David R. Henderson  

On Fringe Benefits I Blew the Equilibrium

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Three commenters whom I respect and whose work I respect--John Goodman, Tim Worstall, and Scott Sumner--made critical comments on my most recent blog post, "Fringe Benefits and Stagnating Wages." My basic point is right, but I blew the equilibrium.

I realized this when wondering why both John Goodman and Scott Sumner thought I had left out the tax on employers of 6.2% for Social Security and 1.45% for Medicare. Of course, I mentioned the tax, but told readers they could skip that paragraph. That was wrong.

Not only did I blow it on the margin, but also I blew it on the infra margin. Let me explain.

When the government taxes pay in money, it gives employers an incentive to pay in non-money form. One such form is employer-provided health insurance. So an employer deciding whether to pay an employee an extra $100 in pay will realize that that costs him about $105 (see my earlier post for why it's not $100 and why it's not $107.65.) The after-tax benefit to the employee is about $72. So the "tax wedge" is about $28 plus $5 or $33.

This gives the employer and the employee an incentive to agree on a pay package that includes untaxed fringe benefits. The first $100 will be the most valuable. Then the next $100 less valuable, etc. Where will it stop? That is, at what point is the employer indifferent between paying in cash and paying in health insurance? Here's the part I got wrong. It will stop when the value to the employee of an extra $100 is not $72, but $67.

But I also got something else wrong--on the infra margin. The hypothetical $15,000 that Arnold Kling discussed as an employer expenditure is not far off the mark. But I would be wrong to apply the 33% tax wedge to the whole thing. As I mentioned above, the first dollars spent on health insurance are worth more than the marginal dollars. So that value of that $15,000 to the employee, although it's not $15,000, is more than 67% of $15,000. It's only the last few dollars that are worth only 67%.


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COMMENTS (2 to date)
Tim Worstall writes:

"Three commenters whom I respect and whose work I respect--John Goodman, Tim Worstall, and Scott Sumner"

Well, that's my ego suitably boosted for the day. Now, if only we can get past the Scots at the rugby to really make the day.....

Shayne Cook writes:

David R. Henderson:

Arnold Kling's original post was highlighting the logical discontinuity of those who argue "stagnant wages", while blissfully ignoring wage costs of fringe benefits such as employer-provided health insurance. As summarized in his last paragraph:

"I should add that if somebody insists on not including fringe benefits in their calculations, you might ask them why then one should consider employer-provided health insurance a good thing."

You followed in your first post on this subject with some interesting arithmetic (corrected here, of course) illustrating just how "good" a thing the "un-taxed" employer-provided health insurance benefit is, and to which tax-benefited party.

Interesting stuff. Thank you - I hadn't previously thought of it that way.

But you also had a very interesting summary statement in the second to last paragraph of your original post:

"Of course, if it's the optimum (from the employers' and employees' perspective, not from society's perspective, because the tax treatment leads to over-insurance), there will be employees who value it less and employees who value it more." [My added emphasis]

Your summary statement leads to and illustrates a far more significant logical discontinuity in discussions about the employer-provided health insurance benefit. Stated as questions ...

Why is only employer-provided health insurance considered a benefit/"good thing", worthy of favorable treatment in the tax code? Alternatively, if health insurance is to be considered a tax-favored benefit/"good thing", why should it matter at all which taxed entity - employer, employee - writes the premium payment check? For that matter, if it is truly health insurance that is considered a benefit/"good thing", deserving of favorable (incentive) tax treatment, why should employment status matter at all?

A bit of accountancy clarification may be wanted here.

When an employer writes a health insurance premium check, on behalf of an employee, it is counted as a pre-tax adjustment (reduction) to gross revenue (income), either under "Selling, General and Administrative" category or "Cost of Goods Sold" category.

The important point is that the employer-provided health insurance benefit is "un-taxed" as an adjustment to employer gross income/revenue.

There is no equivalent line item contained in the bottom half ("Adjustments to Gross Income") of the first page of individual 1040 tax form - such that, any individual who pays their own (mandated) health insurance premiums is at least afforded the exact same favorable tax treatment (un-taxed benefit) as they they would have if their employer were writing the check.

That strikes me as a very gross logical discontinuity. As a matter of fact, David, the last paragraph of your original post even further served to illustrate:

"My second thought is that, as the letter writer to Arnold noted, there are other fringe benefits. One big one, that has grown in the last few decades, is employer contributions to 401(k) and 403(b) pension plans. ..."

There is, in fact, a similar "Adjustments to Gross Income" line item on the 1040 form for individual contributions to "Qualified IRA". (Although I would point out that both of those retirement contribution tax benefits (IRA and/or 401K, et. al.) are actually "tax-deferred" for the individual, rather than "un-taxed" for the individual.)

But again, why is there no "Health Insurance Premiums Paid" line item under the individual 1040 form "Adjustments to Gross Income" section, for those who write their own checks, rather than having an employer do it?

For that matter, if it is actually "Health Care Costs" that motivates Government to afford favorable tax treatment to "Health Insurance Costs" (currently only through employers), there is an even more gross logical discontinuity:

Why are individuals not also provided a line item in the 1040 "Adjustments to Gross Income" section for "Actual Incurred Health Care Costs (not covered by insurance)"?

I just love logical discontinuities. They lead to the most marvelous questions. As Arnold originally noted.


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