Summer Journal Club, Week 2: How Employer-Sponsored Insurance Became the Core of the American System

by Allan Joseph

Welcome to Week 2 of Project Millennial’s 2013 summer journal club. Last week, we explored why people want health insurance. This week, we’ll talk about why American employers offer health insurance and how employer-based insurance has become the core of the American health insurance system. We’ll look at two papers: “Employer-Sponsored Health Insurance in the United States — Origins and Implications” by David Blumenthal, and “Who Pays for Employer-Sponsored Health Insurance?” by Linda Blumberg.

“Employer-sponsored insurance is a cornerstone of the U.S. health care system, as vital in some ways to the health care of Americans as the drugs, devices, and medical services that the insurance covers.” That’s one of the first sentences of David Blumenthal’s 2006 report in the New England Journal of Medicine, and it’s one of the best ways to sum up how important employer-sponsored insurance (ESI) is to American health policy today.

After last week, we know why people want health insurance. But it’s not an immediate jump from that to why people get it through their employers, instead of paying cash for it, like they do with car insurance, for example.

Blumenthal’s article is a fairly succinct history of employer-based insurance going back to the 1930s. He begins by outlining President Franklin D. Roosevelt’s decision not to push for national health insurance after his victory in the 1932 election, how private health insurance plans began shortly afterwards, and most importantly, how a 1954 decision by the IRS formed the foundation for the ESI system today.

During World War II, companies responded to wartime wage freezes by increasing benefits, including health insurance. What wasn’t clear, however, is whether the benefits were taxable. In 1954, the IRS ruled that they weren’t — and that gave employers a real incentive to offer insurance.

Think about it this way: If my employer gives me $25,000 in cash, I have to pay income and payroll taxes on all of that money. However, if I get $20,000 in cash and health insurance worth $5,000, I only have to pay taxes on the $20,000 in cash. For this example, let’s assume my tax rate is 20%. If I only get paid in cash, and want to buy $5,000 worth of insurance, I need $6,250 in pre-tax income. If I get the insurance from my employer, though, I get what I want, and it’s cheaper to my employer (and to me).

Since their workers all wanted health insurance, and it was cheaper for everyone (except the U.S. Treasury) to get the insurance through their employer, companies started offering health insurance at rapid rates throughout the second half of the 20th century. By 2004, 159 million Americans, or 62% of the non-elderly, had ESI (this includes children and spouses). In that same year, the government gave up $189 billion by not taxing the value of the health insurance plan. Essentially, the government subsidizes (by about $1,200 per person) the purchase of health insurance by employers for their employees.

As Blumenthal details, however, that left many people out in the cold. Health insurance is expensive, which means only workers valuable enough to their companies can demand it. It’s hard to hire someone for a $75,000/year job without offering health insurance — they simply won’t take it. It’s easy to hire a minimum-wage worker without it, since they’re easily replaced: “The likelihood that workers will get employer-sponsored insurance depends profoundly on the characteristics of the companies for which they work…The result is a raft of arbitrary inequalities in the availability of health insurance to working Americans.” This access problem was one of the core motivations behind the Affordable Care Act.

There’s another important question embedded in the ESI system, however, and that’s the one Linda Blumberg tries to answer: who pays for it? Obviously, on the superficial level, the employer pays for it, and that’s what most people assume is going on.

But it’s a little more complicated than that. What we really want to know is whether the ESI system operates like the example above. Does insurance turn a $25,000/year job into a $20,000/year job with insurance (that is, the worker ends up paying for it through reduced wages), or does it add insurance to the $25,000 in cash (that is, the employer pays for it through increased labor costs)? The answer has important implications for a couple of reasons:

  • If the worker pays through reduced wages, it shows how workers are harmed by increasing health-insurance costs.
  • If the worker pays, policies regarding whether employers have to provide insurance could hurt take-home pay. (This will be the focus of next week’s journal club, so stay tuned!)

After reviewing the evidence — and there’s a lot of it — Blumberg finds the answer to be pretty clear: the worker pays. A number of studies have shown that an increase of $100 in health benefits causes a reduction of about $80 in wages (though the number may vary due to the industry) — that is, 80% of the cost of the health insurance is ultimately paid for by the worker. The mechanism is still unclear: do employers set wages knowing that’s the case? Do they respond to increases in insurance by holding back on pay raises? Regardless, the result seems to make sense. When a firm wants to hire another worker, what matters to the bottom line is how much total money that worker will cost, not how much is going out in cash alone.

So employers offer health insurance because it’s tax-exempt, but the money that pays for the health insurance comes out of wages. That’s been the core of the American system for the last few decades, but next week, we’ll see if that looks like it will change.

Next week: How do employer mandates work, and are they successful?


Allan Joseph is a senior at the University of Notre Dame studying economics and pre-medical studies. You can follow him on Twitter @allanmjoseph.

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