F. TAX INCENTIVES FOR HEALTH COVERAGE
Tax breaks for health insurance premiums and other health expenses are among the largest tax expenditures in the Federal budget. In 2007, the total value in foregone revenue for health tax benefits was more than $300 billion.78 Congress should explore ways to restructure the current tax incentives to encourage more efficient spending on health and to target our tax dollars more effectively and fairly.
Current tax law favors individuals who receive health insurance through their employer. The employer's contribution to health care and premiums is excluded from an individual's income for both income and payroll tax purposes. In addition, an employee's share of the premium cost can be excluded if it is made through what is called a cafeteria benefit plan.
This means workers are not taxed on the value of their health premiums, even though the premiums are part of the worker's total compensation package. There is no limit on the
amount of premiums that can be excluded from wages. The tax exclusion fosters employment-based health coverage, because it lowers the cost of buying insurance through an employer.
In addition to the employee exclusion, other incentives to purchase health care and health
coverage are available through the tax code. An employee's pre-tax contributions for health insurance or medical expenses through a Flexible Spending Account (FSA) are excluded from income and therefore not subject to tax. There are no limits on the amount of wages an employee can contribute on a pre-tax basis to an FSA. For individuals who qualify to contribute to a Health Savings Account (HSA) by enrolling in a high-deductible health plan, up to $2,900 of those contributions for individuals and $5,800 for families are deductible in tax year 2008.
Self-employed individuals can deduct the cost of health insurance premiums for themselves, their spouse, and their dependents for income tax purposes, but they must pay self-employment tax on these amounts. This is less favorable treatment than employer provided health insurance. And finally, those who purchase health insurance through the individual market, and those who have out-of-pocket medical expenses, may deduct their spending to the extent that it exceeds 7.5 percent of their adjusted gross income and they itemize their deductions.
Most economists argue there are problems with the current set of tax incentives for heath care. 79,80,81,82 First, they argue that the incentives are inequitable because the amount of tax benefit received differs based on how health coverage is received: those covered through their employers are rewarded with the largest tax breaks, while those who must obtain coverage on the individual market receive a much smaller tax break, or none at all. Current incentives are also regressive because they are, for the most part, more valuable to taxpayers who are subject to higher marginal rates. As such, they give larger subsidies to higher-income workers, instead of to the lower-income Americans who need more help buying insurance.
Second, many economists argue that the unlimited employee tax exclusion leads to increased health spending. The unlimited tax benefit for the exclusion encourages workers to purchase more expensive coverage to avoid co-payments and deductibles. This lower cost sharing can lead to higher use of services that are considered non-urgent and discretionary. Additionally, employees who have different health insurance options from which to choose may spend health care dollars unnecessarily to simply buy the most expensive plan they can afford, instead of looking at the amount of coverage that they actually need.
Some have proposed eliminating the current tax exclusion for employer-based health insurance premiums and converting the benefit to a tax deduction or tax credit.83,84 This approach goes too far because it could cause widespread disruption in employer-based health benefits. Reform should not endanger coverage for the more than half of all Americans who now have health insurance through an employer.
More targeted reforms of the exclusion might make the incentive more equitable and reduce spending in the health care system. One option for reform is to cap the amount of health care premiums that can be excluded from employee wages for income and payroll tax purposes. This could be done by limiting or capping the tax exclusion based on the value of health benefits or, as an alternative, based on a person's income - or both. Employees could be allowed to exclude, for example, up to a specific dollar amount in health benefits from their wages each year. If they purchase health plans with greater benefits, the difference between a more generous plan and the cap could be subject to Federal and state income taxes. Alternatively, the exclusion could be available on a sliding scale based on income: people with low wages could be allowed to exclude 100 percent of the premiums offered through their employers, with the percent allowed phasing down or out with income.85
Tax incentives can be an effective way of subsidizing the cost of health insurance. New
tax incentives for small businesses and low-income individuals were discussed earlier in
this plan. Current tax policies for health coverage must promote efficient uses of care and
distribute subsidies fairly. We must also balance any tax reforms in this area with the desire of Americans to maintain employer-based health coverage.
