Section 89: Tax Policy Gone Crazy

by Roy E. Cordato

Over the last decade workers have come to benefit by an invigorating dose of competition and choice with respect to health insurance plans. While most companies once offered their employees one health insurance policy, take it or leave it, now most workers have the opportunity to choose among dozens of options. Workers can now make trade-offs between higher or lower wages and more or less extensive health care insurance coverage. They can tailor their compensation packages to their own needs.

One section of the Internal Revenue Code threatens to take a good part of that freedom away by penalizing both employers and employees in workplaces where these kinds of options are available. The justification for Section 89, instituted as part of the Tax Reform Act of 1986, is based on knee-jerk egalitarianism. The tax system is being used here to reduce "employee-benefit discrimination," i.e., to see to it that lower paid workers get the same health care coverage as higher paid workers.

In order to comply with Section 89 employers will have to correct disparities in health care coverage that is freely chosen by lower and higher paid workers. If these disparities are not corrected, those higher paid workers with more extensive plans will have to pay a tax penalty. The virtues of free choice are turned into vices by the tax code.

There are many problems with the Section 89 requirement, not the least of which is the underlying assumption that all workers within a workplace should have the same level of health insurance coverage. The fact is that when free choice is allowed, it is likely that equality of result will never be achieved. People make choices based on their own needs and preferences which always differ from one person to another. Policies that attempt to force equality of result at the expense of free choice can never make people better off. Section 89 is no exception.

But even from an egalitarian perspective, this provision in the tax code doesn't make much sense. Its intent is not to ensure that everyone's level of compensation is the same, but to equalize one component of everyone's compensation package in a given workplace. In fact, however, the after-tax dollar value of workers' compensation packages isn't likely to be any more "equitable" after than before Section 89's leveling process takes place.

If lower paid workers are forced to take more extensive health insurance coverage, it will be at the expense of money wages or some other benefits. The issue for employers is how much it costs them to compensate labor, not what form that compensation takes. The value of a worker's compensation package is determined by how much the worker contributes to the production process. Without an increase in productivity from the worker, there is no reason to expect that the dollar value of his compensation package would be increased.

This would be especially damaging to very low paid employees, working at or near the minimum wage. Since their wages could not be lowered, those whose productivity does not justify a higher valued compensation package would lose their jobs. In cases where higher paid workers have to take less extensive coverage, wages or other benefits would have to be increased in order for employers to retain their services. Section 89 would neither make compensation among workers more equitable nor make workers better off.

Obviously Section 89 is no deal for employers either. Many companies offer their employees hundreds of health insurance options to choose from. Remember, simply offering health insurance plans in a nondiscriminatory way is not good enough for the social engineers who crafted Section 89. Companies will have to determine if the dollar value of the insurance plans that their employees actually choose is distributed among them in such a way that lower paid employees do not have lower valued plans. As with nearly all government programs, free choice is the enemy of Section 89.

Given that the administrative costs of this process will be very high, it may be cost effective for companies to take what might best be called the noncompliance option. If a company decides not to put itself through the battery of tests that the IRS requires, or if the IRS determines that inequities still exist, those employees earning over $50,000 who have higher valued plans will be taxed on a portion of those benefits. Since this would be tantamount to a pay cut for these workers, it is likely that employers, in order to retain these workers, would increase their wages to compensate for the added tax burden. It may be less expensive for an employer to do this than to bear the administrative costs associated with strict compliance. Of course the Treasury is hoping that many employers will take this option because it is these tax penalties that are supposed to make Section 89 a $300 million revenue raiser for the government.

This suggests that Section 89 was put in the tax code more for its possibilities as a revenue raiser than as a means of achieving social justice. The government benefits from Section 89 to the extent that it is not complied with. This could provide the logic behind why it has been made so complicated.

Section 89 also might be a back-door method of implementing a mandated health insurance program. Like the proposals to mandate health insurance, the formula that is used to determine if the values of health insurance policies are distributed equally includes part-time employees working more than 17.5 hours per week. This means that many part-time employees, who typically don't qualify for health insurance benefits, will have to be provided with the same plans as full-time workers.

This could impose real hardships on these workers. In particular, it would create an incentive for employers to offer part-time employment that entails less than 17.5 hours of work per week. Workers who would desire less than full-time employment, but more than just a few hours a week, may have to piece together an income from several different sources. Those employees who remain part-time, but work more than 17.5 hours per week, will probably have to trade off lower wages in exchange for their health insurance benefits. As social policy, Section 89 of the IRS Code has no justification. It presumably is meant to improve living standards for lower paid workers. But in reality it will make workers in all income categories worse off by restricting their liberty to choose the compensation package that best fits their needs and to freely negotiate labor contracts.