Order Code IB98037
CRS Issue Brief for Congress
Received through the CRS Web
Tax Benefits for Health Insurance:
Current Legislation
Updated September 24, 2004
Bob Lyke
Domestic Social Policy Division
Congressional Research Service ˜ The Library of Congress

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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
Health Savings Accounts
Health Coverage Tax Credit
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
Health Coverage Tax Credit
Savings Accounts for Health Care Expenses
Flexible Spending Accounts
Expanded Tax Deduction
Expanded Tax Credit
Small Employer Tax Credit
FOR ADDITIONAL READING
Appendix

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Tax Benefits for Health Insurance: Current Legislation
SUMMARY
Various proposals are before Congress
receiving a pension paid by the Pension Bene-
for new or expanded tax benefits for health
fit Guarantee Corporation can receive an
insurance. President Bush has proposed that
advanceable, refundable tax credit (the health
individuals who make contributions to the
coverage tax credit, HCTC) to purchase cer-
newly-authorized health savings accounts
tain types of insurance. (5) Coverage under
(HSAs) be allowed to deduct the cost of their
Medicare and Medicaid is not considered
health insurance; in addition, the government
taxable income. (6) With some exceptions,
would make account contributions for lower-
benefits received from private or public insur-
income taxpayers. He has also proposed a
ance are not taxable.
refundable tax credit to help lower income
families purchase insurance. Proponents of
By lowering the after-tax cost of insur-
these and other measures generally argue that
ance, these tax benefits help extend coverage
new tax benefits are needed to reduce the
to more people; they also lead insured people
number of uninsured and to address efficiency
to obtain more coverage than otherwise. The
and equity problems; opponents claim they
incentives influence how coverage is acquired:
would primarily benefit higher income taxpay-
the uncapped exclusion for employer-paid
ers (in the case of the deduction) and do little
insurance, which can benefit nearly all work-
for most without coverage. Some opponents
ers and is easy to administer, is partly respon-
argue that expanding government programs
sible for the predominance of employment-
(such as Medicaid) would be preferable.
based insurance in the United States.
Employment-based insurance has both advan-
Current law contains significant tax
tages and disadvantages for the typical
benefits for health insurance. (1) Most im-
worker. The tax benefits also increase the
portant is the exclusion of employer-paid
demand for health care by enabling insured
coverage from the determination of income
people to obtain services at discounted prices.
and employment taxes. Two-thirds of the
This is one reason health care prices have
noninstitutionalized population under age 65
risen more rapidly than general inflation.
are insured through employment-based plans;
Moreover, since many people would likely
on average, large employers pay about 80% of
obtain some insurance without the tax bene-
its cost, though some pay all and others none.
fits, they can be an inefficient use of public
The exclusion also applies to health insurance
dollars. They also raise questions of equity,
provided through cafeteria plans. (2) Self-
largely because the tax savings they generate
employed taxpayers may deduct 100% of their
depend upon the taxpayer’s marginal tax rate.
health insurance, even if they do not itemize
When viewed as a form of personal consump-
deductions. (3) Taxpayers who do itemize
tion, giving tax incentives for health insurance
may deduct insurance payments to the extent
provides more benefits to higher income
they and other unreimbursed medical expenses
families who may not need them. Compre-
exceed 7.5% of adjusted gross income. While
hensive reforms (e.g., capping the employer
not widely used, this deduction benefits some
exclusion or replacing it with deductions and
who purchase individual market policies and
credits) might address these concerns, though
others who pay for employment-based insur-
they could be difficult to implement and may
ance with after-tax dollars. (4) Some workers
cause inequities of their own.
eligible for Trade Adjustment Assistance or
Congressional Research Service ˜ The Library of Congress

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MOST RECENT DEVELOPMENTS
On May 4, 2004, during a debate on S. 1637 (legislation dealing with export taxation
and other matters), the Senate rejected an attempt to expand the health coverage tax credit
(HCTC) that currently applies to individuals who have lost manufacturing jobs due to
increased foreign imports or shifts in production outside the United States. Among other
things, the proposed amendment would have extended eligibility to individuals who had
service sector jobs and increased the credit rate from 65% to 75%.
On May 12, 2004, the House approved an amended version of H.R. 4279
(Representative McCreary) which among other things would allow taxpayers to carryover
up to $500 in unused flexible spending account balances or to roll them over into their health
savings account. (Under current law, unused flexible spending account balances are forfeited
at the end of the year. Health savings accounts are new tax-advantaged accounts for
unreimbursed medical expenditures; they were authorized by the Medicare prescription drug
legislation, P.L. 108-173.)
On September 15 and 21, 2004, the House rejected two proposed amendments to the
FY2005 Transportation, Treasury, and Independent Agencies Appropriations bill that would
have blocked (in the case of the Moran amendment) or restricted use of (in the case of the
Norton amendment) health savings accounts in the Federal Employees Health Benefits
Program (FEHBP).
On September 23, 2004, the House and Senate both passed the Working Families Tax
Relief Act of 2004 (H.R. 1308), which among others things includes a two-year extension
(through December 31, 2005) of the deadline for establishing new medical savings accounts.
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.
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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).
Over 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.
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 2002 and then received an insurance reimbursement
in 2003). 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) estimates the FY2003 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 will be $75.1 billion. The estimate does not include the
effect of the exclusion on employment taxes.
Medical Expense Deduction. Taxpayers who itemize their deductions may deduct
unreimbursed medical expenses, but only the amount of such expenses that exceeds 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.
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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 1998, about 31% of all individual
income tax returns had itemized deductions, and of these only about 15% (i.e., about 4.5%
of all returns) claimed a medical expense deduction.
The JCT estimates the FY2003 revenue loss attributable to the medical expense
deduction (including long-term care expenses) will be $6 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 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
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 was 60% of insurance payments in 1999
through 2001, 70% in 2002, and 100% in 2003 and thereafter. 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. For additional information, see CRS
Report 98-515, Tax Treatment of Health Insurance Expenditures by the Self-Employed:
Current Law and Selected Economic Effects, by Gary Guenther.
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.)
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In 1998, about 3.4 million tax returns (about 2.7% of all returns) claimed the self-
employed health insurance deduction. For FY2003, the JCT estimates the revenue loss
attributable to the deduction (including the deduction for long-term care insurance) to be $2.4
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. Federal employees who participate in the Federal Employees Health Benefits
Program (FEHBP) have been able to elect this option since October, 2000; however, the
option is not available to federal retirees.
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 and Chris L. Peterson.
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 1999, about 22% of private-sector firms could have a health care FSA, but actual
participation 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
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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). The formal name of MSAs is now Archer MSAs.
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 and Chris L. Peterson.
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 following a determination that the number of
taxpayers with accounts exceeded certain thresholds (eventually, 750,000). 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 became active participants through a participating employer. The Community Renewal
Tax Relief Act of 2000 (P.L. 106-554) included an extension of eligibility for new
participants until December 31, 2002; it also changed the formal name to Archer MSAs for
the retiring chairman of the House Ways and Means Committee. The Job Creation and
Worker Assistance Act (P.L. 107-147) extended eligibility for new participants until
December 31, 2003.
In October, 2002, the IRS estimated that there would be 78,913 MSA returns filed for
tax year 2001; it also determined that 20,592 taxpayers who did not make contributions in
2001 established accounts in the first six months of 2002. These numbers are far less than
the 750,000 statutory ceiling. (Not all MSAs are counted toward the ceiling; for example,
accounts of taxpayers who previously were uninsured are not taken into consideration.)
MSAs should be distinguished from Medicare MSAs, which are discussed below under the
tax treatment of Medicare and Medicaid.
Health Savings Accounts. The Medicare prescription drug legislation signed by
President Bush on December 8, 2003 (P.L. 108-173) authorized new heath savings accounts
(HSAs) for unreimbursed medical expenses. HSAs are similar to medical savings accounts
(MSAs), and it is thought in time HSAs will replace them. HSAs are available to taxpayers
generally; individuals do not have to be either self-employed or employed by a small
employer that provides high deductible insurance. There is not any limit on the number of
accounts.
HSA contributions can be made when individuals have qualifying health insurance: for
self-only insurance, the deductible must at least $1,000 and required out-of-pocket expenses
for covered benefits cannot exceed $5,000; for family coverage, the deductible must be at
least $2,000 and required out-of-pocket expenses for covered benefits cannot exceed
$10,000. In 2004, contributions are limited to the lesser of $2,600 or 100% of the deductible
for self-only coverage; for family coverage, they are limited to the least of $5,150, 100% of
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the overall deductible, or the embedded deductible (the deductible applying to one
individual) multiplied by the number of covered family members. Individuals aged 55
through 64 may contribute an additional $500. Contributions may be made by employers,
individuals, or both.
The effective date for HSAs is January 1, 2004; however, people who may be interested
in them may not yet have qualifying insurance.
Health Coverage Tax Credit. On August 6, 2002, President Bush signed into law
the Trade Act of 2002 (P.L. 107-210). The law allows workers displaced by trade to receive
a tax credit for purchasing insurance. The amount of the credit is equal to 65% of the
premiums paid by the worker for qualified health insurance. The credit is advanceable,
meaning that workers can receive the credit when purchasing insurance rather than receiving
it after filing their tax returns. The credit is also refundable; eligible workers can receive the
credit even if they have zero tax liability for the year. To be eligible for the credit, a worker
must be (1) a recipient of a trade readjustment allowance under the Trade Act of 1974, or
who would be except he or she has not exhausted all rights to unemployment insurance; (2)
an eligible alternative Trade Adjustment Act recipient; or (3) an individual who is over the
age of 55 and is receiving a pension benefit from the Pension Benefit Guaranty Corporation
(PBGC).
The HCTC applies only to specific types of health insurance. The credit can be applied
towards premiums paid to continue employer-sponsored health insurance under the
Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA). The credit can also
be used to purchase an individual health insurance policy (if the worker was covered by an
individual policy at least 30 days prior to becoming unemployed) or to purchase a group
policy offered through a spouse’s employer. An eligible worker can use the credit to
purchase various types of state-based insurance coverage, such as coverage through a state-
sponsored high-risk pool, coverage through a health insurance program offered to state
employees, and coverage through an arrangement between private entities and the state.
State-based coverage must be guaranteed issue, cannot limit coverage due to pre-existing
conditions, cannot charge higher premiums than those charged to individuals who do not
receive the tax credit, and must offer the same benefits as those provided to individuals who
do not receive the tax credit.
Some Members of Congress have stated that the law was not intended to allow states
to enter into agreements with private insurers offering individual coverage. However, others
argue that the intent of the law was to allow states to enter into agreements with private
insurers, even those offering individual coverage.
Additional information about this tax credit can be found through the IRS website
[http://www.irs.gov]. Once there, search under “HCTC” in the box in the upper-left corner
of the screen and then click on the overview document, which has links for individuals and
frequently-asked-questions, among other things.
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
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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 FY2003 revenue
loss attributable to CHAMPUS and Tricare is estimated to be $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 estimates the revenue loss attributable to the exclusion of
Medicare benefits will be $27.1 billion in FY2002. 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. The Medicare prescription drug
legislation renamed Medicare+Choice plans Medicare Advantage plans.
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 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.
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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.
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.
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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 35% bracket would save $1,400 (i.e., $4,000
x 0.35). If health insurance is considered a form of personal consumption like 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
In the 108th Congress, numerous proposals for new or expanded tax benefits for health
insurance have been introduced. In general, proponents of new or expanded tax benefits
argue that they are needed to extend coverage to the uninsured and to address efficiency and
equity problems. Opponents generally argue that tax benefits are unlikely to make much
difference for most people who do not now have insurance.
This Issue Brief will not attempt to identify all bills relating to tax benefits for health
insurance. For a comprehensive list of bills providing tax benefits for health insurance,
Congressional offices can use the Legislative Information System (LIS) available through the
CRS home page [http://www.crs.gov].
Health Coverage Tax Credit
Under current law, the HCTC is available only for qualifying insurance, including
coverage sponsored by state governments. State-sponsored or arranged coverage must meet
certain requirements: it must be guaranteed issue, cannot have limits for pre-existing
conditions, and must have the same benefits and no higher premiums as the coverage
provided to individuals who do not receive the tax credit.
On June 19, 2003, the House passed an amended version of H.R. 1528, the Taxpayer
Protection and IRS Accountability Act of 2003. One provision would allow certain
insurance to qualify for the HCTC if the eligible taxpayer elects to waive requirements for
guaranteed issue and no preexisting condition exclusion, provided the taxpayer does not
reside in a state with state-sponsored or arranged coverage qualifying for the credit. The
waiver would apply through December 31, 2004. The bill would not allow the waivers to
supersede state laws relating to consumer insurance protections. (H.R. 1528 as introduced
had different language regarding these waivers, as did the version reported by the Committee
on Ways and Means.)
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Proponents of the waiver contend that it is needed to give more options to trade-
displaced workers who live in states without qualifying state-sponsored or arranged
coverage. Opponents argue that it would allow insurance companies to “cherry-pick”
workers whom they would like to cover, as well as the conditions they would cover.
H.R. 1528 would also provide that consumer protection provisions of the current tax
credit law would not apply to insurance under state continuation coverage.
S. 1693 (Senator Grassley) would extend eligibility for the tax credit to individuals who
are eligible for unemployment compensation.
In his FY2005 budget, President Bush proposed a number of clarifying amendments to
the HCTC.
On May 4, 2002, during a debate on S. 1637 (legislation dealing with export taxation
and other matters), the Senate rejected an attempt to expand the HCTC. Among other
things, the proposed amendment would have extended eligibility to individuals who had
service sector jobs and increased the credit rate from 65% to 75%. (While a majority of
senators voted for the proposal, 60 votes were needed to waive a section of the Congressional
Budget Resolution for 2004.)
Savings Accounts for Health Care Expenses
As described above, relatively few tax-advantaged Archer medical savings accounts
(MSAs) have been established since they first became available in 1997. The slow growth
can be attributed to a number of factors including product unfamiliarity, consumer aversion
to financial risk, and the reluctance of insurance agents to sell lower-priced policies;
however, statutory restrictions undoubtedly have played some role. On September 23, 2004,
the House and Senate both passed the Working Families Tax Relief Act of 2004 (H.R. 1308),
which among others things includes a two-year extension (through December 31, 2005) of
the deadline for establishing new medical savings accounts.
With the adoption of health savings accounts, some might question whether
authorization to establish new MSAs needs to be extended. Until HSAs become readily
available, however, an argument could be made for allowing more people to sign up for
MSAs.
In his FY2005 budget, the President proposed allowing individuals with HSAs to deduct
the cost of their health insurance. The deduction would be available to all taxpayers with the
insurance, not just those who itemize. One bill to authorize this deduction, H.R. 3901, was
introduced on March 4 by Representative Crane.
In early September 2004, the President also proposed tax credits for small businesses
that make contributions to their employees’ HSAs. In addition, low income families could
receive direct deposits from the federal government to their HSAs.
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Flexible Spending Accounts
President Bush’s FY2004 budget would allow up to $500 in unused balances in health
care flexible spending accounts (FSAs) to be carried over to the following year without being
taxed. Under current law, unused balances must be forfeited to the employer. The proposal
would also permit unused balances to 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). H.R. 176 (introduced by Representative Royce) and H.R. 1177
(introduced by Representative DeMint) would also allow limited amounts of unused balances
to be carried forward to the following year.
On June 19, 2003, the House Committee on Ways and Means approved an amended
version of H.R. 2351 which would allow up to $500 in unused health care FSA balances to
be carried over, contributed to a qualified retirement or deferred compensation plan, or
contributed to a health savings account (which that same legislation would allow). The
provision was also included in H.R. 2596, which the House passed on June 26 (see the
discussion above for tax-advantaged health savings accounts) and then was appended to H.R.
1, the House Medicare prescription drug bill, also passed that day. However, the conference
agreement on H.R. 1 that was released on November 20 did not contain the provision.
On May 12, 2004, the House approved an amended version of H.R. 4279
(Representative McCreary) which among other things would allow taxpayers to carryover
up to $500 in unused flexible spending account balances or to roll them over into their health
savings account.
The principal argument for allowing these options is that taxpayers might be more
willing to participate in FSAs if unused balances at the end of the year were not lost.
Allowing carryovers or rollovers might also discourage participants from spending remaining
balances carelessly, just to use them up. 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. It is not
clear in the President’s proposal when rollovers to deferred compensation plans would occur;
employers generally would need time to run nondiscrimination tests to see if additional
contributions to these plans would be permissible.
Expanded Tax Deduction
In his FY2005 budget, President Bush has proposed allowing individuals with health
savings accounts (HSAs) to deduct the cost of their health insurance. The deduction would
be “above-the-line,” that is, not restricted to taxpayers who itemize.
Some 108th Congress bills would allow expanded deductions that were not limited to
taxpayers with HSAs. One bill would allow individuals deduct 100% of their insurance
premiums, regardless of whether they itemize (H.R. 198, introduced by Representative
Stearns). Another would remove would allow itemizers to deduct all of their medical
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expenses (H.R. 53, introduced by Representative Cox). As discussed above, the current law
deduction 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.
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.) 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 $700 for someone in the 35% bracket (i.e.,
$2,000 x 0.35) 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.
Expanded Tax Credit
President Bush’s FY2005 budget includes a refundable tax credit for health insurance
for individuals under age 65. The credit would equal 90% of the premium and would
decrease for higher incomes; the credit would phase out at $30,000 for individuals and at
$40,000 or $60,000 (depending on the number of adults) for families. The amount of the
credit be limited to $1,000 for an adult covered by a policy and $500 for each child, up to
two children. Individuals participating in public health plans (such as Medicaid or the State
Children’s Health Insurance Program) or employer health plans would not be eligible for the
credit. The credit would be claimed through the normal tax-filing process in the following
tax year; alternatively, it could be claimed in advance (based on the individual’s prior year
tax return), allowing reduced premium payments. In the latter case, the insurer would be
reimbursed for the credit directly from the U.S. Treasury.
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.
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Small Employer Tax Credit
In the 108th Congress, a number of bills have been introduced that would authorize a tax
credit for small employers that offer or maintain health insurance for their workers. Included
among these bills are H.R. 450 (Representative Dunn), H.R. 1936 and H.R. 1937 (both by
Representative Moore), H.R. 3607 (Representative Hooley), S. 10 and S. 414 (Senator
Daschle), S. 53 (Senator Durbin), S. 86 (Senator Clinton), S. 100 (Senator Collins), S. 906
(Senator Stabenow), S. 1901 (Senator Bayh), and S. 1972 (Senator Boxer).
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.
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.
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Appendix
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 (everything counted for tax purposes)
2.
minus Deductions (or adjustments) for AGI (i.e., “above the line deduction”)
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 (i.e., “regular tax liability”)
9.
minus Credits
10. = Final tax liability
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