Battle #1: Taxing health benefits

NEW YORK (CNNMoney.com) -- As the debate on how to fix health care picks up pace, so does discussion about one of the most lucrative ways to pay for it: Scale back the tax break that workers enjoy for health insurance.

It's still a leading contender, but the idea faces political and practical headwinds.

If nothing else, those who would limit the benefit face the prospect of reducing a tax benefit that Americans have come to expect.

"[W]orkers and businesses do not see the employee exclusion as a 'tax subsidy' ... rather, they view it as duly-earned income that should be protected from the tax collector," the U.S. Chamber of Commerce wrote in a letter to Sens. Max Baucus, D-Mont., and Charles Grassley, R-Iowa.

Employers typically pay the lion's share of a worker's health insurance costs, and that contribution is treated as tax-free to the employee both in terms of income tax and payroll tax, which funds Social Security and Medicare.

The tax-free arrangement was born during the days of wage control in 1943, according to Paul Fronstin, director of the health research program at the Employee Benefit Research Institute. Since employers couldn't attract workers on the basis of better pay, they were allowed to offer tax-free health coverage as a way to compete for the best talent.

Fast forward 66 years, and today employers are Americans' primary and most affordable source for health insurance.

But in myriad ways, the system is far from perfect.

For starters, tax and health experts say, it's inequitable. High-income workers and those with the most expensive health insurance plans enjoy the biggest break as a result of the tax exclusion.

Not that anyone's really aware of that, though, which is part of the problem, experts say.

Workers don't know how much their health benefits really cost because they only pay a portion of the bill. So, the theory goes, they are more likely to consume health services they don't really need, which over time helps drive up health costs.

Moreover, the tax exclusion is not available to those who don't buy insurance through an employer, which contributes to the burgeoning ranks of the roughly 46 million uninsured.

Proposals to cap the exclusion may go a long way toward paying for the cost of reforming the system -- estimated at more than $1 trillion over 10 years.

Just how it's capped, however, will have a big effect on how much revenue can be raised. Comparing six different options, the Tax Policy Center estimates that limiting the exclusion could generate anywhere from $41 billion over 10 years to more than $1 trillion.

But judging from the issues raised by tax, budget and insurance experts at an Urban Institute forum this week, the idea is not as simple as it sounds.

"If policy makers wish to cap the amount of the employer exclusion without creating serious inequities, no perfect solution is available," Stan Dorn, a senior research associate at the institute, wrote in a paper released for the event.

Part of the problem is that setting a cap could mean some people will pay tax for reasons that seem unfair. That is, they could end up paying more than the cap not because their benefits are unusually generous or because they use more health care than most, but because of other factors. For instance:

• Where they live -- health care costs more in some places than others;
• Where they work -- if it's for a small business, chances are the health plan will cost more than average because the participant pool is too small to have much bargaining power;
• How healthy their coworkers are -- pools with older participants or many with chronic diseases tend to cost more.

Indeed, Dorn said at the forum, "health status is the primary force in setting premiums and you can't adjust for that."

There are different ways to set a cap, and different ways to ameliorate potential inequities. For instance, if a cap is based on premiums, it can be adjusted for regional variations.

But figuring out where a cap should be set may be complicated in other ways, since it's possible it will apply not just to the cost of a medical plan per se, but to the total amount of health benefits an employer provides, including dental and vision plans or on-site clinics.

And figuring out how to sell the idea on Capitol Hill will be equally complex.

Many tax and health experts favor a cap, as do some key Democrats and at least one leading Republican leading the charge on health reform for their parties.

But not all leading Democrats like it -- notably, the House's chief tax writer, Charles Rangel, D-N.Y. And President Obama has also been opposed, but he has indicated he may be open to negotiating the issue.

A cap is a no-go for unions. And there's been some talk that they could push to be exempt from any change because of their collective bargaining agreements.

Businesses aren't big proponents of a cap. But they may be ready to deal, even though they will have concerns about the potential cost and complexity of administering the change.

The U.S. Chamber of Commerce has already fired a shot across the bow on any union exemptions.

"Good policy should not be at the mercy of collective bargaining agreements -- if Congress decides to make this landmark change, the changes should apply to everyone," the Chamber said in its letter to Baucus and Grassley.

Just as proponents will need to sell influential lobbies on the idea, they'll need to sell it to the public, too. As with any tax, that may not be easy.

"It's got to look transparent and sensible," said Stuart Butler, vice president of economic policy at the Heritage Foundation. "I have to understand what I'm being taxed on."