TAX EXPENDITURES FOR HEALTH CARE 

Scheduled for a Public Hearing 

Before the 

SENATE COMMITTEE ON FINANCE 

on July 31, 2008 

Prepared by the Staff 

of the 

JOINT COMMITTEE ON TAXATION 

 

July 30, 2008 

JCX-66-08
i

CONTENTS 

Page

I. OVERVIEW ............................................................................................................................ 1 

II. EMPLOYMENT RELATED TAX EXPENDITURES............................................................ 4 

A. Employer-Provided Health Care......................................................................................... 4 

B. Deduction for Health Insurance Premiums of Self-Employed Individuals ...................... 18 

III. OTHER HEALTH CARE TAX EXPENDITURES............................................................... 20 

A. Medicare ........................................................................................................................... 20 

B. Itemized Deduction for Medical Expenses....................................................................... 22 

C. HSAs and Archer MSAs................................................................................................... 25 

D. Refundable Credit for Health Insurance Expenses of Certain Classes of Individuals...... 30 

E. Other Programs ................................................................................................................. 31 

1. Welfare benefit funds, VEBAs, and retiree medical accounts.................................... 31 

2. Long-term care............................................................................................................ 31

3. Distributions for public safety officers ....................................................................... 33 

APPENDIX A: Comparison of Present-Law Tax Benefits for Health Expenses........................ 34 

APPENDIX B: Comparison of Value of Health Tax Benefits: 

Non-High-Deductible Health Plan................................................................................................ 37 

APPENDIX C: Comparison of Value of Health Tax Benefits: 

High-Deductible Health Plan........................................................................................................ 38 
1 

I. OVERVIEW 

The Senate Committee on Finance has scheduled a public hearing on July 31, 2008, titled 

“Health Benefits in the Tax Code: The Right Incentives.” This document,1 prepared by the staff 

of the Joint Committee on Taxation, provides a description of present law tax expenditures for 

health care. 

The Internal Revenue Code2

 includes a number of significant tax expenditures for health 

expenses.3

 The availability of these different benefits depends in part on: 

1. Is the individual covered under an employer-provided health plan? 

2. Does the individual have self-employment income? 

3. Does the individual itemize deductions and have medical expenses that exceed a 

certain threshold? 

4. Is the individual covered by a high-deductible health plan? 

Table 1 shows estimates of the tax expenditures for the health care sector in 2007. The 

largest tax expenditure is for employer-provided health care benefits. The exclusion of Medicare 

benefits is the next largest tax expenditure, but at a total of $39.3 billion, is only a fraction of the 

size of the expenditure for employer-provided health care benefits. The remaining tax 

expenditures, such as the self-employment exclusion and the deduction for medical expenses 

greater than 7.5 percent of adjusted gross income, were each less than $10 billion, while the 

estimated tax expenditure for health savings accounts was less than $500 million. 

 1

 This document may be cited as follows: Joint Committee on Taxation, Tax Expenditures for 

Health Care (JCX-66-08), July 30, 2008. This document is available at www.jct.gov. 

2

 Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as 

amended (the “Code”). 

3

 Appendix A compares in tabular form the various tax provisions that mitigate the costs of 

health care under present law. 
2 

Table 1.–Calendar Year Tax Expenditure for Health, 2007 

Billions

 of 

Value of Tax Expenditures Dollars 

Exclusion of employer sponsored health care............................................................................ 246.1 

 Income ............................................................................................................. 145.3 

 FICA................................................................................................................ 100.7 

Exclusion of Medicare benefits from income .............................................................................. 39.3 

 Hospital Insurance (Part A) ............................................................................... 20.2 

 Supplementary Medical Insurance (Part B)....................................................... 13.3 

 Prescription Drug Insurance (Part D) .................................................................. 4.8 

 Exclusion of subsidies to employers who maintain prescription drug plans....... 1.0 

Deduction for medical expenses above 7.5% of adjusted gross income........................................ 8.7 

Self-employed health insurance deduction .................................................................................... 4.8

Exclusion of medical care and TRICARE insurance for military dependents 

and retirees not enrolled in Medicare............................................................................................. 2.1 

Exclusion of health insurance benefits for military retirees enrolled in Medicare ........................ 1.0 

Health savings accounts................................................................................................................. 0.3 

Health coverage tax credit.............................................................................................................. 0.1 

Source: JCT Staff calculations. 

The presentation in Table 1 differs from conventional estimates of tax expenditures in 

two respects. This presentation has been selected to provide a sense of the full scope of the 

amounts involved in the special tax treatment of the health tax items listed. 

First, these estimates do not include the effects of “tax form behavior.” In particular, 

conventional expenditure estimates prepared by the Staff of the Joint Committee on Taxation 

(the “JCT Staff”) assume that when taxpayers are denied an exclusion for employer sponsored 

insurance, they can deduct premiums under section 213 to the extent that their expenses exceed 

7.5 percent of adjusted gross income. By contrast, the figures in this Table 1 assume that, if the 

exclusion for employer sponsored health insurance were repealed, employees would not be 

permitted to take into account the insurance premiums towards the section 213 medical expense 

deduction. If tax form behavior were taken into account and insurance premiums paid by an 

employer remained eligible for section 213, the income tax expenditure would decline from 

$145.3 billion to approximately $105 billion. 

In addition, conventional tax expenditures are calculated only with respect to their effect 

on income taxes, and thus do not include payroll tax (FICA) effects. The estimate for the FICA 

effects of the employer exclusion in Table 1 does not reflect the effects of changes in current 

FICA liability on the present value of taxpayers’ future social security benefits. Finally, unlike 

revenue estimates, neither the estimates in Table 1 nor conventional tax expenditure estimates 

assume other behavioral responses by taxpayers. 
3 

The most favorable tax treatment under present law generally is provided to individuals 

who are in an employer plan where the employer pays the premium.4 Such individuals may 

exclude from income and wages employer-provided health insurance; depending on the 

employer’s plan, they may also exclude from income amounts expended for medical care not 

covered by insurance. Self-employed individuals receive the next most favorable treatment; they 

may deduct 100 percent of the cost of their health insurance from their income tax, but they may 

not deduct their health insurance premiums from their payroll tax base. In the case of the 

employer-provided exclusion and the self-employed deduction, there is no cap on the tax benefit 

that would limit the generosity of health plans that can be purchased with pre-tax dollars. 

Present law also provides additional, less significant, tax expenditures for health care benefits. 

There are significant non-tax advantages to operating through the employer-provided 

system. Providing health insurance coverage through a large group provides significant savings 

because of risk mitigation and lower administrative costs. Employers typically have superior 

negotiating power, compared to individual consumers, in negotiating the terms of insurance 

coverage with insurers. In addition, a group system mitigates the problems of adverse selection 

and results in coverage of less healthy individuals who may be unable to obtain insurance outside 

of a pooled arrangement. The combination of tax and economic advantages of employerprovided health care have resulted in the employer-provided system providing the vast majority 

of health care coverage, resulting in the large tax expenditure seen in Table 1 for employerprovided health care. 

Nevertheless, the current system of providing a generous tax subsidy for employerprovided health care with no or little subsidy in the case of insurance purchased outside of the 

employer market distorts taxpayer and market behavior. The existence of the subsidy reduces 

the price of the consumption of health care, leading to overconsumption of health care relative to 

other goods and services for those taxpayers with qualifying plans, and very expensive health 

care for taxpayers in the individual market. Unlike most tax expenditures, the large subsidy 

associated with employer-provided health care is subject to few statutory limitations. 

 4

 The refundable HCTC provides a greater tax benefit than the exclusion. Fewer than one-half 

million taxpayers per year, however, are estimated to be eligible for the credit. 
4 

II. EMPLOYMENT RELATED TAX EXPENDITURES 

A. Employer-Provided Health Care 

In general

The Code generally provides that an employee is not taxed on (that is, may “exclude” 

from his or her gross income) the value of employer-provided health care. The exclusion for 

employer-provided health care is the largest tax expenditure under the current tax system. The 

tax expenditure for the exclusion for employer-provided health care is estimated to be $246.1 

billion for 2007, using the methodology described in connection with Table 1. This represents 

by far the largest portion of the total tax expenditures for health and is the third largest health 

expenditure if measured against direct Federal spending, exceeded only by direct expenditures 

for Medicare and Medicaid. 

Income generally is defined to include compensation paid to a service provider in any 

form, whether in cash or in kind. The value of health insurance that an employer purchases for 

its employees unquestionably constitutes compensation to each covered employee in this general 

sense. The exclusion therefore represents a departure from the Code’s general tax principle that 

compensation should be included in income; for that reason, the JCT Staff treats employerprovided health insurance as a tax expenditure.5

 

 5

 For a discussion of the JCT Staff’s general approach to tax expenditures analysis, see Joint 

Committee on Taxation, A Reconsideration of Tax Expenditure Analysis (JCX-37-08), May 12, 2008. 
5 

Table 2.–Calendar Year Employer Exclusion Tax Savings1

, 2007 

Adjusted Gross Income 

Total 

Savings 

(millions) 

Income Tax 

Savings 

(millions) 

FICA Tax 

Savings 

(millions) 

Total Tax 

Returns 

(thousands) 

Average 

Savings Per 

Return 

(dollars) 

 

< 10,000 4,185 -4812 4,666 6,692 625 

10,000 – 29,999 38,860 20,095 18,765 19,355 2,008 

30,000 – 49,999 45,696 24,451 21,245 18,261 2,502 

50,000 – 74,999 49,075 26,471 22,604 15,798 3,106 

75,000 – 99,999 39,713 24,343 15,370 9,998 3,972 

100,000 – 199,999 51,984 36,999 14,985 11,543 4,504 

200,000 – 499,999 13,104 10,685 2,419 2,828 4,634 

> 500,000 3,455 2,785 670 788 4,385 

Total 246,072 145,348 100,724 85,263 2,886 

1

 See discussion immediately following Table 1 for the methodologies applied in calculating the value of this 

exclusion. Table 2 reflects both income tax and FICA distributional consequences. 

2

 Negative amounts reflect the fact that the exclusion reduces earned income for purposes of the earned income 

credit, resulting in a decrease in refundable credits for some recipients. 

Source: JCT Staff calculations. 

Table 2 shows the total savings from the employer exclusion for eight income brackets. 

This table shows that those in the lower income brackets obtain cash savings from the exclusion 

for employer-provided health care valued at between $600 and $3,000, while those earning more 

than $100,000 per year have average cash savings worth between $4,000 and $5,000.

As with other compensation, the amount paid by an employer for employer-provided 

health care of employees is deductible. Unlike other forms of compensation, however, if an 

employer contributes to a plan providing health coverage for an employee (and his or her spouse 

and dependents), the contribution and all benefits (including reimbursements) for medical care 

under the plan are excludable from the employee’s income for both income and payroll tax 

purposes.6

 The exclusion applies both in the case in which employers absorb the cost of their 

employees’ medical expenses not covered by insurance (i.e., a self-insured plan) as well as 

employer payments to purchase health insurance. There is no limit on the amount of employerprovided health coverage that is excludable. 

 6

 Secs. 104, 105, 106, 125, and 3121(a)(4). Health coverage provided to active members of the 

uniformed services, military retirees, and their dependents are excludable under section 134. That section 

provides an exclusion for “qualified military benefits,” defined as benefits received by reason of status or 

service as a member of the uniformed services and which was excludable from gross income on 

September 9, 1986, under any provision of law, regulation, or administrative practice then in effect. 
6 

Active employees participating in a cafeteria plan7

 may pay their share of premiums on a 

pre-tax basis through salary reduction. Such salary reduction contributions are treated as 

employer contributions and thus also are excluded from gross income and wages for payroll 

taxes. 

The Employee Retirement Income Security Act of 1974 (“ERISA”) preempts State law 

relating to certain employee benefit plans, including employer-sponsored health plans.8 While 

ERISA specifically provides that its preemption rule does not exempt or relieve any person from 

any State law which regulates insurance, ERISA also provides that an employee benefit plan is 

not deemed to be engaged in the business of insurance for purposes of any State law regulating 

insurance companies or insurance contracts. As a result of this ERISA preemption, self-insured 

employer-sponsored health plans need not provide benefits that are mandated under State 

insurance law. Further, self-insured employer plans are not subject to State insurance taxes or 

regulation, such as premium taxes imposed on insurance companies under State law. 

Unlike tax-qualified pension plans, present law includes few requirements or limitations 

on the design of employer-provided health care plans. In particular, and in contrast to most other 

Federal tax benefits, there is no limitation on the amount of health benefits that an employer can 

provide on a tax-free basis. This effectively allows taxpayers to control the amount of their tax 

benefit. Employer-provided health plans are not required to cover all employees or to provide 

the same benefits to all employees.9

 In addition, the tax exclusion is not predicated on coverage 

of certain illnesses or conditions. 

 7

 If an employer offers employees a choice between taxable benefits (which include cash 

compensation) and qualified benefits (which include employer-provided accident and health coverage), 

the choice must generally be provided under a cafeteria plan that satisfies section 125. Otherwise 

providing this choice may result in income inclusion even if the employee chooses an excludable benefit. 

See sec. 125 and proposed Treas. Reg. secs. 1.125-1 through -7, published in the Federal Register on 

August 6, 2007, 72 FR 43938. 

A cafeteria plan must be in writing and must not provide for deferred compensation except as 

specifically provided in section 125(d). Certain excludable benefits are not permitted to be provided in a 

cafeteria plan, including long-term care benefits, contributions to Archer MSAs, qualified scholarships 

under section 117, benefits under educational assistance programs under section 127, and certain fringe 

benefits under section 132. HSA contributions are allowed through a cafeteria plan. If benefits provided 

under a cafeteria plan discriminate in favor of highly compensated participants, any exclusion from 

income for benefits under the plan may not apply to such highly compensated participants. Any qualified 

benefit must also satisfy any specific requirements under the section that allows its exclusion. 

8

 ERISA sec. 514. 

9

 An exception to this general rule applies in the case of self-insured group health plans, which 

must satisfy certain nondiscrimination rules in order for the benefits of highly compensated individuals to 

be excludable. Sec. 105(h). As previously discussed, benefits provided under a cafeteria plan are subject 

to certain nondiscrimination requirements. 
7 

Distinct from the exclusion, certain rules relating to coverage apply in the case of group 

health plans.10 The Consolidated Omnibus Reconciliation Act of 1985 (“COBRA”) requires that 

a group health plan must offer continuation coverage to qualified beneficiaries in the case of a 

qualifying event (such as a loss of employment). In addition, in the case of group health 

coverage, the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) imposes a 

number of requirements that are designed to provide protections to health plan participants.11 

For example, HIPAA provides rules on when a pre-existing condition exclusion may be imposed 

with respect to a participant or beneficiary and rules that prohibit discrimination with respect to 

eligibility and premium contributions on the basis of health status. HIPAA also provides rules 

relating to specific coverage (e.g., rules for minimum hospital stays following the birth of a child 

if such benefit is provided under the plan). 

The employee income and wage exclusion for employer-provided health care is not 

dependent on satisfying the requirements of COBRA and HIPAA. Instead, the Code imposes an 

excise tax on group health plans that fail to meet these requirements.12 The excise tax is 

generally equal to $100 per day during the period of noncompliance and is imposed on the 

employer sponsoring the plan if the plan fails to meet the requirements. 

In addition to offering health insurance (or self-insurance), employers often agree to 

reimburse medical expenses of their employees (and their spouses and dependents). These 

arrangements are commonly used by employers to pay or reimburse employees for medical 

expenses that are not covered by health insurance. These arrangements include health flexible 

spending arrangements (“FSAs”) and health reimbursement arrangements (“HRAs”). 

Health FSAs typically are funded on a salary reduction basis under a cafeteria plan, 

meaning that employees are given the option to reduce their current cash compensation and 

instead have the amount made available for use in reimbursing the employee for his or her 

medical expenses. Health FSAs that are funded on a salary reduction basis are subject to the 

Code’s requirements for cafeteria plans, including a requirement that amounts remaining in a 

health FSA under a cafeteria plan as of the end of a plan year must be forfeited by the employee 

(referred to as the “use-it-or-lose-it-rule”).13 If the health FSA under a cafeteria plan meets 

 10 A group health plan is defined as a plan (including a self-insured plan) of, or contributed to by, 

an employer (including a self-employed person) or employee organization to provide health care (directly 

or otherwise) to the employees, former employees, the employer, others associated or formerly associated 

with the employer in a business relationship, or their families. 

11 The requirements are enforced through the Code, ERISA, and the Public Health Service Act 

(“PHSA”). 

12 Secs. 4980B; 4980D. 

13 Sec. 125(d)(2). See proposed Treas. Reg. secs. 1.125-1 through -7. However, if a plan 

chooses, a grace period not to exceed two and one-half months immediately following the end of the plan 

year during which unused amounts may be used is allowed. Notice 2005-42, 2005-1 C.B. 1204. Health 

FSAs are subject to certain other requirements, including rules that require that the FSA have certain 

characteristics similar to insurance. 
8 

certain requirements, the compensation that is forgone is not includible in gross income or 

wages. Reimbursements for medical care from the health FSA similarly are excludable from 

gross income and wages. 

Health reimbursement arrangements (“HRAs”) operate in a manner similar to health 

FSAs, in that they are an employer-maintained arrangement that reimburses employees for 

medical expenses. Some of the rules applicable to HRAs and health FSAs are similar (e.g., the 

amounts in the arrangements can only be used to reimburse medical expenses and not for other 

purposes), but the rules are not identical. In particular, HRAs cannot be funded on a salary 

reduction basis and the use-it-or-lose-it rule does not apply. Thus, amounts remaining at the end 

of the year may be carried forward to be used to reimburse medical expenses in the next year.14 

Unlike a health FSA, an HRA is permitted to reimburse an employee for health insurance 

premiums. 

Unlike the section 213 itemized deduction for medical expenses which (as discussed 

below), in the case of drugs, is limited to prescribed drugs,15 tax-free reimbursement for nonprescription drugs is permitted in the case of an employer-provided health plan. Thus, for 

example, amounts paid from an FSA, HRA, or health savings account (described later in the 

pamphlet) to reimburse the employee for nonprescription medicines, such as sunscreen, 

nonprescription aspirin, allergy medicine, antacids, or pain relievers, are excludable from 

income. This creates an even greater tax preference for employer-provided health care 

arrangements. 

Coverage under employer-sponsored health care 

The vast majority of Americans finance health care through employment-based insurance 

coverage. 

 14 Guidance with respect to HRAs, including the interaction of FSAs and HRAs in the case of an 

individual covered under both, is provided in Notice 2002-45, 2002-2 C.B. 93. 

15 Under section 213(b), in the case of medicine or drugs, an expenditure is taken into account 

only if it is incurred for a prescribed drug or insulin. 
9 

Figure 1.–Health Insurance Coverage Source for the Nonelderly Population, 

2008

[millions of persons]

Employer Sponsored 

Insurance, 163.8

Non-group, 8.4

Self Employed, 6.6

Medicaid and SCHIP, 42.1

Medicare (disability), 5.8

TRICARE, 11.5

Uninsured, 44.2

16.7%

4.3%

2.2%

15.9%

61.8%

2.5%

3.2%

* Total exceeds 100% because individuals may have multiple sources of health insurance coverage.

Source: JCT Staff calculations based on Medical Expenditure Panel Surveys (2001-3), and Internal Revenue 

Service Statistics of Income 2005 data; Congressional Budget Office March 2008 baseline. 

All employers do not provide equal access to health insurance. Historically, small 

businesses are far less likely than large businesses to offer health insurance.16 Small businesses 

are more sensitive to price than are large businesses when considering offering health insurance. 

Therefore, if the price of health insurance changes due to a change in the tax treatment of health 

insurance, the greatest impact will be seen in the rates at which health insurance is offered by 

small businesses. 

The Congressional Budget Office (CBO) estimates that a 10 percent increase in the cost 

of premiums to employees would cause a 7.2 percent reduction in the offer of health insurance 

for individuals working at firms with fewer than 100 employees. The same 10 percent price 

 16 Thirty-eight percent of workers in firms with fewer than ten employees are eligible for 

coverage, compared to 78 percent of workers in firms with more than 1,000 employees. When offered 

insurance, employee enrollment was 81 percent, ranging from 78 percent for small-moderate firms to 83 

percent for very large firms. Thomas M. Selden and Bradley M. Gray, “Tax Subsidies For EmploymentRelated Health Insurance: Estimates For 2006” Health Affairs. Vol. 25 Issue 6, November/December, 

2006 pp. 1568-1579. 
10 

increase would cause a 0.4 percent decrease in the health insurance offer for individuals working 

for firms with more than 100 employees.17

Employer involvement in the purchase of health insurance has both advantages and 

disadvantages in the market. The primary advantage is that health insurance costs less when 

purchased through an employer as compared with the non-group market; non-group insurance is 

fundamentally more expensive. 

The principal reason for the price advantage of group over individual health insurance is 

that insuring a group has less per capita risk than insuring an individual; therefore, the risk 

premium paid to the insurance company is lower. Employer-sponsored health plans provide a 

pooling mechanism that is unrelated to the health status of the insured, which minimizes 

problems with adverse selection into health plans. (Adverse selection refers to the phenomenon 

that those most in need of insurance are the most likely to seek it out.) 

Economies of scale also reduce the administrative costs for group plans, and therefore 

health insurance premiums are lower to this extent for employer plans relative to premiums in 

the non-group market.18 As a result, insurance purchased through the group market is less 

expensive, because it is less costly to sell to and maintain one group of several hundred people 

than to sell and maintain hundreds of groups of one to two people. CBO has estimated that 29 

percent of the premium in the non-group market is spent on administration, while in the large 

group market administration costs only nine percent of the premium.19 

Finally, employers generally have superior negotiating power with an insurance company 

than does an individual consumer. Employers have more experience and sophistication in 

evaluating insurance proposals, can offer much larger blocks of business by virtue of the group 

nature of employer-provided insurance, and may have other business relationships with the 

insurer. 

There is some recent evidence from the financial services sector that shifting people into 

the individual market would increase the time and effort required to purchase health insurance. 

This may lead to procrastination in obtaining insurance and a temporary or even a permanent rise 

in the rate of uninsurance. Complexity of choice, paired with the absence of a deadline for 

acquiring insurance, will likely lead to delays in the purchase of insurance. For example, some 

have argued that employers are good agents for their employees and provide invaluable research 

 17 Congressional Budget Office, “CBO’s Health Insurance Simulation Model: A Technical 

Description,” October 2007. 

18 A Congressional Research Service Report from 1988 found that insurance in small groups 

(fewer than five members) cost 40 percent more than in large groups (more than 10,000 members). 

Congressional Research Service, Costs and Effects of Extending Health Insurance Coverage, 1988. 

19 Congressional Budget Office, “CBO’s Health Insurance Simulation Model: A Technical 

Description,” October 2007. 
11 

into the appropriate health plans to offer.20 The employer acts as an agent to limit and guide 

choice. The open enrollment period, which is a limited time window when insurance can be 

chosen, prevents excessive procrastination before purchase. These complexity problems were 

seen by some American seniors after the release of the Medicare Part D plans in 2004, which 

required many seniors to choose a prescription drug plan in order to optimize prescription drug 

benefits. There were reports that, with so many complicated options, many seniors had difficulty 

choosing a plan.21 

Although the individual market is at a cost disadvantage relative to the employer market 

for health insurance, it provides greater choice for health insurance coverage. This said, only one 

percent of those offered employer insurance decline it and purchase insurance in the individual 

market.22 

Some employees may feel locked into their current jobs because switching to a different 

employer could result in a loss of their current health coverage. Despite the protection of 

HIPAA for pre-existing conditions,23 an employee who has insurance with a certain level of 

coverage for a specific condition through his or her current employer may nevertheless lose that 

level of coverage if the employee were to move to a new job because the new employer’s health 

plan does not cover that condition or does not provide the same level of coverage for the 

condition. Even if the health plan is substantially identical, the employee might be concerned 

that the new job might not work out, and the employee might become unemployed resulting in a 

loss of coverage or the potential for significantly higher premium costs. The resulting labor 

market inefficiency is commonly referred to as “job lock”, where individuals remain with 

employers in order to maintain their current health insurance when their preference is to leave 

 20 Research on retirement plans finds that as the number of investment options increased by 10, 

participation declined by 1.5 to 2 percentage points. S.S. Iyengar, G. Huberman, and W. Jiang. “How 

Much Choice Is Too Much?: Contributions to 401(k) Retirement Plans,” in Olivia Mitchell and Stephen 

Utkus, eds., Pension Design and Structure: New Lessons from Behavioral Finance (Oxford, UK: Oxford 

University Press, 2004): pp. 83-96. 

21 John Leland, “73 Options for Medicare Plan Fuel Chaos, Not Prescriptions,” New York Times, 

May 14, 2004. 

22 Congressional Budget Office, “CBO’s Health Insurance Simulation Model: A Technical 

Description.” October 2007. 

23 Although a group health plan sponsored by an employer is limited by HIPAA in its ability to 

impose a pre-existing condition exclusion on a plan participant, a plan is permitted to exclude conditions 

diagnosed within the six-month period ending on enrollment in the plan, provided that the exclusion 

generally may not extend for longer than 12 months (18 months in the case of certain late enrollees in the 

plan) and the maximum exclusion period must be reduced by the participant's aggregate periods of 

“creditable coverage.” Creditable coverage includes a participant's coverage under a group health of a 

prior employer provided that there is no more than a 63 day gap in coverage between the new plan and the 

old plan. Sec. 9801. 
12 

the workforce or find new work.24 There are other examples of job lock. Job lock may prevent 

an individual from leaving a large employer that offers insurance and starting a new independent 

business due to extra health insurance premiums that may be charged with respect to an 

individual health insurance policy.25 Job lock also may prevent an employee who is sick or has a 

sick dependent from switching to an employer with another health plan for fear of disrupting the 

patient-physician relationship. 

Market distortions from employer-provided health care

The tax treatment of health care affects the health care market and can distort consumer 

choices. Reduced taxation of income spent on health insurance is an implicit subsidy to eligible 

consumers by the Federal government. This “discount” on the employer purchase of health 

insurance provides an incentive for the purchase of more generous health insurance benefits than 

would otherwise be purchased without the discount. Increased health insurance benefits 

generally include some combination of reduced copayments, deductibles and expanded benefits. 

Because consumers are responsive to changes in the cost of health care,26 increased health 

insurance benefits lead to an increase in the use of health care services. Therefore, the tax 

exclusion for health insurance and other medical services increases the demand for health care 

services. 

The distortion in the market caused by the tax preference afforded health insurance arises 

from a two-part market response: 1) demand for medical care increases, increasing the price of 

health care services; and 2) increased prices draw additional resources into the medical services 

sector, and away from other less tax-favored sectors. Moving resources from one sector where 

they are more productive to another sector may result in less efficient production of additional 

medical services, thus resulting in generally higher medical costs. 

These market mechanisms affect all prices for health care services in the market, not only 

the extra services paid for through insurance. The market inefficiency arising from the taxinduced spending on health care versus other goods generates a loss to the economy referred to 

 24 Evidence of job lock in the literature is mixed, with some papers finding health insurance 

decreasing mobility, some papers finding no effect and some papers finding an effect only under certain 

specifications. Brigitte C. Madrian, “The U.S. Health Care System and Labor Markets,” National Bureau 

of Economic Research, Working Paper # 11980, January 2006. 

25 While HIPAA contains rules that generally require that an individual who loses employerprovided health coverage have access to an individual health insurance policy without being subject to 

preexisting condition exclusions, such rules are subject to a number of exceptions (including rules that 

permit a State to implement alternative individual health insurance protections) and the rules do not 

provide protections with respect to the premium that may be charged for the policy. See 42 U.S.C. sec. 

300gg-41, 44. 

26 Joseph P. Newhouse, “Free For All?: Lessons From the RAND Health Insurance Experiment.” 

Harvard University Press, 1996. 
13 

as “dead weight loss,”27 because it results in a net loss of consumer welfare. Therefore, the 

impact on the economy materially exceeds the loss of tax revenues from subsidizing health care 

expenditures. The elimination of this distortion could lead the economy to function more 

efficiently and increase individuals’ collective welfare. 

There is substantial evidence that the tax preference for health care does indeed increase 

demand; however, estimates of the size of the increase span an extremely wide range, indicating 

considerable uncertainty among economists on the true size of the increase in the volume and 

price of health care due to the tax exclusion.28 

On the other hand, some observers argue that tax subsidies for health insurance and other 

medical expenditures may correct a market failure, in the form of a tendency of many people to 

under-spend on health insurance and health services. Under this view, the tax subsidy might 

make the health care market more efficient and may improve welfare.29 

Equity issues relating to employer-provided health care

The current tax treatment of health care expenditures is criticized as inequitable because 

it provides an inconsistent tax benefit based on how health coverage is provided.30 Generally, 

those who obtain their health insurance through their employer are afforded the most favorable 

tax treatment. Those who are employed but who must obtain health insurance in the individual 

market receive the worst tax treatment. Many observers believe that this inequity combined with 

the lack of group rates in the individual market may lead to some persons remaining uninsured. 

Some critics assert that the tax exclusion for employer-provided health is inherently 

regressive, and thus unfair − those with the greatest income are in the highest tax brackets, and 

therefore receive the greatest tax benefit from the exclusion from income. For example, a single 

individual with no dependents and $100,000 of taxable income per year has a marginal tax rate 

of 28 percent, excluding the effects of Social Security and Medicare taxes. If that person 

purchases a health plan through an employer that costs $5,000, the Federal income tax value of 

 27 Martin S. Feldstein, “The Welfare Loss of Excess Health Insurance.” Journal of Political 

Economy Vol. 81 Issue 2, (Mar-April 1973): pp. 251-280. 

28 Joseph P. Newhouse, “Free For All?: Lessons From the RAND Health Insurance Experiment,” 

Harvard University Press, 1996. 

29 For example, one study found that 25 percent of patients took zero or one drug after a heart 

attack rather than two or more drugs due to the drugs’ copayment costs even though the extra drugs cost 

$1,855, per year, they provided $35,000 in health care benefits (not including savings from decreases in 

future medical costs). This study indicated that costs greatly impact the purchase of these drugs and they 

are often underused. Niteesh K. Choudhry, et. al., “Cost-Effectiveness of Providing Full Drug Coverage 

to Increase Medication Adherence in Post Myocardial Infarction Medicare Beneficiaries” Circulation Vol. 

117 (2008) pp. 1261-1268. 

30 See Appendix B and Appendix C for illustrations of the tax benefits for an individual 

depending on the source and type of coverage. 
14 

the tax exclusion (the income tax not paid) is $1,400. A single individual with no dependents 

and taxable income of $30,000 is in the 15 percent bracket and would therefore receive a 15 

percent, or $750, subsidy for the same health plan. 

The argument that the exclusion (or a similar deduction) for employer-provided health 

care is unfair because it is regressive is somewhat incomplete, in that the asserted unfairness of 

the exclusion follows directly from the tax rate structure being progressive. For example, under a 

single tax rate system (a flat tax), the tax benefit in the example above would be identical for the 

$100,000 earner and the $30,000 earner. 

Any deduction will be regressive given a progressive rate structure, but the 

appropriateness of a deduction in defining the tax base arguably should be determined 

independently of the rate structure.31 If the tax base is intended to reflect ability to pay, then a 

deduction for an expenditure that reduces ability to pay may be appropriate, notwithstanding that 

the decision to have a progressive rate structure means that a given deduction will have more 

value the greater is the taxpayer’s marginal tax rate. 

Additionally, it must be recognized that policies with respect to permitted deductions and 

the marginal rate structure are set concomitantly to achieve the desired level of progressivity of 

the tax code overall. If a deduction were not permitted, the rate structure, including the bracket 

widths, might have evolved differently. That is, the same overall degree of progressivity of the 

tax code can be achieved with or without a given deduction, through the alteration of the rate 

structure. In the example above, it would be possible to permit the exclusions for employerprovided health care but alter the rate structure to raise taxes on the employee with $100,000 of 

income by $1,400, and the employee with $30,000 of income by $750, thus negating the tax 

advantage of the exclusion and preserving the overall progressivity of the tax code. 

Alternative tax policies subsidizing insurance coverage

If a deduction or exclusion is merely intended to provide a Federal subsidy for a 

particular expenditure, and has no meritorious independent place in an income tax system other 

than as a means to deliver the subsidy, then a good case can be made that the deduction or 

exclusion should be altered to mitigate any distortionary effects it may have on economic 

behavior. Employer-provided health care has important nontax advantages compared to an 

entirely individual-consumer-based heath care system,32 but also has some economic deadweight 

loss associated with it. Policy analysts have focused a great deal of attention on the trade-off 

between those advantages and economic deadweight loss. 

 31 For related discussion, see William D. Andrews, “Personal Deductions in an Ideal Income 

Tax”, 86 Harv. L. Rev. 309, 1972. 

32 See, for example, Melissa A. Thomasson, "The Importance of Group Coverage: How Tax 

Policy Shaped U.S. Health Insurance," National Bureau of Economic Research, Working Paper 7543, 

February 2000. 
15 

 Because of the efficiency and equity concerns associated with subsidizing health 

insurance through the exclusion for employer-sponsored health care, many health reform 

proposals begin with removing the employer exclusion. On the other hand, policy makers need 

to keep in mind the price sensitivity of the market. Removal or reduction of the exclusion of 

employer-provided health care from an employee’s taxable income and wages could reduce the 

number of firms offering health insurance, possibly increasing the number of uninsured. 

For example, one study estimated that the total number of employees offered health 

insurance would drop by 15.5 percent if all of the exclusions were repealed and by 9.7 percent if 

the income tax exclusion were repealed, but the payroll and state tax exclusions remained.33 

Thus, in practice most comprehensive health care proposals tend either to limit the exclusion, or 

replace it with some other form of Federal subsidy. 

The unlimited exposure of the Federal budget created by the exclusion could be reduced 

by capping the dollar amount of the exclusion per person or per tax return. The cap would also 

reduce the incentive for individuals to over-consume health insurance, to the extent that the cap 

is lower than the policy an individual currently carries. If the cap is not indexed, or is indexed to 

a measure such as the consumer price index that typically grows more slowly than medical costs, 

the subsidy for employer-provided health care would decline relative to the cost of the care over 

time. Thus, the economic distortion effects of the exclusion would be reduced gradually over 

time. 

Another approach to reforming the exclusion would be to replace it with a limited 

deduction. Under present law, if the employer exclusion for health insurance were removed, 

many individuals would still be able to deduct at least part of the cost of their premiums as 

itemized medical expenses under section 213.34 As is discussed in more detail in Part III.B. 

below, there may be reasons to retain the section 213 deduction if the exclusion is eliminated and 

not replaced by some other tax subsidy for the purchase of health insurance. In brief, the section 

213 deduction recognizes that many medical expenditures are not discretionary, and an income 

tax base that reflects ability to pay would allow a deduction of these expenses. In addition, the 

section 213 deduction is less regressive than the exclusion with respect to upper income 

taxpayers, because the 7.5 percent threshold for the deduction is difficult to overcome at higher 

income levels. 

Replacing the exclusion with a deduction for expenditures over some threshold may link 

the tax subsidy more closely to ability to pay, but it does not address the efficiency issue that 

providing larger subsidies for larger insurance payments provides an incentive to over-consume 

health insurance. A different approach, which would reduce the incentives provided by the 

exclusion for individuals to over-consume employer-provided health insurance, would be to 

 33 Jonathan Gruber and Michael Lettau, “How elastic is the firm’s demand for health insurance?” 

Journal of Public Economics, Vol. 88 (2004), pp. 1273-1293. 

34 That deduction is only allowable to the extent that a taxpayer’s medical expenses exceed 7.5 

percent of his total adjusted gross income (see more detailed discussion of section 213 in Part III. B., 

below). 
16 

replace the exclusion with a deduction of a flat amount that is unrelated to the price of the 

insurance policy. 35 Under this approach, depending on the level set for this flat deduction, the 

tax subsidy would be large enough to enable people to continue insurance coverage, but there 

would be no tax advantage for a taxpayer to purchase more expensive insurance. If such a 

deduction were provided for the purchase of insurance in the individual market in addition to 

employer-provided insurance, individuals who do not have the option of obtaining employersponsored health insurance would be able to use the deduction to help purchase insurance in the 

individual market, thus reducing the number of uninsured. The advantage of obtaining insurance 

through one’s employer would also be reduced, possibly leading to a reduction in the number of 

people who receive offers of health insurance coverage through their employers. 

The net effect of this policy on the number of uninsured individuals would depend on the 

size of the fixed deduction relative to the cost of a typical insurance policy.36 The amount of the 

deduction could be chosen to limit Federal budget exposure, and, like the cap, it could be 

indexed to grow more slowly than medical expenditures, thus reducing the Federal budget 

impact and the tax subsidy for health insurance over time. 

An additional consideration in the setting of subsidy levels for employer and non-group 

insurance is the interaction of these changing subsidies with adverse selection. Non-group 

insurance is generally more attractive to individuals with low medical costs. To the extent that 

there is a substantial re-alignment between the attractiveness of employer insurance and nongroup insurance, younger, healthier individuals may decline employer coverage to such an extent 

that the advantages of risk pooling by employers are lost, resulting in significant declines in the 

offer of employer insurance. To the extent that this occurs without some alternate risk pooling 

mechanism being made available, this could result in a significant increase in the number of 

uninsured individuals. 

One problem with providing for a flat deduction (or exclusion) amount is that it could 

result in insurance products with minimal coverage being offered to individuals who are more 

interested in obtaining the deduction than in obtaining genuine health insurance coverage. The 

policy amounts could be set at amounts worth less than the tax value of the deduction. This 

would undermine the goal of promoting broader insurance coverage, at some cost to the 

taxpayer. In order to prevent such a result, the availability of the deduction could be linked to 

purchase of an insurance policy that met certain standards. However, this requirement would 

require additional administrative work by the IRS, in terms of determining whether an individual 

has health insurance that qualified for the deduction. 

 35 See, for example, the proposal included in the Administration’s Fiscal Year 2009 Revenue 

Proposals. 

36 For example, the Congressional Budget Office finds that removing the exclusion and replacing 

it with flat deductions of $7,000 for single policies and $15,000 for family policies would reduce the 

number of uninsured people by about five million in the first several years after enactment. Congressional 

Budget Office, "An Analysis of the Presidents Budgetary Proposals for Fiscal Year 2009," March 2008, 

p.10. 
17 

None of the approaches described above addresses the limitations of the exclusion or 

deduction in providing subsidies for the purchase of health insurance to those who are least able 

to afford it: to people who have little income and thus little or no tax liability. To address this 

problem, the exclusion or deduction could be converted to a refundable credit.37 In contrast to an 

exclusion or deduction (even a deduction of a fixed amount), a refundable credit will provide the 

same benefit or subsidy to all taxpayers regardless of their income levels. A non-refundable 

credit for an expenditure would generally be as easy to administer as a deduction for the same 

expenditure. A refundable tax credit poses significant difficulties in administration for several 

reasons.38 It brings into the income tax system people who otherwise would not be part of the 

tax system, and thus the IRS may not have easily verifiable information about their income and 

other information necessary to monitor compliance with the credit. Additionally, some have 

proposed that refundable tax credits be made available on an advance basis, so that they could be 

used directly to purchase health insurance. Such a system could require timely verification of 

insurance status and credit eligibility by the IRS. Some believe refundable credits, particularly 

advanceable refundable credits, may encourage fraud. Existing refundable credits in the Code 

that have been paid in error have proven difficult for the IRS to recoup.39 

Even the provision of a refundable tax credit to subsidize the costs of purchasing health 

insurance may not provide enough of an incentive to ensure that the estimated 44 million people 

who are currently uninsured obtain health insurance. For this reason, some have proposed 

making purchase of insurance mandatory for all citizens, and combining this requirement with a 

tax liability that would contribute to the payment of the premiums. Under such an arrangement, 

individuals would have a strong incentive to purchase insurance as they are paying for at least 

part of it through the tax system. However, because many individuals cannot afford to pay either 

the insurance or the tax liability, these proposals are often combined with subsidies in the form 

of deductions and refundable, or advance refundable tax credits. Such proposals are complex 

and far-reaching and face administrative and compliance challenges. 

Exclusion from income, in contrast to either deductions or credits, has the administrative 

advantage of not requiring valuation or verification of the excluded item, at least when the 

exclusion is not capped. Providing a tax benefit through an exclusion has limited application 

however, as it requires that the subsidized item be provided to the taxpayer in the form of 

compensation, or other form of income. 

 37 Lily L. Batchelder, Fred T. Goldberg Jr., Peter R. Orszag, “Efficiency and Tax Incentives: The 

Case for Refundable Tax Credits”, 59 Stan. L. Rev. Vol. 23 (2006). 

38 See, for example, the following papers regarding the administration of the earned income 

credit: Janet McCubbin, “Non-compliance with the Earned Income Tax Credit” pp. 237-273; and Jennifer 

Romich and Thomas Weisner, "How Families View and Use the Earned Income Tax Credit: Advance 

Payments Versus Lump-Sum Delivery," pp. 366-391, in Making Work Pay, Bruce Meyr and Douglas 

Holtz-Eakin, eds, New York: Russell Sage Foundation, 2001. 

39 Government Accountability Office, “Advanced Earned Income Tax Credit: Low Use and 

Small Dollars Paid Impede IRS’s Efforts to Reduce High Noncompliance,” Report to the Joint Committee 

on Taxation, GAO-07-1110, August 2007. 
18 

B. Deduction for Health Insurance Premiums 

of Self-Employed Individuals 

Under present law, self-employed individuals may deduct the cost of health insurance for 

themselves and their spouses and dependents.40 The tax expenditure for the deduction for health 

insurance premiums for self-employed individuals was $4.8 billion for 2007. 

The deduction is not available for any month in which the self-employed individual is 

eligible to participate in an employer-subsidized health plan. Moreover, the deduction may not 

exceed the individual’s self-employment income. The deduction applies only to the cost of 

insurance, i.e., it does not apply to out-of-pocket expenses that are not reimbursed by 

insurance.41 The deduction does not apply for self-employment tax purposes. For purposes of 

the deduction, a more than two percent shareholder-employee of an S corporation is treated the 

same as self-employed individual.42 Thus, the exclusion for employer-provided health care 

coverage does not apply to such individuals, but they are entitled to the deduction for health 

insurance costs as if they were self employed. 

This deduction can be claimed to have the effect of putting a self-employed individual in 

a similar position to an employee by allowing the self-employed individual to receive the 

equivalent of an income tax exclusion for health insurance coverage provided by the business for 

which the self-employed individual performs services. In fact, however, the two regimes differ 

in several important respects. First, as described above, a deduction from income for selfemployment tax purposes is not provided in the case of a self-employed individual. For this 

reason, a self-employed individual receives less favorable tax treatment than does an employee 

with the same coverage provided by their employer. The employer-provided exclusion retains 

another significant advantage because the exclusion for self-employed individuals does not apply 

in the case of non-insurance arrangements, such as an HRA. 

On the other hand, a self-employed individual, particularly a partner or a self-employed 

individual with a minority interest in a business, may be at an advantage over an employee 

because the self-employed individual may unilaterally decide to purchase health insurance 

 40 Sec. 162(l). 

41 Premiums for a self-insured plan are eligible for the deduction if the self-insured plan actually 

constitutes an insurance arrangement, which generally means that the arrangement must result in adequate 

risk-shifting and not merely reimburse the individual for health expenses. For example, the IRS has ruled 

that a self-insured health plan of a law firm covering 200 self-employed partners and 800 employees 

demonstrated adequate risk shifting where the plan charged premiums that were determined on the basis 

of the actuarial costs of the plan and each partner was liable for a pro-rata share of plan experience losses. 

Pvt. L. Rul. 200007025. Self-employed individuals are not eligible to participate in HRAs. See Notice 

2002-45, 2002-2 C.B. 93. In addition, self-employed individuals are not eligible to participate in a 

cafeteria plan, including a health FSA funded by elective contributions, because cafeteria plan 

participation is limited to employees. See sec. 125(d)(1)(A). 

42 Sec. 1372. 
19 

regardless of whether the business offers health coverage to its employees. A significant cost 

differential may exist, however, because the self-employed individual may have to purchase 

coverage on the individual market and thus not have the benefit of administrative savings and 

risk pooling from the group market unless the business has other self-employed individuals or 

common-law employees under the same plan.43

 43 Even if a self-employed individual's business does not employ and cover enough employees to 

generate the advantage of risk pooling, state law may provide assistance. Under HIPAA, an employer 

with two to fifty employees is generally guaranteed access to insurance in the small group market, and 

States are permitted to allow sole proprietors with no employees to purchase health insurance on the small 

group market rather than being limited to the individual market. 42 U.S.C. sec. 300gg-11, 91(e). While 

HIPAA does not require the States to provide protections as to the amount of premiums charged in the 

small group market, many States do provide for premium protection rules for this market. 
20 

III. OTHER HEALTH CARE TAX EXPENDITURES 

A. Medicare 

Medicare benefits—that is, the dollar value of Medicare services received by participants 

in the Medicare system—are excluded from the recipient’s income.44 The tax expenditure for 

the exclusion for Medicare is the second largest health tax expenditure at $39.3 billion for 

2007.45 

Medicare is a Federal program that provides medical insurance coverage to people age 65 

and older and certain other individuals who are younger than age 65 (e.g., certain persons with 

disabilities and individuals with end-stage renal disease). In general, Medicare comprises three 

types of coverage: (1) Part A, which provides coverage for in-patient hospital care; (2) Part B, 

which provides coverage for doctor services and outpatient medical care; and (3) Part D, which 

provides coverage for prescription drugs.46 In general, individuals are not required to pay any 

premium for Part A coverage, while premiums are charged for Part B and Part D coverage. 

Under the Health Insurance (“HI”) tax component of FICA, workers and employers make 

contributions to pay for Medicare Part A coverage during the employee’s working years. The HI 

tax is imposed on both employers and employees at a rate of 1.45 percent of wages paid by 

employers (for a combined rate of 2.9 percent of wages). Total Medicare benefits for 2007 were 

$425.2 billion and total HI receipts for 2007 were $191.9 billion.47 

The value of Medicare Part A coverage generally is greater than the HI tax contributions 

that Medicare enrollees made during their working years. Similarly, the value of Medicare Part 

B coverage and Medicare Part D coverage is generally greater than the premiums that enrollees 

must pay. The exclusion of the value of Medicare Part A coverage in excess of HI tax 

 44 The benefits, of course, also do not constitute taxable wages, because they are not paid in 

respect of an employment arrangement. 

45 The tax expenditures for the three types of coverage for 2007 are: (1) $20.2 billion for 

Medicare Part A; (2) $13.3 billion for Medicare Part B; and (3) $4.8 billion for Medicare Part D. In 

addition, there is $1.0 billion in tax expenditures for the exclusion of subsidies to employers who 

maintain prescription drug plans. Section 1860D-22 of the Social Security Act provides a subsidy for 

sponsors of retiree prescription drug plans that provide drug coverage that is at least actuarially equivalent 

to the Medicare Part D benefit. The subsidy is available only with respect to retirees who are eligible for, 

but do not enroll in, Medicare Part D and who are covered under the employer’s retiree prescription drug 

plan. Section 139A of the Code provides that gross income does not include any employer subsidy 

payment received under section 1860D-22 of the Social Security Act. 

46 Medicare Part C contains rules under which private companies may contract with Medicare to 

provide coverage for Medicare beneficiaries who elect to enroll in the plans offered by such companies. 

The plans offered under Part C are generally referred to as Medicare Advantage Plans. 

47 2008 Annual Report of the Boards of Trustees of the Federal Hospital Insurance and Federal 

Supplemental Medical Insurance Trust Funds, page 5. 
21 

contributions made during the taxpayer’s earning years is classified as a tax expenditure, as is the 

exclusion of the value of Medicare Part B and Part D coverage in excess of the premiums paid by 

enrollees. 
22 

B. Itemized Deduction for Medical Expenses 

Individuals may claim an itemized deduction for unreimbursed medical expenses, but 

only to the extent that such expenses exceed 7.5 percent of adjusted gross income.48 As a result, 

the deduction is beneficial only if two conditions are met: the taxpayer’s medical expenses must 

exceed the 7.5 percent of adjusted gross income threshold, and the taxpayer must have sufficient 

personal deductions in general to claim an itemized deduction. 

The tax expenditure for the itemized deduction for medical expenses was $8.7 billion for 

2007. The deduction is classified as a tax expenditure because the Code generally denies 

deductions for personal consumption expenditures (that is, expenses not incurred directly in 

order to produce income). 

Table 3 shows the medical expense deduction by income bracket for 2007. The greatest 

total tax expenditure is in the middle of the income distribution. 

Table 3.–Calendar Year Medical Expense Deduction, 2007 

Adjusted Gross 

Income 

Medical Expense 

Deduction Number 

of Returns 

(thousands) 

Income Tax Savings 

(millions) 

Average Savings 

Per Return 

(Dollars) 

< 10,000 853 8 9 

10,000 – 29,999 2,762 711 257 

30,000 – 49,999 2,571 1,508 587 

50,000 – 74,999 2,296 2,054 895 

75,000 – 99,999 1,204 1,605 1,333 

100,000 – 199,999 923 2,060 2,232 

200,000 – 499,999 86 586 6,814 

> 500,000 7 138 19,714 

 Total 10,702 8,670 810 

Source: JCT Staff calculations. 

This deduction is available both to insured and uninsured individuals, thus, an individual 

with employer-provided health insurance (or another form of tax-subsidized health benefits, as 

summarized in this section) may also claim the itemized deduction for the individual’s medical 

expenses not covered by that insurance if the 7.5 percent adjusted gross income threshold is met. 

Moreover, an individual’s nonsubsidized health insurance premiums can be counted towards the 

7.5 percent threshold. In practice, however, it is very unusual for an individual who purchases 

insurance with after-tax dollars to meet the income threshold solely through the premiums that 

the individual has paid. 

 48 For alternative minimum tax purposes, the itemized deduction is calculated using a floor of 10 

percent of adjusted gross income. Sec. 56(b)(1)(B). 
23 

There are a few common ways that individuals use this deduction. For those who are 

insured, it mainly consists of payments for expensive medical items that are not covered in an 

individual’s insurance, including mental health care, dental care, and long-term care. Mental 

health care can consist of either frequent use of outpatient services, such as psychotherapy, or the 

use of inpatient services such as an inpatient rehabilitation facility for substance abuse or other 

mental illness. Dental care is only insured in a subset of those who have health insurance and 

frequently dental insurance is insufficient to cover expenses. People may reach the 7.5 percent 

limitation due to use of acute dental services such as root canal surgery. Lastly, need for nursing 

home care, particularly in the elderly population is a reason for the use of the medical deduction. 

Medicare covers up to 100 days, Medicaid coverage is only available once an individual can 

show he or she is impoverished, and long-term care insurance is rare and frequently insufficient. 

Therefore the cost of a nursing home frequently is paid directly by the user. Anyone in a nursing 

home is too sick to work, therefore, may have limited income and thus would likely qualify for 

the deduction for the entire cost of the nursing home in excess of 7.5 percent of income. 

Health insurance is designed to spread the risk of expensive health care over time and 

across people through the payment of insurance premiums. The 7.5 percent of adjusted gross 

income threshold, however, arguably distorts the decision whether to buy insurance or self 

insure. Thus, if an individual without access to any tax-advantaged health insurance has a major 

medical event costing 50 percent of income every 10 years, that person can pay for 42.5 percent 

(50 - 7.5) of that event tax-free through the section 213 medical expense deduction if they self 

insure. If, however, that person pays an actuarially fair premium every year, his or her annual 

the medical expenses are below 7.5 percent and therefore, he or she cannot deduct any of it. (In 

practice, however, it is unlikely that those individuals who do not purchase health insurance will 

have the liquidity to pay medical expenses that are a large portion of their annual income.) 

The deduction for medical expenses above 7.5 percent of adjusted gross income, like 

other deductions for expenses not directly incurred to earn income, might be criticized on the 

grounds that the deduction is inconsistent with the Code’s general measure of taxable income, 

and (more importantly) might at the margin distort taxpayer behavior, by encouraging taxpayers 

to view the U.S. Treasury as a partial co-insurer of major medical expenses (through the tax 

benefits of the deduction), thereby crowding out the private insurance market.49 Under this view, 

adverse selection would work against the interest of the Treasury (i.e., taxpayers in general), and 

in favor of those who rely on the existence of the deduction to mitigate the net cost of their major 

medical expenses. 

 49 Moreover, not all medical expenses are involuntary, and to this extent the deduction for 

medical expenses creates additional efficiency costs in that it encourages excessive consumption of some 

medical services since the government becomes a partner in the cost of the services. Thus, while the 

deduction is not likely to encourage excess consumption of some services, such as critical need surgeries, 

it could cause excessive consumption of ancillary services, such as private hospital rooms, etc. Similarly, 

other medical expenditures have a strong personal consumption component, such as the quality or variety 

of one’s eye glass frames, and a deduction or exclusion that includes these types of medical expenses is 

more likely to create economic distortions in consumption. 
24 

On the other hand, there is a longstanding consensus that a personal income tax should 

account for an individual’s ability to pay tax, and that medical expenses, by their largely 

involuntary nature, have a direct impact on the taxpayer’s ability to pay tax.50 It therefore is 

argued that, for the income tax to be horizontally equitable— that is, to tax equally those with 

equal ability to pay— a deduction for medical expenses should be provided. Thus, a taxpayer 

with $50,000 in income, but with $10,000 in medical expenses, would, via the deduction for 

medical expenses, be taxed in the same amount as a taxpayer with $40,000 of income and no 

medical expenses. 

This argument would imply that individuals should be able to deduct all of their medical 

expenses if the tax system is premised on ability to pay. In response, a floor on the deductibility 

of medical expenses can be argued to be appropriate for administrative reasons, to eliminate the 

need for the Internal Revenue Service to audit millions of returns each claiming deductions for 

minor medical expenses. 

Medical expenses that qualify for deduction are narrower than medical expenses for 

which a flexible spending arrangement or health savings account can be used. For example, nonprescription medicines such as aspirin are not deductible under the medical deduction, but could 

be purchased using dollars set aside in an HSA, HRA or an FSA. 

 50 See William D. Andrews, “Personal Deductions in an Ideal Income Tax,” 86 Harv. L. Rev.

309, 1972; William J. Turnier, “Personal Tax Deductions and Tax Reform: The High Road and the Low 

Road,” 31 Vill. L. Rev. 1703, 1986. Andrews argues that the main point of the Haig-Simons definition of 

income (Income = Consumption + Change in Wealth) is to focus on the uses of income and not its 

sources, and that an ideal income tax would not treat income differently based on its source. He argues 

that an ideal income tax should focus on elaborating the notion of taxable consumption embodied in the 

Haig-Simons definition of income in order to arrive at a fairer definition of taxable income. He concludes 

that a medical expense deduction is necessary in an ideal income tax, i.e., that consumption of medical 

care should not be taxable consumption. Turnier rejects some of Andrews’ reasoning, but ultimately 

arrives at the same conclusion that a deduction for medical expenses is necessary for an income tax to 

accurately base tax on ability to pay. 
25 

C. HSAs and Archer MSAs 

Present law provides that individuals with a high deductible health plan (and no other 

health plan except for a plan that provides permitted coverage)51 may establish and make taxdeductible contributions to a health savings account (“HSA”). The tax expenditure for HSAs 

was $334 million for 2007. HSAs are one of the lowest cost tax expenditure in the health care 

sector. However, HSAs are relatively new and utilization is expected to increase in the next 

several years.52

Table 4.–Calendar Year Tax Expenditures for Health Savings Accounts, 2007 

Adjusted Gross 

Income 

Number of Returns 

(thousands) 

Income Tax Savings 

(millions) 

Average Savings 

Per Person 

(Dollars) 

< 10,000 11 0 -- 

10,000 – 29,999 61 11 185 

30,000 – 49,999 64 18 286 

50,000 – 74,999 86 36 421 

75,000 – 99,999 64 30 464 

100,000 – 199,999 139 107 770 

200,000 – 499,999 77 89 1,147 

> 500,000 32 43 1,357 

 Total 534 334 626 

Source: JCT Staff calculations. 

Like opening an individual retirement account (“IRA”), the decision to create and fund an 

HSA is made on an individual-by-individual basis, but unlike the case of an IRA, an HSA is 

subject to a condition precedent that the individual is covered under a high deductible health plan 

(purchased either through the individual market or through an employer). Subject to certain 

limitations, contributions made to an HSA by an individual are deductible for income tax 

purposes, regardless of whether the individual itemizes personal deductions. Moreover, the 

 51 An individual with other coverage in addition to a high deductible health plan is still eligible 

for an HSA if such other coverage is “permitted insurance” or “permitted coverage.” Permitted insurance 

is: (1) insurance if substantially all of the coverage provided under such insurance relates to (a) liabilities 

incurred under worker’s compensation law, (b) tort liabilities, (c) liabilities relating to ownership or use of 

property (e.g., auto insurance), or (d) such other similar liabilities as the Secretary may prescribe by 

regulations; (2) insurance for a specified disease or illness; and (3) insurance that provides a fixed 

payment for hospitalization. Permitted coverage is coverage (whether provided through insurance or 

otherwise) for accidents, disability, dental care, vision care, or long-term care. Effective after December 

20, 2006, with respect to coverage for years beginning after December 31, 2006, certain coverage under a 

health FSA is disregarded in determining eligibility for an HSA. 

52 Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2007-

2011, (JCS-3-07), September 24, 2007. 
26 

individual can exclude from income (and from taxable wages) contributions that the individual’s 

employer (including contributions made through a cafeteria plan through salary reduction) makes 

to the individual’s HSA. 

A high deductible health plan is a health plan that has an annual deductible that is at least 

$1,100 for self-only coverage or $2,200 for family coverage (for 2008) and that limits the sum of 

the annual deductible and other payments that the individual must make in respect of covered 

benefits to no more than $5,600 in the case of self-only coverage and $11,200 in the case of 

family coverage (for 2008).53 

Earnings on amounts in an HSA accumulate on a tax-free basis. Distributions from an 

HSA that are used for qualified medical expenses are excludable from gross income regardless of 

the taxpayer’s age and regardless of whether treated as paid out of the account’s corpus or its 

earnings. 

Distributions from an HSA that are not used for qualified medical expenses are includible 

in gross income and are subject to an additional tax of 10 percent. The additional 10-percent tax 

does not apply, however, if the distribution is made after death, disability, or the individual 

attains the age of Medicare eligibility (i.e., age 65). 

In sum, HSAs provide the opportunity to pay for current out-of-pocket medical expenses 

on a tax-favored basis, as well as the ability to save for future medical and nonmedical expenses 

on a tax-favored basis. To the extent that amounts in an HSA are not used for qualified 

expenses, an HSA provides tax benefits similar to an IRA,54 including the same tax deferral of 

contributions ultimately used to fund general living expenses after age 64 and the same 10 

percent additional tax for nonqualified distributions before age 65. 

In contrast to a flexible spending arrangement or health reimbursement arrangement, both 

of which require substantiation for tax-free reimbursement of a medical expense, an individual is 

not required to provide substantiation to the trustee or custodian of an HSA that a distribution is 

for a qualified expense in order to be entitled to the exclusion.55 Instead, the individual simply 

 53 These amounts are indexed for inflation. 

54 Other tax-favored vehicles may also be used to save for future medical expenses, but do not 

provide the same tax benefits. For example, funds in an IRA may be used to pay medical expenses, but 

distributions for medical expenses are includible in gross income (and subject to the same 10-percent 

additional tax for early withdrawal) in the same manner as are other IRA distributions. 

55 Qualified medical expenses include expenses for diagnosis, cure, mitigation, treatment, or 

prevention of disease, including prescription drugs, transportation primarily for and essential to such care, 

and qualified long-term care expenses. Qualified medical expenses do not include expenses for insurance 

other than for (1) long-term care insurance, (2) premiums for health coverage during any period of 

continuation coverage required by Federal law, (3) premiums for health care coverage while an individual 

is receiving unemployment compensation under Federal or State law, and (4) premiums for individuals 

who have attained the age of Medicare eligibility, other than premiums for policies that provide 

supplemental coverage for individuals whose primary insurance is Medicare. 
27 

maintains his or her own books and records with respect to the expense and claims the exclusion 

for a distribution from the HSA on his or her return if it is used for a qualified expense. This 

may result in certain nonqualified distributions not being reported as subject to tax, including the 

10-percent additional tax. 

For 2008, the maximum aggregate annual contribution that can be made to an HSA is 

$2,900 in the case of self-only coverage and $5,800 in the case of family coverage.56 The annual 

contribution limits are increased for individuals who have attained age 55 by the end of the 

taxable year (referred to as “catch-up contributions”). In the case of policyholders and covered 

spouses who are age 55 or older, the HSA annual contribution limit is greater than the otherwise 

applicable limit by $900 in 2008, and $1,000 in 2009 and thereafter. Contributions, including 

catch-up contributions, cannot be made once an individual is enrolled in Medicare. 

If an employer makes contributions to employees’ HSAs, the employer must make 

available comparable contributions on behalf of all employees who have comparable coverage 

during the same period. Employer contributions are not includable in employees’ incomes or 

taxable wages. Contributions are considered comparable if they are either of the same amount or 

the same percentage of the deductible under the plan. If employer contributions do not satisfy 

the comparability rule during a period, then the employer is subject to an excise tax equal to 35 

percent of the aggregate amount contributed by the employer to HSAs for that period. The 

comparability rule does not apply to contributions made through a cafeteria plan. 

A taxpayer may not combine the benefits of an HSA with those of an Archer MSA. 

Amounts can be rolled over, however, into an HSA from another HSA or from an Archer MSA. 

One-time rollovers are permitted from IRAs to HSAs. 

Like an HSA, an Archer MSA is a tax-exempt trust or custodial account to which taxdeductible contributions may be made by individuals with a high deductible health plan.57 

Archer MSAs provide tax benefits similar to, but generally not as favorable as, those provided by 

HSAs for individuals covered by high deductible health plans. The main differences include: 

(1) only self-employed individuals and employees of small employers are eligible to have an 

Archer MSA; (2) for Archer MSA purposes, a high deductible health plan is a health plan with 

(a) an annual deductible of at least $1,950 and no more than $2,900 in the case of self-only 

coverage and at least $3,850 and no more than $5,800 in the case of family coverage and (b) 

maximum out-of pocket expenses of no more than $3,850 in the case of self-only coverage and 

 56 These amounts are the same as the maximum deductible amounts permitted under a high 

deductible plan for purposes of Archer MSAs and are indexed for inflation. In the case of individuals 

who are married to each other, if either spouse has family coverage, both spouses are treated as only 

having the family coverage with the lowest deductible and the contribution limit is divided equally 

between them unless they agree on a different division. Limitations based on the amount of the 

deductible under the high deductible plan applied to years beginning before January 1, 2007. 

57 Sec. 220. 
28 

no more than $7,050 in the case of family coverage;58 and (3) the additional tax on distributions 

not used for medical expenses is 15 percent rather than 10 percent. 

After 2007, no new contributions can be made to Archer MSAs except by or on behalf of 

individuals who previously had made Archer MSA contributions and employees who are 

employed by a participating employer. In light of this fact, the fact that HSAs are more generous 

than Archer MSAs, and the fact that an individual can roll over an Archer MSA into an HSA, 

one can expect Archer MSA to soon be replaced by HSAs. 

Proponents of high deductible health plans believe that such plans help to alleviate the 

distortions caused by the exclusion for employer-provided health insurance and other tax-favored 

medical expenditures. Some proponents of HSAs believe that many current health insurance 

policies cover routine medical expenses and that the tax laws should provide a subsidy only for 

insurance for substantial and unpredictable medical expenses. 

The creation of HSAs was intended to encourage high deductible health plans and to 

control the growth of health care spending. Proponents of HSAs believe that if consumers 

personally pay for a greater portion of their health care purchases (because of the large 

deductible) out of a fund that can be used for savings (and therefore ultimately is the consumer’s 

money to use as they wish), they will be more prudent in their health spending. In theory, this 

would result in lower volume of services and potentially consumer pressure to drive down prices 

of health care services.59 

Prior to the introduction of HSAs, there was a clear tax advantage to structuring 

employer-provided health insurance to have a low deductible. The tax exclusion for premiums 

meant that purchasing a more generous plan with no deductible, essentially paying the deductible 

through the increased premium, was tax advantaged because any deductible had to be paid out of 

after-tax dollars, but the premium could be paid with pre-tax dollars. HSAs were meant to 

address this by tax subsidizing individuals who purchase high deductible health plans. 

Concerns exist that HSAs and high deductible health plans are likely to be more attractive 

to healthier individuals, with the result that adverse selection will occur. If correct, this could 

erode the group market and result in higher insurance costs for individuals with greater health 

risks. When insurance is priced on a group basis, individuals with lower health risks in effect 

subsidize higher risk individuals. If the healthy, low risk individuals leave the pool to seek 

cheaper, high deductible insurance, the average cost will increase for those remaining. This in 

 58 These deductible and out-of-pocket expenses dollar amounts are for 2008. These amounts are 

indexed for inflation. 

59 Evidence from the RAND Health Insurance experiment indicates that health expenditures are 

elastic; those who can access health care for free used 20 percent more hospital visits than those who paid 

a 25 percent coinsurance payment or higher for medical care. See Robert H. Brook, et. al. “The Health 

Insurance Experiment: A Classic RAND Study Speaks to the Current Health Reform Debate,” RAND 

Corporation. 2006. http://www.rand.org/pubs/research_briefs/2006/RAND_RB9174.pdf Accessed 24 

July 2008. 
29 

turn may cause the next-lowest risk individuals to leave the pool, with a concomitant rise in cost 

for those still remaining, resulting in a spiral that could drive a plan with generous benefits to 

price itself out of the market. 

To the extent that amounts in HSAs are not used for current medical expenses, HSAs 

provide a tax benefit similar to that of an IRA, in that HSAs allow tax-free compounding of 

earnings.60 HSA proponents argue that this feature may help contribute to lowering medical 

costs by in effect rewarding lower spending on medical care. Because HSAs operate similarly to 

IRAs, there is concern that they will be used as an additional tax shelter for retirement income 

for wealthy individuals. Critics argue that HSAs are primarily attractive to higher income 

individuals who can afford to self-insure on a current basis for the higher deductible under the 

high deductible plan and who are primarily interested in a long-term tax-favored savings vehicle. 

In this regard, critics observe that a taxpayer can fund both an HSA and a deductible IRA, 

thereby substantially increasing the individual’s annual contributions for tax-preferred savings. 

In response, proponents of HSAs argue that the additional tax of 10 percent for uses other than 

health care before age 65 (the age of Medicare eligibility) may mitigate this issue. 

 60 For a discussion of the economic value of deferring tax on investment income, see Joint 

Committee on Taxation, Economic Efficiency and Structural Analyses of Alternative U.S. Tax Policies for 

Foreign Direct Investment (JCX-55-08), June 25, 2008 at pp.14-15. 
30 

D. Refundable Credit for Health Insurance Expenses 

of Certain Classes of Individuals 

Under the Trade Adjustment Assistance Reform Act of 2002,61 certain individuals are 

eligible for the health coverage tax credit (“HCTC”).62 The HCTC is a refundable tax credit 

equal to 65 percent of the cost of qualified health coverage paid by an eligible individual. 

In general, eligible individuals are individuals who receive a trade adjustment allowance 

(and individuals who would be eligible to receive such an allowance but for the fact that they had 

not exhausted their regular unemployment benefits), individuals eligible for the alternative trade 

adjustment assistance program, and individuals over age 55 who receive pension benefits from 

the Pension Benefit Guaranty Corporation. The credit is available for “qualified health 

insurance,” which includes certain employer-based insurance, certain State-based insurance, and 

in some cases, insurance purchased in the individual market. The credit is available on an 

advance basis through a program established by the Secretary of the Treasury. Persons entitled 

to Medicare and certain other governmental health programs, covered under certain employersubsidized plans, or with certain other specified coverage are not eligible for the credit.63 

The HCTC is often cited as an example of how a broad-based refundable tax credit for 

health insurance (or health expenses) could operate. However, the size of the population eligible 

for the HCTC is not representative of the population at large. In addition, the costs of 

administering the credit were very significant in the first several years of implementation. 

 61 Pub. L. No. 107-210, secs. 201(a), 202 and 203 (2002). 

62 Sec. 35. 

63 Sec. 35(f). 
31 

E. Other Programs 

1. Welfare benefit funds, VEBAs, and retiree medical accounts 

Generally, an employer (including an employer that self insures) is not able to prefund 

employer-provided health care coverage for active employees, whether through a welfare benefit 

fund or otherwise.64 In contrast, the Code permits an employer to deduct contributions to a 

welfare benefit fund for retiree medical benefits that generally are funded over the working lives 

of the covered employees.65 For retirees, deductible contributions can be made to two types of 

tax exempt funding vehicles, either to a voluntary employees beneficiary association (VEBA)66

or, if an employer sponsors a tax-qualified pension plan, to the tax-exempt trust that funds the 

pension plan (referred to as a “retiree medical account”).67 In addition to direct deductible 

contributions, a retiree medical account under a defined benefit plan may be funded by transfers 

to the account of excess pension assets under the pension plan of which the account is a part.68 

2. Long-term care 

Present law also provides tax subsidies for qualified long-term care insurance contracts 

and expenses for qualified long-term care services. A qualified long-term care insurance 

contract is defined as any insurance contract that provides only coverage for qualified long-term 

care services, and that meets additional requirements.69 Per diem-type and reimbursement-type 

contracts are permitted. Qualified long-term care services are necessary diagnostic, preventive, 

therapeutic, curing, treating, mitigating, and rehabilitative services, and maintenance or personal 

 64 Secs. 419(c)(3) and 419A(c)(1). The Code generally limits the deductions that may be taken 

with respect to contributions to a “welfare benefit fund" for active employees to (1) the amount which 

would have been allowable as a deduction for the benefits provided during the taxable year as if the 

employer had provided such benefits directly and (2) claims for benefits incurred but unpaid as of the 

close of the taxable year (and administrative costs with respect to such claims). 

65 Sec. 419A(c)(2) and Treas. Reg. sec. 1.404(a)-3(f)(2). 

66 Secs. 419(e) and 501(c)(9). Contributions also may be made to a VEBA to fund health 

coverage benefits for active employees. 

67 Sec. 401(h). Except for the exclusion for distributions from governmental retirement plans for 

health insurance premiums for public safety officers, excludable employer-provided health coverage 

generally may only be provided under a tax-qualified retirement plan through a retiree medical account 

under a tax-qualified pension plan. Rev. Rul. 2005-55, 2005-2 C.B. 284; Prop. Treas. Reg. sec. 1.401(a)-

1(e), published in the Federal Register on April 20, 2007, 72 FR 46421. 

68 Sec. 420. 

69 Sec. 7702B(b). For example, the contract is not permitted to provide for a cash surrender 

value or other money that can be paid, assigned or pledged as collateral for a loan, or borrowed (and any 

premium refunds must be applied as a reduction in future premiums or to increase future benefits). 
32 

care services that are required by a chronically ill individual and that are provided pursuant to a 

plan of care prescribed by a licensed health care practitioner.70 

A qualified long-term care insurance contract is treated as an accident and health 

insurance contract.71 Thus, amounts received under the contract generally are excludable from 

income as amounts received for personal injuries or sickness.72 In the case of per diem contracts, 

the excludable amount is subject to a dollar cap of $270 per day (for 2008), as indexed. If 

payments under such contracts exceed the dollar cap, then the excess is excludable only to the 

extent of actual costs in excess of the dollar cap that are incurred for long-term care services. 

An employer's plan that provides employees with coverage under a long-term care 

insurance contract generally is treated in the same manner as employer-provided health care. As 

a result, the employer’s premium payments are generally excludable from income and wages, 

and benefits payable under the contract generally are excludable from the recipient’s income.73 

This exclusion does not apply, however, to long-term care insurance provided under a cafeteria 

plan.74 As a result, a cafeteria plan cannot offer long-term care coverage as a tax-favored option. 

(As noted earlier, an employee’s share of employer-provided health care, by contrast, can be 

funded through a cafeteria plan.) 

Long-term care insurance expenses of a self-employed individual are deductible under 

the self-employed health deduction.75

Premiums paid for a qualified long-term care insurance contract76 and unreimbursed 

expenses for qualified long-term care services are treated as medical expenses for purposes of the 

itemized deduction for medical care (subject to the floor of 7.5 percent of adjusted gross 

income). Unreimbursed expenses for qualified long-term care services provided to the taxpayer 

 70 Sec. 7702B(c)(1). A chronically ill individual is generally one who has been certified within 

the previous 12 months by a licensed health care practitioner as being unable to perform (without 

substantial assistance) at least two activities of daily living (ADLs) for at least 90 days due to a loss of 

functional capacity (or meeting other definitional requirements). Sec. 7702B(c)(2). 

71 Sec. 7702B(a)(1). 

72 Secs. 104(a)(3), 105, and 106. 

73 Secs. 105, 106, and 3121(a)(2). 

74 Section 106(c) provides that gross income of an employee will include employer-provided 

coverage of qualified long-term care services (as defined in section 7702B(c)) to the extent such coverage 

is provided through a flexible spending or similar arrangement. 

75 Sec. 162(l). 

76 Premiums paid for long-term care coverage are deductible only to the extent that the premiums 

do not exceed a dollar cap measured by the insured's age at the end of the taxable year. Sec. 213(d)(10). 
33 

or the taxpayer’s spouse or dependent also are treated as medical expenses for purposes of the 

itemized deduction. 

3. Distributions for public safety officers 

Present law provides an exclusion from income for distributions from governmental 

retirement plans that are used to pay for health insurance premiums for eligible retired public 

safety officers and their spouses and dependents.77 The exclusion is limited to $3,000 annually. 

An eligible retired safety officer is an individual who, by reason of disability or attainment of 

normal retirement age, is separated from service as a public safety officer with the employer that 

maintains the retirement plan from which the distributions are made. The premiums do not have 

to be for a plan sponsored by the employer; however, the exclusion does not apply to premiums 

paid by the employee and reimbursed with pension distributions. Amounts excluded under this 

provision are not taken into account in determining the itemized deduction for medical expenses 

or the deduction for health insurance expenses of self-employed individuals. 

 77 Sec. 402(l). This rule is effective for taxable years beginning after December 31, 2006. 
34 

APPENDIX A 

COMPARISON OF PRESENT-LAW TAX BENEFITS FOR HEALTH EXPENSES1

Provision Tax Benefit Class Eligible Maximum Dollar Limit on Tax Benefit 

1. Employer contributions to an accident or health plan (sec. 106) 

Exclusion from gross income and wages. 

Employees (including former employees). 

No limit on amount excludable. 

2. Employer reimbursement of medical expenses (sec. 105) 

Exclusion from gross income and wages. 

Employees (including former employees). 

No limit on amount excludable. 

3. Employer-provided health benefits offered under a cafeteria plan (sec. 125) 

Exclusion from gross income and wages (for salary reduction contributions). 

Employees. No limit on amount 

excludable. 

4. Health reimbursement arrangements (secs. 105 and 106) 

Employer-maintained arrangement providing exclusion from gross income and wages for amounts used to reimburse employees for medical expenses. Amounts remaining at the end of the year can be carried forward to reimburse medical expenses in later years. There is no tax-free accumulation of earnings. 

Employees (including former employees). 

No limit on amount excludable. 

5. Health flexible spending arrangements (secs. 105, 106, and 125) 

Typically employee salaryreduction arrangement providing exclusion from gross income and wages for amounts used to reimburse employees for medical expenses. 

Employees. No limit on amount 

excludable. 

1 The table describes the legal limits that apply under present law. Employers may establish rules and limitations consistent with 

example, it is common for employers to place a limit on the amount of expenses that may be reimbursed through an FSA or HRA
35 

Provision Tax Benefit Class Eligible Maximum Dollar Limit on Tax Benefit 

6. Deduction for health insurance expenses of selfemployed individuals (sec. 162(l)) 

Income tax deduction for cost of health insurance expenses of self-employed individuals. Deduction does not apply for selfemployment tax purposes. 

Self-employed individuals. No specific dollar limit; 

deduction limited by amount of taxpayer’s earned income from the trade or business. 

7. Itemized deduction for medical expenses (sec. 213) 

Itemized deduction for unreimbursed medical expenses to extent expenses exceed 7.5 percent of adjusted gross income (10 percent for alternative minimum tax purposes). 

Any individual who itemizes deductions and had unreimbursed medical expenses in excess of 7.5 percent of adjusted gross income. 

No maximum limit. 

8. Health Savings Accounts (“HSAs”) (sec. 223) 

Contributions are deductible if made by an eligible individual and excluded from gross income and wages if made by an employer (including contributions made through a cafeteria plan through salary reduction). Distributions used for qualified medical expenses excludable from gross income. Earnings on amounts in the HSA accumulate on a tax-free basis. 

Individuals with a high deductible health plan and no other health plan other than a plan that provides certain permitted coverage. High deductible health plan is a plan with a deductible of at least $1,100 for self-only coverage and $2,200 for family coverage (for 2008). Out-of-pocket expense limit must be no more than $5,600 for self-only coverage and $11,200 for family coverage (for 2008). 

Maximum annual contribution is $2,900 for self-only coverage or $5,800 for family coverage (for 2008). Additional contributions permitted for individuals age 55 or older. No limit on the amount that can be accumulated in the HSA. 

9. Archer Medical Savings Accounts (“Archer MSAs”) (sec. 220) 

Contributions are deductible if made by an eligible individual and excluded from gross income and wages if made by an employer. Distributions used for qualified medical expenses 

Employees of small employers who are covered under an employersponsored high-deductible health plan (and no other health plan other than a plan that provides certain 

Maximum annual contribution is 65 percent of the annual deductible under the high-deductible health plan in the case of self-only coverage, and 75 percent of the annual deductible in the 
36 

Provision Tax Benefit Class Eligible Maximum Dollar Limit on Tax Benefit 

are excludable from gross income. Earnings on amounts in the Archer MSA accumulate on a tax-free basis. 

permitted coverage) and selfemployed individuals covered under a highdeductible health plan. Definition of high-deductible health plan differs from that for HSAs. No new contributions may be made after 2007 except for individuals who previously had an MSA or work for an employer that made MSA contributions. 

case of family coverage. No limit on the amount that can be accumulated in the MSA. 

10. Health Coverage Tax Credit (sec. 35) 

Refundable tax credit of 65 percent of the cost of qualified health insurance coverage. 

Individuals receiving trade adjustment assistance and certain individuals receiving benefits from the PBGC. 

Limited to 65 percent of the cost of qualified health insurance. No specific dollar limit. 
37 

 APPENDIX B 

COMPARISON OF VALUE OF HEALTH TAX BENEFITS: NON-HIGH-DEDUCTIBLE HEA

Assume that husband (H) has a health insurance plan that provides coverage for his wife (W) and dependents. The 

$850 per month ($10,200 annually) and has a $700 deductible. The family’s out-of-pocket expenses are approximately $1,

H’s annual medical costs are $11,600. H and W file a joint income tax return and their annual adjusted gross income is $80

Situation 

Tax-Subsidized 

Employer 

Premiums 

Tax-Subsidized 

Employee Premiums 

Tax-Subsidized 

Out-of-Pocket 

Expenses 

Value of 

Employment Tax1 

(E) and Income 

Tax2 (I) Subsidy 

(a) H’s health insurance is provided through his employer. The employer pays 75 percent of the premium for such coverage. 

$7,650 $0 $0 

$1,086 (E) 

$1,913 (I) 

$3,000 total 

(b) The employer also allows the employee’s share of the annual premium to be paid on a tax-free basis (i.e., through a cafeteria plan). 

$7,650 $2,550 $0 

$1,448 (E) 

$2,550 (I) 

$3,998 total 

(c) The employer also offers a reimbursement account (i.e., either a health flexible spending arrangement or a health reimbursement arrangement). 

$7,650 $2,550 $1,400 

$1,647 (E) 

$2,900 (I) 

$4,547 total 

(d) H is self-employed.3 NA $10,200 $0 $0 (E) $2,550 (I) (e) H does not have employerprovided coverage and is not self-employed.3

NA 

Taken into account in determining itemized deduction of $5,6004 

Taken into account in determining itemized deduction of $5,6004

$0 (E) 

$1,400 (I) 

1 The employment tax subsidy includes both the employer and employee portions of old-age, survivors, and disability insurance (“OAS

insurance (“HI”). The effective employment tax subsidy rate is the combined employer and employee tax rate divided by gross-of-tax effective subsidy is thus 0.153 / (1 + .0765) = 14.2%. The subsidy rate drops substantially for taxpayers with earnings above the Social 

2 This example assumes an effective marginal income tax rate of 25 percent. Subsidies to state and local income taxes are ignored here3 This example ignores the fact that this policy in an individual market would either be more expensive or provide less comprehensive 4 Medical expenses are deductible to the extent they exceed 7.5 percent of adjusted gross income ($80,000 X 7.5% = $6,000. $11,600 

addition, the taxpayer must claim itemized deductions on Schedule A. For most taxpayers, this means that total itemized deductions ex

deduction. For alternative minimum tax purposes, medical expenses are deductible to the extent they exceed 10 percent of adjusted gro
38 

APPENDIX C 

COMPARISON OF VALUE OF HEALTH TAX BENEFITS: HIGH-DEDUCTIBLE HEALT

Assume that H has a high-deductible health insurance plan that provides coverage for his wife (W) and dependents. The po

month ($9,180 annually) and has a $2,000 deductible. H makes contributions of $2,000 to a health savings account (“HSA”). The expenses are approximately $2,420 for the year. Thus, H’s annual medical costs are $11,600. H and W file a joint income tax retu

gross income is $80,000. 

Situation 

TaxSubsidized 

Employer 

Premiums 

Tax Subsidized 

Employee 

Premiums 

Tax-Subsidized 

Out-of-Pocket 

Expenses 

TaxDeductible 

HSA 

Contribution1

Value o

Employment 

(E) and Inc

Tax3 (I) Sub

(a) H’s health insurance is provided through his employer. The employer pays 75 percent of the premium for such coverage. 

$6,885 $0 $0 $2,000 

$ 978 (

$2,221 (

 $3,199 to

(b) The employer also allows the employee’s share of the annual premium to be paid on a tax-free basis (i.e., through a cafeteria plan). 

$6,885 $2,295 $0 $2,000 

$1,304 (

$2,795 (

 $4,099 to

(c) The employer also offers a reimbursement account (i.e., either a health flexible spending arrangement or a health reimbursement arrangement). 

$6,885 $2,295 $2,4204 $2,000 

$1,647 (

$3,400 (

 $5,047 to

(d) H is self-employed.5 NA $9,180 $0 $2,000 $0 (E

$2,795 (

(e) H does not have employerprovided coverage and is not self-employed.5

NA 

Taken into account in determining itemized deduction of $5,6006 

Taken into account in determining itemized deduction of $5,6006

$2,000 $0 (E

$1,900 (

1 Amounts contributed to a HSA can be used to pay qualified out-of-pocket expenses on a tax-free basis. 2 The employment tax subsidy includes both the employer and employee portions of old-age, survivors, and disability insurance (“OASDI”) and 

example assumes that HSA contributions are made by the taxpayer. HSA contributions made by the employer would also be excluded from wagSee footnote 1 to Appendix B for calculation of employment tax subsidy. 

3 This example assumes an effective marginal income tax rate of 25 percent. Subsidies to state and local income taxes are ignored here. 4 Individuals eligible to make contributions to an HSA must have a high deductible health plan and no other health plan, other than certain perm

reimbursement account is permitted if it allows reimbursements only for certain limited purposes (e.g., vision or dental) or in certain other limite

5 This example ignores the fact that this policy in an individual market would either be more expensive or provide less comprehensive coverage6 Medical expenses are deductible to the extent they exceed 7.5 percent of adjusted gross income ($80,000 X 7.5% = $6,000. $11,600 - $6,000 

minimum tax purposes, medical expenses are deductible to the extent they exceed 10 percent of adjusted gross income. Distributions from an H

determining the itemized deduction. If H used distributions of $2,000 from his HSA to pay qualified medical expenses, the itemized deduction w