The “Cadillac” tax will soon hit many cities and states

Editor’s note: This post originally appeared in RealClear Markets on May 12, 2015.

While much has been written on the ACA’s implications for private sector employers, only a few commentators have focused on the ACA’s implications for cities and states. Like any for-profit employer, any local government with 50 or more full-time employees (100 or more in 2015) must offer an ACA-compliant healthcare plan, or pay significant penalties. Moreover, under current law, the healthcare plans of many local governments will become subject in 2018 to the “Cadillac” tax – an excise tax on healthcare costs above specified annual amounts.  The idea behind the Cadillac tax is to help rein in the spiraling cost of health care by putting pressure on employers to offer less generous health insurance plans.

Most states and cities offer generous healthcare plans to their civil servants during their working years and through their retirement until they go on Medicare.  In general, local governments offer their employees a broad range of high-quality medical services with little or no co-payments and minimal deductibles.  And local governments pay most, if not all, of the annual premiums for such generous healthcare plans.

But this situation will change dramatically because of two factors.  Earlier this year, the US Supreme Court unanimously decided that a collective bargaining agreement should not be construed to provide workers with free healthcare benefits for life — unless that agreement explicitly required the employer to pay all healthcare premiums for the lifetime of its employees.  Instead, the Supreme Court declared, the healthcare benefits included in a collective bargaining agreement presumptively end when that agreement expires.  As a result, local governments will have the opportunity to renegotiate their healthcare benefits with the public unions as their collective bargaining agreements end.

In these negotiations over the next few years, local governments should be very concerned about running afoul of the “Cadillac” tax.  In 2014, government healthcare plans were 17.5 percent higher cost than the average citizen’s plan, and their employee contributions were 45 percent less than the average plan, according to a survey of nearly 10,000 employers by United Benefit Advisors.    

If these patterns continue, many state and city healthcare plans will run up against the “Cadillac” tax in 2018 – a 40 percent tax on the amount of total healthcare premiums (from employers and employees) exceeding $10,200 per year for individuals or $27,500 per year for families. In a 2013 letter, the deputy mayor for operations in New York City estimated that the Cadillac tax would cost the City $22 million in 2018, rising to $549 million in 2022. Similarly, the Association of Washington Cities, which offers a pooled plan to municipalities in Washington State, estimated that the “Cadillac” tax could increase local taxes by $76 million over the decade starting in 2018.

The “Cadillac” tax would effectively be paid out of current tax revenues by affected cities and states, along with most of the insurance premiums for the healthcare plans of their employees. That’s because retiree healthcare plans, unlike pension plans, are not generally advance-funded with investment assets to help finance future benefits. As a result, if healthcare costs of local governments continue to rise and they start paying the “Cadillac” tax, the combination will jeopardize public spending on essential services like schools and police. 

So what can be done by local governments to avoid paying the “Cadillac” tax and reduce their healthcare cost? A few local governments are planning to stop offering their own healthcare plans and switch their employees to the ACA insurance exchange. However, if a local government stopped offering a healthcare plan, it would have to pay a penalty of up to $3,000 per full-time employee (minus the first 30 employees).  In turn, its employees would usually pay a larger portion of their insurance premiums on these exchanges than they do now for the healthcare plan of the local government — though some employees may have low enough incomes to qualify for federal premium subsidies on policies offered through an ACA exchange.   

To help defray these healthcare premiums on the new exchanges, some employers — private and public — have proposed to provide their employees with cash payments through a healthcare reimbursement account.  But the federal authorities have effectively blocked this proposal by declaring that an employer making such cash payments, instead of offering an ACA-compliant healthcare plan, would be subject to another penalty of over $36,000 per year for each of its employees.

In most cases, local governments will try to avoid the “Cadillac” tax by constraining the growth of their healthcare costs. For example, local governments are likely to ask public employees to contribute more of their insurance premiums, make larger co-payments for doctor visits (except for preventative care) and accept a narrower range of covered services.

Of course, the union representing public employees would resist having their members pay more or receive less on the grounds that these employees reasonably relied on a full healthcare benefit package when accepting their jobs and staying in them.  But there may be a viable middle ground in the negotiations between the local governments and the public unions.  For example, the reduction in benefits could apply only to public employees below a certain age, and the local government could commit to a schedule for advance funding of a negotiated package of healthcare benefits.  

In short, the Supreme Court’s recent decision, together with the threat of the “Cadillac” tax, will lead to the renegotiation of healthcare benefits in many cities and states.  To avoid this harsh tax, local governments probably will try to persuade public employees to accept a less generous package of healthcare benefits.  At the same time, these public employees should demand stronger assurances that this package will actually be delivered — by gradually building a fund dedicated to future healthcare benefits.