As part of its ongoing review of the tax code, the federal government may eliminate Ottawa’s tax exemption for employer-provided health and dental plans. This exemption distorts economic decisions and adds complexity to our tax system, so its removal would be a positive move—but only if the government uses the extra revenue to reduce tax rates.

Currently, the federal government allows Canadians to exempt employer-provided health and dental benefits from their taxable income. As a result of this special tax privilege, the government foregoes approximately $2.9 billion in revenue.

There are several problems with this policy. For starters, it creates unfairness in the tax system by treating Canadians with employer-provided health and dental plans differently than those who buy their plans outside of their employer. Put differently, individuals who receive these benefits through their employer are paying for them with whole pre-tax dollars while individuals purchasing such benefits outside of work are paying for them with partial after-tax dollars, which can be as low as 50 cents on the dollar, making the benefits markedly more expensive.

In addition, the policy creates an incentive for employers to shift the form of compensation they pay employees to health, dental and related-care insurance instead of wages, which of course are taxed at normal rates.

For a clear example of how this policy can create economic distortions and unintended consequences, consider the experience of the United States, where most people receive their health insurance from their employer and like Canada these benefits are tax exempt.

This has caused a number of major problems. For instance, it has increased the number of employers providing health insurance and the amount of health coverage purchased. This, in turn, has artificially raised the demand for health care, contributing to runaway costs in the U.S.

Of course, this is a much bigger issue in the U.S. than in Canada because south of the border most people receive comprehensive health insurance through their employers. In Canada, employer health benefits are generally much smaller because they only cover dental and extended health care (pharmaceutical drugs, paramedical, vision care, etc.).

Despite these differences, the American experience provides an example of the problems created by differentiating the tax treatment of employer-based health insurance payments from other forms of compensation.

The problems with the tax exemption for employer-paid health and dental benefits are symptomatic of a larger problem with our tax system. A growing number of tax carve outs has artificially created winners by bestowing privileges on a select group of taxpayers (in this case, those with employer-provided health and dental plans).

Special tax preferences also increase the cost of complying with the tax system because claiming a tax benefit (credit, exemption, deduction) requires keeping records, ensuring eligibility, and perhaps hiring an accountant to ensure you’re not missing out on any tax benefits.

And with more special tax preferences, the government must maintain higher income tax rates to raise the same amount of revenue.

By eliminating a large number of ineffective tax preferences, the government could dramatically reduce personal income tax rates for all Canadians. Such a reform would result in a much simpler tax system that improves the incentive for Canadians to work, save, invest and be entrepreneurial—all things that help propel the economy forward.

The last fundamental reform to Canada’s personal income tax system took place in 1987, so the next round of reform is overdue. Eliminating tax exemptions such as the one for employer-provided health and dental benefits can be a part of this reform process, if the government uses the extra revenue to reduce tax rates instead of boosting its own revenues.