Order Code IB98037
CRS Issue Brief for Congress
Received through the CRS Web
Tax Benefits for Health Insurance:
Current Legislation
Updated January 11, 2001
Bob Lyke
Domestic Social Policy Division
Congressional Research Service ˜ The Library of Congress

---

CONTENTS
SUMMARY
MOST RECENT DEVELOPMENTS
BACKGROUND AND ANALYSIS
Tax Benefits in Current Law
Overview of Current Provisions
Employment-Based Plans
Medical Expense Deduction
Individual Private Market Policies
Self-Employed Deduction
Cafeteria Plans
Flexible Spending Accounts
Medical Savings Accounts
Military and Veterans Health Care
Medicare and Medicaid
Some Consequences of the Tax Benefits
Increases in coverage
Source of Coverage
Increase in Health Care Use and Cost
Equity
Current Proposals
Medical Savings Accounts
Self-Employed Deduction
Cafeteria Plans and Flexible Spending Accounts
Expanded Tax Deduction
Tax Credit
Employer Tax Credit
Appendix
LEGISLATION
FOR ADDITIONAL READING

---

IB98037
01-11-01
Tax Benefits for Health Insurance:
Current Legislation
SUMMARY
At the start of the 107th Congress, a
come. (5) With some exceptions, benefits
number of new or expanded tax benefits for
actually received from private or public insur-
health insurance are being discussed. Propo-
ance are not taxable.
nents generally argue that changes are needed
to extend coverage to the uninsured and to
By lowering the after-tax cost of insur-
address efficiency and equity problems; oppo-
ance, the tax benefits help extend coverage to
nents generally doubt that the changes under
more people; they also lead insured people to
consideration would make much difference.
obtain more coverage than otherwise. The
One overarching issue is whether new or
incentives influence the way in which coverage
expanded benefits would limit the reductions
is acquired: the uncapped exclusion for
in general tax rates that President-elect Bush
employer-paid insurance, which can benefit
and others seek.
nearly all workers and is easy to administer, is
partly responsible for the predominance of
Current law contains significant tax
employment-based insurance in the United
benefits for health insurance. (1) Most impor-
States. Employment-based insurance has both
tant is the exclusion of employer-paid health
advantages and disadvantages for the typical
insurance from the determination of income
worker.
taxes. (Employer-paid health insurance is also
excluded from employment taxes.) Nearly
The tax benefits also increase the demand
two-thirds of the noninstitutionalized popula-
for health care by enabling insured people to
tion under age 65 is insured through
obtain services at discounted prices. This is
employment-based insurance; on average,
one reason why prices for health care have
large employers pay about 80% of its cost,
risen more rapidly than the general rate of
though some pay all and others none. The
inflation. Moreover, since many people would
exclusion also applies to health insurance
likely obtain some insurance without the tax
provided through cafeteria plans. (2) Self-
benefits, they can be an inefficient use of
employed taxpayers may deduct 60% of their
public dollars. They also raise questions of
health insurance payments, a proportion
equity, largely because the tax savings they
scheduled to rise to 100% in 2003. (3) Tax-
generate depend upon the taxpayer’s marginal
payers who itemize deductions may deduct
tax rate. When viewed as a form of personal
insurance payments to the extent they and
consumption, giving tax incentives for health
other medical expenses exceed 7.5% of ad-
insurance provides more benefits to higher
justed gross income. While not widely used,
income families who may not need them.
this deduction benefits some with employment-
Comprehensive reforms (e.g., capping the
based insurance (for the employee share),
employer exclusion or replacing it with deduc-
some self-employed (the remaining 40% of
tions and credits) might address some of these
their cost) and others who purchase individual
concerns, though they could be difficult to
market policies. (4) Coverage under Medicare
implement and may cause serious inequities of
and Medicaid is not considered taxable in-
their own.
Congressional Research Service ˜ The Library of Congress

---

IB98037
01-11-01

MOST RECENT DEVELOPMENTS
The final tax legislation for the 106th Congress (the Community Renewal Tax Relief Act
of 2000, P.L. 106-554) included a two-year extension of eligibility for new medical savings
account (MSA) participants. The 106th Congress had considered a number of other tax
benefits for health insurance, including a new deduction not limited to itemizers and a new
tax credit, but none became law.
BACKGROUND AND ANALYSIS
Tax Benefits in Current Law
Current law provides significant tax benefits for health insurance. The tax
subsidies—for the most part federal income tax exclusions and deductions— are widely
available, though not everyone can take advantage of them. They reward some people more
than others, raising questions of equity. They influence the amount and type of coverage that
people obtain, which affects their ability to choose doctors and other providers. In addition,
the tax benefits affect the distribution and cost of health care.
Overview of Current Provisions
This section summarizes the current tax treatment of the principal ways that people
obtain health insurance. It describes general rules but does not discuss all limitations,
qualifications, and exceptions. To understand possible effects on tax liability, readers may
want to refer to the Appendix for an outline of the federal income tax formula. (For example,
exclusions are items that are omitted from gross income, while deductions are subtracted from
gross income in order to arrive at taxable income.) Section number references are to the
Internal Revenue Code of 1986 as amended.
The tax treatment of long-term care insurance is not discussed below. For information
on this topic, see CRS Report RL30254, Long-Term Care: The President’s FY2001 Budget
Proposals and Related Legislation, by Carol O’Shaughnessy, Bob Lyke, and Carolyn Merck.
Employment-Based Plans. Health insurance paid by employers generally is excluded
from employees’ gross income in determining their income tax liability; it also is not
considered for either the employee’s or the employer’s share of employment taxes (i.e., social
security, Medicare, and unemployment taxes). (Sections 106 and 3121, respectively) The
income and employment tax exclusions apply to both single and family coverage, which
includes the employee’s spouse and dependents. Premiums paid by employees generally are
not deductible, though they may be counted towards the itemized medical expense deduction
or subject to a premium conversion arrangement under a cafeteria plan (both of which are
discussed below).
Nearly two-thirds of the noninstitutionalized population under age 65 is insured under
an employment-based plan. On average, large employers pay about 80% of the cost for
employment-based insurance, though some pay all and others pay none. Employers typically
pay a smaller percentage for family than for single coverage.
CRS-1

---

IB98037
01-11-01
Insurance benefits paid from employment-based plans are excluded from gross income
if they are reimbursements for medical expenses or payments for permanent physical injuries.
Benefits not meeting these tests are taxable in proportion to the share of the insurance costs
paid by the employer that were excluded from gross income. (Sections 104 and 105)
Benefits are also taxable to the extent taxpayers received a tax benefit from claiming a
deduction for the expenses in a prior year (for example, if taxpayers claimed a medical
expense deduction for expenditures in 2000 and then received an insurance reimbursement
in 2001). In addition, benefits received by highly-compensated employees under
discriminatory self-insured plans are partly taxable. A self-insured plan is one in which the
employer assumes the risk for a health care plan and does not shift it to a third party.
Employers may deduct their insurance payments as a business expense. The deduction
is not a tax benefit but a calculation necessary for the proper measurement of the net income
that is subject to taxation. Revenue loss attributable to this deduction is not considered a tax
expenditure.
The Joint Committee on Taxation (JCT) estimated the FY2000 federal revenue loss
attributable to the exclusion for employer contributions for health insurance, medical care
(including that provided through cafeteria plans and flexible spending accounts, described
below) and long-term care insurance to be $58 billion. The estimate did not include the effect
of the exclusion on employment taxes.
Medical Expense Deduction. Taxpayers who itemize their deductions may deduct
unreimbursed medical expenses to the extent they exceed 7.5% of adjusted gross income
(AGI). (Section 213) Medical expenses include health insurance premiums paid by the
taxpayer, such as the employee’s share of premiums in employment-based plans, premiums
for individual private market policies, and part of the premiums paid by self-employed
taxpayers. More generally, medical expenses include amounts paid for the “diagnosis, cure,
mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure
or function of the body.” They also include certain transportation and lodging expenditures,
qualified long-term care service costs, and long-term care premiums that do not exceed
certain amounts. Currently, the deduction is intended to help only those with catastrophic
expenses.
The medical expense deduction is not widely used. For most taxpayers, the standard
deduction is larger than the sum of itemized deductions; moreover, most do not have
unreimbursed expenses that exceed the 7.5% AGI floor. In 1996, about 27% of all individual
income tax returns had itemized deductions, and of these only about 15% (i.e., about 4% of
all returns) claimed a medical expense deduction.
The JCT estimated the FY2000 revenue loss attributable to the medical expense
deduction (including long-term care expenses) to be $4.4 billion.
Individual Private Market Policies. Payments for private market health insurance
purchased by individuals are a deductible medical expense, provided the taxpayer itemizes
deductions and applies the 7.5% AGI floor as just described. Premiums for the following
insurance, however, are not deductible: policies for loss of life, limb, sight, etc.; policies that
pay guaranteed amounts each week for a stated number of weeks for hospitalization; and the
part of car insurance that provides medical coverage for all persons injured in or by the
CRS-2

---

IB98037
01-11-01
policyholder’s car. Benefits paid under accident and health insurance policies purchased by
individuals are excluded from gross income, even if they exceed medical expenses.
About 6% of the noninstitutionalized population under age 65 is insured through these
private policies. Likely purchasers include early retirees, young adults, employees without
access to employment-based insurance, and the self-employed.
Self-Employed Deduction. Self-employed taxpayers may deduct payments for health
insurance in determining their AGI. (Section 162) Their insurance typically is an individual
private market policy. The self-employed deduction, an “above-the-line” deduction, is not
restricted to itemizers, as is the medical expense deduction. Following enactment of the
Omnibus Consolidated and Emergency Supplemental Appropriations Act for Fiscal Year
1999 (P.L. 105-277), the deduction is 60% of insurance payments in 1999 through 2001,
70% in 2002, and 100% in 2003 and thereafter. So limited, the deduction cannot exceed the
net profit and any other earned income from the business under which the plan is established,
less deductions taken for certain retirement plans and for one-half the self-employment tax.
It is not available for any month in which the taxpayer or the taxpayer’s spouse is eligible to
participate in a subsidized employment-based health plan (that is, one in which the employer
pays part of the cost). These restrictions prevent taxpayers with little net income from their
business (which may not be uncommon in a new business, for example, or in a part-time
business that grows out of a hobby) from deducting much if any of their insurance payments.
However, the portion not deductible under these rules may be treated as an itemized medical
expense deduction.
Self employed individuals include sole proprietors (single owners of unincorporated
businesses), general partners, limited partners who receive guaranteed payments, and
individuals who receive wages from S-corporations in which they are more than 2%
shareholders. (S-corporation status may be elected by corporations that meet a number of
Internal Revenue Code requirements. Among other things, they cannot have more than 75
shareholders or more than one class of stock. S-corporations are tax-reporting rather than
tax-paying entities, in contrast to C-corporations that are subject to the corporate income
tax.)
In 1995, about 3 million tax returns (about 2.5% of all returns) claimed the self-
employed health insurance deduction. For FY2000, the JCT estimated the revenue loss
attributable to the deduction (including the deduction for long-term care insurance) to be $1.2
billion.
Cafeteria Plans. Health benefits provided through a cafeteria plan are excludable for
both income and employment tax purposes. A cafeteria plan is a written benefit plan under
which employees may choose between receiving cash and certain nontaxable benefits such as
health coverage or dependent care. (Cash here includes any taxable benefits.) Under an
option known as a premium conversion plan, employees may elect to reduce their taxable
wages in exchange for having their share of health insurance premiums paid on a pre-tax
basis; the effect is the same as if employees could claim an above-the line deduction for their
payments. Starting in October, 2000, federal executive branch employees who participate in
the Federal Employees Health Benefits Program (FEHBP) could elect this option. Some
legislative and judicial branch entities also have adopted it.
CRS-3

---

IB98037
01-11-01
Nontaxable benefits provided through cafeteria plans are exempt from income and
employment taxes under the Internal Revenue Code rules applicable to those benefits, such
as employer-paid insurance. A separate statutory provision (Section 125) extends these
exclusions to situations in which employees are given the option of receiving cash; were it not
for this provision, the nontaxable benefit would be taxable since the employees had been in
constructive receipt of the cash.
Flexible Spending Accounts. Benefits paid from flexible spending accounts (FSAs) are
also excludable for income and employment tax purposes. FSAs and cafeteria plans are
closely related, but not all cafeteria plans have FSAs and not all FSAs are part of cafeteria
plans. FSAs funded through salary reductions are exempt from taxation through cafeteria
plan provisions (since otherwise employees would be in constructive receipt of cash) while
FSAs funded by nonelective employer contributions are exempt directly under provisions
applying to employer-paid insurance. For additional information on FSAs, see CRS Report
96-500, Flexible Spending Accounts and Medical Savings Accounts: A Comparison, by Bob
Lyke.
Health care FSAs must exhibit some of the risk-shifting and risk-distribution
characteristics of insurance. Among other things, participants must elect a specific benefit
amount prior to the start of a plan year; this election cannot be revoked except for changes
in family status. The full benefit amount (less any benefits paid) must be made available
throughout the entire year, even if employees spread their contributions throughout the year.
Any amount unused at the end of the year must be forfeited to the employer (thus, “use it or
lose it”). FSAs cannot be used to purchase insurance; however, they can be combined with
premium conversion plans under cafeteria arrangements to achieve the same tax effect.
In 1997, about 40% of full-time employees in medium and large size private firms could
have a health care FSA. Actual participation likely was far less.
Medical Savings Accounts. Medical savings accounts (MSAs) are personal savings
accounts for unreimbursed medical expenses. They are used to pay for health care not
covered by insurance, including deductibles and copayments. Currently, a limited number of
MSAs may be established by individuals who have qualifying high deductible insurance (and
none other, with some exceptions) and who either are self-employed or are employees
covered by a high deductible insurance plan established by their small employer (50 or fewer
employees on average).
Employer contributions to MSAs are excludable for both income and employment tax
purposes, while individuals’ contributions (allowed only if the employer does not contribute)
are deductible for determining AGI. Contributions are limited to 65% of the insurance
deductible for single coverage and 75% for family coverage. Account earnings are excludable
as well, as are distributions used for unreimbursed medical expenses, with some exceptions.
Non-qualified distributions are included in gross income and an additional 15% penalty is
applied. For further information, see CRS Report 96-500, Flexible Spending Accounts and
Medical Savings Accounts: A Comparison, by Bob Lyke..
Tax-advantaged MSAs, which first could be established in 1997, are not yet widespread.
The Internal Revenue Service (IRS) has determined that 42,477 MSA returns were filed for
1998 and that 44,784 are likely to be filed for 1999. For additional information, see General
CRS-4

---

IB98037
01-11-01
Accounting Office report HEHS-99-34, Medical Savings Accounts: Results from Surveys
of Insurers.
MSAs should be distinguished from Medicare+Choice MSAs, which are discussed below
under the tax treatment of Medicare and Medicaid.
Military and Veterans Health Care. Coverage under military and veterans health care
programs is not taxable income, nor are the benefits these programs provide. The tax
exclusion (Section 134) applies as well to the Civilian Health and Medical Program of the
Uniformed Services (CHAMPUS) and Tricare, which serve military dependents, retirees, and
retiree dependents. In 1996, about 2.2% of the noninstitutionalized population under age 65
had military or veterans health care as their primary form of coverage. The FY1999 revenue
loss attributable to CHAMPUS and Tricare was $1.5 billion. For more information, see CRS
Issue Brief IB93103, Military Medical Care Services: Questions and Answers, by Richard
A. Best.
Medicare and Medicaid. Coverage under Medicare or Medicaid is not taxable income.
Similarly, benefits paid from either program are not subject to taxation. Medicare covers over
38 million people, including 96% of those ages 65 and older. Medicaid covers over 41 million
people. The JCT estimated the revenue loss attributable to the exclusion of Medicare
benefits to be $24.9 billion in FY2000. Medicaid beneficiaries, who must meet certain
categorical requirements (aged, blind, or disabled, or specified members of families with
dependent children) are generally poor and unlikely to have tax liability.
The employment tax individuals pay for Medicare Part A is not a deductible medical
expense. However, premiums paid by individuals who voluntarily enroll in Part A are
deductible, provided the taxpayer itemizes deductions and applies the 7.5 % AGI floor as
described above. (Medicare Part A is insurance for hospitalization, skilled nursing facilities,
home health and hospice care. Individuals age 65 and older may voluntarily enroll in Part A
if they or their spouse do not have at least 10 years of Medicare-covered employment.)
Medicare Part B premiums are also deductible subject to those same limitations, as are
premiums for Medigap insurance. (Medicare Part B is supplementary insurance for doctors’
fees and outpatient services. Medigap insurance is private insurance that covers Medicare
deductibles, co-payments, and benefits not covered under Medicare.)
Beginning in 1999, legislation allowed a limited number of Medicare beneficiaries to
elect Medicare+Choice medical savings accounts instead of traditional Medicare.
Contributions to these accounts (made only by the Secretary of Health and Human Services)
are exempt from taxes, as are account earnings. Withdrawals are likewise not taxed nor
subject to penalties if used to pay unreimbursed medical expenses, with some exceptions. No
Medicare+Choice MSA plans have ever been offered.
Some Consequences of the Tax Benefits
Increases in coverage. By lowering the after-tax cost of insurance, the tax benefits
described above help extend coverage to more people. This of course is the intention:
Congress has long been concerned about whether people have access to health care. The
public subsidy implicit in the incentives (foregone tax revenues) usually is justified on grounds
that people would otherwise under-insure, that is, delay purchasing coverage in the hope that
CRS-5

---

IB98037
01-11-01
they will not become ill or have an accident. Uninsured people are an indication of market
failure; they impose spill-over costs on society in the form of public health risks and
uncompensated charity care (the free-rider problem). Moreover, if insurance were purchased
only by people who most need health care, its cost would become prohibitive for others (the
adverse selection problem).
However, the tax benefits also lead insured people to obtain more coverage than they
would otherwise choose. They purchase insurance that covers more than hospitalization and
other catastrophic expenses, such as routine doctor visits, prescription drugs, and dental care.
They obtain coverage with smaller deductibles and copayments. On the other hand,
comprehensive coverage and lower cost-sharing are thought to lead to better preventive care
and possibly long-run savings for certain medical conditions.
Source of Coverage. Tax benefits influence the way in which insurance coverage is
acquired. The uncapped exclusion for employer-paid insurance, for example, which can
benefit nearly all workers and is easy to administer, is partly responsible for the predominance
of employment-based insurance in the United States. In contrast, restrictions on the itemized
deduction allowed for individual private market insurance may be one reason why that
insurance covers only 6% of the population under age 65.
Employment-based insurance carries both advantages and disadvantages for the typical
worker. Generally costs are lower, and usually individual premiums do not vary by age or
risk. (Thus, young and healthy workers may pay more than their actuarial risk would cost,
though they are protected as they get older or need additional health care.) However, plans
chosen by employers may not meet individual workers’ needs (particularly if there are limited
options), and changing jobs may require both new insurance and doctors.
Increase in Health Care Use and Cost. The tax benefits increase the demand for
health care by enabling insured people to obtain services at discounted prices. This induced
demand can be beneficial to the extent it reflects needed health care (that which society deems
everyone should have) that financial constraints otherwise would have prevented. It can be
wasteful to the extent it results in less essential or ineffective care. In either case, many
economists argue, the additional demand is one reason why prices for health care have risen
more rapidly than the general rate of inflation.
Whether insurance coverage could be encouraged without increasing the cost of health
care has been a matter of debate. Comprehensive reforms that might accomplish this goal
include capping the exclusion for employer-paid insurance and replacing both the exclusion
and the deduction with a limited tax credit. But these changes could be difficult to implement
and may create serious inequities. A 1994 Congressional Budget Office study, The Tax
Treatment of Employment-Based Health Insurance, provides an overview of the issues and
questions these approaches raise.
Many people probably would obtain some health insurance even without the tax benefits.
The cost of subsidizing people for what they would otherwise do is an inefficient use of public
dollars. Ideally, the tax incentives should lead to insurance being purchased only to the extent
it results in better health care for society as a whole. But how they could be revised to
accomplish this goal is a difficult question given the different ways insurance is provided, the
various ways it is regulated, and the voluntary nature of decisions to purchase it.
CRS-6

---

IB98037
01-11-01
Equity. Questions might be raised about the distribution of the tax incentives. Since
as a practical matter they are not available to everyone, problems of horizontal equity arise.
Workers without employment-based insurance generally cannot benefit from them, nor can
many early retirees (people under the age of 65). Even if these individuals itemized their
deductions, they can deduct health insurance premiums only to the extent that they (and other
health care expenditures) exceed 7.5% of AGI. In contrast, the exclusion for employer-paid
insurance is unlimited.
Even if everyone could benefit from the tax incentives, there would be questions of
vertical equity. Tax savings from the exclusions and deductions described above generally are
determined by taxpayers’ marginal tax rate. Thus, taxpayers in the 15% tax bracket would
save $600 in income taxes from a $4,000 exclusion (i.e., $4,000 x 0.15) for an employer-paid
premium, while taxpayers in the 36% bracket would save $1,440 (i.e., $4,000 x 0.36). If
health insurance is considered a form of personal consumption (such as food or clothing), this
pattern of benefits would strike many people as unfair. It is unlikely that a government grant
program would be designed in this manner. However, to the extent that health insurance is
considered a way of spreading an individual’s catastrophic economic risk over multiple years,
basing tax savings on marginal tax rates might be justified.
For additional information on the economics of health insurance, see CRS Report
RL30762, Tax Subsidies for Health Insurance for the Uninsured: An Economic Analysis of
Selected Policy Issues for Congress, by Gary Guenther.
Current Proposals
At the beginning of the 107th Congress, a number of new or expanded tax benefits for
health insurance are being discussed: broadened eligibility for medical savings accounts, an
immediate 100% deduction for health insurance by the self-employed, allowing carryovers
and rollovers in flexible spending accounts, and authoring an expanded (above-the-line) tax
deduction or tax credit for the purchase of insurance. Proponents generally argue that these
changes are needed to extend coverage to the uninsured and to address efficiency and equity
problems, while opponents generally argue that tax benefits are unlikely to make much
difference for people who do not now purchase insurance.
An overarching issue is whether Congress should approve targeted tax benefits for health
insurance (as well as education, child care, and so on) instead of larger reductions in general
tax rates. While some targeted tax benefits would result in relatively little revenue loss,
others, such as a refundable tax credit for health insurance, might involve significant costs
(depending on specifications), as might collectively a number of benefits. For further
discussion of these issues, see CRS Issue Brief IB10068, Major Tax Issues in the 107th
Congress, by David L. Brumbaugh.
In a typical Congress, well more than 100 bills are introduced regarding tax benefits for
health insurance. This issue brief does not attempt to identify let alone discuss all of them;
rather, its focus is on bills that have been (or are likely to be) reported from committee or
considered on the House and Senate floor. For summaries of these measures, see the
Legislation section, below. However, a number of representative measures are identified in
the discussion that follows.
CRS-7

---

IB98037
01-11-01
Congressional offices can construct comprehensive lists of bills on particular proposals
by using the Legislative Information System (LIS) available through the CRS home page.
Under the Legislation heading, click on the LIS and then on Bill Text: Adv. In the
Word/Phrase box, type either a term like “medical savings accounts” or a combination of
words and connectors like “credit adj/5 health” or “deduction adj/5 health” and then click on
Search. Depending on the terms and connectors used, search results may yield some
irrelevant bills without identifying all relevant ones; thus, the lists should be reviewed
carefully. For technical assistance with searches, congressional staff might call the La Follette
Congressional Reading Room at 7-7100.
Medical Savings Accounts
The original medical savings account legislation (the Health Insurance Portability and
Accountability Act of 1996 (P.L. 104-191), authorized a limited number of MSAs under a
demonstration beginning in 1997. Eligibility was to be restricted after the earlier of (1)
December 31, 2000, or (2) specified dates in the years 1997-1999 following a determination
that the number of taxpayers with accounts exceeded certain thresholds. Once eligibility was
restricted under these tests, MSAs generally would have been limited to individuals who
either were active participants (had contributions to their accounts) prior to the cut-off date
or become active participants through a participating employer. The final tax legislation for
the 106th Congress (the Community Renewal Tax Relief Act of 2000, P.L. 106-554) included
a two-year extension of eligibility for new participants, i.e., until December 31, 2002
The IRS projected that fewer than 55,000 MSAs had been established by June 30, 1999,
far lower than the 750,000 threshold that applied that year. (The IRS has not released more
recent estimates. It should be noted that MSAs are not counted towards the threshold if the
owners were previously uninsured; thus, not all of the 55,000 were considered in determining
whether 1999 was a cut-off year.) The slow growth of MSAs can be attributed to many
factors, including consumer unfamiliarity and the reluctance of insurance agents to sell lower-
priced policies, but the statutory restrictions undoubtedly are playing some role. Thus,
proponents are urging Congress to expand eligibility for MSAs and modify restrictions on the
required high deductible insurance. In their view, MSAs ought to be encouraged since they
can make insurance more affordable, allow a wider choice among doctors, and protect patient
rights better than government regulation. Critics generally oppose expansion, arguing that
MSAs will result in adverse selection among health plans, underutilization of preventive care,
and unwarranted tax breaks for high income families. (For early analysis of these and other
questions, see CRS Report 96-409, Medical Savings Accounts: Background Issues, by Bob
Lyke.) The Clinton administration opposed expanding MSA eligibility.
In the 106th Congress, both the House-passed and Senate-passed patient protection bills
(H.R. 2990 and S. 1344, no conference agreement) would have expanded eligibility for
MSAs. Their provisions, which might serve as models for new legislation, would have:

! removed current law provisions restricting MSAs to employees of small
employers and self-employed individuals, making them generally available to
individuals with qualifying high deductible health plans;
! eliminated numerical limits on the number of taxpayers with MSAs;
! allowed contributions up to the amount of the insurance deductible (thus
deleting the 65% and 75% ceilings); and
CRS-8

---

IB98037
01-11-01
! lowered minimum insurance deductibles (prior to applying the cost-of-living
adjustment) from $1,500 to $1,000 for single coverage and $3,000 to $2,000
for family coverage.
In addition, the House bill would have allowed MSAs to be offered under cafeteria plans and
permited contributions to be made by both employers and employees. The Senate bill would
have allowed rollovers to MSAs from cafeteria plans and flexible spending accounts, preempt
state laws prohibiting health issues from offering high deductible plans, and modify the penalty
for nonqualified distributions. The Senate bill also would have authorized a high deductible
insurance/MSA plan for the Federal Employees Health Benefits Program (FEHBP).
Self-Employed Deduction
The Omnibus Consolidated and Emergency Supplemental Appropriations Act for Fiscal
Year 1999 (P.L. 105-277) accelerated the schedule for full deductibility of health insurance
costs by the self-employed. Limited to 45% of the amount paid in 1998, the deduction is
limited to 60% in 1999 through 2001, 70% in 2002, and 100% in 2003 and thereafter.
Numerous 106th Congress bills would have allowed a 100% deduction starting in 2000
or 2001 (depending on when the bill was introduced), but none became law.
The principal argument for increasing the deduction is equity. People who have
employment-based insurance—nearly two-thirds of those under age 65—may exclude from
their gross income the amount of insurance paid by the employer. The exclusion, which is
uncapped, also applies to employment taxes. (In contrast, self-employed taxpayers may not
deduct their health insurance expenditures in calculating their self-employment tax.)
Equitable treatment between corporate owners and owners of unincorporated businesses
would remove an incentive to choose the form of business organization merely for tax
reasons. Since Congress has already decided to allow the full deduction, advancing the date
it becomes available may raise only budget, not policy issues.
Nonetheless, questions might still be raised about whether a 100% deduction would be
equitable. As mentioned above, large employers on average pay about 80% of the cost of the
insurance they offer, leaving employees to pay the other 20% with after-tax dollars. Perhaps
capping the deduction at 80% would be the equivalent, though this would not offset the
employment tax exclusion. Moreover, self-employed taxpayers are owners; for the most part,
they can choose whatever insurance they want, even expensive coverage. A full deduction
might not lead them to be as cost-conscious as corporate owners. Finally, it is debatable
whether accelerating the deduction would make it more likely that the employees of self-
employed owners will be provided health insurance. Some argue that the deduction should
not be increased unless it is coupled with a nondiscrimination requirement. The original
authorization for the deduction in 1986 had such a requirement, but it was repealed in 1989,
leaving the owners with tax advantages their employees do not have.
Cafeteria Plans and Flexible Spending Accounts
Some 106th Congress legislation (such as the Senate-passed patient protection
legislation, S. 1344), would have allowed up to $500 in unused balances in cafeteria plans and
flexible spending accounts (FSAs) to be carried over to the following year without being
CRS-9

---

IB98037
01-11-01
taxed. In the case of health care and dependent care FSAs, unused balances could also be
distributed to participants (in which case they would be taxed) or rolled over into certain
qualified deferred compensation plans (section 401(k), 403(b), and 457 plans) or a medical
savings account (MSA). None of this legislation became law.
The principal argument for allowing these options is that taxpayers might be more willing
to participate in cafeteria plans and FSAs if unused balances at the end of the year were not
lost. Under current law, unused balances must be forfeited. Allowing carryovers or rollovers
might also discourage participants from spending remaining balances carelessly, just to use
them up. Cafeteria plans and FSAs generally do not restrict patients’ choice of doctors; thus,
some might favor them as a way around limitations of managed care.
However, the options might result in tax breaks that are unwarranted, particularly for
higher income families. Some participants might increase their FSA contributions just to take
advantage of them. The health care FSA carryover could become another form of MSA,
though limited in size and without account earnings that accrue to the employee.
Expanded Tax Deduction
A number of 106th Congress bills would have allowed an above-the-line deduction (not
limited to itemizers) for health insurance. Generally, the deduction would have been limited
during a phase-in period and would not apply to months in which the taxpayer participates
in a health plan maintained by employer if 50% or more of cost is paid or incurred by
employer, or if taxpayer is enrolled in certain public programs. Among the more prominent
bills with this provision were H.R. 2488, the Taxpayer Refund and Relief Act of 1999 (the
omnibus tax bill that President Clinton vetoed on September 23, 1999) and the House-passed
patient protection legislation (H.R. 2990). An expanded deduction did not become law.
An expanded tax deduction would improve horizontal equity since more taxpayers could
receive tax benefits similar to those associated with employer-paid coverage. (An above-the-
line deduction has the same income tax effect as the exclusion allowed that coverage.) As
discussed above, the deduction allowed under current law is restricted to taxpayers who
itemize and is further limited to insurance and medical costs that exceed 7.5% adjusted gross
income; thus, most taxpayers cannot benefit from it.
At the same time, an expanded deduction would not improve vertical equity since the
tax benefits generally would be proportional to the taxpayer’s marginal tax rate. A $2,000
premium would result in tax savings of $720 for someone in the 36% bracket (i.e., $2,000 x
0.36) but only $300 for someone in the 15% bracket (i.e., $2,000 x 0.15). It might also be
doubted whether tax savings of 15% would enable more lower income taxpayers to obtain
insurance.
H.R. 2488 also would have allowed a new above-the-line deduction for prescription drug
insurance coverage for Medicare beneficiaries (effective in 2003) if certain Medicare
structural changes occur and low-income assistance is available. How to provide Medicare
beneficiaries with a prescription drug benefit is an issue in the 107th Congress.
CRS-10

---

IB98037
01-11-01
Tax Credit
Numerous bills for a generally available health insurance tax credit were introduced in
the 106th Congress, but none was reported from committee or considered on the House or
Senate floor. The principal objective of most bills was to extend coverage to people without
insurance; other goals included improving tax equity and giving employees more health plan
options.
A tax credit could be attractive in several respects. If it were generally available, a credit
could aid taxpayers who do not have access to employment-based insurance (or who are
dissatisfied with it) and who cannot claim the medical expense deduction. A credit could
provide all taxpayers with the same dollar reduction in final tax liability; this would avoid
problems of vertical equity associated with the tax exclusion and tax deduction. A credit
might also provide lower income taxpayers with greater tax savings than either the exclusion
or the deduction; this might reduce the number of the uninsured. If the credit were
refundable, it could even help taxpayers with limited or no tax liability.
But the effects of tax credits can vary widely, depending on how they are designed. One
important question is whether the credit would supplement or replace existing tax benefits,
particularly the exclusion for employer-paid insurance. Another is whether the credit would
be the same for all taxpayers or more generous for those with lower incomes. Ensuring that
lower income families benefit from any credit may be difficult if they cannot afford to
purchase insurance beforehand. Similarly, it might be asked whether the credit would vary
with factors that affect the cost of health insurance, such as age, gender, place of residence,
or health status. Whether the insurance must meet certain standards for benefits, coinsurance,
and underwriting might also be a factor. For additional analysis, see CRS Report RL30762,
Tax Subsidies for Health Insurance for the Uninsured: An Economic Analysis of Selected
Policy Issues for Congress, by Gary Guenther.
Some tax credit bills were for more limited purposes, such as helping military retirees
and certain senior citizens pay Medicare Part B premiums or helping Medicare beneficiaries
pay for supplemental prescription drug coverage. President Clinton proposed a 25% credit
in his last budgets for older individuals who buy into Medicare before age 65 (once that were
authorized) or who pay COBRA continuation coverage premiums.
Employer Tax Credit
No employer tax credit legislation was enacted in the 106th Congress. In his last
budgets, President Clinton proposed a 20% credit for small businesses that begin offering
health insurance to their workers. The 1999 Senate omnibus tax bill (H.R. 2488, originally
S. 1429) included a tax credit for small employers (9 or fewer employees, on average) for
health insurance paid for certain lower income employees (individuals whose annual wages
exceed $5,000 but not $16,000). The credit would equal 60% of the cost of individual
coverage up to $1,000 and 70% of the cost of family coverage up to $1,715.
CRS-11

---

IB98037
01-11-01
Appendix
The Federal Income Tax Formula
Listed below is the general formula for calculating federal income taxes. The list omits
some steps, such as prepayments (from withholding and estimated payments) and the
alternative minimum tax.
1.
Gross income
2.
minus Deductions (or adjustments) for AGI (i.e., “above the line”)
3.
= Adjusted gross income (AGI)
4.
minus Greater of standard or itemized deductions
5.
minus Personal and dependency exemptions
6.
= Taxable income
7.
times Tax rate
8.
= Tax on taxable income (“regular tax liability”)
9.
minus Credits
10. = Final tax liability
LEGISLATION
This section will include bills that have been (or are likely to be ) reported by committee
or considered on the House or Senate floor. Congressional offices may obtain summaries of
other bills and track their status by using the Legislative Information System (LIS) available
through the CRS home page. Under the Legislation heading, click on “Bill Summary and
Status for 107th Congress,” search by bill number, and then click on either “CRS Summary”
or “Bill Status.” Some bills (particularly Senate bills) are also summarized in the
Congressional Record when they are introduced. For guidance on searching for legislation
addressing tax benefits for health insurance, see the introduction to Current Proposals, above.
FOR ADDITIONAL READING
Cunningham. Laura E. National Health Insurance and the Medical Deduction. Tax Law
Review. V. 50 (1995), p. 237-264.
Gruber, Jonathan and Larry Levitt. Tax Subsidies for Health Insurance: Costs and Benefits.
Health Affairs. V. 19 (2000), p. 72-85.
Gruber, Jonathan and James Poterba. Tax Incentives and the Decision to Purchase Health
Insurance: Evidence from the Self-Employed. The Quarterly Journal of Economics.
V. 109 (1994), p. 701-733.
Kaplow, Louis. The Income Tax as Insurance: The Casualty Loss and Medical Expense
Deductions and the Exclusion of Medical Insurance Premiums. California Law Review,
v. 79 (1991), p. 1485-1510.
Kahn, Charles N. and Ronald F. Pollack. Building a Consensus for Expanding Health
Coverage. Health Affairs. V. 20 (January/February 2001), p. 40-48.
CRS-12

---

IB98037
01-11-01
Pauly, Mark. Taxation, Health Insurance, and Market Failure in the Medical Economy.
Journal of Economic Literature. V. 24 (1986), p. 629-675.
Pauly, Mark and Bradley Herring. Expanding Coverage via Tax Credits: Trade-Offs and
Outcomes. Health Affairs. V. 20 (January/February, 2001), p. 9-26.
Sheils, John and Paul Hogan. Cost of Tax-Exempt Health Benefits in 1998. Health Affairs.
V. 18 (1999), p. 176-181.
U.S. Congress. Congressional Budget Office. The Tax Treatment of Employment-Based
Health Insurance. Washington, March, 1994.
U.S. Congress. House. Committee on Ways and Means. Subcommittee on Health. Health
Insurance Premium Tax Deductions for the Self-Employed. Hearings, 104th Congress,
1st session. January 27, 1995. Washington, U.S. Govt. Print. Off., 1996.
U.S. General Accounting Office. Medical Savings Accounts: Results from Surveys of
Insurers GAO/HEHS-99-34. Washington, December, 1998.
CRS-13

---