The idea of financially penalizing people for not buying health insurance sounds dodgy, even repugnant. It’s long been a popular idea among health policy wonks that, until 2009, enjoyed a bipartisan imprimatur. That said, voters hate the idea. Judging by oral arguments at the Supreme Court this week, the justices are skeptical, too. Even President Obama himself denounced it repeatedly when campaigning against Hillary Clinton for the Democratic nomination. And yet you might be surprised to learn that this seemingly controversial idea—that preferring more money and less health insurance should be penalized—is already at the core of the American health care system and has been for decades.
If you’re not retired and you do have health insurance, the odds are good that you get that insurance through your employer as compensation for the work you do. But at first glance, it’s not obvious why that should be the case. After all, your employer doesn’t give you car insurance or homeowners insurance. Why should health insurance be different?
The mystery deepens when you consider that, in a sense, your employer really does give you your car insurance. Or, rather, your employer gives you money and you use the money to buy car insurance and whatever other kinds of insurance you want. By the same token, your employer doesn’t give you shoes or furniture. You get paid money and you do what you want with your money. This is better for you, since money is more fungible than furniture, and it’s also better for your employer since it means your company’s HR department doesn’t need to spend time mucking around with furniture catalogs. So why would any company want to give its employees health insurance?
It all dates back to World War II. During the war, the United States temporarily suspended the operation of capitalism to maximize war production. There were many details involved in this, but the basic approach was to use wage controls, price controls, rationing, and intense social pressure to invest in low-yield war bonds to depress domestic consumption. The idea was to devote as large a share of output as possible to the cause of killing Germans. The government wanted Rosie the Riveter to help build airplanes, but they didn’t want her spending high wages on increased food and clothing consumption—they wanted all the food and fabric the country could spare to go to the battle front along with the airplanes. Wage controls led to windfall profits for some firms, which, in turn, were subject to extortionate rates of taxation. In response to all this, clever employers hit upon the idea of offering workers non-wage benefits including, among other things, health insurance.
This new norm carried some momentum with it, but you might have expected the end of the war to lead to a return to old practices. But the IRS ruled in 1943 that employer contributions to a health insurance plan didn’t count as taxable income. That policy carried forward even after wartime price controls were lifted, giving firms an incentive to offer some compensation in the form of insurance. The IRS reversed itself in 1953 noting, sensibly, that getting $1,000 and getting a $1,000 discount on an insurance premium are actually the same thing. But in 1954, Congress passed Section 106 of the Internal Revenue Code instructing the IRS to go back to the wartime system. And so it’s been ever since. This decision is one of two pillars of the current American insurance system.
The other pillar is a rule that says that if employers want to offer a health plan to their workers, they have to offer it on the same terms to all full-time employees. A healthy young worker pays the same premium as a middle-aged one with high blood pressure. This ensures that within any given firm there’s considerable cross-subsidy flowing from younger and healthier workers to older and sicker ones. If all the young people dropped out of the plan, then the premiums charged to the remaining members would need to go way up. That’s because the healthier employees are, on average, receiving fewer dollars per year in health care services than they and their employers are paying into the plan in premiums. Why would anyone do that? In part it’s risk aversion, but in large part it’s the tax issue. If you and your employer agreed that your company would stop subsidizing your insurance premiums and just raise your salary instead, suddenly thousands of dollars worth of tax-free subsidies would turn into taxable income. Your decision to opt out of the insurance pool would, in other words, be penalized to the tune of hundreds of dollars.
Absent that penalty, however, the system would be basically unworkable. People would drop out of employer-provided insurance pools, leading to higher premiums, leading to more dropouts, leading to even higher premiums.
Unlike the high-profile struggle over Obama’s mandate, this penalty operates subtly in the background of the American system, so invisible that many people mistake it for the operation of a free market. But non-taxation of group health plans doesn’t come cheaply. The Congressional Research Service calculates that it will cost the federal government $164.7 billion in fiscal year 2014. Those billions of dollars require higher taxes on everyone who doesn’t benefit from the deduction. Consequently, it’s both coercive—penalizing people who’d like to opt out of the system—and deeply unfair, since many entrepreneurs, part-timers, freelancers, or small-business owners are simply ineligible for it. And whatever the Supreme Court does with the Affordable Care Act, it’s here to stay.
Read all of Slate’s coverage of the Affordable Care Act.