Employee Health Insurance

Prior to World War II, very few American companies provided health insurance for their employees, and less than half of the U.S. population was covered by health insurance. During the war, however, as soldiers went to serve overseas, there was a shortage of workers back home. The combination of a reduced supply of workers, a booming economy, and rationing of scarce consumer goods led the government to impose price and wage freezes to try to limit inflation. Since employers were not allowed to increase wages to attract new workers, they began offering fringe benefits such as health insurance as a way to attract and keep workers. Thus, having employer-provided health insurance became prevalent not because of economic justification for insurance being linked with employment, but as a way for employers to circumvent the wage freezes imposed by government.

A second factor that has contributed significantly to the prevalence of employer-provided health insurance is a special tax treatment such that while wages are subject to taxation, employees do not have to pay any income tax for health insurance benefits. This has provided a strong financial incentive for employees to get insurance from their employer rather than purchasing insurance privately, since these insurance policies are essentially purchased with pre-tax dollars. In the 1950s, when federal marginal tax rates reached over 90 percent (meaning that an individual must pay more than 90 cents in taxes for each additional dollar in income), the tax incentives were particularly intense, and thus the momentum begun by the labor shortages during the war continued long after the war. While marginal tax rates are much lower than they were in the 1950s, a study in 2000 by Anne Beeson Royalty found that the tax rate continues to have a significant effect on employer-provided health care—a one-point increase in the marginal tax rate increases the probability an employee will be offered employer-provided health insurance by almost 1 percent. The Congressional Budget Office estimated that having health insurance benefits be tax-free reduced government tax revenue by $120 billion in 2001.

Although it may seem that having employers provide insurance is a benefit to the employee and a cost to the employer, according to economic theory the employee pays the cost of insurance in the form of lower wages. The demand for workers depends on the total compensation that employers must pay, both wages and fringe benefits; if total compensation is higher, the firm is not willing to hire as many workers. The supply of workers is determined by how many workers are willing to work at various compensation levels. If an employer offers health insurance benefits at the current wage, the total compensation package increases and more people are willing to work. Thus, if employers offer health insurance while keeping wages the same, there will be a surplus of workers because employers want to hire a smaller number of workers at the same time that more workers are willing to be employed.

The result of a surplus of workers is a reduction in wages until wages reach the point where the number of workers a firm wants to hire equals the number of workers willing to work at that compensation level. Because the supply of workers is less sensitive to wage changes than the demand for workers, most of the cost of insurance gets passed on to the worker in the form of lower wages. The lower wages may not happen immediately, since employers are often hesitant to reduce employee wages, but more likely will happen over time in the form of smaller raises to compensate for the higher benefits package. The bottom line, from the economic theory, is clear; the cost of health insurance gets passed on to the employee in the form of lower wages. (For more discussion of this, see Mark Pauly's book Health Benefits at Work, which provides a thorough, nontechnical explanation of the economic theory of who pays for employer-provided health insurance. For a more technical treatment, see B. Mitchell and Charles Phelps's 1976 article in the Journal of Political Economy.)