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How are fringe benefits taxed

how are fringe benefits taxed


The U.S. income tax has always excluded some forms of compensation from the individual income tax base, while employers have always been allowed to deduct the cost of fringe benefits as well as wages from their taxable incomes. Employer contributions for accident and health insurance plans were nontaxable in the original income tax in 1913, although there was some ambiguity about the tax status of fringe benefits until the Internal Revenue Code of 1954. Similarly, term life insurance premiums became tax-exempt in 1920 and deferred compensation plans received favorable tax status in 1921.

By the early 1980s, several other fringe benefits had received statutory exclusions: up to $5,000 of death benefits, parsonage allowances, certain benefits provided to members of the Armed Services, meals and lodging for the convenience of the employer, group legal services, commuting through van pools, dependent care assistance, and employee educational assistance. The statute governing van pooling expired in the mid-1980s. Many other miscellaneous fringe benefits had always been untaxed even without statutory provisions; the Tax Reform Act of 1984 formalized the exclusions of miscellaneous fringe benefits. Miscellaneous fringe benefits that meet one of the following criteria are untaxed: a no-additional-cost service, a qualified employee discount, a working-condition fringe, a de minimis fringe, a qualified transportation fringe, or a qualified moving expense reimbursement. Special rules were written for parking, eating, and on-site athletic facilities. The Tax Reform Act of 1986 allowed self-employed workers to deduct 25 percent of their health insurance premiums; this percentage rose to 100 by 2003.

Beginning in the 1970s, employers began providing fringe benefits in the form of cafeteria or flexible benefit plans whereby employees could choose from a menu of several compensation options, including cash and several fringe benefits. These fringe benefits were made nontaxable in 1978. A related approach is the flexible spending plan, or salary reduction arrangement, which allows employees to set aside pretax dollars to spend on certain expenses (mostly health and child care) not covered by existing benefit plans.

Most of the statutory fringe benefits receive tax preferences only if provided in a nondiscriminatory manner, dating back to 1942, when nondiscrimination rules governing pensions were instituted. Other important limits are the $50,000 limit on the amount of term life insurance that can be provided taxfree to employees, the various restrictions and funding rules for pension and stock plans initiated by the Employee Retirement Income Security Act of 1974, and nondiscrimination and qualification rules for health and life insurance plans.

Fringe benefits as a share of total compensation were quite low until the three decades after World War II, when there was a rapid expansion. This expansion was caused by an increase in the number of fringe benefits offered as well as increased employer contributions to the traditional benefit plans. Rapid growth of fringe benefits as a form of compensation stopped around 1980. Both coverage and generosity of fringe benefits plans, especially health insurance plans, have declined for the past couple of decades.

The tax advantage to employees of receiving fringe benefits depends on marginal tax rates. Because most fringe benefits are excluded from federal, state, and Social Security tax bases, the tax price of fringe benefits (that is, the amount of after-tax wages that would be given up for a dollar’s worth of fringe benefits) is considerably less than $1. Since 1980, the tax price has risen slightly as federal and state marginal tax rates have fallen. Because higher-income taxpayers generally have higher marginal tax rates, they receive a greater advantage.

In some cases, other tax subsidies can reduce the tax benefit of receiving fringe benefits. For example, the Health Insurance Portability and Accountability Act of 1996 created medical savings accounts for self-employed workers and workers at small firms; these individuals can set up tax-deferred savings plans, reducing the tax advantages of employer-provided pensions.

Efficiency effects

Not taxing fringe benefits gives rise to a consumption inefficiency because the goods provided as fringe benefits are made cheaper by the tax code. In this respect, health insurance has received the most attention. Many economists believe that the tax preference encourages more comprehensive health insurance to be provided and contributes to rising health care costs as consumers are shielded from the direct costs of their medical care.

The tax preferences given to pensions and other deferred compensation plans may affect national saving, although the effect is ambiguous because the tax preferences (other things being equal) lead to a larger government budget deficit. In addition, pensions may affect other forms of private saving (for example, someone who expects to receive a pension may feel less need to save for retirement).

Tax preferences for fringe benefits may also have important effects in labor markets. Tax preferences reduce the cost of labor differentially across firms and individuals because tax benefits increase with higher marginal tax rates. This effect may differ across workers, and some firms have cost advantages over others. Moreover, if employee preferences for fringes vary with skill levels, firms that use the skills of workers with a stronger preference for fringe benefits disproportionately may have lower costs than firms using other skill levels.

Because fringe benefits are tied to jobs, when compensation is paid in the form of fringes, labor mobility may be reduced, although this has good as well as bad effects. Some fringe benefits, notably pensions, can also affect the timing of retirement as well as quitting behavior.

The labor market effects of not taxing fringe benefits depend greatly on whether employees sort themselves into firms based on their differing demands for fringe benefits. Because the nondiscrimination rules that accompany the tax breaks given to fringe benefits mean that employers cannot tailor their fringe benefit offerings to each of their employees’ wishes, heterogeneous preferences for fringe benefits should lead to a sorting equilibrium where some firms offer generous fringe benefit packages and others offer few or no fringes. Some firms are also more likely to replace the part of their workforce that do not want fringes with independent contractors, leasing arrangements, and part-time workers in order to satisfy the nondiscrimination rules. If workers are not perfect substitutes for each other, this leads to production inefficiencies. Sorting also exacerbates the adverse selection problem accompanying some fringe benefits, such as health insurance, because less healthy workers tend to congregate in firms offering more generous health insurance packages.

The importance of the distortions caused by the tax preferences given to fringe benefits depends on three things: the incidence of the tax preferences, the extent of job sorting that takes place, and the size of the effect tax preferences have on the amount of fringe benefits offered. Investigation of all of these issues is hampered by data problems.

Economic theory strongly suggests that workers bear the incidence of fringe benefit costs, and thus the incidence of tax preferences as well. Many arguments made about fringe benefits, however, are clearly based on the presumption that employers bear the costs (and receive the tax benefits). Statistical evidence has been inconclusive, although more and more studies are finding significant trade-offs between wages and a variety of fringe benefits (consistent with employee incidence).

Empirical evidence regarding whether workers sort into jobs on the basis of fringe benefit offerings is meager. There seems to be support, though, for the hypothesis that some sorting occurs.

The relationship between tax incentives and the provision of fringe benefits has been the subject of many studies, although the data problems outlined earlier plague this research as well. There is evidence that tax subsidies have significant effects on firms’ decisions of whether to offer particular fringe benefits, especially health insurance. The tax subsidy seems to matter more for small firms than for large firms, for which

there are other compelling reasons (for example, risk pooling leading to lower insurance costs) for offering fringe benefits. Tax considerations can also explain differences across firms and across time in the extent to which employees pay part of the cost of health insurance plans. There is also agreement that the tax advantage from paying compensation through fringes rather than wages affects fringes’ share in total compensation. The magnitude of this effect, however, is uncertain. The results of some studies imply that full taxation of fringe benefits would cut by half or more the share of compensation paid as fringes. Other studies find smaller effects, with the fringe share of compensation falling by less than 15 percent if benefits are taxed fully.

Should fringe benefits be taxed?

Tax preferences are usually justified on the grounds of economic efficiency, equity (horizontal and vertical), or administrative efficiency.

Tax preferences for fringe benefits may improve economic efficiency if private markets lead to an underprovision of the fringes as a result of market failures. Indeed, there has been definite congressional intent to encourage the private provision of many goods typically provided as fringe benefits. Economists, however, seem more concerned with the distortions tax preferences cause than with the market failures they might correct.

Horizontal equity received much attention in the 1980s in the debate about taxing fringe benefits. A common argument was that tax subsidies for fringes are horizontally inequitable because two workers with identical total compensation will pay different amounts of tax if one receives more compensation as wages and the other more fringe benefits. But the disparity may be more apparent than real if workers choose their mix of wages and fringes by sorting themselves among employers who provide different ranges of fringe benefits.

The impact on vertical equity also depends on the incidence of the tax preferences. If employers can appropriate the benefits, few would argue that vertical equity is improved. If employees receive the benefits, the issue is whether well-off taxpayers or poorer taxpayers receive more benefits. Because the tax savings resulting from the tax preferences increase with marginal tax rates, taxing fringe benefits may improve vertical equity. Evidence also suggests that well-paid employees are more likely to receive a higher fringe share of compensation than low-paid workers, although there is evidence that moderate-income workers receive a higher fraction of their compensation as health insurance than do high-income workers. Some research suggests that younger workers respond more to changes in the tax advantages of pensions than do older workers and that tax subsidies are more important for blue-collar workers than for white-collar workers.

There is also evidence that low-income workers respond more to tax incentives than do high-income workers, so taxing fringe benefits could lead low-income workers to receive fewer fringes while high-income workers continue to receive them. This might have important social consequences if fringe benefits provide goods that society values and that the government would provide if private markets did not.

One reason fringe benefits have been excluded from the tax base is concern over the administrative complexity for the government, employers, and employees of including the value of fringe benefits in taxable income. Part of this complexity is simply the paperwork; another important element is uncertainty about the benefits’ proper valuation. While the employee’s willingness to pay for the fringe benefit is theoretically the best measure of value, employer cost is administratively easier (although it may be difficult for firms to allocate their total costs to individual workers properly).

Proposals to tax fringe benefits

Three reforms of the tax treatment of fringe benefits have been proposed: limits on the amount of benefits that can be received tax-free, tax credits for some percentage of the fringes’ value as a replacement for the tax exclusion of fringes, and employerbased taxes. All of these options would reduce the tax benefits from receiving compensation as fringes rather than wages.

Limits, or caps, on the amount of benefits that can be received tax-free would tend to improve efficiency and vertical equity by eliminating the tax benefits of fringes high-income taxpayers receive while retaining the tax benefits for middleand lower-income workers who receive less compensation in the form of fringes. Because of the way life insurance and pension benefits are valued, these limits would especially affect older workers. Also, because the costs of providing identical fringe benefits may differ substantially by region and industry, a single limit for all taxpayers may not be optimal. If limits are placed on specific benefits, other benefits would likely be substituted. To avoid this response, a limit on the overall amount of compensation provided as tax-free benefits is an attractive option. Replacing the exclusion of fringe benefits with a tax credit could also improve efficiency and vertical equity. The credit would work better for fringes currently excluded entirely from the tax base than for fringes such as pensions, whose tax benefits are based on deferring taxation.

Taxing employers instead of workers would be administratively less costly while still reducing the tax benefits of fringe benefits.


Many economists and tax experts think that some form of taxation of fringe benefits is desirable. They believe that both efficiency and equity would be improved. Potentially large amounts of revenue could be raised, which could finance new government spending, lower other taxes, or reduce the government budget deficit. Public opposition is strong, however, and there is no indication that any reform will be enacted soon.


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