Employee Benefits and Tax Reform

Abstract

The current tax treatment of pensions and health insurance in the United States is a hybrid that lacks consistency under either an accrual income tax system or a consumption tax system. Under an accrual income tax, employer contributions to pension plans represent an addition to wealth that would be taxed at the time they are made. The interest earned on pension contributions also represents an addition to wealth that would be taxed annually. When a worker retires, all applicable taxes would already have been paid on the benefit, and the flow of retirement income received by the worker would not be taxed. Similarly, employer-provided health insurance arguably represents a current benefit that, under the income tax, should be taxed annually as current income. Under a consumption tax, things are different for pensions. The idea of the consumption tax is to tax what an individual takes out of the system. Since pension contributions represent saving, they are not taxed when they are made. Neither is the interest earned on pension contributions taxed under a consumption tax, since it is reinvested and accumulated. Only when the worker retires and starts to draw retirement income are pension contributions taxed. And only the portion of the retirement income that is consumed is taxed if only half is consumed, taxes are paid only on that half. Although pensions fare better under a consumption tax than under an income tax, it is unclear whether health insurance would, too. If health insurance expenditures are considered current consumption (as most economists believe they should be), the same tax that applied to any other consumption would apply to employer contributions to health insurance. On the other hand, one could argue (as in footnote 3) that health insurance is a merit good and medical expenditures are unfortunate, so that both pensions and health insurance should be excluded from the definition of consumption. The existing tax treatment of employee benefits in the U(This abstract was borrowed from another version of this item.)