Tax Benefits for Health Insurance: Current Legislation

This report discusses a variety of potential proposals to change the tax benefits for health insurance and medical expenses, including measures that would expand the availability and attractiveness of health savings accounts (HSAs), or employer tax credits.

Order Code IB98037 CRS Issue Brief for Congress Received through the CRS Web Tax Benefits for Health Insurance and Expenses: Current Legislation Updated February 6, 2006 Bob Lyke Domestic Social Policy Division Congressional Research Service ˜ The Library of Congress CONTENTS SUMMARY MOST RECENT DEVELOPMENTS BACKGROUND AND ANALYSIS Tax Benefits in Current Law Overview of Current Provisions Employment-Based Plans Medical Expense Deduction Individual Private Market Policies Self-Employed Deduction Cafeteria Plans Flexible Spending Accounts Health Reimbursement Accounts Health Savings Accounts Medical Savings Accounts Health Coverage Tax Credit Military and Veterans Health Care Medicare and Medicaid Some Consequences of the Tax Benefits Increases in Coverage Source of Coverage Increase in Health Care Use and Cost Equity Current Proposals Flexible Spending Accounts Cafeteria Plans Health Savings Accounts Health Coverage Tax Credit Expanded Individual Tax Credit Employer Tax Credit Expanded Tax Deduction FOR ADDITIONAL READING Appendix IB98037 02-06-06 Tax Benefits for Health Insurance and Expenses: Current Legislation SUMMARY The second session of the 109th Congress will likely consider a variety of proposals to change the tax benefits for health insurance and medical expenses. President Bush has proposed measures that would expand the availability and attractiveness of health savings accounts (HSAs). There may be calls for employer tax credits. Proponents generally argue that new tax benefits would reduce the number of uninsured and address efficiency and equity problems; opponents claim they often would primarily benefit higher income taxpayers and do little for most without coverage. Some argue that expanding government programs such as Medicaid would be a more effective use of government money. 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 and Medicaid 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 help extend coverage to more people; they also lead insured people to obtain more coverage than otherwise. The incentives 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 employmentbased insurance in the United States. The tax benefits also increase the demand for health care by enabling insured people to obtain services at discounted prices; this is one reason health care prices have risen more rapidly than general inflation. Since many people would likely obtain some insurance without tax benefits, they can be an inefficient use of public dollars. When insurance is viewed as a form of personal consumption, tax benefits appear inequitable since the savings they generate depend on taxpayers’ marginal tax rates. When viewed as spreading catastrophic economic risk over multiple years, however, basing savings on marginal rates might be justified as the proper treatment for losses under a progressive tax system. Current law contains significant tax benefits for health insurance and expenses: (1) Most important is the exclusion of employer-paid coverage from the determination of income and employment taxes. Twothirds of the noninstitutionalized population under age 65 are insured through employmentbased 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 do 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 some who purchase individual market policies and others who pay for employment-based insurance with aftertax dollars. (4) Some workers eligible for Trade Adjustment Assistance or receiving a Congressional Research Service ˜ The Library of Congress IB98037 02-06-06 MOST RECENT DEVELOPMENTS In his FY2007 budget, which was released on February 6, 2006, President Bush proposed a number of measures that would increase the availability and attractiveness of health savings accounts (HSAs), among them the following: (1) an above-the-line deduction and a refundable income tax credit for the purchase of HSA-eligible individual market insurance; (2) increases in allowable HSA contributions and a refundable income tax credit for HSA contributions not made by employers; (3) a refundable tax credit for lower income individuals to purchase HSA-eligible individual market insurance; (4) allowing 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; (5) allowing HSAs to reimburse (as a qualified medical expense) premiums for HSA-eligible individual market insurance; and (6) allowing employers to contribute additional sums to HSAs on behalf of employees (or their spouse or dependents) who are critically ill. The President also proposed minor changes to the health coverage tax credit. On December 15, 2005, the House passed pension reform legislation (H.R. 2830, the Pension Protection Act of 2005) that includes a provision allowing up to $500 in unused health care FSA funds to be carried over to the following year or contributed to a health savings account. BACKGROUND AND ANALYSIS Tax Benefits in Current Law Current law provides significant tax benefits for health insurance and expenses. The tax subsidies — for the most part federal income tax exclusions and deductions — are widely available, though not everyone can take advantage of them. They reward some people more than others, raising questions of equity. They influence the amount and type of coverage that people obtain, which affects their ability to choose doctors and other providers. In addition, the tax benefits affect the distribution and cost of health care. Overview of Current Provisions This section summarizes the current tax treatment of the principal ways that people obtain health insurance. It describes general rules but does not discuss all limitations, qualifications, and exceptions. To understand possible effects on tax liability, readers may want to refer to the Appendix for an outline of the federal income tax formula. (For example, exclusions are items that are omitted from gross income, while deductions are subtracted from gross income in order to arrive at taxable income.) Section number references are to the Internal Revenue Code of 1986 as amended. Employment-Based Plans. Health insurance paid by employers generally is excluded from employees’ gross income in determining their income tax liability; it also is not considered for either the employee’s or the employer’s share of employment taxes (i.e., social security, Medicare, and unemployment taxes). (Sections 106 and 3121, respectively.) CRS-1 IB98037 02-06-06 The income and employment tax exclusions apply to both single and family coverage, which includes the employee’s spouse and dependents. Premiums paid by employees generally are not deductible, though they may be counted towards the itemized medical expense deduction or subject to a premium conversion arrangement under a cafeteria plan (both of which are discussed below). Nearly two-thirds of the noninstitutionalized population under age 65 is insured under an employment-based plan. On average, large employers pay about 80% of the cost for employment-based insurance, though some pay all and others pay none. Employers typically pay a smaller percentage for family than for single coverage. Insurance benefits paid from employment-based plans are excluded from gross income if they are reimbursements for medical expenses or payments for permanent physical injuries. Benefits not meeting these tests are taxable in proportion to the share of the insurance costs paid by the employer that were excluded from gross income. (Sections 104 and 105) Benefits are also taxable to the extent taxpayers received a tax benefit from claiming a deduction for the expenses in a prior year (for example, if taxpayers claimed a medical expense deduction for expenditures in 2002 and then received an insurance reimbursement in 2003). In addition, benefits received by highly-compensated employees under discriminatory self-insured plans are partly taxable. A self-insured plan is one in which the employer assumes the risk for a health care plan and does not shift it to a third party. Employers may deduct their insurance payments as a business expense. The deduction is not a tax benefit but a calculation necessary for the proper measurement of the net income that is subject to taxation. Revenue loss attributable to this deduction is not considered a tax expenditure. The Joint Committee on Taxation (JCT) estimates that the FY2005 tax expenditure (change in aggregate tax liability) attributable to the exclusion for employer contributions for health insurance, medical care (including that provided through cafeteria plans and flexible spending accounts, described below) and long-term care insurance will be $78.6 billion. The estimate does not include the effect of the exclusion on employment taxes. Medical Expense Deduction. Taxpayers who itemize their deductions may deduct unreimbursed medical expenses, but only the amount of such expenses that exceeds 7.5% of adjusted gross income (AGI). (Section 213) Medical expenses include health insurance premiums paid by the taxpayer, such as the employee’s share of premiums in employmentbased plans, premiums for individual private market policies, and part of the premiums paid by self-employed taxpayers. More generally, medical expenses include amounts paid for the “diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body.” They also include certain transportation and lodging expenditures, qualified long-term care service costs, and long-term care premiums that do not exceed certain amounts. Currently, the deduction is intended to help only those with catastrophic expenses. The medical expense deduction is not widely used. For most taxpayers, the standard deduction is larger than the sum of itemized deductions; moreover, most do not have unreimbursed expenses that exceed the 7.5% AGI floor. In 2001, about 34% of all individual CRS-2 IB98037 02-06-06 income tax returns had itemized deductions, and of these only about 17% (i.e., about 5.8% of all returns) claimed a medical expense deduction. The JCT estimates the FY2005 tax expenditure attributable to the medical expense deduction (including long-term care expenses) will be $7.7 billion. Individual Private Market Policies. Payments for private market health insurance purchased by individuals are a deductible medical expense, provided the taxpayer itemizes deductions and applies the 7.5% AGI floor just described. Premiums for the following insurance, however, are not deductible: policies for loss of life, limb, sight, etc.; policies that pay guaranteed amounts each week for a stated number of weeks for hospitalization; and the part of car insurance that provides medical coverage for all persons injured in or by the policyholder’s car. Benefits paid under accident and health insurance policies purchased by individuals are excluded from gross income, even if they exceed medical expenses. Under 7% of the noninstitutionalized population under age 65 is insured through these private policies. Likely purchasers include early retirees, young adults, employees without access to employment-based insurance, and the self-employed. Self-Employed Deduction. Self-employed taxpayers may deduct payments for health insurance (typically individual private market coverage) in determining their AGI. (Section 162) Called an “above-the-line” deduction, this tax benefit is not restricted to itemizers or subject to a floor, as is the medical expense deduction described above. Starting in 2003, 100% of the cost may be taken into consideration. The deduction cannot exceed the net profit and any other earned income from the business under which the plan is established, less deductions taken for certain retirement plans and for one-half the self-employment tax. It is not available for any month in which the taxpayer or the taxpayer’s spouse is eligible to participate in a subsidized employment-based health plan (that is, one in which the employer pays part of the cost). These restrictions prevent taxpayers with little net income from their business (which may not be uncommon in a new business, for example, or in a part-time business that grows out of a hobby) from deducting much if any of their insurance payments. However, the portion not deductible under these rules may be treated as an itemized medical expense deduction. Self employed individuals include sole proprietors (single owners of unincorporated businesses), general partners, limited partners who receive guaranteed payments, and individuals who receive wages from S-corporations in which they are more than 2% shareholders. (S-corporation status may be elected by corporations that meet a number of Internal Revenue Code requirements. Among other things, they cannot have more than 75 shareholders or more than one class of stock. S-corporations are tax-reporting rather than tax-paying entities, in contrast to C-corporations that are subject to the corporate income tax.) In 2003, about 3.7 million tax returns (about 2.8% of all returns) claimed the selfemployed health insurance deduction. For FY2005, the JCT estimates the tax expenditure attributable to the deduction (including the deduction for long-term care insurance) to be $3.2 billion. Cafeteria Plans. Health benefits provided through a cafeteria plan are excludable for both income and employment tax purposes. A cafeteria plan is a written benefit plan under CRS-3 IB98037 02-06-06 which employees may choose between receiving cash and certain nontaxable benefits such as health coverage or dependent care. (Cash here includes any taxable benefits.) Under an option known as a premium conversion plan, employees may elect to reduce their taxable wages in exchange for having their share of health insurance premiums paid on a pre-tax basis; the effect is the same as if employees could claim an above-the line deduction for their payments. Federal employees who participate in the Federal Employees Health Benefits Program (FEHBP) have been able to elect this option since October, 2000; however, the option is not available to federal retirees. Nontaxable benefits provided through cafeteria plans are exempt from income and employment taxes under the Internal Revenue Code rules applicable to those benefits, such as employer-paid insurance. A separate statutory provision (Section 125) extends these exclusions to situations in which employees are given the option of receiving cash; were it not for this provision, the nontaxable benefit would be taxable since the employees had been in constructive receipt of the cash. Flexible Spending Accounts. Benefits paid from flexible spending accounts (FSAs) are also excludable for income and employment tax purposes. FSAs and cafeteria plans are closely related, but not all cafeteria plans have FSAs and not all FSAs are part of cafeteria plans. FSAs funded through salary reductions are exempt from taxation through cafeteria plan provisions (since otherwise employees would be in constructive receipt of cash) while FSAs funded by nonelective employer contributions are exempt directly under provisions applying to employer-paid insurance. Health care FSAs must exhibit some of the risk-shifting and risk-distribution characteristics of insurance. Among other things, participants must elect a specific benefit amount prior to the start of a plan year; this election cannot be revoked except for changes in family status. The full benefit amount (less any benefits paid) must be made available throughout the entire year, even if employees spread their contributions throughout the year. Any amount unused at the end of the year must be forfeited to the employer (thus, “use it or lose it”), though employers may allow a 2 ½-month grace period. FSAs cannot be used to purchase insurance; however, they can be combined with premium conversion plans under cafeteria arrangements to achieve the same tax effect. 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. The average amount contributed was $1,295. For additional information on FSAs, see CRS Report RL32656, Health Care Flexible Spending Accounts, by Chris L. Peterson and Bob Lyke. Also see CRS Report RS21573, Tax-Advantaged Accounts for Health Care Expenses: Side-by-Side Comparison, by Bob Lyke and Chris L. Peterson for a quick overview of FSAs and the three other accounts discussed below. 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 is the case with FSAs, contributions CRS-4 IB98037 02-06-06 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 upon 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 Section 105 of the Internal Revenue Code, which allows health plan benefits used for medical care to be exempt from taxes, and Section 106 of the Code, which allows employer contributions to those plans to be tax-exempt. Rules regarding HRAs are spelled out in IRS revenue rulings and notices issued in 2002. Health Savings Accounts. The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA, P.L. 108-173) authorized new heath savings accounts (HSAs) for unreimbursed medical expenses. HSAs are similar to medical savings accounts (MSAs), and it is thought in time HSAs will replace them. HSAs are available to taxpayers generally; individuals do not have to be either self-employed or employed by a small employer that provides high deductible insurance. There is not any limit on the number of accounts. HSA contributions can be made when individuals have qualifying health insurance: for self-only insurance, the deductible in 2006 must be at least $1,050 and required out-of-pocket expenses for covered benefits cannot exceed $5,250; for family coverage, the deductible must be at least $2,100 and required out-of-pocket expenses for covered benefits cannot exceed $10,500. In 2006, contributions are limited to the lesser of $2,700 or 100% of the deductible for self-only coverage; for family coverage, they are limited to the least of $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. Individuals age 55 and older may contribute an additional $700. Contributions may be made by employers, individuals, or both. HSAs were first allowed as of January 1, 2004, and many insurers and employers have only recently begun offering products. According to America’s Health Insurance Plans (AHIP), as of March, 2005, more than 1 million individuals were covered by insurance plans that accompany HSAs, most of them in the private individual market; that number may be 3 million now. For additional information, see CRS Report RL32467, Health Savings Accounts, by Bob Lyke, Chris L. Peterson, and Neela Ranade, and CRS Report RL33257, Health Savings Accounts: Overview of Rules for 2006, by Bob Lyke. Medical Savings Accounts. Medical savings accounts (MSAs) are personal savings accounts for unreimbursed medical expenses. They are used to pay for health care not covered by insurance, including deductibles and copayments. Currently, a limited number of MSAs may be established by individuals who have qualifying high deductible insurance (and none other, with some exceptions) and who either are self-employed or are employees covered by a high deductible insurance plan established by their small employer (50 or fewer employees on average). The formal name of MSAs is now Archer MSAs. Employer contributions to MSAs are excludable for both income and employment tax purposes, while individuals’ contributions (allowed only if the employer does not contribute) CRS-5 IB98037 02-06-06 are deductible for determining AGI. Contributions are limited to 65% of the insurance deductible for single coverage and 75% for family coverage. Account earnings are excludable as well, as are distributions used for unreimbursed medical expenses, with some exceptions. Non-qualified distributions are included in gross income and an additional 15% penalty is applied. The original medical savings account legislation (the Health Insurance Portability and Accountability Act of 1996, P.L. 104-191) authorized a limited number of MSAs under a demonstration beginning in 1997. Eligibility was to be restricted after the earlier of (1) December 31, 2000 (extended by subsequent legislation to December 31, 2003) or (2) specified dates following a determination that the number of taxpayers with accounts exceeded certain thresholds (eventually, 750,000). Once eligibility was restricted under these tests, MSAs generally would have been limited to individuals who either were active participants (had contributions to their accounts) prior to the cut-off date or became active participants through a participating employer. In October 2002, the IRS estimated that there would be 78,913 MSA returns filed for tax year 2001; it also determined that 20,592 taxpayers who did not make contributions in 2001 established accounts in the first six months of 2002. These numbers are far less than the 750,000 statutory ceiling. (Not all MSAs are counted toward the ceiling; for example, accounts of taxpayers who previously were uninsured are not taken into consideration.) MSAs should be distinguished from Medicare MSAs, which are discussed below under the tax treatment of Medicare and Medicaid. Health Coverage Tax Credit. This tax credit equals 65% of the premiums paid by eligible individuals for qualifying insurance. The Health Coverage Tax Credit (HCTC) is payable in advance, meaning that workers can receive the credit when purchasing insurance rather than receiving it after filing their tax returns. It is also refundable; eligible workers can receive the credit even if they have zero tax liability for the year. Three groups of taxpayers are eligible for the HCTC: (1) 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; (2) individuals age 50 and over receiving an Alternative Trade Adjustment Assistance allowance; and (3) individuals age 55 and over receiving a Pension Benefit Guaranty Corporation (PBGC) pension payment, including those who received a lump sum payment from the PBGC after August 5, 2002. Eligible individuals cannot be enrolled in certain other health insurance, including Medicaid employment-based insurance for which the employer pays 50% or more of the cost, or entitled to Medicare. The HCTC can be claimed only for 10 types of insurance coverage specified in the statute, seven of which require state action to become effective. As of November 2004, 39 states and the District of Columbia made at least one of these seven forms of coverage available; in the remaining 11 states, only the three automatically qualified forms not requiring state action were available, though not to all who were eligible for the credit. The HCTC does not appear to be widely used. As of November 2004, 13,369 of the estimated 223,307 taxpayers who were potentially eligible for the credit were receiving advance payments, or about 6%. Others might have claimed the credit for that year without an advance payment, but at the time their number was not thought to be to be large. For CRS-6 IB98037 02-06-06 additional information, see CRS Report RL32620, Health Coverage Tax Credit Authorized by the Trade Act by Julie Stone-Axelrad and Bob Lyke. However, a more recent Economic and Social Research Institute study estimated that altogether about 25,500 taxpayers claimed the credit for 2004, and that many of those who were potentially eligible actually were not because they had access to disqualifying insurance (such as employer-paid coverage through a spouse). The study said that a better estimate of the take-up rate is about 22%. Military and Veterans Health Care. Coverage under military and veterans health care programs is not taxable income, nor are the benefits these programs provide. The tax exclusion (Section 134) applies as well to the Civilian Health and Medical Program of the Uniformed Services (CHAMPUS) and Tricare, which serve military dependents, retirees, and retiree dependents. For 2005, the JCT estimates that the tax expenditure attributable to CHAMPUS and Tricare will be $1.6 billion. For more information, see CRS Issue Brief IB93103, Military Medical Care Services: Questions and Answers, by Richard A. Best, Jr. Medicare and Medicaid. Coverage under Medicare or Medicaid is not taxable income. Similarly, benefits paid from either program are not subject to taxation. Medicare covers more than 38 million people, including 96% of those ages 65 and older. Medicaid covers more than 41 million people. For FY2005, the JCT estimates the tax expenditure attributable to the exclusion of Medicare benefits will be $27.3 billion. Medicaid beneficiaries, who must meet certain categorical requirements (aged, blind, or disabled, or specified members of families with dependent children) are generally poor and unlikely to have tax liability. The employment tax individuals pay for Medicare Part A is not a deductible medical expense. However, premiums paid by individuals who voluntarily enroll in Part A are deductible, provided the taxpayer itemizes deductions and applies the 7.5 % AGI floor as described above. (Medicare Part A is insurance for hospitalization, skilled nursing facilities, home health and hospice care. Individuals age 65 and older may voluntarily enroll in Part A if they or their spouse do not have at least 10 years of Medicare-covered employment.) Medicare Part B premiums are also deductible subject to those same limitations, as are premiums for Medigap insurance. (Medicare Part B is supplementary insurance for doctors’ fees and outpatient services. Medigap insurance is private insurance that covers Medicare deductibles, co-payments, and benefits not covered under Medicare.) Presumably, Part D premiums (for prescription drug coverage) will also be deductible subject to those limitations. Beginning in 1999, legislation allowed a limited number of Medicare beneficiaries to elect Medicare+Choice medical savings accounts instead of traditional Medicare. Contributions to these accounts (made only by the Secretary of Health and Human Services) are exempt from taxes, as are account earnings. Withdrawals are likewise not taxed nor subject to penalties if used to pay unreimbursed medical expenses, with some exceptions. The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA, P.L. 108-173) renamed Medicare+Choice plans Medicare Advantage plans. No Medicare MSAs have ever been offered. CRS-7 IB98037 02-06-06 Some Consequences of the Tax Benefits Increases in Coverage. By lowering the after-tax cost of insurance, the tax benefits described above help extend coverage to more people. This of course is the intention: Congress has long been concerned about whether people have access to health care. The public subsidy implicit in the incentives (foregone tax revenues) usually is justified on grounds that people would otherwise under-insure, that is, delay purchasing coverage in the hope that they will not become ill or have an accident. Uninsured people are an indication of market failure; they impose spill-over costs on society in the form of public health risks and uncompensated charity care (the free-rider problem). Moreover, if insurance were purchased only by people who most need health care, its cost would become prohibitive for others (the adverse selection problem). However, the tax benefits also lead insured people to obtain more coverage than they would otherwise choose. They purchase insurance that covers more than hospitalization and other catastrophic expenses, such as routine doctor visits, prescription drugs, and dental care. They obtain coverage with smaller deductibles and copayments. On the other hand, comprehensive coverage and lower cost-sharing are thought to lead to better preventive care and possibly long-run savings for certain medical conditions. Source of Coverage. Tax benefits influence the way in which insurance coverage is acquired. The uncapped exclusion for employer-paid insurance, for example, which can benefit nearly all workers and is easy to administer, is partly responsible for the predominance of employment-based insurance in the United States. In contrast, restrictions on the itemized deduction allowed for individual private market insurance may be one reason why that insurance covers less than 7% 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 most care. Usually employee premiums do not vary by age or risk; while 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 health care. However, plans chosen by employers may not meet individual workers’ needs (particularly if there are limited options), and changing jobs may require both new insurance and doctors. Increase in Health Care Use and Cost. The tax benefits increase the demand for health care by enabling insured people to obtain services at discounted prices. This induced demand can be beneficial to the extent it reflects needed health care (that which society deems everyone should have) that financial constraints otherwise would have prevented. It can be wasteful to the extent it results in less essential or ineffective care. In either case, many economists argue, the additional demand is one reason why prices for health care have risen more rapidly than the general rate of inflation. Whether insurance coverage could be encouraged without increasing the cost of health care has been a matter of debate. Comprehensive reforms that might accomplish this goal include capping the exclusion for employer-paid insurance and replacing both the exclusion and the deduction with a limited tax credit. But these changes could be difficult to implement and may create serious inequities. A 1994 Congressional Budget Office study, CRS-8 IB98037 02-06-06 The Tax Treatment of Employment-Based Health Insurance, provides an overview of the issues and questions these approaches raise. Many people probably would obtain some health insurance even without the tax benefits. The cost of subsidizing people for what they would otherwise do is an inefficient use of public dollars. Ideally, the tax incentives should lead to insurance being purchased only to the extent it results in better health care for society as a whole. But how they could be revised to accomplish this goal is a difficult question given the different ways insurance is provided, the various ways it is regulated, and the voluntary nature of decisions to purchase it. Equity. Questions might be raised about the distribution of the tax incentives. Since as a practical matter they are not available to everyone, problems of horizontal equity arise. Workers without employment-based insurance generally cannot benefit from them, nor can many early retirees (people under the age of 65). Even if these individuals itemized their deductions, they can deduct health insurance premiums only to the extent that they (and other health care expenditures) exceed 7.5% of AGI. In contrast, the exclusion for employer-paid insurance is unlimited. Even if everyone could benefit from the tax incentives, there would be questions of vertical equity. Tax savings from the exclusions and deductions described above generally are determined by taxpayers’ marginal tax rate. Thus, taxpayers in the 15% tax bracket would save $600 in income taxes from a $4,000 exclusion (i.e., $4,000 x 0.15) for an employer-paid premium, while taxpayers in the 35% bracket would save $1,400 (i.e., $4,000 x 0.35). If health insurance is considered a form of personal consumption like food or clothing, this pattern of benefits would strike many people as unfair. It is unlikely that a government grant program would be designed in this manner. However, to the extent that health insurance is considered a way of spreading an individual’s catastrophic economic risk over multiple years, basing tax savings on marginal tax rates might be justified. Under a progressive income tax system, economic losses theoretically ought to be deducted at applicable marginal rates, just as economic gains are taxed at those rates. Current Proposals This issue brief focuses on bills that would change tax benefits for health insurance and medical expenses that have received committee or floor action or that otherwise are the subject of discussion. It does not identify all relevant bills because in a typical Congress these have numbered in the hundreds. Congressional staff who are interested in other bills might search for them through the Legislative Information System (LIS); in particular, they might use the Advanced Search link (in the middle of the screen) and search for terms such as “health insurance” AND “credit” AND “Internal Revenue Code.” For assistance, telephone CRS at 7-5700. 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. For the past several CRS-9 IB98037 02-06-06 Congresses, there have been efforts 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. Other bills introduced in the 109th Congress to allow a rollover of some health care FSA funds include H.R. 1803 (Royce), H.R. 1998 (McCrery), H.R. 3075 (Paul), S. 309 (DeMint), S. 723 (Snowe), and S. 1359 (Smith). S. 723 would 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 these proposals 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 sometimes conflict with HSAs. FSAs cannot be used to pay deductibles and copayments associated with the high deductible insurance that allows individuals to make HSA contributions; while individuals may have both types of accounts, they must cover different categories of expenses. Thus, rule changes that might make FSAs more popular may inhibit the spread of HSAs. Allowing unused balance to be carried over or rolled over would also increase revenue losses associated with FSAs. H.R. 4511 (Cantor) would amend the health savings account provisions to allow greater combined use of FSAs and HSAs. Cafeteria Plans 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. 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 insurance coverage. Including the latter groups would substantially increase the cost of the legislation. Health Savings Accounts The Administration strongly supports HSAs as a way of helping people acquire affordable insurance (since the deductibles are higher) and build reserves that can be used for health care expenses in later years. In his FY2007 budget, President Bush has proposed CRS-10 IB98037 02-06-06 a number of measures that would increase the availability and attractiveness of these accounts, among them the following: (1) an above-the-line deduction and a refundable income tax credit for the purchase of HSA-eligible individual market insurance; (2) increases in allowable HSA contributions and a refundable income tax credit for HSA contributions not made by employers; (3) a refundable tax credit for lower income individuals to purchase HSA-eligible individual market insurance; (4) allowing 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; (5) allowing HSAs to reimburse (as a qualified medical expense) premiums for HSA-eligible individual market insurance; and (6) allowing employers to contribute additional sums to HSAs on behalf of employees (or their spouse or dependents) who are critically ill. In his FY2006 budget the previous year, the President proposed only two tax incentives associated with HSAs: (1) an above-the-line deduction for the cost of qualifying high deductible insurance for taxpayers who contribute to health savings accounts, and (2) a refundable tax credit for small for-profit employers that contribute to their employees’ health savings accounts. Among the bills that would authorize these provisions are H.R. 37 (King), H.R. 1872 (Johnson-TX), S. 978 (Santorum), and S. 1503 (Frist). H.R. 2063 (Shuster) would permit one-time, tax-free distributions from retirement plans to fund HSAs. H.R. 3075 (Paul) would increase the deduction allowed for contributions to HSAs. H.R. 4511 (Cantor) would amend the health savings account provisions to allow greater combined use of FSAs and HSAs. Health Coverage Tax Credit Though first available only in December 2002, the HCTC has been the subject of much controversy and proposals for change. One issue is eligibility: under current law, taxpayers must be in one of three groups discussed above, that is, recipients of Trade Readjustment Assistance (or eligible individuals still receiving state unemployment compensation), Alternative Trade Adjustment Assistance, or a pension paid by the Pension Benefit Guaranty Corporation. Some argue that eligibility should be expanded to include other groups, such as service industry workers displaced by foreign trade (Trade Adjustment Assistance is now limited to manufacturing workers), the spouse of someone who is no longer eligible (perhaps because they enrolled in Medicare), or even Katrina survivors. H.R. 1281 (King) and S. 1309 (Baucus) would extend trade adjustment assistance to service workers. A second issue involves the consumer protection standards (guaranteed issue, no preexisting condition exclusion, nondiscriminatory premiums, and substantially the same benefits for eligibles and noneligibles) required of state qualified insurance plans. Although some argue that these provisions make access to insurance more equitable and guarantee premiums and benefit packages like those offered others in a particular state, others claim the provisions limit the availability of state qualified plans and raise costs. In the 108th Congress, the House passed legislation which would allow individuals to temporarily waive some of these provisions, but it was not enacted. CRS-11 IB98037 02-06-06 In his FY2007 budget, the President has proposed a number of clarifications and other minor changes to the HCTC. Some 109th Congress bills that would amend the HCTC include S. 4 and S. 1503 (both by Frist), S. 14 (Stabenow), and S. 1365 (Rockefeller). Expanded Individual Tax Credit In his FY2007 budget, President Bush has proposed a 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. President Bush’s FY2006 budget, like his FY2005 budget, included a refundable tax credit that was not limited to HSA-eligible individual market insurance. The credit in the FY2006 budget would equal 90% of the cost of health insurance, up to a maximum of $1,000 for each adult and $500 for each of two children; the credit would be reduced and eventually phased out for incomes above $15,000 for single tax filers with no dependents and above $25,000 for other tax filers. If the premium were for qualifying high deductible insurance, individuals could elect to have 30% of the credit deposited in their health savings account. The credit would be claimed through the normal tax-filing process in the following tax year; alternatively, it could be claimed in advance (based on the individual’s prior year tax return), allowing reduced premium payments. In the latter case, the insurer would be reimbursed for the credit directly from the U.S. Treasury. In general, an expanded tax credit could be attractive in several respects. If it were generally available, a credit could aid taxpayers who do not have access to employmentbased insurance (or who are dissatisfied with it) and who cannot claim the medical expense deduction. A credit could provide all taxpayers with the same dollar reduction in final tax liability; this would avoid problems of vertical equity associated with the tax exclusion and tax deduction. A credit might also provide lower income taxpayers with greater tax savings than either the exclusion or the deduction; this might reduce the number of the uninsured. If the credit were refundable, as in the President’s FY2006 proposal, it could even help taxpayers with limited or no tax liability. But the effects of tax credits can vary widely, depending on how they are designed. One important question is whether the credit would supplement or replace existing tax benefits, particularly the exclusion for employer-paid insurance. Another is whether the credit would be the same for all taxpayers or more generous for those with lower incomes. Ensuring that lower income families benefit from any credit may be difficult if they cannot afford to purchase insurance beforehand. Similarly, it might be asked whether the credit would vary with factors that affect the cost of health insurance, such as age, gender, place of residence, or health status. Whether the insurance must meet certain standards for benefits, coinsurance, and underwriting might also be a factor. A number of bills have been introduced that would authorize refundable individual tax credits for health insurance; these include H.R. 765 (Representative Kennedy), H.R. 2089 (Representative Granger), H.R. 2033 (Representative Shadegg), H.R. 3075 (Representative CRS-12 IB98037 02-06-06 Paul), S. 4 (Senator Frist), S. 160 (Senator Murkowski), S. 1178 (Senator Martinez), S. 1225 (Senator Collins), and S. 1503 (Senator Frist). Several bills would authorize tax credits only with respect to coverage for dependent children; these include H.H. 3077 (Representative Paul), S. 16 (Senator Kennedy), and S. 114 (Senator Kerry. Employer Tax Credit In his FY2006 budget, the President proposed a tax credit for small employers that make contributions to their employees’ health savings accounts. Small employers are defined as having fewer than 100 employees on a typical business day. The credit could reimburse employers for HSA contributions of up to $200 for single coverage and $500 for family coverage. The President’s FY2007 budget does not contain a comparable provision. A number of bills have been introduced that would authorize tax credits for small employers to help them start or maintain health insurance for their workers; these include H.R. 118 (Hooley), H.R. 2001 (Moore-KS), H.R. 2002 (Moore-KS), H.R. 2073 (Barrow), H.R. 2259 (Dingell), S. 1012 (Kennedy), S. 1225 (Collins), and S. 1329 (Bayh). Expanded Tax Deduction The current law deduction for health insurance is restricted to taxpayers who itemize and is further limited to payments for insurance and unreimbursed medical expenses that exceed 7.5% adjusted gross income; thus, 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 since there are also employment tax savings). In recent Congresses, there have been several proposals to allow all taxpayers to deduct the full cost of their health insurance premiums as an above-the-line deduction (i.e., a deduction not limited to itemizers). Bills in the 109th Congress that would authorize an expanded tax deduction include H.R. 218 (Stearns) and H.R. 2176 (Chabot). In his FY2007 budget, President Bush proposed allowing individuals with HSAs to deduct the cost of their health insurance. FOR ADDITIONAL READING Cunningham. Laura E. National Health Insurance and the Medical Deduction. Tax Law Review, vol. 50 (1995), pp. 237-264. Gruber, Jonathan and Larry Levitt. Tax Subsidies for Health Insurance: Costs and Benefits. Health Affairs. vol. 19 (2000), pp. 72-85. Gruber, Jonathan and James Poterba. Tax Incentives and the Decision to Purchase Health Insurance: Evidence from the Self-Employed. The Quarterly Journal of Economics, vol. 109 (1994), pp. 701-733. CRS-13 IB98037 02-06-06 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. 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. Sheils, John and Paul Hogan. Cost of Tax-Exempt Health Benefits in 1998. Health Affairs, vol. 18 (1999), pp. 176-181. U.S. Congressional Budget Office. The Tax Treatment of Employment-Based Health Insurance. March 1994. U.S. Congress. House. Committee on Ways and Means. Subcommittee on Health. Health Insurance Premium Tax Deductions for the Self-Employed. Hearings, 104th Congress, 1st session. January 27, 1995. Washington: GPO, 1996. U.S. Government Accountability Office. Medical Savings Accounts: Results from Surveys of Insurers. GAO/HEHS-99-34. December 1998. CRS-14 IB98037 02-06-06 Appendix Listed below is the general formula for calculating federal income taxes. The list omits some steps, such as prepayments (from withholding and estimated payments) and the alternative minimum tax. 1. Gross income (everything counted for tax purposes) 2. minus Deductions (or adjustments) for AGI (i.e., “above the line deduction”) 3. equals Adjusted gross income (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 CRS-15