PAGENO="0001" DISTRIBUTION AND ECONOMICS OF EMPLOYER- PROVIDED FRINGE BENEFITS çf `~) ~ HEARINGS BEFORE THE SuBCOMMITTEE ON SOCIAL SECURITY AND STJECOMIMTTTEE ON SELECT REVENUE MEASURES OF THE COMIMIITTEE ON WAYS AND MIEANS HOUSE OF REPRESENTATIVES NINETY-EIGHTH CONGRESS SECOND SESSION SEPTEMBER 17 AND 18, 1984 Serial 98-98 Printed for the use of the Committee on Ways and Means ~j ~7 ~ U.S. GOVERNMENT PRINTING OFFICE 40-0460 WASHINGTON : 1985 PAGENO="0002" COMMITI'EE ON WAYS AND MEANS DAN ROSTENKOWSKI, illinois, Chairman SAM M. GIBBONS, Florida J.J. PICKLE, Texas CHARLES B. RANGEL, New York FORTNEY H. (PETE) STARK, California JAMES R. JONES, Oklahoma ANDY JACOBS, JR., Indiana HAROLD FORD, Tennessee ED JENKINS, Georgia RICHARD A. GEPHARDT, Missouri THOMAS J. DOWNEY, New York CECIL (CEC) HEFFEL, Hawaii WYCHE FOWLER, JR., Georgia FRANK J. GUARINI, New Jersey JAMES M. SHANNON, Massachusetts MARTY RUSSO, Illinois DON J. PEASE, Ohio KENT HANCE, Texas ROBERT T. MATSUI, California BERYL ANTHONY, JR., Arkansas RONNIE G. FLIPPO, Alabama BYRON L. DORGAN, North Dakota BARBARA B. KENNELLY, Connecticut BARBER B. CONABLE, JR., New York JOHN J. DUNCAN, Tennessee BILL ARCHER, Texas GUY VANDER JAGT, Michigan PHILIP M. CRANE, illinois BILL FRENZEL, Minnesota JAMES G. MARTIN, North Carolina RICHARD T. SCHULZE, Pennsylvania BILL GRADISON, Ohio W. HENSON MOORE, Louisiana CARROLL A. CAMPBELL, Ji~, South Carolina WILLIAM M. THOMAS, California FORTNEY H. (PETE) STARK, California, Chairman JOHN J. DUNCAN, Tennessee RICHARD T. SCH1JLZE, Pennsylvania GUY VANDER JAGT, Michigan W. HENSON MOORE, Louisiana JAYNE Boyu~, Professional Staff Josm~ JONAS, Professional Staff I Joiss~ J. SALMON, Chief Counsel JosEPH K. Dowi.EY, Assistant Chief Counsel ROBERT J. LEONARD, Chief Tax Counsel A.L. SINGIEFON, Minority Chief of Staff SUBCOMM1TPEE ON SOCIAL SECURITY J.J. PICKLE, Texas, Chairman ANDY JACOBS, JR., Indiana BILL ARCHER, Texas RICHARD A. GEPHARDT, Missouri BILL GRADISON, Ohio JAMES M. SHANNON, Massachusetts PHILIP M. CRANE, illinois WYCHE FOWLER, JR., Georgia WILLIAM M. THOMAS, California ROBERT T. MATSUI, California BERYL ANTHONY, JR., Arkansas ERwTh~ Hy~rs~sa, Professional Staff Csssiu~Es M. B1IAIIe, Professional Staff PA'rIucIA E. Dui.EY, Professional Staff JOSEPH H. Gw~r, Professional Staff SUBCOMMIrPEE ON SELECT REVENUE MEASURES CECIL (CEC) HEF1'EL, Hawaii FRANK J. GUARINI, New Jersey RONNIE G. FLIPPO, Alabama BYRON L. DORGAN, North Dakota BARBARA B. KENNELLY, Connecticut ED JENKINS, Georgia (II) PAGENO="0003" CONTENTS Page Press release of Wednesday, August 29, 1984, announcing the hearings 1 WITNESSES Department of the Treasury, Ronald A. Peariman, Acting Assistant Secretary for Tax Policy 28 Department of Health and Human Services: Robert B. Helms, Acting Assistant Secretary for Planning and Evalua- tion, and Bruce Steinwald, Acting Deputy Assistant Secretary for Health Policy 46 Harry C. Ballantyne, Chief Actuary, Social Security Administration, and Bruce Schobel, Actuary 50 Small Business Administration, Frank S. Swain, Chief Counsel for Advocacy... 188 Alexander, Donald C., Chamber of Commerce of the United States 104 American Federation of Labor & Congress of Industrial Organizations, Ray Denison and Arnold Cantor 559 Beadle, Carson E., William M. Mercer-Meidinger, Inc 471 Cantor, Arnold, American Federation of Labor & Congress of Industrial Orga- nizations 559 Castells, Manuel, Kwasha Lipton 518 Chamber of Commerce of the United States, Donald C. Alexander and Mi- chael J. Romig 104 Curran, Jack, National Coordinating Committee for Multiemployer Plans 551 Denison, Ray, American Federation of Labor & Congress of Industrial Organi- zations 559 Employee Benefit Research Institute, Dallas L. Salisbury 62 Federal Reserve Bank of Boston, Alicia H. Munnell 417 Georgine, Robert A., National Coordinating Committee for Multiemployer Plans 551 Hewitt Associates, Susan Koralik 467 International Union, United Automobile, Aerospace & Agricultural Imple- ment Workers of America, Alan Reuther 573 Kaye, Lloyd S., William M. Mercer-Meidinger, Inc 471 Koralik, Susan, Hewitt Associates 467 Kwasha Lipton, Manuel Castells 518 Mercer-Meidinger, William M., Inc., Carson E. Beadle and Lloyd S. Kaye 471 Millipore Corp., Kenneth D. Simonson 435 Minarik, Joseph J., the Urban Institute 428 Mobil Oil Corp., Robert B. Peters 528 Munnell, Alicia H., Federal Reserve Bank of Boston 417 National Coordinating Committee for Multiemployer Plans, Robert A. Geor- gine, Jack Curran, and Peter Schmidt 551 Peters, Robert B., Mobil Oil Corp 528 President's Commission on Industrial Competitiveness, Kenneth D. Simonson. 435 Project HOPE, Gail R. Wilensky 455 Prudential Insurance Co. of America, Robert C. Winters 542 Reuther, Alan, International Union, United Automobile, Aerospace & Agri- cultural Implement Workers of America 573 Romig, Michael J., Chamber of Commerce of the United States 104 Salisbury, Dallas L., Employee Benefit Research Institute 62 Schmidt, Peter, National Coordinating Committee for Multiemployer Plans 551 (III) PAGENO="0004" Iv Page Simonson, Kenneth D., President's Commission on Industrial Competitive- ness, and Millipore Corp 435 Sun Co., Inc., Howard Weizmann 533 Tiner, Michael L., United Food & Commercial Workers International Union, AFL-CIO 570 United Food & Commercial Workers International Union, AFL-CIO, Michael L. Tiner 570 Upjohn, W.E., Institute for Employment Research, Stephen A. Woodbury 448 Urban Institute, Joseph J. Minarik 428 Weizmann, Howard, Sun Co., Inc 533 Wilensky, Gail R., Project HOPE 455 Winters, Robert C., Prudential Insurance Co. of America 542 Woodbury, Stephen A., W.E. Upjohn Institute for Employment Research 448 SUBMISSIONS FOR THE RECORD U.S. Department of Labor, Robert A.G. Monks, Administrator, Office of Pen- sion and Welfare Benefit Programs, statement 590 Aetna Life & Casualty, Burton E. Burton, statement 593 AGRI Industries Retirement Committee, Thomas C. Walker, statement 754 Air Line Pilots Association, International, statement 596 Albertine, James J., American Society of Association Executives, letter and attachment 608 American Academy of Actuaries, Stephen G. Kellison, statement 598 American Council of Life Insurance and Health Insurance Association of America, joint statement 628 American Dental Association, statement 602 American Dental Hygienists' Association, statement 603 American Hospital Association, statement 605 American Psychiatric Association, Jay B. Cutler, letter 607 American Society of Association Executives, James J. Albertine, letter and attachment 608 American Telephone & Telegraph Co., statement 622 Ameritech, Donald W. Phfflips, letter 626 Andrews, Emily S., Washington, DC, statement 638 Associated General Contractors of America, statement 655 Associated Specialty Contractors, Inc., statement 656 Association for Advanced Life Underwriting, statement 658 Atlantic Richfield Co., Dwaine H. Smith, statement 665 Bankers Life Co., statement 675 Barber, Jane, Tektronix, Inc., statement 748 BellSouth Corp., Roy B. Howard, Clyde V. Manning, and Randy L. New, joint statement 678 Biggins, Peter A., LTV Corp., statement 719 Blue Cross & Blue Shield Association, statement 683 Boel, Hal, Pacific Telesis, statement 744 Burton, Burton E., Aetna Life & Casualty, statement 593 Chen, Yung-Ping, Bryn Mawr, PA, statement 686 CIGNA Corp., Hartzel Z. Lebed, statement 687 Chollet, Deborah J., Washington, DC, statement 690 Comprehensive Accounting Services, Paul W. Giesler, letter 701 Connecticut General Life Insurance Co., Hartzel Z. Lebed, statement 687 Cutler, Jay B., American Psychiatric Association, letter 607 Delta Dental Plans Association, Erik D. Olsen, statement 701 Dreux, Joan Albert, National Association of Casualty & Surety Agents, letter. 730 Dunstone, William H., Haddon Craftsmen, Inc., letter 705 Giesler, Paul W., Comprehensive Accounting Services, letter 701 Haake, J.F., Southwestern Bell Telephone, letter 748 Haddon Craftsmen, Inc., William H. Dunstone, letter 705 Health Insurance Association of America and American Council of Life Insur- ance, joint statement 628 Howard, Roy B., BellSouth Corp., statement 678 Hy-Vee Food Stores, Inc., Ronald D. Pearson, statement 706 Kellison, Stephen G., American Academy of Actuaries, statement 598 Korczyk, Sophie M., Alexandria, VA, statement 709 Lawson, Gary B., Jenkens & Gilchrist, letter 718 PAGENO="0005" V Page Lebed, Hartzel Z., CIGNA Corp., and Connecticut General Life Insurance Co., statement 687 LTV Corp., Peter A. Biggins, statement 719 Manning, Clyde V., BellSouth Corp., statement 678 Maytag Co., Jay R. Storey, statement 728 National Association of Casualty & Surety Agents, Joan Albert Dreux, letter.. 730 National Employee Benefits Institute, statement 731 National Rural Electric Cooperative Association, Martin D. Wood, statement.. 739 Nelson, John M., Rockford, IL, letter addressed to Senator Alan Dixon 744 New, Randy L., BellSouth Corp., statement 678 Olsen, Erik D., Delta Dental Plans Association, statement 701 Pacific Telesis, Hal Boel, statement 744 Pearson, Ronald D., Hy-Vee Food Stores, Inc., statement 706 Pfizer Inc., Edmund T. Pratt, letter 746 Phillips, Donald W., Ameritech, letter 626 Picker International, Russell Spector, letter 747 Pratt, Edmund T., Pfizer Inc., letter 746 Southwestern Bell Telephone, J.F. Haake, letter 748 Smith, Dwaine H., Atlantic Richfield Co., statement 665 Spector, Russell, Picker International, letter 747 Storey, Jay R., Maytag Co., statement 728 Tektronix, Inc., Jane Barber, statement 748 Travelers Insurance Cos., John F. Troy, statement 751 Troy, John F., Travelers Insurance Cos., statement 751 Walker, Thomas C., AGRI Industries Retirement Committee, statement 754 Wood, Martin D., National Rural Electric Cooperative Association, statement. 739 PAGENO="0006" PAGENO="0007" DISTRIBUTION AND ECONOMICS OF EMPLOYER-PROVIDED FRINGE BENEFITS MONDAY, SEPTEMBER 17, 1984 HOUSE OF REPRESENTATIVES, COMMITTEE ON WAYS AND MEANS, SUBCOMMITTEE ON SOCIAL SECURITY, AND SUB- COMMITTEE ON SELECT REVENUE MEASURES, Washington, DC. The subcommittees met at 10:05 a.m., pursuant to notice, in room 1100, Longworth House Office Building, Hon. J.J. Pickle (chairman of the Subcommittee on Social Security) and Hon. Fortney H. (Pete) Stark (chairman of the Subcommittee on Select Revenue Measures) presiding. [The press release announcing the hearing and background infor- mation follow:] [Press release No. 10, Wednesday, August 29, 1984] THE HONORABLE J.J. PICKLE (D., TEXAS), CHAIRMAN, SUBCOMMITTEE ON SOCIAL SECIJ- RITY, AND THE HONORABLE FORTNEY H. (PETE) STARK (D., CALIF.), CHAIRMAN, SUB- COMMITTEE ON SELECT REVENUE MEASURES, COMMITTEE ON WAYS AND MEANS, U.S. HOUSE OF REPRESENTATIVES, ANNOUNCE A HEARING TO GATHER GENERAL INFORMA- TION ON THE DISTRIBUTION AND ECONOMICS OF EMPLOYER PROVIDED FRINGE BENE- FITS The Honorable J.J. Pickle (D., Texas), Chairman of the Subcommittee on Social Security, and the Honorable Fortney H. (Pete) Stark (D., Calif.), Chairman of the Subcommittee on Select Revenue Measures, Committee on Ways and Means, U.S. House of Representatives, today announced a joint oversight hearing on the distri- bution and economics of employer provided fringe benefits. The hearing will be held on Monday, September 17, 1984, and Tuesday, September 18, 1984, in the Committee's main hearing room, 1100 Longworth House Office Building, beginning at 11:00 a.m. Testimony will be received from invited witnesses representing the Administration, plan providers, employee and management organi- zations, and invited public witnesses. In announcing the hearing, Chairman J.J. Pickle stated: "The subcommittees do not have a legislative proposal before them and these hearings are not designed to draft any particular legislative proposal. Rather these hearings are designed to gather information and better inform the Congress and the public about certain as- pects of fringe benefits. First of all, the subcommittees are interested in determining the prevalence of fringe benefits in the working population in general and among different types of workers in particular. Secondly, the subcommittees will be explor- ing the economics of fringe benefits and will be interested in learning how employ- ers and employees consider the tax status of various fringes in devising a total com- pensation package. The economic effects of these decisions will also be of interest." Chairman Stark noted, "Last year the Select Revenue Measures Subcommittee re- ported out legislation (now part of P.L. 98-369) that codified long-established nonsta- tutory fringe benefits, but subjected all benefits not expressly exempted to tax. Now that we have eliminated the distinction between statutory and nonstatutory bene- fits, it is time to examine on a comprehensive basis all benefits exempted from tax currently in the Code. We need to understand their true cost, both in terms of lost revenue and in terms of higher taxes paid on nonexempt forms of compensation. While no one doubts that fringe benefits serve many useful social purposes, we in (1) PAGENO="0008" 2 the Congress do not have a clear understanding of the true cost of these exemp- tions." FRAMEWORK FOR HEARINGS While recognizing that the subject of fringe benefits is diverse and complex the subcommittees are particularly interested in receiving testimony on the following: (1) How prevalent are the available fringe benefits. Specifically, what percent of the work force is covered by the various fringe benefits, such as pensions, and what percent of compensation do fringe benefits represent? How does this compare with their historic availability and utilization, and what changes are currently projected to occur in the future? (2) Which employees by salary range and occupation receive the various fringe benefits? (3) Since different types of fringe benefits are subject to different tax treatment, how do employers and employees decide to structure a total compensation package which includes cash, taxable fringe and nontaxable fringe? What is the effect of tax- favored treatment on the selection of certain fringe benefits in comparison to other fringe benefits and cash remuneration? What would be the effect of the, availability and use of various fringe benefits if the favorable tax treatment were changed, for instance, if FICA tax were imposed? (4) What are the economic effects of the utilization of fringe benefits? What is the effect of the tax-favored treatment of certain fringe benefits on the horizontal and vertical equity of the income tax system? For example, for any given level of overall federal revenue, would the incidence of the income tax shift significantly if current- ly nontaxable fringe benefits were subject to income taxes? (5) How much could FICA tax rates be lowered if nontaxable benefits were includ- ed in the social security wage base? What is the effect of the exclusion of certain fringe benefits from the social security wage base on social security benefits re- ceived by various types of workers? (6) What would be the effect of placing a fixed dollar cap, flat excise tax, or a limit on the percent of compensation which could be accorded tax-exempt or tax- deferred treatment? What levels or limits would be necessary in order to prevent further erosion of tax bases? (7) What is the relationship between fringe benefits provided by employers and social programs provided by government agencies? What social purposes are served by various fringes? If certain fringe benefits were not provided by employers, would there be an increased dependency on existing federally funded social programs or a need to create federafly funded social programs? Which is the most efficient use of resources in providing specific services or benefits: encouraging employers to pro- vide them through perferred tax treatment or providing them through directly funded public programs? WRITTEN STATEMENTS FOR THE RECORD OF THE HEARING Testimony will be received from invited witnesses only. All other interested par- ties wishing to submit written statements for the record of the hearing are encour- aged to do so. Persons submitting written statements should submit at least six (6) copies by the close of business Friday, September 21, 1984, to John J. Salmon, Chief Counsel, Committee on Ways and Means, U.S. House of Representatives, 1102 Long- worth House Office Building, Washington, D.C. 20515. If those ffling written state- ments for the record of the hearing wish to have their statements distributed to the press and the interested public, they may provide 100 additional copies for this pur- pose to the Committee office, 1102 Longworth Building, before the hearing begins. PAGENO="0009" 3 [JOINT COMMITTEE PRINT] OVERVIEW OF THE TAX TREATMENT OF FRINGE BENEFITS SCHEDULED FOR JOINT HEARINGS BEFORE THE SUBCOMMITTEE ON SOCIAL SECURITY AND THE SUBCOMMITTEE ON SELECT REVENUE MEASURES OF THE COMMITTEE ON WAYS AND MEANS ON SEPTEMBER 17 AND 18, 1984 PREPARED BY THE STAFF OF THE JOINT COMMITTEE ON TAXATION w SEPTEMBER 14, 1984 U.S. GOVERNMENT PRINTING OFFICE 38-301 0 WASHINGTON: 1984 JcS-33-84 PAGENO="0010" 4 CONTENTS Page INTRODUCTION . 1 I. SUMMARY . 2 II. OVERVIEW OF TAX TREATMENT OF FRINGE BENEFITS 5 A. Statutory Fringe Benefit Provisions 5 B. Miscellaneous Fringe Benefits 11 C. Benefits Provided Under a Cafeteria Plan 13 D. Welfare Benefit Plans 14 E. Qualified Pension, Profit-Sharing, and Stock Bonus Plans 17 III. BACKGROUND DATA RELATING TO TAX TREATMENT OF CERTAIN FRINGE BENEFITS 19 A. Revenue Implications 19 B. Growth in Fringe Benefits 20 (III) PAGENO="0011" 5 INTRODUCTION The Subcommittee on Social Security and the Subcommittee on Select Revenue Measures of the Committee on Ways and Means have scheduled joint public hearings on September 17 and 18, 1984, on the Federal tax treatment of fringe benefits. In the press release announcing the oversight hearing, Chairman Pickle of the Social Security Subcommittee stated that "the sub- committees do not have a legislative proposal before them and these hearings are not designed to draft any particular legislative proposal. Rather, these hearings are designed to gather informa- tion and better inform the Congress and the public about certain aspects of fringe benefits. First of all, the subcommittees are inter- ested in determining the prevalence of fringe benefits in the work- ing population in general and among different types of workers in particular. Secondly, the subcommittees will be exploring the eco- nomics of fringe benefits and will be interested in learning how employers and employees consider the tax status of various fringes in devising a total compensation package. The economic effects of these decisions will also be of interest." Chairman Stark stated that "last year the Select Revenue Meas- ures Subcommittee reported out legislation (now part of P.L. 98- 369) that codified long-established nonstatutory fringe benefits, but subjected all benefits not expressly exempted to tax. Now that we have eliminated the distinction between statutory and nonstatu- tory benefits, it is time to examine on a comprehensive basis all benefits exempted from tax currently in the Code. We need to un- derstand their true cost, both in terms of lost revenue and in terms of higher taxes paid on nonexempt forms of compensation. While no one doubts that fringe benefits serve many useful social pur- poses, we in the Congress do not have a clear understanding of the true cost of these exemptions." The first part of the pamphlet is a summary. This is followed by a more detailed overview of the Federal tax treatment of fringe benefits, including qualified pension, profit-sharing, or stock bonus plans, qualified annuity plans, and tax-sheltered annuities. The final part sets forth background information, including revenue im- plications of the tax treatment of certain fringe benefits' and growth in certain fringe benefits. (1) PAGENO="0012" 6 I. SUMMARY In general The Code defines gross income for purposes of the income tax and the tax on self-employment income (SECA) as including "all income from whatever source derived" and specffies that it in- cludes "compensation for services" (sec. 61). Similarly, the social se- curity and unemployment insurance payroll taxes (FICA and FUTA) and income tax withholding generally apply to all remu- neration for employment, including noncash remuneration. Any fringe benefit that does not qualify for exclusion under a specific statutory provision is inducible in gross income, and subject to em- ployment taxes, at the excess of its fair market value over any amount paid by the employee for the benefit. Statutory fringe benefit provisions As a general rule, if an employer-provided fringe benefit pro- gram qualifies under a specific statutory provision of the Code, then the benefits provided under the program are excludable (gen- erally, subject to dollar or other limitations) from the employee's gross income for income tax purposes. The costs of benefits that are excluded from an employee's income nonetheless are deductible by the employer provided they constitute ordinary and necessary busi- ness expenses. The income tax exclusions also generally apply for payroll tax purposes. The Code provides specific exclusions, among others, with respect to employer provision of (1) up to $50,000 of group-term life insur- ance; (2) up to $5,000 of death benefits; (3) accident or health bene- fits; (4) parsonage allowances; (5) certain benefits provided to mem- bers of the Armed Services; (6) meals and lodging for the conven- ience of the employer; (7) group legal services; (8) commuting through use of a van pool; and (9) dependent care assistance. Miscellaneous fringe benefits The Economic Recovery Tax Act of 1981 (P.L. 97-34) extended through December 31, 1983, a moratorium on the issuance of Treas- ury regulations relating to the income tax treatment of nonstatu- tory fringe benefits. The Treasury Department has announced that the Treasury and the IRS "will not issue any regulations or rulings altering the tax treatment of nonstatutory fringe benefits prior to January 1, 1985," and that "present administrative practice will not be changed during this period" (Ann. 84-5, 1984-4 I.R.B. 31). Under the Tax Reform Act of 1984 (P.L. 98-369), certain miscella- neous fringe benefits provided by an employer are excluded from the recipient employee's gross income for Federal income tax pur- poses and from the wage and benefit bases for purposes of social security and other employment taxes. The excluded fringe benefits (2) PAGENO="0013" 7 3 are those that qualify under one of the following five categories as defined in the Act: (1) a no-additional-cost service, (2) a qualified employee discount, (3) a working condition fringe, (4) a de minimis fringe, or (5) a qualified tuition reduction. Special rules apply with respect to certain parking or eating facilities provided to employees and certain on-premises athletic facilities. In the case of a no-additional-cost service, a qualified employee discount, a subsidized eating facility, or a qualified tuition reduc- tion, the exclusion applies with respect to benefits provided to offi- cers, owners, or highly compensated employees only if the benefits are also made available to other employees on a nondiscriminatory basis. The provisions of the Act generally take effect on January 1, 1985, except that the tuition reduction exclusion applies with re- spect to education furnished after June 30, 1985.' Benefits provided under a cafeteria plan Under a cafeteria plan, a participant is offered a choice between cash and certain fringe benefits. (Under the law in effect prior to the Tax Reform Act of 1984, a participant in a cafeteria plan could choose among cash, any taxable benefits (such as use of an employ- er-provided vacation facility), and nontaxable benefits (such as cov- erage under an accident and health plan). If the plan meets certain conditions generally related to nondiscrimination in favor of highly compensated employees, the participant is not treated as having re- ceived cash or a taxable fringe benefit solely because the partici- pant has the opportunity, before the benefit becomes available to the participant, to choose among the taxable and nontaxable bene- fits offered under the plan. On February 10, 1984, the IRS issued a news release (IR-84-22) stating that so-called "flexible spending arrangements" offered as part of a cafeteria plan did not provide employees with nontaxable benefits under the Code because, under such arrangements, em- ployees are assured of receiving the benefit of what they would have received had no covered expenses been incurred. In May, 1984, the IRS issued proposed regulations with respect to the cafe- teria plan rules and the statutory rules governing the exclusion of benefits from gross income. The Tax Reform Act of 1984 limits an individual's choices under a cafeteria plan to cash and fringe benefits that are excludable under a specific provision of the Code (other than scholarships or fellowships, van pooling, and those benefits excludable under the miscellaneous fringe benefit provisions of the Act). The Act also amends the cafeteria plan rules to provide that if, for a plan year, more than 25 percent of the total nontaxable benefits are provided to key employees, the key employees are taxed as if they received all available cash and taxable benefits under the plan. The Act im- poses certain reporting requirements on employers maintaining cafeteria plans. I Also, the Act imposes a moratorium, with respect to lodging furnished after December 31, 1983, and before January 1, 1986, on the issuance of income tax regulations providing for the inclusion in gross income of qualified campus lodging. PAGENO="0014" 8 4 The cafeteria plan provisions of the Act are effective on January 1, 1985. In addition, the Act provides transition relief from the ap- plication of some requirements of the proposed regulations up to January 1, 1985, or, in some cases, July 1, 1985. Welfare benefit plans The Tax Reform Act of 1984 modified the tax treatment of em- ployers with respect to certain benefits provided to employees under a welfare benefit plan. Under the Act, deductions for contri- butions to a welfare benefit fund are limited to qualified costs. Qualified costs generally consist of (1) qualified direct costs and (2) additions, within limits, to a qualified asset account. In general, the qualified asset account limit is the amount estimated to be neces- sary under actuarial assumptions, which are reasonable in the ag- gregate, to fund the liabilities of the plan for the amount of claims incurred but unpaid to provide certain benefits and the administra- tive costs of such benefits. In addition, the Act provides that the qualified asset account may include, within limits, amounts reason- ably necessary to accumulate reserves on a level annual basis under a welfare benefit plan so that a medical benefit or life insur- ance benefit (including a death benefit) payable to or on behalf of a retired employee is fully funded upon retirement. The Act modifies the rules relating to the unrelated business tax- able income of certain tax-exempt organizations that provide em- ployee benefits, and establishes new nondiscrimination standards for these organizations. These provisions of the Act generally are effective for contribu- tions paid or accrued after December 31, 1985. A special effective date is applied to plans maintained pursuant to a collective bar- gaining agreement in effect on July 1, 1985. In addition, the Act provides certain transition rules with respect to existing reserves. The provisions of the Act relating to nondiscrimination require- ments apply to taxable years beginning after December 31, 1984. Qualified pension, profit-sharing, and stock bonus plans If a pension, profit-sharing, or stock bonus plan qualifies under the tax law, then (1) a trust under the plan is generally exempt from income tax, (2) employers are generally allowed deductions (within limits) for plan contributions for the year for which the contributions are made, even though participants are not taxed on plan benefits until the benefits are distributed, (3) benefits distrib- uted as a lump sum distribution may be accorded special long-term capital gain treatment or 10-year income averaging treatment, or may be rolled over, tax-free, to an individual retirement account or annuity (IRA) or another qualified plan, and (4) certain partial dis- tributions may be rolled over, tax-free, to an IRA. Special rules are provided for tax-sheltered annuity contracts and simplified employ- ee pensions. PAGENO="0015" 9 II. DESCRIPTION OF TAX TREATMENT OF FRINGE BENEFITS A. Statutory Fringe Benefit Provisions In general Gross income, for income tax purposes, includes "all income from whatever source derived" (Code sec. 61(a)). This provision "is broad enough to* include in taxable income any economic or financial ben- efit conferred on the employee as compensation, whatever the form or mode by which it is effected" (Comm `r v. Smith, 324 U.S. 177, 181 (1945)). The social security and unemployment insurance payroll taxes (FICA and FUTA, respectively) and income tax withholding apply to "wages," defined in the statutes as all remuneration for employ- ment, including the cash value of all remuneration paid in any medium other than cash (secs. 3121(a), 3306(b) and 3401(a)). The railroad retirement tax (RRTA) applies to any form of money re- muneration (sec. 3231(e)). Regulations applicable to these statutes specify that the value of any noncash item is to be determined by the excess of its fair market value over any amount paid by the recipient for the item (see, e.g., Reg. sec. 31.3121(a)-1(e)). As a general rule, if an employer-provided fringe benefit pro- gram qualifies under a specific statutory provision of Federal income tax law, then the benefits provided under the program are excludable (generally, subject to dollar or other limitations) from the employee's gross income for income tax purposes. Similar ex- clusions also generally apply for employment tax purposes. The costs of benefits that are excluded from the employee's income nonetheless are deductible by the employer, provided they consti- tute ordinary and necessary business expenses (Code sec. 162). The social security tax on self-employment income under the Self-Employment Contributions Act (SECA) applies to net earnings from self-employment defined generally as gross income from an individual's trade or business, less the deductions allowed under the income tax which are attributable to the trade or business. Thus, the fringe benefits excluded from income of self-employed in- dividuals under the income tax generally also are excluded from the base of the self-employment tax. The Internal Revenue Code provides specific income tax exclu- sions, among others, with respect to employer-provided benefits of (1) up to $50,000 of group-term life insurance; (2) up to $5,000 of death benefits; (3) accident or health benefits; (4) parsonage allow- ances; (5) certain benefits provided to members of the Armed Serv- ices; (6) meals and lodging for the convenience of the employer; (7) legal services; (8) commuting through use of a van pool; and (9) de- (5) PAGENO="0016" 10 6 pendent care assistance. These fringe benefits have commonly been referred to as statutory fringe benefits. In addition, the Tax Reform Act of 1984 provided statutory exclu- sions for certain other fringe benefits (see Miscellaneous Fringe Benefits, below). Nondiscrimination rules Under present law, exclusions for most of the statutory fringe benefits are conditioned upon compliance with rules prohibiting discrimination in favor of employees who are owners, officers, shareholders, and highly compensated employees. These nondis- crimination rules generally prohibit discrimination as to eligibility to participate and as to contributions or benefits. A plan or program generally is required to meet the eligibility requirement by covering a classification of employees determined by the Internal Revenue Service not to result in prohibited discrim- ination. A self-insured medical reimbursement plan or group-term life insurance plan may also satisfy the requirement by covering a stated percentage of the employer's employees. Generally employees covered by a collective bargaining agree- ment and who are not covered by a plan can be excluded from con- sideration in applying the nondiscrimination rules if the benefits provided by the plan or program are the subject of good faith bar- gaining between the employer and employee representatives. The eligibility rules for self-insured medical reimbursement plans also provide that employees need not be taken into account if they have not completed three years of service, have not attained age 25, or are part-time or seasonal employees. The present-law nondiscrimination rules applicable to certain types of fringe benefit plans and programs also prohibit discrimina- tion as to contributions or benefits. With respect to self-insured medical reimbursement plans, present law specifically requires that all benefits available to the 5 highest-paid officers, 10-percent shareholders, or the 25-percent highest-paid employees must also be available to all other plan participants. Under present law, if a plan is found to discriminate in favor of employees who are officers, shareholders, or highly compensated, the otherwise applicable income exclusion generally is denied for all benefits provided under the plan, including those benefits pro- vided for rank-and-file employees. (The nondiscrimination rules generally do not provide express guidance as to when an employee is considered highly compensated, or the extent of stock ownership required before an employee is considered a shareholder, because such factors depend on the facts and circumstances of individual cases.) However, under a discriminatory self-insured medical reim- bursement plan or group-term life insurance plan, only those em- ployees with respect to whom discrimination is prohibited are re- quired to include amounts in gross income; other employees retain the benefit of the income exclusion. Group-term life insurance Under present law (sec. 79), the income exclusion for the cost of employer-provided group-term life insurance is subject to several limitations: (1) the exclusion is limited to the cost of the first PAGENO="0017" 11 7 $50,000 of such insurance on the employee's life, computed pursu- ant to tables prescribed by the Treasury Department; (2) no exclu- sion is provided for any "key employee" (officers, five-percent owners, one-percent owners with compensation in excess of $150,000, and certain employee-owners) if the program discrimi- nates in favor of key employees as to either eligibility to partici- pate or the life insurance benefits actually provided under the plan; and (3) no exclusion is provided for self-employed individuals (sole proprietors or partners). The cost of group-term life insurance purchased by an employer for an employee for a taxable year is in- cluded in the employee's gross income to the extent that the cost is greater than the sum of the cost of $50,000 of life insurance plus any contribution made by an employee to the cost of the insurance. If a group-term life insurance plan maintained by an employer dis- criminates in favor of any key employee, the exclusion for the cost of the first $50,000 of this insurance is not available. In that event, the full cost of the group-term life insurance for any key employee is included in the gross income of the employee. The Tax Reform Act of 1984 made three changes in the treat- ment of group-term life insurance. First, the $50,000 limitation on the amount of group-term life insurance that may be provided tax- free to employees also applies to retired as well as active employees (but not to disabled employees). Second, the nondiscrimination rules are applied to plans covering former employees, whether re- tired or disabled. Third, under the Act, if a plan fails to qualify for the exclusion because it is discriminatory, then key employees (whether active or former employees) must include in income the actual cost of their insurance benefit rather than the uniform table cost prescribed by the Treasury. The provisions of the Act are gen- erally applicable to taxable years beginning after December 31, 1983.2 Under FICA, the entire amount of any payment on account of death made to, or on behalf of, an employee or dependents under a plan or system for employees generally or for a class or classes of employees is exempt from tax. Any amount paid by an employer for insurance or annuities or into a fund to provide for such a pay- ment also is exempt from FICA (sec. 3121(a)(2)). Death benefits Present law generally excludes from a beneficiary's gross income proceeds of death benefits received under a life insurance contract (sec. 101(a)) and provides a limited exclusion for other benefits paid by or on behalf of an employer by reason of an employee's death (sec. 101(b)). As stated above, death benefits are entirely exempt from FICA if paid under a plan or system for employees generally or for a class or classes of employees. 2 The new provisions extending the $50,000 limitation and the nondiscrimination rules do not apply to any group-term life insurance plan in existence on January 1, 1984 (or to any compara- ble successor plan), but only with respect to those individuals who retire under the plan, who were employed during 1983 by the employer maintaining the plan, and who attained age 55 on or before January 1, 1984. Also, these new provisions generally do not apply to any employees who retired before January 1, 1984. However, the new rules will apply to any plan that is dis- criminatory after December 31, 1986, with respect to any individual retiring after that date. 40-046 0 - 85 - 2 PAGENO="0018" 12 8 The income tax exclusion for death benefits for employees not paid under an insurance contract is subject to several limitations: (1) only the first $5,000 of benefits attributable to any one employee is eligible for the exclusion; (2) amounts which are income in re- spect of a decedent (e.g., uncollected salary or unused vacation pay) are not eligible for the exclusion; (3) no exclusion is provided for amounts with respect to which the employee had a nonforfeitable right to receive the benefits, unless the source of payment is a qualified pension profit-sharing, or stock bonus plan or certain an- nuity plans; and (4) no exclusion is provided for amounts received under certain joint and survivor annuities if distribution to the participant had commenced prior to death. Except with respect to certain amounts payable from or under qualified plans, this exclu- sion generally is not available to self-employed individuals (sole proprietors or partners). Accident and health benefits Under present law, an employer's contributions to a plan provid- ing accident or health benefits are excludable from the employee's income (sec. 106). No similar exclusion is provided for self-employed individuals (sole proprietors or partners). Benefits actually paid to employees under accident and health plans generally are includible in the employee's gross income to the extent attributable to employer contributions (sec. 105(a)). Re- imbursements for costs incurred for medical expenses (within the meaning of sec. 213) and disability payments which compensate for permanent injury and are computed without reference to the period of absence from work are excluded from gross income (secs. 105(b) and (c)). However, in the case of self-insured medical reim- bursement plans (sec. 105(h)), no exclusion is provided for benefits paid to any employee who is among the 5 highest-paid officers, a 10-percent shareholder, or among the 25-percent highest-paid em- ployees if the program discriminates in favor of this group as to either eligibility to participate or the medical benefits actually pro- vided under the plan. Under FICA, payment of medical or hospitalization expenses in connection with sickness or accident disability made to, or on behalf of, an employee or dependents under a plan or system for employees generally, or for a class or classes of employees, are exempt from social security tax. Any amount paid by an employer for insurance or annuities or into a fund to provide for such a pay- ment also is exempt from FICA (sec. 3121(a)(2)). Also, any payments to or on behalf of an employee on account of sickness or accident disability, or medical or hospitalization ex- penses in connection with such disability, are exempt from FICA after the expiration of six calendar months following the last calen- dar month in which the employee worked for the employer (sec. 3121(a)(4)). In addition, FICA exempts payments to employees on account of retirement for disability under a plan which makes pro- vision for employees generally or a class or classes of employees (sec. 3121(a)(12)). Finally, any payment to an employee while the employee is entitled to disability insurance benefits under section 223(a) of the Social Security Act is exempt from FICA if the entitle- ment commenced prior to the calendar year in which the payment PAGENO="0019" 13 9 is made and if the employee did not perform any services for the employer during the period for which the payment is made (sec. 3121(a)(15)). Parsonage allowances Present law permits a minister of the gospel to exclude from gross income the rental value of a home provided as part of com- pensation, or a rental allowance paid as compensation to the extent used to rent or provide a home (sec. 107). The exclusion is subject to several restrictions: (1) the amount of the exclusion is limited to the rental value of the home or actual amounts paid to rent or pro- vide a home; (2) the exclusion is available only if the home or rental allowance is paid as remuneration for services; and (3) the exclusion for rental allowance is available only if the employer des- ignates such payment as a rental allowance in advance of payment.3 F~social security tax purposes, ministers generally are treated as self-employed individuals subject to SECA (rather than as em- ployees subject to FICA). SECA liability is computed without regard to the income tax exclusion for the rental value of parson- ages (sec. 1402(a)(8)). Benefits provided to members of the Armed Forces Present law permits military personnel to exclude a variety of in-kind benefits and cash payments from gross income. Specific ex- clusions apply to certain disability pensions (sec. 104(a)(4)); qualify- ing combat pay (sec. 112); mustering-out payments (sec. 113); and subsistence, housing, and uniform allowances, as well as the value of quarters or subsistence provided in kind (Regs. sec. 1.61-1(b)). A similar exclusion is provided for FICA (sec. 8121(i)(2)). Meals and lodging for the employer's convenience Present law excludes from gross income the value of certain meals or lodging furnished to an employee (or to the employee's spouse or dependents) by or on behalf of the employer for the con- venience of the employer (sec. 119). The exclusion for meals is available only if the meals are fur- nished (1) on the employer's business premises and (2) for the con- venience of the employer. The exclusion for lodging is available only if (1) the lodging is furnished on the employer's business prem- ises; (2) the lodging is furnished for the convenience of the employ- er; and (3) the employee is required, as a condition of employment, to accept such lodging. FICA exempts the value of any meals or lodging furnished by or on behalf of the employer if it is reasonable to believe that the em- ployee will be able to exclude such items from income under sec- tion 119 (sec. 3121(a)(19)). For social security tax purposes, minis- `In 1983, the IRS ruled that ministers may not take deductions for mortgage interest and real estate taxes on their residences to the extent that such expenditures are allocable to tax- free housing allowances provided for ministers (Rev. Rul. 83-3, 1983-1 C.B. 72). The new deduc- tion disallowance rule generally applied beginning July 1, 1983. Under a transitional rule, in the case of a minister who owned and occupied a home before January 3, 1983 (or had a contract to purchase a home before that date), the deduction disallowance rule generally will not apply until January 1, 1985. The 1984 Act extends this transitional rule date to January 1, 1986. PAGENO="0020" 14 10 ters generally are treated as self-employed individuals subject to SECA (rather than as employees subject to FICA). SECA liability is computed without regard to the income tax exclusion for meals and lodging furnished for the convenience of the employer (sec. 1402(a)(8)). Legal services Present law excludes from gross income employer contributions to a qualified prepaid legal services plan, as well as the value of any legal services received by, or amounts paid as reimbursement for legal services for, the employee or the employee's spouse or de- pendents (sec. 120). Also, the exclusion is available to self-employed individuals covered by qualified prepaid legal services plans. This exclusion is subject to several limitations: (1) the program may provide only for personal (i.e., nonbusiness) legal services; (2) no exclusion is available if the program discriminates in favor of employees who are officers, shareholders, or highly compensated, as to either eligibility to participate or the benefits provided under the plan; and (3) no more than 25 percent of the employer contribu- tions to the plan may be attributable to the group consisting of em- ployees (and their spouses and dependents) who own more than five percent of the stock or of the capital or profits interest in the employer. This exclusion is scheduled to terminate for taxable years ending after 1984. FICA excludes any contribution, payment or service provided by an employer which may be excluded from gross income under sec- tion 120. Van pooling Present law excludes from an employee's gross income the value of certain employer-provided transportation ("van pooling") be- tween an employee's residence and place of employment (sec. 124). This exclusion is subject to several limitations: (1) the exclusion is available only for transportation furnished through use of a com- muter van; (2) no exclusion is provided if the vanpooling arrange- ment discriminates in favor of employees who are officers, share- holders, or highly compensated; and (3) no exclusion is permitted for self-employed individuals (sole proprietors and partners). This exclusion is scheduled to terminate for van pooling provided in taxable years beginning after 1985. Dependent care assistance Present law excludes from an employee's gross income amounts paid or incurred by an employer for dependent care assistance pro- vided under a qualified dependent care assistance program (sec. 129). Also, the exclusion is available to self-employed individuals (sole proprietors or partners). This exclusion is subject to several limitations: (1) the amount ex- cluded may not exceed the employee's earned income (or, if the em- ployee is married, the lower of the earned income of the employee or the employee's spouse); (2) the exclusion is only provided for ex- penses for household services or care of qualifying individuals (de- pendents under the age of 15 or physically or mentally incapacitat- PAGENO="0021" 15 11 ed dependents or spouses) that are incurred to enable the taxpayer to be gainfully employed; (3) no exclusion is available for amounts paid for qualifying services rendered by the employee's dependent or child of the employee who is under the age of 19; (4) no exclu- sion is available if the dependent care assistance program discrimi- nates in favor of employees who are officers, owners, or highly compensated individuals (or their dependents); and (5) no exclusion is available if more than 25 percent of the total benefits paid are for the group consisting of employees who own more than five per- cent of the stock or of the capital or profits interest in the employ- er (or their spouses or dependents). FICA excludes any payment made or benefit furnished if it is reasonable to believe that employee will be able to exclude the pay- ment or benefit from income under section 129 (sec. 3121(ä)(18)). B. Miscellaneous Fringe Benefits Background A moratorium first enacted in 1978 prohibited issuance of Treas- ury regulations relating to the income tax treatment of nonstatu- tory fringe benefits. The legislative moratorium expired on Decem- ber 31, 1983. The Treasury Department has announced that Treas- ury and the IRS "will not issue any regulations or rulings altering the tax treatment of nonstatutory fringe benefits prior to January 1, 1985," and that "present administrative practice will not be changed during this period" (Ann. 84-5, 1984-4 I.R.B. 31). General rule The Tax Reform Act of 1984 provides a statutory exclusion from income and FICA and other employment taxes for (1) no-additional- cost services; (2) qualified employee discounts; (3) working condition fringes; (4) de minimis fringes; and (5) qualified tuition reductions. No fringe benefit (other than a de minimis fringe) is excluded under the Act if another section of the Code provides rules for the tax treatment of that general type of benefit. Under the Act, any fringe benefit that does not qualify for a stat- utory exclusion is expressly includible in gross income, and subject to employment taxes, at the excess of its fair market value over any amount paid by the employee for the benefit. The rules of the Act do not make any change in existing statuto- ry or regulatory exclusions for benefits for military personnel. Exclusion provisions No-additional-cost service.-A service provided to an employee is excluded if- (1) the employer incurs no substantial cost (including foregone revenue) in providing the service; (2) the service is provided by the employer or another business with whom the employer has a written reciprocal agreement, and is of the same type ordinarily sold to the public in the line of busi- ness in which the employee works; (3) the service is provided to a current or retired employee, or a spouse or dependent child of either, or a widow(er) or dependent children of a deceased employee; and PAGENO="0022" 16 12 (4) for certain highly compensated employees, nondiscrimination requirements are met (see below). Qualified employee discount.-A discount on merchandise provid- ed to an employee is excluded to the extent it does not exceed the employer's gross profit percentage (in the relevant line of business). The exclusion does not apply to discounts on real property or to discounts on personal property of a kind commonly held for invest- ment. A discount on services provided to an employee is excluded to the extent it does not exceed 20 percent of the selling price of the serv- ices to nonemployee customers (with no gross profit percentage re- striction). The following conditions generally must be satisfied for the ex- clusion to apply: (1) the property or service is provided by the employee and is of the same type ordinarily sold to the public in the line of business in which the employee works; (2) the property or service is provided to a current or retired em- ployee, a spouse or dependent child of either, or to a widow(er) or dependent children of a deceased employee; and (3) for certain highly compensated employees, nondiscrimina- tion requirements are met (see below). Working condition fringe.-Property or services provided to an employee are excluded to the extent that they would be deductible as ordinary and necessary business expenses (under Code sees. 162 or 167) if the employee had paid for them. The Act excludes, as a working condition fringe, the value of free or reduced-cost parking provided to employees on or near the em- ployer's business premises. De minimis fringe.-Property or services not otherwise tax-free are excluded if their fair market value is so small, taking into ac- count the frequency with which similar fringe benefits (otherwise excludable as de minimis fringes) are provided and other relevant factors, as to make accounting for the benefits unreasonable or ad- ministratively impracticable. For example, benefits that generally are excluded as de minimis fringes include the typing of a personal letter by a company secretary, occasional personal use of the com- pany copying machine, monthly transit passes provided at a dis- count not exceeding $15, occasional company cocktail parties or pic- nics for employees, occasional supper money or taxi fare for em- ployees because of overtime work, and certain holiday gifts of prop- erty with a low fair market value. Subsidized eating facilities operated by the employer also are ex- cluded as a de minimis fringe if located on or near the employer's business premises, if revenue equals or exceeds direct operating costs, and if (for certain highly compensated employees) nondis- crimination requirements are met (see below). Athletic facilitie.s.-An exclusion is allowed for the value of on- premises athletic facilities provided and operated by an employer for use of its employees. Under Code section 274, the employer is not allowed a deduction for the costs of an athletic facility if the facility is not primarily for the benefit of employees (other than employees who are officers, shareholders or other owners, or highly compensated employees). PAGENO="0023" 17 13 Qualified tuition reduction.-The Act provides that a reduction in tuition provided to an employee of an educational institution is excluded for income and employment tax purposes if (1) the tuition is for education below the graduate level provided by the employer or by another educational institution; (2) the education is provided to a current or retired employee, a spouse or dependent child of either, or to a widow(er) or dependent children of a deceased em- ployee; and (3) certain nondiscrimination requirements are met (see above). Nondiscrimination requirements.-The exclusions for no-addition- al-cost services, qualified employee discounts, subsidized eating fa- cilities, and qualified tuition reductions are available to officers, owners, or highly compensated employees only if the property or service is provided on substantially the same terms to each member of a group of employees defined under a reasonable classi- fication, set up by the employer, which does not discriminate in favor of employees who are officers, owners, or highly compensated employees. Effective dates.-Under the Act, the provisions generally are ef- fective beginning January 1, 1985. The provisions of the Act relat- ing to qualified tuition reductions are effective for education für- nished after June 30, 1985. C. Benefits Provided Under a Cafeteria Plan In general Under a cafeteria plan, a participant is offered a choice between cash and one or more fringe benefits. The mere availability of cash or certain taxable benefits under a cafeteria plan does not cause an employee to be treated as having received the available cash or taxable benefits for income tax purposes if certain condi- tions are met (sec. 125). Thus, a participant in such a cafeteria plan is required to include in gross income only those taxable benefits actually received. A highly compensated participant is treated as having received available cash and taxable benefits if the cafeteria plan discrimi- nates in favor of highly compensated individuals as to eligibility or as to benefits or contributions. A highly compensated individual in- cludes an officer, a five-percent shareholder, a highly compensated individual, or a spouse or dependent of any of the preceding indi- viduals. The cafeteria plan rules generally do not affect whether any par- ticular benefit offered under the plan is a taxable or nontaxable benefit. Thus, a benefit that is excludable under the Code when Of- fered separately is an excludable benefit under a cafeteria plan only if the rules providing for the exclusion of the benefit from gross income continue to be satisfied when the benefit is provided under the cafeteria plan. IRS release, regulations On February 10, 1984, the Internal Revenue Service issued a news release (IR-84-22), stating that so-called "flexible spending ar- rangements" offered as part of cafeteria plans do not provide em- ployees with nontaxable benefits under the Code because employ- PAGENO="0024" 18 14 ees are assured of receiving the amounts available under the ar- rangement without regard to whether covered expenses are in- curred. In May, 1984, the Internal Revenue Service issued proposed regu- lations with respect to the cafeteria plan rules and the statutory rules governing the exclusion of benefits from gross income. These proposed regulations provide that an otherwise nontaxable benefit will be nontaxable if offered in a cafeteria plan only if it continues to satisfy the provisions governing exclusion of the benefit from gross income. Accordingly, the proposed regulations provide that employer contributions with res~ect to an accident or health plan, a qualified group legal services plan, or a dependent care assist- ance program are not excluded from a participant's gross income under the Code to the extent that the participant is assured of re- ceiving benefits under the plan without regard to whether the par- ticipant incurs covered expenses. Provisions of the Tax Reform Act of 1984 The Tax Reform Act of 1984 provides that under a cafeteria plan, an employee generally can choose only among cash and fringe ben- efits that are excludable from gross income under a specific section of the Code (other than scholarships or fellowships, van pooling, and those benefits excludable under the miscellaneous fringe bene- fit provisions of the 1984 Act). Also, the Act amends the cafeteria plan rules to provide that if, for a plan year, more than 25 percent of the total excludable bene- fits are provided to employees who are key employees with respect to the plan for such year (as determined under the rules of sec. 416(0(1)), then the key employees will be taxed as though they re- ceived all available taxable benefits under the plan. Generally, in determining the portion of the total excludable benefits that is pro- vided to key employees, coverage under a plan (e.g., an accident or health plan) and not actual expense reimbursements are to be counted. Under the Act, certain reporting requirements are applied with respect to cafeteria plans. The Act provides both general and spe- cial transition relief through January 1, 1985, or, in certain cases, July 1, 1985, with respect to the proposed Treasury regulations on cafeteria plans, for cafeteria plans and "flexible spending arrange- ments" in existence on February 10, 1984. Finally, the Act provides that the Secretary of Health and Human Services, in cooperation with the Secretary of the Treasury, is to submit a report by April 1, 1985, to the House Committee on Ways and Means and the Senate Committee on Finance on the effect of cafeteria plans on the containment of health costs. D. Welfare Benefit Plans Deductions for contributions to funded benefit plans The Tax Reform Act of 1984 modified the tax treatment of em- ployers with respect to welfare benefits provided to employees. Under the Act, deductions for contributions to a welfare benefit fund are limited to qualified costs, generally defined as the sum of PAGENO="0025" 19 15 (1) qualified direct costs and (2) additions, within limits, to a quali- fied asset account. Limitations on qualified asset account.-The Act provides rules relating to the limitation on additions to a qualified asset account. Such an account consists of assets set aside for the payment of dis- ability benefits, medical benefits, supplemental unemployment compensation or severance pay benefits, and life insurance or death benefits. To the extent the qualified asset account exceeds the account limit, additions to the account are not currently de- ductible. In general, the account limit is the amount estimated to be nec- essary, under actuarial assumptions that are reasonable in the ag- gregate, to fund the liabilities of the plan for the amount of claims incurred but unpaid, for benefits described in the previous para- graph, and administrative cOsts of providing those benefits, as of the close of the taxable year. Claims are incurred only when an event entitling the employee to benefits, such as a medical expense, a separation, a disability, or a death, actually occurs. The allowable reserve includes amounts for claims estimated to have been in- curred but which have not yet been reported, as well as those claims which have been reported but have not yet been paid. Child care facilities and other capital expenditures.-Under the Act, in determining qualified direct costs with respect to a child care facility held by a fund, the adjusted basis of the facility is treated as deductible ratably over a period of 60 months. A child care facility is tangible property of a character subject to deprecia- tion and located in the United States, and must be a child care center primarily for children of the employees of the employer. Qualified direct costs with respect to other capital expenditures are those that would be allowed under the usual Code rules which would be applied if the employer owned the asset. Prefunding of life insurance, death benefits, or medical benefits for retirees.-The qualified asset account limit includes amounts reasonably necessary, within limits, to accumulate reserves under a welfare benefit plan for the medical benefit or life insurance (in- cluding death benefit) payable to a retired employee during retire- ment. These amounts may be accumulated no more rapidly than on a level basis over the working life of the employee with the em- ployer, subject to certain additional limitations. Safe harbor.-The Act provides that an actuarial certification by a qualified actuary (determined under Treasury regulations) justi- fying the taxpayer's reserve computations is not necessary if the amount in the qualified asset account does not exceed a prescribed safe harbor level equal to the sum of separate safe-harbor amounts computed with respect to each benefit for which a safe harbor is provided. Certain collectively bargained plans.-The Act provides that before July 1, 1985, the Treasury Department is to publish final regulations establishing special reserve limit principles with re- spect to welfare benefit funds maintained pursuant to certain col- lective bargaining agreements. Transitional rule.-Under the Act, in the case of a plan that was in existence on June 22, 1984, special rules are provided for the de- PAGENO="0026" 20 16 termination of the deduction limit for each of the first four years to which the provision applies. 10-or-more-employer plans.-For a plan year in which no employ- er (or employers related to an employer) is required to contribute more than 10 percent of the total contributions, the Act provides that the deduction limits do not apply. Effective date.-These provisions generally apply to contributions paid or accrued after December 31, 1985. However, in the case of a plan maintained pursuant to a collective bargaining agreement in effect on July 1, 1985, or ratified before that date, the provisions do not apply until the termination of the contract, determined with- out regard to any contract extension agreed to after that date.4 Excise taxes on funded benefit plans Under the Act, an excise tax is imposed on the employer equal to 100 percent of the disqualified benefits provided by a fund under a welfare benefit plan. The Act defines a disqualified benefit as (1) any medical benefit or life insurance benefit provided with respect to a retired key em- ployee (sec. 416(i)) other than from a separate account established for that employee under the new rules relating to deductions under funded welfare benefit plans (sec. 419A(d)); (2) any medical or life insurance benefit provided with respect to a retired employee unless the benefit is provided from a fund that meets the addition- al requirements for tax-exempt status provided by the Act (sec. 505(b)(1)); and (3) any portion of a welfare benefit fund reverting to the benefit of the employer. These excise tax provisions generally apply to contributions paid or accrued after December 31, 1985. However, in the case of a plan maintained pursuant to a collective bargaining agreement in effect on July 1, 1985, or ratified before that date, the provisions do not apply until the termination of the contract, determined without regard to any contract extension agreed to after that date. Tax treatment of exempt benefit organizations Unrelated business income.-Under the Act, the special rules ap- plicable to voluntary employees' beneficiary associations (VEBAs) and social clubs for purposes of the tax on unrelated business tax- able income are extended to supplemental unemployment compen- sation benefit trusts (SUBs) and group legal service organizations (GLSOs). In addition, more specific limits are provided with respect to the amount that may be set aside for exempt purposes by such an organization without incurring unrelated business income tax; these limits generally are the same as those applicable for purposes of limitations on deductions for plan contributions. In addition, the Act generally applies to any contribution of a facility to a welfare benefit fund after June 22, 1984. Under the Act, deductions with respect to such a contribution are to be determined under the usual Code rules applicable to recovery of the cost of assets (but taking account of the special rule for child care facilities described above). Further, these rules apply to other contributions, such as cash, made after that date which are to be used to acquire a facility, so that later acquisition of a facility with the use of such funds will limit the deduction for the original contribution. This rule does not apply for any facility acquired by the fund under a binding contract in effect on and at all times after that date, or any facility under construction by or for the fund before June 22, 1984. PAGENO="0027" 21 17 The Act also provides for a tax on an employer who maintains a welfare benefit fund that is not exempt from income tax. Under the Act, in the case of any welfare benefit fund, such as a retired life reserve account, that is not exempt from income tax as a social club, VEBA, SUB, or GLSO, the employer who maintains the fund is to include in gross income for the taxable year an amount equal to the fund's deemed unrelated income. Deemed unrelated income is the amount of income which would have been subject to the un- related business income tax if the fund were a tax-exempt organi- zation. Discrimination.-The Act establishes new nondiscrimination standards for a tax-exempt VEBA or GLSO. With respect to the nondiscrimination rules, certain employees who are not covered by a plan may be excluded from consideration in applying the nondis- crimination standards. These employees are employees who have not attained the age of 21, employees who have not completed 3 years of service with the employer, less than half-time employees, employees who are included in certain collective bargaining units, and certain nonresident aliens. Effective date.-These provisions generally apply after December 31, 1985. However, in the case of a plan maintained pursuant to a collective bargaining agreement in effect on July 1, 1985, or rati- fied before that date, the provisions do not apply until the termina- tion of the contract, determined without regard to any contract ex- tension agreed to after that date. The nondiscrimination provisions apply to taxable years begin- ning after December 31, 1984. E. Qualified Pension, Profit-Sharing, and Stock Bonus Plans If a pension, profit-sharing, or stock bonus plan qualifies under the tax law (sec. 401(a) or 403(a)), then (1) a trust under the plan is generally exempt from income tax, (2) employers are generally al- lowed deductions (within limits) for plan contributions for the year for which the contributions are made, even though participants are not taxed on plan benefits until the benefits are distributed, (3) benefits distributed as a lump sum distribution may be accorded special long-term capital gain treatment or 10-year income averag- ing treatment, or may be rolled over, tax-free, to an individual re- tirement account or annuity (IRA) or another qualified plan, and (4) certain partial distributions may be rolled over, tax-free, to an IRA. Qualified plans are generally subject to minimum standards (in- cluding standards relating to employee participation, vesting, forms of benefits, and fiduciary conduct) and to limits on contributions or benefits. These plans are prohibited from discriminating in favor of employees who are officers, shareholders, or highly compensated. Pension plans are generally subject to a minimum funding stand- ard. In addition, benefits under a defined benefit pension plan are generally guaranteed (within limits) by the Pension Benefit Guar- anty Corporation. Certain qualified plans may include a qualified cash-or-deferred arrangement (sec. 401(k)). Under a qualified cash or deferred ar- rangement, an employee may elect to receive compensation from PAGENO="0028" 22 18 the employer currently or to have the compensation deferred. Amounts deferred under a qualified cash or deferred arrangement are taken into account in computing social security and unemploy- ment compensation benefits and taxes. No minimum standards or special limits apply to an unfunded plan of deferred compensation. Generally, under ERISA, these pians may not be provided for rank-and-file employees. Under a tax-sheltered annuity program, amounts paid by an edu- cational institution or by an eligible tax-exempt organization to purchase an annuity contract for an employee are excluded from the employee's income, subject to certain limits (sec. 403(b)). Ex- cludable contributions to custodial accounts investing in stock of a regulated investment company (e.g., a mutual fund) are also per- mitted. No nondiscrimination standard applies in the case of a tax- sheltered annuity program. Amounts distributed or made available under tax-sheltered annuities or custodial accounts generally are includible in gross income. However, certain distributions may be rolled over, tax-free, to another such annuity contract or to an IRA. If an IRA qualifies as a sir~iplified employee pension (SEP), the annual IRA deduction (generally, the lesser of $2,000 or 100 per- cent of compensation) is increased by the lesser of $30,000 or 15 percent of compensation. The increase in the deduction limit ap- plies only to employer contributions (sec. 219). Except in the case of certain correcting distributions, all distributions from SEPs are in- cludible in gross income unless rolled over to another IRA. FICA generally excludes payments under or to a qualified pen- sion, profit-sharing, or stock bonus plan, a SEP, a tax-sheltered an- nuity, an exempt governmental deferred compensation plan, or a plan to provide cost-of-living adjustments in benefits under these provisions. However, FICA applies to contributions under a quali- fied cash-or-deferred arrangement or to contributions under a tax- sheltered annuity made by reason of a salary reduction agreement (sec. 3121(a)(5)). PAGENO="0029" 23 III. BACKGROUND DATA RELATING TO TAX TREATMENT OF CERTAIN FRINGE BENEFITS A. Revenue Implications Table 1 below shows the estimated increases in revenues that would result from terminating the present-law exclusions for those benefits described in Part II A and E of this pamphlet. Each entry in the table has two lines. The first represents the estimated increase in income tax receipts that would result if the benefit were included in gross income. The second line shows the estimated increases in social security tax receipts that would result if the benefit were included in the FICA tax base. In terms of revenue effect, qualified pension plans are the largest fringe benefit shown in this table, followed by health insurance. Each of the~other fringe benefits shown in this table have less reve- nue impact. Table 1. Effects of Including Certain Benefits in the Federal Income Tax Base and the FICA Tax Base [In billions of dollars] Item 1984 1985 1986 1987 1988 1989 1. Employer contributions for medical insurance: Income tax 17.6 20.2 23.0 26.2 29.9 34.1 FICA 6.7 7.7 8.8 10.1 11.9 13.7 2. Premiums on group term life insurance: Income tax 2.2 2.4 2.6 2.9 3.2 3.5 FICA 5 .8 .9 .9 1.0 1.1 3. Contributions to prepaid legal services plans: Income tax (1) (1) FICA (1) (1) 4. Employer provided child care: Income tax (1) .1 .1 .1 .2 .2 FICA (1) (1) (1) (1) .1 .1 5. Employee meals and lodging (other than mili- tary): Income tax 7 .8 .9 .9 1.0 1.1 FICA 2 .2 .3 .3 .3 .3 (19) PAGENO="0030" 24 20 Table 1. Effects of Including Certain Benefits in the Federal Income Tax Base and the FICA Tax Base-Continued [Tn billions of dollars] Item 1984 1985 1986 1987 1988 1989 6. Benefits and allowances . to Armed Forces person- nel: Income tax 1.9 2.0 2.2 2.3 2.4 2.6 FICA (2) (2) (2) (2) (2) (2) 7. Net exclusion for pension contributions and earn- . ings Income tax 47.3 52.7 59.0 66.0 73.9 82.9 FICA (2) (2) (2) (2) (2) (2) 1 Less than $50 million. 2 Not available. B. Growth in Certain Fringe Benefits Tables 2 and 3 present data from the national income accounts on the growth between 1950 and 1981 of employer contributions to group health insurance and group life insurance, the two largest generally available statutory fringe benefits which are shown in Table 1, measured in terms of revenue effect. Table 2 shows that during this period, these two benefits have grown considerably faster than wages and salaries. Group health insurance grew from 0.5 percent of wages in 1950 to 3.8 percent of wages in 1981, and group life insurance contributions increased from 0.2 percent of wages in 1950 to 0.4 percent of wages in 1981. Group health insurance, has grown at a much faster rate than group life insurance. Group health insurance has continued to grow throughout the period, while group life has been approxi- mately the same percentage of wages since 1965. Although many factors have influenced the growth of these two fringe benefits, it should be noted that the tax treatment of group term life insur- ance changed in 1964, when a limit was placed on the amount of employer contribution which could be excluded from gross income for income tax purposes. Table 3 shows another way of examining the growth in employer contributions to health and life insurance during this period. These figures compare the increase in wages to the increase in the fringe benefit during this period. Between 1950 and 1955, for example, health contributions in- creased 1.5 cents for every dollar of increase in aggregate wages. By the end of the period, health benefit contributions increased ap- proximately 5.5 cents for each dollar of increase in wages. Thus, there was a significant acceleration in the growth of health bene- fits relative to wages over the 1950 to 1981 period, although this trend stabilized during the 1970s. PAGENO="0031" 25 21 In contrast, increases in group term life insurance as percentage of wage increases declined over the 1950-1981 period. During the first five years, group term life insurance contributions increased 0.5 cents for every dollar of wage increase. This figure reached a peak during the last part of the 1950s. Since that time, however, the increase in life insurance as a percentage of wage increases de- clined significantly, so that by 1981 these contributions increased by only 0.3 cents for every dollar of wage increases. Table 2. Employer Contributions to Group Health and Life Insur- ance as Percentage of Wages and Salaries, United States, 1950- 1981 [In percent] Group Life 1950 0.5 0.2 1955 0.8 0.3 1960 1.3 0.4 1965 1.6 0.5 1970 2.2 0.5 1975 3.0 0.5 1980 3.7 0.5 1981 3.8 0.4 Source: Computed from U.S. Department of Commerc e data. Table 3. Increase in Total Employer Insurance Contributions as Percentage of Total Increase in Wages, United States, 1950-1981 [In percent] Group Life 1950-55 1.5 0.5 1955-60 2.8 0.9 1960-65 2.7 0.6 1965-70 3.3 0.7 1970-75 4.7 0.6 1975-80 4.5 0.3 1980-81 5.5 0.3 Source: Computed from U.S. Department of Commerce data. 0 PAGENO="0032" 26 Chairman PICKLE. This is a joint hearing today of the Subcom- mittee on Social Security and Subcommittee on Select Revenue Measures on the Committee of Ways and Means. We sit today on a joint committee basis. As chairman of the Social Security Subcom- mittee, I welcome you all here this morning as these two subcom- mittees meet on the question of the distribution and economics of the employer-provided fringe benefits. I am glad these hearings are at long last being held. I have rec- ommended on a number of occasions during the past year that hearings be held to examine the whole subject of employee benefits to give Congress a better understanding of this enormous subject and to allow employers and employees to present their views. The only purpose of these hearings is to gather information, to ask questions, and to explore as fully as possible in the time we have all of the various forms of employee benefits. But I want to stress to you that these hearings are not intended to be a forum for competing philosophies. Such a hearing would not serve any pur- pose. We are not considering any specific legislation. We are not pro- posing any course of action. We simply want to understand this subject better. I want to make it clear that I do not think that Con- gress has any intentions of taking away fringe benefits. This is not the purpose of this hearing. On the contrary, Congress acted this summer to eliminate some of the uncertainty in the fringe benefit area in the Deficit Reduc- tion Act, by legislation that came from the Subcommittee on Select Revenue Measures itself. So there is no need for anyone to get frightened about this or to launch a campaign to lobby Members of Congress to protect certain fringe benefits. All we want to do is to examine the issues calmly, responsibly and thoroughly. The issues here are too important for our national economy, for our employees, our businesses and for the Federal Government to let us continue heading blindly on. Congress must decide in the years ahead whether there is a need to take any fur- ther action in this area and, if so, what action should be taken. I hope these hearings will allow us to gather the hard facts we in Congress and you in the public can use to make responsible deci- sions. In conclusion, let me say that I am glad you could all be here to assist us in this endeavor. I look forward to hearing and study- ing your testimony. As I said, I am joined here this morning by my colleague, Mr. Pete Stark, chairman of the Subcommittee on Select Revenue Measures, who has taken a very positive lead in examining this issue previously and has brought us some very important legisla- tion on the subject. I am pleased to yield to him on this at this time to make any statement at the beginning of this hearing that he would care to make. Mr. Stark? Chairman STARK. Thank you, Mr. Chairman. It is a pleasure to be here with you and share this podium with your subcommittee. The work which our subcommittee did this summer was to estab- lish, I guess, a guidance for what will be allowed as fringe benefits in the Tax Code. Actually, anybody can pay any kind of fringe ben- efit to any employee that they choose. The only issue is who will pay taxes if anyone, on the value of the particular fringe. PAGENO="0033" 27 Chairman Pickle is to be commended for often a lonely vigil to protect the base on which the FICA and FUTA taxes are levied. And Jake takes a marvelously statesman-like long-range view of protecting retirement and Medicare system that is so important to so many Americans. I share his concern that this is not a hearing that is intended to open up debate on what additional fringes should be made tax free or indeed, on the other hand, we certainly have no intention of taking any existing fringes and subjecting them to income tax. There is concern that I share about the growing creativity and growing number of fringe benefits. And at some point, we are going to have to face the question if it can be established, that the wage base will be decreasing greatly over the next decade. It may im- pinge on the social security financing and we may have to do some- thing. But I am not sure that any member of either subcommittee has any preconceived notions. I welcome the chance to discuss this in terms particularly of how much revenue we are losing and might indeed lose in the future if a variety of alternatives are taken. And I appreciate and applaud Chairman Pickle for his interest in taking the lead in bringing these hearings about, because they have been long overdue. Chairman PICKLE. Thank you, Mr. Stark. Mr. Duncan, would you care to make a statement? Mr. DUNCAN. I have no prepared statement, Mr. Chairman. I ap- preciate the fact that you have assured those present and others who have an interest in the subject that we are not going to do anything that would jeopardize the fringe benefit legislation passed last year. We have been on this subject for several years. I hope these hear- ings allow us to finally establish a permanent set of fringe benefit rules. I thank you for calling these hearings. Chairman PICKLE. Mr. Gradison. Mr. GRADISON. Thank you, Mr. Chairman. I, too, would like to congratulate the chairmen of the two subcommittees for these hearings, which are very timely. It appears to me that we have had an extraordinary growth in fringe benefits; that fringe benefits have been growing faster than cash compensation and that tax-free fringe benefits have been growing faster than other kinds of fringe benefits. This, no doubt, is what Congress intended. But there are some problems and I hope that these hearings will help us gain addition- al insight into whether these problems are serious or not. Certainly the narrower the tax base, the higher the tax rates. Those of us who are concerned about bringing tax rates, especially marginal rates, down lower than they are today, necessarily have to show some concern about the extent to which the tax base is being nar- rowed. In addition, I think we have to recognize that these fringe bene- fits are not available to everybody on an entirely fair basis. Em- ployees of small businesses generally don't fare as well as employ- ees of larger businesses. Lower paid employees don't usually come out as well as higher paid employees. Sole proprietors and farmers operating as sole proprietorships are particularly disadvantaged as against employees of corporations. 40-046 0 - 85 - 3 PAGENO="0034" 28 One of the disquieting things to me, Mr. Chairman, is that the ink was barely dry on the Deficit Reduction Act, which attempted to put to rest the uncertainty about these fringe benefits and their taxation, when pressures began to build up for changes-liberaliza- tions in some of the actions taken by the Congress and this com- mittee last year. I am especially glad that the announcement for this hearing indi- cated that we were interested in comments on the idea of caps. I personally think that these are worth thinking about and explor- ing, not necessarily with the idea that anything is going to happen tomorrow, but with the recognition that, as we look into the future, something along this line may be appropriate if we are going to continue to move in a meaningful way to lower tax rates. Thank you, Mr. Chairman. Chairman PICKLE. Thank you, Mr. Gradison. Let me make it plain that this is a joint subcommittee hearing and that I am not calling this hearing by myself. The leadership on this program in many respects has come from the Subcommittee on Select Revenue Measures. I appreciate the work they did last year. This is a joint hearing. It is to be held because not only are both our subcommittees affected by this, but the entire Congress and business community are likewise affected. So that is why it is a joint hearing. I also say to you, Mr. Gradi- son, I am pleased-yesterday I noticed on the TV that you ap- peared on a show on this general subject. I thought your comments were appropriate and were helpful. I think we probably will see other programs like this as we move forward. This is a very impor- tant element in our Nation's economy. Mr. GRADISON. Thank you for mentioning that, - Mr. Chairman. Unfortunately, I was dealt the unpopular side. I hope it didn't show in my district. Chairman PICKLE. Well, you were responsible, Mr. Gradison. I appreciate it. Our first witness this morning will be Mr. Ronald Pearlman, who is the Acting Assistant Secretary for Tax Policy. Mr. Peariman, we are glad you could be with us this morning and share your views with us. If you will proceed, we will be glad to have your testimo- ny. STATEMENT OF RONALD A. PEARLMAN, ACTING ASSISTANT SECRETARY FOR TAX POLICY, DEPARTMENT OF TIlE TREASURY Mr. PEARLMAN. Thank you, Mr. Chairman, Mr. Stark, members of the subcommittee. I appreciate the opportunity of being here this morning so that we can discuss the Treasury Department's views on the appropriate taxation of employer provided fringe ben- efits. As several members of the subcommittees have already men- tioned, the Deficit Reduction Act of 1984 made several significant changes in the rule governing fringe benefits. We think that in general, the actions taken by the Congress this summer were ap- propriate steps in rationalizing the tax treatment of employer pro- vided benefits. PAGENO="0035" 29 Needed clarification was provided to individual taxpayers and employees alike and progress was made in limiting the expansion of fringe benefits. This morning I would like to outline the areas of continuing concern to the Treasury Department with respect to the tax treatment of employee fringe benefits. We are concerned, as Mr. Gradison apparently is concerned, that the expansion in fringe benefits excluded from the Federal income and Social Security tax bases has caused tax rates to be higher than they would otherwise be. Our efforts in recent years to con- tain increases in marginal rates and our continuing efforts to try to contain those increases in the future, as well as increases in the Social Security tax rates, could be undermined quickly and signifi- cantly by any major narrowing of the range of compensation sub- ject to tax. We also are concerned that the tax benefits derived from the ex- isting statutory fringe benefits are not fairly distributed among taxpayers. Finally, we are concerned that, in some instances, the exclusion of benefits from gross income fails to promote the policies underlying such favorable treatment. I would like to begin my comments by focusing first on the impact on the income and social security tax bases of statutory nontaxable benefits. One of the announced purposes of these hear- ings was to gather information concerning the prevalence and con- sequent revenue implications of tax-favored fringe benefits. Studies in this area indicate that the volume of tax-favored bene- fits has grown dramatically over the past several years and signifi- cant future growth will occur even if current restrictions on the availability of such fringe benefits are maintained. If these restric- tions are relaxed in any significant way the inevitable result would be further, possibly serious erosion in both the Social Security and income tax bases. In recent years the list of statutory fringe benefits has grown to include employer-provided programs aimed at promoting expendi- ture of compensation in specified ways. These more recent statuto- ry fringe benefits include employee stock ownership plans, group legal service programs, van pooling, educational assistance pro- grams and dependent care assistance programs. We have estimated the nontaxable employer contributions for qualified pension and profit-sharing plans, group health insurance and group life insurance from the period from 1955 through the present and have projected such contributions through 1989. We have also calculated the portion of total wages these contributions have constituted and the revenue effect of excluding these contri- butions from the Federal income tax and Social Security tax bases. These estimates are summarized in table 1 attached to the testi- mony. And I think it is interesting to look at table 1. You will see that it covers the period from 1955 through 1989. A couple of things will jump out at you if you look at the table. First, if you look at the very bottom line of the table the percentage of wages that were attributable to these three categories of statutory fringe benefits-and let me point out here that this does not include a number of the newer fringe benefits that have been enacted in more recent years-was 3.2 percent of total wages in 1955. PAGENO="0036" 30 By 1975, a 20-year period, that number had grown to 8.5 percent of taxable wages, with most of the growth occuring in the pension and profit-sharing area. From 1975, forward, if you look again, for example, from the period 1975 to 1985, which includes a projected period, but a fairly short period of projection-most of it is actual data-you will see that the growth again is dramatic. Indeed, it is about the same number of absolute percentage points, five, as has occurred during the first 20 years-slightly less than five. But the contrast I think you will see is that the growth is not in the pension and profit-sharing area. There has been some growth there. I suspect in part because of Congress' actions in con- nection with ERISA, that has been stemmed a bit, but the growth in group health insurance has been dramatic. You can see the growth has more than doubled from 1975 through the projected period of 1989 and has grown very dramati- cally, although it has not quite doubled from 1970 into the early 1980's. So I think this table would say to us that there is a-there has been a dramatic growth in the amount of wages that has been excluded from the income tax base because of the growth in the nonstatutory fringe area and that indeed if you look at the period from 1983 to 1989, even though the percentage growth is not as dramatic, of course, the dollars involved are very substantial, that the growth is projected to continue. It is the expansion in the scope and volume of tax-favored fringe benefits that represents a significant threat to the Federal income tax and Social Security tax bases. If pressures to increase Social Se- curity and marginal income tax rates are to be resisted, hard choices must be faced as to which fringe benefits can be granted tax-favored treatment and as to whether the tax advantages cur- rently available to fringe benefits can be modified without impair- ing the social policy objectives underlying their favorable tax treat- ment. This is a challenge, I think, that is both on us and the com- mittee. Now I would like to turn to a discussion of one of the more con- temporary areas of statutory fringe benefits; namely, cafeteria plans and so-called flexible spending arrangements which were the subject of recent regulations by the Treasury Department and were the subject of some legislation action in the Deficit Reduction Act. Recent growth in tax-favored benefits provided under employer- sponsored plans has been stimulated by the statutory authorization of cafeteria plans. This is so because they permit individual em- ployees to choose which fringe benefits they will receive, in effect allowing employees to design fringe benefit packages tailored to their individual needs. We recognize that where an employer has historically provided his employees with a very rich tax-favored benefit fringe package, a cafeteria plan may result in a net decrease in the tax benefit in- crease received by such employees. However, in the aggregate, cafe- teria plans significantly narrow the Federal income and Social Se- curity tax bases. For fiscal years 1984 through 1989, we estimate that assuming the continued exclusion of group legal services through December 31, 1984, cafeteria plans will reduce individual income tax receipts PAGENO="0037" 31 by $5.5 billion and Social Security receipts by $3.2 billion, for a total reduction of $8.7 billion. I think some information on the growth of those revenue receipts impact should be of interest on the committee. Our estimate reve- nue reduction for 1984 will be approximately $67 million. For 1985, we expect that revenue impact to more than double to a deficit of about $248 million, growing to $1 billion in 1987 and to a stagger- ing $4.4 billion in 1989. These projections indicate that cafeteria plans provide a powerful incentive for tax-favored forms of compensation. Even more sub- stantial losses in revenue would result, however, if the cafeteria plan rules authorized the exclusion of benefits provided through so- called flexible-spending arrangements. Generally, a flexible-spend- ing arrangement permits an employee to designate some portion of his or her otherwise taxable salary as available fOr the tax-free re- imbursement of specified expenses, such as medical care, legal serv- ices, or dependent-care assistance. Under an FSA, the employee is assured of receiving, in the form of cash or some other benefit, any portion of the designated amount not utilized for the specified ex- pense. We have concluded, as I am sure you are aware and as proposed Treasury regulations on cafeteria plans reflect, that the statutory provisions granting tax-favored treatment to specified benefits and the cafeteria plan rules themselves do not authorize FSA's. There- fore, a benefit does not fall under any of the applicable statutory exclusions if the benefit is provided through an FSA. Our revenue estimates indicate that FSA's would have a dramat- ic effect on the Federal tax base. For the 1984 through4l989 fiscal years, assuming that the exclusion for group legal services is not extended beyond December 31, 1984, we estimate that the $8.7 bil- lion projected revenue loss attributable to cafeteria plans would double to approximately $17 billion if favorable treatment were granted to FSA's. Turning again, this time to welfare-benefit funds, including VEBA's, let me make a few comments. In general, the costs of em- ployee compensation, including employer-provided welfare benefits, are deductible by the employer at the time when the compensation is actually provided to the employees. In addition, if an employer sets aside amounts for future employee compensation, income earned on the amounts set aside is included in the emloyer's gross income for income tax purposes. Exceptions to these general rules have permitted employers, in certain circumstances, to deduct currently contributions to prefund deferred welfare benefits. The critical advantage to an employer in setting aside funds in VEBA's and other effectively tax-exempt en- tities is that the income on such funds accumulates on a tax- exempt basis. The historical development of the VEBA rules indicates that the effectively unlimited tax-exemption for VEBA's did not come about in a considered and deliberate fashion by the Congress. Indeed, before the Deficit Reduction Act, Congress seems not to have ap- preciated the potentially substantial tax benefits that an employer could derive through a VEBA. Instead, Congress generally viewed VEBA's simply as vehicles through which employees could join to- PAGENO="0038" 32 gether to provide certain welfare benefits for themselves without adverse tax consequences. In recent years, however, the growth in the number of VEBA's has substantially accelerated. According to the IRS, 7,091 active VEBA's had received favorable tax IRS determination letters from the commencement of VEBA's in the late 1920's through Novem- ber 30, 1980. By the end of 1983, however, more than 9,400 VEBA's had received favorable determination letters. Thus, over 17 percent of the VEBA's in existence as of the end of 1983 have come into existence during the last 3 of the 55 years for which VEBA's have been tax exempt. One of the reasons for this recent increase was, in our opinion, enactment of the additional limit, reduction in the section 415 limit on contributions and bene- fits and the top heavy rules on qualified pension and profit-sharing plans in TEFRA. VEBA's are subject to neither of these restric- tions. The Deficit Reduction Act does contain rules that limit the extent to which an employer may use a VEBA or similar entity to provide deferred benefits to employees. Let me say we think the ef- forts made by the Congress in the Deficit Reduction Act were very constructive in trying to restrict the scope of VEBA's. In spite of these very important limits, however, significant tax benefits remain for employers using VEBA's or similar entities. I would like to turn now and comment for a moment on the hori- zontal inequity of statutory fringe benefits. This really is a com- ment that can apply to all statutory fringe benefits. The exclusions for fringe benefits from gross income generally are conditioned upon the delivery of the benefits through an em- ployer-sponsored plan. The limitation of tax-favored benefits to em- ployees covered by an employer plan may be seen to discriminate against individuals not so covered. That is, people, for example, who are self-employed. This latter group of noncovered individuals must pay for bene- fits, such as health care, with after-tax dollars, whereas covered employees are able to purchase the same benefits with pretax dol- lars. We have prepared some data showing the percentage of civil- ian employees in different income classes who are covered by pen- sion or profit-sharing plans as well as the percentage who are cov- ered by employer-provided group health insurance. This data is summarized in table II, attached at the end of this testimony. As is reflected-4n table II, the percentage of employees coveted in the very lowest income categories is substantialy smaller than for both the middle- and upper-income groups. Now a couple conclusions can be reached from that. One certain- ly is the question about the fairness of the existing tax treatment of fringe benefits and whether they are-whether the taxation pro- duces an unfair distribution of such benefits among income groups. Current data showing significantly lower employer plan coverage for lowest paid employee groups itself, however, is of concern to us. We would suggest that a comprehensive judgment about fairness should await additional data which we, and I think it is accurate to say, HHS, is undertaking to develop. Let me make one other com- ment regarding this table and the problem of horizontal inequity. And that is, we think that there may well be a correlation between PAGENO="0039" 33 people who are in the lower income groups and those people who are not typically covered by employer-provided benefits. But I would not want to suggest to you that there is an absolute correlation and therefore again, I would recommend that you not take these data as an absolute conclusion that current rules pro- vide unfairness in our system among income groups. But we did want to make that data available. Chairman PICKLE. I would like for you to refer to table 2 in a little more detail so we can understand it. Mr. PEARLMAN. OK. Chairman PICKLE. I have it before me now. Mr. PEARLMAN. All right. Chairman PICKLE. Would you walk us through that table? Mr. PEARLMAN. Certainly. I will try to do that for you. What this table is designed to show is, if you look at employees and the amount of wages they get, just using wage categories, that is, under $5,000, $5,000 to $10,000 and so forth, and I should em- phasize we are talking about wages here, not taxable income or the like, then the first column will show the number in millions. Excuse me. In thousands. But it turns out to be millions of employ- ees in each category. So for example, we have 17.7 million workers who earn $5,000 or less. Chairman PICKLE. All right. Mr. PEARLMAN. The next two categories, excuse me, the next two columns identify the number and percent of workers covered by pension plans. That is, employer-sponsored pension plans. For ex- ample, again looking at the less than $5,000 category, you will find 1.5 million employees or workers covered by employer-sponsored pension plans representing 8.8 percent of the entire work force in that wage category. Now, the percentage of the entire work force in a wage category would include, of course, people not covered by employer-provided plans. The same approach is taken with respect to health plans. Chairman PICKLE. Are you saying that the total wage of salary workers in the first category, 5,000, there would be some 17 million of them, and that in the percentage of workers with pension pro- grams there would be 8 million? Am I interpreting this correctly? Mr. PEARLMAN. I have missed your 8 million. Oh, that is 8 per- cent. Chairman PICKLE. That is percentage. Yes. Mr. PEARLMAN. If you look at the prior column, 1.5 million. Chairman PICKLE. Yes. Mr. PEARLMAN. Then that is the number. Chairman PICKLE. I have got you. Now, you are comparing the 17,766,000 to the 1,568,000? Mr. PEARLMAN. Yes; but let me emphasize again, Mr. Chairman, that the total wage and salary worker column includes people not covered by the employer-provided plans, OK? Chairman PICKLE. Yes. Mr. PEARLMAN. So what we are trying to show you by this table is how many of the total work force are covered by employer-pro- vided plans, and how many, because they are self-employed, for ex- ample, are not. And what this table suggests clearly is that people PAGENO="0040" 34 in the lower wage categories are less likely to be covered both by pension plans and health plans. And the caution-that is of con- cern to us. That raises to us questions of fairness. But what I want to caution is, I wouldn't go overboard in attaching final judgment to this data. We are still working on this data and we hope to be able to provide more defmitive data in the coming months. Let me also just emphasize to you the footnote to that table, which is a very important footnote. And that is that when you are looking, particularly with health coverage, this has to do with health coverage, at people covered in two-earner families, where both spouses are working, obviously, typically there will be an in- centive for one to choose not to be covered beqause the other spouse is covered. And we have to make sure in looking at health plan coverage that we take that into consideration in making the judgment as to whether the distribution data accurately presents data we can use for evaluating fairness. Can I go on, Mr. Chairman? Chairman PICKLE. Yes. Mr. PEARLMAN. Another area where we certainly want to make sure that in making judgments about current statutory fringe ben- efits and about future statutory fringe benefits is the area of non- discrimination. We think that the Congress has very properly made, as a basic justification for providing a tax benefit in the form of an exclusion from gross income, the objective of promoting the delivery of the tax-favored fringe benefit to a broad cross sec- tion of employees on a nondiscriminatory basis. It is thus important that effective coverage and nondiscrimina- tion rules apply with respect to each employer-provided benefit eli- gible for an exclusion from gross income. Coverage and nondiscrimination rules apply to most tax-favored benefits, such as group-term life insurance, self-insured medical re- imbursement plans, group legal service plans, and dependent care assistance programs. However, medical plans provided by an em- ployer under a policy with an insurance company are not subject to nondiscrimination rules. Thus, discrimination in favor of the key and highly compensated employees still is possible in the case of insured health plans. We also are concerned that cafeteria plans undermine the effec- tiveness of the statutory coverage and nondiscrimination rules that presently apply with respect to each of the statutory exclusions. These coverage and nondiscrimination rules generally are based on the availability of the particular benefit provided under the plan. In the absence of a cafeteria plan, an availability-type test ordinari- ly will assure that the benefit is provided to a broad cross section of employees on a nondiscriminatory basis. Availability-based tests, however, are not effective where employees are free to trade tax- favored benefits for cash or other benefits. Also, the existing cover- age and nondiscrimination rules applicable to cafeteria plans gen- erally are not adequate to assure that the basic coverage and non- discrimination objectives are being protected. Now, the last part of my testimony, Mr. Chairman, deals with health policy considerations. And the basic message we are sending there is that we think that there is a serious question as to wheth- er tax incentives provided in employer-provided welfare benefit and PAGENO="0041" 35 health plans really are in fact achieving other important policy ob- jectives. Most specifically, our objective in trying to contain health costs. My written testimony can stand for what it states. I am, how- ever, willing to defer, because of Mr. Helms' presence from HHS, to him to comment on health policy considerations which are clearly more in his expertise than they are mine. Chairman STARK. Would the gentleman yield for just a moment because I wanted to ask, Mr. Helms touches on this in his testimo- ny, do you have any feeling, you mentioned what we had done in nondiscrimination. One of the major areas which we have not placed nondiscrimination rules is in health insurance. Mr. Helms' testimony touches on the fact that the same distortion in the distri- bution lies in that. Do you think it is conceivable that we should put nondiscrimina- tion rules and have them apply to health insurance as well? Mr. PEARLMAN. I think, Mr. Stark, our belief is what, I think, in general Congress' belief has been. And that is nondiscrimination rules generally should be applicable to all statutorily provided fringe benefits. Again, Mr. Chairman, because I think Mr. Helms can better com- ment on the health policy issues than I can, I think I am going to stop at this point. I appreciate the opportunity of being here this morning and giving you our comments. We have a mandate, as you know, from the Congress to provide some additional data to you in the area of statutory fringe benefits. And we will be doing that. And as is usual, we are happy to not only try to answer your ques- tions this morning but provide you any additional assistance we might be able to provide. Thank you. [The prepared statement follows:] STATEMENT OF RONALD A. PEARLMAN, ACTING ASSISTANT SECRETARY (TAx Pouc~), DEPARTMENT OF THE TREASURY Mr. Chairman and Members of the Subcommittees: I am pleased to appear before you today to present the Treasury Department's views on the appropriate tax treat- ment of employer-provided fringe benefits. In the recently enacted Deficit Reduction Act of 1984, Congress made several sig- nificant changes in the rules governing fringe benefits. Among the more important of these were (i) the extension to retired employees of the limits applicable to tax- favored group-term life insurance; (ii) the application of deduction and other limits to voluntary employees' beneficiary associations (VEBAs) and other welfare benefit funds; (iii) the codification of an exclusion for formerly nonstatutory fringe benefits, such as employee discounts and free parking; and (iv) the exclusion from cafeteria plans of taxable benefits other than cash, group-term life insurance in excess of $50,000, certain taxable life insurance for dependents of the employee, and vacation days. The Deficit Reduction Act also adopted reporting requirements, key employee limits, and special transition rules for cafeteria plans. The Deficit Reduction Act was an appropriate step in rationalizing the Federal tax treatment of employer-provided fringe benefits. Needed clarification was provid- ed to individual taxpayers and employers alike, and progress was made in limiting the expansion of fringe benefits. My testimony today will outline areas of continuing concern to the Treasury De- partment with regard to the tax treatment of employee fringe benefits. I will focus on the so-called statutory fringe benefits, those benefits exempted from tax under specific provisions of the tax law, and will discuss in particular the growth in fringe benefits provided under employer-sponsored welfare benefit plans. We are concerned that the expansion in fringe benefits excluded from the Federal income and social security tax bases has caused tax rates to be higher than they would otherwise be. Our efforts in recent years to contain increases in marginal PAGENO="0042" 36 rates of income taxation and in the social security tax rates could be undermined quickly by any significant narrowing of the range of compensation subject to tax. We also are concerned that the tax benefits derived from the existing statutory fringe benefits are not fairly distributed among taxpayers. Current provisions direct a disproportionate share of such preferences to individuals able to participate in em- ployer-sponsored benefit plans. Finally, we are concerned that in some instances the exclusion of benefits from gross income fails to promote the policies underlying such favorable treatment. IMPACT ON THE INCOME AND SOCIAL SECURITY TAX BASES Statutory Nontaxable Benefits-One of the announced purposes of these hearings was to gather information concerning the prevalance and consequent revenue impli- cations of tax-favored fringe benefits. Our studies in this area indicate that the volume of tax-favored fringe benefits has grown dramatically over the past several years and that significant future growth will occur even if current restrictions on the availability of tax-favored fringe benefits are maintained. If these restrictions are relaxed in any significant way, the inevitable result would be further and possi- bly serious erosion in the social security and income tax bases. Generally, an employee is required to include in gross income, for both Federal income and social security tax purposes, all amounts received as compensation, whether in the form of cash or any other benefit, including welfare benefits. Subject to statutory limits, however, benefits provided under an employer-sponsored plan that satisfies the applicable Code provisions are excluded from the income and social security tax bases. Generally, an employer-provided benefit qualifies for an exclusion only if the plan satisfies certain eligibility, coverage, and nondiscrimination rules. (A notable excep- tion is health benefits provided by an employer under a policy of insurance with an insurance company.) The purpose of these rules is to assure that the tax-favored benefit is provided to a broad cross-section of the employer's employees on a nondis- criminatory basis. Prior to the enactment of the Employee Retirement Income Security Act of 1974 (ERISA), the major statutory fringe benefits were qualified pension and profit-shar- ing plans, group-term life insurance, and medical benefits. The favorable tax treat- ment was intended to encourage employers to provide benefits that would protect employees and their families from hardship on account of contingencies such as sep- aration from service, death, and sickness or disability. Beginning with ERISA, how- ever, the list of statutory fringe benefits has grown to include employer-provided programs aimed not at encouraging the extension of protection against hardship re- sulting from specified contingencies, but instead merely at promoting the expendi- ture of compensation in specified ways. These more recent statutory tax-favored benefits include employee stock ownership plans, group legal services programs, van pooling, educational assistance programs, and dependent care assistance programs. The expansion of the statutory nontaxable benefits has the effect of reducing the cost of a broad range of goods or services that are purchased by a wide spectrum of the population. Predictably, this expansion has put pressure on employers to pro- vide increasing portions of compensation in tax-favored forms so as to maximize the "tax effectiveness" of employee compensation packages. We have estimated the nontaxable employer contributions for qualified pension and profit-sharing plans, group health insurance, and group life insurance for the period from 1955 through the present, and have projected such contributions through 1989. Also, we have calculated the portion of total wages that these contri- butions have constituted, and the revenue effect of excluding these contributions from the Federal income and social security tax bases. These estimates are summa- rized in Table I, attached at the end of this testimony. Table I illustrates that, as a percentage of total wages, the total nontaxable em- ployer contributions for qualified pension and profit-sharing plans, group health in- surance, and group life insurance were 3.2 percent in 1955, 5.2 percent in 1965, 8.5 percent in 1975, and 11.1 percent in 1983. We project that this percentage will be 11.5 percent in 1985 and will increase further to 13.4 percent in 1989. In 1983, ex- cluding these employer contributions from the Federal income and social security tax bases reduced Federal income tax revenues by about $53 billion and social secu- rity tax revenues by about $11 billion; for 1985 the corresponding revenue reduc- tions are projected to be $64 billion and $14 billion. The expansion in the scope and volume of tax-favored fringe benefits represents a significant threat to the Federal income and social security tax bases. If pressures to increase social security and marginal income tax rates are to be resisted, hard PAGENO="0043" 37 choices must be faced as to which fringe benefits can be granted tax-favored treat- ment and as to whether the tax advantages currently available to fringe benefits can be modified without impairing the social policy objectives underlying their fa- vorable tax treatment. Cafeteria Plans and Flexible Spending Arrangements.-Recent growth in tax-fa- vored benefits provided under employer-sponsored plans has been stimulated by the statutory authorization of cafeteria plans. Cafeteria plans permit individual employ- ees to choose which fringe benefits they will receive, in effect allowing employees to design fringe benefit packages tailored to their individual needs. The flexibility inherent in cafeteria plans substantially eliminates "employee jeal- ousy" as a restraint on the amount of compensation provided in tax-favored forms. In the absence of a cafeteria plan, employees would choose compensation in the form of nontaxable fring benefits only if the benefits were more desirable than the after-tax value of the additional salary that would otherwise have been paid. Be- cause the desirability of particular benefits differs from employee to employee, fringe benefit compensation generally is sought by some employees and opposed by others. Employee disagreement over the desirability of particular nontaxable bene- fits historically has served as an important restraint on the amount of compensation provided in any particular form. Cafeteria plans virtually eliminate this restraining factor by permitting individual employees to select the fringe benefits which meet their particular needs. Also, where an employer is unwilling to provide additional benefits on a tax-fa- vored basis, cafeteria plans enable employees to use pre-tax dollars, rather than after-tax dollars, to purchase such additional benefits. For example, in the absence of a cafeteria plan, an employee would have to make the required employee contri- bution to a contributory medical plan with after-tax dollars. But if the employer makes the contributory medical plan available through a cafeteria plan, the employ- ee would be able to make the required contribution with pre-tax dollars. We recognize that, where an employer historically has provided its employees with a very rich, tax-favored fringe benefit package, a cafeteria plan may result in a net decrease in the tax-favored benefits received by such employees. However in the aggregate, cafeteria plans significantly narrow the Federal income and social securi- ty tax bases. For fiscal years 1984 through 1989, we estimate that, assuming the ex- clusion for group legal services is not extended beyond December 31, 1984, cafeteria plans will reduce individual income tax receipts by $5.5 billion and social security receipts by $3.2 billion, for a total reduction of $8.7 billion. These projections indicate that cafeteria plans provide a powerful incentive for tax-favored forms of compensation. Even more substantial losses in revenue would result, however, if the cafeteria plan rules authorized the exclusion of benefits pro- vided through so-called "flexible spending arrangements." Generally, a flexible spending arrangement (FSA) permits an employee to designate some portion of his or her otherwise taxable salary as available for the tax-free reimbursement of speci- fied expenses, such as medical care, legal services, or dependent care assistance. Under an FSA, the employee is assured of receiving, in the form of cash or some other benefit, any portion of the designated amount not utilized for the specified ex- pense. We have concluded, as proposed Treasury regulations on cafeteria plans reflect, that the statutory provisions granting tax-favored treatment to specified benefits and the cafeteria plan rules themselves do not authorize FSAs. Therefore, a benefit does not fall under any of the applicable statutory exclusions if the benefit is provid- ed through an FSA. If FSAs were granted favorable tax treatment, employers would be better able to style ordinary compensation as a tax-free reimbursement of their employees' person- al expenses. Such expenses are otherwise nondeductible for fax purposes, or, as in the case of expenses for medical or dependent care, entitled to a deduction or credit only under statutory limitations. The effect of granting favorable tax treatment to FSAs would be write out of the Code, at least for employees in cafeteria plans, the existing limits on deductions and credits for a number of personal expenses. Our revenue estimates indicate that FSAs would have a dramatic effect on the Federal tax base. For the 1984 through 1989 fiscal years (assuming that the exclu- sion for group legal services is not extended beyond December 31, 1984), we estimate that the $8.7 billion projected revenue loss attributable to cafeteria plans would double to approximately $17 billion if favorable treatment were granted to FSAs. Welfare Benefit Funds, Including VEBAs.-Generally, the costs of employee com- pensation, including employer-provided welfare benefits, are deductible by the em- ployer at the time when the compensation is actually provided to the employees. In addition, if an employer sets aside amounts for future employee compensation, PAGENO="0044" 38 income earned on the amounts set aside is included in the employer's gross income for income tax purpose. Exceptions to these general rules have permitted employers, in certain circum- stances, to deduct currently contributions to prefund deferred welfare benefits. The critical advantage to an employer in setting aside funds in VEBAs and other effec- tively tax-exempt entities is that the income on such funds accumulates on a tax- exempt basis. Generally, neither the employer, the plan or VEBA, or the employee- beneficiaries are taxed currently on the fund's growth. The historical development of the VEBA rules indicates that the effectively un- limited tax-exemption for VEBAs did not come about in a considered and deliberate fashion. Indeed, before the Deficit Reduction Act, Congress seems not to have appre- ciated the potentially substantial tax benefits that an employer could derive through a VEBA. Instead, Congress generally viewed VEBAs simply as vehicles through which employees could join together to provide certain welfare benefits for themselves without adverse tax consequences. Congress originally enacted a statutory tax exemption for VEBAs in 1928. The ex- emption was available only for VEBAs with respect to which at least 85 percent of the income was collected from members to pay benefits or administrative expenses. Later, in response to the Internal Revenue Service's argument that employer contri- butions, if in excess of 15 percent of a VEBA's income, destroyed the VEBA's tax- exempt status, Congress provided that employer contributions would be treated as member contributions for purposes of the 85 percent test. Even after the change in treatment of employer contributions, the 85 percent test, by effectively limiting the investment income in a VEBA to 15 percent of the VEBA's income, prevented employers from using VEBAs to accumulate substantial tax-favored reserves. The Tax Reform Act of 1969, however, in a move apparently intended to restrict the tax advantages of VEBAs, subjected VEBAs to the unrelated business income tax and eliminated 85 percent test; Congress appeared to believe that applying the unrelated business income tax rendered the 85 percent test unnec- essary. Under the applicable unrelated business income tax provisions, however, VEBA income was not subject to tax if it was "set aside" to provide permissible ben- efits. Thus, there were no longer any limits on the amounts that an employer could set aside in a VEBA to pay a permissible benefit, or on the tax-free earnings that could accumulate on the amounts set aside. In recent years, and especially since Treasury regulations under the Tax Reform Act of 1969 were issued in 1980, the growth in the number of VEBAs has substan- tially accelerated. According to the IRS, only 7,791 active VEBAs had received fa- vorable IRS determination letters by November 30, 1980. By the end of 1983, howev- er, more than 9,400 VEBAs had received favorable letters. Thus, over 17 percent of the VEBAs in existance as of the end of 1983 have come into existence during the last three of the 55 years for which VEBAS have been tax-exempt. One of the rea- sons for this recent increase was the enactment of the additional limits-the reduc- tion in the section 415 limits on contributions and benefits and the top-heavy rules-on qualified pension and profit-sharing plans in the Tax Equity and Fiscal Responsibility Act of 1982. VEBAs are subject to neither of these restrictions. The combination of the current deduction for deferred welfare benefits and the tax-exempt growth of funds set aside for such benefits provides employers with sub- stantial tax benefits. For example, an employer subject to a 46 percent marginal income tax rate generally bears about 54 percent of the cost of providing an employ- ee with a welfare benefit and the Federal government (or taxpayers generally), through the tax system, bears about 46 percent of the cost of the benefit. To the extent that the employer is able to prefund, on a deductible basis, a deferred benefit through a tax-exempt entity, such as a VEBA, a portion of the cost of the benefit will be purchased with tax-exempt income earned by the entity. In such a case, the Federal government (or taxpayers generally) will pick up a greater share of the total cost of the benefit. If the tax-favored prefunding occurs many years in advance of when the benefit is provided, the government's share of the cost will far exceed the employer's share due to the greater accumulation of tax-exempt income. It is important to note that this shifting of costs to the government occurs even though the funding is actuarially sound, and thus the problem is by no means limited to cases involving acturial overfunding. One way of ifiustrating the magnitude of this tax benefit is by comparing the after-tax amounts generated if the same amounts are set aside, over a period of years, on a deductible and tax-exempt basis, on the one hand, and on a non-deducta- ble and taxable basis, on the other. For example, assume that a corporation is will- ing to devote $2,000 at the beginning of each year for 10 years toward providing a benefit at the end of the 10th year. Assume further that the corporation is in the 46 PAGENO="0045" 39 percent tax bracket for each of these years, and that the annual interest rate is 10 percent. If the corporation uses a VEBA to fund the benefit, it will be allowed to deduct the $2,000 in each year of its contribution to the VEBA. If, however, the corporation merely uses a taxable bank account to fund the benefit, it will be able to set aside in each year only the after-tax value of $2,000, which is $1,080. After ten years of accu- mulation, the VEBA fund will be $35,062.33, whereas the balance in the bank ac- count will be only $14,587.83. The bank account balance, however, will support a benefit of $27,014.50, which would be financed by the tax savings attributable to the deduction for this benefit (.46 x $27.014.50) and the $14,587.83 account balance. Thus, in this example, funding the benefit through the VEBA permits the corpora- tion to provide a 30 percent greater benefit than funding through the taxable bank account. The Deficit Reduction Act contains rules that limit the extent to which an em- ployer may use a VEBA or similar entity to provide deferred benefits to employees. Employer deductions to a VEBA for a year are limited to the sum of the benefits provided during the year plus an amount, determined under reasonable acturial standards, to cover benefit claims incurred but unpaid as of the end of the taxable year and to cover projected post-retirement life insurance and medical benefits. Also, to the extent that the reserves set aside in a VEBA or similar entity exceed the permitted reserve limits (without regard to the reserve for post-retirement medi- cal benefits), the income of the VEBA or similar entity will be subject to the unre- lated business income tax. Finally, the Deficit Reduction Act limits the levels of benefits that may be provided to employees for purposes of calculating these deduc- tion and reserve limits. The Deficit Reduction Act also contains rules aimed at limiting the extent to which an employer may use a VEBA or similar entity for unintended purposes. For example, the Act applies eligibility, coverage, and nondiscrimination rules to VEBAs and provides that funds set aside to provide post-retirement life insurance and medical benefits to a key employee of the employer must be credited to a sepa- rate account and, to the extent attributable to post-retirement medical benefits, must be counted under the annual section 415 limits as employer contributions to a defined contribution plan. Also, a key employee may receive the promised post-re- tirement benefits only out of the funds credited to his or her separate account. In spite of the important limits imposed by the Deficit Reduction Act, significant tax benefits remain for employers using VEBAs or similar entities. HORIZONTAL INEQUITY The statutory exclusions of fringe benefits from gross income generally are condi- tioned upon the delivery of the benefits through an employer-sponsored plan. The limitation of tax-favored benefits to employees covered by an employer plan may be seen to discriminate against individuals not so covered. This latter group of non-cov- ered individuals must pay for benefits, such as health care, with after-tax dollars, whereas covered employees are able to purchase the same benefits with pre-tax dol- lars. We have prepared data showing the precentage of civilian employees in different income classes who are covered by pension or profit-sharing plans as well as the percentage who are covered by employer-provided group health insurance. This data is summarized in Table II, attached at the end of this testimony. As is reflected in Table II, the percentage of employees covered in the very lowest income categories is substantially smaller than for both the middle and upper income groups. Comprehensive judgments about the fairness of the existing tax-treatment of fringe benefits should await additional data concerning the distribution of such ben- efits among income groups. Current data showing significantly smaller employer plan coverage for the lowest paid employees is itself, however, cause for concern. Moreover, it is worth emphasizing that the degree of unfairness attributable to the tax treatment of fringe benefits varies directly with the volume of benefits exempt- ed from tax. As the percentage of compensation paid in the form of tax-favored fringe benefits increases, the issue of how the related tax benefits are distributed among taxpayers takes on increasing importance. Further growth in the volume of tax-favored fringe benefits can only exacerbate already significant concern over tax- payer fairness. NONDISCRIMINATION AND HEALTH POLICY OBJECTIVES Nondizcrimination.-A basic justification for providing a tax benefit in the form of an exclusion from gross income is to promote the delivery of the tax-favored bene- PAGENO="0046" 40 fit to a broad cross-section of employees on a nondiscriminatory basis. It is thus im- portant that effective coverage and nondiscrimination rules apply with respect to each employer-provided benefit eligible for an exclusion from gross income. Coverage and nondiscrimination rules apply to most tax-favored benefits, such as group-term life insurance, self-insured medical reimbursement plans, group legal service plans, and dependent care assistance programs. However, medical plans pro- vided by an employer under a policy with an insurance company are not subject to nondiscrimination rules. Thus, discrimination in favor of the key and highly com- pensated employees still is possible in the case of insured health plans. We also are concerned that cafeteria plans undermine the effectiveness of the statutory coverage and nondiscrimination rules that presently apply with respect to each of the statutory exclusions. These coverage and nondiscrimination rules gener- ally are based on the availability of the particular benefit provided under the plan. In the absence of a cafeteria plan, an availability-type test ordinarily will assure that the benefit is provided to a broad cross-section of employees on a nondiscrim- inatory basis. Availability-based tests, however, are not effective where employees are free to trade tax-favored benefits for cash or other benefits. Also, the existing coverage and nondiscrimination rules applicable to cafeteria plans generally are not adequate to assure that the basic coverage and nondiscrimination objectives are being protected. Health Policy Considerations-The magnitude of the tax benefits available for employer-provided welfare benefit plans may create incentives inconsistent with other important policy objectives. In particular, we are concerned that the generous tax treatment of employer-provided health benefits may have contributed to, rather than helping to contain, increasing health care costs. Section 106 of the Code provides employees with an unlimited exclusion from gross income for the cost of employer-provided health coverage. Medical care and expense reimbursements received under such coverage are provided with an unlim- ited exclusion under section 105(b). A primary effect of these provisions is that em- ployees are supplied with extraordinarily generous health benefits, often with no in- ternal controls on costs or utilization of health care. Some employer-provided health plans are so generous that employees bear little, if any, of the cost of routine doc- tors' visits, hospital care, or medical tests. As a result, the employees tend to over- use doctor and hospital services and medical tests. Such overuse contributes to rising health care costs. In recognition of the effect on health care costs of the tax treatment of employer- provided health benefits, the Administration has proposed a cap on the health bene- fit premium that may be excluded from an employee's gross income. There may be additional methods of encouraging employers to introduce more cost-sharing into their health plans and otherwise to reduce private health spending. All parties- Congress, the Administration, and private industry-should work together to target the tax benefits for health plans more effectively. Furthermore, we believe that health care cost considerations also dictate that fa- vorable tax treatment not be granted to FSAs in cafeteria plans. Because FSAs would allow existing cost-sharing in health plans to be made with pre-tax dollars, the permissive treatment of FSAs would contribute to rising health costs. We recognize the argument that, in particular situations where an FSA replaces first-dollar coverage, the FSA may introduce a relative incentive for employees not to use health care. However, granting favorable tax treatment' to FSAs would permit employees to use pretax dollars to pay for health-related expenses that are currently paid with after-tax dollars. These expenses-cost-sharing under health in- surance, payments for services not covered by insurance, and employee contribu- tions to employer-sponsored health plans-are expected to grow to $118 billion by 1990, according to Department of Health and Human Services estimates. If, through the availability of FSAs, a substantial share of the $118 billion were to be financed with pretax dollars, demand for health services would be increased and health care- cost inflation exacerbated. More effective and equitable strategies than FSAs are available to aid employers in controlling health care costs. For example, utilization review, second opinions, re- structuring of benefits (e.g., to cover noninstitutional care), special service delivery arrangements (e.g., preferred provider organizations), and the promotion of health maintenance organizations are examples of proven and developing strategies for pri- vate health cost containment. Also, cafeteria plans without FSAs permit employers to price health benefit options to encourage employees to select the options with ad- ditional employee cost-sharing. An employee who selects a lower-option health bene- fit would then have additional amounts available to purchase other benefits or to PAGENO="0047" 41 receive as cash, which if necessary could be used to pay for health expenses that are unreimbursed due to the higher deductible or co-payment. We believe thorough analysis clearly indicates that even though FSAs may facili- tate a particular employer in attempting to introduce incentives for its employees to reduce excessive use of health care services, the dominant effect of granting permis- sive tax treatment to FSAs would be to increase health care costs. We thus believe that granting such treatment to FSAs would undercut the effort to formulate an effective health cost containment policy. TABLE 1.-EMPLOYER CONTRIBUTIONS FOR PENSION AND PROFIT SHARING PLANS, GROUP HEALTH INSURANCE, AND GROUP LIFE INSURANCE Calendar year 1955 Actual Projected 1985 1989 1960 1965 1970 1975 1980 1983 Pension and profit sharing: Amount' (dollars) 4,506 7,479 11,317 20,284 42,776 80,791 99,596 124,933 196,585 Percent of wages 2.1 2.8 3.1 3.7 5.3 6.0 6.0 6.4 7.3 Individual income tax liability effect -1,153 -1,915 -2,574 -5,059 -12,046 -26,579 -30,188 -37,230 -58,582 Group health insurance: Amount' (dollars) 1,706 3,374 5,890 12,099 21,301 45,380 77,199 90,370 148,420 Percent of wages 0.8 1.2 1.6 2.2 2.6 3.3 4.7 4.6 5.5 Individual income tax Oability effect (dollars) -357 -707 -1,096 -2,469 -4,908 -12,214 -19,629 -22,032 -37,334 Group life insurance: Amount (dollars) 561 1,080 1,651 2,891 4,368 6,359 7,592 9,186 13,449 Percent of wages 0.3 0.4 0.5 0.5 0.5 0.5 0.5 0.5 0.5 Individual income tax liability effect (dollars) -126 -243 -330 -634 -1,081 -1,839 -2,022 -2,408 -3,525 Total: Amount (dollars) 6,773 11,933 18,858 35,274 68,445 132,530 184,387 224,489 358,454 Percent of wages..... 3.2 4.4 5.2 6.4 8.5 9.8 11.1 11.5 13.4 1 Includes federal civifan, state and local government pension contributions. 2 Actuals are based on Department of Commerce reported data and include employer contributions fur short. and lxng.term disability insurance covering private employees and their dependents for 1955-1970. Actual amounts, for 1975-1983 and Department of Health and Human Services projections for 1985-1989 do not include disability insurance. Source: Office of the Secretary of the Treasury, Office of Tax Analysis, September 14, 1904. TABLE 11.-DISTRIBUTION OF TOTAL CIVILIAN WAGE AND SALARY WORKERS, AND CIVILIAN WAGE AND SALARY WORKERS WITH AN EMPLOYER PENSION PLAN, OR ON EMPLOYER GROUP HEALTH PLAN BY WAGE AND SALARY CLASS 1 Total wage 1903 Wages and salary workers workers with employer plan Pension Health (thousands) Number (thousands) Percent of workers Number (thousands) Percent of workers Less than $5,000 $5,000-$10,000 17,766 16,961 29,926 1,568 4,908 17,405 8.8 28.9 58.2 $10,000-$20,000 $20,000-$30,000 16,103 8,544 12,216 6,672 75.9 78.1 $30,000-$50,000 Over $50,000 2,088 1,529 73.2 Total 91,388 44,298 48.5 3,196 18.0 9,126 53.8 24,484 81.8 14,701 91.3 7,968 93.3 _______________________________________ 1,898 90.9 61,373 67.2 1 Source: 1984 Current Population Survey (refers to 1983 levels). Data shown is self reported and may not completely agree with employer reported data. Note: A substaxtial number of workers not covered by their own employers health play are covered by the health plan of a family member. lx 1977 about 73 percent of the civilian noninstitutional population under age 65 was covered by employer health insurance; about 9 percent of the civilian noninstitutional Population under age 65 was not covered by insurance. Source: Office of the Secretary of the Treasury, Office of Tao Analysis, September 14, 1984. PAGENO="0048" 42 Chairman STARK. Could you comment for a moment on whether or not you looked at what the various tax proposals that are float- ing about would do to both revenue and fringe benefits? For exam- ple, the flat-tax-type proposals or value-added tax proposals which could very well tax services and goods, applied to small companies, have you looked at that? Mr. PEARLMAN. One of the areas we are looking at in connection with our study of fundamental tax reform is both what is the role of statutory provided fringe benefits, and what is the effect on the statutory fringe benefits. You know, one of the things we are doing in connection with our study, Mr. Stark, is developing, which un- fortunately is not yet developed, a very substantially expanded weight of data base, which every one, including members and the staffs of the Hill, will be able to call upon to make more intelligent judgments about what the revenue impacts on various statutory changes are, both on the short term when we deal with the target- ed legislative proposal and when we are looking at more fundamen- tal issues. So the answer to your question is yes, we are looking at that. And we hope, and the data base piece is a mechanical problem. We are hopefully within a couple weeks of having a data base. At least, our fingers are crossed that we will, and that that will permit us to do more intelligent revenue analysis than is possible today. Chairman STARK. Thank you. Chairman PICKLE. All right, go ahead, Mr. Pearlman. Have you finished with your testimony? Mr. PEARLMAN. I have finished, yes, sir. Chairman PICKLE. Mr. Pearlman, have you, before you conclude, made any recommendations about actions for the Congress to take? Mr. PEARLMAN. No, sir; at this point we have not. We are look- ing, obviously, as Treasury generally does, at what things continue to need to be done. Now, we have in our testimony mentioned a few general things. We are interested in the subject of nondiscrim- ination. We are interested in the subject of fairness. Is the current system fair? But two things have occurred that would suggest to us that specific recommendations perhaps might not be appropriate at this point. One is we are taking a hard look at the subject of fringe benefits in connection with our fundamental tax reform study. The second thing is the Congress took some very significant actions-- Chairman PICKLE. Mr. Pearlman, pardon me. You said you are taking a hard look at fringe benefits with respect to the package you might offer. Did I understand you? Mr. PEARLMAN. We believe that part of our commitment in re- sponding to the President's directive to give him some recommen- dations on fundamental tax reform is to look at the subject of statutorily provided fringe benefits in a continuing income tax, or, if our system were to change. And in that regard we are looking at the current system of the delivery of fringe benefits. Chairman PICKLE. Can you tell the committee at what point you might make such recommendations or analyses, further analyses to this committee or the Congress? PAGENO="0049" 43 Mr. PEARLMAN. I would think realistically, Mr. Chairman, unless we are called upon earlier, that the most likely time that we would be making specific recommendations to the Con~ress and whether we will or not, you know, at this point I just can t tell, would be in connection with the budget. But I think, absent additional hear- ings, that I would think certainly not on the very short term. Chairman PICKLE. What I am trying to establish is that you do feel that there is discrimination that should be corrected; that there is a loss of revenue; and that the tax base is being eroded. And that these matters ought to be corrected. And assuming the continuation of this administration, you would probably make a recommendation to make changes after the first of the year? Mr. PEARLMAN. Well, no, I just can't say that because I just don't know. I think that at this point, because of the work we are under- taking now, coupled with the fact that we don't have, and 1 don't think anyone does, in hand what the real implications of the 1984 legislation are. I think at this point I am simply not in a position to tell you that some 6 months from now we will be in a position to make recommendations. We know we have got a commitment to Congress that was imposed upon us by the 1984 legislation to make a report to the Congress in the flexible cafeteria plan spending by next April, and we will certainly do that. Chairman PICKLE. I understand that all things in general, since your testimony points out that there is discrimination, and some unfairness, that there is a-that the employers are taking large de- ductions and that some changes should be made, that we can an- ticipate a recommendation at some point for correction of these things. So whenever that occurs, we would be of course interested in having it. Let me ask you for my information. On your page 9 you said that nondiscrimination rules do apply to life, group health, group legal services, and so forth. However, medical plans provided are not subject to nondiscrimination rules. Why is that? Mr. PEARLMAN. Mr. Chairman, I just can't answer you. I just don't know the answer to that question. I was not around at the time of that legislation, and I don't know why insured plans were excepted. That is one of the areas, however, that we want to look at and we want to try to get handle on what the effect of that is on the broad delivery of tax-favored fringe benefits. But I simply can't answer your question. I don't know. Chairman PICKLE. Perhaps we ought to ask ourselves why that is, to observe this is the last big area which has not been covered. Let me ask you one question that has been submitted to me to ask. We are going to receive testimony shortly from the HHS and SSA. We anticipate, based on the testimony we expect to receive, learn- ing how Social Security tax rates could be reduced without decreas- ing revenues under various assumptions of different amounts of fringe benefits being included in Social Security wage base. Maybe this is what Secretary Regan has referred to as changes in Social Security. Now, we requested this information on tax rates with all fringe benefits being included in the wage base, without further increase in fringe benefits and other projections. So I am wondering if you could provide us with similar-type information on the effect of 40-046 0 - 85 - 4 PAGENO="0050" 44 fringe benefits on income tax rates. For example, if revenue were held constant, how much could tax rates be reduced if all fringe benefits were included in the income tax base? And what could be done to rates if there were no further increases in nontaxable fringe benefits? I would like for you to give us some information when you can, as quickly as you can. Mr. PEARLMAN. Certainly. We will be happy to provide that. TREASURY RESPONSE The exclusion from the individual income tax base of employer contributions to pension and profit sharing plans, group health insurance, and group life insurance resulted in a reduction in 1983 Federal income tax liability of $53 billion computed at 1983 tax rates. Had these items been included in the individual income tax base, the current law level of receipts could have been maintained with an average reduc- tion in rates of about 12 percent. Chairman PIcKu~. The Chair would recognize Mr. Duncan now for any questions that he might have. Mr. DUNCAN. Thank you, Mr. Chairman. Mr. Pearlman, in your study of fringe benefits, have any general conclusions been reached as to the amount individual tax rates could be reduced by increasing the kinds of fringe benefits that are taxed? Mr. PEARLMAN. No, Mr. Duncan. Really, that is the reason we did not provide that data this morning. One of our hopes is that by the expanded data base we are working on that we will be better able to make those judgments. At this point we simply don't have those data. Mr. DUNCAN. Does Treasury view the tightening of the fringe benefits nondiscrimination rules as a means of limiting fringe ben- efits? Mr. PEARLMAN. Oh, I think clearly the-I don't think it would be fair to say that we view the nondiscrimination rules-I mean they will have that effect. I don't think we view the nondiscrimination rules as necessarily a vehicle that should be used to limit them. I think we view the nondiscrimination rules as a, simply a condition that should be applied as a matter of fairness and equity to any statutory fringe benefits that are provided by Congress. If, for ex- ample, we were to suggest to you the expansion of the nondiscrim- ination rules to a particular fringe benefit, it would not be for the purpose of cutting down revenue loss, for example. It would be be- cause we think it is fair that these fringe benefits be provided on a nondiscriminatory basis. But we do believe that the discrimination rules are important and that they should continue to apply to all statutory fringe bene- fits. To the extent they don't apply, we think those are areas we should look at and maybe indeed we will be coming back to you making some suggestions in that area. Mr. DUNCAN. Do you have any idea of what period of time will have to elapse before Treasury gets a fairly accurate reading of how the fringe benefit rules in the 1984 act are actually working? Mr. PEARLMAN. Realistically, if you want really reliable data, the only source of data that we have generally available to us that is really reliable is tax return data. Now, if we wait that long we are talking about some years. Our hope is that we will be able, through PAGENO="0051" 45 data that is voluntarily provided by the industry, interested indus- try groups, and through data which we hope that the Internal Rev- enue Service can develop that is other than pure tax return data, that we may be able to provide you some information in shorter than the normal period of time. For example, now we have good tax return data through 1981 but nothing that is very firm beyond that. So you can see there is a lapse of a few years. And if we wait that long it is going to be awhile. Mr. DUNCAN. Thank you very much, Mr. Pearlman. Thank you very much, Mr. Chairman. Chairman STARK. By referral I was asked to inquire of you, but I think the answer to this question is self-evident. It said there is concern that if you limit the amount of tax-free employer contribu- tions to a health plan, it would result in reducing health benefits. The guess, I would say the other side of that question is, if you limit the amount, you raise the cost, either way, raise costs or limit benefits. Is there any other option in that area? Mr. PEARLMAN. Well, I would really like Mr. Helms to comment on this, too. So I will give you my uninformed comment. That is it seems to me that there is another option. That is how employers tailor their plans. Maybe we are saying the same thing. Raise the cost, but if employees have to-it seems to me that employers and employees have to recognize that it can't be a free ride. That incur- ring health care costs just can't be a free ride to anyone, because it in fact is not. For me, if I am the employee, it will be raising my costs. If there is a higher deductible, there is a higher copayment, that means the cost may go up to me. It may not though. It may mean that without being irresponsible, and I think that is impor- tant, that we are not forcing employees to forgo needed health care, that employees can make a judgment that health services that are really not needed, that are luxurious or duplicative, could be forgone without increasing costs. That it just forces people to make better judgments. And I think one of the things we are concerned about in terms of the cafeteria plan, for example, is that employees are not forced to make that decision. Chairman STARK. So what you are saying is, they may discrimi- nate or be more discriminatory in how they use their benefits if it costs them something? Mr. PEARLMAN. That is correct. Chairman STARK. That I think is a halfway post, between either providing fewer services or increasing cost for the existing ones. And I would share your opinion that, obviously, having it just open ended and-tends to generate things like I suppose cosmetic surgery and dentistry and a lot of things that are likely to advance in the cos- metic world we live in, but may not be something the Federal Gov- ernment wants to pay for. I think our next witness, then-does anyone else have any ques- tions? Yes. Mr. Secretary, while you are perfectly welcome to stay and participate, Secretary Pearlman, we could excuse you and call on Dr. Robert Helms, Acting Assistant Secretary for Policy and Evaluation, Department of Health and Human Services, Mr. Bal- lantyne, Chief Actuary of the Social Security Administration. PAGENO="0052" 46 Are you two testifying separately? STATEMENT OF ROBERT B. HELMS, ACTING ASSISTANT SECRE- TARY FOR PLANNING AND EVALUATION, DEPARTMENT OF HEALTH AND HUMAN SERVICES, ACCOMPANIED BY BRUCE STEINWALD, ACTING DEPUTY ASSISTANT SECRETARY FOR HEALTH POLICY Mr. HELMS. Thank you, Mr. Chairman. I have with me Bruce Steinwald, Acting Deputy Assistant Secre- tary for Health Policy. It is a pleasure to be with you today and to represent the Depart- ment of Health and Human Services and talk about employer-pro- vided fringe benefits. I will focus, as you said, primarily on the topic of employer-provided health care benefits. The availability of employer-provided health insurance protec- tion has contributed to the welfare of most Americans. According to the best data available, 80 percent of the nonaged population are covered by private health plans, of which 82 percent were group plans. The predominance of employer-provided health insurance fi- nancing must be recognized as a success story of major proportions. Indeed, we tend to forget how employer-employee financed group health plans have shaped national policy. In 1965, we took the model of a private health insurance plan for the model of medi- care, and most of the proposals over the years for serious reform have been based on a system of private employer-provided health insurance. In other words, we have never considered other types of models, such as those they used in Europe. Eventually, we realized that our diverse and dynamic system of private insurance was not just a suitable model, but was in fact a superior system to a monolithic national health insurance scheme. But having made that important choice, we were left with some unresolved issues. The dominant role of group health insurance fi- nancing is partly an evolutionary response to preferential tax treatment. The cumulative influence of tax incentives led to plan designs that went well beyond financial protection. Plans were ex- panded to the point of providing coverage paying for routine, budg- etable medical bills, often with no cost-sharing or other controls on excessive use of services. In an environment of liberal third-party financing, hospitals and physicians expanded services utilization and accelerated the pace of medical technology. And so it was that insurance financing in the private sphere, al- ready recognized as a great and beneficial institution, came to be recognized also as contributing to our severe and continuing medi- cal expenditure inflation. As we know only too well, this inflation has added to fiscal imbalance, reduced access to care by those not adequately insured, distorted production and consumption incen- tives, and diverted more and more household income from other forms of consumption. The administration made health care cost inflation a first priori- ty matter. Policy recommendations have focused on reforming in- centives rather than regulating behavior. Two key legislative pro- posals aimed at incentives were developed early in this administra- tion. A plan for prospective payment of hospitals under medicare PAGENO="0053" 47 has been enacted and is already producing constructive results. We also proposed a limitation on the amount of income employees could receive tax-free in the form of health insurance. Under pressure from rising health care costs, and realizing that neither Congress nor the administration would support a regula- tory solution, employers proceeded to adopt a variety of innovative strategies for containing costs. One of these is cost sharing. Cost sharing is rapidly being introduced and extended, often in the context of cafeteria plans offering choice among different levels of coverage. According to a recent Hay-Huggins survey, about one- third of a broad sample of private firms had recently increased de- ductibles; another third were considering such an increase. We know from many types of evidence-most recently and deci- sively from the Rand Health Insurance Study sponsored by my office-that cost sharing significantly affects utilization of services, a result that is repeatedly confirmed by the experience of employer plans where deductibles have been instituted or raised. Second surgical opinions, private utilization review and monitor- ing of physician treatment patterns are all proving effective in cut- ting claims cost. Innovative health care financing and delivery systems, such as preferred provider organizations [PPO] are continuing to prolifer- ate. Enrollment in health maintenance organizations [HMO's] a proven efficient alternative to traditional insurance financing of health care, is growing at over 15 percent per year. I might add that our recent proposed regulations that would open up the HMO's to the medicare population we think will in- crease the rate of HMO growth. We can say that in the 1970's the degree of comprehensiveness for employer-provided health care reached a peak. The 1980's are shaping up as a period of growing discipline in plan design and management. This is a constructive trend that I would like to see continue. As constructive as this direction of movement appears to be, it does not portend immediate solutions to longstanding problems. Indeed, new problems seem to come along as fast as old ones abate. The issue of flexible spending accounts [FSA's] has already been in- troduced by Mr. Pearlman. I would like to elaborate on that sub- ject. As an initial point, let me emphasize the difference between a cafeteria plan-recently referred to also as a flexible benefit plan- and the flexible spending account. To illustrate the distinction, con- sider a prototype cafeteria plan. It might offer employees a choice among standard comprehensive benefits, a low option with a siza- ble deduction, and an HMO. It might also offer other benefits such as a deferred income plan and dependent care. The total value of benefits would be set by the employer but might be augmented by an employee contribution. Flexible spending accounts, developed by some companies and their consultants early in this decade, extended the above concept by allowing employees even wider latitude in determining the pro- portion of their incomes devoted to nontaxable fringe benefits. Such plans were often packaged with increases in cost-sharing under the employer-sponsored health plan. The essential attribute PAGENO="0054" 48 of a flexible spending account is the opportunity it affords the em- ployee to transform the financing of out-of-pocket medical ex- penses, and sometimes other purchases from after-tax income to before-tax income. Testimony by the Department of the Treasury has stressed the potential revenue effects of widespread adoption of FSA's. Recent IRS rules restrict the operation of FSA accounts. Most importantly, no cash refund or carryover is permitted except for some plans that are temporarily grandfathered, and under current rules a flexible spending account can operate only as part of a cafeteria plan. But the cafeteria plan need not include the essential features of a flexible spending account. For this reason, we should be careful to discriminate between ef- fects attributable to FSA's and those associated with cafeteria plans. This distinction is especially important when considering health policy issues relating to tax reform and incentives. Concern about the potential revenue impact of FSA's is based on a projection of household expenses that could be channeled through FSA's barring specific restrictions. It must be remembered that not only a wide class of employee expenses but also employee contribu- tions for health insurance plan premium payments could be paid from such accounts. Out-of-pocket health-related expenses of em- ployees with potential access to FSA's are now preliminarily esti- mated to be over $60 billion and will grow to $100 billion by 1990. Employee premium contributions are $20 billion and will be over $35 billion in 1990. Despite the potential for FSA's to be used as a tax-sheltering device, it is possible that under certain circumstances there may be some benefits to be derived from the invention of FSA's. Under the obvious tax-shelter features of FSA's there exists a basically good idea-the combination of increased front-end cost sharing on health benefits and a specific employee-controlled account guaran- teeing availability of funds to pay medical bills engendered by that cost sharing. Results from the Rand experiment and other evidence show that front-end cost sharing reduces spending on health services with no appreciable effect on employee health. Health spending reductions affect income tax revenues in two ways: reduced corporate ex- penses for health care means higher corporate profits and taxes; and reduced employee compensation in the form of health benefits means more dollars are available for taxable wages. The question remaining about FSA's is how much simple tax sheltering might be expected for any given set of qualifications on use. In addition to the tax revenue losses that could occur, we must also recognize that allowing employees to pay out-of-pocket ex- penses with pretax dollars makes those purchases cheaper, and so encourages utilization of the services thus purchased. This relation- ship could cancel possible constructive effects mentioned above. To resolve these issues, many questions must be answered. Rec- ognizing the need for more information, as you know, Congress mandated further study of the issues as a provision of DEFRA. My office, with the cooperation of the Treasury Department, has un- dertaken this study. We expect to report the results by April 1, 1985. PAGENO="0055" 49 Before concluding, I would like to touch on another policy issue inherent in the distribution of employer-provided health benefits- the issue of equity. Employer-provided benefits are given preferen- tial tax treatment, and the advantages bestowed by this treatment increase with income. According to available data, employer-premi- um contributions for health benefits rise from an average of about $800 for covered workers in the lowest 15-percent-income bracket to $1,300 for workers in the top 40-percent bracket. The higher paid workers have more to gain by receiving compensation in the form of nontaxed benefits because their income tax brackets are higher. In stark contrast, some workers-most often those in marginal, part time, and temporary jobs, the self-employed, and workers be- tween jobs-have no coverage at all. These workers tend to be low income but they receive no benefit whatsoever from the current preferential tax treatment of health insurance. I have touched on three problem areas in employer-provided health insurance: inflation, the flexible spending account phenome- non, and equity. It is only appropriate to mention again a legisla- tive initiative that addresses all these. That is the proposal to place a limit on the total amount of income that employers can pay in the form of tax-free health insurance coverage. The motivating rationale for such a limit remains, as always, to reduce the distorting effect of the tax preference leaving employ- ment groups to develop cost-containment innovations that suit their own needs. It is not a punitive tax on benefits, but rather an effort to make the tax law more neutral in the choice between added wages and added benefits. Such a limit would be enormously helpful in accelerating the trend to more efficient health plans that I summarized earlier. It would facilitate the search for ways to cap- ture the advantages of flexible spending accounts without the ad- verse effects. And it would contribute to fairness. In closing, I will reiterate my admiration for the dynamic world of employer-provided health benefits. The achievements in this area are both evidence of the genius of the private sector and a continuing challenge to public policy. The problems that have been associated with the growth of employer-provided health care are transient effects that may be controlled through a balancing of in- centives. In the interest of retaining the advantages of private-sector re- sponsibility, I hope to see the goal of Federal policy remain that of making employer provision of health and other fringe benefits even more efficient, fair, and conducive to a stable economy. I would be glad to try to answer your questions, Mr. Chairman. Chairman STARK. Thank you, Doctor. I gather that you share the Treasury's view that it would be a good matter of equity to enforce the salary nondiscrimination rules in the area of health benefits or health programs, medical-care pro- grams? Mr. HELMS. You mean the question you put to Mr. Pearlman about nondiscrimination? Chairman STARK. Yes; it is one of the major areas in fringe bene- fits where we don't say the plan has to be the same for all levels of salary, and can't discriminate on the basis of income. PAGENO="0056" 50 Mr. HELMS. Let me make a couple of points about that, Mr. Chairman. In particular, table 2-first of all, I would go along with Mr. Pearlman. I think we would like to consider that these nondiscrim- ination rules be applied to the health-care sector. But, having said that, I am personally not aware that they have been presented as any particular problem. I think the evidence is that most employer- provided plans are made available across the board to employees of each company. The problem addressed in Mr. Pearlman's table 2 is that you have a low percentage of the people in the lower income brackets having health coverage. I don't think they would be greatly affect- ed by nondiscrimination rules. That is mostly a phenomenon of a lot of employed people who work for small firms; they are simply not insured. We have found that over half the noninsured people are full-time workers and their dependents. I just don't think the application of the nondiscrimination rules would directly affect that problem. Chairman STARK. No, I don't think it would, either. It would probably raise a little revenue. There probably is a fairly widespread practice in smaller groups where the owners or highly paid executives have substantially more benefits than the average worker, but that is not to say the average worker's benefits are not good. They may not take care of orthodontia and fitness center trips and cosmetic surgery and the like, hair transplants and some other more-- Mr. HELMS. Gymnasiums. Chairman STARK. No. Gymnasiums now have to be on a nondis- criminatory basis. Mr. HELMS. OK. Chairman STARK. Mr. Duncan. Mr. DUNCAN. I have no questions, Mr. Chairman. Thank you. Chairman STARK. Thank you. We look forward to working with you on this matter. Mr. HELMS. Thank you. Chairman STARK. Our next witness is Harry Ballantyne, Chief Actuary, Social Security Administration. Welcome to the committee, Mr. Ballantyne. Your entire state- ment will appear in the record. You may proceed to summarize it, expand on it, in any fashion you prefer. STATEMENT OF HARRY C. BALLANTYNE, CHIEF ACTUARY, SOCIAL SECURITY ADMINISTRATION, DEPARTMENT OF HEALTH AND HUMAN SERVICES, ACCOMPANIED BY BRUCE SCHOBEL, ACTUARY, SSA Mr. BALLANTYNE. Thank you, Mr. Chairman. Mr. Chairman and members of the subcommittees, I am Harry Ballantyne, Chief Actuary of the Social Security Administration. I have with me Bruce Schobel, one of my assistant actuaries. I am happy to be here today to discuss with you the effects of employer-provided fringe benefits on Social Security program fi- nancing and benefits. My prepared statement is quite short and covers essential points, so I will just present it. PAGENO="0057" 51 Chairman STARK. Please proceed. Mr. BALLANTYNE. For purposes of this statement, "fringe bene- fits" refers to that portion of an employee's total compensation that is not covered for Social Security purposes. As the subcommittees are aware, the proportion of employee compensation represented by nontaxable fringe benefits has grown from about 8 percent in 1960 to about 16 percent this year. From a Social Security perspective, the growth of fringe benefits brings about a concomitant erosion in the proportion of total employee compensation represented by wages. This proportion has thus de- clined over the years, from 92 percent in 1960 to 84 percent this year. Based on the intermediate-Alternative TI-B-assumptions of the 1984 OASDI Trustees Report, we project this figure will decline to about 66 percent by 2060-about 75 years from now. Based on the wage and productivity assumptions in Alternative IT-B, we project that, over most of the next 75 years, wages will grow at an average annual rate of 5.5 percent. Total employee com- pensation, however, is projected to grow at an average annual rate of 5.8 percent. If the rate of growth in fringe benefits outpaces the growth in wages to the extent assumed in the 1984 Trustees Report, by the year 2060 fringe benefits will represent some 34 per- cent of total compensation. I am submitting for the record a graph showing these trends as well as other projections based on the subcommittees' requests. This projection, under present law, reflects the assumption that total wages, as a percentage of total compensation, will decline at a long-term rate equal to about three-fourths the rate of decline over the last 30 years. In part, this slower rate of decline in the future reflects the actions taken by the Congress since 1980 to alter the tax treatment of fringe benefits. As you know, in accordance with the recommendations of the National Commission on Social Security Reform, the 1983 Social Security amendments contained a provision subjecting to Social Se- curity taxes payments into section 401(k) cash or deferred arrange- ments. Such arrangements are among several kinds of fringe bene- fits that are now treated differently for purposes of the Social Secu- rity payroll tax and for the Federal income tax. Also, the Deficit Reduction Act of 1984 provides that any fringe benefits not specifi- cally excluded by statute are taxable for income tax and Social Se- curity tax purposes. The importance of the erosion in wages as a percentage of com- pensation, for purposes of Social Security, is that, because the OASDI program receives most of its income from a tax on covered wages, a decline in the proportion of total compensation subject to payroll taxes can cause income to the program to be lower than it otherwise would be and thus affect the level of the tax rates neces- sary to fund the program adequately-the same is true for the hos- pital insurance program. In addition, if an income shortfall results from continued faster growth in nontaxable fringes, the burden of making up that short- fall would fall not only on those workers who benefit from the ad- ditional fringes but also on those workers whose nontaxable fringe compensation does not keep up with the general rise. PAGENO="0058" 52 Finally, as the mix of covered wages and noncovered fringe-bene- fit compensation changes, workers have a smaller proportion of their total compensation included for purposes of computing their social security benefits. Thus, workers and their families stand to get lower social security benefits when they retire, become disabled or die than they would if the amounts credited to them as earnings for social security benefit purposes more closely resembled their total compensation package. In this connection, I am submitting for the record illustrative ex- amples of the effects of future growth in nontaxable fringes on the amounts of employees' social security taxes and benefits, prepared at your request. These figures can vary considerably, depending on the underlying assumptions. Before I discuss the long-range social security cost effects of the tax and benefit status of fringe benefits, it is important to refer to technical matters that may well have significant impact on any long-range cost figures. In estimating the financial effects, we have assumed that any ex- tension of social security coverage to fringe benefits that are cur- rently exempt from taxation would provide for the inclusion of those earnings for benefit-computation purposes, as well. This as- sumption, however, raises a number of other technical questions. The most important among these is the question of whether any taxable fringe benefits-that is, fringe benefits that would be sub- ject to social security taxes and creditable toward social security benefits-would be included in the annual calculation of the aver- age wage series that is used for purposes of indexing covered earn- ings, the earnings base, the retirement earnings test exempt amounts, and the benefit-formula bend points. Including a broader compensation base in these computations would raise future benefits for today's workers, even for those who get no fringe benefits. Such extra benefits would significantly offset any long-range gain in trust fund income. Consideration of such ef- fects could lead to important policy decisions on the part of the Congress and the administration, as to the proper definition of the wage series to be used for indexing. Let me now turn to specific estimates of the effects of including currently nontaxable, fringe-benefit compensation in taxable income for social security purposes. I will respond to the subcom- mittees' requests in the order in which they were stated in Chair- man Pickle's letter of September 11. I might note that the subcommittee requests were phrased in terms of the long-range tax rates necessary to keep trust fund ratios at currently projected levels over the long range if nontax- able fringes were made taxable for social security purposes under four assumptions with respect to the relative mix of taxable wages and nontaxable fringe benefit compensation. First, if nontaxable fringe benefits as a proportion of total com- pensation were to be maintained at 1984 levels, the long-range OASDJ actuarial balance would increase by 0.50 percent of taxable payroll-implying that a reduction of 0.50 percentage points could be made in the average combined employee-employer OASDI tax rate over the normal 75-year valuation period. PAGENO="0059" 53 Second, if, as a percentage of total compensation, nontaxable fringe benefits were allowed to grow at half the rate implicit in the Trustees Report Alternative IT-B assumptions, the long-range OASDI actuarial balance would increase by 0.25 percent of taxable payroll. Third, if nontaxable fringe benefits were to be brought down to their 1960 level, as a proportion of total compensation, and were kept at that level, the long-range OASDI actuarial balance would increase by 0.65 percent of taxable payroll. Fourth, if all current and future fringes were to be taxable for social security purposes, the long-range OASDI actuarial balance would increase by 0.80 percent of taxable payroll. In conclusion, let me return to the policy matters I referred to earlier and note that these long-range savings would be higher if currently nontaxable fringes that would be subject to social securi- ty taxes and creditable for benefits were not to be included in the computations of the average-wage series used for wage indexing. I am not taking a position on whether such exclusion would be desir- able, but rather wish to highlight this area as one that may need further investigation. That concludes my prepared statement. I will be happy to re- spond to your questions. [The attachments to the statement follow:] PAGENO="0060" FRINGE BENEFITS AS A PERCENTAGE OF TOTAL COMPENSATION 40% 35% 30% 25% 20% 15% 10% 5% 0% 1955 1970 1985 2000 2015 2030 2045 2060 Projections are based on the intermediate (alternative Il-B) assumptions of the 1984 Trustees Report. PAGENO="0061" 55 Table 1 Illustrations of additional contributions and benefits for employee with "average" earnings Assuming no further growth in taxable fringe benefits as a percentage of compensation Social Security Administration Office of the Actuary September 17, 1984 Additional employee contributions OASDI OASDI-HI Additional initial monthly benefits Primary insurance Family amount maximum $65 $81 $3.30 $6.20 A. Retirement 1. Age 60 in at age 65 January 1984, retires in January 1989 2. Age 45 in at age 65 January 1984, retires and 4 months in May 2004 1,705 2,104 93.50 170.10 3. Age 21 in at age 67 January 1984, retires in January 2030 22,345 27,572 868.50 1,570.40 B. Disability . 1. Age 21 in at age 30 January 1984, disabled in January 1993 240 297 29.50 44.20 2. Age 45 in at age 55 January 1984, disabled in January 1994 306 379 34.50 51.70 3. Age 21 in at age 55 January 1984, disabled in January 2018 7,636 9,422 392.20 588.30 C. Survivor 1. Age 21 in at age 30 January 1984, dies in January 1993 240 297 30.50 54.80 2. Age 45 in at age 55 January 1984, dies in January 1994 306 379 34.50 63.40 3. Age 21 in at age 55 January 1984, dies in January 2018 7,636 9,422 392.20 714.10 PAGENO="0062" 56 Table 2 Illustrations of additional contributions and benefits for employee with "average" earnings Assuming one-half of the growth projected under present law in taxable fringe benefits as a percentage of compensation Additional initial monthly benefits Additional employee Primary contributions) insurance Family OASDI OASDI-HI amount maximum A. Retirement 1. Age 60 in January 1984, retires at age 65 in January 1989 $33 $41 $1.50 $2.20 2. Age 45 in January 1984, retires at age 65 and 4 months in May 2004 836 1,032 46.20 83.40 3. Age 21 in January 1984, retires at age 67 in January 2030 10,813 13,342 419.10 758.50 B. Disability 1. Age 21 in January 1984, disabled at age 30 in January 1993 118 147 14.30 21.40 2. Age 45 in January 1984, disabled at age 55 in January 1994 151 187 16.80 25.20 3. Age 21 in January 1984, disabled at age 55 in January 2018 3,720 4,591 190.50 285.80 C. Survivor 1. Age 21 in January 1984, dies at age 30 in January 1993 118 147 14.90 25.60 2. Age 45 in January 1984, dies at age 55 in January 1994 151 187 16.80 31.00 3. Age 21 in January 1984, dies at age 55 in January 2018 3,720 4,591 190.50 346.30 Social Security Administration Office of the Actuary September 17, 1984 PAGENO="0063" 57 Chairman STARK. Thank you very much, Mr. Ballantyne. On your Table 1, do some back-of-the-envelope arithmetic, if you will, with me. Under "A. Retirement," a person 45 years old-take that one-he retires at about 20 years, and under your table that would mean they would put in approximately $100 a year in addi- tional employee contributions under FICA. Am I interpreting that right-somewhere between $1,705 or $2,100, if you include health insurance? Mr. BALLANTYNE. Yes; I think that is right. Chairman STARK. So, in round figures, you can say a man today, or an employee today-single employee, I gather this is-if they paid an additional $200, which is the FICA tax there that they are not paying because of their fringe benefits being tax-free, they would have about-if you take the average for the primary amount-somewhere between $90 and $170-say, $130 a month, to pick a middle figure. So for paying $200 a year for 20 years-- Mr. BALLANTYNE. About $100 a year? Chairman STARK. I beg your pardon? Mr. BALLANTYNE. Wasn t it $100 a year, Mr. Chairman? Chairman STARK. No. It is about $200-excuse me. Yes, $100 a year, yes. You end up getting $100 a month increase in your annuity, as it were. Now, can you tell me roughly what it would cost somebody to buy an annuity to provide, let's say, $1,400 a year or $1,500 a year, or $1,000-whatever is easy to do-and make 20 payments? I have no idea. But I would imagine substantially more than $100 a year. I say this only because I think many times people in my town meetings will say, "I can take this money and invest it and make so much more than social security, if you let me go to E.F. Hutton." I am guessing; you probably have to earn 30 or 40 percent return year-in and year-out on your money tax-free to come anywhere close to getting these kinds of benefits. I understand the employer is paying in as well, but I am just talking from the standpoint of the social security beneficiary. It is a fabulously good deal for people. And I would wonder if they wouldn't be encouraged-if they had any idea how much this would return to them-to just almost voluntarily go ahead and pay the increased FICA on their fringe benefits. I am looking at this table correctly, am I? Mr. BALLANTYNE. Yes; that is right. I agree with you that the return would be much higher than for a private annuity. Chairman STARK. And be better for the system, would it not, be- cause of the other side of the issue-that you have the employer's contributions? Mr. BALLANTYNE. It would be better for the system because there would be a long-range gain. Chairman STARK. So, in effect, by taxing, as far as FICA, we would be giving, by any commercial standard, outstandingly gener- ous, almost unobtainable benefits. I mean, in the realm of commer- cial practice, you couldn't buy a benefit that begins to approach that. Mr. BALLANTYNE. Right. PAGENO="0064" 58 Chairman STARK. Secondly, we would be helping the economic vi- ability of the system. Mr. BALLANTYNE. Right. I think it is difficult to compare with private annuities, but I think that if a reasonable and well-balanced analysis of that issue were to be made you would have to take account of several things, such as the duration of time during which benefits would be re- ceived, interest rates, and cost-of-living-adjustment increases in benefits, as well. I think that by and large the comparison between how much a worker pays in increased contributions-the total amount-and the total benefits he might expect to receive, would be on the average somewhat less than it is under present law, which is-- Chairman STARK. Doesn't this example that we are talking about-or this phenomenon-impact favorably the low income worker far more? Your figures are based on an average salary. But if we take those people that are below $15,000 or below $12,000, whatever the average is, isn't the effect on their benefits even greater? Mr. BALLANTYNE. Right; because of the weighting of the benefit formula. Chairman STARK. And the maximum is at $30,000-- Mr. BALLANTYNE. $37,800. Chairman STARK. Somebody way above that would be getting proportionally less. So if we were to tax or apply the FICA tax to these fringe bene- fits, it would be heavily weighted in favor of the lowest income workers? Mr. BALLANTYNE. There would be somewhat more weighting to- wards them. A worker with more than the maximum wouldn't be affected because I would assume the wages would be counted first, and he is already paying the maximum. So he would have to be under the maximum. Chairman STARK. So it would not be overly progressive in terms of their burden. Mr. BALLANTYNE. Right. Chairman STARK. Well, Chairman Pickle unfortunately had some-not unfortunately for the rest of the world, because he has a speech to make on the floor which I think he is delivering about now, or has just delivered-he wanted to emphasize particularly that last question, that there is a tremendous benefit to the em- ployees, and that benefit is very progressive as to its benefits. And I think I am adequately stating that that is his concern; that people are losing, one, a tremendous opportunity; two, the cost is minimal; and three, I think it is safe to say in behalf of Chairman Pickle that it would be a great benefit to the survival or the sound- ness of the trust fund if we add what seems now to be kind of deal- ing penny-wise and perhaps even pound-foolish-I know there are people concerned that one fringe benefit may be singled out over another to pay taxes on. But I think that in the interests of the working people of this country they would be clamoring to get FICA taxes applied to every fringe benefit they could find. Wouldn't that make economic sense if they were just doing it in a rational sort of approach to their own economic health? They PAGENO="0065" 59 can't buy, as near as I can tell-and I really would appreciate it if you would take one of these examples and say, if you assume the average worker you can assume the average marginal bracket, which is somewhere around 30-some percent, and take it out as to what they would have to earn to accomplish this as individuals. I still think there are people out there who think they can do better; that social security to them is just not a good buy. I think we would do them all a favor if we could dispell that myth. So in behalf of Chairman Pickle, I thank you for preparing this information. And I would like to look forward to working with your office to get this even into simpler language that the average wage- earner like myself can understand. Mr. Duncan. Mr. DUNCAN. I have no questions. Thank you, Mr. Chairman. Chairman STARK. Thank you very much for your excellent testi- mony. We appreciate your appearance. Mr. BALLANTYNE. Thank you, Mr. Chairman. Chairman STARK. The committee will stand in recess until 10 o'clock tomorrow morning. [Whereupon, at 12:33 p.m., the subcommittees recessed, to recon- vene at 10 a.m., Tuesday, September 18, 1984.] 40-046 0 - 85 - 5 PAGENO="0066" PAGENO="0067" DISTRIBUTION AND ECONOMICS OF EMPLOYER-PROVIDED FRINGE BENEFITS TUESDAY, SEPTEMBER 18, 1984 HOUSE OF REPRESENTATIVES, COMMITTEE ON WAYS AND MEANS, SUBCOMMITTEE ON SOCIAL SECURITY AND SUBCOM- MITTEE ON SELECT REVENUE MEASURES, Washington, DC. The subcommittees met at 10:10 a.m., pursuant to notice, in room 1100, Longworth House Office Building, Hon. J.J. Pickle (chairman of the Subcommittee on Social Security) and Hon. Fortney H. (Pete) Stark (chairman of the Subcommittee on Select Revenue Measures) presiding. Chairman PICKLE. The Chair calls to order the joint Subcommit- tees on Social Security and Select Revenue Measures, for consider- ation of employee benefits. When we opened the hearing yesterday we asked for any preliminary remarks by individual members. I am pleased to recognize, before we start our hearings this morning, the distinguished gentleman from Hawaii, Mr. Heftel, a member of the Subcommittee on Select Revenue Measures, and a very effec- tive member of our committee. Mr. Heftel. Mr. HEFTEL. Mr. Chairman, as we carry on with these delibera- tions, I think we are going to have to recognize something that is occurring in the nation, namely that the American people no longer tolerate a tax system in which taxpayers with the same income pay different effective tax rates, and we will have to make that a part of our deliberations, if they are going to be meaningful. Thank you very much. Chairman PICKLE. I thank the gentleman for his comments. Do any other members wish to make preliminary statements? I am pleased to have you with us this morning, Mr. Heftel. You always make a valuable contribution to our hearings. We have several panels today, and therefore we are going to ask the participants to summarize and condense their testimony as much as possible. We are not trying to race through these hearings but, due to the number of people testifying, we hope we can make as much progress as possible. The first panel this morning will consist of Mr. Dallas Salisbury, president of the Employee Benefit Research Institute; Mr. Donald C. Alexander, Esq., on behalf of the U.S. Chamber of Commerce, -and Mr. Frank Swain, chief counsel, Office of Advocacy of the U.S. Small Business Administration. Also we have Mr. Michael Romig, (61) PAGENO="0068" 62 director of the Employee Benefits and Human Resources Policy Center with the chamber of commerce. Our first person will be Mr. Dallas Salisbury, representing the EBRI, a very important and valuable research institution in the United States. STATEMENT OF DALLAS L. SALISBURY, PRESIDENT, EMPLOYEE BENEFIT RESEARCH INSTITUTE Mr. SALISBURY. Mr. Chairman, it is a pleasure to be here today for this important discussion of employee benefits. I refer your at- tention to the package of charts that are in your stack, for my tes- timony. In terms of the press release announcing this hearing, a number of specific questions were asked. First, the question of how preva- lent are employee and fringe benefit programs, and thus how does this compare to the past. Chart 1 in that package provides informa- tion on the prevalence of primary benefits. Chairman PICKLE. Mr. Salisbury, let me interrupt. We have two different forms. Is this your statement? Mr. SALISBURY. No, it is underneath that. It is a much smaller package. Mr. Heftel has it. Chairman PICKLE. You have reference to the charts? Mr. SALISBURY. Right. Chairman Piciu~. Are you following your summary? Mr. SALISBURY. I am following the charts. Chairman PICKLE. The charts, not the summary? Mr. SALISBURY. Right. Chart 1 shows clearly, as was evidenced by Treasury data yester- day, and Health and Human Services data, that primary employee benefits are nearly universal in medium and large employment sit- uations. As will be shown in detail by the SBA testimony, they are not nearly as universal in small businesses, but for those working in employment settings above 250 employees, we find retirement pen- sions for 82 percent of those employees, life insurance for 96 per- cent, health insurance for 96 percent, health insurance for depend- ents in 93 percent of those situations, long-term stability for 45 per- cent, and sickness and accident for 49 percent. How does this compare to the past? One finds that these levels have been fairly consistent for the last 10 years. There has not been significant percentage growth, even though there has been very significant numbers growth, the absolute numbers of millions of Americans protected. Chart 2 provides a slightly different measurement. It looks at retirement coverage, future benefit receipt or vesting, if you will, and health insurance coverage for the entire civilian work force as well as what we have dubbed the ERISA work force because it is those over age 25 in full-time jobs. For that smaller population, you find that among all businesses, 70.1 percent of full- time workers have pension coverage, 36.84 percent have a vested right to benefits. That number has been growing significantly, and 83 percent currently have health insurance coverage. PAGENO="0069" 63 Second, you have asked a question of how much do benefits repre- sent as a percentage of compensation. Chart 3 provides pie dia- grams to give you an indication of what we are talking about when we present data on employee benefit programs. You will see that 9.5 percent is required payments, taxable benefits represent 13.9 percent of wages and salaries, tax-favored benefits 9 percent, 4.6 percent of this is health and other fringe benefits, if you will, 4 per- cent is current contribution to employer retirement programs. On the right, the percentage of all benefits, you see that the tax- favored benefits represent approximately 27 percent of all benefits currently provided by employes. Third, you asked the question of how much have tax-favored em- ployee benefit costs grown. Chart 4 presents a schematic diagram, bearing out the information provided by your witnesses yesterday. As the lines indicate, during the high inflation years of the 1970s, the percentage cost of employee benefits grew very dramatically. I think it is interesting to note that preliminary data on 1983 and 1984 shows that these lines have significantly leveled out. In fact, in terms of what is happening in the future, current sur- veys indicate that in 1984, employer pension contributions in the private sector are expected to drop by approximately 15 percent, health care inflation from a high in recent years of 17 to 20 per- cent in premium increases, this year down to 4 and 5 percent. You have asked the question of how much do benefit costs vary by industry. I think chart 5 is a very interesting graphic presenta- tion of this tremendous cost variation. The tremendous equity issues, if you will, that would arise attempting to put various bene- fit caps into place, they may well be justifiable policy, but they would be very complex. As you see, for businesses today, expendi- tures on tax-favored benefits plus Social Security vary from 12.5 percent of wages and salaries to 29 percent of wages and salaries on average for the Fortune 500. Were one to take this graph and expand it to show the extremes, one would find that some are spending only 6 and 7 percent, others as much as 42 to 43 percent. So, in terms of changing the tax struc- ture, these overriding equity issues would have to be carefully con- sidered. You also asked which employees by salary range receive employ- ee benefits. Chart 6 attempts to show that in a clear graphic way. One finds that both for coverage and vesting of pension programs, very wide distributions. For those below the poverty level, as was pointed out by the Treasury Department yesterday, coverage is only approximately 32 percent. As one moves to the middle income ranges of $10,000 to $50,000 per year, one finds those numbers climbing to as high as 82 percent, and for those $50,000 and over, 85 percent. I think, interestingly, the inference of the Treasury witness yes- terday was that this implies that pensions principally accrue to the most highly paid. As a result, in order to explore that issue, we provide chart 7. Chairman PICKLE. Before you go to chart 7, do you have a chart showing the number of people that are not involved in these pen- sions? PAGENO="0070" 64 Mr. SALISBURY. You could get this simply by subtracting. In the $50,000 and over it would be 15 percent of the people earning that amount of money are not currently covered by those programs. For $25,000 to $50,000, it would be 18 percent of the civilian work force that would not be covered, and for $10,000 to $49,000 you would be going to 32 percent that were not. If one looks at the issue, as was discussed yesterday, in terms of equity of the distributions, chart 7 shows that 51 percent of those employed earn between $10,000 and $25,000 per year. They repre- sent 59 percent of those covered by pensions, an overrepresentation for that income group, if you will, and 62 percent of those who are vested in pensions, again an overrepresentation. If one looks at the highest income categories, they also are over- represented, with 2 percent of employment, 2.9 percent of coverage, and 4 percent of vesting. But to conclude that the pension system principally provides for the wealthy and the highly paid is clearly not held forth by Census Bureau data and Health and Human Services data, as well as private sector data. If one looks at health insurance as a benefit, chart 8 presents that information graphically. One finds that health insurance is much more broadly held than pensions, largely because employer surveys indicate that health insurance is generally the first benefit program that any employer chooses to adopt. Those percentages speak for themselves. Looking at the distributional question, chart 9 shows you that 45.2 percent of all those with health insurance coverage earn be- tween $10,000 and $25,000 per year, 17.1 percent between $25,000 and $50,000 per year. Only 2.8 percent of all those with health in- surance earned over $50,000 per year in the last year. I think, again, this indicates the broad distribution of these programs, the fact that any attempt to make a statement that they principally benefit the highly paid and the wealthy is significantly misplaced. Another question that was asked in the press release was how does employee benefit provision vary by industry. Chart 10 pro- vides that information. As you will see from chart 10, there is sig- nificant variation. The lowest coverage levels are found in con- struction, retail trade, and business and professional services. The highest levels are in the chemical, primary metals, and public em- ployment areas. For health insurance, it indicates that rates of over 97 pecent are found in primary metals, automobiles, chemicals, communications, while business and personal services firms provide only 59 percent at the low end of that scale. So there is in fact, in terms of yester- day's discussion of what we might describe as horizontal equity, do all firms provide equally, the answer is no. I think Mr. Swain's testimony will provide some explanations from the viewpoint of Small Business Administration research as to why that may be the case. You asked what are the economic effects of tax incentives for benefits, and what effects would changes in tax treatment have. Chart 1 presents that information. Yesterday you heard witnesses make statements about levels of tax expenditures, and you had a chart presented to you as table 2 by the Treasury, basically on pro- PAGENO="0071" 65 viding coverage information and implying that these benefits prin- cipally, and the tax incentive principally benefited the highly paid. Chart 11 is taken from a Treasury Department report from the Joint Economic Committee and the Joint Tax Committee in 1982. I think it is very interesting to see what they found in the distribu- tion of taxes paid versus the tax value of benefits. As you see for those under $10,000 per year, in 1981 they paid a toal of 2.6 percent of all taxes paid to the Federal Government, yet received at the minimum 4 percent of the pension tax deferral value, and for non- taxable disability employer-provided programs, a full 83 percent of the tax value. If one goes to the middle income categories, one finds that in the pension area, between $25,000 and $50,000 per year, all of those middle earners actually get more as a percentage of the tax defer- ral value than they pay as a percentage of national taxes. It is only as you get to the wealthy that you find that they would actually be better off economically by the Treasury's estimates of the value to them of pension tax deferrals relative to the amount of income taxes that they pay. So I think this is a Treasury study the com- mittee should definitely ask for and look at as a supplement to the testimony provided yesterday. The tax deferral question, I noticed in the Washington Post this morning the principal thing they noted out of yesterday's hearing was the size, the dollar size of revenue losses to the Treasury. I think chart 12 makes an interesting distinction, the question of revenue lost versus revenue deferred in terms of retirement income programs. If one looks at the pure cash flow methodology and the Treasury itself, former Treasury officials such as Dan Halperin have argued numerous times that a lifetime methodology in this area would be desirable. As you see, that lifetime methodology indicates that only 14 per- cent in noninflation adjusted terms, 40 percent in inflation adjust- ed terms, of the pension tax expenditure is actually ultimately lost to the Treasury. I will not even argue over the accuracy of the Treasury figure of approximately $50 billion in this year's budget as revenue lost. I think the important point in terms of long-term economic security is what ultimately is lost to the Government in return for retire- ment income provision. If one takes their estimate of approximate- ly $50 billion for 1983, in that year approximately $87 billion in pension benefits were paid, and those are taxed, so we already have what one might describe as a favorable economic balance. Chart 13 responds to a question that was asked on the effect of tax changes. I note for reference of the committee, and I think the Department of Health and Human Services should be asked to very carefully look at this particular issue, because many employee benefits are nontaxable today, such as medical benefits, the way in which they are priced for convenience is they are described as a dollar amount per employee. That has been easy, it has been con- venient, and in terms of age levels, it has been nondiscriminatory, if you will, because it has not provided a disincentive to hire older workers. Life insurance, on the other hand, is taxed in excess of $50,000 per year. To accommodate that, the Treasury Department and the PAGENO="0072" 66 IRS, through Congress' mandate, have created a so-called section 79 table that relates the cost of insurance to an actual tax value. Economic theory and tax theory would suggest that if medical ben- efits were taxed, they would have to be priced over this same basis, such that for the 55-year-old worker, the taxable value of life insur- ance would have to be treated as approximately $6,000 per year, whereas the same policy for the worker at age 25 would have a tax- able value of only approximately $700 per year. Chart 13 shows graphically the tremendous increase in the actual outlay cost, because of the amount of benefit paid to an indi- vidual that comes about from these programs. In that sense, plac- ing a tax on the premium might well result in the equivalent of deciding that you want to tax benefits as they are received and paid, rather than the premium income. You may well want to do that, but I think this effect is one that you should carefully consid- er. It is an effect that, if one looks for consistency in the Tax Code, would almost be required if health insurance taxes were put into effect. Tenth and finally, you ask what would happen if you put tax caps into effect. Meeting the objective of avoiding any-and I repeat, any, because that is what the press release said-any fur- ther tax base erosion from employee benefit and fringe benefit ex- penditures, which was the question in the press release, I would stress to the committee there is absolutely no way to totally avoid any further tax base erosion, unless you were to follow a course that are to very, very significantly tax benefits already being pro- vided, and almost lower that limit every year as new employers coming into business decided to provide health insurance or other benefits. I say this not to tell you that you necessarily shouldn't do it, but I think as you look at the numbers and carry it through, if you were, for example, in the health area or in all benefits to say any- thing above 20 percent of compensation will be subject to FICA taxes, for some employers that would mean as much as 20 percent of current wages and salaries would become subject to FICA tax for some of their employees, on the employer and the employee side. Yet for the hundreds of thousands of businesses that Mr. Swain will speak about, small businesses that do not yet have benefit pro- grams, they would still be able to put in benefit programs and spend up to that 20-percent level. So a total elimination of tax base erosion, I would suggest, is almost impossible, unless you want to take a step that basically makes all of these things taxable. A policy option, yes, but it needs, I think, to be understood that there is a stark line to be drawn. It can't be done, given that tremendous cost variation shown in one of the charts, easily. Employer-sponsored programs and social programs, a unique team. Social Security, highly redistributionable, providing signifi- cant benefits to those without pension coverage and low-income persons with pension coverage. Supplemental Security Income, to provide for those who fall totally through the cracks. Individual re- tirement accounts, at least for those without pension coverage, pro- viding an option. Employer-sponsored programs have been shown PAGENO="0073" 67 to provide at least for those with employers of over 250, a nearly universal supplement to retirement income provisions. The system is now maturing. Of new retirees, over 50 percent of married cou- pies are now receiving pension income, over 75 percent will by the. turn of the century. In terms of the dollar-for-dollar value, if one looks at health in- surance, the Treasury noted yesterday, a tax expenditure in 1983 was approximately $17 billion. This financed approximately $77 bil- lion in health benefit payments for working Americans. In 1983, employer-sponsored retirement programs represented a tax expend- iture of approximately $50 billion. This financed approximately $87 billion in retirement benefits in 1983, and have led to an accumula- tion of public and private pension reserves of over $1 trillion for the purpose of paying future benefits. If one looks on the balance of what the government has gotten, what one might be spending from the government from Social Se- curity and Medicare, in the absence of private employee benefits, for working Americans-and I stress for working Americans more than for employers or any other group-for working Americans this has indeed been an effective investment. Thank you, Mr. Chairman. [The prepared statement follows:] STATEMENT OF DALLAS L. SALISBURY ~, PRESIDENT, EMPLOYEE BENEFIT RESEARCH INSTITUTE SUMMARY Retirement, health, life, and disability benefits are widespread, with between 70 percent and 83 percent of full time workers over the age of 25 covered. Nationally an average of 4.6 percent of wages and salaries is spent on voluntary tax exempt benefits and 4.0 percent on tax-deferred benefits. These benefits are provided across the salary range, with most going to middle- income households. Over 75 percent of those with coverage earned less than $25,000 in 1982. Studies by the Treasury and by private economists indicate that benefits enhance tax equity and that taxation of benefits would have the most adverse effect on the lowest earners. FICA taxes could be lowered if benefits were subject to FICA tax. As the maxi- mum taxable wage base rises, the rate could be decreased as well. Current govern- ment estimates overstate the amount, however, because of the assumption that ben- efits will continue to grow until all compensation is paid as benefits. Econometric studies indicate that taxation of benefits would lead to reduced avail- ability, but the exact extent cannot be established. Further, it is impossible to assess how much higher direct expenditures might have to be to accommodate these cut- backs. Imposition of limits or caps that would "prevent further erosion of the tax bases" would (a) mean that no organizations without programs today could establish them or (b) that all employers now with programs would have to pay tax on some portion in order to allow expansion room. Some employers and employees would have to begin paying tax on more than 20 percent of wages and salaries now paid in the form of benefits out of current earnings. Employer-provided benefits complement social programs, help to maintain public confidence in them, reduce demands placed upon them, and strengthen the economy in the process. Employer retirement plan benefit payments in 1983 exceeded the government calculated tax expenditure. by $37 billion and health benefit payments by $60 billion. And costs per covered participant were far below the per participant expense of social programs. * The views expressed in this statement are those of Dallas Salisbury and should not be attrib- uted to the Employee Benefit Research Institute, its officers, trustees, sponsors, or other staff. PAGENO="0074" 68 Employer-provided benefit programs and social programs appear to be an effective partnership. Each provides for particular segments of the population in an effective manner. Each adds to economic security. There are some programs that do not meet this test. During this time of limited resources, they should be reconsidered. STATEMENT Mr. Chairman, I am pleased to appear before the Committee today to discuss em- ployee benefits. Following these hearings I would look forward to an opportunity to provide additional assistance to the Committee. The Committee is to be commended for holding this exploratory hearing into em- ployee benefits and the tax code. The general tax treatment of employee benefit pro- grams has been relatively consistent over time, with health insurance being tax exempt and retirement and capital accumulation programs being tax deferred. The tax treatment of fringe benefits is in transition, with additional "sunsets" ahead. Nearly all current American workers have experienced the present tax treatment of primary benefits for their entire careers. These workers have come to take the pres- ence of social and employer-provided employee benefits for granted: including the current tax treatment of primary employer provided benefits. Tax laws favoring specific employer retirement and health insurance plans and other statutory employee benefits were enacted under the premise that extensive coverage of workers and their dependents under these plans is desirable social policy. Numerous research studies have documented the fact that these employer based programs complement Social Security and Medicare and reduce long-term de- mands on these social programs. Further, as I will document, they complement the design of these programs. The press release announcing this hearing asked a number of specific questions that I will attempt to answer for the Committee. First, how prevalent are employee benefit and fringe benefit programs, and how does this compare to the past? Chart 1 provides information on prevalence for the primary benefits of retire- ment, life, health, sickness, and disability for medium and large firms among full- time workers. Health, life, and disability programs are provided to between 90 and 95 percent of these full-time workers and retirement programs to 82 percent. Infor- mation is not collected on the fringe benefits (education, legal, van pool) because very small numbers of employees are covered by these programs. Not all workers are with medium and large firms, however, so we must also look at the total civilian work force. Data collected by the Bureau of the Census in May 1983 for EBRI and the U.S. Department of Health and Human Services provides this information for retirement and health programs. Chart 2 and Table 1 show that retirement and health programs are prevalent, particularly among those working over 1,000 hours per year. Among full-time em- ployees over the age of 25, 70.01 percent are covered by a pension and 36.84 percent currently are entitled to a vested benefit. Of all civilian workers age 14 to 64, 52.07 percent are covered and 24.35 percent are entitled to a vested benefit. Health insur- ance is also more readily available to full-time workers, with 83.07 percent having primary coverage compared to 59.66 of all civilian workers. Retirement program and health insurance coverage have grown significantly in absolute terms, but remained relatively constant in percentage terms over the past ten years. Second, how much do benefits represent as a percentage of compensation? According to Chamber of Commerce data, presented in Chart 3 and Table 2, em- ployer contributions to tax-exempt and tax-deferred employee benefits totaled 9.0 percent of wages and salaries in 1982. Employer contributions to tax-favored benefits-those that are not taxed as cur- rent income to the employee-can be divided into two groups: benefits on which taxes are deferred and benefits that are tax exempt. Tax-deferred benefits include primarily employer contributions to retirement income and capital accumulation plans. These constituted about 4.0 percent of wages and salaries in 1982. Taxation of these benefits is deferred until the employee withdraws funds from the plan. Tax-exempt include employer contributions to group health insurance and a vari- ety of smaller benefits that include dental insurance, child care, merchandise dis- counts, and employer-provided meals. These benefits constituted 4.6 percent of wages and salaries in 1982. Failure to distinguish among the growth of legally required employer payments, fully taxable employee benefits, tax-deferred benefits, and tax-exempt benefits has PAGENO="0075" 69 greatly distorted the perception of the tax-base erosion that can be attributed to tax- favored and tax-exempt benefits. Third, how much have tax-favored employee benefit costs grown? Over the past thirty years, tax-favored employee benefits have grown more rapid- ly than wages and salaries and slightly faster than either legally required employer payments or fully taxable employee benefits. Consequently, tax-favored benefits have absorbed a rising share of total compensation. Chart A and Table 3 show that pension and profit sharing contributions grew significantly in the post ERISA period, and health care cost inflation felt by employer and social programs doubled expenditures for group health insurance. The recent slower growth of employer pen- sion contributions appears to be likely to continue, according to the most recent em- ployer surveys. The slower growth between 1980 and 1982 of employer health insur- ance contributions as a share to total compensation may reflect the maturation of group health coverage and benefits, as well as employer efforts to contain the cost of private health insurance plans. "Fringe" benefit expenditures have not increased significantly over this 30 year period. Government data shows that expenditures are less than .5 percent of wages and salaries. Fourth, how much do costs vary by industry? The cost of discretionary employee benefits varies significantly from employer to employer, even within industries. Further, there is significant variation among in- dustries. During 1982 total average expense ranged from 12.5 to 29.0 percent of total compensation among Fortune 500 firms. The expenditure would be lower for very young and small businesses. Chart 5 and Table 4 present data for the Fortune 500 for twelve different industry groups. It documents significant variation in expendi- tures for voluntary tax-exempt and tax-deferred employee benefits. Fifth, what is expected to happen in the future? Retirement program and health insurance coverage may well be at a plateau for the near term. For retirement programs, benefits receipt will continue to grow as the system continues to mature, but there are structural questions that need to be explored. Employee benefit cost rate growth is likely to continue to slow. Employer contri- butions to retirement programs are expected to decline by 15 percent in 1984 as more plans reach the point of full funding. Health cost inflation is down significant- ly, which will hold down premium growth. Additionally, employers are moving on many fronts to control health care expenditures today and in the future. Surveys of employers indicate that a changing work force, changing industry structure, and international competition, are combining to put an effective lid on excessive future employee benefit growth. Employee expenditures on a tax-favored basis, however, are expected to continue to grow. These "salary reduction" features were a part of the Revenue Act of 1978. And contributions to Individual Retirement Accounts (IRAs) are expected to contin- ue to grow also. Expenditures on all other employee and fringe benefits combined are small, as shown by Chart 3 and Table 2, and these expenditures are not expected to grow sig- nificantly. Sixth, which employees by salary range receive employee benefits? Primary benefits are broadly distributed across the income spectrum. Charts 6 and 7 and Table 5 show that nearly 83 percent of all nonagricultural wage and salary workers earn less than $25,000 per year. Pension coverage and vesting follow this pattern with 76 percent of those covered earning less than $25,000 and 70 per- cent of those vested earning less than $25,000. The table also shows that while the proportion of those earning over $50,000 participating in a retirement program is high, these persons represent only 2.89 percent of all pension participants. Growth of employer group health insurance coverage among workers and their dependents has promoted wide access to health care throughout the population. Health insurance is the `most common benefit offered employees in the United States. Charts 8 and 9 and Table 6 show that in 1982 health insurance enjoyed a broad distribution across the income spectrum. Those earning less than $25,000 con- stituted 80.1 of those with health insurance protection. Other employee and fringe benefits now, as a matter of law, have to be provided on a non-discriminatory basis. While data is not available, this requirement likely means that distributions are similar. Seventh, how does employee benefit provision vary by industry? Retirement program coverage, as shown in Chart 10 and Table 7, varies consider- ably by industry. The lowest coverage levels are found in construcition, retail trade, PAGENO="0076" 70 and business and professional services. The highest levels are in the chemical, pri- mary metals, and public employment areas. Chart 10 and Table 7 indicate that health insurance provision is more consistent across industries, but that variation does exist. Rates of over 97 percent are found in primary metals, automobiles, chemicals, and communications, while business and personal services firms provide for 59.92 percent. Health insurance is generally the first benefit employers provide. Eighth, what are the economic effects of tax incentives for benefits and what ef- fects would changes in tax treatment have? A number of studies have been done to assess horizontal and vertical equity of the tax provisions. The Treasury Department conducted such a study in 1982. The re- sults of that study are confirmed by a just completed study by economist Sophie Korczyk. Chart 11 and Table 8 show that the tax value of employee benefit incen- tives parallels tax payments, with low income persons getting more of the value of the tax reductions than their share of tax payments and the highest paid getting less. In other words, a change in the tax treatment of benefits would lead to a re- gressive result. More recent studies by economists Deborah Chollet and Sophie Korczyk confirmed these findings, as did a CBO analysis of the health care tax cap proposal published in 1983. Private retirement program tax expenditures form the single largest category of tax expenditures in the federal budget. They arise from the deferral of taxes paid on: (1) pension and retirement saving contributions and (2) earnings on these contri- butions. The dollar value of the tax expenditure demands that equity and efficiency questions be explored (see Appendix II for a brief discussion of the tax expendi- tures). A major new study by Sophie Korczyk assesses these incentives in a lifetime context. She finds that the economic value to the government is significantly great- er than looking at tax expenditure numbers alone would imply. As much as 72 per- cent of the real (i.e., inflation-adjusted) value of taxes deferred during the pension participants' working career is ultimately repaid as income tax during retirement. Chart 12 and Table 9 show that Treasury tax expenditure statistics, calculated on a cash-flow basis, leave the impression that the proportion of current tax deferrals permanently lost to the Treasury is very large. Treasury statistics imply that 83 cents out of every deferred dollar is permanently lost, with the other 17 cents ac- counted for by current tax payments by retirees. When examined in a lifetime con- text, the proportion of deferred taxes lost to the Treasury ranges from 14 cents out of every dollar to 40 cents, depending on whether or not one adjusts for inflation and interest on deferred taxes and the interest factor used. One factor that has not generally been considered is discussing changes in the tax treatment of employee benefits, however, that could involve a significant shift in the incidence of the income tax is the increasing cost, and therefore value of bene- fits, as workers age. This would represent a major effect of tax policy change. Employee benefits such as defined-benefit pensions and health insurance are almost always discussed as a flat dollar cost per employee or as a level percentage of pay per employee. Employee representatives, employees, and employers have been content with this approach since the actual distribution of cost does not affect either the taxes to be paid by the employee or the employer. As a result, the only attention given to date to actual per employee cost variation has been undertaken very re- cently to assess: (1) approaches to health care cost containment and (2) possible dis- incentives to hiring or keeping on older workers. These recent studies show very significant cost variation by age (Chart 13 and Table 10). Does this cost variation make a tax policy difference? The answer will be yes if employee benefits were to be subjected to income tax or FICA tax. Employees would come to recognize the inequity involved in paying taxes without reference to the true economic value of the benefit being provided. This could lead to demands for taxing based upon the actual dollar value of the benefit provided or a move to tax the benefits paid instead of the premium. This would require a total restructuring of the way in which benefit programs are run. Present approaches to health insurance pricing and delivery were developed in the present tax environment. A major change in that environment will have a major affect on those approaches and structures. Nearly all of the government and academic research done on this subject to date assumes that a change in tax policy will not change the method of providing or pricing benefits. Finally, econometric estimates of private health insurance suggest that significant numbers of persons now covered would not choose to purchase health insurance if it was not available from an employer and largely paid for by the employer. Tenth, what levels or limits would have to be placed on benefit expenditures to prevent further tax base erosion? PAGENO="0077" 71 Meeting the objective of avoiding any further tax base erosion from employee ben- efit and fringe benefit expenditures could be achieved in a number of ways, but none would be simple. 1.FICA a. Any expenditures beyond those now being made would be subject to FICA tax. This would mean that on average expenditures above 9 percent of wages and sala- ries would be subject to FICA. But it would also mean that any new plans estab- lished would be subject to FICA beginning with the first dollar of expenditure. b. Any expenditures beyond the current national average would be subject to FICA. Table 4 shows that this would require some employers and employees to begin paying FICA on more than 20 percent of wages and salaries where it is not now paid. To avoid any further erosion, any organization putting in a plan for the first time would pay FICA on every dollar. c. Any expenditures above 5 percent of wages and salary would be subject to FICA. This would require almost all organizations with benefit programs to pay FICA on some portion of their current expenditures (some on 24 percent of wages and salaries-or more) but would allow room for new organizations to establish pro- grams. Under present law organizations can spend 15 percent of compensation on retire- ment programs, and last year the value of the federal civil service pension contribu- tion was over 27 percent. Health, life, and disability add more. This would mean very significant employee tax payments out of current income. 2. INCOME TAX The same alternatives are available. In the income tax area as well, a goal of "no further erosion"would lead to inequities and to major individual worker and organi- zational transitions. Table 2 shows the average level above which contributions would have to be taxable, and Table 4 shows how such caps would affect different industries. Finally, what is the relationship of employer sponsored benefits to social pro- grams? Social Security, employer-sponsored pensions, and IRAs are complementary, work- ing together to assure retirement incomes. They are not perfect substitutes in terms of benefit delivery, but change in one would effect public pressures for, support for, and confidence in the others. Social Security provides a floor of protection on a redistributional basis, with lower earners receiving proportionally greater benefits. Many of those who rely most heavily on Social Security do not have high enough incomes to allow savings, and their work is such that they are unlikely to have employer-sponsored retire- ment plans. Social Security is a pay-as-you-go program. Research indicates that it has no effect, or a negative effect, on aggregate national savings. Employer-sponsored plans provide another form of "forced" savings that repre- sents a tier of income above Social Security. Among employers with more than 250 employees, these programs are almost universal. Among smaller employers they are not. For a significant portion of the population these advance funded programs rep- resent their only real savings. As a result, research indicates that each dollar con- tributed to a pension increases aggregate national savings by at least 35 cents. IRAs are a vehicle for voluntary savings. They are used by 17 million persons as compared to over 50 million with pension coverage. Over 13 million IRA holders also have pension coverage. There are also differences in what these programs provide, or must provide, under current law. These differences affect the degree to which employer-sponsored plans and IRAs "complement" Social Security in terms of retirement income provision. Social Security only pays benefits as a stream of monthly benefits. Employer-sponsored plans are of two types: (1) those that only pay benefits as a stream of monthly benefits-most defined-benefit plans and some defined-contribu- tion plans such as TIAA-CREF and (2) those that make one time "lump-sum" pay- ments at change of employment or at retirement age and thus may or may not produce retirement income-most defined-contribution plans. IRAs allow the money to be withdrawn at any time with the payment of a small penalty and after age 59 and ½ allow it to be removed as a lump-sum. Employer-sponsored health programs provide risk protection to most workers and their dependents. Research indicates that taxation of these programs might lead to a reduction in coverage. This in turn could produce significant pressure for a gov- ernment program to complement present health programs for the poor (Medicaid) PAGENO="0078" 72 and the elderly (Medicare). Employers also increasingly are providing health insur- ance for retirees to supplement Medicare. Were these programs eliminated it could increase long-term costs of Medicare due to a reduction in wellness. In 1983 health insurance, according to the Treasury, represented a tax expendi- ture of approximately $17 billion. This financed approximately $77 billion in benefit payments. In 1983 employer-sponsored retirement programs represented a tax ex- penditure of approximately $50 billion. This financed approximately $87 billion in retirement benefits paid in 1983. Numerous research studies have been undertaken to assess the degree to which contributions to retirement programs, over $100 billion in 1983, add to national savings. The most pessimistic of these studies concludes that there is a 35 percent addition, or $35 billion in 1983. Proposals for tax reform, therefore, need to be carefully scrutinized. To the degree the full taxation of these programs as income rests on the assumption that they will continue to exist, research indicates that for mfflions of workers they will not. Fur- ther, taxation could lead to an unintended age discrimination effect if health insur- ance were given an income value equal to the benefit provided, which would in- crease dramatically with age. CONCLUSION During a time when there are no apparent limits on direct federal expenditures, or on "tax incentives," analysis may not need to focus on the diversity of employee benefits. During a time of apparent limitations, however, when priorities must be decided upon, careful analysis is required of each employee benefit and why each employee benefit exists. You are to be commended for undertaking this review effort. I would welcome the opportunity to be of additional assistance in the future. Thank you. PAGENO="0079" Chart 1 Insurance and pension plans: Percent of full~time employees covered, medium and large firms, 1983 SOURCE: U.S. Department of Labor, Bureau of Labor Statistics, Employee Benefits in Medium and Large Firms, 1083, Bulletin 2213 (Washington, DC: ll.S. Government Printing Office, August 1984). Retirement pension Life Insurance Health insurance~ employees Health inaurance, dependents Long-term disability insurance Sickness and accident insurance 82% 96% 96% 93% 45% 49% 50 Percent PAGENO="0080" C) F- C) Retirement Coverage Future Benefit Health Coverage Source: Employee Benefit Research Institute Chart 2 Prevalence of Employee Benefits LEGEND Civilian Employment ~ ERISA Work Force 90 80 70 60 50 - 40 - 30 20 -C) 6) >~ 0 E LU 0 PAGENO="0081" Table 1 Employment, Retirement Program Coverage, Future Benefit Eritit]ement, and Primary Health Insurance Coverage, Hay 1983 Retirement Future Benefit Primary Health Employment Coverage Entitlement Insurance Coverage (000's and % of Employed) Civilian Employment 98,964 51,530 24,095 59,041 (All employees & self-- 100.00% 52.07% 24.35% 59.66% employed) ERISA Work Force 54,363 38,057 20,027 45,161 (age 25 to 64, working 100.00% 70.01% 36.84% 83.07% 1000 hours or more, one year of tenure or more) SOURCE: Preliminary Employee Benefit Research Institute tabulations of the May 1983 EBR1/IIHS CI'S pension supplement and May 1979 DOL/SSA CPS pension supplement. PAGENO="0082" Chart 3 Composition of Employee Benefits I jT*x_F*?~.dD.~.tLt~ T&ubl. B.n.t1t. T*z~b1. ~ E.q~th~d P&y~.~L. 9.8Z Percentage of Wages and Salaries R.q~ir.4 ~ T.z--F~,~.d H.~.t1t. Percentage of All Benefits Source: Employee Benefit Research Institute PAGENO="0083" 77 Table 2 ç~~oaitior oL.~ loyce Bertef its by Benefit Group. 1982 Employer Pay~'enis Employer Payments as a Percentage of as a Percentage of Benefit Group Wages and Salaries All Benefits Total Benefit Payments 32.5 100.0 Le~aily Required Erployer Payments: 9.5 Social Security (FICA) 5.2 160 Unemployment Compensation 1.1 Workers' Compensation 0.9 2.8 Other Legally Required Payments a/ 2.3 7.1 DIscretionary Taxable Benefits: 13.9 42.8 Time not worked b/ 9.8. 30.2 Rest Periods 3.3 11.7 Other Taxable Benefits cl 0.3 0.9 Discretionary Tax-Favored Benefits: 9.0 Contributions to pension and Profit-Sharing Plans d/ 4.0 12.3 Group Health, Life, Short-Term Disability Insurance 4.4 13.5 Other Tax-Favored Benefits e/ 0.6 1.3 Surs4cZ: Legally Required Employer Payments and Discretionary Taxable Benefits 23.5 72.0 All Discretionary Benefits 23.0 61.5 Fully Taxable Benefits 13.9 42.8 Tax-Favored Benefits 9.0 27.7 SOURCE: EBRI tabulations of estimates produced by the U.S. Chamber of Commerce, Employee Benefits 1982 (1983), pp. 11 and 28. a! Includes government employee retirement, Railroad Retirement Tax, Railroad Unemployment and Cash Sickness Insurance, and state sickness benefits insurance. b/ Includes paid vacations and payments in lieu of vacation; payments for holidays not worked; paid sick leave; payments for State or Rational Guard duty; jury, witness, and voting pay allowances; and payments for time lost because of death in family or other personal reasons. c/ EBRI estimate based on Chamber of Commerce report of amount of Christmas or other special bonuses, service awards, suggestions awards, special wage payments ordered by courts, and payments to union stewards. d/ EBRI estimate of Chamber of Commerce report of employer contributions to profit-sharing plans. a! EBRI estimate of Chamber of Commerce report of employer-paid dental premiums, merchandise discounts, employee meals furnished by company, payments for vision care and prescription drugs, moving expenses, and contributions to employee thrift plans and employee education expenditures. Tax-preferred benefits are overstated by the amount of separation or termination pay received by employees but not distinguishable from other tax-favored benefits in the Chamber of Commerce estimates. PAGENO="0084" 6 5 U, 3 ~1 / / ~ /7 - - - - - - - - - - - - - . - - -- -- - - -;~ - - :--~ Chart 4 Employee Benefits Growth 1950 - 1962 Type of BenefiL L~gU11y U dUtUd fl~~UUfit~ - - P&i~~~t~ P~~UI!~~ U~d 1'~~11t ~ C m.~t Empk,y~~' LLU~Ut - - - GzUup U..d~h ~ GrUup Lif. 1n.ur.rnU. 2 o I 1950 1960 1970 1982 Yer~r Source: Employee Benefit Re8earch Institute PAGENO="0085" 79 Table 3 Employer Outlays for Employee Benefits in the National Income and Product Accounts br Selected Years, 1950-1982 950 1960 1970 1982 Total Total Total Total Amoont Cottttten,atton Smoont Cootpensotton An,oont Cotttpcn~ntton At,tount Cornpcnntstton Type of ttoooflt (ttttltom) (tomcat) (tiUtkots( (I'omottt) (11ttttoo~) (t'emo,tt) (Litlltoos) l1'et'centl Legaily mandated benefits Social Security Old-Age Survivors and Disability Insurance 81.3 0.0 $5.6 1.9 816.2 2.6 $69.2 3.7 Social Security Hospital insurance a a a a 2.3 0.4 16.4 0.9 Unemployment Insurance 1.5 1.0 2.8 1.0 3.5 0.6 17.4 0.9 Worker's Compensation J.,Q Q,,~ ..J.2 Q.2 _i2 _.Q.~ J.2.2 ._U. Total 13.8 2.4 110.3 3.6 $26.7 4.4 8122.9 6.6 Voluntary benefits Private pensions and profit-sharing 1.7 Federal, state, and local government employees' retirement plans 1.1 0.7 Group health insurance 0.7 0.5 Grcup life insuratacie 0.3 - 0.2 1.1 ::, 4.9 1.6 13.1 2.1 65.2 3.5 2.9 1.0 7.8 1.3 33.8 1.8 3.4 (.1 12.1 2.0 65.7 3.5 1.1 0.4 2.9 0.5 7.2 0.4 SOURCE: Sophie M. Korc:yk, Retirement Security and Tax Policy (Washington, DC: Employee Benefit ~ PAGENO="0086" Chart 5 Employee Benefits Cost Variation Low LEGEND Avg. Htgh Worker Ineur~nce Source: Employee Benefit Research Institute Retiree Die. & Health Total PAGENO="0087" 81 Table 4 Low, Average and High Esployer Contributions to Discretionary Employee Benefits as a Percent of Total Compensation, 1982 Source: ~RI calculations of data provided by Hewitt Associates. 1/ Based on Fortune magazine's industrial classifications. 2/ Total worker retirement includes employer contributions to defined benefit and defined contribution pension plans, and profit sharing plans. 3/ Total worker insurance benefits includes employer outlays to group life and survivor plans long- and short-term disability plans, and health insurance (including medical, dental and vision plans). 4/ Total retiree disability and health includes employer contributions to health insurance arid disability income for retirees. Total Worker Total Worker Total Retiree Retirement !f Insurance BenefitsYDis. Health - Grand Total iP~3trial Classifications!' _Avg. Hughi Low Avg. High ~ Higj~ Low Avg. High Petrolesm S Refining 8.6 11.2 13.9 6.9 9.0 11.2 .7 .9 1.1 16.2 21.1 26.2 Electronics (Appliances) 6.0 7.6 9.2 7.2 9.0 10.9 .5 .6 .7 13.8 17.2 20.8 Office Equipment (includes computers) s.i 6.5 7,7 7.6 9.6 11.3 .6 .7 .8 13.3 16.8 19.8 Industrial and Farm Equipment Pharmaceuticals Chemicals Paper, Fiber and Wood Products Fond Utilities Life Insurance Banks Retailing Fortune 500 15.9 .20.7 29.0 16.3 19.4 21.5 19.4 22.3 28.8 7.5 9.7 13.6 7.8 10.1 14.1 .7 .9 1.3 7.4 8.8 9.8 8.1 9.7 10.8 .8 .9 1.0 10.1 11.6 15.0 8.5 9.8 12.6 .8 .9 1.2 7.5 9.2 10.3 8.0 9.9 11.1 .9 1.1 1.2 16.4 8.3 10.0 11.6 8.2 9.9 11.5 .7 .9 1.0 17.3 7.4 10.1 12.6 6.9 9.5 11.9 1.1 1.5 1.9 15.4 8.1 12.5 15.0 6.0 9.1 11.1 1.0 1.6 2.0 15.1 l1.~,/l3.9 15.0 7.2 8.8 10.0 .7 .8 .9 19.3 20.2 22.6 20.8 24.1 21.1 26.4 23.2 28.3 23.5 26.8 14.9 16.4 20.6 29.0 6.0 7.1 7.8 6.2 7.4 8.1 .3 .4 .4 12.5 5.1 9.8 15.0 6.0 9.8 14.1 .3 1.1 2.0 12.5 PAGENO="0088" ft 2 80 50 8 .5 30 LEGEND Coven~ed Vc~ted Chart 6 Pensions by Earnings Source: Employee Benefit Research Institute PAGENO="0089" st0000 Vesting Chart 7 Pensions by Earnings Percentage Distribution Across Income Groups $io.000 - Employment Coverage Source: Employee Benefit Research Institute PAGENO="0090" 84 Table 5 Employment Coverage and Vesting: Distribution by Earnings for Nonagricultural Wage and Salary Workers, Nay 1983 Number of Workers (000's)* Earnings Employment Coverage Total Vested Benefits Total 80,289 47,372 27,603 $l-4,999 10,014 2,433 358 $5,000-9,999 15,323 5,747 2,023 $lO,000-14,999 17,827 10,328 5,484 $15,000-19,999 13,101 9,422 5,874 $20,000-24,999 10,283 8,159 5,641 $25,000-29,999 5,515 4,365 3,048 $30,000-50,000 6,611 5,547 4,072 $50,000 and over 1,615 1,371 1,106 Percentage Employment Distribution Within Income Group % Covered % Vested Total to Employed to Employed 100.00% 59.00% 34.38% $1-4,999 100.00 24.29 3.57 $5,000-9,999 100.00 37.51 13.20 . $lo,000-l4,999 100.00 57.93 30.76 $15,000-19,999 100.00 71.92 44.83 $20,000-24,999 100.00 79.34 54.85 $25,000-29,999 100.00 79.14 55.26 $30,000-50,000 100.00 83.91 61.57 $50,000 and over 100.00 84.90 68.50 Percentage % Employ- Distribution Across Income Groups % of % of Total Total ment Coverage Vesting 100.00% 100.00% 100.00% $1-4,999 12.47 5.14 1.30 $5,000-9,999 19.08 12.13 7.33 $10,000-14,999 22.20 21.80 19.87 $15,000-19,999 16.32 19.89 21.83 $20,000-24,999 12.81 17.22 20.43 $25,000-29,999 6.87 9.21 11.04 $30,000-50,000 8.23 11.71 14.75 $50,000 and over 2.01 2.89 4.01 *Excludes workers without reported earnings SOURCE: Employee Benefit Research Institute tabulations of May 1983 EBRI/HHS CPS pension supplement. PAGENO="0091" Chart 8 Health Insurance by Earnings 100 90 60 ~7O 0 *~ 60 C;' ~50 ~ 40 ci ~ 30 0~ 20 10 0 $1 - $9999 $10000 - $24999 $25000 - $49,999 $50,000 & Over Source: Employee Benefit Research Institute PAGENO="0092" Chart 9 Health Insurance by Earnings Percent of All Workers with Coverage $50,000 & Over 28% $10000 - $24,999 ~ $25,000 - $49,999 Source: Employee Benefit Research Institute PAGENO="0093" 87 Table 6 Distribution of Workers Covered by an Employer Group Health Insurance Plan by Personal Earnings, 1982 al Workers with Percent of Employer Percent of All Workers Coverage b/ Workers within with Employer Personal Earnings (in nillions) Earnings Group Coverage Loss 1.1 41.2 0.5 $ 1-$ 4,999 29.5 53.3 18.4 5,000- 7,499 10.8 64.6 8.1 7,500- 9,999 9.1 74.1 7.9 10,000- 14,999 19.0 84.7 18.8 15,000- 19,999 14.3 90.0 15.1 20,000- 24,999 10.5 92.5 11.3 25,000- 29,999 6.8 93.6 7.5 30,000- 34,999 4.2 93.0 4.6 35,000- 39,999 2.3 93.0 2.5 40,000- 49,999 2.3 90.8 2.5 50,000- 59,999 1.1 91.1 1.2 60,000- 74,999 0.7 88.3 0.7 75,000 or more 0.9 86.2 0.9 Total, All Workers cl 112.7 75.9 100.0 Summary: Loss-$ 9,999 50.5 59.2 34.9 $10,000- 24,999 43.8 88.3 45.2 25,000- 39,999 13.4 93.3 14.6 40,000 or more 5.1 89.7 5.3 SOURCE: Employee Benefit Research Institute tabulations of the March 1983 Current Population Survey (U.S. Department of Commerce, Bureau of the Census). a! Includes all nonagricultural civilian workers who reported employer group health insurance coverage at any time during 1982, except workers in families in which the greatest earner is a member of the Armed Forces or an agricultural worker. b/ Includes coverage from the worker's own employer group plan or from the plan of another worker. ~/ Items may not add to totals because of rounding. PAGENO="0094" PAGENO="0095" 89 Table 7 Employment and Coverage in the ERISA Work Force by Industry, May 1983 SOURCE: Preliminary Employee Benefit Research Institute tabulations of the May 1983 EBRI/HHS CPS pension supplement and May 1979 DOL/SSA CPS pension supplement. a Number of workers too small to be statistically significant. INDUSTRY Employment (000's) Percent Covered Pension Health GOVERNMENT 11,905 88.26% 88.73% DURABLE MANIJ. Primary Metals Automobiles 8,492 702 823 * 79.84 89.81 92.56 94.17 97.70 98.41 NONDURABLE MANLY. Apparel Chemicals 5,862 697 970 72.56 45.82. 91.89 90.52 75.55 97.38 TRANSPORTATION (ex-railroads) 1,454 ` 68.98 86.56 ~ CONSTRUCTION 2,130 44.56 `71.93 PUBLIC UTILITIES 811 93.11 95.30 * COMMUNICATIONS 1,200 88.75 97.46 MINING 660 82.72 96.43 FINANCE, INSURANCE & REAL ESTATE . 3,444 , 72.42 84.20 PROFESSIONAL SERVICES 6,401 . 63.95 . 74.48 WHOLESALE TRADE 2,682 63.26 86.50 RETAIL TRADE 5,833 45.96 64.56 BUSINESS & PER- SONAL SERVICES 3,184 33.83 59.92 PAGENO="0096" C-) M ci ci * Chart 11 Benefits Revenue Loss and rFaxes Paid LEGEND IIoclth Wkr. Cmp. F~~J Lillill Pon~ion In~rnc. Tcixc~c Pd. 0 $lOtc - $15k Source: Employee Benefit Research Institute PAGENO="0097" `laI)lO 8 ftuVcuLiO Louc (or Hajor bunaftia and Tuxea Paid by licuic Clasu lie Pucunt of Total Adjusted Cross Income Class, i9Ul~ tJOTL': Purcente may not add to 100.0 pecont due to rounding. 1981 income levels and 1982 law. blncludes the exclusion of contributions and earnings for employer plans and plans for the self employed arid others. -~ CIziclild~ promluma for group-term life ineurenca and accident and disability insurance. Exclusion of Employer Con- ~xcluaton of Uci Adjusted Groua income Claus tributions for liedical insurance & Hedicel Care Exclusion Woikur'~ pensatiori Benefits of Corn- Untaxed Unem- ploynont In- surance Benefits Excluaion Disability Pay of txclusion of Pencion Con- tributlons 6 tarningab Exclusion Insurance Premlumac of Percent of Total Taxes Paid Leac than $10,000 6.5% 29.4% 50.6% 83.0% 4.01. 4.5% 2.61. $ 10,000 to $ 15,000 8.7 16.6 26.4 14.4 5.6 6.1 5.7 $ 15,000 to $ 20,000 10.7 11.7 9.7 0.7 7.8 8.8 8.0 $ 20,000 to $ 30,000 28.3 24.8 12.8 2.0 22.6 24.0 20.6 $ 30,000 to $ 50,000 32.8 12.9 0.4 - 34.1 34.7 30.4 $ 50,000 to *100,000 10.6 3.5 - - 17.8 15.2 18.1 $100,000 t.~ *200,000 1.9 0.7 - - 6.0 4.8 . 8.3 $200000 and over 0.4 0.3 - - 2.1 1.9 6.3 SOUUCE: EBRI calculations based on U.S. Congress, 1r~c~t~ Tax, July 1983 (Washington, D.C.; and 63. Congressional Budget Office, ~~Ln~jp4jy1~oJ. U.S. Government Printing Office, 1983), Table 9, pp. 62 PAGENO="0098" T.x.. I~at~ Chart 12 Pensions Revenue Lost Vs. Deferral Lifetime - Real/Discounted T.. D.t.n~d Treasury Cash Flow Lifetime - Nominal T.x.. Dsf.n.d Source: Employee Benefit Research Institute PAGENO="0099" 93 Table 9 How Muchof Pension-Related ~. Deferrals is Lost to the Treasury? Taxes Method Used Taxes Lost Deferred Treasury Method 83% 17% Lifetime Method: Nominal dollars a! 14 86 Real dollars b/ 28 72 Discounted for interest: Cl at pension rate 40 60 at federal rate 36 64 SOURCE: Sophie N. Korezyk, Retirement Security and Tax Policy (Washington, DC: Employee Benefit Research Institute, 1984). ~/ Before adjusting for inflation. b/ After adjusting for inflation. c/ Interest rate used to discount taxes paid in retirement to the year of retirement. PAGENO="0100" 300 -s-c U] 0 L) sf50 Of) ~0 i-c -cc' 200 9-i 0 11) 150 U I-c 1) 13-c 100 Chart 13 Benefit Cost by Age 350 Type of F3cnefit. - Medical Defined l3ancfit - - - Life Inscurence / V ~- /\ I /~ 7, /7 /_,, 50 --------------~-~ 7 7 7 / / Under 30 35 - 30 45 - 49 55 - 59 65 - 130 30-34 40-44 50-54 60-64 Age Source: Employee Benefit Research Institute PAGENO="0101" Summa r~y~ 95 Table 10 of Cost Factors by Age for Use in Costing Benefit Plans SOURCE: The Costs of Employing Older Workers (Washington, DC: U.S. Special Committee on Aging and the Employee Benefit Research Institute, forthcoming). Note: Same life insurance cost is assumed for 65-69 as. for 60-64 because it is assumed that the benefits will be reduced to equal cost; regulations allow a 30% reduction. If benefits are not reduced, assume costs at 65-69 are about 30% higher. Age Gr~~ Medical Cost Factor as % of Average Cost Defined Benefit Cost Factor as Z of Average Cost Life Insurance Cost as Z of Pay for One Times Pay Under 30 80.0% 23.0% 0.1% 30-34 80.0% 33.0% 0.1% 35-39 80.0% . 48.0% 0.2% 40-44 80.0% 69.0% 0.3% 45-49 100.0% 100.0% 0.6% 50-54 112.5% 146.0% 1.0% 55-59 125.0% 216.0% 1.5% 60-64 160.0% 323.0% . 2.3% 65-69 225.0% * 2.3% Defined contribution costs are the same by age. PAGENO="0102" 96 ENDNOTES Should you wish to review the primary economy research on which this statement is based the following are suggested. For background on flexible benefits plans and their relevance to changing employ- ee needs, see Dallas L. Salisbury, ed., America in Transition: Implications for Em- ployee Benefits (Washington, DC: Employee Benefit Research Institute, 1982); EBRI Issue Brief, "Flexible Compensation and Public Policy," No. 24 (Washington, DC: Employee Benefit Research Institute, November 1983); and Chapter XXII, "Flexible Compensation Plans" in Fundamentals of Employee Benefit Programs (Washington, DC: Employee Benefit Research Institute, 1983). For further analysis of the tax treatment issues, see Sophie M. Korczyk, Retire- ment Security and Tax Policy (Washington, DC: Employee Benefit Research Insti- tute, 1984). See also EBRI Issue Brief "Pension-Related Tax Benefits," No. 25 (Wash- ington, DC: Employee Benefit Research Institute, December 1983); and EBRI Issue Brief "Employee Benefit Research Institute, February 1984). For discussion of the interrelationship of programs see Sylvester J. Schieber, Social Security: Perspectives on Preserving the System (Washington, DC: Employee Benefit Research Institute, 1982). Alternative tax systems would require detailed judgments about the treatment of various sources and uses of income. Both would also create some formidable imple- mentation and transition problems. These problems and issues are treated in detail elsewhere. For a discussion of employer pensions in basic tax reform, see Sophie M. Korczyk, Retirement Security and Tax Policy (Washington, DC: Employee Benefit Research Institute, 1984) and EBRI Issue Brief, "Basic Tax Reform: Implications for Employee Benefits," No. 28 (Washington, DC: Employee Benefit Research Institute, March 1984. For a wide-ranging discussion of theoretical and practical issues in basic tax reform, see Dallas L. Salisbury, ed., Why Tax Employee Benefits? (Wash- ington, DC: Employee Benefit Research Institute, 1984). In smaller plans, the cost of providing health insurance for the marginal employ- ee is based on the average costs of insuring the insured population of that communi- ty. In larger plans, the cost of insuring the marginal employee is based on the aver- age cost of insuring the population represented by that employer's work force. While these two methods would be likely to yield different insurance costs for any given employee, under either method the cost of insuring that employee does not represent the cost of that employee's expected claims. For a thorough discussion of health insurance see Deborah J. Chollet, Employer- Provided Health Benefits: Coverage, Provisions, and Policy Issues (Washington, DC: Employee Benefit Research Institute, 1984), p. 94. An EBRI simulation of private health insurance suggests that 56 to 87 percent of all covered workers with 1979 family income less than $15,000 would not have purchased private health insurance if an employer had not offered and contributed to their health insurance plan. APPENDIX I WHAT ARE EMPLOYEE BENEFITS? Employee benefits represent virtually any form of compensation that is provided in a form other than direct wages, paid for in whole or in part by the employer, even if provided by a third party. Generally, media articles, cost surveys, and re- ports lump all benefits together. But different benefits serve different social and eco- nomic needs. For legislative policy assessment purposes, benefits can be classified into at least nine categories: 1. Legally required benefits (including employers contributions to Social Security, Medicare, unemployment insurance, and workers' compensation insurance); 2. Discretionary benefits that are fully taxable (primarily, payment for time not worked); 3. Discretionary benefits that insure the employee against financial risks and are tax exempt (including employer contributions to health, life, and disability insur- ance plans); 4. Discretionary benefits that help the employee meet special needs and are tax exempt (including employer contributions to child care and legal plans); 5. Discretionary benefits that have traditionally been called fringes and are in- tended to meet employer needs and are tax exempt (including employer provision of purchase discounts, job site cafeterias, special bonuses and awards, van pools, clubs, and parking); 6. Discretionary "reimbursement account" benefit programs that have been legal- ly allowed since 1978 which allow employees to have reimbursement accounts- PAGENO="0103" 97 funded by the employer or through salary reduction-to pay expenses that fall into "statutory benefit" areas and are tax exempt (including health care reimbursement, child care reimbursement, etc.); 7. Discretionary benefits that provide retirement income as a stream of payments and for which taxes are deferred until benefits are received (including employer contributions to defined benefit pension plans and to defined contribution plans which require payment in the form of an annuity); 8. Discretionary benefits that provide for the deferral of salary until termination of employment, generally pay benefits as a lump sum, and for which taxes are de- ferred until benefits are received (including contributions to some profit sharing plans, to money purchase plans and ESOPs); and 9. Discretionary benefits that provide for the deferral of salary until special needs arise (loans and hardship), or until termination of employment, generally pay bene- fits as a lump sum, and for which taxes are deferred until benefits are received (in- cluding contributions to some profit sharing plans, thrift-savings plans, and salary reduction plans). APPENDIX II A COMMENT ON THE CONTROVERSEY OVER TAX EXPENDITURE ESTIMATES FOR PENSION PLANS (By Dallas L. Salisbury*) The United States Treasury makes annual estimates of tax expenditures in re- sponse to mandate of the Congressional Budget Act of 1974. These estimates are published each year in the President's Budget along with many cautionary notes on how they can legitimately be used. A reading of academic, public, and other publications leads one to the irrefutable conclusion that these cautions are frequently unneeded. For example, some use them to indicate the revenue that would be gained by the government if the law were changed. The Budget points out that this is not a proper use of the numbers because, among other reasons, they are calculated as if no other tax provisions ex- isted and as if human behavior would in no way be affected by eliminating the tax preference. The Employee Benefit Research Institute (EBRI) is concerned with economic secu- rity and with doing what it can to assure that policy makers have appropriate infor- mation available to them as they assess policy choices. Early in 1983, EBRI received press inquiries regarding the tax expenditure numbers in the FY 84 Budget. As a result of those discussions, the then EBRI resarch director and economist Sylvester J. Schieber wrote and published EBRI Issue Brief Number 17 (April 1983) on the subject of "Retirement Program Tax Expenditures." Alicia H. Munnell suggests in her note on this subject that the Issue Brief "initi- ated the debate over the accuracy of the estimates." The literature indicates that this debate has been ongoing, but I will agree that the Issue Brief was an addition to the debate. Munnell then mentioned that "a primary concern of EBRI was that the figures published by the Treasury jumped dramatically and apparently without explanation from year to year." The Issue Brief raised other concerns as well: Budget deficits might cause pension policy to be made based upon considerations of perceived cost without sufficient consideration of benefits provided. Tax expenditure estimates could be used inappropriately as indicators of revenue that could be gained by changes in the tax treatment of pensions without reference to the limitations inherent in the numbers which are outlined in the budget. Dramatic increases in the numbers which were unexplained might inappropriate- ly be attributed to a changed pension system rather than inclusion of public pen- sions for the first time. The Issue Brief then explored the question of whether or not the figures, as pres- ently published by the Treasury, accurately reflect the revenue loss associated with the favorable tax treatment of pensions. Munnell's note failed to deal with the most important factor in making this determination: the partial equilibrium nature of the Treasury calculations. Partial equilibrium means that real world behavior is as- sumed away. That is, if the law is changed, everyone is assumed to still behave in exactly the same way. If the IRA tax preference were removed, people would still * President, Employee Benefit Research Institute. The views expressed herein are the authors and should not be attributed to EBRI. PAGENO="0104" 98 put their money in IRA's. The budget goes to great lengths to warn against using the tax expenditure numbers to assess how much revenue could be gained if a par- ticular tax incentive were removed. In other words, no partial equilibrium number is "accurate." Munnell then says that "two arguments could be made that the calculated figures exaggerate the impact of employer-sponsored pension plans on tax revenues." She is correct that pension fund earnings may be overstated. She is also correct that con- tributions overstate the cost of current benefits. She ignores other reasons however. For example: Other tax code provisions such as the elderly double exemption bring marginal rates down. This reduces pension repayment and increases what is called the pen- sion tax expenditure. But this increase is due to the other provision. The cross section approach used in the budget offsets this year's contributions and earnings against benefits paid this year. These numbers relate to different groups of people and fail to account for the age of the pension system or the fact that this relationship will change in the future. This overstates the tax expenditure today and will understate it thirty years from now. The current method of calculation counts as pension tax expenditures amounts that would not be taxed in the absence of pensions due to other provisions of the code such as capital gains tax deferrals, municipal bonds, the elderly real estate gain exclusion, etc. Munnell then quickly notes: "On the other hand, the revenue loss for public plans is almost certainly underestimated since these funds are not fully funded and hence contributions are less than accruing benefits." Whether under Social Security, civil service retirement, military retirement or private pensions, the concept that the tax expenditure should be calculated on the benefit accrual rather than contributions is revolutionary. Under such a new approach the Social Security and Medicare tax ex- penditures would dwarf those for pensions, and employees would be "charged with income" that they might never see due to the benefits being unfunded. Munnell's new approach cannot be justified. Yet, it is the only reason she provides for stating that the tax expenditures are understated. Therefore, Munnell's conclusion that "In view of the offsetting errors, then, the Treasury's current estimates of the tax expenditure for pension plans probably pro- vide a reasonable approximation of the revenue loss" cannot be supported. And Munnell certainly does not document it in her note. Munnell then states: "Essentially, the calculation is designed to meausre how much higher federal revenues would be in a given year if a particular subsidy had not been enacted." This statement directly contradicts the budget of the United States. The budget specifically warns against using the number for this purpose be- cause of its partial equilibrium limitations. The number could only be used in this way if the preference being evaluated were the only tax preference item available. Munnell then agrees with the Issue Brief in noting that a lifetime basis should be used to calculate the pension tax expenditure. Munnell then undertakes a partial equilibrium present value exercise that approximates a lifetime estimate. She pro- duces a high number and concludes: "Thus, the revenue loss associated with the fa- vorable treatment of pension contributions and earnings is substantial regardless of how it is measured." Again, Munnell cannot support her numbers or her conclusion. By using the cur- rent level of contributions, investment earnings and benefit payments, Munnell as- sumes that the system will never change. Demographic changes in the future will guarantee that this assumption is wrong. Further, Munnell's new calculation is still partial equilibrium and has all the weaknesses that the budget attributes to the Treasury numbers. Munnell concludes her note with the comment that: "The debate over the precise magnitude of the tax expenditure is an unproductive digression that diverts atten- tion froth the important topic of whether the favorable tax treatment accorded con- tributions to private pension plans represents an efficient and equitable use of scarce federal resources." The problem is that one can only assess whether benefits are sufficient to justify the cost, if one knows tl~e cost. The tax favored pension plans will, according to gov- erriment estimates, pay $87.5 billion in benefits to retirees in 1985. What should this be measured against? $28 billion; $50 billion; $62 billion? Do all these numbers indi- cate that at this point the government gets more than it gives? Munnell never mentions anything but the tax expenditure. Her articles don't pro- vide the information that would allow one to pursue the "important topic." Munnell is prepared to use the tax expenditure number in a way that the budget says it cannot be used; EBRI is not. EBRI attempts to provide information to allow persons PAGENO="0105" 99 to assess both the cost and the benefit issue; Munnell does not. Munnell advocates particular policy courses; EBRI does not. EBRI subscribes to the American notion that there is a role to be played by the public sector, the private sector, and the individual in meeting economic security needs; Munnell's written work indicates that she believes it could best be done by Social Security. Munnell distributes critiques of the work of others without first dis- cussing the work being critiqued with the author-as the Munnell note evidences; EBRI does not. A debate over any established public policy is justified and further, should take place from time to time to assure that a national consensus still exists. Such debate, when it involves the pension benefits of over 16 million current retirees and over 50 million current workers, must be based upon an accurate assessment of costs and benefits-as should all debates. No time spent attempting to get to accurate num- bers can legitimately be labeled "an unproductive digression." Those who feel that a call for facts is "an unproductive digression" cannot be viewed as objective analysts. Thus, Munnell should be seen as an advocate for the policy positions she has articu- lated in her written work. Munnell has already reached her conclusions without aid of accurate estimates of the cost of the pension tax incentives and without the facts on the benefits the system provides. EBRI is doing over $1 million in research each year to get the facts. Whatever they are, they are broadly distributed. They will, in time, provide the basis for informed decisions on whether tax incentives for pen- sions are efficient and effective. They have already provided a basis for more com- plete understanding than was possible when Munnell reached her conclusions in 1981. EMPLOYEE BENEFITS-RETIREMENT AND HEALTH-BY STATE Reports have been issued in the past assessing pension and health insurance cov- erage for the nation. The tables that follow break down the 98.9 million civilian workers by state for two populations: Tables 1 and 2 present the informatiOn for all civilian workers. The tables indi- cate significant state by state variation in coverage levels. Nationally pension cover- age is 52 percent; varying from 37 percent in Arkansas to 62 percent in Delaware for all workers. Health coverage nationally is 59 percent; varying from 37 percent in Montana to 66 percent in Delaware. Tables 3 and 4 present the information for the "ERISA work force": those over age twenty-five with at least one year on the job and working more than 1,000 hours during the year. Among these full-time, full-year workers, pension coverage is 70 percent nationally; varying from 53 percent in Florida to 82 percent in Delaware. Health coverage was 83 percent nationally; varying from 72 percent in North Dakota to 89 percent in North Carolina. This second population is more useful for analysis since these are work related benefits. The total civilian work force, for example, includes all persons over age fourteen who work at all for pay during the year. The tables also provide average income figures for all workers and for those with pension and health protection. For the total civilian work force, average income is 22 percent below that of those with benefit protection. The total civilian work force has average income 21 percent below the older ERISA work force. Those with pension and health coverage earn 9.2 percent more, on average, than the total ERISA work force. PAGENO="0106" -I ~ ~ 2~5 ~ 22 ~ ~-= ~ 2 ~*= ~ -~ ~ co. ~ q ~ -~ 2.~ 8~