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Will Small Businesses Stop Offering Health Insurance If Reform Passes?

Friday, September 18, 2009

For the average business, paying a penalty will cost them less than providing insurance.

In the discussion about healthcare reform, one question has received scant attention: If one of the proposed plans goes through, will small business owners stop offering employee health insurance? There is some evidence to suggest that, for many businesses, the answer would be "yes."

The House plan, America’s Affordable Health Choices Act (HR3200), contains what has come to be known as the employer mandate. This provision would require larger small businesses to either offer their employees health insurance or pay a penalty, an 8 percent payroll tax. If this plan passes Congress, a number of small businesses would opt to pay the 8 percent payroll tax in lieu of providing employee health insurance because, for the average business, paying the payroll tax would be cheaper.

How do I know that paying the penalty would be cheaper? Well, it required some estimating. Here's how I did it: using data from the Department of Health and Human Services’ Medical Expenditure Panel Survey on the weighted average premium for employee health insurance and data provided by the Small Business Administration on employer firm payrolls, I came up with an estimate for the share of payroll that employee health insurance would constitute if all employer businesses offered it.

If the House plan passes Congress, a number of small businesses would opt to pay the 8 percent payroll tax in lieu of providing employee health insurance.

Please note that I excluded businesses with 500 or more employees, because many would find dropping insurance difficult from a public relations perspective and might be contractually bound to offer it. I also excluded those with fewer than 15 employees, because they are likely to be exempted from the proposed payroll tax.

Here’s what I came up with: In 2006, for businesses with between 15 and 499 employees the cost of healthcare would have averaged 14 percent of payroll if employers paid 70 percent of each employee's health insurance premium. Of course, employee health insurance is tax deductible, so the effective cost of providing insurance would have been less. Assuming a marginal tax rate of 35 percent, I figure the effective cost of providing employee health insurance would have been 9.1 percent of payrolls. Thus, my first estimate indicates that a typical company would have the choice of paying 9.1 percent of its payroll for healthcare coverage or 8 percent in a penalty.

But that’s based on pre-reform numbers. It’s possible that the cost of providing the full coverage required by the House plan will be even higher. The Lewin Group, a policy research and consulting firm focused on healthcare, conducted an analysis that estimated the employer share of premiums for an acceptable insurance option for an individual under the proposed law. Adjusting that estimate by the Department of Health and Human Services Survey’s data, I estimate that, under the proposed House plan, to avoid the tax penalty, the average company with between 15 and 499 employees would need to spend 17.5 percent of its payroll on health insurance premiums. Factoring in a 35 percent marginal tax rate and the proposed tax credits for smaller businesses to purchase insurance, the effective cost to employers would be 11.3 percent of payroll—a significant leap above the 8 percent penalty.  

It's important to note that the cost of paying for 70 percent of employee health insurance premiums would be more than the tax penalty for all sizes of small businesses. In fact, for businesses with fewer than 15 employees, paying for insurance is the more expensive option even after factoring in the proposed tax credits.  

Reform may give companies that would not be willing to drop health coverage under the current system an additional reason to do so.

And these are the numbers today. Given the rate at which health insurance premiums have been increasing—three times as fast as payrolls from 1999 to 2006—it’s a good bet that the cost of providing health insurance will go up faster than company payrolls. Unless Congress increases the penalty repeatedly, it seems likely that, in the future, paying the tax will become even cheaper relative to offering employee health insurance.

Of course, not all small businesses will choose to pay the payroll tax just because it will cost them less than providing employee health insurance. Some business owners will consider providing health insurance to be the right thing to do or a competitive advantage and will offer it even though paying the payroll tax would cost them less. But it seems likely that many owners will be swayed by the economics and opt to pay the tax.  

In fact, reform may give companies that would not be willing to drop health coverage under the current system an additional reason to do so. Right now, many employers would not want to drop employee health insurance because other insurance options for their employees are not very good. Under the proposed House plan, ironically, more employers might be willing to drop health insurance because their employees would probably have better alternative options.

So what happens if a large number of small businesses opt to pay the payroll tax rather than provide employee health insurance?

Under the proposed plan, to avoid the tax penalty, the average company with between 15 and 499 employees would need to spend 11.3 percent of its payroll on health insurance premiums.

The expectation is that those employees whose employers choose to pay the penalty rather than offer health coverage will go out and buy their own health insurance from newly created exchanges. Because the employer tax penalty is only expected to “help fund" these purchases, the employees might have to foot the bill for the difference.

One way Congress might do this would be to require employees to pay a greater share of their health insurance premiums. Instead of paying 30 percent of the cost of health insurance, they might need to pay closer to 50 percent of the premiums. That would help balance the numbers.

Alternatively, Congress could raise the size of the tax penalty closer to 12 percent of payroll to make paying the payroll tax less attractive than providing employee health insurance. Of course, to deter the smallest businesses from dropping employee health insurance—the ones that Congress proposes be exempt from the tax penalty under current plans—they would have to impose the tax penalty on them too.

Or Congress might cover the shortfall between the payroll tax and the cost of insurance from somewhere else, either by borrowing or increasing taxes or making cuts elsewhere.

The author is the A. Malachi Mixon III Professor of Entrepreneurial Studies in economics at the Weatherhead School of Management at Case Western Reserve University. He last wrote for THE AMERICAN about low-productivity businesses.

FURTHER READING: Increasing productivity in healthcare is possible, writes Tim Worstall, in “Baumol’s Solution to Baumol’s Effect.” In “Here’s Why the Public Plan Won’t Work,” Joseph Antos and Jeet Guram explain that federal regulations will eliminate the private healthcare market.  John S. Hoff follows up by explaining that “Eliminating the Public Option is Not Enough.” Scott Harrington considers “What the States’ Experience with Mandates Should Tell Us about Universal Healthcare Coverage.” Mark Pauly and Antos join other scholars in explaining “Bending the Cost Curve.” Antos further analyzes “The Case for Real Healthcare Reform.”

Image by Darren Wamboldt/Bergman Group.

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