(5) Repeal the exclusions for employee benefits with respect to highincome employees Present Law In general, employer-provided health coverage, group-term life insurance, and dependent care assistance are excludable from an employee's income. These exclusions are conditioned, however, on the benefits being provided under a plan meeting certain nondiscrimination and qualification requirements. In addition, the exclusion of group-term life insurance does not apply to coverage in excess of $50,000. The dependent care exclusion is limited to $5,000 in a taxable year ($2,500 in the case of a separate return by a married individual). Employer-provided health coverage and group-term life insurance are unconditionally excludable from wages for purposes of the FICA and FUTA taxes. Employer-provided dependent care assistance is excludable from wages for FICA and FUTA purposes if, at the time the assistance is provided, it is reasonable to assume that the assistance will be excludable from income. Possible Proposal The exclusion from income and wages of employer-provided health coverage, group-term life insurance, and dependent care could be repealed for taxpayers (or employees) with adjusted gross income (or compensation) equal to or exceeding $60,000. The exclusions could be phased out between $50,000 and $60,000. In conjunction with this proposal, the applicable nondiscrimination rules could be repealed with respect to such benefits. Arguments for the proposal Pros and Cons 1. The exclusions of employee benefits from income and wages can result in taxpayers with the same economic income paying different amounts of tax because of the form in which their compensation is received. The exclusions from income and wages also narrow the tax base, thereby requiring higher tax rates to produce a given amount of revenue. 2. The justification for the exclusions is that they are intended to encourage the provision of the benefits by employers to low- and middle-income employees who otherwise might not purchase such benefits. The rationale for excluding the benefits from the income and wages of high-income employees is that, if the exclusions did not apply to high-income employees, employers would not adopt the employee benefit plans. In fact, for the vast majority of employers, the provision of employee benefits, especially health coverage, is necessary from an employee relations perspective. Thus, denying the exclusions to the high-income employees generally will not affect employers' willingness to maintain such plans. 3. High-income employees do not need what is, in effect, a government subsidy (provided through the tax system) to purchase benefits. There are many examples of tax benefits that are not available to high-income taxpayers or are available on a more restrictive basis (e.g., IRAs, dependent care credit, elderly credit, earned income credit). 4. Repealing the nondiscrimination rules applicable to the specified employee benefits would simplify the law. Arguments against the proposal 1. If the exclusions are not available with respect to high-income employees, employers will not maintain employee benefit plans and thus low- and middle-income employees will not receive the benefits. 2. In the case of a small or medium size employer, the employer's willingness to make benefits available generally to lower-income employees will be influenced to a great extent by the availability of an exclusion for higher-income employees. This is particularly true given the administrative cost to the employer of maintaining employee benefit plans. 3. High-income taxpayers have the same need for health coverage, life insurance, and dependent care as low- and middle-income taxpayers. Moreover, if such benefits are not provided to them by their employer (due to the repeal of the exclusions), such highincome taxpayers may not purchase such benefits on their own. 4. Phasing in an income inclusion as a taxpayer's income (or compensation) rises has the effect of increasing the taxpayer's marginal tax rate within the phase-in range. (6) Limit the exclusion for cafeteria plan benefits Present Law Under present law, compensation generally is taxable to employees when actually or constructively received. An amount is constructively received by a taxpayer if it is made available to the tax payer. There are various exceptions to this basic principle of constructive receipt. Under one exception, no amount is included in the income of a participant in a cafeteria plan meeting certain requirements solely because, under the plan, a taxable benefit is available to the participant. Nontaxable benefits that may be available under a cafeteria plan include, for example, health coverage, group-term life insurance, and dependent care assistance. The cafeteria plan exception from the principles of constructive receipt generally also applies for purposes of FICA and FUTA taxes. Under another exception, an employee is not required to include in income employer contributions to a qualified cash or deferred arrangement merely because the employee could have elected to receive the amount in cash. This exception to the constructive receipt principle is limited to $7,000 in an employee's taxable year. In addition, this exception does not apply for FICA and FUTA purposes, even if the qualified cash or deferred arrangement is part of a cafeteria plan. Possible Proposals 1. The cafeteria plan exception to the constructive receipt principle could be limited to a certain dollar amount, such as $500, for purposes of income, FICA, and FUTA taxes. As under present law, a plan offering an employee a choice only among nontaxable benefits would not be subject to this cap. 2. The cafeteria plan exception to the constructive receipt principle could be repealed for FICA and FUTA purposes. 3. A plan offering dependent care assistance could be considered ineligible for the cafeteria plan exception to the constructive receipt principle. Pros and Cons Arguments for the proposals 1. Limiting the constructive receipt exception for cafeteria plans to a certain dollar amount, such as $500, would serve purposes similar to those served by the $7,000 limit on elective deferrals under a qualified cash or deferred arrangement. Because elective arrangements can allow some of the most needy employees to elect cash instead of benefits without violating the applicable nondiscrimination rules, the current revenue cost of cafeteria plans is not justified by the results. In addition, in some cases, the dollar limit will result in cafeteria plans functioning as supplements to nonelective employee benefit plans, rather than in lieu of such nonelective plans. The dollar limit does not eliminate an employer's ability to allow different employees to choose different benefits. The dollar limit simply limits the tax benefits provided to such an arrangement. 2. Repealing the cafeteria plan exception to the constructive receipt principle for FICA and FUTA purposes would be consistent with the retirement plan area in which exceptions to the constructive receipt principle may reduce income, but not wages. The rationale for such a rule is that social security is intended to be a mandatory program; individuals generally should not be entitled to elect out of the program, even partially. 3. In general, low-income employees do not elect dependent care assistance under a cafeteria plan, since for them the dependent care credit (to the extent available) is more advantageous than the income exclusion for the assistance. Thus, allowing dependent care assistance to be elected under a cafeteria plan functions largely to enable high-income taxpayers to obtain a larger tax benefit for their housekeepers and to avoid certain restrictions applicable to the dependent care credit. The applicable nondiscrimination rules do not prevent such favoring of high-income taxpayers. 4. A significant portion of the projected long-term deficit in the social security trust funds is attributable to the shrinking of the taxable wage base from the exclusion of fringe benefits for FICA purposes. As the portion of compensation paid in nontaxable fringe benefits grows, the size of the taxable payroll shrinks. By subjecting wages excluded from income under cafeteria plans to FICA tax, this shrinkage in the wage base would be slowed and the long-term financing of social security would be strengthened. 5. As pointed out in a study issued by the Department of Health and Human Services in July 1985, cafeteria plans can, under present law, have an adverse effect on efforts to contain health costs. Arguments against the proposals 1. The proposed limitations on cafeteria plans would reduce their usage by employers and thus could result in some employees receiving benefits they do not need and others not receiving benefits they do need. Such a result may lead to an inefficient use of tax expenditures if employers provide employees with unnecessary benefits. The concern that low- and middle-income employees will take cash instead of benefits is adequately addressed by the nondiscrimination rules. 2. If one of the first two proposals were enacted, employers would be less likely to provide employee benefits to low- and middleincome employees. In addition, many of these lower-income employees would not purchase such benefits on their own. Accordingly, such employees may in some cases need public assistance. The cost of providing this assistance may well exceed the cost of retaining the present-law unlimited exclusion for cafeteria plans. 3. If a taxpayer's dependent care expenses exceed the amount eligible for the credit, it would be advantageous for such a taxpayer to elect dependent care expenses under a cafeteria plan regardless of income level. In addition, there are a significant number of middle-income taxpayers for whom the exclusion is more beneficial than the credit. Retaining the availability of dependent care assistance under a cafeteria plan thus is justified as a matter of social policy. |