- 16 -

gross income (AGI). Through 1993, self-employed persons were

in a slightly better position than under present law because they
could deduct 25 percent of their health insurance expenses for
income tax purposes.

There are a number of different ways to achieve or improve
horizontal equity. One approach would be to repeal the exclusion
for employer-provided health care. Another would be to repeal
the exclusion and replace it with a tax credit available to all
taxpayers for the purchase of health insurance or other health
care expenses. Still another would be to retain the exclusion,
but to provide an unlimited deduction against AGI (or in arriving
at AGI) for the purchase of health care by persons who do not
have employer-provided health care. The latter approach would
improve horizontal equity, but would not attain it fully because
those who receive employer-provided health care would also
receive the benefit of the exclusion for payroll tax purposes.
Concern about horizontal equity also could lead to repeal of the
exclusion for employer-provided health care or to limits on the
amount of the exclusion. The deduction for individual medical
expenses in excess of 7.5 percent of AGI might be retained even
if the exclusion were repealed on the theory that the medical
expense deduction adjusts an individual’s income for
extraordinary medical expenses to better reflect the individual's
ability to pay taxes.

Horizontal equity could be improved, but not eliminated, by
limiting an employer’s deduction for health care expenses. A
deduction disallowance will affect employers differently. For
example, governmental and tax-exempt employers, and employers
with operating losses, will not be subject to a deduction
disallowance. To the extent that the increased costs
attributable to a deduction disallowance are passed through to
employees, employees of employers that are not affected by a
deduction disallowance will be benefited relative to employees of
profitable employers and individuals whose employers do not
provide health care. On the other hand, imposing an excise tax
on all employers as a means of limiting the tax benefits
attributable to employer-provided health care will affect all
employers who are subject to the tax, including governmental and
tax-exempt employers.

Vertical equity

The vertical equity of a tax system reflects the extent to
which it is viewed as appropriately distributing the burden of

18 Not only is the income tax treatment not equivalent, but

individuals who purchase health care on an after-tax basis also
receive no payroll tax benefit.



- 37 -

in the account is nonforfeitable; and (6) certain rules will be
applicable to the distribution of the entire interest of
beneficiaries of the trust. An account held by a4 U.S. insurance
company would be treated as a medical savings account (and the
insurance company would be treated as a bank) if (1) the account
is part of a health insurance plan that includes a catastrophic
health plan, (2) the account is exclusively for the purpose of
paying the medical expenses of the beneficiaries of the account
who are covered under the catastrophic health plan, and (3) the
written instrument governing the account meets certain additional
requirements.

Medical savings accounts would be exempt from tax.
Def tion ical en:

Under the bill, medical expenses would include medical care
(within the meaning of sec. 213 of the Code) and long-term care,
but only to the extent such amounts are not reimbursed by
insurance or otherwise. In addition, the bill would provide that
medical expenses would not include any amount paid for coverage
under a health plan except (1) in the case of an individual under
age 65, for amounts paid for coverage under a catastrophic health
plan or a long-term care insurance plan, or (2) in the case of an
individual age 65 or older, for amounts paid for coverage under a
medicare supplemental policy, under a long-term care insurance
policy, or for payment of Medicare Part A or B premiums.

‘axa: £ distrib ons

Any amount paid or distributed from a medical savings
account would be included in the gross income of the individual
for whom the account was established unless the amount is used
exclusively to pay the medical expenses of the individual or the
spouse or any dependent of the individual. No amount would be
included in income if the entire amount received is paid into
another medical savings account for the benefit of the individual
not later than 60 days after the date of the distribution.
Contributions in excess of the deduction limits that are
withdrawn on or before the date prescribed by law for filing the
individual’s Federal income tax return for the year (including
extensions) would not be treated as distributions that must be
included in income but earnings related to such excess
contributions would be included in income.

An additional 10-percent income tax would be imposed on any
distribution from a medical Savings account that is includible in
income. This additional tax would be increased to 50 percent if,
after the distribution from the account, the balance of the
medical savings account is less than the amount of the deductible
under the catastrophic health plan covering the individual.



- 33 -

4. Deduction for health plan premium expenses of individuals

Under the bill, individuals who purchase health coverage
under an AHP through a HPPC or large employer” would be
permitted a deduction in determining AGI (i.e., an above-the-line
deduction) to the extent the premiums for such coverage do not
exceed the reference premium rate for the individual’s premium
class (as defined above) reduced by any premium amounts paid by
any other entity (including an employer or any government) for
the individual’s coverage.

Under the bill, full-time employees of large employers who
decline employer coverage would not be eligible for coverage
through a HPPC. Because the above-the-line deduction would be
allowed only in the case of individuals who obtain health
coverage under an AHP either through a HPPC or through a large
employer, full-time employees of large employers who decline
employer coverage would not be entitled to an above-the-line
deduction for premiums for health coverage under an AHP.

Coverage under Part A or B of Medicare would not be
considered coverage under an AHP. Thus, the above-the-line
deduction would not be permitted with respect to the costs of
coverage under Part A or B of Medicare.

The present-law rules relating to the deductibility of
health insurance premiums would continue to apply to premiums
that do not satisfy the limitations described above (i.e., those
premiums paid for coverage under a health plan that is not an AHP
and the amount of any premiums paid in excess of the reference
premium rate). Thus, an individual would be permitted an
itemized deduction for medical expenses to the extent that such
expenses exceed 7.5 percent of AGI.*

Effective date.--The provision would apply to amounts paid
after December 31, 1994, and taxable years ending after such

self-employed individuals during 1994.

7 A large employer generally would mean an employer that
normally employed more than 100 employees during the previous
year.

*% It is unclear under the bill whether premiums that are
deductible without regard to the 7.5 percent of AGI floor would
be taken into account in determining whether a taxpayer has
medical expenses that exceed 7.5 percent of AGI. In the absence
of a specific provision to the contrary, it would appear that the
premiums that are otherwise deductible would be taken into
account in determining whether a taxpayer has medical expenses
that exceed the floor.



-10-

reduction. FSAs also may be provided by an employer outside a
cafeteria plan (i.e., when the employee is not permitted to elect
cash in lieu of a qualified benefit). FSAs are commonly used,
for example, to reimburse employees for medical expenses not
covered by insurance.

There is no special exclusion for benefits provided under a
FSA. Thus, benefits provided under a FSA are excludable from
income only if there is a specific exclusion for the benefits in
the Code (e.g., the exclusion for employer-provided health or
group-term life insurance coverage). FSAs that are part of a
cafeteria plan must comply with the rules applicable to cafeteria
plans generally. One of these rules is that a cafeteria plan may
not offer deferred compensation except through a qualified cash
or deferred arrangement (sec. 401(k)). According to proposed
Treasury regulations, a cafeteria plan offers deferred
compensation if it includes a health FSA which reimburses
participants for medical expenses incurred beyond the end of the
plan year.© Thus, amounts in an employee's FSA that are not used
for medical expenses incurred before the end of a plan year must
be forfeited. This rule is often referred to as the "use it or
lose it" rule.

In addition, proposed Treasury regulations contain
additional requirements that health FSAs must comply with in
order for the coverage and benefits provided under the FSA to be
excludable from income.’ These rules apply with respect to a
health FSA without regard to whether the health FSA is provided
through a cafeteria plan.

The proposed regulations define a health FSA as a benefit
program that provides employees with coverage under which
specified, incurred expenses may be reimbursed (subject to
reimbursement maximums and any other reasonable conditions) and
under which the maximum amount of reimbursement that is _ .
reasonably available to a participant for a period of coverage is
not substantially in excess of the total premium (including both
employee-paid and employer-paid portions of the premium) for such
participant's coverage. A maximum amount of reimbursement is not
substantially in excess of the total premium if the maximum
amount is less than 500 percent of the premium.*

6 prop. Treas. Reg. 1.125-2 Q&A-5(a).
7 prop. Treas. Reg. 1.125-2 Q&A-7(b).

® prop. Treas. Reg. 1.125-2 Q&A-7(c).



- 20 -

specified package is and also what other cost containment
features are in the health care reform proposal.

Denying the deduction for employer-provided health care or
imposing an excise tax on employers with respect to certain
health care expenses should, at least in the long run, have a
similar effect on overall costs as a comparable limit on the
exclusion. In the short run, if employers are obligated to
provide a certain level of health care by contract (e.g., through
a collective bargaining agreement), then they will not be able to
adjust their spending on health care until the contract expires.
Thus, they may be subject to the deduction denial or the excise
tax even if they cannot immediately adjust health care spending.

Further, as discussed above, to the extent that an
employer’s marginal tax rate is lower than the marginal tax rate
of employees, the effect of a deduction denial or excise tax may
be to reduce, but not eliminate, the incentive to provide
compensation in the form of health care. For example, ifa
deduction disallowance is imposed, a tax-exempt employer will not
face an increase in costs of health care and, therefore, the
incentive to provide compensation in the form of health care will
still exist.

3. Subsidize the purchase of health insurance by some or all
individuals

Some health care proposals seek to subsidize the purchase of
health care coverage by low-income individuals to make such
coverage more affordable. The present-law exclusion for
employer-provided health care subsidizes the cost of insurance
for some low-income individuals, but also subsidizes the cost of
insurance for many high-income taxpayers as well. Thus, if
providing low-income subsidies is a primary goal, then the tax
benefits for health care could be better targeted.

Excluding some or all of employer-provided health care will
only provide a subsidy for individuals who receive employer-
provided health care. Because not ali low-income individuals
have employer-provided health care, means other than the
exclusion are necessary to provide a subsidy for all low-income
individuals. One alternative would be to replace the exclusion
with a refundableTM tax credit for low-income individuals.
Another alternative would be to limit the exclusion to low-income
individuals, and provide a deduction against gross income for
low-income individuals who do not have employer-provided health
care. As mentioned above, this approach would not place all

1% A tax credit would not have to be refundable. However,
if it is not refundable then it would not provide a subsidy to
low-income individuals who have no tax liability.



- 38 -

Effective date

The provisions of the bill relating to medical savings
accounts would be effective for taxable years beginning after the
first December 31 following the date that is one year after the
date the insurance reforms in the bill are established.

D. S. 1743--Sen. Nickles and others (The Consumer Choice Health
Security Act of 1993)

1. In general

The bill generally would repeal the present-law exclusion
from income for employer contributions to an accident or health
plan and the medical expense deduction for individuals, generally
effective after December 31, 1996.7 In addition, the bill would
provide a refundable health care expenses tax credit for certain
qualified individuals and provide a nonrefundable tax credit for
individuals for contributions to a medical savings account,
generally effective in 1997.

2. Refundable health care expenses tax credit
unt ax cr:

Under the bill, a qualified individual would be permitted a
credit against tax in an amount equal to the sum of (1) 25
percent of the amount of qualified health insurance premiums and
unreimbursed expenses for medical care paid by the individual
during the taxable year that do not exceed 10 percent of the
individual’s AGI for the year, (2) 50 percent of the amount of
such premiums and unreimbursed expenses that exceed 10 percent,
but not 20 percent, of the individual’s AGI, and (3) 75 percent
of the amount of such premiums and unreimbursed expenses that
exceed 20 percent of the individual’s AGI. A qualified
individual would mean the taxpayer, the spouse of the taxpayer,
and each dependent of the taxpayer who is enrolled in a Federally
qualified health insurance plan. A qualified individual would
not include certain individuals entitled to health care under
certain Federal programs. If the taxpayer is a qualified
individual for only part of the year, the credit would be limited
to the applicable percentage of the credit amount. The
applicable percentage would be determined by the number of whole
months in the year in which the taxpayer is a qualified

2% The intent of the bill is to retain present law as it
relates to the 25-percent deduction for health insurance costs of
self-employed individuals. In other words, the bill would not
reinstate the 25-percent deduction for taxable years beginning
after December 31, 1996. A drafting change will be required to
accomplish the intent of the bill.



INTRODUCTION

This pamphlet,' prepared by the staff of the Joint Committee
on Taxation, provides a general discussion and analysis of the
issues surrounding the tax treatment of health care, together with
a description of proposals relating to tax incentives for the
provision of health care contained in the following health care
reform bills: S. 1757, S. 1775, S. 1579, S. 1770, and S. 1743. The
Senate Committee on Finance has scheduled a public hearing on these
issues on April 26, 1994.

The "Health Security Act" was introduced by Senator Mitchell
and others on November 20, 1993, as S. 1757 and was introduced by
Senator Moynihan on November 22, 1993, as S. 1775, both on behalf
of the Administration. S. 1579 (the "Managed Competition Act of
1993") was introduced by Senator Breaux and others on October 21,
1993. S. 1770 (the "Health Equity and Access Reform Today Act of
1993") was introduced by Senator Chafee and others on November 22,
1993. S. 1743 (the "Consumer Choice Health Security Act of 1993")
was introduced by Senator Nickles and others on November 20, 1993.

Part I of the pamphlet presents an overview of issues relating
to the present-law tax incentives for health care benefits and a
summary description of the proposals in the bills; Part II
describes the taxation of health care benefits and expenses under
present law; Part III discusses some of the issues that arise when
changes to the tax treatment of health care benefits are
considered; and Part IV describes specific legislative proposals in
the bills.

' This pamphlet may be cited as follows: Joint Committee on

Taxation, Di i an a. is Pro 1 1 ia

fax Treatment of Health Care (S. 1757, S. 1775, S. 1579, §. 1770
an 7 - (JCS-3-94), April 26, 1994.



- 31 -

primarily at workplace health care and health promotion or
related population-based preventive health activities. Thus, for
example, health plan expenses would include employer
contributions (including pre-tax salary reduction contributions)
to a cafeteria plan and any coinsurance or deductibles paid by
the employer.

The bill would direct the Commission to establish rules to
determine the amount of health plan expenses contributed by an
employer for each employee under a self-insured plan based on the
principles by which employers with self-insured accident or
health plans determine the premiums that qualified beneficiaries
are required to pay for coverage under the health care
continuation rules (Code sec. 4980B(f) (4) (B)). Under those
rules, the premium for continuation coverage under a self-insured
plan must be a reasonable estimate of the cost to the plan of
providing coverage to a similarly situated individual determined
on an actuarial basis and taking into account factors that the
Secretary of the Treasury sets forth in regulations. The
Secretary of the Treasury has not yet issued regulations on this
issue.

De ion es: alth en,

Under the bill, excess health plan expenses would include
all health plan expenses incurred or paid by an employer for any
month on behalf of any beneficiary of a group health plan except
certain expenses attributable to coverage under an AHP. Expenses
attributable to coverage under an AHP would also be excess health
plan expenses (1) if the employer's contribution is not uniform
for a premium class regardless of which AHP is selected by the
beneficiary, (2) if, in the case of a small employer, the
employer contribution is not made through a health plan
purchasing cooperative (HPPC), and (3) to the extent the expense
attributable to any particular beneficiary exceeds the "reference
premium rate" pertaining to that beneficiary.

The reference premium rate would be the lowest premium
offered by an open plan (that enrolls a minimum number of
eligible individuals) in the HPPC area for the relevant premium
class. The reference premium rate would also include the
applicable HPPC overhead amount for the open AHP.

Under the bill, the reference premium rate would vary by
premium class and would apply to all beneficiaries residing in
the HPPC area. The Commission would establish premium classes
based on the four types of enrollment under the bill and the age
of the principal enrollee (sec..1205(a) (2) of the bill). In the
case of closed AHPs that elect to establish premiums that vary by
type of enrollment rather than premium class {i.e., disregarding
the age adjustments) or to treat one or more HPPCs as a single
HPPC area (as specified by the Commission) with respect to the



-17-

taxation tax across individuals with differing economic
circumstances. The U.S. Federal tax system is generally
considered to be progressive, i.e., the average rate of tax paid
by an individual increases as that individual’s income increases.
In that context, vertical equity refers to the extent to which
the effect of a tax provision preserves progressivity in the tax
system. The exclusion for employer-provided health care provides
an individual with a subsidy that is proportional to his or her
marginal tax rate, so that individuals with higher marginal tax
rates receive a greater tax benefit than those with lower
marginal tax rates.’ Thus, the exclusion tends to reduce the
vertical equity of a progressive tax system. In addition, a
second source of inequity exists to the extent that employees
with higher incomes tend to receive more valuable employer-
provided health care benefits than low-income taxpayers.

Vertical equity could be better achieved in a variety of
ways. For example, the exclusion could be repealed. It is not
necessary, however, to repeal the tax benefits for employer-
provided health care to address concerns about vertical inequity;
this problem could be solved by structuring the tax benefits in a
different way. For example, the exclusion for employer- provided
health care could be replaced with a tax credit for health care
expenses. The credit would be equivalent to the exclusion from
income for employer-provided health care only for those taxpayers
whose marginal tax rate is equal to the credit rate.” Limiting
the exclusion to persons with incomes below certain levels would
also reduce the vertical inequity inherent in the exclusion. If
it is true that high-income individuals are, in general, more
likely to have larger employer-provided health care, then
limiting the exclusion (or a comparable credit) to a fixed level
of benefits or costs would also tend to increase vertical equity.

3. Raise revenue

Another possible objective in limiting the tax benefits for
employer-provided health care is to raise revenue. If this is

‘© The effect is somewhat different when payroll taxes are
taken into account. For example, a taxpayer in the 15-percent
marginal rate bracket receives the benefit of the exclusion both
for income and payroll tax purposes. A taxpayer in a higher
bracket may be above the social security tax base, and so may
only receive the benefit of the exclusion for income tax purposes
and hospital insurance tax purposes. The exact effect of the
exclusion for payroll tax purposes is difficult to quantify
because the amount of social security benefits received May be
affected depending on whether employer-provided tax care is
included in the payroll tax base.

7 This assumption ignores the effects of Payroll taxes.



- 23 -

there are a number of different approaches that could be
utilized.

One possible approach would be to have the limit on the
exclusion vary by region. This could be done directly or
indirectly. For example, if a dollar limit is used, different
dollar limits could be specified for each State or region. If
the limit is based on the cost of a specified health care package
within the region where the individual lives, then the limit will
vary by region. If the exclusion is for the cost of a particular
benefit package, then there are implicitly different limits for
different areas. A percentage limit on employer-provided health
care (e.g., limiting the exclusion to 50 percent of health care
expenses) is sometimes also suggested as a way of addressing
concerns about regional disparities in health care costs. Under
this approach, all individuals would be able to obtain a subsidy
with respect to the same portion of health expenditures.

2. Administrative issues

Any limits on the tax benefits for employer-provided health
care raise administrative issues for taxpayers as well as for the
Internal Revenue Service (IRS). The extent of administrative
difficulty will vary greatly depending on the specifics of any
proposal, but some general issues can be articulated.

Any proposal that limits the exclusion for employer - provided
health care will impose additional administrative burdens on
employers, who may have to determine the value of health care
received by each employee and whether it is limited. Presumably,
employers will be required to report the amount of health care
received by the employee to the employee and the IRS. This
burden may be greater under some Proposals that others. For
example, if the amount that is excludable from income varies
based on the employer's place of business or on an employee's
place of residence, then an employer that operates in more than
one region (or that has employees who live in more than one
region) may have to determine the amount that is excludable for
any particular employee based on that employee's particular
circumstances. In addition, if the limit is not based on
information within the employer's control (e.g., if it is based
on the average cost of health insurance in the area), then a
third party (such as the IRS) will have to inform the employer of
what the applicable limit or limits are. Administrative burdens
on the employer will be lessened to the extent that the employer
can design a plan to avoid being affected by the exclusion limit.

Denying the employer deduction or imposing an excise tax on
the employer in lieu of requiring employees to include amounts in
income may be somewhat easier for the IRS to enforce than an
exclusion, because it would be enforced at the employer level
rather than the employee level. Thus, fewer taxpayers would be



coverage, regardless of whether they would have purchased
coverage without the exclusion. The exclusion also is not
necessarily targeted to those individuals who may be most in need
of a subsidy for the purchase of health insurance. In
particular, as described above, the exclusion provides a greater
benefit for higher-income individuals than for lower-income
individuals, whereas lower-income individuals are more likely to
be in need of a subsidy for the purchase of health care.

The exclusion also does not provide a subsidy for all
persons who might purchase less insurance than is socially
desirable. Individuals who are self-employed or who work for an
employer that does not provide health care do not receive a
subsidy comparable to the exclusion for employer-provided health
care.

2. Control health care costs

By inducing individuals to purchase more health care than
they would in the absence of the exclusion from income for
employer-provided health care, the exclusion may increase the
aggregate national expenditure for health insurance’ and services.
To the extent this is a problem, it can be addressed by causing
individuals to face more of the true cost of the health services,
i.e., by reducing the Federal subsidy for employer-provided
health care.

Any limit on employer-provided health care will reduce the
subsidy, and may cause some individuals to purchase less health
care services than they would in the absence of the subsidy. The
ultimate effect will depend on the extent to which the subsidy is
limited.

Certain current proposals to limit the tax benefits for
employer-provided health care would limit the benefits based ona
dollar limit determined with reference to the cost of a specified
benefit package. Others limit the benefit to the purchase of a
specified benefit package whatever its cost. Both types of
proposals have cost containment as a goal. The first type would
discourage the purchase of health insurance in excess of the
applicable dollar amount. Those who can purchase the specified
benefit package below the cap amount would also be able to
purchase some amount of supplemental coverage on a tax-favored
basis. In contrast, if the subsidy is limited to a particular
package, then supplemental insurance is not subsidized. The
latter approach also ensures that the specified package is
subsidized no matter what its cost, whereas the former does not.
For example, if a fixed dollar cap on the exclusion is based on
the lowest cost in an area for a fixed specified benefit package,
not all persons will necessarily be able to purchase the package
at that price. The extent to which these proposals will lead to
cost containment will depend in part on how generous the



- 32 -

establishment of premiums, or both, the bill would require such
closed AHPs to convert the reference premium rate from a premium
that varies by premium class to a premium that varies by type of
enrollment or across HPPC areas or both. Under the bill, closed
AHPs would include health plans limited by structure or law to
one or more large employers and collectively bargained health
plans established as of September 7, 1993.

If a group health plan is not a primary payor under
Medicare, health plan expenses paid or incurred for the coverage
of individuals eligible for Medicare Part A benefits would not be
considered excess health plan expenses subject to the excise tax.
Thus, in general, the excise tax would not apply to employer-
provided health care for Medicare-eligible retirees.

fe ve te

In general, the excise tax would apply to expenses incurred
for the provision of health services after December 31, 1994. In
the case of a collectively bargained plan, the excise tax would
be effective on the earlier of (1) the termination of the
collective bargaining agreement (determined without regard to any
extensions agreed to after the date of enactment) or (2) January
1, 1997.

3. Increase in deduction for health plan premium expenses of
self-employed individuals

The bill would extend the 25-percent deduction for health
insurance expenses of self-employed persons for 1994, and would
replace it with a permanent deduction of 100 percent of certain
health insurance expenses for years beginning on or after January
1, 1995.

The 100-percent deduction would be limited to amounts paid
to a HPPC for coverage under an AHP that do not exceed the
reference premium rate (as defined above) for the self-employed
individual’s premium class.

Effective date.--The provision relating to the 100-percent
deduction would be effective for taxable years beginning after
December 31, 1994. The 25-percent deduction would be extended
effective for taxable years beginning after December 31, 1993,
and would expire on the date the 100-percent deduction becomes
effective.*

% The bill is intended to provide a 25-percent deduction
for self-employed health insurance expenses for taxable years
beginning in 1994. A drafting change will be required to
accomplish this intent because, under the bill as drafted, no
deduction would be allowed for the health insurance expenses of



- 14 -
even though such taxes are statutorily imposed on employers.

The fact that limiting the employer deduction or imposing an
excise tax on certain employer-provided health care is a proxy
for limiting the exclusion does not mean that it will have the
same actual effects. For example, consider an employee in the
15-percent rate bracket who works for an employer in the 34-
percent corporate rate bracket. If some or all of employer-
provided health care is includible in income, it would be taxed
at a rate equal to the sum of the income tax rate plus the
payroll tax rate. This includes the 15-percent income tax, the
employee portion of payroll taxes (7.65 percent) and the employer
payroll taxes. On the other hand, if a deduction denial
applies, the effective tax rate would be the marginal tax rate of
the employer, or 34 percent in this example. Thus, in this
example, denying the deduction would impose a greater cost on
health care provided in excess of the limit than would limiting
the employee exclusion. For an employee in a higher rate
bracket, the effect of denying the employer’s deduction may be
less than the effect of requiring the employee to include the
value of the health care in income.

In general, if the employer’s marginal tax rate is higher
than the employee’s, then disallowing the employer deduction will

3° This may not be true in the short run or in all cases.
For example, collective bargaining agreements may prevent the
employer from reducing cash compensation to take into account
increases in health care costs. Also, the wages of minimum wage
workers cannot be reduced. In the case of such workers,
increasing non-cash wage costs could result in reductions in
employment .

4 The appropriate way to view payroll taxes is a difficult
issue. Imposing a payroll tax on amounts paid for employer-
provided health care increases the current tax liability of the
employee. However, this increased tax entitles the employee to
future Social Security and Medicare benefits. The net effect of
such increased taxes and increased benefits is unclear. The
appropriate treatment of payroll taxes will depend upon whether
one views the payroll taxes as payments for future benefits or as
taxes transferred to current recipients of benefits. Thus,
whether denying an employer’s deduction for health care expenses
is equivalent to requiring employees to include the value of
employer-provided health care in income will depend not only upon
the marginal tax rate of the employer relative to the marginal
tax rates of employees, but will also depend upon one’s view of
the appropriate way to consider payroll taxes.



-6-

4. §. 1743--Sen. Nickles and others (The Consumer Choice Health
Security Act of 1993)

The bill would repeal the exclusion for employer-provided
health care and the medical expense deduction for health expenses
of individuals. The bill would provide a refundable tax credit for
certain health care expenses and provide a nonrefundable tax credit
for contributions to a medical savings account.



deduction is effective.

Limi 100- ent di

The bill would provide a deduction for up to 100 percent of
the amount paid for health insurance by a self-employed
individual, but only to the extent that the health insurance
constitutes comprehensive health coverage as described in the
bill and is purchased from a qualified alliance.

Under the bill, self-employed individuals who do not pay 100
percent of the weighted average premium (as determined under the
Health Security Act) for each of their employees would only be
entitled to deduct the percentage of their own insurance equal to
the lowest percentage paid by the individual for the health
coverage of any of its employees. Thus, the deduction would be at
least 80 percent of health insurance costs, because all employers
would be required to pay 80 percent of the weighted average
premium for each of its employees under the bill.

Similar to the 25-percent deduction under prior law, a
self-employed individual would not be permitted to claim the
100-percent deduction on amounts paid to purchase comprehensive
health coverage during any month in which the individual was
employed on a full-time basis by an employer. For purposes of
this provision, an individual would be considered employed on a
full-time basis if employed by an employer for at least 120 hours
in a month. The bill would provide for the establishment of rules
by the National Health Board for determining an employee’s hours
of employment including rules for determining the hours of
employment of salaried and commissioned employees.

Finally, as under prior law, the 100-percent deduction would
not be allowed to the extent that the amount of such deduction
exceeds the taxpayer’s earned income as defined in section 401(c)
of the Code.

Effective date

The provision relating to the 100-percent deduction would be
effective on the earlier of January 1, 1997, or the first day on
which the taxpayer could purchase comprehensive health coverage
from a health alliance. The 25-percent deduction would be
extended effective for taxable years beginning after December 31,
1993, and would expire on the date the 100-percent deduction
becomes effective.

B. 23 oe Breaux and others (The Managed Competition Act
of 1993

1. In general



- 26 -

also be excludable from income and wages. Under the bill, a
cost-sharing policy would be defined to include a health
insurance policy or health insurance plan which provides coverage
for deductibles, coinsurance, and copayments imposed under the
comprehensive benefit package, whether imposed under a higher
cost-sharing plan or with respect to out-of-network providers.”
The bill would also require cost-sharing policies to satisfy
certain standards.” .

rmi ve:

Under the bill, other permitted coverage that would qualify
for the present-law exclusion would include (1) coverage
providing wages or payments in lieu of wages for any period
during which the employee is absent from work on account of
sickness or injury, (2) coverage providing payment for permanent
injuries of an employee, his or her spouse or a dependent that is
computed with reference to the nature of the injury without
regard to the period the employee is absent from work (i.e.,
coverage for payments described in sec. 105(c)), (3) coverage
provided to an employee or former employee after such employee
has attained age 65 unless such coverage is provided by reason of
the current employment of the individual with the employer
providing the coverage, (4) coverage under a qualified long-term
care policy (as defined under the bill), (5) coverage provided
under Federal law to veterans or any member of the Armed Forces
of the United States and their spouses and dependents, and (6)
any other employer-provided coverage which the Secretary of the
Treasury determines should be excludable.

Cafeteria plans

Under the bill, the cafeteria plan exception from the
principle of constructive receipt would not apply to
employer-provided accident or health coverage or health FSAs
offered under a cafeteria plan unless the coverage constitutes
wages or payments in lieu of wages for any period during which
the employee is absent from work on account of sickness or
injury.

F. ible Gis rra: ents (FSAs

The bill’s limits on the exclusion for employer-provided
accident or health coverage would apply to coverage provided
through an FSA just as they apply to other employer -provided

2 Section 1421(b) (2) of the Health Security Act.

21 section 1423 of the Health Security Act.



The Federal tax expenditure for the exclusion of employer-
provided health care is estimated to be $36.7 billion for fiscal
year 1994, and $213 billion for fiscal years 1994 through 1998.?
This is the third largest single tax expenditure item. The largest
is the net exclusion for pension contributions and earnings ($55.3
billion for fiscal year 1994) and the second largest is the
deduction for home mortgage interest ($45.5 billion for fiscal year
1994). .

The most commonly cited rationale for the exclusion for
employer-provided health care is that it encourages employers to
provide health care to their employees. Employees should prefer to
receive compensation in the form of health care rather than in cash
or in other taxable forms of compensation. The exclusion makes
health care cheaper for employees than if they were to purchase it
on an after-tax basis, and may cause some employees to purchase
more health care services or insurance than they otherwise would.

duction medic: en:

Individuals can deduct their medical expenses, not otherwise
covered by insurance, but only to the extent that total medical
expenses for a taxable year exceed 7.5 percent of the taxpayer's
adjusted gross income (AGI) for the year. This is the only tax
benefit available to individuals who do not receive employer-
provided health care. The tax expenditure for the medical expense
deduction is estimated to be $3.5 billion for fiscal year 1994 and
$24.2 billion for fiscal years 1994-1998,

The rationale for the itemized deduction for medical expenses
appears to be different from that for the exclusion of employer-
provided health care. Because the deduction is only allowed for
expenses in excess of a floor, the deduction reflects the idea that
if an individual has extraordinary medical expenses, it affects his
or her ability to pay taxes. :

Deduction for health insurance expenses of self-employed
individuais

For years beginning before January 1, 1994, self-employed
individuals could deduct 25 percent of their health insurance
expenses. The deduction expired for years beginning on or after
January 1, 1994.

° In general, tax expenditures are reductions of individual

or corporate income tax liabilities that result from special tax
provisions or regulations. A special provision is classified as
a tax expenditure if the provision represents a departure from a
normal income tax structure that is made for reasons other than
administrative feasibility. Tax expenditure estimates do not
include the effect of payroll taxes or State or local taxes.



-2-
I. BACKGROUND AND OVERVIEW
A. Tax Incentives for the Purchase of Health Care
1. Present law
In ra.

The principal goal of the Federal income tax system is the
proper measurement and taxation of economic income in order to
raise revenue to finance government operations. However, the
Federal income tax laws have also been used historically to provide
incentives for certain socially desirable behavior. For example,
Federal tax laws have historically provided incentives for
employers to provide health care to employees.

In considering health reform proposals, Federal tax law is
frequently viewed not only as a source of revenue to offset the
estimated cost to the Federal budget of the particular reform being
proposed, but also as a tool for achieving particular health care
policy goals by providing incentives or disincentives for
particular categories of taxpayer behavior.

Present Federal tax law provides a number of tax benefits for
the purchase of health care. The most significant of these tax
benefits are: (1) the exclusion from income and employment taxes
for employer-provided health care, (2) an itemized deduction for
the cost of obtaining health care in excess of a threshold based on
the taxpayer's adjusted gross income, and (3) a partial deduction
of health insurance costs of self-employed individual’. In
addition, under present law, employers are permitted to deduct the
cost of health care benefits provided to employees.

Exclusion from income for employer-provided health care

Under present law, an employee is not required to treat the
value of employer-provided health care benefits as income for
purposes of the Federal income tax or as wages for purposes of
Federal payroll taxes. Under present law, this exclusion is
unlimited, and the provision of employer-provided health care is
relatively unregulated compared to other forms of tax- favored
employee compensation. For example, tax-favored employer-provided
pension benefits are subject to a variety of rules and restrictions
under Federal tax and labor laws, including nondiscrimination
rules, minimum participation rules, vesting requirements, and
funding rules. There are also dollar limits on the tax benefits
provided. In contrast, there is no comprehensive set of similar
rules in the health area.

2 This provision expired on January 1, 1994.



Heaton ERASE,

- 15 -

provide a disincentive for employers to provide health care. If
the employer’s tax rate is lower than the employee’s, there will
still be an incentive to provide compensation in the form of
health care, but the incentive will be smaller than it is under
present law. Thus, if the disallowance were enacted, employees
in rate brackets higher than the employer’s bracket who want
health care may negotiate with their employer to provide the
health care and forgo the deduction, because that is cheaper for
the employees than paying for the health care on an after-tax
basis. This could occur on an individual basis or a firmwide
basis. Thus, firms with high-wage workers (who face relatively
high marginal tax rates) may tend to continue to provide
insurance and those employers with low-wage workers (who face
lower marginal tax rates) may suspend such coverage (at least for
their low-wage employees) .

The economic effect of imposing an excise tax would be
similar to that of denying the deduction. The actual effect
would depend on the excise tax rate and the difference between
that rate and the employees’ marginal tax rates. Imposing an
excise tax on all employers would affect the decision to provide
health care in the case of tax-exempt employers and employers
with no current taxable income (employers with tax losses),
whereas a deduction disallowance only affects taxable employers
to the extent they have taxable income.

2. Equity among taxpayers

The Federal income tax system is generally concerned with
two types of equity, referred to as horizontal equity and
vertical equity.

Horizonal equity

Horizontal equity is the idea that similarly situated
taxpayers should have the same tax liability. For example, an
employee who receives $22,000 of taxable wages and $3,000 of
employer-provided health care will have less taxable income than
an otherwise similarly situated employee who receives $25,000 in
cash wages and purchases the same health coverage for $3,000,
even though their economic income is the same.

If horizonal equity among taxpayers is the primary
objective, then similarly situated taxpayers should receive the
same tax subsidy for the purchase of health care, regardless of
whether they purchase health care directly or it is provided by
their employer. Present law does not accomplish this objective,
because taxpayers who have employer-provided health care receive
a full exclusion for income and payroll tax purposes, whereas
taxpayers who purchase health care on their own on an after-tax
basis can only deduct those expenses to the extent that all
health care expenses for the year exceed 7.5 percent of adjusted



provided by the bill (including any cost-sharing amounts). The
bill would also provide that health care benefits cannot be
provided under a cafeteria plan. The bill would make the 25-
percent deduction for health insurance expenses of self-employed
individuals permanent and increase the amount of the deduction to
up to 100 percent of such expenses, depending on the percentage of
health care insurance the self-employed individual pays for his or
her employees. .

The bill would not limit the employer deduction for employee
health care expenses.

2. §S. 1579--Sen. Breaux and others (The Managed Competition Act of
1993)

The bill would impose a 34-percent excise tax on excess health
plan expenses of employers. In general, excess health plan
expenses would be amounts paid in excess of the premium for the
lowest cost plan available in the area (the "reference premium
rate"). The bill would extend the 25-percent deduction for health
insurance expenses of self-employed individuals through 1994. For
1995 and following years, the deduction would be made permanent and
would be increased to 100 percent of the reference premium rate for
the individual. The bill would permit individuals an above-the-
line deduction for the cost of health insurance up to the reference
premium rate for the individual. The bill would treat partners and
more than 2-percent S corporation shareholders as employees of
partnerships and S corporations for purposes of the taxation of
employer-provided health care and would exclude from gross income
contributions by a partnership or S corporation to a health plan
covering its partners or employees.

The bill would not limit the exclusion for employer - provided
health care or the employer’s deduction for employee health care
expenses.

3. S. 1770--Sen. Chafee and others (The Health Equity and Access
Reform Today Act of 1993)

The bill would limit the exclusion for employer- provided
health care and the employer deduction for health care expenses to
an amount equal to the average premium of the lowest priced one-
half of standard health benefit packages offered in the area for
the calendar year (the "applicable dollar limit"). The bill would
make the 25-percent deduction for health insurance expenses of
self-employed individuals permanent and increase the amount of the
deduction to 100 percent of the applicable dollar limit. The bill
would permit individuals an above-the-line deduction for premiums
up to the applicable dollar limit. The bill would permit
individuals to make deductible contributions to medical savings
accounts.



SEES ESE
ea :

taxpayers in an equal position. Those who receive employer-
provided health care would not pay payroll taxes on such health
care. However, individuals who work for an employer who does not
offer employer-provided health care would Pay tax on their cash
compensation and would not get the benefit of the payroll tax
exclusion for health care.

Another issue arises with respect to subsidies for the
purchase of health care if the available subsidies differ
depending on whether an individual receives employer-provided
health care. If this is the case, then individuals and employers
will attempt to structure employment and compensation
arrangements to take advantage of the largest subsidy. For
example, if, under a proposal, certain low-income persons receive
a full Federal subsidy for the purchase of health insurance if
they do not receive employer-provided health coverage, and if any
subsidy is reduced by the value of employer-provided coverage,
then employers will have an incentive to exclude such persons
from health care coverage if permitted to do so.

C. Coordinate Federal Tax and Health Policy Laws

To the extent that a health reform proposal mandates
universal health insurance coverage, the issue of whether any tax
benefits for the provision of health care should be retained must
be addressed. The present-law treatment of employer-provided
health care provides an incentive for the purchase of health
care. If a health care reform Proposal that guarantees universal
coverage is enacted, then the reason to provide an incentive for
the purchase of health care may no longer exist.

Further, as discussed above, the exclusion for employer-
provided health care may encourage individuals to overutilize
health care. This incentive to overutilize health care services
may be inconsistent with the goals of health care reform.

If the exclusion for the purchase of employer-provided
health care were repealed and all other things are presumed to be
constant (e.g., health care costs do not change), then the cost
of health care will increase for employees who have received
employer-provided health care. The amount of the cost increase
for any employee is the amount of tax the employee pays on the
value of the employer-provided health care. Thus, the effect of
repealing the exclusion generally is greater for higher-income
employees than for lower-income employees.”

If payroll taxes are taken into account, the effect on an

employee just above the wage base for social security taxes may
be less than the effect on employees just below the wage base.
But, in general, the effects of repealing the exclusion rise as
income rises.



DESCRIPTION AND ANALYSIS OF PROPOSALS
RELATING TO THE TAX TREATMENT OF HEALTH CARE

(S. 1757, S. 1775, S. 1579, S. 1770, AND S. 1743)

Scheduled for a Hearing
Before the
SENATE COMMITTEE ON FINANCE

on April 26, 1994

Prepared by the Staff
of the
JOINT COMMITTEE ON TAXATION

April 26, 1994

Advance Copy
JCS-3-94



-8-

the medical care is provided by a physician ina licensed hospital
or in a medical care facility that is related to, or the equivalent
of, a licensed hospital. The deduction of lodging expenses is
limited to $50 for each night for each individual.

The cost of medicine or a drug qualifies as a medical care
expense only if it is a prescription drug or is insulin. In
addition, the cost of cosmetic surgery or other similar procedures
qualifies as a medical expense only if the surgery or procedure is
necessary to ameliorate a deformity arising from or directly
relating to a congenital abnormality, a personal injury resulting
from an accident or trauma, or a disfiguring disease.

For alternative minimum tax purposes, individuals may deduct
medical expenses only to the extent that the total of such expenses
exceeds 10 percent of. the taxpayer's AGI (sec. 56(b) (1) (B)).

C. Deduction for Health
Insurance Costs of Self-Employed Individuals

Self-employed individuals cannot exclude the cost of health
insurance from gross income. For this purpose, self-employed
individuals include sole proprietors, partners in partnerships,
and more than 2-percent shareholders of S corporations. Prior to
January 1, 1994, a self-employed individual could deduct 25
percent of the health insurance costs of the individual and his
or her spouse or dependents, provided that certain requirements
were satisfied.’ The 25-percent deduction was also available to
more than 2-percent shareholders of S corporations.

D. Cafeteria Plans

In_general

Compensation generally is includible in gross income when
actually or constructively received. An amount is constructively
received by an individual if it is made available to the
individual or the individual has an election to receive the
amount. Under one exception to the general principle of

5 The 25-percent deduction was not available for any month
if the taxpayer was eligible to participate in a subsidized
health plan maintained by an employer of the taxpayer or the
taxpayer’s spouse. In addition, no deduction was available to the
extent that the deduction exceeded the taxpayer's earned income.
The amount of expenses paid for health insurance in excess of the
deductible amount could be taken into account in determining
whether the individual was entitled to a medical expense
deduction (sec. 213). Thus, such amounts were deductible to the
extent that, when combined with other unreimbursed medical
expenses, they exceeded 7.5 percent of AGI (sec. 162(1)).



II. PRESENT LAW
A. Exclusion for Employer-Provided Accident or Health Coverage

In general, employer contributions to an accident or health
plan are excludable from an employee’s income (sec. 106). This
exclusion for employer-provided health coverage also generally
applies to coverage provided to former employees and to the spouses
or dependents of employees or former employees. In the case of a
self-insured medical reimbursement plan, the exclusion is
conditioned on the coverage being provided under a plan meeting
certain nondiscrimination requirements (sec. 105(h)). Insured
health plans generally are not subject to nondiscrimination rules.
Similarly, employer-provided accident or health coverage generally
is excludable from wages for employment tax purposes without regard
to whether the coverage is provided on a nondiscriminatory basis
(sec. 3121(a) (2)).

Benefits paid under employer-provided accident or health plans
are also generally excludable from income to the extent they
represent reimbursements for medical care (as defined in sec. 213)
or to the extent the benefits constitute payments for the permanent
loss of use of a member or function of the body or permanent
disfigurement and are computed with reference to the nature of the
injury and without regard to the period the employee is absent from
work (sec. 105).

B. Itemized Deduction for Medical Expenses

Individuals who itemize deductions may deduct amounts paid
during the taxable year (if not reimbursed by insurance or
otherwise) for medical care of the taxpayer and the taxpayer’s
spouse and dependents, to the extent that the total of such
expenses exceeds 7.5 percent of the taxpayer's adjusted gross
income (AGI).

Medical care expenses eligible for the deduction are amounts
paid by the taxpayer for: (1) health insurance (including employee
contributions to employer health plans); (2) the diagnosis, cure,
mitigation, treatment, or prevention of disease or for the purpose
of affecting any structure or function of the body; (3)
transportation primarily for and essential to medical care; and (4)
lodging while away from home primarily for and essential to medical
care, subject to the following limitations. Amounts paid for
lodging while away from home seeking medical care qualify as
medical expenses if there is no significant element of personal
pleasure, recreation, or vacation in the travel away from home and

‘ References are to the Internal Revenue Code of 1986, as

amended.



- 40 -

eligibility certificate and (3) in accordance with tables
provided by the Secretary of the Treasury.

Effective date

The provisions of the bill relating to the health care
expenses tax credit would be effective for taxable years
beginning after December 31, 1996.”

3. Medical savings accounts

In_general

Under the bill, an individual would be permitted a
nonrefundable credit against tax in an amount equal to 25 percent
of cash payments to a medical savings account during a taxable
year for the benefit of the individual or for the benefit of any
Spouse or dependent of such individual up to certain limits. The
maximum amount that would be allowed as a tax credit for any
individual for any taxable year would be 25 percent of the sum of
$3,000 plus $500 for each dependent of the individual for whose
benefit the medical savings account has been established. The
dollar limits would be adjusted for increases in the cost of
living for taxable years beginning after 1997. Contributions in
excess of the applicable dollar limit for any individual for any
taxable year would be subject to a 6-percent excise tax unless
such contributions and any related earnings are withdrawn on or
before the date prescribed by law for filing the individual’s
Federal income tax return for the year (including extensions) .

No more than one medical savings account could be maintained on
behalf of an individual.

Def io} me 1_ sav: ount

Under the bill, a medical savings account would mean a trust
created exclusively for the purpose of paying the medical
expenses of the beneficiaries of the trust and that meets the
following requirements: (1) other than certain permitted rollover
contributions, no contribution is accepted unless it is in cash
and does not exceed the deduction limit for the year; (2) the
trustee is a bank or another person that demonstrates to the
satisfaction of the Secretary that the trust will be administered
in a manner consistent with the requirements of the bill; (3) no
part of the trust assets will be invested in life insurance
contracts; (4) the assets of the trust will not be commingled
with other property except in a common trust fund or common
investment fund; (5) the interest of an individual in the balance
in his account is nonforfeitable; and (6) certain rules will be
applicable to the distribution of the entire interest of
beneficiaries of the trust. An account held by a U.S. insurance
company would be treated as a medical savings account (and the
insurance company would be treated as a bank) if (1) the account



- 28 -

an employer pays part of an employee’s premium, it must make the
same dollar payment to all employees with the same family status
in the same health alliance. If the total employer contribution
(mandatory and voluntary) for the employee's coverage exceeds the
annual premium of the employee's health plan, the employer would
be required to pay to the employee a cash rebate equal to the
excess.% The rebate would be taxable to the employee for both
income and employment tax purposes. For example, suppose an
employer pays 100 percent of the total premium regardless of
which plan the employee chooses. In such a case, because the bill
would require the employer to make the same dollar payment to all
employees, employees who do not choose the most expensive plan
would receive a cash rebate equal to the difference between the
employee premium for the most expensive plan selected by any
employee and the employee premium for the plan selected by the
employee. On the other hand, no rebates would occur if the
employer pays 100 percent of the employee premium for the least
expensive plan available to employees.

The bill would provide an exception to the general principle
of constructive receipt for cash rebates. Under the bill, no
amount would be included in the gross income of an employee
solely because the employee could have selected coverage under a
health plan which results in a cash rebate. That is, only cash
rebates actually received are includible in income.

ive

The provision limiting the exclusion for employer-provided
health coverage would be effective on and after January 1, 2004,
except that it would apply to FSAs on and after January 1, 1997.
The provision relating to the tax treatment of employer-provided
accident or health coverage provided through cafeteria plans
would be effective on and after January 1, 1997.

3. Deduction for health insurance costs of self-employed
individuals

In_generai

The bill would make permanent the deduction for health
insurance expenses of self-employed persons, and increase the
amount of the deduction to up to 100 percent of such expenses.
The 25-percent deduction would continue until the 100-percent

% Section 1607(b) of the Health Security Act. The equal
payment rule and the rebate requirement would not apply to
"voluntary" employer premium payments made pursuant to a
collective bargaining agreement.



- 27 -

accident or health coverage, except that the limits would have an
earlier effective date. Thus, coverage provided through an FSA
would be excludable from income only to the extent it is within
the bill’s limits, i.e., health coverage provided through an FSA
under a cafeteria plan would be excludable from gross income only
if the coverage constitutes wages or payments in lieu of wages
for any period during which the employee is absent from work on
account of sickness or injury. .

_ For this purpose, an FSA would be defined as a benefit
program that provides employees with coverage under which
specified expenses may be reimbursed (subject to reimbursement
maximums and any other reasonable conditions) and under which the
maximum amount of reimbursement that is reasonably available to a
participant for such coverage is less than 200 percent of the
value of such coverage. In the case of an insured plan, the
maximum amount reasonably available would be determined on the
basis of the underlying coverage.

Ss em heal ove ie

In general, under the bill, any health benefits that are not
provided under the comprehensive benefit package would be
considered supplemental health benefits and would not be
excludable from income and wages. Under the bill, a supplemental
health benefit policy would be defined to include an insurance
policy or health benefit plan that provides coverage for services
and items not included in the comprehensive benefit package or
coverage for items and services included in the package but not
covered because of a limitation in amount, duration, or scope.”
The bill would also require supplemental health benefit policies
to satisfy certain standards.”

Valuation rules

Under the bill, the value of any employer-provided coverage
that is includible in income would be based on the average cost
of providing the coverage. The provision would permit cost
determinations to be made on the basis of reasonable estimates as
provided by the Secretary of the Treasury.

Tax treatment of rebates

Under the bill, employers would be permitted to pay any
portion of the employee’s share of premiums for a health plan. If

® Section 1421(b) of the Health Security Act.

® Section 1422 of the Health Security Act.



-4-

The 25-percent deduction provided self-employed individuals
with a greater tax benefit than the benefit available to persons
who do not receive employer-provided coverage. However, the effect
of the deduction was to provide less favorable tax treatment for
sole proprietors than for individuals who operate businesses in
corporate form. Thus, for example, a sole shareholder-employee of
a subchapter C corporation could obtain the benefit of the
exclusion for employer-provided health care.

Employer deduction for employee health care

Employers are entitled to deduct the cost of employer-provided
health care as an ordinary and necessary business expense. This
deduction is not considered a tax expenditure, but rather is part
of the normal operation of an income tax system. In arriving at a
proper measure of the economic income of a business, it is
appropriate to allow deductions for reasonable expenses, including
employee compensation expenses such as employer-provided health
care.

2. Imposing limits on the tax benefits for employer-provided
health care

The tax benefits for employer-provided health care could be
limited by (1) limiting the employee’s ability to exclude the value
of the coverage from income, (2) limiting the employer deduction,
(3) imposing an excise tax on the employer, or (4) using a
combination of approaches. There are also various ways to set the
limit on the tax benefits, including using a stated dollar amount
per employee, a limit based on a particular benefit package, or
limiting the tax benefit depending on the income of the employee.

Whether and to what extent the tax benefits for employer-
provided health care should be limited depends on the policy
objectives sought to be achieved. For example, if the goal is the
proper measurement of income, the exclusion for employer-provided
health care should be repealed. If the goal is to raise a certain
amount of revenue, then the dollar amount of the exclusion could be
limited to the extent necessary to reach the revenue target. In
the context of overall health care reform, there may be more
complicated policy objectives, not all of which may be consistent
or lead to the same conclusion. These health policy objectives
should shape the discussion as to what limits on employer-provided
health care are appropriate.

B. Summary of Proposals

1. S. 1757--Sen. Mitchell and others; S. 1775--Sen. Moynihan (The
Health Security Act)

The Health Security Act would limit the exclusion § for
employer-provided health care to the comprehensive benefit package



- 18 -

the primary objective, then the limit should be designed to raise
the desired revenue in the most administrable and equitable
manner. Repealing the exclusion is relatively simple and
promotes both vertical and horizontal equity as compared to
present law. If this approach raises more revenue than is
desired, a partial limit on the exclusion could be designed to
achieve any such intermediate revenue goal.

The amount of revenue that can be raised by limiting the tax
benefits for employer-provided health care will be very sensitive
to the context in which the limit is imposed (i.e., the overall
health care reform proposal) and on the design of the limit
itself.

B. Achieve Health Care Policy Goals
1. Expand health care coverage

The exclusion for employer-provided health care causes
employees to prefer health care over taxable wages. The
exclusion makes health care less expensive for employees than it
would be if they purchased health care on an after-tax basis;
thus, some employees may purchase more health care services or
insurance than they otherwise would.

Encouraging individuals to purchase more health care than
they otherwise would may be socially desirable. If some of the
benefits of an individual being insured accrue to other people,
then some individuals may not purchase as much insurance as is
socially desirable. Economists refer to this as a positive
externality. For example, if the cost of uncompensated care for
uninsured individuals is passed on to other individuals, then
some people will be underinsured. Providing a subsidy for the
cost of insurance in such cases could shift health care costs to
the individual who receives the services. Providing a subsidy
for the purchase of health insurance may be particularly
necessary in the case of low-income individuals who may not be
able to afford insurance at market prices. However, it may not
be very efficient to deliver subsidies to low-income individuals
through the tax system because such individuals may have little
or no tax liability.

Whether or not tax benefits are necessary to induce
individuals to purchase coverage depends in part on the overall
health care reform package. If a health reform proposal mandates
that all individuals have insurance, then a subsidy is not
necessary to induce coverage, because individuals are required to
have health insurance in any event.

The exclusion for employer-provided health care is not
necessarily the most efficient means of expanding coverage. The
exclusion applies to all persons who have employer-provided



- 35 -

The applicable dollar limit would be determined annually by
the Secretary of the Treasury in consultation with the Secretary
of Health and Human Services. Further, the applicable dollar
limit would be determined separately for individual and family
enrollments and, within each enrollment class, would be
determined separately with respect to the age of the principal
enrollee. The bill would authorize the Secretary of the Treasury
to establish reasonable age bands within which premium amounts
could not vary by type of enrollment.

Effective date.--The provision relating to the exclusion
from income for employer-provided health coverage would be
effective for taxable years beginning after the first December 31
following the date that is one year after the date the insurance
reform standards in the bill are established. The provision
relating to the exclusion from wages for employment tax purposes
would be effective on and after the first January 1 following the
date the insurance reform standards in the bill are established.

3. Limits on deduction of health plan expenses
Employer deductions

The bill would provide that expenses paid or incurred by an
employer for a group health plan or contributed to an employee’s
medical savings account would not be deductible unless the plan
is a qualified health plan and the amount does not exceed the
applicable dollar limit for the employee.

= ed h th luc

The bill would extend the 25-percent deduction for health
insurance costs of self-employed individuals, effective for
taxable years beginning after December 31, 1993. In addition,
effective for taxable years beginning after the first December
31, following the date that is one year after the date the
insurance reforms in the bill are established, the bill would
permit self-employed individuals to deduct 100 percent of
premiums paid for coverage under a qualified health plan to the
extent such amount does not exceed the applicable dollar limit
for the individual.

ndividual dedu 8 fied he. san premium

The bill would permit individuals an above-the-line
deduction for amounts paid with respect to coverage under a
qualified health plan (without regard to the present-law AGI
limitation) to the extent such amounts do not exceed the
applicable dollar limit for the individual. For this purpose,
the applicable dollar limit would be reduced by any payments made
to, or on behalf of, the individual by the Secretary of Health
and Human Services or any other entity (including employers and



- 36 -
governmental agencies) .

Effective date

Except as otherwise provided above, the provision of the
bill relating to deductions for the costs of health coverage
would be effective for taxable years beginning after the first
December 31 following the date that is one year after the date
the insurance reforms in the bill are established.

4. Medical savings accounts
Eli it

Under the bill, individuals covered by a catastrophic health
plan would be permitted to deduct cash payments made to a medical
savings account for the benefit of the individual or for the
benefit of any spouse or dependent who is covered under a
catastrophic health plan.

etd Limi

The allowable deduction for any year would be limited to an
amount that does not exceed the excess of (1) the applicable
dollar limit with respect to the individual for the year over (2)
the amount paid by, or on behalf of, the individual as a premium
for a catastrophic health plan covering the individual plus the
aggregate amount contributed to the medical savings account by
persons other than the eligible individual. No more than one
medical savings account could be maintained on behalf of an
individual. Contributions in excess of the deduction limit for
any individual for any taxable year would be subject to a 6-
percent excise tax unless such contributions and any related
earnings are withdrawn on or before the date prescribed by law
for filing the individual’s Federal income tax return for the
year (including extensions) .

Defi: nm of ical vings a

Under the bill, a medical savings account would mean a trust
created exclusively for the purpose of paying the medical
expenses of the beneficiaries of the trust and that meets the
following requirements: (1) other than certain permitted rollover
contributions, no contribution is accepted unless it is in cash
and does not exceed the deduction limit for the year; (2) the
trustee is a bank or another person that demonstrates to the
satisfaction of the Secretary that the trust will be administered
in a manner consistent with the requirements of the bill; (3) no
part of the trust assets will be invested in life insurance
contracts; (4) the assets of the trust will not be commingled
with other property except in a common trust fund or common
investment fund; (5) the interest of an individual in the balance



- 24 -

involved and it would be easier for the IRS to audit. From the
employer perspective, however, it is not clear that such
approaches would be more administrable. The employer might still
need to determine whether the limit or limits had been exceeded
with respect to each employee.

If the limit is based on an individual’s income, then
employers will generally not be able to administer it, because
they will not have information regarding the nonwage income of
their employees.

Administrative burdens on individual taxpayers are of
particular concern in the case of low-income subsidies, such as
tax credits, because many people will not take advantage of the
subsidy if obtaining the subsidy is too complex. One problem
with providing low-income subsidies through the income tax system
is that not all low-income persons are currently required to file
tax returns. If the tax system is the only subsidy mechanism,
then many low-income individuals will have to file tax returns
merely to claim the subsidy.



2. Limit on exclusion for employer-provided

health care . 2... 1 1 ee ee ee ee ee ee BF
3. Limits on deduction of health plan expenses . . 35
4. Medical savings accounts ........... 36
S. 1743--Sen. Nickles and others (The Consumer Choice
Health Security Act of 1993) re)
1. In general . .... 2... 1 ee ee ee ee 38
2. Refundable health care expenses tax credit .. 38

3. Medical savings accounts ........... .- .40



- 41 -

is part of a health insurance plan that includes a catastrophic
health plan, (2) the account is exclusively for the purpose of
paying the medical expenses of the beneficiaries of the account
who are covered under the catastrophic health plan, and (3) the
written instrument governing the account meets certain additional
requirements.

Medical savings accounts would be exempt from tax.

Taxation of distributions

Any amount paid or distributed from a medical savings
account would be included in the gross income of the individual
for whom the account was established unless the amount is used
exclusively to pay the qualified medical expenses of the
individual or the spouse or any dependent of the individual. For
this purpose, qualified medical expenses would include premiums
for coverage under a Federally qualified health insurance plan
and the unreimbursed expenses for medical care (as defined for
purposes of the health care expenses tax credit) of the
individuals for whose benefit the account was established. No
amount would be included in income if the entire amount received
is paid into another medical savings account for the benefit of
the individual not later than 60 days after the date of the
distribution. Contributions in excess of the applicable dollar
limits that are withdrawn on or before the date prescribed by law
for filing the individual's Federal income tax return for the
year (including extensions) would not be treated as distributions
that must be included in income but earnings related to such
excess contributions would be included in income. An additional
10-percent income tax would be imposed on any distribution from a
medical savings account that is includible in income.

Eft edi
The provisions of the bill relating to medical savings

accounts would be effective for taxable years beginning after
December 31, 1996.



Under the proposed regulations, the employer-provided health
coverage under the FSA and the reimbursements and other benefits
received under the health FSA will be excludable from an
employee's income only if the health FSA satisfies certain
additional requirements. According to the proposed regulations,
health FSAs are required to: (1) provide the maximum amount of
reimbursement available under the FSA at all times during the
period of coverage (properly reduced as of any particular time
for prior reimbursements for the same period of coverage); (2)
offer coverage for 12 months or, in the case of a short plan
year, the entire short plan year; (3) only reimburse medical
expenses as defined for purposes of the itemized deduction for
medical care expenses (sec. 213); (4) reimburse only those
medical expenses for which the participant provides a written
Statement from an independent third party stating the amount of
the medical expense and that the medical expense has not been
reimbursed or is not reimbursable under any other health plan;
(5) reimburse only those medical expenses that are incurred
during the participant’s period of coverage; and (6) allocate
experience gains with respect to a year of coverage among premium
payers on a reasonable and uniform basis.°

° Prop. Treas. Reg. 1.125-2 Q&A-7(b).



- 13 -

Employee A’s net compensation is $19,337.50 ($25,000 minus (22.65
percent times $25,000). Employee B’s net compensation is $20,017
($25,000 minus (22.65 percent times $22,000).”

Tax policy objectives suggest that there should be no
exclusion from income for employer-provided health care in the
absence of a more compelling goal. Further, excluding certain
forms of income from taxation erodés the tax base and distorts
economic decision making, because individuals tend to structure
their compensation arrangements to reduce taxable income.

Proposals that limit the tax benefits for employer-provided
health care by limiting the exclusion rather than by some other
means (such as by limiting the employer deduction or imposing an
excise tax) are preferable from a tax policy perspective because
they result in better measurement. of income. Indeed, the
objective of proper measurement of income, viewed in isolation,
provides a compelling argument for the complete repeal of the
exclusion.

From a tax policy perspective, limiting the employer
deduction is not a preferred approach. Proper measurement of
business income includes a deduction for ordinary and necessary
business expenses, and reasonable compensation (including
employer-provided health care) is a business expense. Thus, the
deduction for employer-provided health care should not be viewed
as a subsidy or as a tax expenditure.

However, limiting the deduction for, or imposing an excise
tax on, certain employer-provided health care expenses may be
viewed as a proxy for income inclusion. Because employer-
provided health care is a component of employee wages, economists
believe that, in the long run, any increase in employer-provided
health care costs (whether as a result of taxes or otherwise)
will generally be borne by employees in the form of lower cash
wages or, at least, a slower growth rate in cash wages. That is,
employees’ total compensation will remain the same, and if health
care costs rise, some other part of compensation, such as cash
wages, will be reduced. Thus, the effects of denying the
employer deduction for, or imposing an excise tax on the employer
with respect to, certain health costs will be borne by employees,

” If A’s AGI is less than $40,000, then A’s after-tax
compensation will be somewhat greater than the above computation
indicates. This is because A will be entitled to deduct that
portion of his insurance costs ($3,000) that exceed 7.5 percent
of his AGI. However, this deduction will not eliminate the
disparity.



3. Raise revenue..........2..4.2..
Achieve Health Care Policy Goals .......
1. Expand health care coverage .....

2. Control health care costs ..........

3. Subsidize the purchase of health insurance by
some or all individudls ...........

Coordinate Federal Tax and Health Policy Laws . .
Other Issues ..............2.224.4.
1. Regional impact ...............

2. Administrative issues ............

DESCRIPTION OF BILLS ...........4.24.224.2..

A.

S$. 1757--Sen. Mitchell and others and S. 1775--
Sen. Moynihan (The Health Security Act) .....

1. In general ...........0...2..2.22

2. Exclusion for employer-provided accident or
health coverage ...........-2.4..

3. Deduction for health insurance costs of self-
employed individuals ..........2..

S. 1579--Sen. Breaux and others (The Managed
Competition Act of 1993) ............

1. In general ..............20224

2. Excise tax on excess employer health plan
expenses .. 1... . . eee eee

3. Increase in deduction for health plan premium
expenses of self-employed individuals ....

4. Deduction for health plan premium expenses of
individuals... .... 2...

5. Exclusion from gross income for contributions
by a partnership or S corporation to a health
plan covering its partners or shareholders

S. 1770--Sen. Chafee and others (The Health Equity
and Access Reform Today Act of 1993) ee ee ee

1. In general .... 2... 2. .....0024.4

17
18
18

19

20
21
22
22
23

25

25

25

25

28

29

29

30

32

33

34

34
34


- 34 -
date.

5. Exclusion from gross income for contributions by a
partnership or S corporation to a health plan covering its
partners or shareholders

Under the bill, partners would be treated as employees of a
partnership for purposes of the taxation of employer -provided
health care under a subsidized accident or health plan; thus they
would be entitled to exclude such health care from gross income.
A partner who is eligible to receive such health care would not
be entitled to claim the deduction for health insurance expenses
of self-employed individuals (as extended and modified under the
bill).

Similarly, any amounts paid by an S corporation for health
care coverage under a subsidized accident or health plan would be
excludable from the income of the S corporation shareholder.

Effective date.--The provision would apply to taxable years
beginning after December 31, 1994.

Cc. S. 1770--Sen. Chafee and others (The Health Equity and Access
Reform Today Act of 1993)

1. In general

The bill would limit the exclusion for employer-provided
health care and the employer deduction for health care expenses
to an amount equal to the average premium of the lowest priced
one-half of standard packages offered in the area for the
calendar year (the "applicable dollar limit"). The bill would
make the 25-percent deduction for health insurance expenses of
self-employed individuals permanent and increase the amount of
the deduction to 100 percent of the applicable dollar limit. The
bill would permit individuals an above-the-line deduction for
premiums up to the applicable dollar limit. The bill would
permit individuals to make deductible contributions to medical
savings accounts.

2. Limit on exclusion for employer-provided health care

Under the bill, the present-law exclusion for employer
contributions to an accident or health plan would be limited to
contributions for coverage under a qualified health plan or
contributions to an employee’s medical savings account up to the
applicable dollar limit for the individual for the calendar year.
A qualified health plan would mean either an insured plan that is
certified to be a qualified health plan or a self-insured health
plan of a large employer that meets certain requirements. The
bill would impose a similar limit on the exclusion from wages of
employer-provided health coverage for employment tax purposes.



- 22 -

However, in the context of overall health care reform, it
may be perceived appropriate to continue to provide a tax benefit
for the purchase of health care. In particular, some health
reform proposals provide particular subsidies for low-income
individuals. Continuing the exclusion for employer- provided
health care would provide a subsidy for middle-income taxpayers
who otherwise might face a significant increase in health care
costs under a system of mandated health insurance. For example,
to the extent that employers are required to provide health
insurance for employees who have not previously received it (and
who have not purchased it on their own), economists generally
believe that the employees will bear the cost of the mandated
insurance. If that is the case, middle-income employees who are
not eligible for low-income subsidies could face significant
increases in health care costs under a mandated system of health
insurance. Maintaining the present-law exclusion for employer-
provided health care would provide a subsidy for the increased
costs of these employees.

D. Other Issues
1. Regional impact

Health care costs are higher in some parts of the United
States than others. One of the issues that arises in the context
of limiting the tax benefits for employer-provided health care is
whether a limit will have a different impact depending on where
an individual lives. For example, if the exclusion for employer-
provided health care were limited by a set dollar amount, then
individuals living in high cost areas would receive a smaller
subsidy for the total cost of health care coverage than
individuals living in low cost areas.

The Federal tax laws generally do not take into account
regional disparities in costs of living. One reason such
disparities are not taken into account is that, although costs of
living may be higher in some parts of the country, it is also
generally true that incomes are higher in higher cost areas. For
example, the amount of the standard deduction does not vary based
on the area of the country in which a taxpayer resides.

In the case of reducing the tax benefits accorded to
employer-provided health care, there may be a perception that
regional disparities in health care costs should be taken into
account. If the exclusion for employer-provided health care is
repealed entirely, there is no regional disparity issue.
Individuals in higher cost areas will have a larger amount
included in income because their employers are paying more to
provide them with health care. However, if the exclusion is not
repealed in its entirety, but rather is limited in some manner,
and adjusting for regional disparities in health costs is a goal,



CONTENTS

INTRODUCTION . . 2. 2 ee ee ee ee ee eee ee ee
I. BACKGROUND AND OVERVIEW... . . - 6 es © © ee ee ee
A. Tax Incentives for the Purchase of Health Care . .

1. Present law... 2/1 ee ee ee ee ee

2. Imposing limits on the tax benefits for
employer-provided health care .....-+-+.-.

B. Summary of Proposals ......-.+ ++ +e eee
1. S. 1757--Sen. Mitchell and others;
S. 1775--Sen. Moynihan (The Health Security
Act) 2. ee ee ee ee ee ee ee ee

2. S. 1579--Sen. Breaux and others (The Managed
Competition Act of 1993) .....-+-+-+4.-.

3. S. 1770--Sen. Chafee and others (The Health
Equity and Access Reform Today Act of 1993) . .

4. §. 1743--Sen. Nickles and others (The Consumer
Choice Health Security Act of 1993) ......

It. PRESENT LAW. . 2 we ee ee ee ee ee ee ee

A. Exclusion for Employer-Provided Accident or Health
Coverage 2... ee ee ee ee ee eee

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

C. Deduction for Health Insurance Costs of Self-
Employed Individuals .........+.++.++-+4--.

D. Cafeteria Plans... .... eee eee ee eee

E. Flexible Spending Arrangements ..........

IIl.

DISCUSSION OF ISSUES .......-+.4+. 4.
A. Achieve Income Tax Policy Goals... .
1. Proper measurement of income ...

2. Equity among taxpayers ......

12
12
12
15



- 30 -

The bill would impose a 34-percent excise tax on excess
health insurance expenses of the employer. In general, excess
health plan expenses would be amounts paid in excess of the cost
of the lowest-cost plan available in the area. The bill would
extend the 25-percent deduction for health insurance expenses of
self-employed individuals through 1994. For 1995 and following
years, the deduction would be made permanent and increased to 100
percent of the lowest cost plan available in the area. The bill
would permit individuals to deduct from gross income the cost of
health insurance up to the value of the lowest cost plan in the
area. The bill would treat partners and more than 2-percent S
corporation shareholders as employees of partnerships and S
corporations for purposes of the taxation of employer-provided
health care and would exclude from gross income contributions by
a partnership or S corporation to a health plan covering its
partners or employees.

2. Excise tax on excess employer health plan expenses
In ra.

Under the bill, "excess health plan expenses" would be
subject to a 34-percent excise tax payable by the employer.
The excise tax would be imposed on all employers with excess
health plan expenses, including tax-exempt and governmental
employers. The excise tax would be deductible.

Under the bill; employer-provided health coverage would
continue to be fully deductible and the bill would not limit the
exclusion from gross income for any health coverage provided by
an employer.

Defini £ healt: dan

Under the bill, health plan expenses would include all
employer contributions under any group health plan, other than
expenses for direct services which are determined by the Health
Care Standards Commission (the "Commission") to be aimed

2 Because the excise tax rate is deductible and is fixed at

34 percent, a particular taxable employer may have more or less
than a complete deduction disallowance under the bill. For
example, a corporate employer in the 35-percent marginal tax
bracket would have a deduction denied for 63.1 percent of excess
health plan expenses. An employer in the 15-percent marginal tax
bracket, however, would have a deduction denied for 192.7 percent
of excess health plan expenses. If the bill is intended to
impose an excise tax that is equivalent to a deduction
disallowance for taxable employers, the excise tax should be
increased to the marginal income tax rate for the employer and
should not be deductible.



individual.

Qualified health insurance premiums would mean premiums for
(1) a Federally qualified health insurance plan and (2) any other
benefits or plans supplementary to such a Federally qualified
health insurance plan. A Federally qualified health insurance
plan would mean a health insurance plan offered, issued or
renewed after January 1, 1997 and which at a minimum (1) provides
coverage for all medically necessary acute care (as defined in
sec. 112 of the bill), (2) varies premiums only on the basis of
age, sex, and geography, (3) guarantees coverage at standard
rates for all applicants, and (4) limits preexisting condition
exclusions as provided in the bill.

efi: ion o edit e

For purposes of the bill, medical care would be defined as
under present law except that medical expenses that are .
reimbursed or subsidized by the Federal Government or a State or
local government and are excluded from the recipient’s gross
income would not qualify as medical expenses under the bill and
any amounts distributed from an individual’s medical savings
account during the taxable year that are excludable from gross
income under the bill would not qualify as medical care expenses
for purposes of the tax credit.

The bill would provide for the advance Payment of the health
Care expenses tax credit in a manner similar to the advance
Payment of the earned income tax credit under the Code. Under
the bill, an individual could elect to receive the health care
expenses tax credit on an advance basis by furnishing a
certificate of eligibility to his or her employer. For such an
individual, the employer would make an advance payment of the
credit at the time wages are paid.

The certificate of eligibility would (1) certify that the
employee will be eligible for the health care expenses tax credit
for the taxable year, (2) certify that the employee does not have
a certificate of eligibility filed with another employer for the
calendar year, (3) state whether the employee's spouse has a
certificate of eligibility in effect, and (4) estimate the amount
of premiums for a Federally qualified health insurance plan and
unreimbursed expenses for medical care (as defined in the bill)
to be incurred during the calendar year.

The amount of the advance payment of the credit would be
determined based on (1) the employee's wages from the employer
for each payroll period, (2) the employee’s estimated premiums
for coverage under a Federally qualified health insurance plan
and unreimbursed expenses for medical care included in his or her



- 25 -
Iv. DESCRIPTION OF BILLS

A. S. 1757--Sen. Mitchell and others and S. 1775--Sen. Moynihan
(The Health Security Act)

1. In general

The Health Security Act would limit the exclusion for
employer-provided health coverage to the comprehensive benefit
package provided by the bill, including cost-sharing amounts.

The bill would also provide that health care benefits cannot be
provided under a cafeteria plan. The bill would make the
deduction for health insurance expenses of self-employed
individuals permanent and increase the amount of the deduction to
100 percent of such expenses, depending on the percentage of
health care insurance the self-employed individual provides his
or her employees.

2. Exclusion for employer-provided accident or health coverage

In general

Under the bill, the present-law exclusion for employer
contributions to an accident or health plan, including
contributions to a flexible spending arrangement (FSA), would be
limited to employer contributions for (1) comprehensive health
coverage as described in section 1101 of the Health Security Act,
(2) cost-sharing amounts under the comprehensive benefit package
(including cost-sharing policies), or (3) other permitted
coverage. The value of employer-provided supplemental health
coverage (as defined in sec. 1421(b) of the Health Security Act)
would be includible in gross income and wages for income and
employment tax purposes.

The bill would not affect the tax treatment of amounts an
individual receives under an accident or health plan paid for by
an employer. Such amounts would continue to be excludable from
the individual's income to the extent excludable under present
law.

Comprehensive health coverage

Under the bill, all employer contributions for coverage
under the nationally guaranteed comprehensive benefit package,
including employer contributions to an FSA, would be excludable
from income and wages.

Cost-sharing

Employer contributions for cost-sharing amounts (e.g.,
deductibles, copayments and coinsurance), including employer
contributions for coverage under a cost-sharing policy, would



spleen

constructive receipt, no amount is included in the gross income
of a participant in a cafeteria plan described in section 125 of
the Code solely because, under the plan, the participant may
elect among cash and certain nontaxable qualified benefits.

In general, a qualified benefit is one of certain benefits
that are excludable from an employee’s gross income by reason of
a specific provision of the Code. Thus, employer-provided
accident or health coverage, group-term life insurance coverage,
and benefits under dependent care assistance programs may be
provided through a cafeteria plan.

A cafeteria plan must be in writing, must include only
employees (including former employees) as participants, and must
satisfy certain nondiscrimination requirements. An employer that
maintains a cafeteria plan is required to file an annual return
relating to such plan. >

The cafeteria plan exception from the principle of
constructive receipt generally also applies for employment tax
purposes.

fons or tion le:

The exception to the constructive receipt principle provided
for cafeteria plans does not apply to highly compensated
individuals if the plan discriminates in favor of such
individuals as to eligibility to participate or as to
contributions or benefits under the plan. A plan is not
discriminatory as to eligibility if the plan benefits a
nondiscriminatory classification of employees and requires no
more than 3 years of employment as a condition of participation.
Special rules apply for determining whether a plan that provides
health coverage is discriminatory with respect to contributions
and benefits. In addition, a plan is deemed not to be
discriminatory if the plan is maintained pursuant to a collective
bargaining agreement.

In the case of a key employee, the exception to the
constructive receipt principle does not apply if the qualified
benefits provided under the plan to such key employees exceed 25
percent of the aggregate of such benefits provided for all
employees under the plan. A key employee is defined as under the
top-heavy rules applicable to qualified pension plans (sec. 416).

E. Flexible Spending Arrangements

A flexible spending arrangement (FSA) is a reimbursement
account or similar arrangement under which an employee is
reimbursed for medical expenses or other nontaxable
employer-provided benefits, such as dependent care. An FSA may
be part of a cafeteria plan and may be funded through salary



- 12 -
III. DISCUSSION OF ISSUES

There are a variety of possible ways to modify the tax
benefits for the purchase of health care services and insurance.
The most appropriate method depends on the goals of the reform
effort of which the limitation is a part. Possible policy
objectives and possible legislative approaches to satisfy those
objectives by modifying the tax benefits for the purchase of
health care are discussed below.

A. Achieve Income Tax Policy Goals
1. Proper measurement of income

From a tax policy perspective, an important objective of an
income tax system is to raise revenue in an efficient and
equitable fashion. To ensure an equitable distribution of the
burden of taxation, it is necessary to measure an individual’s
ability to pay taxes. Ideally, an individual’s ability to pay
taxes should be measured by reference to the individual's total
access to economic resources. The Federal income tax system
generally measures an individual’s ability to pay taxes by
reference to the individual’s personal income.”

Under present law, the taxable income of an employee who
receives employer-provided health care benefits in lieu of cash
compensation will be less than the taxable income of an otherwise
similarly situated employee who receives only cash compensation
of equal value and purchases health care separately. This occurs
because the employee receiving employer- provided health care is
not required to include the compensation received in the form of
health care in income for purposes of the Federal income tax or
as wages for purposes of Federal payroll taxes.

For example, consider two employees. Employee A receives
$25,000 of cash compensation and purchases health insurance
privately for $3,000. Employee B receives $22,000 of cash
compensation and $3,000 of employer-provided health care. Assume
that each employee's income is subject to tax at a 15-percent
rate. In addition, the employees’ cash compensation is subject |
to the employee share of payroll taxes (7.65 percent of wages).

1 Other possible measures of ability to pay include
consumption and wealth.

| Economists generally believe that employees bear the
burden of all payroll taxes, including the employer’s share of
those taxes. For the sake of simplicity, the effect of the
employer’s share of payroll taxes is ignored in the example. To
include such a discussion would complicate the example
substantially without changing the qualitative result.