By John C. Goodman 

Originally posted on Forbes, August 2015

Beginning in 2018, high-cost, private sector health plans will be subject to a special levy, popularly known as the “Cadillac plan” tax. Under a provision of the Affordable Care Act, health plans must pay a tax equal to 40 percent of each employee’s health benefits to the extent they exceed $10,200 for individual coverage and $27,500 for family coverage.

In many ways, the Cadillac Plan tax is a stealth tax. It doesn’t even become effective until eight years after the Affordable Care Act passed Congress. And back in 2008, the thresholds were so high that it must have seemed like the tax would apply only to a handful of employers. But health care inflation has a way of escalating base line costs through time.

So much so that a Kaiser Family Foundation study estimates that the first year it is applicable, one in four employers will be subject to the Cadillac plan tax unless they change their benefits. Going forward, the thresholds are indexed to the rate of general inflation – which historically is well below the rate of medical cost inflation. As a result, the study estimates that the share of employers potentially affected could grow to 30 percent by 2023 and 42 percent by 2028.

Ostensibly, the purpose of the Cadillac plan tax was to help pay for the cost of Obamacare. But that can’t have been its real purpose, since employers can easily avoid the tax by spending less on health benefits and more on something else – like more generous pension contributions.

The more persuasive argument for the tax is to thwart the way the current tax system encourages us to overinsure and spend too much on health care.

As is well known, employers today can purchase health insurance with pre-tax dollars. Whereas wages are subject to income and payroll taxes, money spent on health insurance is tax free. For all practical purposes, 150 million Americans who get their health insurance through a place of work, can always lower their taxes by taking more of their compensation in the form of health insurance rather than as wages.

Take a worker in the 30 percent tax bracket (income and payroll taxes combined). If an employer tries to give this worker a dollar in wages, Uncle Sam will take 30 cents – leaving the worker with only 70 cents in take-home pay. But if the employer spends the dollar on health insurance, Uncle Sam gets zilch. That means the health insurance could be worth only 71 cents on the dollar and still look attractive. No wonder our health care system is so wasteful.

The Cadillac plan tax is a way of putting limits on wasteful spending. But it is a crude and highly ineffective way of combatting the core problem. For one thing, it only affects those plans that are at the thresholds. At every other place of work, the perverse incentives are just as bad as they were before. For another thing, even among plans that are subject to the tax, it only affects the last few dollars spent (those above the threshold). For spending below the threshold, the perverse incentives remain.

How could we eliminate perverse incentives in a better way?

Suppose an employer health plan costs $30,000 in 2018 for a worker in the 30 percent tax bracket. Under the pre-Obamacare system, this worker’s tax subsidy is $9,000. However, the Cadillac Plan tax is 40 percent of the last $2,500 of spending – or $1,000. That reduces the government’s implicit tax subsidy for the worker to $8,000.

Let’s now contrast that approach with something I have been advocating for a long, long time. Replace the tax exclusion system with a dollar-for-dollar credit against the first $8,000 spent on family coverage and nothing beyond that.

Under both approaches the total tax relief is the same. However, under Obamacare the worker and his employer have an incentive only to change the last $2,500 of benefits (to avoid a 40 percent tax).

Under the tax credit approach, the change in incentives is almost 10 times as great. The tax credit approach pushes the tax subsidy to the first dollars spent – the first $8,000 in this example. That means the last $22,000 in health insurance costs is all effectively after tax.

Suppose the employer and the employees now consider a more economical way to purchase health insurance. Suppose that by choosing a narrow network and shedding benefits of marginal value they manage to cut the $22,000 in half. Then the worker can potentially have an increase in take-home pay of $11,000!

More generally, beyond the first $8,000 of spending, the employer and the employees get to keep 100 percent of every dollar of waste they eliminate. Conversely, they have to pay 100 percent of the cost of every dollar of waste they don’t eliminate.

Under the tax credit system, all of us get to keep the full benefits of every good decision we make and bear the full cost of every bad one.

An incentive system just doesn’t get any better than that.

This article was originally posted at Forbes on August 26, 2015.