Include Employer-Paid Premiums for Income Replacement Insurance in Employees' Taxable Income

Benefits that replace income for the unemployed, injured, or disabled are currently subject to different tax treatments. Whereas unemployment benefits are fully taxable, benefits paid under workers' compensation programs (for work-related injuries or illnesses) are tax-exempt. Disability benefits (for non-work-related injuries) may be taxable, depending on who paid the premiums for the disability insurance. If the employer paid the premiums, the benefits are taxable (although the recipient's tax liability can be offset partly by special income tax credits for elderly or disabled people). If the employee paid the premiums out of after-tax income, the benefits are not taxed.

This option would eliminate existing taxes on income replacement benefits but would include in employees' taxable income the value of several taxes, premiums, and other contributions paid by employers. Specifically, all of the following would be subject to the individual income tax and the payroll taxes for Social Security and Medicare: the taxes that employers pay under the Federal Unemployment Tax Act and to various state unemployment programs; 60 percent of premiums that employers pay for workers' compensation (excluding the 40 percent that covers medical expenses); and the portion of insurance premiums or contributions to pension plans that employers pay to fund disability benefits. Together, those changes would increase revenues by $136 billion from 2012 through 2016 and by $316 billion over the 2012- 2021 period. Over the long term, the gain in revenues would result almost entirely from adding workers' compensation premiums to taxable income. Including those various items in employees' taxable income, and thus in the wage base from which Social Security benefits are calculated, also would increase federal spending for Social Security. On net, the option would reduce federal budget deficits by $135 billion from 2012 through 2016 and by $312 billion from 2012 through 2021.

An advantage of this option is that it would treat different kinds of income replacement insurance similarly and thereby eliminate the somewhat arbitrary discrepancies that currently exist. For example, people who are unable to work because of an injury would not be taxed differently on the basis of whether their injury was related to a previous job. In addition, the option would spread the tax burden among all workers covered by such insurance rather than placing the burden solely on those who need the benefits, as is presently the case with unemployment insurance and employer-paid disability insurance.

A disadvantage of this option is that it would not eliminate all disparities in the way income replacement benefits are treated. For example, the income replacement portion of adjudicated awards and out-of-court settlements for injuries not related to work and not covered by insurance would remain entirely exempt from taxation. Also, recipients of the supplemental unemployment benefits that the government sometimes provides during economic downturns would receive those benefits tax-free, even though no amount corresponding to an employer's contribution had ever been included in the recipients' taxable income.

Another disadvantage of the option is that it would initially exempt from taxation the benefits received by people whose premiums were not taxed, providing particularly large benefits to that cohort relative to earlier or subsequent cohorts. Transition rules could be devised to limit or prevent such gains, but those rules would probably be complicated and difficult to implement.

The option would reduce nearly every worker's take- home pay but by a relatively small amount--less than one-half of one percent, on average. For some workers, that reduction in after-tax income would be somewhat mitigated because any unemployment benefit or employer-financed disability insurance, received at some future date, would no longer be taxable.