PRESENT LAW AND ANALYSIS RELATING TO 

THE TAX TREATMENT OF HEALTH CARE EXPENSES 

Scheduled for a Public Hearing 

Before the 

SENATE COMMITTEE ON FINANCE 

on March 8, 2006 

Prepared by the Staff 

of the 

JOINT COMMITTEE ON TAXATION 

 

March 6, 2006 

JCX-12-06
i

CONTENTS 

Page

INTRODUCTION .......................................................................................................................... 1 

I. PRESENT LAW ................................................................................................................. 2 

II. ISSUES RAISED UNDER PRESENT LAW .................................................................. 10 

III. DISCUSSION OF POSSIBLE OPTIONS........................................................................ 15 

A. General Description of Possible Options.................................................................... 15 

B. Discussion of Issues.................................................................................................... 16 
1

INTRODUCTION 

The Senate Committee on Finance has scheduled a public hearing on March 8, 2006, on 

the taxation of health care coverage and related issues. This document,1 prepared by the staff of 

the Joint Committee on Taxation, provides a description of the individual income tax provisions 

relating to the taxation of health care expenses, discusses issues raised under present law, and 

provides a general analysis of possible proposals to modify present law. 

 1

 This document may be cited as follows: Joint Committee on Taxation, Present Law and 

Analysis Relating to the Tax Treatment of Health Care Expenses, (JCX-12-06), March 6, 2006.
2

I. PRESENT LAW 

In general

Present law includes a variety of provisions that provide tax benefits for health expenses. 

The specific tax treatment of such expenses depends in part on whether the taxpayer is covered 

under a health plan paid for by an employer, whether the taxpayer has self-employment income, 

or whether an individual itemizes deductions and has medical expenses that exceed a certain 

threshold. Individuals who are covered by a high deductible health plan are able to contribute to 

a health savings account (“HSA”). Certain limited classes of individuals are eligible to receive a 

refundable tax credit of 65 percent of the cost of health insurance coverage. Table 1, below, 

provides a comparison of the various tax provisions of present law. Each provision is discussed 

in more detail, below.2

Exclusion for employer-provided accident and health coverage3

An employer’s contribution to a plan providing health coverage for an employee, and his 

or her spouse and dependents, is excludable from the employee’s income for both income and 

payroll tax purposes. In addition, active employees participating in a cafeteria plan 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 are also excluded from gross income 

and payroll taxes. Reimbursements under an employer plan for medical expenses are also 

excludable from gross income and wages. There is no limit on the amount of employer-provided 

health coverage that is excludable. 

The exclusion for employer-provided health coverage applies to medical expenses not 

covered by insurance as well as health insurance expenses. Arrangements commonly used by 

employers to reimburse medical expenses of their employees (and their spouses and dependents) 

include health flexible spending arrangements (“FSAs”) and health reimbursement accounts 

(“HRAs”). 

 2

 Some of the tax provisions described below apply to long-term care as well as health care. For 

example, the deduction for health insurance expenses of self-employed individuals applies to qualified 

long-term care insurance. The tax treatment of long-term care is not addressed in this pamphlet. 

3

 Secs. 104, 105, 106, 125, and 3121(a)(4). All section references are to the Internal Revenue 

Code of 1986 (“the Code”) unless otherwise indicated. 
3

Table 1.–Comparison of Present-Law Tax Benefits for Health Expenses 

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 arrangement (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) 

Employee salary-reduction arrangement providing exclusion from gross income and wages for amounts used to reimburse employees for medical expenses. 

Employees. No limit on amount 

excludable. 

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. 
4

Provision Tax Benefit Class Eligible Maximum Dollar Limit on Tax Benefit 

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 $1,050 for self-only coverage and $2,100 for family coverage (for 2006). Out-of-pocket expense limit must be no more than $5,250 for self-only coverage and $10,500 for family coverage (for 2006). 

Maximum annual contribution is the lesser of (1) 100 percent of the annual deductible, or (2) $2,700 for self-only coverage or $5,450 for family coverage (for 2006). 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 are excludable from gross income. Earnings on amounts in the Archer MSA accumulate on a tax-free basis. 

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 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 

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 case of family coverage. No limit on the amount that can be accumulated in the MSA. 
5

Provision Tax Benefit Class Eligible Maximum Dollar Limit on Tax Benefit 

after 2005 except for individuals who previously had an MSA or work for an employer that made MSA contributions. 

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. 
6

Health FSAs are typically funded on a salary reduction basis, meaning that employees are 

given the option to reduce current compensation and instead have the compensation used to 

reimburse the employee for medical expenses. If the health FSA meets certain requirements, 

then the compensation that is forgone is not includible in gross income or wages and 

reimbursements for medical care from the health FSA are excludable from gross income and 

wages. Health FSAs are subject to the requirements relating to cafeteria plans generally, 

including a requirement that a cafeteria plan generally may not provide deferred compensation.4

This requirement is often referred to as the “use-it-or-lose-it-rule.” Until May of 2005, this 

requirement was interpreted to mean that amounts remaining in a health FSA as of the end of a 

plan year must be forfeited by the employee. In May 2005, the Treasury Department issued a 

notice that allows 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.5 Health FSAs are subject to 

certain other requirements, including rules that require that the FSA have certain characteristics 

similar to insurance. 

HRAs operate in a manner similar to health FSAs, in that they are an employermaintained 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. Some of the rules are 

different. For example, HRAs cannot be funded on a salary reduction basis and the use-it-orlose-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.6

Deduction for health insurance expenses of self-employed individuals7

Self-employed individuals may deduct the cost of health insurance for themselves and 

their spouse and dependents. The deduction is not available for any month in which the selfemployed individual is eligible to participate in an employer-subsidized health plan. The 

deduction may not exceed the individual’s self-employment income. The deduction applies to 

the cost of insurance, i.e., it does not apply to out-of-pocket expenses. The deduction does not 

apply for self-employment tax purposes. For purposes of the deduction, more than two-percent 

shareholder-employees of an S corporation are treated the same as self-employed individuals.8

 

Thus, the exclusion for employer-provided health coverage does not apply to such individuals, 

but they are entitled to the deduction for health insurance costs as if they were self employed. 

 4

 Sec. 125(d)(2). 

5

 Notice 2005-42, 2005-23 IRB 1204. 

6

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

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

7

 Sec. 162(l). 

8

 Sec. 1372. 
7

Itemized deduction for medical expenses9

Individuals may claim an itemized deduction for unreimbursed medical expenses, only to 

the extent that such expenses exceed 7.5 percent of adjusted gross income.10 Thus, an individual 

(other than a self-employed individual) may deduct health insurance premiums only to the extent 

that aggregate unreimbursed medical expenses exceed 7.5 of adjusted gross income. 

Refundable credit for health insurance expenses of certain classes of individuals11

Under the Trade Adjustment Assistance Reform Act of 2002,12 certain individuals are 

eligible for the health coverage tax credit (“HCTC”). The HCTC is a refundable tax credit for 65 

percent of the cost of qualified health coverage paid by an eligible individual. In general, 

eligible individuals are individuals receiving 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 and receiving 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 employer-subsidized 

plans, or with certain other specified coverage are not eligible for the credit.13 

Health savings accounts14

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

health plan other than a plan that provides certain permitted coverage) may establish a health 

savings account (“HSA”). An HSA is a tax-exempt trust or custodial account. Subject to certain 

limitations, contributions to an HSA are deductible above-the-line if made by the individual and 

are excludable from income and wages if made by the employer (including contributions made 

through a cafeteria plan through salary reduction). Earnings on amounts in an HSA accumulate 

on a tax-free basis. Distributions from an HSA that are for qualified medical expenses are 

excludable from gross income. Distributions from an HSA that are not used for qualified 

 9

 Sec. 213. 

10 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). 

11 Sec. 35. 

12 Pub. L. No. 107-210, sec. 201(a), 202 and 203 (2002). 

13 Sec. 35(f). 

14 Sec. 223. 
8

medical expenses are includible in gross income and are subject to an additional tax of 10 

percent, unless the distribution is made after death, disability, or the individual attains the age of 

Medicare eligibility (i.e., age 65). HSAs provide the opportunity to pay for current out-ofpocket medical expenses on a tax-favored basis, as well as the ability to save for future medical 

and nonmedical expenses. 

A high deductible health plan is a health plan that has a deductible that is at least $1,050 

for self-only coverage or $2,100 for family coverage (for 2006) and that has an out-of-pocket 

expense limit that is no more than $5,250 in the case of self-only coverage and $10,500 in the 

case of family coverage (for 2006). 

The maximum aggregate annual contribution that can be made to an HSA is the lesser of 

(1) 100 percent of the annual deductible under the high deductible health plan, or (2) for 2006, 

$2,700 in the case of self-only coverage and $5,450 in the case of family coverage.15 The annual 

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

taxable year. 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 $700 in 2006, $800 in 

2007, $900 in 2008, and $1,000 in 2009 and thereafter. 

Archer medical savings accounts (“MSAs”)16

Like HSAs, 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. Archer 

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

for certain individuals covered by high deductible health plans. 

The rules relating to Archer MSAs and HSAs are similar. The main differences include: 

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

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

annual deductible of at least $1,800 and no more than $2,700 in the case of self-only coverage 

and at least $3,650 and no more than $5,450 in the case of family coverage and (b) maximum 

out-of pocket expenses of no more than $3,650 in the case of self-only coverage and no more 

than $6,650 in the case of family coverage;17 and (3) the additional tax on distributions not used 

for medical expenses is 15 percent rather than 10 percent. 

After 2005, no new contributions can be made to Archer MSAs except by or on behalf of 

individuals who previously had Archer MSA contributions and employees who are employed by 

a participating employer. 

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

deductible plan for purposes of Archer medical savings accounts (“MSAs”). 

16 Sec. 220. 

17 The deductible and out-of-pocket expenses dollar amounts are for 2006. These amounts are 

indexed for inflation in $50 increments. 
9

Definition of medical care

For purposes of the itemized deduction for medical expenses, section 213(d) defines 

“medical care” to mean amounts paid for: (1) the diagnosis, cure, mitigation, treatment, or 

prevention of disease, or for the purpose of affecting any structure or function of the body; (2) 

transportation primarily for and essential to medical care referred to in (1); (3) qualified longterm care services; and (4) insurance covering medical care referred to in (1) or (2), or for 

eligible long-term care premiums for a qualified long-term care insurance contract.18 

Expenditures for items that are merely beneficial to the general health of an individual, such as 

expenditures for vacation or vitamins, are not medical care. Expenditures for “medicines and 

drugs” are medical care. Toiletries (e.g., toothpaste), cosmetics (e.g., face creams), and sundry 

items are not “medicines and drugs” and amounts expended for such items are not expenditures 

for “medical care.” In general, cosmetic surgery and similar procedures do not constitute 

medical care. 

For purposes of the exclusions for reimbursements under employer accident and health 

plans and distributions from HSAs, the limitation (applicable to the itemized deduction) that only 

prescription medicines or drugs and insulin are taken into account does not apply. Thus, for 

example, amounts paid from an FSA, HRA, or HSA to reimburse the employee for 

nonprescription medicines, such as sunscreen, nonprescription aspirin, allergy medicine, 

antacids, or pain relievers, are excludable from income; however, if the employee paid for such 

amounts directly (without such reimbursement), the expenses could not be taken into account in 

determining the itemized deduction for medical expenses. 

 18 Sec. 213(d). The amount of long-term care premiums that may be taken into account for 

purposes of the itemized deduction is subject to a dollar limit based on the age of the covered individual. 
10

II. ISSUES RAISED UNDER PRESENT LAW 

The appropriateness of the present-law Federal tax treatment of health expenses has been 

the subject of discussion over time from a variety of perspectives, including as part of debates 

relating to health care reform and tax reform. The exclusion for employer-provided health care 

is typically a focal point of such discussions. The exclusion represents a departure from the 

normal income tax principle that compensation should be included in income, and has 

consistently been one of the three largest tax expenditure items.19 

The present-law favorable tax treatment of employer-provided health coverage has 

generally been justified on the grounds that it encourages employees to prefer health coverage 

over taxable compensation, thereby increasing health insurance coverage and reducing the 

number of uninsured. Employees in employer-provided health plans not only receive a tax 

subsidy, but may also benefit from group rates which may make coverage more affordable. 

From this perspective, the exclusion may be said to be effective. For 2005, approximately 90 

million policyholders are estimated to have employer-provided health coverage.20

Nevertheless, the present-law rules have been the subject of a number of criticisms. One 

criticism is that the present-law rules are inequitable because they do not provide a consistent tax 

benefit for health coverage. Some argue that this inequity provides the worst treatment in some 

cases for those who need the tax benefit the most, because many individuals who face the highest 

insurance rates also receive no tax subsidy for the purchase of such insurance (e.g., individuals 

who are not self employed and who purchase insurance in the individual market). Some argue 

that this may lead to some persons remaining uninsured. 

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

who are in an employer plan.21 Such individuals may exclude from income and wages 

employer-provided health insurance and, depending on the employer’s plan, may also exclude 

from income amounts expended for medical care not covered by insurance. Self-employed 

individuals receive the next most favorable treatment, and may deduct 100 percent of the cost of 

their health insurance. Individuals who are not self employed and pay for their own health 

insurance receive the least favorable tax treatment; such individuals may deduct the cost of 

health insurance only to the extent that aggregate medical expenses exceed 7.5 percent of 

adjusted gross income and only if they itemize deductions. In the case of individuals covered by 

a high deductible health plan, the recently-enacted provisions relating to HSAs alter this 

 19 For Federal fiscal years 2005-2009, the tax expenditure for the exclusion of employer 

contributions for health care, health insurance premiums, and long-term care insurance premiums is 

estimated to be $493.7 billion. Joint Committee on Taxation, Estimates of Federal Tax Expenditures for 

Fiscal Years 2005-2009 (JCS-1-05), January 12, 2005. 

20 The policy may cover more than one individual, e.g., the policyholder and his or her family. 

21 The refundable HCTC provides a greater tax benefit than the exclusion. However, the credit is 

available to only limited classes of taxpayers. Less than one-half million taxpayers per year are estimated 

to be eligible for the credit. 
11

comparison to some extent; however, those with employer coverage still have the highest 

potential tax benefit.22 Table 2, below, shows an example of the various tax treatments of 

medical expenses for an individual depending on the individual’s circumstances. Table 3, below, 

shows an example of the various tax treatments of medical expenses for an individual with an 

HSA. 

The present-law tax benefits for health coverage, particularly the exclusion for employerprovided health care, have been criticized as contributing to higher health care costs because 

individuals are not faced with the full cost of health care. That is, the cost of insurance or out-ofpocket expenses paid by the individual is reduced by the tax benefit received, effectively 

reducing the price of health care relative to other goods.23 In addition, some argue that the 

unlimited exclusion for employer-provided coverage leads to very generous insurance coverage, 

which further contributes to increases in health costs because individuals are not as likely to 

question medical treatments to the extent the cost is paid by a third party through insurance. 

While some proponents of HSAs had a goal of reducing the tax benefit for health care and 

causing individuals to face more of their own expenses, HSAs allow individuals with a high 

deductible plan to receive tax-favored treatment for the first dollar of health care expenses. 

Thus, for example, expenses under the deductible amount are not reimbursed by an insurer, but 

do receive a tax subsidy. 

Some argue that the present-law tax treatment of health coverage is inappropriate because 

it is not neutral. That is, the present-law rules create distinctions in both the way the coverage is 

purchased (e.g., through an employer or the individual market) and the type of insurance (e.g., 

high deductible policies or another type of policy). 

 22 With an HSA, both self-employed individuals and those with employer-provided coverage 

receive a tax benefit for the purchase of the health insurance as well as a tax benefit for out-of-pocket 

expenses (through the HSA). However, in some circumstances, an employee could, in addition, have an 

FSA or HRA that provides coverage for additional expenses on a tax-free basis. Thus, for example, an 

employer plan could provide that the cost of a high deductible plan is paid by the employer and could also 

allow an FSA that provides certain limited coverage, e.g., for dental or vision benefits. In addition, under 

Treasury guidance, the individual could also have an FSA or HRA in certain other situations, such as an 

FSA or HRA that pays expenses in excess of the deductible under the high deductible plan. In such cases, 

the individual could also have an HSA to which deductible contributions could be made. A selfemployed individual, in contrast, would not have the opportunity to have an FSA or HRA. Individuals 

(other than self-employed individuals) who purchase a high deductible plan may make deductible 

contributions to an HSA, but would not receive a subsidy for the purchase of the insurance unless 

aggregate medical expenses exceed the adjusted gross income threshold. There is not always a clear 

distinction between out-of-pocket expenses and expenses covered by insurance, because insurance 

policies differ. That is, some insurance policies will cover expenses that are out-of-pocket expenses other 

policies. 

23 Specifically, because of the income tax exclusion, a dollar of consumption of tax favored 

health care actually costs the taxpayer only $(1-t), where t is the tax rate of the individual. In other words, 

the taxpayer is able to convert $(1-t) dollars of after-tax income into $1 of health consumption. The last 

column of Tables 2 and 3 reports the value of the tax subsidy as a percentage of the total health costs. 
12

Discussions regarding inequities of the present-law rules typically do not include the 

itemized deduction for medical expenses that exceed 7.5 percent of adjusted gross income. This 

is because that deduction is generally viewed as having a different policy rationale than the other 

provisions relating to health care. While the other provisions are generally intended to provide 

subsidies in various ways for the purchase of health care, the policy behind the itemized 

deduction for medical expenses is that such expenses generally are not discretionary and that 

high levels of such expenses adversely impact the individual’s ability to pay taxes.
13

Table 2.–Comparison of Value of Health Tax Benefits: Non-High-Deductible Health Plan 

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 $70

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)  $1,760 (I)  $2,846 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)  $2,346 (I)  $3,794 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)  $2,668 (I)  $4,315 total 

(d) H is self-employed.3 NA $10,200 $0 $0 (E) $2,346 (I) (e) H does not have employerprovided coverage and is not self-employed.3

NA 

Taken into account in determining itemized deduction of $6,3504

Taken into account in determining itemized deduction of $6,3504

 $0 (E)  $1,461 (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-t The effective subsidy is thus 0.153 *(1 + .0765) = 14.2% 

2 This example assumes an effective income tax rate of 23 percent. 3 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 ($70,000 X 7.5% = $5,250. $11,600 

 alternative minimum tax purposes, medical expenses are deductible to the extent they exceed 10 percent of adjusted gross income. 
14

Table 3.–Comparison of Value of Health Tax Benefits: High-Deductible Health Plan 

Assume that H has a high-deductible health insurance plan that provides coverage for his wife (W) and dependents. The policy’s prem

annually) and has a $2,000 deductible. H is eligible to make contributions to a health savings account (“HSA”). The family’s out-of-pocket expthe year. Thus, H’s annual medical costs are $11,600. H and W file a joint income tax return and their annual adjusted gross income is $70,000

Situation 

TaxSubsidized 

Employer 

Premiums 

Tax-Subsidized 

Employee 

Premiums 

Tax-Subsidized 

Out-of-Pocket 

Expenses 

Tax-Deductible 

HSA 

Contribution1

Value of 

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  $2,044  $3,022 

(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  $2,571  $3,875 

(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  $3,128  $4,775 

(d) H is self-employed.5 NA $9,180 $0 $2,000 $0 

$2,571 

(e) H does not have employerprovided coverage and is not selfemployed.5 NA Taken into account in determining itemized deduction of $6,3506 Taken into account in determining itemized deduction of $6,3506 $2,000 $0 

$1,921 

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 w See footnote 1 to table Table 2 for calculation of employment tax subsidy. 

3 This example assumes an effective income tax rate of 23 percent. 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 lim

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 ($70,000 X 7.5% = $5,250. $11,600 - $5,250 

 minimum tax purposes, medical expenses are deductible to the extent they exceed 10 percent of adjusted gross income. Distributions from an  in determining the itemized deduction. If H used distributions of $2,000 from his HSA to pay qualified medical expenses, the itemized deduc
15 

III. DISCUSSION OF POSSIBLE OPTIONS 

A. General Description of Possible Options 

A variety of proposals have been suggested that would modify the present-law tax 

treatment of health care expenses. Many such proposals have the common goals of providing 

more equitable tax treatment for the purchase of health care and reducing the number of 

uninsured individuals. Some proposals have other goals as well, such as reducing the tax 

expenditure associated with health care expenses or encouraging a particular type of health 

coverage delivery system or product. The details of such proposals, even those with the same 

objective, may differ substantially. 

Sample proposals include the following very broad outlines of proposals. This is not 

intended as an exhaustive list of possible proposals. 

(1) Impose a cap on the exclusion for employer-provided health care; 

(2) Provide a tax credit (refundable or nonrefundable) or an above-the-line deduction 

for the purchase of health coverage; 

(3) Provide a tax subsidy only for high deductible health insurance; and 

(4) Impose a mandate on individuals to purchase (or employers to provide) health 

insurance. 

These proposals are not necessarily mutually exclusive. For example, a cap on the 

exclusion for employer-provided health care could be combined with a credit for the purchase of 

health insurance. 
16 

B. Discussion of Issues 

In general

Any proposal to substantially modify the present-law treatment of health coverage, while 

perhaps resolving some concerns under the present-law rules, will raise new (and sometimes 

conflicting) issues of health and Federal tax policy. The specific issues will, of course, depend 

on the details of any particular proposal. However, even with very broadly defined proposals, it 

is possible to identify a number of issues that would need to be addressed. The following 

discussion provides an overview of such issues. 

Issues relating to limiting the exclusion for employer-provided health care

Potential effects on the group health market

Any proposal that seeks to cap or eliminate the exclusion for employer-provided health 

benefits must include a method of valuing such benefits. Under present law, the premium faced 

by individuals with employer-provided health coverage may vary based on the health plan and 

the type of coverage (e.g., self-only or family coverage) but may not vary based on age or health 

status. Thus, for example, if an employer pays for 80 percent of the cost of coverage under a 

health plan, a single employee age 25 with no adverse health history will pay the same amount 

for the coverage as an employee age 55 with high blood pressure and diabetes. By comparison, 

in the individual health market, these individuals would likely face very different premiums. 

Proposals that seek to limit or repeal the exclusion for employer-provided health care 

typically value such coverage consistent with present law; that is, the cost of any particular 

health care plan generally is determined by dividing the total cost equally among all employees 

covered, with variations based on type of coverage (e.g., self-only vs. family coverage). Most 

employers are already familiar with this type of approach, as it is essentially that used for 

purposes of determining permissible premiums under the health care continuation rules.24 

While this approach may appear to avoid issues of discrimination based on age or health 

status, it may have the potential to erode the group market through adverse selection with the 

result that individuals with higher expected health costs (e.g. the 55-year old with diabetes) pay 

more for health insurance. If the cost of health insurance were imputed uniformly without regard 

to health risk, higher risk individuals in the pool would benefit, because their premium would be 

less than their expected costs (which are higher than average). 25 Lower-risk individuals would 

 24 Employers with 20 or more employees are subject to the COBRA health care continuation 

rules. While the statute provides the basic rule for determining premiums, many issues are left up to yetto-be issued regulations. In the absence of regulations, a good faith interpretation of the statutory rules 

may result in inconsistent methods among employers. If such a result is not considered desirable under 

proposals to limit the exclusion for employer-provided health care, then additional statutory specification 

may be needed. 

25 A main argument against pricing goods without regard to risk is that individuals with 

expensive tastes would receive subsidies from those with more modest needs or tastes. In the context of 
17 

be disadvantaged because their premiums would be higher than their expected costs (which are 

lower than average). In effect, the lower risk individuals would be subsidizing the higher risk 

individuals. If individuals were allowed to choose whether or not to purchase the insurance, 

lower risk individuals might decide that it is better to forgo insurance at such a high price 

(relative to the value they place on it). When lower risk individuals leave the pool, however, the 

average cost of insurance increases for those remaining. As prices increase, more lower risk 

individuals will have an incentive to leave the pool. This process of attrition, known as adverse 

selection, could continue until only the very high risk individuals are left in the insurance pool. 

Of course, not all low risk individuals will necessarily leave the pool. Those with high incomes 

or less willingness to bear risk may be willing to pay a higher price for greater coverage. In 

addition, the extent of adverse selection may vary depending on any particular proposal. For 

example, a relatively high cap on the exclusion for employer-provided health care would likely 

produce less of an adverse selection effect than a lower cap. Some argue that any proposal that 

has the effect of shifting the purchase of insurance more toward the individual market should 

include market reforms that would help to counter balance effects of adverse selection and 

incorporate some of the consumer protections currently provided in the group market. 

Those who support reducing reliance on the current employer-based system argue that 

such a reduction could have some positive effects. For example, the current reliance on 

employer-based coverage is sometimes cited as contributing to a “job lock” effect in that 

employees may stay at their current place of employment because of fear of an undesirable 

change in health care coverage. It is also argued that, even if employer groups are eroded, other 

group markets may arise, such as risk pools and purchasing cooperatives. The extent to which 

such cooperatives would result in true risk sharing and group rating that does not reflect health 

status would depend on a number of factors, including the regulatory environment in which they 

are established. It is also argued that, even if the tax subsidy for employer-provided health care 

were no longer available, employers could give employees the opportunity to purchase group 

coverage, thereby making group rates available.

Design of a cap on the exclusion for employer-provided health care

A variety of design issues would need to be addressed in developing a cap on the 

exclusion for employer-provided health coverage. Most proposals impose a dollar limit on such 

coverage, with different amounts based on whether the coverage is self-only coverage or family 

coverage. There are a number of different ways that a dollar cap could be set, all of which may 

have different policy implications. For example, a cap could be based on the average cost of 

health insurance. Some have suggested that a dollar cap should vary based on geographic locale 

because health care costs differ throughout the county. A cap could be indexed for medical cost 

inflation, so that the excludable share of the health insurance premium is not eroded over time. 

 

health services, this argument would take the form that individuals with low health needs should not be 

required to subsidize those with greater health needs. This argument is most frequently made with respect 

to health risks that are viewed as life-style choices, such as smoking, drinking, or eating habits. When 

health risks are looked at over an individual’s lifetime, there is less of a difference between individuals 

with respect to health risk status. 
18 

Alternatively, a cap could be indexed based on the overall rate of inflation, in which case the 

excludable share would most likely fall over time. 

Other limitations could be applied in addition to or in lieu of a dollar limit. For example, 

the exclusion could be limited to policies that provide a minimum package of specified benefits 

in order to ensure that some standard of comprehensive medical coverage is met. The exclusion 

could be made inapplicable to certain types of policies that provide only limited types of 

coverage, such as vision or dental care or coverage only for a specified disease. The exclusion 

could be made inapplicable to policies that fail to satisfy certain minimum standards with respect 

to copayments and deductibles, under the theory that policies that do not meet such requirements 

would provide excessively generous first-dollar coverage. 

Employer-provided health coverage that is eligible for the exclusion can take many forms 

under present law. For example, health coverage may be provided through commercial 

insurance or through a self-insured plan (or some combination of both). Employers may provide 

for reimbursement of out-of-pocket expenses through an HRA or FSA or make contributions to 

an HSA. Contributions for health coverage may be made directly by the employer or on a salary 

reduction basis. In general, in order for a cap to be effective, all types of coverage to which the 

exclusion currently applies would need to be taken into account. 

On-site health care coverage also presents issues. Some have argued that certain types of 

health benefits that are provided on a nondiscriminatory basis should be disregarded in applying 

a cap. For example, many employers have an on-site nurse or first aid facility, free health 

screenings, or programs relating to weight loss or smoking cessation. It is argued that such 

services typically are of minimal value and also may be difficult to value, e.g., issues arise as to 

whether value should be attributed to all eligible employees or only those that use the programs. 

On the other hand, some employers may provide more comprehensive on-site health care. 

Excluding on-site programs entirely may provide a means for avoiding application of the cap. 

Issues arise as to how a cap would be applied in a variety of circumstances, including the 

cases of an individual with coverage from more than one employer and spouses with separate 

coverage under different plans (which may or may not be from the same employer).26 

Definition of medical expenses

A far more limited proposal than imposing a cap on the exclusion for employer-provided 

health care is to conform the definition of medical expenses for purposes of the exclusion (as 

well as for HSA and MSA purposes) to that used for the itemized deduction. Thus, for example, 

 26 For example, suppose there is a cap of a specified dollar amount per month for self-only 

coverage and a cap of twice that amount for family coverage and that a husband and wife have two 

children and that each spouse has employer-provided coverage covering the spouse and one child. May 

each spouse exclude the value of coverage up to the family cap (for a total exclusion for the couple of 

four times the single cap)? Does it matter if they file a joint return? Does it matter if they are employed 

by the same employer (but covered under different plans)? Similar issues are likely to arise with respect 

to other fact patterns. 
19 

nonprescription medicines, such as sunscreen, could not be reimbursed through an FSA. Such an 

approach would provide greater consistency in the tax treatment of medical expenses. It is also 

argued that such expenses are generally routine purchases made by most taxpayers and that, like 

other personal expenses, should not be deductible or excludable. In addition, providing a 

subsidy for over-the-counter medicines may result in noncompliance, as it may be more difficult 

to distinguish products that are deemed to be medical from those that are considered to promote 

general health (and therefore not eligible for the subsidy), such as toiletries. 

There have also been proposals to expand the tax subsidies available for over-the-counter 

medicines. Supporters of such proposals argue that at least certain over-the-counter medicines 

are not routine for most taxpayers and can be expensive. Also, some over-the-counter products, 

such as certain allergy medicines and smoking cessation products, were recently available by 

prescription only. Some argue that it is appropriate to provide a subsidy for such products. 

Issues relating to a credit or deduction for health care coverage

Proposals to provide a credit for health insurance generally have as a basic goal making 

health insurance more affordable and reducing the number of uninsured. As with other 

proposals, a credit for health insurance could take many forms. One alternative would be to 

replace the present-law tax provisions relating to health expenses with a credit available to 

everyone with health insurance. A credit could also be targeted to a more limited group, such as 

lower income individuals. 

To the extent that making health insurance more affordable is a goal of a credit, the 

amount of the credit needs to be such that it adequately subsidizes the cost of coverage, 

particularly at lower income levels. A nonrefundable credit would provide a subsidy only for 

individuals with tax liability; a refundable credit would be needed to provide a subsidy for 

individuals with little or no tax liability. 

Some have argued that, in order to make a credit more useful to lower income 

individuals, it should be refundable and provided on an advance basis. Experience with the 

earned income credit under present law indicates that refundable credits may increase the 

potential for fraud by taxpayers. For this reason, some have suggested that any credit (at least to 

the extend refundable) should be provided only to health care insurers or in the form of vouchers 

that can only be used to purchase health care coverage. The present-law HCTC provides some 

experience with respect to implementing such an approach. However, a broad-based advance 

refundable credit will raise different issues than those raised under the more limited HCTC. 

Some proposals take the approach of providing an above-the-line deduction for health 

coverage rather than a credit. Like a nonrefundable credit, a deduction will not provide a subsidy 

for individuals with little or no tax liability and thus would not be as effective as a nonrefundable 

credit in lowering health coverage costs for low income individuals. A deduction may be more 

attractive than a credit for taxpayers with a higher marginal tax rate than the credit rate. In such 

cases, the deduction will offset more tax liability than would a credit. On the other hand, if the 

credit rate is higher than the taxpayer’s marginal tax rate, the credit is more favorable than a 

deduction. For this reason, many credits are more attractive to lower-income individuals that a 

deduction. 
20 

Issues relating to providing a tax subsidy for high deductible health insurance

Recent attention has focused on high deductible insurance and HSAs. Some have 

proposed providing additional tax subsidies for the purchase of high deductible health insurance 

in conjunction with an HSA. Under present law, purchase of high deductible health plans is 

subsidized indirectly by the requirement that HSAs are permitted only to those covered by such 

plans. HSAs provide a tax benefit that is, at minimum, equivalent to an above-the-line deduction 

for medical expenses, up to the annual cap on contributions to an HSA. To see this, note that 

because the contribution to an HSA is deductible, the act of contributing to the HSA and 

immediately withdrawing the funds to pay for medical expense is equivalent, economically, to 

providing an above-the-line deduction for the medical expense itself. To the extent that the 

taxpayer is able to fund the HSA well in advance of the medical expense, the HSA additionally 

provides the ability to save for medical expenses on a pre-tax basis. The combined tax benefit 

can be thought of as providing the ability to take a current deduction for a future expense. 

If the funds in the HSA are not used for qualified medical expenses, they may be 

withdrawn subject to income tax and a 10-percent early withdrawal tax. The early withdrawal 

tax ceases to apply after the age of Medicare eligibility, currently 65. Thus, funds that 

accumulate and are withdrawn for purposes other than to pay qualified expenses receive a tax 

benefit equivalent to the benefit provided to a deductible IRA. 

Proposals in this area include providing a direct subsidy for the purchase of high 

deductible health plans by permitting a deduction or credit for premiums for such plans in 

situations where a tax subsidy is not currently provided (e.g., in the case of someone who is not 

self employed and who does not have employer-provided health insurance). Other proposals 

enhance the indirect subsidy provided to high deductible health plans by increasing the amounts 

that may be contributed to HSAs. 

Proponents of such proposals believe that the use of high deductible plans promotes 

responsible health policy by making individuals more conscious of their health care costs 

because fewer expenses are paid by a third party insurer. Some proponents of such proposals 

believe that many current health insurance policies cover routine medical expenses and that the 

tax laws should provide a subsidy only for insurance for unpredictable medical expenses. 

However, the HSA itself may undermine that goal to some extent because, as noted above, it 

provides a subsidy for the first dollar of medical expenses. Others argue that it is inappropriate 

to favor any kind of health care product and that if only high deductible plans receive a tax 

subsidy (or a greater subsidy than other types of plans) then market decisions will be distorted. 

Those who do not favor providing additional tax benefits for high deductible plans are 

concerned that such plans are likely to be more attractive to healthier individuals, with the result 

that adverse selection will occur and result in higher insurance costs for individuals with greater 

health risks. This issue is discussed in detail, above. It is also argued that increasing the 

contribution limits for HSAs makes it more likely that they will be used by higher income 

individuals as an additional tax-favored savings vehicle. 
21 

Issues relating to mandated health care coverage

The desire to have universal health coverage and avoid issues relating to adverse 

selection are sometimes advanced as arguments in favor of requiring individuals to purchase 

insurance. Another argument offered as a rationale for mandated coverage is that the 

government may not be able to commit to denying health care services to those needing them, in 

which case some individuals will have an incentive to “free ride,” that is, to obtain services that 

others pay for. It is also argued that individuals may not be sufficiently informed regarding 

health care choices and may therefore choose a level of coverage (including no coverage) that is 

lower than what society in general views as appropriate. While mandates need not involve the 

tax laws, past proposals relating to mandates have often included a tax component.

Implementing an individual mandate would raise a variety of issues. A mandate could be 

enforced through the tax law, for example, by imposing a “premium tax” or denying certain tax 

benefits unless an individual provides proof of coverage. Proposals including mandates typically 

include specifications as to the minimum services and benefits the coverage must provide, and 

may also include provisions relating to risk pools or purchasing cooperatives, rules relating to 

community rating, and allowing certain individuals to pay for coverage under Medicare. 

Mandates that employers provide health insurance coverage for their employees have 

been proposed both in lieu of and in addition to an individual mandate. From an economic 

perspective, the arguments for an employer mandate are less well established in economic theory 

than those for an individual mandate. Some of the more compelling arguments are premised on 

the idea that many individuals currently receive health coverage through their employer and that 

health care reforms should result in little disruption in current practices. The employer-provided 

health care system is also sometimes proposed to be used as part of an enforcement mechanism 

for an individual mandate, e.g., by requiring employers to withhold premiums. Economists 

generally argue that independent of whether a payment on behalf of an employee is made by the 

employer or the employee, the true economic impact of the requirement is the same--it is borne 

by the employee. 

Complexity

Proposals to significantly modify the present-law tax treatment of health care are likely to 

involve increased complexity in many cases compared to present law. While the present law 

regime may raise a variety of issues, in many cases it is relatively simple to apply. For example, 

the exclusion for employer-provided health insurance is simple for both employers and 

employees because there is no limit on the exclusion and, in many cases, few requirements to be 

met for the exclusion to apply. Additional requirements apply in some cases. For example, 

under HRAs and FSAs, employers need to comply with rules to ensure that expenses submitted 

for reimbursement qualify for the exclusion. Proposals that impose a cap on the exclusion for 

employer-provided health care are likely to impose additional administrative burdens on 

employers. Proposals that place the burden on individuals to demonstrate compliance, such as a 

tax credit or a deduction for health coverage, will increase burdens for many individuals 

compared to present law. 
22 

On the other hand, complexity may be reduced in some cases. For example, under 

present law, FSAs, HRAs, and HSAs provide similar tax treatment for out-of-pocket health 

expenses but are subject to very different rules. A proposal that provides uniform treatment for 

such expenses could reduce complexity compared with present law.