Order Code RL33505
Tax Benefits for Health Insurance and Expenses:
Overview of Current Law and Legislation
Updated February 20, 2007
Bob Lyke
Specialist in Social Legislation
Domestic Social Policy Division
Julie M. Whittaker
Specialist in Economics
Domestic Social Policy Division

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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 perennial
subject of discussion in Washington. The issue is prompted by the size of the tax
subsidies, particularly the exclusion for employer-paid insurance; by their effect on
the cost and allocation of health care resources; and by interest in comprehensive tax
and health care reform. There is much discussion of President Bush’s proposal to
tax the insurance that workers receive from their employer and provide a new
standard deduction for health insurance for those who purchase coverage through
their employer or in the individual or small group markets.
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 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, these tax benefits generally help
extend coverage to more people; they also lead some people to obtain more coverage
than they otherwise would. 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 will be updated for legislative activity and other developments.

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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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Health Savings Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Medical Savings Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Health Coverage Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Military Health Care . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Veterans Health Care . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Medicare . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Medicaid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
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
Exclusion for Employer-Paid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Expanded Tax Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Self-Employed Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Premium Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Flexible Spending Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Health Savings Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Health Coverage Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Refundable Individual Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Employer Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Tax Penalties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Value Added Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
For Additional Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

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Tax Benefits for Health Insurance and
Expenses: Overview of Current Law and
Legislation
Most Recent Developments
As part of his FY2008 budget, President Bush is proposing to tax the insurance
that workers receive from their employer and provide a new standard deduction for
health insurance for those who purchase coverage through their employer or in the
individual or small group markets. One consequence of taxing employer-paid health
insurance is that tax-advantaged Flexible Spending Accounts would terminate. In
addition, the budget proposal would expand and make Health Savings Accounts more
attractive and make minor changes to the Health Coverage Tax Credit.
The Tax Relief and Health Care Act of 2006 (P.L. 109-432), which the
President signed on December 20, 2006, included a number of provisions that expand
the availability and attractiveness of Health Savings Accounts.
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

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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. In the average plan, employers pay about 84% of
the cost of single coverage and 73% of the cost of family coverage, though some pay
all and others pay none.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
deduction for medical expenditures in 2006 and then received an insurance
reimbursement for them in 2007). 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). Current estimates the JCT makes may be somewhat
different. 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 2005, by Chris L. Peterson, and Employer Health Benefits: 2006
Summary of Findings, by the Kaiser Family Foundation and the Health Research and
Educational Trust. 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.

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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) estimated that the FY2007 tax
expenditure attributable to the exclusion for employer payments for health insurance
and health care (for self-insured plans) will be $99.7 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 2003, just under 34% of all individual income
tax returns had itemized deductions; of these returns, less than 20% (about 6.7% of
all returns) claimed a medical expense deduction.8
The JCT estimated that the FY2007 tax expenditure attributable to the medical
expense deduction (including long-term care expenses) will be about $8.2 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 FY2007
tax expenditure estimate from the Administration is considerably higher, $146.8 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, 2003,” Statistics
of Income Bulletin, vol. 25 no. 2 (fall 2005), U.S. Internal Revenue Service, table 3.

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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.
Self-employed individuals may not deduct their health insurance costs in
determining the employment taxes they pay (the self-employment tax).
In 2003, about 3.8 million tax returns (about 2.9% of all returns) claimed the
self-employed health insurance deduction. For FY2007, the JCT estimated that the
tax expenditure attributable to the deduction (including the self-employed deduction
for long-term care insurance) will be $4.2 billion.
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).

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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.11 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.12 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 FY2007, the JCT estimated that the tax expenditure attributable to cafeteria
plans will be $30.6 billion. The estimate includes the tax expenditures attributable
to dependent care flexible spending accounts.13
11 Section 125. “Cash” in this context includes any taxable benefit.
12 Rev. Rul. 2003-62.
13 The JCT estimate for health insurance received through cafeteria plans is also included
in the exclusion for employer-paid insurance (discussed above).

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Flexible Spending Accounts
Flexible spending accounts (FSAs) are employer-established benefit plans that
reimburse employees for specified expenses as they are incurred.14 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.15
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.16 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.
In 2004, about 20% of private-sector establishments offered a health care FSA
to their workers.17 They are more common in larger firms: 61.5% of establishments
with 50 or more workers offered them, but only 6.5% of smaller establishments.
Similarly, more employees had access to an FSA if they worked in larger firms: 68%
of workers did in firms with 50 or more workers, but only 11% did in smaller firms.
Overall, 52% of private-sector employees could establish a health care FSA.
Most people with access to an FSA do not use them. A 2006 survey by Mercer
Human Resources Consulting showed that an average of 36% of eligible employees
participated in health care FSAs offered by employers with 10 or more employees.
The average amount contributed was $1,208.
14 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.
15 For additional information, see CRS Report RL32656, Health Care Flexible Spending
Accounts, by Chris L. Peterson and Bob Lyke.
16 The Tax Relief and Health Care Act of 2006 (P.L. 109-432) allows individuals to make
limited, one-time rollovers from termination balances in their health care FSAs to Health
Savings Accounts.
17 Data in this paragraph are from the 2004 Medical Expenditure Panel Survey.

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Federal employees have had the opportunity to use FSAs since July 2003. In
2005, there were 157,991 federal health care FSAs.
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. 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 2007, the deductible for self-only coverage must be
at least $1,100 with an annual out-of-pocket limit not exceeding $5,500; the
deductible for family coverage must be at least $2,200 with an annual out-of-pocket
limit not exceeding $11,000.
The annual HSA contribution limit in 2007 for individuals with self-only
coverage is $2,850; for family coverage, it is $5,650. Individuals who are at least 55
years of age but not yet enrolled in Medicare may contribute an additional $800.
Contributions may be made by employers, individuals, or both.20
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
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 2007, by Bob Lyke.

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CRS-8
if used for other expenses or to purchase health insurance, with some exceptions.
Account earnings are tax-exempt. Unused balances may accumulate without limit.
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
For FY2007, the JCT estimated that the tax expenditure attributable to HSAs will
be about $300 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.
MSAs should be distinguished from Medicare MSAs, which are discussed below
under “Medicare.”
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.
22 Section 220.

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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
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 between 21,700 and 26,600 eligible taxpayers claimed
the HCTC for December, 2005, or between 13% and 21% of all potentially eligible
workers who did not have access to disqualifying insurance.24
For FY2007, the JCT estimated that the tax expenditure attributable to the HCTC
will 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
23 For additional information of the eligibility rules, see CRS Report RL32620, Health
Coverage Tax Credit Authorized by the Trade Act, by Julie Stone-Axelrad and Bob Lyke.
24 Stan Dorn, Take-Up of Health Coverage Tax Credits: Examples of Success in a Program
with Low Enrollment, The Urban Institute, December, 2006.

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are called Tricare plans. Nearly 9 million people are eligible for services and coverage
by these arrangements.25
Coverage under military health care programs and the benefits they provide are
not considered taxable.26
For FY2007, the JCT estimated that the tax expenditure attributable to medical
care and Tricare insurance for military dependents, retirees, and dependents of retirees
will be approximately $2.0 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. Just over 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
25 For more information, see CRS Report RL33537, Military Medical Care Services:
Questions and Answers, by Richard A. Best, Jr.
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 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.

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CRS-11
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 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, as may the Part D premiums themselves.32
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. In 2007, for the
first time there are Medicare Medical Savings Account plans offered under Part C.
The tax treatment of these plans is similar to that of Health Savings Accounts:
contributions and account earnings are exempt from taxes, as are withdrawals used to
pay medical expenses.33 However, other specifications differ depending on the plan.
Contributions to Medicare MSA plans are made by the Centers for Medicare and
Medicaid Services (CMS) of the U.S. Department of Health and Human Services.
For FY2007, the JCT estimated that the tax expenditure attributable to the
exclusion of Medicare Part A benefits will be $20.7 billion. The tax expenditures
attributable to Part B and Part D were estimated to be $14.2 billion and $6.2 billion,
respectively.34
30 Rev. Rul. 66-216.
31 Rev. Rul 66-216.
32 IRS Publication 502, Medical and Dental Expenses, p. 9.
33 Section 138.
34 JCS-2-06.

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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
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 63 million people
are covered by Medicaid each year.35

Coverage under Medicaid and the benefits it pays for qualifying expenses are not
considered taxable.36
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.
35 For an overview, see CRS Report RL33202, Medicaid: A Primer, by Elicia J. Herz.
36 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.

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CRS-13
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. 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
substantial changes along these lines could be difficult to implement and might create

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serious inequities. Consumer-driven health care (most commonly associated with
high deductible insurance plans coupled with Health Reimbursement Accounts and
Health Savings Accounts) is a recent attempt to help people obtain coverage without
driving up costs as much. The Congressional Budget Office analyzed this approach
in a December 2006 publication, Consumer-Directed Health Plans: Potential Effects
on Health Care and Spending Outcomes.
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.37 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.38 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
37 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.
38 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.

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unclear given differences in their preferences for insurance, their attachment to
particular employers, and broader labor market forces.
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 them all. In some Congresses, tax measures pertaining to health
insurance and expenses have numbered in the hundreds, not all of which are easily
tracked. In addition, not all bills are available in the Legislative Information System
(LIS) as of the date of this report.
A list of all bills on a particular topic (e.g., tax credits for health insurance) is
available to congressional staff through the 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 ostensibly has 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.
Exclusion for Employer-Paid Insurance
President Bush is proposing that the exclusion for employer-paid health
insurance be terminated; in its place, all people who obtain health insurance coverage
would be allowed a standard above-the-line deduction, as described below.
S. 334 (Wyden) would also terminate the exclusion for employer-paid health
insurance, with several exceptions (e.g., coverage for retirees under existing retiree
health plans). The provision is part of his comprehensive health care reform plan.

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Expanded Tax Deduction
As part of his FY2008 budget, President Bush is proposing that all taxpayers who
obtain health insurance be allowed a standard above-the-line deduction. The
deduction would be $7,500 for self-only coverage or $15,000 for family coverage,
regardless of how much one pays for the insurance. The deduction would apply to
employment-based coverage as well as coverage obtained in the individual or small
group markets.
S. 334 (Wyden) would also establish standard above-the-line deductions for
health insurance. The deduction amounts would vary according to family status. It
would not be available to people with incomes below the poverty line (who would
receive other subsidies for their insurance), and it would phase out starting at incomes
of $62,500 ($125,000 for a joint return). The provision is part of his comprehensive
health care reform plan.
In recent Congresses, there have been a number of proposals allowing an above-
the-line deduction for what taxpayers actually paid for their health insurance. In the
110th Congress, H.R. 227 (Sterns) would allow this deduction for health insurance and
unreimbursed prescription drug costs. H.R. 636 (Bachman) would allow this
deduction for health insurance and unreimbursed medical care costs. H.R.1110 (Tom
Davis) would allow this deduction for Tricare supplemental premiums or enrollment
fees.
Self-Employed Deduction
The President’s FY2008 budget proposal to replace the tax exclusion for
employer-paid coverage with a new standard deduction for health insurance would
also terminate the tax deduction for self-employed taxpayers.
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 were introduced in the 109th Congress that would have allowed self-
employed taxpayers to subtract their health insurance costs in determining their self-
employment taxes; these included H.R. 727 (Sanchez), H.R. 3841 (Manzullo), H.R.
4961 (Hart), and S. 663 (Bingaman). Similar bills are likely to be introduced in the
110th Congress.
Premium Conversion
President Bush’s FY2008 budget proposal to replace the tax exclusion for
employer-paid coverage with a new standard deduction for health insurance would
terminate premium conversion arrangements.
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.

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CRS-17
H.R. 1110 (Tom Davis) would allow retired military and civilian federal workers
to pay their premiums on a pretax basis. This is a version of the 109th Congress
measure (H.R. 994; Tom Davis) which was ordered to be reported by the House
Committee on Government Reform on June 16, 2005. The bill was also referred to
the House Committee on Armed Services and the Committee on Ways and Means.
S. 484 (Warner) was 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.
Flexible Spending Accounts
President Bush’s FY2008 budget proposal to replace the tax exclusion for
employer-paid coverage with a new standard deduction for health insurance would
also terminate tax-advantaged Flexible Spending Accounts. The accounts could
continue without the tax advantage (i.e., employees could divert part of their taxable
wages into an account to be used for health care expenses), but it is not obvious who
would want these arrangements.
Under current IRS rules, FSA balances not used by the end of the year generally
are forfeited to the employer, though the employer may allow a 2½-month grace
period.39 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.
A number of 109th Congress bills would have allowed a carryover or rollover of
health care FSA funds; these included 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. 2457 would have made 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. In the 110th
Congress, H.R. 298 would allow a carryover of health care FSA funds.
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
39 The Tax Relief and Health Care Act of 2006 (P.L. 109-432) allows individuals to make
limited, one-time rollovers from termination balances in their health care FSAs to Health
Savings Accounts.

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CRS-18
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.
Health Savings Accounts
The Tax Relief and Health Care Act of 2006 (P.L. 109-432), which the President
signed on December 20, 2006, included a number of provisions that expanded the
availability and attractiveness of Health Savings Accounts. Included in the measure
were provisions allowing rollovers from FSAs and HRAs, increasing the contribution
limits by eliminating the ceilings based on insurance plan deductibles, allowing one-
time contributions from individual retirement accounts, permitting full-year
contributions for people enrolled only for part of the year, and other matters.
The President’s FY2008 budget includes several measures that would expand
HSAs and make them more attractive. These include allowing
! health insurance plans that require 50% coinsurance (rather than the
current-law minimum deductible) to be qualifying insurance;
! medical expenses to be considered qualified for purposes of HSA
withdrawals if they were incurred on or after the date the taxpayer
became eligible for the year (even if prior to when the HSA was
established);
! employers to make larger contributions for the chronically ill;
! family coverage to give individuals benefits once they have reached
the minimum deductible required for individuals for qualifying
insurance;
! both spouses to contribute catch-up contributions to an HSA owned
by one, assuming both meet the age tests; and
! individuals to contribute to HSAs when covered by an FSA or HRA,
but reducing the maximum allowable HSA contribution by the level
or FSA or HRA coverage.
In the 110th Congress, S. 46 (Ensign) would allow HSA funds to be used (as a
qualified distribution) to pay the premiums of individual market high deductible
health plans. H.R. 749 (Blackburn) would allow people entitled to Medicare to
instead receive a voucher to purchase high deductible insurance and contribute to
HSAs. H.R. 991 (Campbell) would allow individuals eligible for veterans health
benefits to contribute to HSAs.
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.

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Currently, only manufacturing workers are eligible for Trade Adjustment Assistance
and Alternative Trade Adjustment Assistance.
The President’s FY2008 budget includes a proposal that would allow state
qualified plans to impose a pre-existing condition exclusion for a period of up to 12
months, provided the plan reduces the restriction period by the length of the eligible
individual’s creditable coverage as of the date of application for the state qualified
plan.
The FY2008 budget also proposes allowing the spouse of an HCTC-eligible
individual to claim the credit when the HCTC-eligible individual becomes entitled to
Medicare. The spouse would have to be at least 55 years of age.
Several 109th Congress bills would have extended eligibility to service workers,
thus allowing them to get the tax credit; these included H.R. 1281 (King), H.R. 4156
(Smith of WA), and S. 1309 (Baucus). Similar bills may be introduced in the 110th
Congress.
Some 109th Congress bills would have allowed family members to continue
eligibility for the credit after the person through whom they had coverage became
entitled to Medicare; these included 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 have continued their eligibility in other circumstances. There may be 110th
Congress bills for these purposes as well.
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.
Some 109th Congress bills (H.R. 4156, S. 14, and S. 1365) would also have
increased the credit rate and expanded 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.
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.40 The HCTC (described above) is
40 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.

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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 have authorized a refundable individual
income tax credit for health insurance included 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).
In the 110th Congress, H.R. 914 (Ryan), S. 158 (Collins), and S. 397 (Martinez)
would all authorize a refundable individual income tax credit for health insurance.
Several
109th Congress bills would have authorized 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 the 110th Congress, S. 95 (Kerry) would authorize a refundable tax credit for
health insurance coverage for children; this is part of a more comprehensive children’s
health insurance bill.
In the 110th Congress, H.R. 343 (Emerson) would authorize a refundable tax
credit for Medicare Part B premiums for military retirees.
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,
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

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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.
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.
A number of health insurance employer tax credit bills were introduced in the
109th Congress. Many were aimed at small employers, among them 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 have
limited the credit to catastrophic costs. Some bills would have given employers tax
credits for contributing to HSAs.
In the 110th Congress, S. 99 (Kerry) would authorize a refundable tax credit for
small business employee health insurance expenses.
Tax Penalties
Under current law, there are no tax penalties for individuals and families that do
not have health insurance coverage. Proposals requiring coverage of everyone often
include a tax penalty in order to encourage compliance. For example, in the
Massachusetts health care reform plan, people who do not have insurance and are not
exempt from the mandate will lose their state income tax personal exemption. Late

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enrollers will also face an additional premium-based penalty that will be collected
through the state tax system.
S. 99 (Kerry) would limit the dependent exemption that could be claimed with
respect to a child to the same percentage that represents the proportion of the year that
the child was covered by qualified health insurance. (The bill would also authorize
a refundable tax credit for the purchase of children’s coverage and expand both
SCHIP and Medicaid.)
The comprehensive health care reform bill of Senator Wyden (S. 334) would also
establish penalties for individuals who fail to purchase coverage, with some
exceptions, but the penalties are not tax penalties.

Value Added Tax
H.R. 15 (Dingell) would establish a national health insurance system with
payments made from a National Health Care Trust Fund. The source of revenue for
the Fund would be a value added tax (a general sales tax on most goods and services).

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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. Consumer-Directed Health Plans: Potential
Effects on Health Care Spending and Outcomes. December 2006.
—— The Tax Treatment of Employment-Based Health Insurance. March 1994.

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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
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