Philadelphia Reflections

Henry Kaiser's Cleverness Out of Control

The Henry Kaiser caper. In 1943 during the Second World War, Henry Kaiser has given "Liberty Ship" contracts to build freighters for the Pacific Theater. To build ships in East Coast shipyards was to invite German U-boats to sink them as they headed for the Panama Canal. There was a price-control mandate from the War Production Board, seeking to restrain wartime inflation by prohibiting raises or bonuses. So Kaiser protested he had difficulty attracting steelworkers to California because he could not offer incentives to move. By whatever means of persuasion, Kaiser was able to obtain an exemption, permitting him to treat healthcare fringe benefits as non-salary, thus exempt from income taxation. As Cicero noticed, "In times of war, the Law falls silent." Other expedients may have been allowed, just in order to win the war, but such loopholes were apparently closed after victory was achieved. This one persisted.

Henry J. Kaiser

In later post-war years, just exactly who negotiated with whom remains unclear, but in essence, the IRS continued to treat employer health benefits as tax-exempt gifts and still does, eighty years later -- provided the employer pays the premium. This unintended post-war extension is fiercely defended by organized labor whenever someone brings it up, and they are quietly supported by the management of a big business. Congressmen are scared of the whole subject because of bad experiences with united lobbying, linking unions, and big business. In Washington, such an alliance unites the support of the leaders of both political parties. It must be mentioned here that Government itself is one of the biggest beneficiaries, acting as a huge employer offering fringe benefits, itself. Consequently, Congress itself finds it has a conflict of interest when the subject is on the floor.

The ones carrying the placards are seldom running the show.

Protest Politics

The central feature is, the employer must give a gift of insurance to the employee; self-employed and unemployed persons are not entitled to it, nor would employees be, if they bought it for themselves. After a while economists agree the gift becomes an accepted part of the wage cost and the pay packet gradually falls to adjust for it. However, other taxes and charges are based as a percent of wages, and so the gift results in even greater tax benefit than the same amount in wages would. How long it takes for wages to adjust an equivalent amount can be argued, but after eighty years, it is safe to say they are fully adjusted. Since the corporate income tax is about double the individual rate, the savings to the employer are appreciably greater than the savings to the employee.

The clamor to retain this tax ruse is joined by non-profit charities and state, local and federal businesses, who are included in the favored tax-excluded group -- even though it would appear the employers do not share in this feature. Their revenues are often fixed, and their budgets have shifted to expect this gift; consequently, their noise is equally loud when discontinuation is suggested. My own medical society employees participate. As James Madison feared when he designed the Constitution, the number in the wagon being pulled outnumber the people pulling the wagon. In the lobbying case, the ones carrying the placards are seldom the ones running the show, and seldom fully understand the issue.

Small businesses are entitled to the tax exemption but many do not avail themselves of the opportunity when they discover premium rates for their group of employees are often higher than the individual rate. Furthermore, small businesses are overall less dependably profitable than big ones, so their tax rates are usually lower. The essence of the self-interest of big business for "employee" health benefits tends to concentrate in those companies who make big profits, and thus pay high corporate taxes; less profitable businesses have less tax liability to play games with. Things take time to emerge, but after eighty years there has been plenty of time for the "gift" to be taken for granted, and the pay packet gradually adjusted to recognize that fact. Nothing remains to justify it except the tax deduction.

While it is hard to be precise, it is obvious that when things get less expensive they attract more buyers. Generally speaking, higher-wage businesses have lower health insurance premiums, because they can be more selective in their hiring, partly as a consequence of lower costs in their experience rating. Moreover, if an employee somehow gets a gift of his insurance premium, his employer actually saves more than he does, although less attention gets drawn to it. If there is anything a big business gets fierce about, it is to be deprived of savings which seem to result from its own cleverness. In this case, that argument seems more acceptable than it really is, since the benefit is now almost exclusively sustained by lobbying. The employee would have had to pay a higher income tax on a higher salary if he bought his own insurance with after-tax dollars. But that tax is based on his gross before-tax cost, including Social Security, Medicare, and other assessments, which the employer pays less of, on a lowered salary. Nor must he pay half of this and half of that, itemized on the pay stub, in matching money. This part of his cost is reduced by about 35% when he gives away the health insurance, and everything else is a tax wash. That is, other taxes have been warped to take advantage of the tax exclusion, with the result the employer community is not entirely unwilling to have unions demand they be coordinated that way.

The overall result is both employee and employer are better off than by just a straight tax deduction on the insurance premium, while the employer is far better off because he can multiply it by the number of his employees. Google, for example, has 55,000 employees, some of whom are paid extraordinary salaries. And then, the employer's tax deduction is against a 40% tax rate instead of against a blended tax rate for the employees of perhaps 20%. And finally, the insurance premium is reduced below the individual rate by forming a group and demanding hospital discounts. All of this is the result of gifting health insurance premiums on behalf of the employees. For executives with a very high salary, it can probably accomplish remarkable savings for the shareholders by giving the executive a Cadillac plan. Because it makes a good smoke-screen, no one troubles to correct wide-spread misapprehensions, especially among others who are already tax-exempt.

Gifts to employees are more tax-sheltered than equivalent salary would be.

Indeed, a little multiplication is convincing that tax abatement is not only supporting a substantial proportion of health insurance, but it represents a noticeable portion of corporate profits. So, although a major portion of this distortion would soon readjust to a new climate of opinion, any move in the direction of removing it abruptly would probably unnerve the stock market for an indeterminate time. It took eighty years to build up to this condition, and it cannot be corrected in a few days. It would, therefore, be important to have a solution to it, ready to be announced. Here's my proposal.

Proposal 4: That a schedule of reduction of both the tax exemption of employer-based health insurance and the corporate income tax be prepared along the following lines: That in consultation with economists, the corporate income tax rate be reduced until it matches the average blended individual tax rate. And the tax exemption for employer-based health insurance be reduced in a step-wise fashion until it disappears. The process shall take no longer than three (3) tax years, keep the two reductions in balance, and be commented upon by the Federal Reserve, and overseen by an appropriate committee of both House and Senate.

While it is conventional to ascribe a tax evasion to the employee and to blame it on those dreadful unions, the employer gets somewhat more tax benefit than each employee, multiplied by thousands of employees in the bigger firms -- but it's just a tax dodge for both shareholders and employees, with the shareholders coming out somewhat ahead. Nevertheless, the employer advantage mostly derives from comparing an individual employee gain with an aggregated corporation gain. It may reflect union salesmanship that the aggregate employee gain is usually not displayed since that immediately makes the two more nearly equal.

Since salesmanship has come up, I might as well apply a little of it to my own proposal. I believe sober analysis reaches the conclusion that the tax exemption is about all that matters, to anyone. Following the proposal, the government would gain taxes and corporation stakeholders would have to pay them. The shareholders would be compensated by a corporate tax reduction, but the employees would not. Although the employer might argue either side, the employees would be the ones who would surely complain. But let's take it another step.

Let's recall what happened in Ireland when the corporate tax rate was reduced to 12.5% in 1983 from its former rate of 50% in 1982. Essentially nothing happened to government revenue, which has only varied at much as 10% between 1975 and 2015. There was hardly a ripple in 1983. That's not to say nothing happened, it just did not affect government revenue much. For that to be the case, it is mathematically necessary to have more corporations, each paying less tax. That's indeed what seemed to happen, but it took twenty years to convulse the Irish economy, starting from a comparatively low level. Ireland is mostly a rural nation, and new corporations came in from abroad (UK and Scandinavia, mostly) to locate primarily in Dublin, as city dwellers. That started a housing boom, which required mortgages, and eventually toppled the banks. The

Irish corporate tax rates remained at 12.5% before, during and after the crash. The present American state and the federal tax rate are the highest in the world, and our situation is that corporations are fleeing abroad to escape it. The corporate tax refugees in Ireland have so far generally remained in Ireland, probably because it is disruptive to move and the people speak English.

Judging by the Irish experience, America could similarly expect the fundamentals might change more slowly than might be guessed, but probably more quickly than they did in Ireland. The net effect on government revenues would be negligible, but the effect on employment would be strikingly positive. With higher employment, wages would rise. Somebody would lose, but it wouldn't be America; a deft new President might even be able to deploy some new power abroad, peacefully but firmly.

The current President might have to ride a bucking broncho for a few weeks. So in summary, most of the economic turmoil to be feared would likely be short-term and in the financial markets. I can easily imagine the skepticism with which the affected employees would greet this analysis and all the op-ed columns in the usual newspapers. Balanced against that, American medical care would at least get a lot of distortion wrung out of its accounting processes, and surely would be improved in the long run, by regaining control of its own finances.

Let's return to the details. It is sometimes argued the gift of insurance premiums is an addition to the salary, but almost all economists agree the salary soon re-adjusts up or down, to reappear in the pay packet. Stop calling it wages and treat it as total wage costs, and you soon see the point. No doubt it takes time to adjust, and it seems fair to say the employer benefits from corporate tax reduction more quickly than the individual employee does. The tax amount comes close to $2000 per year per employee. Because the hidden benefit lies in taxes, the profitability of the company enters in as well, and what is true of one employer may not be as true of another. In particular, it is not true of the government and non-profit sectors, who have no corporate income taxes to pay. There may be some political hope in that.

If a business is profitable to the full limit of corporate taxes, the nominal benefit is the full limit of the employee's tax bracket, but the offset to the employer can be about twice that rate in corporate taxes. Here, we assume a blended income tax rate of 20% for the employee and 39% top state and federal rates for the employer. In companies with 10,000 employees, financial saving alone can be considerable. Almost all corporations listed on an exchange are profitable most of the time; there might be more swing in smaller businesses.

Anyway, sometimes it just seems more attractive for small businesses to have Subchapter S tax treatment. On that subject, it is a little difficult to say what pressures motivate small family businesses. Some people allege the whole Subchapter S complexity is a reaction to utilizing this distinction and therefore should be counted as an indirect benefit of the Henry Kaiser gambit. During the 2009 Tea Party agitations however, it was noticeable that small businessmen at the microphone were extremely vocal in their opposition to Obamacare. Unfortunately, it is hard to know how well small business understands the inside operations of big businesses. As they say, Macy's doesn't tell Gimbels.

With regard to all employees as a class, it seems safe to say, people who are well enough to be employed, have mostly lower healthcare costs, and therefore seem more attractive in the eyes of their health insurance company. That would maybe result in lower premiums. Since only 25% of persons aged 25-34 are insured, Obamacare calculated they would break even if they enrolled 40% of the "young invincibles" at average rates. Generally speaking, that would be males, who -- without the Henry Kaiser gimmick -- might have an 80% avoidance rate. But remember, there's also the automobile insurance phenomenon: compulsory auto insurance induces a great many to stop paying premiums after the first month or two.

With Obamacare, the dropout rate is reported to be 13% during the first year of operation. The kids resent being overcharged for something they feel they don't need and calling them "young invincibles" inflames rather than softens that feeling. The much more important point is they don't get anything back when they are older , except sympathy. That's the central flaw in employer-based one-year term insurance, and let's hope you notice the Health Savings Account corrects the injustice. With auto accidents, young people have higher rates, and that's accepted as normal. With health insurance following the same logic, it ought to be the other way around, shouldn't it?

Taken all together, it is pretty easy to see why big business demanded a one-year exempted delay from Obamacare, which later was extended another year. No doubt they intend to keep a low profile but will keep demanding "temporary" exemptions, at least until the recession is over, and possibly forever. Until we see the eventual experience with employees, the largest group affected, it will be impossible to predict the limits of the subsidy program for the uninsured. Nevertheless, it is fairly obvious this essentially political impasse is being treated as an untouchable issue, and believable estimations of "fairness" will be a long time in coming. Businesses of all sizes like to present themselves as a big happy family. But in fact, the large common market produced by our continental boundaries means a comparatively small amount of American trade (but admittedly a growing one) is international. The main competition for big American business is small American business, and don't you forget it.

To a fairly large extent, this split is also a split between family-controlled business and stockholder-controlled business, between Subchapter S and Subchapter C corporations, and between university-educated management and small-college educated bosses. It's geographic, it's regional; it's R and it's D. If you ever watched a pro football game with businessmen in the audience, you know both large ones and small ones always feel challenged, and both intend to win, even when they might both end up losing.

Solutions: Nevertheless, the issue of revenue neutrality, at least for employer-based health insurance, is easily summarized. You don't have to be a professional negotiator to see that something close to a 2/3 exemption for everybody could make it revenue neutral. And then, through inflation and other traditional means of attrition, mid-course corrections might whittle it down.

But that's only part of it. Remember, the employee payroll deduction is only half of the issue. The employer gets the other half, by paying lower corporate taxes. His total payroll cost ends up much the same, but by this time the reader should see that doesn't matter. Corporate taxes are too high, probably in part because of class antagonisms. We have a flight of corporations abroad, and we see the Irish example that you shouldn't go too fast. But a reassuring part of this problem is we have Congress to negotiate it. Having learned how to raise food stamps by raising farm subsidies, they don't need any lessons in triangulation. No need to mention volume discounts on the insurance premiums, and discounts the insurance company shifts to the hospital. The details of such features are not public information.

Taken altogether, it sometimes appears equal treatment might be easier to attain than the elimination of the tax exemption. If everyone received a tax exemption, at least in part, we might at least eliminate the distortions imposed by rent-seeking the loopholes. It might raise healthcare prices at a time we need to lower them, so a stepwise approach might turn out to be the only feasible one. This is a time when healthcare is so expensive that only a really radical approach might be noticeable. Perhaps it is time just to get rid of the inequality, so later sacrifices for the economy will not seem so hypocritical.

There's one other misconception to be wary of. A tax reduction at the 50% employer rate is not at all the same as a 50% reduction of the employer's taxes, although it may sound like it. It's likely to be far smaller.

Originally published: Sunday, April 12, 2015; most-recently modified: Tuesday, May 21, 2019