the Cadillac Tax Is Coming!

This Article is adapted from a Forbes Article published in February 2014.

The Cadillac Tax was designed to raise revenue for the ACA. Most economists thinking seriously about the depth of our deficit agree that the Employer Sponsored Insurance (ESI) tax subsidy is a significant part of the problem. ESI subsidies date back to the freeze on wage increases during World War II. To offset the freeze, the ESI allowed companies to use pre-tax dollars to pay for generous health benefits tax-free.

The ability to funnel wages into health benefits is not just the purview of the wealthy. State and local government workers often find much of their compensation tied up in health benefits. Governments and many unions use the subsidy to compensate middle-income workers at a lower cost to the employer.

How the Cadillac Tax works

Rather than simply repealing the old tax structure, the Obamacare solution is an additional tax, a penalty imposed on “Cadillac” or very high cost health plans. It calls for a 40% excise tax on employer-sponsored plans spending more than $10,200 per employee (or $27,500 per family). This number includes employer and employee-paid premiums and employer contributions to Health Savings Accounts (HSAs) or Flexible Spending Accounts (FSAs). There will purportedly be some adjustment for areas where healthcare is more expensive and for employees in high-risk jobs, but the regulations have not yet been promulgated.

The purpose of the Cadillac tax is threefold: to address cost of the ESI, to help finance the Affordable Care Act (ACA), and to reduce employer incentive to overspend on health plans and employee incentive to overuse services encouraged by these high-cost plans.

The Congressional Budget Office (CBO) originally projected the tax would raise $137 billion over the first decade starting in 2013. However, due to effective lobbying by pro-union groups and others, the tax is delayed until 2018. Beyond its role as a funding mechanism, the Cadillac tax could have significant unintended consequences for employees and the health system as a whole.

Based on the plan size defined by the tax, in 2018, about 16% of employer-sponsored plans will be affected. However, if healthcare spending continues to exceed inflation, a greater percentage of plans will qualify as “Cadillac plans”—spending more than $10,200 per employee or $27,500 per family— each year. The tax is tied to the Consumer Price Index (CPI) +1% for the first 2 years of implementation but then just the CPI. If healthcare spending continues to grow at approximately 6% per year (the historic average, though it has grown at a lower rate in recent years), the Cadillac tax will swallow 75% of employer-sponsored plans by 2029.

The Cadillac Tax will change the way employers offer health coverage

First, employers will move toward reducing the cost of plans to avoid the tax, but not to curb overall health care spending.

The most obvious strategy for lowering employer contribution is to pass costs to employees, either as higher employee premiums, higher deductible plans, removing employer contribution to HSAs and FSAs, increasing co-pays and coinsurance, or just decreasing covered services. While these changes may avoid the tax, they will only decrease the healthcare costs of an employer’s work force if the employee then turns around and spends their healthcare dollars wisely. Alternatively, if employees just avoid healthcare they need due to cost, it could result in more expensive hospitalizations and sick days down the road.

Second, “high-cost” plans are not necessarily “benefit-rich” plans. Sicker populations, including the elderly and chronically ill, and populations with more women are simply more expensive to insure. Despite attempts to tailor their plans, employers will not be able to decrease their community rating if they have large numbers of older employers and women. Especially considering the ACA requires more comprehensive coverage for some areas like preventative and obstetrical care, creating a “bare bones” plan is actually antithetical to the rest of the ACA. To dodge this internal inconsistency, workers will likely find themselves in the exchanges. While these workers will still have a health insurance option, if it happens in great numbers it will affect the cost of premiums in the exchanges. In other words, the exchanges will take on the risk and cost of insuring older and sicker workers without the balance of the young-healthy population to share the cost.

Finally, given that state and local employers frequently use benefits to make up for lower salaries, the tax will likely affect wages. This may result in increased salary, but will definitely result in decreased benefits, higher premiums, and more cost sharing. Due to the misalignment of inflation and the cost of healthcare—healthcare costs rise faster than inflation—a subtle whittling of plans each year to avoid the Cadillac tax will eventually lead to an underinsured work force. We are already hearing stories about people taking on higher deductible plans where the deductible exceeds their ability to pay. In other words, the Affordable Care Act will result in unaffordable plans and an underinsured workforce.

The tax will stimulate private-sector innovation

On the other hand, the Cadillac tax could have a positive impact on the pricing of healthcare if employers take into account the long-term effects of their immediate maneuvers to avoid the tax. Rather than scheming to avoid the tax at all costs, employers can accept some portion of increased tax while instituting cost-sharing mechanisms that use consumer shopping and market forces to drive down overall healthcare prices. For example, employers can employ strategies like referenced-based pricing and consolidation of services with specific providers to allow for lower contracted costs. Creative solutions like these will actually decrease the cost of care, not just move money around on the balance sheet.