Rethinking IRS Non-Discrimination Rules for Non-Wage Compensation

• In Event: Taxes, Technology, and Regulation

Abstract

Many types of non-wage compensation such as employer sponsored heath care, group life insurance and various qualified benefits are tax-preferred—ostensibly to achieve certain social insurance goals by reducing the after-tax price of private benefit provision.

Importantly, to qualify for exclusion from an employee’s gross income, the provision of the fringe benefits under these four code sections must be non-discriminatory—the benefits must be available to most employees regardless of wage/salary level. These non-discrimination requirements are meant to prevent employers from targeting tax-preferred compensation to their higher-wage employees, who face higher marginal tax rates and therefore benefit disproportionately from the tax exclusion or deferral. Such targeted provision is counterproductive to the government’s objective in two ways: first, it limits wide access to the benefit, and second, it reduces the efficiency of the tax expenditure, because higher-wage employees are more likely to be inframarginal—they would have purchased health insurance regardless, so the exclusion is a (regressive) subsidy that has little effect on behavior.

Yet while these non-discrimination requirements may be intended to broaden access and improve economic efficiency, how firms respond to them may undermine this objective. Because providing these fringe benefits is costly to firms, and the benefits’ value is particularly large for higher-wage employees, firms may be incentivized by the non-discrimination requirements to cut back on their use of lower-wage employees. As a result, these non-discrimination requirements may have the unintended consequence of exacerbating total labor income inequality.

Author

• Eleanor Wilking, ewilking@cornell.edu