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
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Tax Benefits for Health Insurance and Expenses: Current Legislation
SUMMARY
The second session of the 109th Congress
pension paid by the Pension Benefit Guaran-
will likely consider a variety of proposals to
tee Corporation can receive an advanceable,
change the tax benefits for health insurance
refundable tax credit (the health coverage tax
and medical expenses. President Bush has
credit, HCTC) to purchase certain types of
proposed measures that would expand the
insurance. (5) Four tax-advantaged accounts
availability and attractiveness of health sav-
are available to help taxpayers pay their health
ings accounts (HSAs). There may be calls for
care expenses: Flexible Spending Accounts,
employer tax credits. Proponents generally
Health Reimbursement Accounts, Health
argue that new tax benefits would reduce the
Savings Accounts; and Medical Savings
number of uninsured and address efficiency
Accounts. (6) Coverage under Medicare and
and equity problems; opponents claim they
Medicaid is not considered taxable income.
often would primarily benefit higher income
(7) With exceptions, benefits received from
taxpayers and do little for most without cover-
private or public insurance are not taxable.
age. Some argue that expanding government
programs such as Medicaid would be a more
By lowering the after-tax cost of insur-
effective use of government money.
ance, these tax benefits help extend coverage
to more people; they also lead insured people
Current law contains significant tax
to obtain more coverage than otherwise. The
benefits for health insurance and expenses:
incentives influence how coverage is acquired:
(1) Most important is the exclusion of
the uncapped exclusion for employer-paid
employer-paid coverage from the determina-
insurance, which can benefit nearly all work-
tion of income and employment taxes. Two-
ers and is easy to administer, is partly respon-
thirds of the noninstitutionalized population
sible for the predominance of employment-
under age 65 are insured through employment-
based insurance in the United States. The tax
based plans; on average, large employers pay
benefits also increase the demand for health
about 80% of their cost, though some pay all
care by enabling insured people to obtain
and others none. The exclusion also applies to
services at discounted prices; this is one rea-
health insurance provided through cafeteria
son health care prices have risen more rapidly
plans. (2) Self-employed taxpayers may de-
than general inflation. Since many people
duct 100% of their health insurance, even if
would likely obtain some insurance without
they do not itemize deductions. (3) Taxpayers
tax benefits, they can be an inefficient use of
who do itemize may deduct insurance pay-
public dollars. When insurance is viewed as
ments and other unreimbursed medical ex-
a form of personal consumption, tax benefits
penses to the extent they exceed 7.5% of
appear inequitable since the savings they
adjusted gross income. While not widely used,
generate depend on taxpayers’ marginal tax
this deduction benefits some who purchase
rates. When viewed as spreading catastrophic
individual market policies and others who pay
economic risk over multiple years, however,
for employment-based insurance with after-
basing savings on marginal rates might be
tax dollars. (4) Some workers eligible for
justified as the proper treatment for losses
Trade Adjustment Assistance or receiving a
under a progressive tax system.
Congressional Research Service ˜ The Library of Congress
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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.)
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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 employment-
based plans, premiums for individual private market policies, and part of the premiums paid
by self-employed taxpayers. More generally, medical expenses include amounts paid for the
“diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of
affecting any structure or function of the body.” They also include certain transportation and
lodging expenditures, qualified long-term care service costs, and long-term care premiums
that do not exceed certain amounts. Currently, the deduction is intended to help only those
with catastrophic expenses.
The medical expense deduction is not widely used. For most taxpayers, the standard
deduction is larger than the sum of itemized deductions; moreover, most do not have
unreimbursed expenses that exceed the 7.5% AGI floor. In 2001, about 34% of all individual
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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 self-
employed 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
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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
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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)
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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
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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.
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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,
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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
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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
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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.
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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 employment-
based insurance (or who are dissatisfied with it) and who cannot claim the medical expense
deduction. A credit could provide all taxpayers with the same dollar reduction in final tax
liability; this would avoid problems of vertical equity associated with the tax exclusion and
tax deduction. A credit might also provide lower income taxpayers with greater tax savings
than either the exclusion or the deduction; this might reduce the number of the uninsured.
If the credit were refundable, 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
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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.
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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.
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Appendix
Listed below is the general formula for calculating federal income taxes. The list omits
some steps, such as prepayments (from withholding and estimated payments) and the
alternative minimum tax.
1.
Gross income (everything counted for tax purposes)
2.
minus Deductions (or adjustments) for AGI (i.e., “above the line deduction”)
3.
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
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
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Tax Benefits for Health Insurance and Expenses: Current Legislation
SUMMARY
The second session of the 109th Congress
pension paid by the Pension Benefit Guaran-
will likely consider a variety of proposals to
tee Corporation can receive an advanceable,
change the tax benefits for health insurance
refundable tax credit (the health coverage tax
and medical expenses. President Bush has
credit, HCTC) to purchase certain types of
proposed measures that would expand the
insurance. (5) Four tax-advantaged accounts
availability and attractiveness of health sav-
are available to help taxpayers pay their health
ings accounts (HSAs). There may be calls for
care expenses: Flexible Spending Accounts,
employer tax credits. Proponents generally
Health Reimbursement Accounts, Health
argue that new tax benefits would reduce the
Savings Accounts; and Medical Savings
number of uninsured and address efficiency
Accounts. (6) Coverage under Medicare and
and equity problems; opponents claim they
Medicaid is not considered taxable income.
often would primarily benefit higher income
(7) With exceptions, benefits received from
taxpayers and do little for most without cover-
private or public insurance are not taxable.
age. Some argue that expanding government
programs such as Medicaid would be a more
By lowering the after-tax cost of insur-
effective use of government money.
ance, these tax benefits help extend coverage
to more people; they also lead insured people
Current law contains significant tax
to obtain more coverage than otherwise. The
benefits for health insurance and expenses:
incentives influence how coverage is acquired:
(1) Most important is the exclusion of
the uncapped exclusion for employer-paid
employer-paid coverage from the determina-
insurance, which can benefit nearly all work-
tion of income and employment taxes. Two-
ers and is easy to administer, is partly respon-
thirds of the noninstitutionalized population
sible for the predominance of employment-
under age 65 are insured through employment-
based insurance in the United States. The tax
based plans; on average, large employers pay
benefits also increase the demand for health
about 80% of their cost, though some pay all
care by enabling insured people to obtain
and others none. The exclusion also applies to
services at discounted prices; this is one rea-
health insurance provided through cafeteria
son health care prices have risen more rapidly
plans. (2) Self-employed taxpayers may de-
than general inflation. Since many people
duct 100% of their health insurance, even if
would likely obtain some insurance without
they do not itemize deductions. (3) Taxpayers
tax benefits, they can be an inefficient use of
who do itemize may deduct insurance pay-
public dollars. When insurance is viewed as
ments and other unreimbursed medical ex-
a form of personal consumption, tax benefits
penses to the extent they exceed 7.5% of
appear inequitable since the savings they
adjusted gross income. While not widely used,
generate depend on taxpayers’ marginal tax
this deduction benefits some who purchase
rates. When viewed as spreading catastrophic
individual market policies and others who pay
economic risk over multiple years, however,
for employment-based insurance with after-
basing savings on marginal rates might be
tax dollars. (4) Some workers eligible for
justified as the proper treatment for losses
Trade Adjustment Assistance or receiving a
under a progressive tax system.
Congressional Research Service ˜ The Library of Congress
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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.)
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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 employment-
based plans, premiums for individual private market policies, and part of the premiums paid
by self-employed taxpayers. More generally, medical expenses include amounts paid for the
“diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of
affecting any structure or function of the body.” They also include certain transportation and
lodging expenditures, qualified long-term care service costs, and long-term care premiums
that do not exceed certain amounts. Currently, the deduction is intended to help only those
with catastrophic expenses.
The medical expense deduction is not widely used. For most taxpayers, the standard
deduction is larger than the sum of itemized deductions; moreover, most do not have
unreimbursed expenses that exceed the 7.5% AGI floor. In 2001, about 34% of all individual
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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 self-
employed 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
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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
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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)
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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
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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.
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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,
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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
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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
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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.
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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 employment-
based insurance (or who are dissatisfied with it) and who cannot claim the medical expense
deduction. A credit could provide all taxpayers with the same dollar reduction in final tax
liability; this would avoid problems of vertical equity associated with the tax exclusion and
tax deduction. A credit might also provide lower income taxpayers with greater tax savings
than either the exclusion or the deduction; this might reduce the number of the uninsured.
If the credit were refundable, 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
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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.
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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.
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Appendix
Listed below is the general formula for calculating federal income taxes. The list omits
some steps, such as prepayments (from withholding and estimated payments) and the
alternative minimum tax.
1.
Gross income (everything counted for tax purposes)
2.
minus Deductions (or adjustments) for AGI (i.e., “above the line deduction”)
3.
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
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