing the remaining $7.6 billion would exceed the estimated $5.5 billion net cost increase for the new Low-Income Credit by $2.1 billion.

The $2.1 billion net savings could finance tax credits for other low-income workers who now decline coverage but would be “firewalled” from assistance under current proposals. Any remaining net savings would reduce affordability credit costs for other workers receiving credits for Exchange coverage. We do not have data adequate to estimate these respective costs.

These savings could be captured without increasing higher-income workers’ net contribution costs, and without varying from the conventional 50-50 FICA share for workers and employers. First, Section 125 could be changed to parallel treatment of worker contributions to section 401(k) plans—worker-paid premiums would be excluded from income only for income tax purposes and not for payroll tax purposes. Then, to compensate higher-income workers for their loss of payroll-tax savings (the credit for low-income workers would already substantially exceed their loss of payroll-tax savings), workers above 250% FPL could be given a credit equal to 7.65% of the premiums they pay. (For workers earning more than the Social Security wage base—currently $106,800—this credit would be reduced to 1.45%, since the 6.2% Social Security tax does not apply to earnings above that level.)

Alternative tax credit variations could completely replace Section 125 plan tax sheltering of worker premium payments. Two illustrative schedules laid out in Exhibits 2 and 3 would provide a credit of 80% of worker contributions for those under poverty (who would also have access to Medicaid).

Alternative A would follow the Low-Income Credit schedule under 250% FPL but would continue to slide down to 20% of worker contributions for those at 251% FPL and above. Estimated net (annual) federal savings for 2008 would total $8.3 billion (more than $100 billion over 10 years). This alternative would: (1) result in only modest net cost increases for workers now enjoying Section 125 plan savings, and significant savings for those not currently enrolled in such plans; and (2) generate net federal revenues that could help finance a premium credit of comparable amounts for middle- income people enrolled in the Exchange, thus improving horizontal equity.

Alternative B would slide down more slowly to 10% of worker contributions for those up to 450% of poverty, with no credits for incomes above that level. Assuming no change in employer contribution percentages, estimated federal savings for 2008 would be $17.1 billion (or well above $200 billion over 10 years). Alternative B would: (1) afford greater horizontal equity relative to wage-and-salary workers ineligible for employer coverage receiving coverage in the Exchange (where no premium credits are proposed above 400% FPL); (2) increase after-tax costs by less than 1% of income for workers at 500% FPL who face typical employee contribution costs, and less for higher-income workers; and (3) result in net contribution costs within given employer groups (with varying employee contribution requirements) that represent comparable percentages of income across low- and middle income workers covering the same-size family (see Exhibit 4).

Addressing High Cost Sharing in Some Employer Plans. Some employer plans impose relatively high deductibles and/or co-payments and coinsurance. Such plans might not provide adequate financial protection for low-income workers and their families. These concerns could be addressed in either of the following ways:

(1) Give low-income workers a choice between staying with their employer plan, with a tax credit, or enrolling in subsidized coverage through the Exchange, with the employer required to make its “normal” contribution (on an age-adjusted basis) to the Exchange.

(2) Or give employers who object to sending their normal contribution to the Exchange “with the worker” the option to instead offer tax-credit-eligible workers a benefit package with lower cost sharing—one that meets the same actuarial-value requirements as Exchange plans will have to meet for subsidy recipients—and pay the same percentage of the premium that the employer pays for its standard plan.

Continuity. Health reform should facilitate rather than impede people’s ability to afford stable sources of coverage. For example, when a family enrolled in a worker’s employer plan suffers an income cut because the spouse is laid off, it should be able to get needed assistance for continued coverage in their current plan rather than being forced to switch to Exchange coverage (often temporarily) to get assistance, or being “firewalled” from assistance altogether. The tax credits outlined above would achieve that goal.

Similarly, laid-off workers should be able to afford to pay COBRA premiums to remain in their employer’s plan. Under Committee-approved bills, workers would have to purchase coverage through the Exchange in order to obtain public subsidies. When they find a new job offering health benefits, they would have to switch to that plan. Thus, two plan and enrollment source switches, often entailing provider changes, could be a financial imperative (given individual responsibility) within a relatively short period of time.

That is not the easy access that reforms are billed to achieve. Such impediments to stability of coverage source could be avoided if sliding-scale tax credits could be provided for COBRA coverage.

In conclusion, sliding-scale tax credits and associated policies would better target federal tax spending and better align incentives to avoid crowd-out of employer financing. It could also assure convenient, affordable, and more stable coverage for many modest-income workers who have suffered disproportionate costs and wage concessions to participate in employer coverage, or have remained uninsured due to unaffordable contribution requirements. We believe this would help fulfill the promise that reform will make coverage more easily accessible and affordable for working Americans.