Should government tax health insurance benefits?

By Justin Hatherly
AIMS on Campus Fellow

A recent column by Andrew Coyne reports that the federal government will soon propose to tax health and dental benefits, which many Canadians receive as part of their employment compensation. While Canada does not need a higher overall tax burden, and though such a move is bound to be unpopular, in principle such a tax reform would actually be highly defensible and probably desirable.

At present, many Canadian workers receive health insurance benefits through their employers to pay for treatments such as prescription drug coverage and dental care that are not fully covered under the public health system. However, unlike cash wages, these benefits are not included in the tax base and thus not taxable.

There is no defensible reason for this anomaly. While insurance benefits may not be cash income, they still are a form of remuneration with a marketable cash value. Consequently, failing to tax these insurance benefits simply creates inequities between workers without insurance (who are taxed on all their income) and those with insurance (who are exempt from tax on a substantial part of their compensation).

This discrepancy inevitably violates horizontal equity: the notion that people with similar incomes, regardless of how those incomes are composed, should pay a similar level in income tax.

Moreover, the existing preferences for employer-provided insurance don’t necessarily enhance the welfare of those who receive these benefits. All other things being equal, a typical worker might prefer his or her compensation be paid entirely in cash. This would allow workers to exercise greater autonomy over their finances because they could choose how their pay would be allocated.

While it is true that taxing insurance insurance benefits would cause fewer employers to offer them, in Canada’s competitive labour market, workers would see no real change in compensation; to attract labour, employers would be unable to arbitrarily lower compensation and would offer higher cash income in place of insurance benefits. Employees that truly did value medical insurance could simply take their higher wages and privately purchase a policy.

Finally, making insurance benefits taxable could help to improve Canada’s poor productivity. Many employees might be unwilling to change jobs to retain fringe benefits, such as insurance that their existing employment provides. However, as taxing such benefits would probably reduce the number of employers providing insurance benefits, the prevalence of job lock would also decline. No longer afraid of leaving a job merely because they would lose insurance benefits, more workers would be free to move from employment in which they are less productive, to employment in which they are more productive.

None of this analysis should be taken as an unqualified endorsement of whatever the federal government might do with regards to this policy area. Making benefits taxable, without implementing offsetting tax reduction in other areas, would sharply add to the already high and growth-reducing tax burden that Canadians face.

Nonetheless, the exclusion of employer health benefits from the tax base represents an inequitable subsidy that benefits some Canadians at the expense of others.

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