Order Code RL33505
CRS Report for Congress
Received through the CRS Web
Tax Benefits for Health Insurance and Expenses:
Overview of Current Law and Legislation
June 30, 2006
Bob Lyke
Specialist in Social Legislation
Domestic Social Policy Division
Congressional Research Service ˜ The Library of Congress

---

Tax Benefits for Health Insurance and Expenses:
Overview of Current Law and Legislation
Summary
How tax policy affects health insurance and health care spending is a subject of
increasing discussion in Washington. The issue is prompted both by the size of the
tax subsidies, particularly the exclusion for employer-paid insurance, and by growing
interest in comprehensive tax and health care reform. At the moment, however,
attention is focused on narrower goals, such as improving health savings accounts
and allowing carryovers of unused balances in flexible spending accounts.
Current law contains significant tax benefits for health insurance and expenses:
(1) Employer-paid coverage is excluded from the determination of income and
employment taxes. More than 60% of the noninstitutionalized population under age
65 is insured through employment-based plans; on average, large employers pay
about 80% of their cost, though some pay all and others none. The exclusion also
applies to health insurance provided through cafeteria plans. (2) Self-employed
taxpayers may deduct 100% of their health insurance, even if they do not itemize
deductions. (3) Taxpayers who itemize may deduct insurance payments and other
unreimbursed medical expenses to the extent they exceed 7.5% of adjusted gross
income. While not widely used, this deduction benefits those who purchase
individual market policies or who have catastrophic costs. (4) Some workers eligible
for Trade Adjustment Assistance or receiving a pension paid by the Pension Benefit
Guarantee Corporation can receive an advanceable, refundable tax credit (the health
coverage tax credit, HCTC) to purchase certain types of insurance. (5) Four
tax-advantaged accounts are available to help taxpayers pay their health care
expenses: Flexible Spending Accounts, Health Reimbursement Accounts, Health
Savings Accounts, and Medical Savings Accounts. (6) Coverage under Medicare,
Medicaid, SCHIP, and military and veterans health care programs is not considered
taxable income. (7) With exceptions, benefits received from private or public
insurance are not taxable.
By lowering the after-tax cost of insurance, some of these tax benefits help
extend coverage to more people; they also lead some people to obtain more coverage
than they would otherwise. The incentives also influence how coverage is acquired:
the uncapped exclusion for employer-paid insurance, 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 addition, the tax benefits
increase the demand for health care by enabling insured people to obtain services at
discounted prices; this in turn contributes to rising health care costs. Because many
people would likely obtain insurance without tax benefits, they can be an inefficient
use of public dollars. When insurance is viewed as a form of personal consumption,
the tax benefits appear inequitable because taxpayers’ savings depend on marginal
tax rates. When viewed as spreading catastrophic economic risk over multiple years,
however, basing those savings on marginal rates might be justified as the proper
treatment for losses under a progressive tax system. This report replaces CRS Issue
Brief IB98037, Tax Benefits for Health Insurance and Expenses: Current
Legislation, and it will be updated as warranted by legislative activities and other
developments.

---

Contents
Most Recent Developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Tax Benefits in Current Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Employer-Paid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Unreimbursed Medical Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Individual Market Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Self-Employed Individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Cafeteria Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Premium Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Flexible Spending Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Health Reimbursement Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Health Savings Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Medical Savings Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Health Coverage Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Military Health Care . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Veterans Health Care . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Medicare . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Medicaid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
SCHIP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Some Consequences of the Tax Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Increases in Coverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
The Source of Insurance Coverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Increases in Health Care Use and Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Current Proposals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Premium Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Flexible Spending Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Health Savings Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Increased Incentives to Purchase Qualifying Insurance . . . . . . . . . . . . 17
Increased Incentives to Make Account Contributions . . . . . . . . . . . . . 17
Health Coverage Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Refundable Individual Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Employer Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Expanded Tax Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Self-Employed Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
For Additional Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

---

Tax Benefits for Health Insurance and
Expenses: Current Law and Legislation
Most Recent Developments
In his FY2007 budget, released on February 6, 2006, President Bush proposed
tax incentives that would increase the availability and attractiveness of Health
Savings Accounts. He also proposed minor changes to the health coverage tax credit.
The House Committee on Ways and Means held a hearing on Health Savings
Accounts on June 28, 2006. There was discussion about whether the accounts will
help reduce the number of people without health insurance and what effect they
might have on health care costs.
Tax Benefits in Current Law
Current law provides significant tax benefits for health insurance and expenses.
The tax subsidies (mostly 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.
This section of the report summarizes the current tax treatment of the principal
ways that people obtain health insurance and pay their health care expenses. It
describes general rules but does not discuss all limitations, qualifications, or
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 omitted from gross income, whereas 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.
This section also includes Joint Committee on Taxation (JCT) estimates of tax
expenditures, where available. Tax expenditures measure the difference in tax
liabilities for individuals and corporations due to provisions that are exceptions to a
normative comprehensive income tax. Tax expenditures are not the same as revenue

---

CRS-2
losses to the government, the measurement of which reflects assumed behavioral
responses, timing considerations, and changes in employment tax receipts.1
Most of the tax rules discussed here have also been adopted by states that have
income taxes.
Employer-Paid Insurance
More than 60% of the noninstitutionalized population under age 65 is insured
under an employment-based plan. On average, employers pay about 80% of the cost
of this insurance, though some pay all and others pay none. Employers typically pay
a higher percentage for single coverage and a lower percentage for families.2
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).3 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 may be subject to a premium
conversion arrangement under a cafeteria plan or counted towards the itemized
medical expense deduction (both of which are discussed below).
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 previously excluded from
gross income. 4 Benefits are also taxable to the extent that taxpayers received a tax
benefit from deducting expenses in a prior year (e.g., if taxpayers claimed a medical
expense deduction for expenditures in 2005 and then received an insurance
reimbursement in 2006). 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.
1 All JCT estimates are from Estimates of Federal Tax Expenditures for Fiscal Years 2006-
2010, JCS-2-06 (Apr. 25, 2006). The JCT report discusses how tax expenditures are defined
(pp. 2-3) and measured (pp. 26-27). Tax expenditures should not be added together since
they do not take account of interaction effects among provisions.
2 CRS Report 96-891, Health Insurance Coverage: Characteristics of the Insured and
Uninsured Populations in 2004, by Chris L. Peterson; Employer Health Benefits: 2005
Summary of Findings, by the Kaiser Family Foundation and the Health Research and
Educational Trust; and Health Insurance Coverage in America: 2004 Data Update, by the
Kaiser Commission on Medicaid and the Uninsured. Much of the employers’ cost for this
insurance is probably passed on to employees through reductions in wages and other forms
of compensation.
3 Sections 106 and 3121, respectively.
4 Sections 104 and 105.

---

CRS-3
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 that the FY2006 tax
expenditure attributable to the exclusion for employer payments for health insurance
and health care (for self-insured plans) will be $90.6 billion. The estimate does not
include the effect of the exclusion on employment taxes.5
Unreimbursed Medical Expenses
Taxpayers who itemize their deductions may deduct unreimbursed medical
expenses that exceed 7.5% of adjusted gross income (AGI).6 Medical expenses
include health insurance premiums paid by the taxpayer, principally premiums for
individual market policies and the employee’s share of premiums for employment-
based coverage (aside from those subject to a premium conversion arrangement).
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.”7 They also include certain transportation and
lodging expenditures, qualified long-term care costs, and long-term care insurance
premiums that do not exceed certain amounts.
The deduction is intended to help only people with catastrophic expenses, so by
design, it is not widely used. For most taxpayers, the standard deduction is larger
than the sum of their itemized deductions; moreover, most do not have unreimbursed
expenses that exceed 7.5% AGI. In 2002, about 35% of all individual income tax
returns had itemized deductions; of these returns, only about 19% (about 6.6% of all
returns) claimed a medical expense deduction.8
The JCT estimates that the FY2006 tax expenditure attributable to the medical
expense deduction (including long-term care expenses) will be about $7.3 billion.
Individual Market Policies. About 6% of the noninstitutionalized
population under age 65 is insured through private individual market policies. Likely
purchasers include early retirees, young adults, employees without access to
employment-based insurance, and the self-employed. All of these people can claim
5 The JCT estimate includes payments of premiums through cafeteria plans. The tax
expenditure estimate from the Administration is considerably higher, $132.7 billion.
Analytical Perspectives, Budget of the United States Government, Fiscal Year 2007, p. 289.
The difference is attributable to several factors, the most important of which is the JCT
assumption that without the exclusion the itemized deduction for medical care would be
higher.
6 Section 213.
7 Section 213(d)(1)(A).
8 Michael Parisi and Scott Hollenbeck, “Individual Income Tax Returns, 2002,” Statistics
of Income Bulletin, vol. 24 no. 2 (fall 2004), U.S. Internal Revenue Service, table 3.

---

CRS-4
the medical expense deduction just described, provided they qualify (i.e., they must
itemize and then can deduct only unreimbursed expenses that exceed 7.5% AGI).
Many self-employed taxpayers can claim a more generous deduction described
below.
Premiums for certain types of individual market insurance are not deductible,
including policies for loss of life, limb, and sight; policies that pay guaranteed
amounts each week for a stated number of weeks for hospitalization; policies to
provide payment for loss of earnings; and the part of car insurance that provides
medical coverage for 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.
Self-Employed Individuals. 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.9
Self-employed taxpayers may deduct payments for health insurance in
determining their AGI (i.e., as an “above-the-line” deduction).10 The “above-the-
line” deduction for the self-employed is not restricted to itemizers or subject to a
floor, as is the medical expense deduction described above. Currently, 100% of the
insurance cost may be taken into consideration. However, 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 (i.e., one in which the employer pays part of the cost). These restrictions
prevent taxpayers with little net income from their business (which is not uncommon
for a new business) from deducting much if any of their insurance payments. The
portion not deductible under these rules may be treated as an itemized medical
expense deduction.11
Self-employed individuals may not deduct their health insurance costs in
determining the employment taxes they pay (the self-employment tax).
In 2002, about 3.6 million tax returns (about 2.7% of all returns) claimed the
self-employed health insurance deduction. For FY2006, the JCT estimates the tax
9 Corporations may elect S-corporation status if they meet a number of Internal Revenue
Code requirements. Among other things, they cannot have more than 100 shareholders or
more than one class of stock. S-corporations are tax-reporting rather than tax-paying
entities, in contrast to C-corporations, which are subject to the corporate income tax.
10 Section 162(l).
11 For more information, see CRS Report RL33311, Federal Tax Treatment of Health
Insurance Expenditures by the Self-Employed: Current Law and Issues for Congress, by
Gary Guenther.

---

CRS-5
expenditure attributable to the deduction (including the self-employed deduction for
long-term care insurance) to be $3.8 billion.
Cafeteria Plans
Cafeteria plans are employer-established benefit plans under which employees
may choose between receiving cash (typically additional take-home pay) and certain
normally nontaxable benefits (such as employer-paid health insurance) without being
taxed on the value of the benefits if they select the latter. A general rule of taxation
is that taxpayers given these options will be taxed on whichever they choose because
they are deemed to be in constructive receipt of the cash. The cafeteria plan
provisions of the Code provide an express exception to this rule when the plan meets
various reporting and nondiscrimination requirements.12 Nontaxable benefits
received under a cafeteria plan are exempt from both income and employment taxes.
Cafeteria plans may be simple or complex. Simple plans might allow
employees to choose between cash and one nontaxable benefit, such as additional
health insurance. Complex plans might give employees a “pot of money” to allocate
among health insurance and reimbursement accounts, dependent care assistance,
group term life insurance, commuter benefits, and cash as they see fit.
Premium Conversion. Under a cafeteria plan option known as premium
conversion, employees may elect to reduce their taxable wages in exchange for
having their share of health insurance premiums paid on a pretax basis. The
arrangement saves both income and employment taxes. Federal employees who
participate in the Federal Employees Health Benefits Program (FEHBP) have been
able to elect this option since October 2000. Private sector and state or local
government employees may also elect premium conversion if their employers permit.
Premium conversion is not available to retirees. The barrier is not the cafeteria
plan rules but an Internal Revenue Service (IRS) determination that distributions
from qualified retirement plans are always subject to taxes, aside from several minor
exceptions.13 The IRS ruling precludes former employees from recasting pension
payments as pretax income, as active workers can recast their wages. However,
employer payments for retiree health insurance is excluded from taxes, just as they
are for active workers. For many retirees, the employer pays much of the premium.
For FY2006, the JCT estimates the tax expenditure attributable to cafeteria
plans to be $27.9 billion. The estimate pertains to all forms of nontaxable benefits,
not just health insurance.14
12 Section 125. “Cash” in this context includes any taxable benefit.
13 Rev. Rul. 2003-62.
14 The JCT estimate for health insurance received through cafeteria plans is also included
in the exclusion for employer-paid insurance (discussed above).

---

CRS-6
Flexible Spending Accounts
Flexible spending accounts (FSAs) are employer-established benefit plans that
reimburse employees for specified expenses as they are incurred.15 Accounts may be
used for dependent care or for medical and dental expenses, though there must be
separate accounts for these two purposes. FSAs and cafeteria plans are closely
related, but not all cafeteria plans have FSAs and not all FSAs are part of cafeteria
plans. FSA reimbursements funded through salary reduction agreements (the most
common arrangement) are exempt from income and employment taxes under
cafeteria plan provisions because employees have a choice between cash (their
regular salary) and a nontaxable benefit. In contrast, FSA reimbursements funded
by nonelective employer contributions are exempt from taxation directly under
provisions applying to employer-paid dependent care or health insurance.16
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. Amounts unused at the end of the year must be
forfeited to the employer (the “use it or lose it” rule), though employers may allow
a 2½-month grace period. FSAs cannot be used to purchase insurance; however, they
can be combined with premium conversion arrangements under cafeteria plans to
achieve the same tax effect.
FSAs are more common in large firms than small firms. According to a 2004
survey by Mercer Human Resources Consulting, 81% of employers with 500 or more
employees offered a health care FSA, and an average of 20% of eligible employees
participated. Among employers with 10 or more employees, 25% offered a health
care FSA, and an average of 36% of eligible employees participated.17 Federal
employees have had the opportunity to use FSAs since July 2003.
Health Reimbursement Accounts
Health Reimbursement Accounts (HRAs) are employer-established
arrangements to reimburse employees for medical and dental expenses not covered
by insurance or otherwise reimbursable. As with FSAs, reimbursements are not
subject to either income or employment taxes. In contrast, however, contributions
cannot be made through salary reduction agreements; only employers may contribute.
15 Some FSAs are linked to employers’ health insurance plans so provider payments can be
made directly from the accounts. These arrangements avoid the need for employees to pay
first and then seek reimbursement.
16 For additional information, see CRS Report RL32656, Health Care Flexible Spending
Accounts, by Chris L. Peterson and Bob Lyke.
17 Tom Herman, “A Setback for a Popular Health Benefit: Treasury Rejects Effort to Ease
‘Use-It-or-Lose-It’ Provision of Flexible Spending Accounts,” Wall Street Journal, Jan. 5,
2005, p. D1.

---

CRS-7
Employers need not actually fund HRAs until employees draw on them; the accounts
may be simply notional. Also unlike FSAs, reimbursements can be limited to
amounts previously contributed. Unused balances may be carried over indefinitely,
though employers may limit the aggregate carryovers.
HRAs are governed by the Code provisions discussed above for the exclusion
of benefits paid from employment-based plans and various IRS guidance.18
Health Savings Accounts
Health Savings Accounts (HSAs) are one way that people can pay on a tax-
advantaged basis for unreimbursed medical expenses (deductibles, copayments, and
services not covered by insurance).19 Eligible individuals can establish and fund
accounts when they have a qualifying high deductible health plan and no other health
plan, with some exceptions. For 2006, the deductible for self-only coverage must be
at least $1,050 and the annual out-of-pocket limit must not exceed $5,250; the
deductible for family coverage must be at least $2,100 and the annual out-of-pocket
limit must not exceed $10,500.
The annual HSA contribution limit in 2006 for individuals with self-only
coverage is $2,700 or 100% of the insurance deductible, whichever is lower. For
family coverage, the annual contribution limit is $5,450, 100% of the overall
deductible, or the embedded deductible (the deductible applying to one individual)
multiplied by the number of covered family members, whichever of the three is
lowest. Individuals who are at least 55 years old but not yet enrolled in Medicare
may contribute an additional $700. Contributions may be made by employers,
individuals, or both.20
In January 2006, there were about 3.2 million people covered by qualifying high
deductible insurance plans; the number includes both policyholders and their family
members. The number of people covered by HSAs is likely smaller because it is not
necessary to establish an account along with the insurance. Moreover, some accounts
may not be funded. Nonetheless, the number of HSAs appears to be growing
rapidly.21
18 Section 105, Rev. Rul. 2002-41, and IRS Notice 2002-45.
19 For an overview of HSAs and three other types of tax-advantaged accounts (Flexible
Spending Accounts, Health Reimbursement Accounts, and Medical Savings Accounts) see
CRS Report RS21573, Tax-Advantaged Accounts for Health Care Expenses: Side-by-Side
Comparison, by Bob Lyke and Chris L. Peterson.
20 Section 223. For more information, see CRS Report RL33257, Health Savings Accounts:
Overview of Rules for 2006, and CRS Report RS22437, Health Savings Accounts: Some
Current Policy Issues, both by Bob Lyke.
21 January 2006 Census Shows 3.2 Million People Covered by HSA Plans. America’s
Health Insurance Plans (AHIP) Center for Policy and Research (March 2006). (The
Census was an AHIP Survey.) Also see CRS Report RS22417, Data on Enrollment,
Premiums, and Cost-Sharing in HSA-Qualified Health Plans, by Chris L. Peterson.

---

CRS-8
HSA contributions are deductible as an above-the line deduction if made by
individuals, and they are exempt from both income and employment taxes if made
by employers. Contributions may be made through salary reduction agreements, in
which case they are treated as if made by employers. Withdrawals are not taxed if
used for qualified medical expenses; however, they are taxable and usually subject
to a penalty if used for other expenses or to purchase health insurance, with some
exceptions. Account earnings are tax-exempt. Unused balances may accumulate
without limit.
For FY2006, the JCT estimates the tax expenditure attributable to HSAs to be
about $100 million.
Medical Savings Accounts
Medical Savings Accounts (MSAs) are an older, more-restrictive version of
HSAs. Begun as a demonstration program in 1997, they are limited to people who
either are self-employed or are employees covered by a high deductible insurance
plan established by a small employer (50 or fewer employees). Like HSAs, annual
contributions are limited and can be made only when account owners have qualifying
high deductible insurance, though the specific rules are different. Unlike HSAs,
contributions can be made by individuals or employers, not both, and they cannot
occur through salary-reduction agreements. The official name of MSAs is now
Archer MSAs.22
MSA contributions are deductible (as an above-the-line deduction) if made by
individuals, and they are exempt from both income and employment taxes if made
by employers. Withdrawals are not taxed if used for qualified medical expenses
under rules similar to those for HSAs. Account earnings are tax-exempt. Unused
balances may accumulate without limit.
The upper limit on the number of MSAs is 750,000 (not counting accounts of
owners who previously were uninsured, among others), though there never has been
close to that many established. For tax year 2003, the IRS estimated that there were
fewer than 80,000 accounts in total. Many of these have probably now been rolled
into HSAs. Currently no new MSAs can be established, with some minor
exceptions, though nearly everyone who would like to do so can set up an HSA.
MSAs should be distinguished from Medicare MSAs, which are discussed
below under “Medicare.”
Health Coverage Tax Credit
Three groups of taxpayers are potentially eligible for the health coverage tax
credit (HCTC):
! individuals receiving a Trade Readjustment Assistance allowance,
including those eligible for but not yet receiving the allowance
22 Section 220.

---

CRS-9
because they have not yet exhausted their state unemployment
benefits;
! individuals aged 50 and older receiving an Alternative Trade
Adjustment Assistance allowance; and

! individuals aged 55 and older receiving a Pension Benefit Guaranty
Corporation pension payment, including those who received a lump
sum payment after August 5, 2002.
Recipients cannot be enrolled in certain other health insurance, including
Medicaid or employment-based insurance for which the employer pays at least half
the cost, nor can they be entitled to Medicare.23
The HCTC equals 65% of the premiums the taxpayer pays for qualifying
insurance. Up to 10 types of coverage are specified in the statute, though most
require state action to become effective. The credit is payable in advance to insurers,
allowing workers to benefit before they file their tax returns. It is also refundable:
workers can receive the full credit even if they have no regular tax liability.
One study estimates that about 25,500 eligible taxpayers claimed the HCTC in
2004, or about 22% of all potentially eligible workers who did not have access to
disqualifying insurance.24
For FY2006, the JCT estimates the tax expenditure attributable to the HCTC to
be about $200 million.
Military Health Care
The U.S. Department of Defense (DOD) provides health care to active duty
military personnel, military retirees, and their dependents. In general, active duty
personnel receive care without cost (aside from small per diem charges), while the
others may have deductibles, copayments, and premiums depending on where they
are served and the particular insurance plan they are in. Military insurance plans
currently are called Tricare plans. Nearly 9 million people are eligible for services
and coverage by these arrangements.25
23 For additional information, see CRS Report RL32620, Health Coverage Tax Credit
Authorized by the Trade Act, by Julie Stone-Axelrad and Bob Lyke.
24 Stan Dorn et al., Limited Take-Up of Health Coverage Tax Credits and the Design of
Future Tax Credits for the Uninsured, Economic and Social Research Institute, Nov. 3,
2005.
25 For more information, see CRS Issue Brief IB93103, Military Medical Care Services:
Questions and Answers, by Richard A. Best, Jr.

---

CRS-10
Coverage under military health care programs and the benefits they provide are
not considered taxable.26
For FY2006, the JCT estimates that the tax expenditure attributable to medical
care and Tricare insurance for military dependents, retirees, and dependents of
retirees to be approximately $1.9 billion.
Veterans Health Care
The U.S. Department of Veterans Affairs provides health care directly to
veterans through hospitals, nursing homes, residential rehabilitation treatment
centers, and community-based outpatient clinics. In some cases, it pays for care
provided by independent doctors and other health care professionals. Veterans health
care is not an entitlement (unlike Medicare Part A, for example), and eligibility for
services is prioritized according to several factors, including the severity of
disabilities, whether disabilities occurred during or after military service, certain
military events (e.g., having been a prisoner of war), the period of service, and means
testing. Nearly 5 million veterans receive services.27
Coverage under veterans health care programs and the benefits they provide are
not considered taxable.28
Medicare
Medicare is a national health insurance program for people aged 65 and older
or who meet certain disability tests. Nearly 42 million people are covered by one or
more of its parts. Coverage under Medicare and the benefits it pays for qualifying
expenses are not considered taxable.29
Medicare Part A (insurance for hospitalization, skilled nursing facilities, post-
hospitalization home health, and hospice care) is financed largely by employment
taxes that workers and their employers both pay, currently 1.45% of covered wages.
Individuals cannot take these tax payments into account for the itemized deduction
26 Section 134. The exemption of certain combat zone compensation under Section 112
might also apply, as might employer-provided health care and coverage under Sections 105
and 106.
27 For additional information, see CRS Report RL32961, Veterans’ Health Care Issues in
the 109th Congress, and CRS Report RL33409, Veterans’ Medical Care: FY2007
Appropriations, both by Sidath Viranga Panangala.
28 Section 134 of the Internal Revenue Code and 38 USC § 5301.
29 Rev. Rul. 70-341. The ruling states that benefits received under Part A are not legally
distinguishable from certain Social Security benefits and thus are excluded from taxation
as disbursements made to further a social welfare function of the government. In contrast,
benefits received under Part B are excluded from taxation as medical insurance proceeds
under Section 104.

---

CRS-11
for medical expenses.30 However, employers may deduct what they pay as a business
expense.
Workers and their spouses become entitled to Part A once the workers have paid
employment taxes on covered wages for certain periods of time. They pay no
additional premium to be enrolled. People aged 65 and older who are not entitled to
Part A may voluntarily enroll by paying a monthly premium. This premium may be
taken into account for the itemized deduction for medical expenses, as may the
deductibles and copayments associated with Part A.
Medicare Part B (insurance for doctors’ fees, hospital outpatient services, most
home health, and other medical services) is financed by general tax revenues and
monthly premiums paid by those who enroll. Usually the premiums are withheld
from Social Security benefits. These premiums may be taken into account for the
itemized deduction for medical expenses, as may the deductibles and copayments
associated with Part B.31

Medicare Part D (insurance for prescription drugs) is also financed by general
tax revenues and monthly premiums paid by those who enroll. Deductibles and
copayments associated with Medicare Part D may be taken into account for the
itemized deduction for medical care. No official guidance has been issued regarding
the tax treatment of Part D premiums.
Medicare Part C authorizes a number of alternative Medicare health plans, now
called Medicare Advantage plans. Participants must be enrolled in both Medicare
Part A and Part B. Some of these plans may charge an additional premium, which
can be taken into account for the itemized deduction for medical expenses. The tax
treatment of Medicare Advantage Medical Savings Accounts is similar to that of
Health Savings Accounts. Contributions and account earnings are exempt from
taxes, as are withdrawals used to pay medical expenses.32 No Medicare Medical
Savings Account plan has ever been offered.
For FY2006, the JCT estimates that the tax expenditure attributable to the
exclusion of Medicare Part A benefits will be $18.5 billion. The tax expenditures
attributable to Part B and Part D are estimated to be $12.5 billion and $3.4 billion,
respectively.33
Medicaid
Medicaid is a form of health insurance for the elderly, people who have
disabilities, pregnant women, families with dependent children, and children who
have low income and few assets. It also pays for long-term care for people meeting
similar needs tests. As each state designs and administers its own program, there is
30 Rev. Rul. 66-216.
31 Rev. Rul 66-216.
32 Section 138.
33 JCS-2-06.

---

CRS-12
variation within broad federal guidelines with respect to who is served, benefits and
delivery systems, and cost-sharing and other patient requirements. Medicaid waivers
allow states even more flexibility for certain populations. Nearly 60 million people
are covered by Medicaid.34

Coverage under Medicaid and the benefits it pays for qualifying expenses are
not considered taxable.35
SCHIP
The State Children’s Health Insurance Program (SCHIP) provides health
insurance to children in families without coverage and with income above Medicaid
eligibility levels. Some states expand their Medicaid programs to cover these
children, whereas others have separate programs or a combination of both. SCHIP
waivers allow states to cover adults as well. More than 6 million children are
covered by SCHIP, as are about 650,000 adults.
As with Medicaid, coverage under SCHIP and the benefits it pays for qualifying
expenses are not considered taxable.
Some Consequences of the Tax Benefits
Increases in Coverage
By lowering the after-tax cost of insurance, some of the tax benefits described
above help extend coverage to more people. This is, of course, the intention:
Congress has long been concerned about whether people have access to health care.
The public subsidy implicit in the incentives (the foregone tax revenue) usually is
justified on grounds that people would otherwise under-insure; that is, they would
delay purchasing coverage in the hope that they will not become ill or have an
accident. Uninsured people are an indication of what economists call market failure;
they impose spill-over costs on society in the form of public health risks and
uncompensated charity care. If insurance were purchased only by people who most
need health care, its cost would become prohibitive for others.
Tax benefits also lead some people to obtain more coverage than they might
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 than are
necessary. However, many people are risk-averse with respect to health care, so the
tax benefits are only one factor influencing the amount of insurance purchased.
34 For an overview, see CRS Report RL33202, Medicaid: A Primer, by Elicia J. Herz.
35 There apparently is no statutory provision or revenue ruling that Medicaid coverage and
benefits are exempt from taxation. The question would not often arise because Medicaid
usually is for individuals and families with low income.

---

CRS-13
Some people contend that comprehensive coverage and lower cost-sharing lead to
better preventive care and possibly long-term savings for certain medical conditions.
Tax benefits associated with Heath Savings Accounts are an attempt to
encourage people to purchase less coverage by having higher deductibles. In this
respect, they appear to differ from the tax benefits usually associated with health
insurance. However, the accounts themselves might be viewed as a form of
insurance, particularly as they grow in size, so it is not clear what their impact will
be in reducing overall coverage.
The Source of Insurance Coverage
Tax benefits influence the way in which insurance coverage is acquired. The
uncapped exclusion for employer-paid insurance, 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 this insurance covers only about 6% of the noninstitutionalized population
under age 65.
Employment-based insurance carries both advantages and disadvantages for the
typical worker. The principal advantage is that coverage is based on larger and often
more stable risk pools; this generally lowers the cost for people who need more care.
Usually, employee premiums do not vary by age or risk. Although young and healthy
workers sometimes pay more than they would for identical individual market
coverage, they are protected from cost increases as they get older or need additional
care. However, plans chosen by employers may not meet individual workers’ needs,
particularly if there is only one available health plan, and changing jobs may require
both new insurance and doctors.
Increases in Health Care Use and Cost
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 that 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 any case, increasing use
of health care contributes to rising health care costs.
Whether insurance coverage could be encouraged without increasing the cost
of health care has long 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 might 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.
Consumer-driven health care (most commonly associated with high deductible
insurance plans coupled with Health Reimbursement Accounts and Health Savings

---

CRS-14
Accounts) is a recent attempt to help people obtain coverage without driving up costs
as much.
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. One important goal of the tax incentives is for
insurance to be purchased only to the extent it results in better health care for society
as a whole. But how the incentives 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. Because
as a practical matter they are not available to everyone, problems of horizontal equity
arise.36 Workers without employment-based insurance generally cannot benefit from
them, nor can many early retirees (people under 65, the age of Medicare eligibility).
Even if these individuals itemize their deductions, they may 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.37 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, whereas 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. Under a progressive income tax
system, economic losses ought to be deducted at applicable marginal rates, just as
economic gains are taxed at those rates.
Assessing the equity of tax incentives for health insurance is complicated by
uncertainty as to who pays for employer subsidies. In the long run, the cost of these
subsidies presumably is passed on to the workers in the form of reductions to wages
and other benefits. But whether these reductions are shared equally by all workers
is unclear given differences in their preferences for insurance, their attachment to
particular employers, and broader labor market forces.
36 Horizontal equity is a tax principle which in the case of an income tax holds that people
who have essentially equal economic income should be treated the same.
37 Vertical equity is a tax principle which in the case of an income tax holds that people who
have higher economic income should have higher tax liabilities.

---

CRS-15
Current Proposals
This section focuses on bills that have received committee or floor action or that
otherwise are the subject of discussion. It identifies other relevant bills but does not
attempt to cite all of them. In a typical Congress, tax measures pertaining to health
insurance and expenses number in the hundreds, not all of which are easily tracked.
A list of all bills on a particular topic (e.g., tax credits for health insurance) is
available to congressional staff through the Legislative Information System (LIS).
The Advanced Search link in the middle of the screen enables users to search for
terms such as “‘Internal Revenue Code’ AND ‘health insurance’ AND ‘credit.’”
Often it is helpful to restrict searches to terms that are likely to be in close proximity
to each other in the bills. For example, the previous search might be modified to
“‘Internal Revenue Code’ AND ‘health insurance’ adj/7 ‘credit’.” Whatever the
search terms, it is not unusual to miss relevant bills and turn up others that are
irrelevant. For assistance, call the CRS inquiry number at 7-5700.
In considering bills on a particular topic, it is important to take account of
whether the legislation would make other changes to health care financing (e.g., by
authorizing the sale of insurance across state lines) or to the tax system (e.g., by
changing the definition of dependents or reducing tax rates). The effect of one
provision could differ substantially depending on the scope of these other changes.
Some changes might occur through legislation that has ostensibly little to do
with a particular topic. For example, a tax credit for health insurance could increase
the number of health savings accounts by enabling currently uninsured people to
purchase qualifying high deductible insurance. Similarly, capping the exclusion for
employer-paid insurance could increase the number of people who claim the medical
expense deduction because they would have more unreimbursed expenses.
Premium Conversion
Federal retirees who participate in the Federal Employees Health Benefits
Program (FEHBP) do not have the option of paying their premiums on a pretax basis.
One measure that would allow them to do so (H.R. 994; Davis-VA) was ordered to
be reported by the House Committee on Government Reform on June 16, 2005. The
bill has also been referred to the House Committee on Armed Services and the
Committee on Ways and Means. S. 484 (Warner) is similar.
Paying FEHBP premiums on a pretax basis is currently available to federal
workers, and it would appear equitable to allow federal retirees the same option,
particularly since retirees generally have less income than workers. However, it
would not seem equitable to allow this tax treatment for federal retirees but not
retirees with private sector or state and local governmental coverage. Including the
latter groups would substantially increase the cost of the legislation.

---

CRS-16
Flexible Spending Accounts
Under current IRS rules, unused FSA balances are forfeited to the employer at
the end of the year, though employers may allow a 2½-month grace period. One
rationale for this requirement is that cafeteria plans, under which most health care
FSAs are funded, cannot include deferred compensation aside from one express
exception. For the past several Congresses, efforts have been made to relax this
requirement. The pension reform legislation that passed the House on December 15,
2005 (H.R. 2830, the Pension Protection Act of 2005) would allow up to $500 in
unused health care FSA funds to be carried over to the following year or contributed
to a health savings account. The comparable bill that passed the Senate on
November 16, 2005 (S. 1783, the Pension Security and Transparency Act of 2005)
does not include an FSA provision. These two bills are now before a conference
committee.

Other bills introduced in the 109th Congress to allow a carryover or rollover of
health care FSA funds include H.R. 1803 (Royce), H.R. 1998 (McCrery), H.R. 3075
(Paul), S. 309 (DeMint), S. 723 (Snowe), S. 1359 (Smith), and S. 2457 (Snowe). S.
723 and S. 2457would make other changes to FSAs as well, including making it
easier for small employers to offer plans, setting a statutory limit on the amount that
can be contributed to the accounts, limiting reimbursements to account balances, and
permitting more modifications to the accounts within a plan year.
The principal argument for allowing rollovers 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.
However, FSAs provide tax benefits for the first dollars of health care spending,
which is just the opposite of the restriction limiting the medical expense deduction
to catastrophic expenses (i.e., those exceeding 7.5% of AGI.). FSAs also conflict
with the rationale for high deductible insurance, which is not to provide third-party
assistance for expenditures that are customary and routine. Some argue that
expansion of FSAs may inhibit the spread of health savings accounts. Allowing
unused balances to be carried over or rolled over would also increase revenue losses
associated with FSAs.
H.R. 4511 and H.R. 5262 (both by Cantor) would amend the health savings
account provisions to allow greater combined use of FSAs and HSAs.
Health Savings Accounts
In his FY2007 budget, which was released on February 6, 2006, President Bush
proposed measures that would increase the availability and attractiveness of Health
Savings Accounts (HSAs). Such measures include the following:
! allow an above-the-line deduction and refundable income tax credits
for the purchase of HSA-eligible individual market insurance;

---

CRS-17
! increase HSA contribution limits and allow a refundable income tax
credit for HSA contributions not made by employers;
! allow HSAs to reimburse (as a qualified medical expense) medical
expenses incurred earlier in the year, provided the individual had
HSA-eligible insurance at the time;
! allow HSAs to reimburse (as a qualified medical expense) premiums
for HSA-eligible individual market insurance; and
! allow employers to contribute additional sums to HSAs on behalf of
employees or their spouse or dependents who are critically ill.
One bill that would carry out the President’s proposals is H.R. 5262 (Cantor).
Other bills that would authorize one or more of the proposals or something similar
are listed below.
Increased Incentives to Purchase Qualifying Insurance. An expanded
(above-the-line) deduction for HSA-qualified insurance would be allowed by H.R.
37 (King), H.R. 1872 (Johnson-TX), S. 4 (Frist), S. 160 (Murkowski), S. 978
(Santorum), S. 1503 (Frist), S. 2492 (Burns), and S. 3488 (Coburn).
Premiums for individual market high deductible health plans could be
considered a qualified HSA distribution under H.R. 5586 (Johnson-TX), S. 2549
(DeMint), S. 2554 (Ensign), and S. 3488 (Coburn).
Individuals would receive a refundable tax credit for the premiums they paid for
HSA-qualifying insurance under S. 2492 (Burns) and S. 3488 (Coburn).
To aid portability, qualified medical expenses would include amounts paid to
insurers for the right to purchase insurance in the future under S. 3488 (Coburn).
Increased Incentives to Make Account Contributions. HSA
contribution limits would be increased by H.R. 3075 (Paul), H.R. 4511 (Cantor), S.
2424 (Allen), and S. 3488 (Coburn).
Distributions from qualified retirement accounts would be tax-free if used to
fund HSAs under H.R. 3873 (Fortenberry). H.R. 2063 (Shuster) would allow this
exemption to occur only once.
Employers would receive a tax credit for HSA contributions under H.R. 1872
(Johnson-TX), S. 4 (Frist), S. 160 (Murkowsi), S. 978 (Santorum), S. 1503 (Frist),
and S. 2457 (Snowe). and S. 2492 (Burns).
Employers would be allowed to make additional contributions to accounts of
employees who are (or whose family member are) acutely or chronically ill under
Coburn (S. 3488).
An individual tax credit for HSA contributions would be allowed under S. 2492
(Burns) and S. 3488 (Coburn).

---

CRS-18
Unused balances in flexible spending could be rolled over into HSAs under
H.R. 1803 (Royce), H.R. 1998 (McCrery), H.R. 3075 (Paul), S. 309 (DeMint), S. 723
(Snowe), S. 1359 (Smith), and S. 2457 (Snowe).
Greater combined use of HSAs and FSAs would be allowed by H.R. 4511
(Cantor).
For all of the bills mentioned above, the principal issue is whether HSAs should
be made more available and attractive. In general, people who favor HSAs would
support the bills, whereas people who object to HSAs would oppose them. Some
argue that further legislation should wait until more information is available. It
would be useful to know the income and health status of the taxpayers who have
HSAs and whether high deductible insurance reduces health care spending without
increasing costs for others. However, it may be several years before any of these
factors can be determined.38
The House Committee on Ways and Means held a hearing about HSAs on June
28, 2006.
Health Coverage Tax Credit
The HCTC is restricted to taxpayers who receive Trade Readjustment
Assistance (or would once their state unemployment benefits end), Alternative Trade
Adjustment Assistance, or a pension paid by the Pension Benefit Guaranty
Corporation. Currently, only manufacturing workers are eligible for Trade
Adjustment Assistance and Alternative Trade Adjustment Assistance, but several
bills would extend eligibility to service workers, allowing them to get the tax credit:
H.R. 1281 (King), H.R. 4156 (Smith of WA), and S. 1309 (Baucus).
Some bills would allow family members to continue eligibility for the credit
after the person through whom they had coverage became entitled to Medicare; these
include H.R. 4156 (Smith of WA), S. 4 and S. 1503 (both by Frist), S. 14
(Stabenow), and S. 1365 (Rockefeller). S. 4156 and S. 1365 would also continue
their eligibility in other circumstances.
The narrow eligibility requirements are one reason why not many people use the
HCTC. The requirements appear unfair with respect to people who are in similar
circumstances, such as service workers whose jobs have been shifted overseas or lost
due to foreign trade. Although the bills remove this inequity for the groups
mentioned above, they are a small fraction of the many who now are ineligible.
H.R. 4156, S. 14, and S. 1365 would also increase the credit rate and expand
insurance options. These steps would likely help cash-strapped families that now
cannot afford to pay the remaining 35% of the insurance cost or that cannot find
qualifying insurance. However, some might question whether additional subsidies
should be provided to narrowly targeted groups while others get nothing.
38 See CRS Report RS22437, Health Savings Accounts: Some Current Policy Issues, by Bob
Lyke.

---

CRS-19
President Bush proposed a number of clarifications and other minor changes to
the HCTC in his FY2007 budget.
Refundable Individual Tax Credit
In recent years, there has been much discussion of a refundable income tax
credit for health insurance. Refundability allows taxpayers to receive the full amount
of a credit even if it exceeds their regular tax liability.39 The HCTC (described
above) is one example of a refundable tax credit. Unlike that credit, however, most
of the recent proposals would not be restricted to narrow eligibility groups.
An individual tax credit for health insurance could be claimed through the
normal tax-filing process. Taxpayers would include the credit when they file their
tax returns (normally by April 15 of the following year) and then use it either to
offset additional amounts they owe or to obtain a larger refund. It would also be
possible for taxpayers to adjust their withholding in order to benefit from the credit
earlier, but experience with the earned income tax credit suggests few would do so.
Most proposals would allow taxpayers to claim a refundable health insurance tax
credit in advance based on their prior year’s income. In this case, the insurer would
be reimbursed for the credit directly from the U.S. Treasury Department. Advance
payments now occur for some who receive the HCTC.
Bills in the 109th Congress that would authorize a refundable individual income
tax credit for health insurance include H.R. 765 (Kennedy-MN), H.R. 1399 (Kaptur),
H.R. 1872 (Johnson-TX), H.R. 2089 (Granger), H.R. 2203 and H.R. 2732 (Shadegg),
H.R. 3075 (Paul), H.R. 4219 (McHugh), H.R. 4527 (Boswell), S. 4 (Frist), S. 160
(Murkowski), S. 978 (Santorum), S. 1178 (Martinez), S. 1225 (Collins), S. 1503
(Frist), and S. 2701 (Santorum).

Several bills would authorize tax credits only with respect to coverage for
dependent children; these include H.R. 1668 (Waxman), H.R. 3077 (Paul), S. 16
(Kennedy), and S. 114 (Kerry).
In his FY2007 budget, President Bush proposed a refundable tax credit for
lower-income individuals who purchase HSA-eligible individual market insurance.
Refundable credits would also be available for all individuals who claim above-the-
line deductions for HSA-eligible individual market insurance or who make
contributions to their HSAs; the latter credits generally would equal 15.3% of the
premium or the contribution.
A refundable tax credit for health insurance could be attractive. If it were
generally available, a credit could aid taxpayers who do not have access to
employment-based insurance but cannot claim the medical expense deduction. A
credit could provide all taxpayers with the same dollar reduction in final tax liability,
39 It is also possible to place limits on refundability. For example, the credit might be
limited to the taxpayer’s regular tax liability plus payments for Social Security taxes. A
credit might be refundable for purposes of the regular income tax but not the alternative
minimum tax.

---

CRS-20
avoiding vertical equity problems associated with exclusions and deductions. A
credit could also provide lower-income taxpayers with sufficient resources to
purchase insurance, likely reducing the number of the uninsured.
The effects of tax credits, however, can vary widely depending on the
legislation. One important question is whether a credit would supplement or replace
existing tax benefits, particularly the exclusion for employer-paid insurance. If the
credit replaced the exclusion, it probably would have to be made available to people
with high as well as low income. A generous individual credit may lead employers
to drop coverage (or to not start it in the first place), possibly increasing the number
of the uninsured. A credit that is not generous would not enable lower-income
families to purchase insurance. Advance payments would be essential for many
families but might not work well on a large scale.
The most difficult questions about tax credits have to do with health policy. If
a credit were generous enough to provide meaningful help to lower income people,
it is likely that the legislation would have to specify what is qualifying insurance.
Otherwise, there would be no assurance that public funds would be used efficiently
and effectively. Defining qualifying insurance would involve decisions about
minimum benefits, deductible and copayment limits, guaranteed issue and pre-
existing condition exclusions, and other contentious issues.
Employer Tax Credit
Under current law, employers may deduct the expenses they incur for
employees’ health insurance and health care and the contributions they make to their
tax-advantaged health care savings accounts. Depending on the employer’s marginal
tax rate, a tax credit might result in greater tax savings, thereby providing an
additional incentive to start and maintain health insurance plans. Tax credits could
also be useful for government and nonprofit employers that are not subject to income
taxes; the credits would offset some of the employment taxes they pay.
In the 109th Congress, a number of bills have been introduced that would
authorize an employer tax credit for health insurance. Typically these bills are aimed
at small employers, usually defined as having fewer than 50 or 100 employees.
Included among these bills are H.R. 118 (Hooley), H.R. 2001 (Moore-KS), H.R.
2002 (Moore-KS), H.R. 2073 (Barrow), H.R. 2259 (Dingell), H.R. 4527 (Boswell),
S. 16 (Kennedy), S. 1012 (Kennedy), S. 1225 (Collins), S. 1329 (Bayh), and S. 2457
(Snowe). S. 2558 (Stabenow) would limit the credit to catastrophic costs.
Compared with the individual tax credits discussed above, an employer credit
could be targeted to industries or localities that have greater need. They can be
linked to employer contributions. An employer credit might not require advance
payments, though if necessary these probably would be easier to provide than in the
case of individual taxpayers. On the other hand, employer credits cannot be
accurately varied by employee income (because employers know only what they pay
workers, not their total income) and they would not be effective if employers do not
want to provide health insurance.

---

CRS-21
Employers would receive a tax credit for HSA contributions under H.R. 1872
(Johnson-TX), S. 4 (Frist), S. 160 (Murkowsi), S. 978 (Santorum), S. 1503 (Frist),
and S. 2457 (Snowe).
Expanded Tax Deduction
The current deduction for health insurance is restricted to taxpayers who itemize
their deductions and whose payments for insurance and unreimbursed medical
expenses exceed 7.5% adjusted gross income. Most taxpayers cannot benefit from
it. At the same time, taxpayers who have employment-based insurance can exclude
the value of employer payments, and if they have a premium conversion plan, they
can pay their share of the premiums on a pretax basis as well. The tax savings from
the exclusion and premium conversion are roughly equivalent to a full deduction
(actually, they are greater because there are also employment tax savings). This
divergent treatment appears inequitable.
In recent Congresses, there have been several proposals to allow all taxpayers
to deduct the full cost of their health insurance as an above-the-line deduction. Bills
in the 109th Congress that would authorize this include H.R. 218 (Stearns), H.R. 2176
(Chabot), H.R. 4218 (McHugh), and S. 2379 (Burr). H.R. 4527 (Boswell) would
limit the deduction to the first $2,000 of premiums.
Some bills would allow an above-the-line deduction for only HSA-qualified
(high deductible) insurance; these include H.R. 37 (King), H.R. 1872 (Johnson-TX),
S. 4 (Frist), S. 160 (Murkowski), S. 978 (Santorum), S. 1503 (Frist), and S. 2492
(Burns).
H.R. 994 (Davis-VA) and S. 484 (Warner) would allow an above-the-line
deduction for Tricare supplemental premiums or enrollment fees.
H.R. 2599 (Rohrabacher) would allow an above-the-line deduction for all
medical expenses, including contributions to new medical checking accounts.
H.R. 3075 (Paul) would repeal the 7.5% floor on the itemized deduction for
medical expenses.
Self-Employed Deduction
Self-employed individuals may not deduct their health insurance costs in
determining the employment taxes they pay (the self-employment tax). In contrast,
employer-paid health insurance is excluded from employment taxes of both
employees and the employer. Some people consider this treatment inequitable.
Several bills have been introduced in the 109th Congress that would allow self-
employed taxpayers to subtract their health insurance costs in determining their self-
employment taxes. Among these bills are H.R. 727 (Sanchez), H.R. 3841
(Manzullo), H.R. 4961 (Hart), and S. 663 (Bingaman).

---

CRS-22
For Additional Reading
Feldman, Roger and Bryan Dowd. A New Estimate of the Welfare Loss of Excess
Health Insurance. American Economic Review. vol. 81 (March 1991), pp. 297-
301.
Gruber, Jonathan. Tax Policy for Health Insurance. NBER Working Paper 10977
National Bureau of Economic Research. December 2004. 35 p.
Hubbard, R. Glenn, John F. Cogan, and Daniel P. Kessler. Healthy, Wealthy, and
Wise: Five Steps to a Better Health Care System. AEI Press/ The Hoover
Institution. November 2005.
Kaplow, Louis. The Income Tax as Insurance: The Casualty Loss and Medical
Expense Deductions and the Exclusion of Medical Insurance Premiums.
California Law Review, vol. 79 (1991), pp. 1485-1510.
Kahn, Charles N. and Ronald F. Pollack. Building a Consensus for Expanding
Health Coverage. Health Affairs, vol. 20 (January/February 2001), pp. 40-48.
Smart, Michael and Mark Stabile. Tax Credits and the Use of Medical Care. NBER
Working Paper 9855. National Bureau of Economic Research. July 2003.
35 p.
Pauly, Mark. Taxation, Health Insurance, and Market Failure in the Medical
Economy. Journal of Economic Literature, vol. 24 (1986), pp. 629-675.
Pauly, Mark and Bradley Herring. Expanding Coverage via Tax Credits: Trade-Offs
and Outcomes. Health Affairs, vol. 20 (January/February, 2001), pp. 9-26.
The President’s Advisory Panel on Federal Tax Reform. Simple, Fair, and Pro-
Growth: Proposals to Fix America’s Tax System. November 2005.
Sheils, John and Randall Haught. The Cost of Tax-Exempt Health Benefits in 2004.
Health Affairs, Web exclusive (January - June 2004), pp. W106-W112.
U.S. Congressional Budget Office. The Tax Treatment of Employment-Based Health
Insurance. March 1994.

---

CRS-23
Appendix
The general formula for calculating federal income taxes appears below. 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 determining adjusted gross income
(AGI) — “above the line deductions”
3.
Equals AGI
4.
Minus greater of standard or itemized deductions
5.
Minus personal and dependency exemptions
6.
Equals taxable income
7.
Times tax rate
8.
Equals tax on taxable income (i.e., “regular tax liability”)
9.
Minus credits
10.
Equals final tax liability

---