By Charles Lammam
and Ben Eisen
The Fraser Institute
As part of its review of the tax code, the federal government may eliminate its tax exemption for employer-provided health and dental plans. The move would be positive – but only if the government uses the extra revenue to reduce overall tax rates.
The government allows Canadians to exempt employer-provided health and dental benefits from their taxable income. This exemption distorts economic decisions and adds complexity to our tax system. And as a result of the exemption, the government foregoes approximately $2.9 billion in revenue.
This policy creates unfairness in the tax system by treating Canadians with employer-provided health and dental plans differently than those who buy plans outside of their employer. Individuals who receive these benefits through their employer pay for them with whole pre-tax dollars. Individuals who buy benefits outside work pay for them with partial after-tax funds, which can be as low as 50 cents on the dollar, and that makes the benefits markedly more expensive.
In addition, the policy creates an incentive for employers to shift the compensation to employees to health, dental and related care insurance instead of wages, which of course are taxed at normal rates.
For a clear example of how this can create economic distortions and unintended consequences, consider the experience of the United States, where most people receive their health insurance from their employers and like Canada these benefits are tax exempt.
This has caused a number of major problems. It has increased the number of employers providing health insurance and the amount of health coverage purchased. This artificially raises the demand for healthcare, contributing to runaway costs in the U.S.
Of course, this is a much bigger issue in the U.S. than in Canada. South of the border, most people receive comprehensive health insurance through their employers. In Canada, employer health benefits are generally much smaller because they only cover dental and extended care (pharmaceutical drugs, paramedical, vision care, etc.).
Still, the American experience provides an example of the problems created by differentiating the tax treatment of employer-based health insurance payments from other forms of compensation.
The problems with the tax exemption for employer-paid benefits are symptomatic of a larger issue with our tax system. A growing number of tax carve-outs artificially created winners by bestowing privileges on a select group of taxpayers (in this case, those with employer-provided health and dental plans).
Special tax preferences also increase the cost of complying with the tax system because claiming a tax benefit (credit, exemption, deduction) requires keeping records, ensuring eligibility and perhaps hiring an accountant to ensure you’re not missing out on any tax benefits.
And with more special tax preferences, the government must maintain higher tax rates to raise the same revenue.
By eliminating a large number of ineffective tax preferences, the government could dramatically reduce personal income tax rates for all Canadians. That would result in a much simpler tax system that improves the incentive for Canadians to work, save, invest and be entrepreneurial – all things that help propel the economy forward.
The last fundamental reform to Canada’s personal income tax system took place in 1987, so the next round of reform is overdue. Eliminating tax exemptions such as the one for employer-provided health and dental benefits can be a part of this reform, if the government uses the extra revenue to reduce tax rates instead of boosting its own revenues.
Charles Lammam and Ben Eisen are analysts with the Fraser Institute.