BENEFIT CONCERNS MAY SINK FLAT TAX

Despite the presidential primary season hoopla over a flat tax, such a system is unlikely to be implemented without preserving tax-favored employer-sponsored benefit plans, experts say.

The current proposals carry considerable implications for pensions and other employee benefits. But, if the 1980s tax reform debate teaches anything, the proposals surfacing now are not a good barometer of what will remain when the dust settles.

Like an earthworm pie, tax reform might look good to everybody on the surface. It's only after probing beneath the appealing crust that many see what they regard as something far less palatable.

As in the 1980s, once special interests get a good look beneath the surface of the latest flat tax bills, they're bound to send the pie back to the kitchen, demanding something a little more satisfactory.

That was the case in the years leading to the 1986 Tax Act, a process that began with a familiar-sounding goal: to draft a tax code simple enough that Americans could file their tax returns on postcards. Volumes have been written about the lobbying efforts that shaped the tax code various lawmakers and presidential candidates now seek to reform.

But history hasn't stopped Republican presidential candidate Malcolm "Steve" Forbes Jr. from making an exemptionless, single-rate flat tax proposal a cornerstone of his campaign.

Meanwhile, the National Commission on Economic Growth and Tax Reform appointed by Sen. Bob Dole, R-Kan., and House Speaker Newt Gingrich, R-Ga., and headed by Jack Kemp, also has advocated a flat tax.

"After the Kemp Commission held its major non-event, at least half a dozen members of Congress told their staff, 'Gee, let's put together our own tax reform scheme,'" said Stuart Brahs, vp of federal government relations for The Principal Financial Group in Washington. "It's sort of the political flavor of the month."

Tax reform has "a lot of allure," said Frank McArdle, consultant in the Washington office of Hewitt Associates L.L.C. "But when the public finds out that the price of a flat tax might be taking away some of the advantages they enjoy now for mortgage interest or employee benefits, then the bloom will be off the rose as far as they're concerned and it will be more difficult to pass."

"There's a big middle class that's interested in keeping the status quo," said Olivia S. Mitchell, the International Foundation of Employee Benefit Plans professor of insurance and risk management at the Wharton School of the University of Pennsylvania in Philadelphia. "It's hard to see those exemptions falling by the wayside."

Adding to the sense of deja vu is that again the drumbeat for tax reform comes against a backdrop of demand for balancing the federal budget. But many suggest most of the proposals released so far would increase the deficit if key exemptions were kept in place.

Eliminating some popular tax exemptions could go a long way toward making a tax reform measure "revenue neutral." For example, the congressional Joint Committee on Taxation has estimated that excluding employer contributions to employee medical care from taxation would cost the U.S. Treasury $48.4 billion this year and $279.8 billion in the five-year period ending in 2000.

Eliminating the home mortgage interest deduction, meanwhile, offers similar revenue raising potential, with the committee estimating its cost to the Treasury at $59.2 billion in 1996 and $333.1 billion between now and 2000.

"I think opposition will emerge from many different quarters once it becomes apparent that in order to keep the proposal (revenue) neutral, most of the deductions would have to go away," Mr. McArdle said. "Already the Realtors and the homebuilders are mobilizing in anticipation of tax reform."

"I would expect organized labor to be opposed to key pieces of tax reform," he said, such as the elimination of employers' deductions for health and welfare program costs and probably to the possibility that a flat tax could reduce the tax burden of the wealthiest Americans while increasing that of middle- or lower-income taxpayers.

"I think my friends in the real estate industry-of which we are a very small part-have already weighed in on the home-interest deduction, and certainly they will continue to do so," said The Principal's Mr. Brahs. If the insurance and financial services industries see their products and services threatened, they too will weigh in against the measures, he added.

While commending the Kemp Commission for its efforts, the Washington-based Health Insurance Assn. of America started to stake out its position by saying the commission's commitment to a "pro-family tax code....underscores the value of employer-sponsored health coverage."

"It is imperative that we encourage employers to continue this role by preserving the exclusion of employer contributions from employees' taxable income," the HIAA statement said. "Removing the favorable tax treatment for health benefits would discourage some employees from purchasing health insurance."

The Kemp Commission report calls for making all employer health and welfare costs non-deductible business expenses. Discussion and background papers accompanying it called for the taxation of all labor income including fringe benefits.

With most of the tax reform plans still "amorphous," it's difficult to develop a thorough position on the issue, Mr. Brahs said.

"If anyone tells you that they know what their position is on federal tax restructuring, I don't think they're being totally candid with you," he said. "Most of us are in a situation where we are assessing what the implications will be for our products and services down the road."

The potential implications for pensions and benefits are numerous, stemming from such direct sources as possible elimination of employers' tax deductions for benefit payments or taxing employees on the value of employer-paid benefits or indirectly from such proposals as giving all forms of savings the same tax advantages currently enjoyed by qualified retirement plans.

"It's difficult to generalize because there are many proposals," said Hewitt's Mr. McArdle. "But in general, tax reform would likely alter the relationship between the company and the employees."

"The tax effectiveness of benefits under tax reform would either be eliminated or be diminished," he said. And, while other reasons might remain for employers to offer benefits, "companies would be likely to be driven by impact on the bottom line," Mr. McArdle said. "In that schema, benefit issues are likely to be well down on the company's list of priorities, and that would be bad news for people who rely on benefits and people who work with them."

The Wharton School's Ms. Mitchell recently examined the issue of taxing benefits when she co-chaired a technical panel on retirement savings for the Advisory Council on Social Security, a panel appointed by Health and Human Services Secretary Donna Shalala to study the existing Social Security system and make recommendations on how to strengthen it.

"My panel was asked to think about the possibility of taxing benefits, and in that case the issue was raising money for the Social Security system," she said. "My panel was unanimous against the idea."

One problem, Ms. Mitchell said, is that benefit programs would be less attractive to workers if they were taxed based on a uniform value, a situation that could lead to an "unraveling," particularly in the health care market.

For example, she contends, an employer currently paying 100% of group health insurance costs actually pays a premium based on an average cost for all employees in the group. If the government begins trying to tax employees on the value of that benefit, "a very young, very healthy single employee might reasonably protest that he didn't use $5,000 worth of coverage," or whatever the average cost per employee is, she said.

That young, healthy employee might demand an opportunity to opt out of the health plan to reduce their tax burden, and "since the essence of insurance is risk pooling, that might lead to a breakdown of risk pooling," Ms. Mitchell said.

"If a dollar of benefits is the same as a dollar of wages, I can see companies just giving up benefit plans and giving employees cash and telling them to get their own insurance," said Michael Pikelny, corporate actuary and employee benefits consultant at Chicago-based Hartmarx Corp.

Such a system would create several problems, however, including the inability of an employee with a pre-existing condition to get coverage outside of a companywide health plan, he said.

And economists who have studied the issue predict many workers would deliberately choose to purchase less health care coverage than what they currently receive from their employers, noted Dallas L. Salisbury, president of the Washington-based Employee Benefit Research Institute. "It would lead to a significant reduction in the number of individuals with health insurance," he said.

Pension plans, meanwhile, definitely would be affected by giving the same tax advantages to other forms of savings. "When that happens, the tax reasons for having a qualified plan change, because individuals can do just as well outside of those plans and have more control over their money and more flexibility," Mr. McArdle said.

"I think it would lead to more terminations and tremendous pressure by employees to receive cash in lieu of pension contributions," Mr. Salisbury said.

Ms. Mitchell noted that while pensions' primary purpose is to provide retirement savings, companies have other reasons for offering them, such as attracting and retaining workers and encouraging them to retire at an appropriate age. Any tax plan that diminishes pensions' attractiveness would reduce their value to employers, she said.

But, with companies already moving to give employees more benefit flexibility and greater responsibility in directing their retirement plans, tax reform proponents such as the Kemp Commission see tax reform as a way to promote those efforts. Tax reform could prompt companies to replace their benefit plans with extra cash to employees to be used as they see fit in meeting their health and welfare needs.

The result "may be a shift from the company's role as a financier of benefits to a facilitator of benefits," Mr. McArdle said.

However, he said, "Employer plans may be discouraged, but employee needs will persist. And if those needs are unmet, what will the consequences be for the company and the individual and the country?"

Of course, many of these proposals have been offered before. "I know in the past there have been proposals to eliminate deductions for medical plans or limit deductions to a certain amount, but that ends up going away and then gets resurrected," said Hartmarx's Mr. Pikelny.

Most recently, that talk surfaced during the Clinton administration's ill-fated health care reform effort, another experience some believe this tax reform process might echo.

"Tax reform is likely to turn out as troublesome for the Republicans as health care reform was for the Democrats," Mr. McArdle said.

The entire tax reform process could take three years, Mr. McArdle believes, and the 1996 election is key.

"I think if President Clinton wins re-election and there is a Republican-controlled Congress, then the odds of any tax reform are probably 40/60, and any tax reform changes would be far less," he said. If the Republicans win the White House and retain control of Congress, "then the odds rise sharply for something called 'tax reform.'"

EBRI's Mr. Salisbury also sees the November election as critical but believes that should the Republicans retain control of Congress, "the likelihood of the elimination of the deduction for benefits is almost certain."

"If Clinton's in the White House, it would likely be a compromise proposal rather than out-and-out taxation," he said. One result might be allowing an exemption only for employer-provided catastrophic health insurance.

Whatever the course, Mr. Pikelny said his hope "is that whatever does get passed is based on decisions that relate to employee benefits rather than decisions that are based on taxes."

The past has given him little reason for optimism, though, since previous tax law changes have made benefit administration more cumbersome, he said, because they were purely tax-driven rather than written with an eye toward their impact on employee benefits.