Under the Medicare Modernization Act, employers will receive about $124 billion in tax-free subsidies to encourage them to continue prescription drug coverage for retirees. Because of a long history of taxpayer-funded health benefits “crowding out” employer-sponsored coverage, Congress wanted to reduce the incentive for employers to drop retirees into the new Medicare drug benefit (Medicare Part D).

The subsidy works out to roughly 28 percent of what Medicare would pay under the Part D benefit and is available as long as the employer can show that their retiree drug coverage is actuarially equivalent or better than the federal program. Per retiree, it’ll work out to $668 on average in 2006. According to a survey of large employers by Mercer Human Resource Consulting, about 60 percent of employers plan to take the subsidy.

While the subsidy payments are exempt from federal taxation, nothing stops a state from considering it as taxable income. Looks like some states are noodling about it. Nationwide, it could generate several billion dollars in new state tax revenue over the next ten years. And it might serve as modest form of policy revenge for the $100 billion clawback. However, it may encourage employers to cost shift retiree drug costs to federal taxpayers and retirees themselves…at least faster than they would otherwise.