The cost-reducing benefits of the section 125 tax shelter depend on one's tax bracket (). Federal income tax brackets range from 10 to 35 percent and lower-income people receive extra benefits under the earned income tax credit (Quincy 2008a
Also saved are Social Security and Medicare “FICA” taxes of 7.65 percent, and any state and local taxes. In these case studies, state and local income taxes ranged from roughly 4–6 percent, but in some states they are 10 percent or more.4
The cumulative tax savings can be quite impressive, even for some lower-income workers as illustrated in .
Tax Rates—Federal Plus State Single, 2009
Potential Marginal Tax Rates Facing a Single Parent with Two Children (Negative Rates Not Displayed) (2008)*
Employers also benefit. Payroll taxes and assessments do not apply to wages in cafeteria plans. These taxes include the employer's matching 7.65 percent for FICA, and unemployment insurance in many states (typically, from 1 to 5 percent but sometimes higher for specific industries). An employer that had 10 workers opting for U.S.$5,000 coverage might save roughly U.S.$5,000 a year.
Reducing costs should increase coverage. A 2008 study by Mathematica estimated that, in Minnesota, requiring all employers to offer section 125 plans would increase the number of people with individual insurance by 6.3 percent, which would reduce average premiums by 5–6 percent, thus reducing the number of uninsured by 12.4 percent (Chollet et al. 2008
). Nationally, in estimating the impact of President Bush's proposal to provide a more generous tax credit regardless of source of insurance, the Congressional Budget Office (CBO) (2007)
concluded that equalizing the tax treatment of individual and employer insurance (as section 125 plans do) would increase newly insured individuals by about 7 million.
Insurance Expansion Effects
Despite this potential, the initial take-up of individual insurance under section 125 plans was very low to nonexistent after 1 or 2 years in each study state. Massachusetts had the most take-up. It coupled the section 125 employer mandate with an “individual mandate” unless available insurance costs exceed a state-defined affordability threshold. Despite this mandate, only a few thousand individuals in Massachusetts purchased their insurance through this tax shelter. Complete figures are not available statewide, but they are reported for insurance sold through the state's “Commonwealth Connector.” As of July 2009, only 1,352 of the Connector's 15,385 nongroup subscribers purchased through a section 125 plan, from among at least 3,500 employers who had established their section 125 plans with the Connector. The two largest private insurers reported “similar” or “negligible” enrollment, suggesting that the statewide total was probably broadly around 5,000.
In the other two states, which allowed or incentivized section 125 plans but did not require them, few employers had adopted them, and so naturally few employees used them. In Missouri, a health policy expert said that provision has “not come up once” in his extensive conversations across the state.
Indiana's tax credit has been only modestly more successful. In 2008, 204 employers, uninsured previously, claimed the credit for establishing section 125 plans. They enrolled at least 2,900 employees, based on the total credit claimed of U.S.$145,000. That amount, however, is only about 10 percent of what legislative budget analysts predicted. Of the eight experienced insurance agents and benefits consultants interviewed in the state, half were completely unaware of the tax credit law. The others remarked on how little interest it has generated.
Why do not more employees, when given the opportunity, choose to purchase their own insurance, or coverage for family members, with pretax payroll deduction? Massachusetts interviews supplied most (but not all) of the explanations we heard. One frequent observation was simply that insurance remains unaffordable, despite the substantial discounts. Related to this, several people noted that a tax shelter vehicle is not an especially good fit for the lower-wage workers who are more likely to lack group insurance.
Naturally, a lower tax bracket confers less of a discount, but also, the discount is only implicit and so does not decrease the visible premium cost. Experienced advisors noted that workers who “live paycheck to paycheck,”“just trying to put food on the table,” are “put off” by the requirement that money is first deducted from wages and then later used to pay next month's insurance bill. This reluctance is confirmed by studies showing low use of FSAs by lower-wage workers, even when they incur the dependent care and medical costs that FSAs cover (Feldman and Schultz 2001
; Hamilton and Marton 2008
Insurance agents said they are not highly motivated to encourage section 125 plans for individual insurance. They offer to set up section 125 plans for employers as another “arrow in their quiver” to “get in the door,” but only as a way to sell group, not individual, insurance. As a Missouri agent said, “How hard do I want to work to get an appointment with an employer who doesn't want to provide health insurance?”
Many employers also lack motivation to promote understanding and use of section 125 plans. The lower-wage and part-time workers who most likely lack group insurance are also the part of the workforce that employers have the least investment in, and the least concern about losing. Also, part-time workers often do not consistently earn enough to pay an entire premium from their paychecks, and there is no ready way through section 125 plans to supplement premium payments from nonpayroll sources.
In sum, there was little confidence that section 125 plans had the potential to greatly increase coverage among those who otherwise would remain uninsured. Instead, several informed sources thought that their main benefit is to reduce the effective costs for those who otherwise already have individual insurance. That reality, however, did not undermine support for these laws, which was widespread across these states. Informants from multiple perspectives thought that it is manifestly unfair to deny a tax break only to those who lack employer-sponsored insurance, and they noted repeatedly that providing a tax break to both employees and employers is a “no brainer,”“win/win” proposition, especially when most of the tax revenues are foregone by federal rather than state government. Also, several policy analysts noted that reducing individuals' effective costs can reduce the portion of premiums that government would have to subsidize in order to bring more people within a defined affordability range.5
However, for these benefits to be realized, employers first must establish section 125 plans.
These study states reflect three distinct methods to induce employer take-up: a mandate, a tax credit, and merely permitting the use of section 125 for “list-billed” individual insurance. The level of employer adoption observed in each state tracks the stringency of these different measures. Missouri, which only permits this arrangement, experienced almost no detectable activity (but this was influenced considerably by the federal legal issues discussed below). Indiana, which provides a tax credit, saw adoption by 204 previously uninsured employers in 2008. Massachusetts reported widespread compliance with its mandate of employers with 11 or more full-time workers. Based on filings with the state in 2008, fewer than 10 percent of employers subject to the mandate had failed to comply, and fewer than 5 percent of employers with more than 50 employees. As a result, through the end of 2009 no employer had yet incurred a “free rider surcharge,” which applies to noncompliant employers if their uninsured employees receive more than U.S.$50,000 of uncompensated care in a year. A survey sample of 1,003 employers in 2008 confirmed >90 percent compliance by larger employers, but found only 72 percent compliance by firms under 51 (Gabel et al. 2008b
In interviews, employer representatives and advisors in all study states consistently reported employer opposition to government mandating any employee benefits, including section 125 plans. Employers reportedly view mandates as intrusive, inflexible, expensive, and contrary to free market principles. However, these attitudes did not undermine Massachusetts' successful implementation of its section 125 mandate. Initially, this more technical provision of its comprehensive reform law was “the one thing that seemed to cause the most angst” among employers, according to one observer. Others said that insurers, agents, government officials, and trade associations worked hard to assist with the “mad scramble” of meeting compliance deadlines. And, some said that compliance was not that difficult, nothing more than some initial “hiccups.” They noted, or we observed, that the Connector, the state's leading insurers, and many agents set up section 125 plans for free, especially for new or established clients. Helpful instruction manuals were available online,7
some of which enabled those who were so inclined to set up these fairly simple plans themselves; for others, there were assisted options that cost as little as U.S.$100 for initial setup.8
In any event, once Massachusetts employers had their section 125 plans in place, then most observers reported that employers generally were quite content with the arrangement. These impressions were confirmed in 2008 by a representative survey of 1,003 employers, showing general support for the overall reform law (Gabel et al. 2008b
We also inquired why the general idea of offering these plans for uninsured workers to purchase their own coverage has not caught on more in other states. First, cafeteria plans and voluntary benefits are fairly foreign to smaller employers. For instance, FSAs (which cover out-of-pocket medical and dependent care expenses) are much more prevalent among larger employers. This is also the case for cafeteria plans that cover group health insurance premiums. Almost universally, larger employers deduct workers' portion of group insurance premiums through a section 125 plan, but this is done by only 30–70 percent of firms under 200 (depending on particular survey, year, and firm size grouping), according to national surveys.9
Various reasons were cited for smaller employers' tendency to avoid cafeteria plans. First, economies of scale mean that the savings in payroll taxes (coupled with the tax credit in Indiana) may not offset even the modest setup and ongoing administrative expenses. Second, cafeteria plans and voluntary benefits (such as life or disability or cancer insurance) tend to come further down the list of fringe benefits that firms offer (Abraham, DeLeire, and Royalty 2009
). By this logic, it would be rare to expect an uninsured firm to jump down the list to the specialized benefits that are less prevalent and so less expected by workers.
Finally, for cafeteria plans a special tax rule requires that no more than 25 percent of the contributions come from owners or highly compensated employees. Many informants noted that this “nondiscrimination” rule is virtually impossible to meet for firms under 10, and it is often difficult for those with fewer than 25 workers, unless business owners and key management decline to use the plan. According to one agent, “They look at you like you're from Borneo if you tell them they can't participate in their own plan.”10
Other concerns apply to larger employers as well. There are numerous potential complexities that go beyond simply signing the simple startup paperwork. Some arrangements may require employers to deal with list-billing from multiple different insurers. For part-time workers, weekly paychecks may vary, such that wages sometimes fall short of billed amounts, leaving employers potentially on the hook to collect the difference.11
Also, cafeteria plans work most smoothly when the same amount is deducted from each paycheck for the year, because initial setups cannot be changed absent specified changes in circumstances, and even these require extra paperwork to implement. It all amounts to an administrative “nightmare,” according to three different Massachusetts agents.12
A major concern expressed was legal uncertainty under federal law. State law controls whether list-billing violates small-group market reforms, but federal law controls whether list-billed insurance qualifies for federal tax exclusion (Hall and Monahan 2010
). Because of a peculiar quirk in federal law (owing to how HIPAA, ERISA, and the tax code all interrelate), there is a strong, but unsettled, argument that section 125 plans may not be used for health insurance that is medically underwritten (Hall and Monahan 2010
). Massachusetts avoided this problem by reforming its individual market, applying the same guarantee issue and community-rating rules to it as it does to small group insurance. In most states, where this is not the case, this federal law uncertainty intimidates many agents, consultants, employers, and benefits administrators from using cafeteria plans for underwritten health insurance. In fact, due to this legal threat, the Missouri Department of Insurance has declined to issue regulations that implement the legislature's section 125 law, since “it would be problematic for employers to place themselves in a position which may conflict with current interpretation of federal law in an effort to comply with Missouri state law.”
Potentially, PPACA resolves this problem starting in 2014 by banning medical underwriting. PPACA declares that section 125 plans may not be used for individual insurance purchased through the new exchanges, but it leaves open this possibility for insurance outside the exchanges. However, regulatory guidance is needed to be certain.
Even if this major uncertainty were resolved, other legal concerns would remain. Tax law in general, and cafeteria plan rules in particular, are complex, subject to differing interpretations, and frequently updated with new rulings. Not being in full technical compliance could “blow the whole thing up” (according to a national consultant), causing a significant tax penalty. Even though experts said there is no substantial threat of draconian prosecution for technical violations, benefits advisors and administrators play up this volatile legal environment in sales pitches that tout their professional services.
Nevertheless, most insurers, agents, regulators, and benefits administrators supported these laws, noting that, even where there was not widespread adoption, at least the laws helped to call attention to this low-cost device for reducing employees' premium contributions, either for individual or group insurance.
The flip side of low employer take-up is too much success for section 125 plans. If they worked too well, they might make individual insurance so attractive that employers stopped offering group coverage. These case studies found some basis to take this “crowd-out” concern seriously. First, the few insurers who have attempted to develop section 125 plans as a sales vehicle are the same insurers who tend to also specialize in individual insurance. The impetus and support for these laws in each state came in part from some agents or employers whose “eyes light up” (in the words of one state regulator) at the prospect of moving away from employer sponsorship and toward individual purchase. “This is a mission of mine,” according to one bill sponsor. The attitude favoring individual over employer group insurance was not widely shared, but those who held it saw establishing section 125 plans as a way for employers to transition out of direct purchase of benefits without abandoning employees' needs altogether. Employers who made this move typically also gave employees a pay raise to compensate for the loss of employee benefits.
A number of informants (including government officials) felt that a section 125 incentive or requirement might push employers over the edge who are already “sitting on the fence,”“looking for an excuse to get out of the health insurance business” in a way that is more “palatable.” Therefore, insurance regulators in one state (not part of this study) opposed a section 125 mandate, and some knowledgeable experts advise states against adopting section 125 laws unless as part of more comprehensive health insurance reforms, like those in Massachusetts, that also require employer contributions and prohibit medical underwriting (Curtis & Neuschler 2006
; Curtis 2008
;). This concern is also supported, to some extent, by econometric projections that making all health insurance tax excludable would diminish employer-based coverage by roughly 10–15 percent (Royalty 2000
; Gruber and Lettau 2004
Many other informed sources, from all vantage points, thought this level of concern was overblown. They acknowledged the theoretical concern, or that it might happen at the margins, but they noted that employer dropout has been discussed for years but has not happened yet (Fronstin 2007
), and they felt that, on balance, it is not likely to become widespread simply because of enhanced tax benefits to employees. Instead, these experts reported that employers decide for independent economic reasons whether they need to, or can afford to, continue offering insurance. If they are forced to drop insurance, then they might consider replacing it with a section 125 plan, but this probably would be only after the fact, as a way to “cushion the blow,” recognizing that “something is better than nothing,” rather than the section 125 plan being a motivating or causative factor.
Several points were noted frequently in support of this informed view. First, employers and agents who drop group insurance face a legal risk in replacing it with an employer-facilitated arrangement for individual insurance. The insurers who sell individual insurance through list-billing vehicles, for instance, do so with a clear and firm warning that these are not to be used to replace employer-sponsored insurance. Insurers who promote 125 plans noted that they also have significant business in the small group market, which motivates them to protect that market segment. Others noted that, because section 125 plans can also be used for the employee's portion of group insurance, these plans can help keep the group policy intact. This is because insurers in most states can drop the group if there is not a minimum level of participation among employees, and conferring a tax advantage for family coverage, for instance, can increase employee take-up.
The strongest, and most frequently mentioned, reason given for employers not dropping group coverage is that doing so forces employees to seek coverage in the “wild and wooly” medically underwritten market. Then, employers would have to deal with “grumpy,”“resentful” employees who did not pass underwriting. Because PPACA will eliminate medical underwriting in 2014, this raises the concern that employer drop-out might increase. However, in Massachusetts, which also prohibits medical underwriting, employer dropout has not occurred, even though the state also mandates section 125 plans by all employers over 10. Despite this open opportunity, several studies confirm what our informants consistently said—that employer-sponsored insurance has remained intact in Massachusetts (Gabel, Whitmore, and Pickreign 2008a
; Gabel et al. 2008b
; Long and Masi 2008
In part, this is because Massachusetts requires employers to contribute to insurance premiums, but this is not a strong mandate, only a mild “pay or play” tax on uninsured firms of about U.S.$300 per employee. Therefore, the primary explanation given was that the individual mandate reinforces labor market pressures to continue offering health insurance as a job benefit. As one Massachusetts agent explained things, before the individual mandate, lower-wage workers would prefer a job that pays U.S.$11/hour with no benefits to one at U.S.$10/hour with health insurance, but now that being uninsured results in a substantial penalty (currently, about U.S.$1,000), this preference has reversed, so even places like fast-food restaurants are starting to contribute to health insurance costs.