BACKGROUND

PAPER Tax Subsidies for

Medical Care:

Current Policies

and Possible Alternatives

January 1980

(Reprinted

April 1980)

Congress of the United States

Congressional Budget Office
TAX SUBSIDIES FOR MEDICAL CARE:

CURRENT POLICIES AND POSSIBLE ALTERNATIVES

Congressional Budget Office

Congress of the United States
For sale by the Superintendent of Documents, U.S. Government Printing Office Washington, D.C. 20402
PREFACE

In the current debate over inflation, few issues have aroused

more controversy than the rapid increase in health-care costs.

This paper, prepared at the request of the Subcommittees on Health

and Oversight of the House Ways and Means Committee, examines an

important aspect of this issue: tax subsidies for medical care.

Tax Subsidies for Medical Care was prepared by Joshua E.

Greene under the direction of James M. Verdier of CBO's Tax Analysis Division and with the assistance of Paul Ginsburg and other

members of CBO's Tax Analysis and Human Resources and Community

Development divisions. Charles Davenport, Peter Karpoff, and

others at CBO provided valuable comments and suggestions on

earlier drafts of the paper.

Many people outside CBO gave generously of their time and

help during the preparation of this study. Peter Davis and Van-Xe

Nguyen of the Joint Committee on Taxation and Roy Wyscarver of the

Treasury Department prepared many of the computer runs that provided data for the paper. Numerous people also commented on

earlier drafts, including Lawrence Brown, Bruce F. Davie, Deborah

Freund, Clark Havinghurst, Joseph Newhouse, Joseph Pechman, Eugene

Steuerle, Stanley Surrey, Ronald Vogel, and Ira Tannenbaum. Many

other people also provided valuable information, including staff

members at the Department of Health, Education, and Welfare and

other Executive Branch agencies, several municipal bond firms,

state health-care facilities financing authorities, and the

American Hospital Association. Linda Brockman and Shirley

Hornbuckle prepared the manuscript for publication.

In accordance with CBO's mandate to provide objective and

impartial analysis, the paper offers no recommendations of policy

options.

Alice M. Rivlin

Director

January 1980

CONTENTS

PREFACE iii

SUMMARY xi

CHAPTER I. INTRODUCTION 1

Organization of the Paper 3

CHAPTER II. THE EXCLUSION OF EMPLOYER HEALTH CONTRIBUTIONS

FROM EMPLOYEES1 TAXABLE INCOME 5

Legislative History and Rationale 6

Distribution of Tax Savings 7

Analysis 9

Effects on Relative Tax Liabilities 9

Effect on Health Insurance Coverage 10

Effect on Medical Spending 13

Low Visibility and Controllability of

Expenditures 14

Alternatives to the Current Exclusion ..... 15

Limiting the Exclusion to a Fixed-Dollar

Amount 15

Replacing the Exclusion with a Limited

Tax Credit 17

Limiting the Exclusion to Plans with

Certain Features. . 18

CHAPTER III. THE MEDICAL EXPENSE DEDUCTION 25

Legislative History 25

Distribution of Tax Savings 27

Analysis •• 31

Tax Subsidy or Ability-to-Pay Provision? . . 31

Problems with the Deduction as Tax Subsidy. . 32

Other Problems with the Medical Deduction . . 33

CONTENTS (CONTINUED)

Page

Interaction of the Deduction with Health

Insurance 35

Alternatives to the Present Deduction ..... 36

Changing the Deduction to a Tax Credit for

Extraordinary Medical Expenses 37

Raising the Threshold for Subsidized Medical

Outlays ...... 41

Replacing or Supplementing the Deduction with

a Direct Expenditure Program Providing

Catastrophic Health Insurance 43

CHAPTER IV. TAX-EXEMPT FINANCING FOR PRIVATE HOSPITAL

PROJECTS * . 47

The History of Federal Subsidies for Hospital

Construction 50

Legislative History and Mechanics 51

Analysis 53

Are Federal Subsidies for Hospital Construction Desirable Under Present

Conditions? 53

Special Problems with Tax-Exempt Bonds as

a Subsidy 54

Other Considerations 57

Policy Options for Tax-Exempt Hospital Bonds. . 58

Maintaining Current Law 59

Eliminating Tax-Exempt Bonds for Hospital

Projects 59

Limiting Tax-Exempt Hospital Bonds to

General Obligation Issues .... 61

vii

TABLES

TABLE 1. DISTRIBUTION OF TAX SAVINGS FROM THE EXCLUSION

OF EMPLOYER CONTRIBUTIONS TO EMPLOYEE HEALTH

INSURANCE PLANS, 1977 8

TABLE 2. HEALTH INSURANCE COVERAGE IN THE UNITED STATES BY

INCOME LEVEL: 1976 12

TABLE 3. DISTRIBUTION BY INCOME LEVEL OF TAX SAVINGS FROM

THE MEDICAL EXPENSE DEDUCTION 28

TABLE 4. DISTRIBUTION OF TAX SAVINGS FROM THE DEDUCTION

FOR EXTRAORDINARY MEDICAL EXPENSES 30

TABLE 5. EFFECT ON TAX LIABILITIES OF REPLACING THE

DEDUCTION FOR EXTRAORDINARY MEDICAL EXPENSES

WITH A REFUNDABLE 25 PERCENT TAX CREDIT FOR

MEDICAL EXPENSES ABOVE 3 PERCENT OF ADJUSTED

GROSS INCOME 38

TABLE 6. EFFECT ON TAX LIABILITIES OF RAISING THE MINIMUM

DEDUCTION FOR EXTRAORDINARY MEDICAL EXPENSES TO

5 PERCENT OF ADJUSTED GROSS INCOME 42

TABLE 7. TAX-EXEMPT BONDS AS A SHARE OF TOTAL HOSPITAL

CONSTRUCTION FUNDING, 1971-1979 49

ix

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SUMMARY

Some of the largest federal subsidies for health care

result from items that do not appear as direct spending measures: the tax provisions affecting medical care. In fiscal year

1980, the revenue losses resulting from these provisions may

exceed $14.5 billion—an amount equal to one-fourth of the

federal government's direct expenditures on health care.

Of the possible $14.5 billion in revenue losses, about $9.6

billion results from the exclusion from taxable income of

employer contributions to employee health insurance plans—what

this paper calls the "employer exclusion." Another $3.1 billion

results from the deductibility of health insurance premiums and

large out-of-pocket medical expenses. The remaining revenue

losses come from the deductibility of charitable contributions

to not-for-profit medical facilities and the financing of

hospital facilities by tax-exempt bonds. This paper analyzes

three of these four tax subsidies: the employer exclusion, the

medical expense deduction, and the use of tax- exempt bonds to

finance capital projects at private hospitals and medical

institutions.

THE EMPLOYER EXCLUSION

The employer exclusion exempts from taxable income all

employer contributions to health and accident insurance plans

for employees, including plans established by employees themselves. Employees, therefore, receive a discount equal to their

marginal tax rate for each dollar of health insurance purchased

through employer contributions. This saving provides a powerful

incentive for employees to bargain for employer-provided health

and accident insurance. It also encourages employers to provide

group health coverage, since a dollar of direct cash compensation may be less attractive to employees than a smaller amount

of employer-provided health benefits.

While the employer exclusion stimulates health insurance

coverage, it has adverse consequences for the level of medical

xi
spending. The exclusion encourages employees to buy more health

insurance coverage than they otherwise would, and this in turn

encourages more frequent use and more elaborate forms of medical

care. As a result, total medical expenditures tend to increase. The incentive to obtain more health insurance is particularly strong because employer contributions are excluded

from taxable income without limit. This feature of the exclusion, together with the substantial discounts available to those

purchasing group health insurance, eliminates most of the incentive to choose health insurance with cost-containment features.

The result is a proliferation of group policies providing full

reimbursement for insured medical expenses.

Besides its adverse effect on medical spending, the exclusion has other defects. For example, the tax savings generated

by the exclusion are concentrated disproportionately among

persons with higher incomes, since the rate of tax subsidy

equals the employee's marginal tax rate and tax rates rise with

taxable income. The exclusion can also be faulted as a device

for securing universal health insurance coverage. Although it

gives employers incentives to provide health benefits for their

employees, not all do so. Individual health insurance, moreover, is typically much more expensive than group coverage, and

the subsidies for individual coverage under the medical expense

deduction are generally far less than those provided by the

employer exclusion. Thus, it is not surprising that a substantial number of low- and moderate-income households do not have

any type of private health insurance. Even after taking into

account Medicare, Medicaid, and other government programs, a

significant proportion of such households—over 16 percent of

those with incomes below $10,000 in 1976—have no form of public

or private health-care coverage.

Possible Alternatives

Three alternatives to the employer exclusion are examined

in this report. Two of them—limiting the exclusion to a fixeddollar amount and requiring that tax-subsidized policies have

certain features—would serve mainly to reduce the exclusion's

inflationary effects. The third—converting the exclusion to a

tax credit with a fixed-dollar ceiling—would also bring about a

more equal distribution of tax benefits across income groups.

xii
Limiting the Exclusion to a Fixed-Dollar Amount* One of

the simplest methods of reducing the inflationary consequences

of the exclusion would be to limit it to a fixed-dollar amount,

preferably a sum near the cost of a federally qualified Health

Maintenance Organization (HMO) or a conventional health insurance policy with significant cost sharing requirements, such as

deductibles and coinsurance. A limit of this sort would encourage employees to choose less inflationary health insurance

plans, since only plans with incentives to curb spending would

most likely be fully subsidized and additional coverage would

have to be purchased with taxable dollars. Limiting the exclusion could also benefit individuals who prefer higher cash

compensation to more extensive health benefits, if firms

responded to the change by substituting cash payments for

subsidies to health plans. On the other hand, a fixed-dollar

limit would burden firms with the requirement of reporting any

excess contributions for health plans to the Internal Revenue

Service (IRS), because these sums would become taxable income.

Converting the Exclusion to a Limited Tax Credit. Another

option would be to convert the exclusion to a limited tax credit

for employer contributions to employee health plans. Under this

option, all employer contributions would become taxable income

to the employee, but a portion—the first $1,000, for example—

would qualify for a tax credit. Converting the exclusion to a

tax credit would eliminate the present difference in subsidy

rates under the exclusion, since taxpayers at all income levels

would receive the same rate of subsidy for each dollar of qualifying employer contributions. The tax credit method would also

allow subsidies to be limited to a fixed-dollar expenditure on

health insurance, in order to encourage employees to choose

less-expensive health plans. Another advantage of the tax

credit approach is that it could easily be expanded to provide

benefits for taxpayers without employer-provided group insurance

who do not itemize their deductions. A—

One disadvantage of replacing the exclusion with a tax

credit is that it could impose a reporting burden on firms with

employment-related health plans, since all employer contributions would have to be reported to the IRS as taxable employee

income. This burden, however, may not be very great. A tax

credit would also leave intact the budgetary defects of the

exclusion, such as low visibility and uncontrollability of

xiii
expenditures. These problems are characteristic of subsidies

that are provided through tax expenditures rather than through

direct expenditure programs.

Requiring Specific Features in Health Insurance Plans. A

third option, which would also reduce the inflationary consequences of the exclusion, would be to limit the exclusion to

employer contributions for health insurance plans with specific

features. Two particular limitation proposals have received

considerable attention in the last few years as ways of reducing

medical costs: limiting the exclusion to health plans with

significant cost sharing requirements for all services, and

requiring employers to offer a choice of health plans, and to

contribute equally to each one. Some proponents of limiting the

exclusion have also suggested that qualifying plans contain a

minimum set of health benefits. This last suggestion has been

made to prevent employees from staying under the ceiling by

eliminating coverage for important supplementary services,

rather than by accepting coinsurance, deductibles, or membership

in an HMO.

The two leading proposals for limiting costs through

mandated specific features each have important strengths and

weaknesses. The proposal to require cost sharing for all

insured services, for example, would increase consumers1 sensitivity to medical costs, because consumers would bear some

direct expense for all insured services. This change should

curb spending and reduce the utilization of medical services.

The resulting savings might not, however, be very large. First,

many medical services are not that responsive to increases in

the out-of-pocket cost of care. For example, the cost sensitivity of spending for hospital care, the component of medical

care for which expenditures are growing the most rapidly, is

fairly low. Second, even if cost sharing were required for all

tax-subsidized health insurance, consumers would still be free

to supplement employer-provided coverage out of their after-tax

income. If large numbers of consumers purchased extra insurance, despite its probable high cost, much of the decrease in

utilization resulting from cost sharing would disappear. Such

supplementation would be particularly likely if specific types

of cost-sharing provisions such as mandatory coinsurance for

hospital services were required.

xiv
The proposal to require that employees be offered a choice

of health insurance plans and that employers make equal contributions to each one, with a ceiling on all contributions, also

stands to reduce medical spending. Under this option, medical

outlays could be cut not only through reduced utilization but

also through increased competition among providers, since the

more expensive health plans would require additional contributions from employees. For significant savings to occur, however, viable prepaid care plans such as HMOs would have to be

available. Otherwise, employees might continue to select highcost insurance offering "first dollar11 coverage for all insured

services. This has been the experience under the Federal

Employees Health Benefits Plan, where the share of membership in

alternative practice plans has remained fairly low except in

states such as California and Hawaii, which have strong HMOs.

THE MEDICAL EXPENSE DEDUCTION

The medical expense deduction allows taxpayers who itemize

their deductions to subtract from taxable income one-half the

cost of payments for health insurance, with a maximum deduction

of $150, plus the bulk of all remaining out-of-pocket medical

expenses that in total exceed 3 percent of adjusted gross

income. All payments for medical services, the remaining cost

of health insurance, and pharmaceutical purchases above 1

percent of adjusted gross income may be included in this total.

The medical expense deduction has often been described as

promoting the taxation of income on the basis of ability to

pay. With the rapid growth of health insurance, however, the

medical deduction has become for many families a source of tax

subsidies for medical costs not covered by their health-insurance policies. For affluent households, who are the prime beneficiaries of the deduction, it can provide generous subsidies

for plastic surgery, trips to warm climates, and other types of

elective care. Thus, it may be more reasonable to view the

deduction as a tax subsidy than as an ability-to-pay provision.

If the medical deduction is viewed as a tax subsidy, it can

be faulted in several major respects. First, the pattern of tax

savings it provides for different income groups is contrary to

most assumptions regarding need. Persons who do not itemize

deductions—a group that includes most low- and moderate-income

xv
individuals—cannot benefit from it. At the same time, tax

savings per dollar of deductible expenses increase with taxable

income, and overall savings among those claiming the deduction

go disproportionately to upper-income taxpayers. A second problem is that payments are not available when expenses are incurred; they come only later, when tax returns are filed. Finally,

the deduction subsidizes a rather broad spectrum of medical outlays rather than concentrating on very high medical expenses

related to catastrophic illness, which can pose the greatest

financial hardship to families and individuals.

Possible Alternatives

Several alterations in the medical deduction have been

suggested. This report examines three of these proposals:

changing the deduction to a tax credit, raising the minimum for

subsidized out-of-pocket medical expenses above 3 percent of

adjusted gross income, and establishing government-sponsored

insurance for "catastrophic" health expenses.

Changing the Deduction to a Tax Credit. Chang ing the

deduction to a tax credit, particularly a refundable credit,

would equalize the rate of subsidy for tax-subsidized medical

expenses and extend benefits to taxpayers who do not itemize

their deductions. Such a change, however, could increase the

revenue losses from the provision, unless the rate of credit

were set fairly low.

Raising the Minimum for the Deduction. Raising the minimum

for the deduction would reduce revenue losses from the provision

and concentrate its benefits among taxpayers with particularly

heavy medical outlays. Many taxpayers, however, would then face

higher tax liabilities, although increases among those with high

expenditures could be offset by providing a supplementary tax

credit for medical outlays above, say, 10 or 15 percent of

adjusted gross income.

Providing Catastrophic Health Insurance. A catastrophic

health insurance program would be more effective than the deduction at subsidizing very high medical expenses, particularly for

low- and moderate-income persons. Government provision of

catastrophic health insurance would be far more costly than the

medical expense deduction, however, and would require much

greater effort to administer. In addition, providing coverage

for all "catastrophic" medical services could increase total

xv i
medical spending if doctors and patients felt less constrained

in using medical services as a result.

THE USE OF TAX-EXEMPT BONDS TO FINANCE CAPITAL PROJECTS AT

PRIVATE HOSPITALS

Current law allows private hospitals, particularly taxexempt, not-for-profit medical facilities, to obtain lowinterest loans for capital projects through tax-exempt bonds.

These bonds, which are typically issued by state and local

government agencies on behalf of hospitals and other designated

public and private institutions, provide significant savings to

the organizations for which they are issued. These savings now

represent the largest form of federal government support for

capital projects at hospitals and other medical institutions.

In fiscal year 1980, the revenue loss to the Treasury from taxexempt hospital bonds is estimated to be about $400 million.

Government subsidies for hospital construction have been

justified in the past because many areas of the United States

had a shortage of hospital beds. A growing number of researchers, however, have found evidence suggesting this is no longer

true. The leading studies on this issue indicate that the

nation now has an excess of hospital beds nationwide, although

estimates differ on the extent of the excess. Moreover, hospital

construction has continued despite the creation of state agencies to monitor the growth of hospital facilities.

If hospitals are to receive federal subsidies, tax-exempt

bonds have problems as a vehicle for providing aid. Although

the bonds provide savings quickly and with little federal paperwork, they are not now designed to target aid on the most needy

projects. As a rule, tax-exempt bonds can be issued to finance

any project at a financially-sound hospital for which a certificate-of-need can be obtained from the requisite state health

planning agency. In theory, this certification process should

limit hospital projects to those for which significant need can

be demonstrated. Recent studies, however, question the effectiveness of this process in regulating the growth of hospital

facilities. At the same time, the creditworthiness standards

imposed by bond markets mean that some needed projects at financially weak hospitals cannot be subsidized by tax-exempt bonds.

xvii

61-467 0-80- 3
Another problem with the bonds is that a substantial "gap"

exists between the savings provided to institutions and the

revenues lost to the Treasury. Most studies indicate that only

about 70 to 75 percent of the subsidy provided by tax-exempt

bonds actually reaches the intended beneficiaries. The rest

goes as extra tax savings to bond purchasers in high tax

brackets and as fees to the many participants needed to arrange

tax-exempt bond financing. The extra tax savings to highbracket bond purchasers reduce the progressivity of the income

tax, while the revenue losses from the bonds have low visibility

in the federal budget and are not subject to the regular controls of the budget process.

Maintaining Present Law. The simplest policy option available to the Congress would be to maintain the current law

regarding tax-exempt hospital financing. This option would

preserve the advantages of using tax-exempt bonds as a subsidy,

such as the availability of savings without requiring prior

approval from a federal agency. It would also preserve the disadvantages of using tax-exempt bonds. These include uncontrollable expenditures, a regressive effect on the federal tax

system, and a relatively high cost of providing funds to the

intended beneficiaries. Maintaining present law would also

leave untouched the possibility that subsidies will be provided

for "unnecessary" projects while deserving projects at financially weak institutions go unsupported. This last problem,

however, might also be remedied by improving the current health

planning process, rather than changing the availability of taxexempt bonds.

Eliminating Tax-Exempt Funding for Hospital Projects.

Another option would be to prohibit tax-exempt funds for hospital projects. This step would prevent the subsidizing of hospital facilities with questionable need. It would also, however,

block access to subsidies for many worthwhile projects, since

direct expenditure subsidies for the typical urban or suburban

hospital are now limited to mortgage guarantee insurance. If

the Congress wished to expand direct expenditure federal

subsidies for hospitals in order to compensate for eliminating

tax-exempt hospital bonds, the restrictions imposed by current

health planning rules would have to be modified. Changing these

rules, however, might weaken the incentives for states to limit

hospital capacity through regulation. Some health analysts

might find such changes more unattractive than the disadvantages

xviii
that now arise from subsidizing hospital construction through

tax- exempt bonds.

Requiring that Tax-Exempt Hospital Bonds Be General Obligation Issues* A third option would be to require that tax-exempt

hospital bonds be "general obligation" bonds backed by the full

faith and credit of the issuing government agency. Revenue

bonds, backed only by hospital income, would no longer be

permitted. These are now the typical form in which tax-exempt

hospital bonds are issued.

Limiting tax-exempt hospital bonds to general obligation

issues would tend to restrict the number of hospital projects

financed by tax-exempt issues, since each governmental unit has

a practical ceiling on the volume of general obligation bonds it

can issue without being forced to pay high interest rates or

jeopardizing its credit rating. If tax-exempt hospital bonds

were general obligation issues, the issuing governments might

begin to view hospital projects as competing with other projects

financed by that government's tax-exempt bonds. State and

local governments would then be likely to limit tax-exempt bonds

to those hospital projects with the greatest apparent public

benefits. In theory, these would be the projects that are most

needed, although other factors could also influence the choice

of projects to be financed. Financially strong jurisdictions

with high bond ratings might also be given an artificial

advantage by this option, even though the hospital projects

being financed were no more worthy than those from weaker

jurisdictions with lower bond ratings.

One difficulty with limiting tax-exempt hospital bonds to

general obligation issues is that it could preclude private

hospitals in many states from receiving tax-exempt financing.

Many states have statutory or constitutional prohibitions

against issuing for private projects or institutions tax-exempt

bonds backed by the full faith and credit of the issuing government. In other states, hospital bond authorities may issue

revenue bonds for private hospitals, but not general obligation

bonds. To take into account these legal barriers, the effective

date of any provision requiring that hospital bonds be general

obligation bonds could be delayed for a few years after enactment. This would allow time for states with legal prohibitions

against using general obligation bonds to reconsider these

provisions and modify them if they chose.

xix

CHAPTER I. INTRODUCTION

The sharp rise in medical costs during the last several

years has generated concern about the effectiveness of current

government activities to contain medical spending. To date, the

major federal efforts in this area have involved health-planning

activities, including state-based controls on the expansion of

hospital facilities. Legislation has also been proposed to

supplement these controls with a limit on the increase in

revenues private hospitals may receive. * Despite these efforts,

however, medical costs have continued to accelerate.

This paper focuses on a frequently ignored portion of the

federal budget that many analysts now consider an important

factor in the medical cost spiral: tax expenditures for medical

care.^ These expenditures, which result from tax provisions

such as the medical expense deduction, now cost the federal

government about $14.5 billion a year in lost tax revenues.3

This amount is roughly one-fourth the size of the federal

government's direct expenditures for programs under the health

1. For a review of recent cost-containment proposals, see

Congressional Budget Office, Controlling Rising Hospital

Costs, Budget Issue Paper (September 1979).

2. Tax expenditures are revenue losses that arise from provisions of the tax code that extend special or selective tax

relief to certain groups of taxpayers. These revenue losses

are called tax "expenditures" because they are payments made

through a reduction in taxes rather than a direct: grant.

3. See CBO, Five-Year Budget Projections and Alternative Budgetary Strategies for Fiscal Years 1980-1984; Supplemental

Report on Tax Expenditures (June 1979), Table 1; and estimates developed in Chapter IV of this paper for the revenue

loss from tax-exempt hospital bonds.
budget function, which are expected to exceed $55 billion in

fiscal year I960.4

Although tax expenditures for medical care are less visible

than direct expenditure programs such as Medicare and Medicaid,

they have powerful effects on the price and use of medical

services. By subsidizing the cost of health insurance and outof-pocket medical spending, the tax provisions encourage both

the use of health-care resources and the development of more

elaborate forms of medical care. Prices and utilization are

also affected by tax provisions that lower the cost to hospitals

of borrowing for capital improvements. Recognition of these

consequences has led the Chairman of the House Ways and Means

Committee and other legislators to introduce bills that would

impose significant constraints on these tax subsidies.

4. CBO estimates combined federal outlays and tax expenditures

for health care under the health budget function at $69.8

billion for fiscal year 1980. This sum includes approximately $55.6 billion in direct outlays. The remaining $14.1

billion arises from various tax expenditures, including $1.2

billion in foregone revenues attributable to the deductibility of charitable contributions for health-related activities. As much as $400 million more in revenue losses

results from tax-exempt hospital bonds for hospital construction now classified under the "General Purpose Fiscal

Assistance" budget function. See CBO, Five-Year Budget

Projections, Fiscal Years 1980-1984; Tax Expenditures,

Tables 1 and 3. If tax expenditures for health care are

compared to federal outlays for all health-related programs,

including those outside the health budget function, the

proportion of direct and indirect expenditures attributable

to tax subsidies is approximately 18 percent. See Budget of

the United States Government, Fiscal Year 1980, p. 246.

5. See, for example, the "Health Cost Restraint Act of 1979,"

H.R. 5740, introduced by Chairman Al Ullman of the House

Committee on Ways and Means; the "Health Incentives Reform

Act of 1979," S. 1968, introduced by Senator David

Durenberger of Minnesota; the "Comprehensive Health Care

Reform Act," S. 1590, introduced by Senator Richard

Schweiker of Pennsylvania; and H.R. 3943, introduced by
Of the four tax provisions generally identified as tax

expenditures for health care, three seem most closely linked to

the medical sector: the exclusion from taxable income of

employers' contributions to employees1 health insurance plans,

the medical expense deduction, and the ability of hospitals to

benefit from tax-exempt bond issues. These three provisions

account for roughly $13.1 billion of the revenue losses attributable to tax subsidies for medical care." The fourth tax

expenditure—the deductibility of charitable contributions to

medical institutions—is not discussed in this paper, because

most of the issues it raises involve the deductibility of charitable contributions in general.^

ORGANIZATION OF THE PAPER

Chapter II analyzes the exclusion from taxable income of

employer contributions to health insurance for employees. This

chapter examines the effects of the exclusion on the demand for

and extent of health insurance coverage, and it notes the impliRepresentative James Jones of Oklahoma; all introduced

during the 1st session of the 96th Congress (1979).

6. The exclusion from taxable income of employer health contributions is expected to generate about $9.6 billion in revenue losses in fiscal year 1980, while the projected cost for

the medical expense deduction is $3.1 billion. The revenue

loss from tax-exempt hospital bonds is somewhat harder to

project, because not much is known about the assets taxexempt bonds displace. If these bonds displace mostly

taxable issues, the revenue loss could exceed $400 million.

For more discussion on this issue, see Chapter IV.

7. For an examination of this subject, see Commission on Private Philanthropy and Public Needs, Giving in America

(1975); Martin Feldstein and Amy Taylor, "The Income Tax and

Charitable Contributions,11 Econometrica, vol. 44 (November

1976), pp. 1201-22; and Harold M.Hochman and James D.

Rodgers, "The Optimal Tax Treatment of Charitable Contributions," Na t ional Tax Journal, vol. 30 (March 1977), pp.

1-18.
cations of the exclusion for the level of medical spending.

Three possible changes in the current law are discussed:

limiting the exclusion to a fixed-dollar amount of employer

contributions, replacing the exclusion with a limited tax

credit, and imposing specific restrictions on health plans that

qualify for the exclusion.

Chapter III examines the best known of the tax provisions

involving health care: the medical expense deduction. In this

chapter, the history of the deduction is reviewed and its current role as a tax subsidy is assessed. The chapter also

examines several alternatives to the deduction. These include

converting the deduction to a tax credit, raising the floor for

the deduction, and replacing the deduction with "catastrophic"

health insurance provided by the federal government.

Chapter IV examines the use of tax-exempt bonds to finance

construction and other capital projects for private hospitals

and medical institutions. This chapter reviews the history of

federal programs to subsidize hospital construction and analyzes

the particular effects of using tax-exempt bonds as a subsidy

device. In addition, three policy options are discussed: maintaining current policy, eliminating the use of tax-exempt bonds

to finance hospital construction, and limiting tax-exempt hospital bonds to general obligation issues.
CHAPTER II. THE EXCLUSION OF EMPLOYER CONTRIBUTIONS FOR HEALTH

INSURANCE FROM EMPLOYEES1 TAXABLE INCOME

Section 106 of the Internal Revenue Code excludes from taxable income all contributions made by employers to health and

accident insurance plans for employees. In addition, Section 3104

excludes these contributions from the wage base for determining

Social Security taxes, although the resulting revenue losses are

not considered tax expenditures.* For fiscal year 1980, the

revenue losses from Section 106 are expected to total almost $9.6

billion, and the losses from Section 3104 are estimated at more

than $4 billion.^ Thus, the exclusion of employer contributions—

termed the "employer exclusion" in this paper—is the largest tax

expenditure for medical care.3

1. Social Security payments, unlike other federal government outlays, are tied to contributions. Thus, any reduction in

contributions is reflected in lower benefits. Tax expenditures, by contrast, are not related to contributions.

2. CBO, Five-Year Budget Projections, Fiscal Years 1980-1984; Tax

Expenditures, Table 1; and Eugene Steuerle and Ronald Hoffman,

"Tax Expenditures for Health Care," U.S. Treasury Department,

Office of Tax Analysis, OTA Paper No. 38 (April 1979), p. 11.

3. The employer exclusion, moreover, is the fifth largest tax

expenditure for individuals in the federal income tax. The

only larger income tax expenditures for individuals are the

deductibility of nonbusiness state and local taxes ($19.1

billion in fiscal year 1980), the exclusion of pension contributions and earnings ($12.9 billion), the special tax treatment of capital gains income ($10.1 billion), and the tax

treatment of capital gains realized at death ($10.0 billion).

See CBO, Five-Year Budget Projections, Fiscal Years 1980-1984;

Tax Expenditures, Table 1.

61-467 0-80- 4
LEGISLATIVE HISTORY AND RATIONALE

The legislative history of the employer exclusion parallels

that for many fringe benefits whose tax-exempt status is not codified. Originally, employer contributions to employee pension

plans were not subject to tax, because noncash fringe benefits

were generally considered not to be taxable income. In 1943, an

Internal Revenue Service (IRS) ruling made this exemption explicit

for employer contributions to group health insurance policies.^

Employer contributions to individual health insurance policies,

however, were declared to be taxable income in an IRS Revenue

Ruling in 1953.6 Section 106, which was introduced in 1954, was

enacted to reverse the 1953 ruling. As a result, all employer

contributions to employee health and accident plans are now

excluded from taxable income.

Although the legislative history of Section 106 indicates only

a desire to make uniform the tax treatment of employer contributions to group and individual health insurance plans, several

other purposes for the exclusion can be suggested. For example,

the exclusion may be considered a device to make uniform the tax

treatment of employer health contributions and other noncash

fringe benefits, most of which are not included in taxable income.

The exclusion can also be viewed as a special subsidy to taxpayers with employer-subsidized health insurance. From this perspective, it can be compared with other measures to promote health

4. For a further description of the tax treatment of fringe benefits, see "Taxation of Fringe Benefits," prepared for the Task

Force on Employee Fringe Benefits, House Committee on Ways and

Means, by the staff of the Joint Committee on Taxation, August

11, 1978; and "Tax Treatment of Fringe Benefits," prepared

statements before the House Committee on Ways and Means, 95th

Congress, 2nd sess., August 15, 1978.

5. See Special Ruling, October 26, 1943, CCH Federal Tax Service,

vol. 443, paragraph 6587.

6. See Revenue Ruling 210, IRS Cumulative Bulletin, 1953, vol. 2,

p. 114.
insurance coverage, such as direct government provision of comprehensive health coverage—what is often called "national health

insurance." This view of the exclusion has been adopted by the

three federal agencies that record tax expenditures—the Office of

Management and Budget, the Congressional Budget Office, and the

Joint Committee on Taxation of the U.S. Congress. It is also

accepted by leading tax analysts.^

DISTRIBUTION OF TAX SAVINGS

The distribution of savings to taxpayers from the exclusion

cannot be calculated directly, since employees do not report the

value of employer-provided health insurance premiums on their tax

returns. By making certain assumptions about the cost of health

insurance and the pattern of coverage among employees at different

income levels, however, a rough estimate of the distribution of

tax savings can be made. The U.S. Department of the Treasury, in

a recent study of tax expenditures for health care, has provided

such an estimate for 1977 (see Table 1). According to the

Treasury study, average tax savings rise sharply with taxpayer

income. Taxpayers with expanded incomes below $20,000 averaged

less than $10 a year in tax savings from the provision, while

those with expanded incomes of $30,000 or more averaged savings of

more than $190." According to the Treasury estimate, more than

half of the total savings went to the 20 percent of all taxpayers

with expanded incomes of $20,000 or more. This pattern of benefits is the opposite of what would normally be expected from a

subsidy based on need.

Although tax savings from the exclusion are concentrated among

upper-income taxpayers, taxpayers at all income levels do benefit.

Of the roughly 163 million persons in the United States with

private health insurance coverage in 1976, more than 122 million—

7. See, for example, Stanley S. Surrey, Pathways to General Tax

Reform (Harvard University Press, 1973), pp. 192-193.

8. "Expanded income" is a broader definition of taxpayer income

than adjusted gross income. In addition to adjusted gross

income, it includes the untaxed part of capital gains, percentage cost depletion, and other tax preferences subject to
TABLE 1. DISTRIBUTION OF TAX SAVINGS FROM THE EXCLUSION OF EMPLOYER CONTRIBUTIONS TO EMPLOYEE

HEALTH INSURANCE PLANS, 1977

Expanded Income

Class (in Dollars)

Less than 5,000

5,000- 10,000

10,000- 15,000

15,000- 20,000

20,000- 30,000

30,^000- 50,000

50,000-100,000

100,000\and over

All Returns

Number of

Taxpayers in

Income Class

(in Thousands)

24,727

19,300

15,145

12,022

11,891

4,433

1,182

297

88,997

Total Tax

Savings

for All

Taxpayers in

Income Class

(in Millions

of Dollars)

91

494

814

1,028

1,547

882

456

248

5,560

Average Tax

Savings per

Taxpayer in

Income Class

(in Dollars)

4

26

54

86

130

199

386

835

62

Percent of

Total Tax

Savings to

Taxpayers in

Income Class

1.6

8.9

14.6

18.5

27.8

15.9

8.2

4.5

100.0

Percent of

Taxpayers

All

in

Income Class

27.8

21.7

17.0

13.5

13.4

5.0

1.3

0.3

100.0

SOURCES: Treasury Department tax model, 1977 tax law at 1977 income levels; and Steuerle and

Hoffman, "Tax Expenditures for Health Care," Table 3.
about three-fourths—had employer-subsidized health insurance. ^

Thus, the exclusion provides tax savings to a large group of taxpayers—much larger, for example, than the number of taxpayers now

itemizing deductions (about 25 million).

ANALYSIS

Effects on Relative Tax Liabilities

The employer exclusion has two effects on tax liabilities

that could be said to create inequities in the tax system. First,

the exclusion favors persons who receive part of their incomes in

the form of health benefits over those whose earnings come

entirely in taxable forms (wages and salaries, for example).

Although the differences in tax liabilities are not great for lowand moderate-income families, they can be significant for workers

in relatively high marginal tax brackets. A worker in the 40

percent tax bracket, for example, whose employer offers a health

insurance plan worth $500, saves $200 in income taxes as a result

of the exclusion. By comparison, self-employed persons or workers

who receive higher wages rather than employer-subsidized health

insurance would pay $200 more in taxes and could not buy as much

insurance with their after-tax wages.

Second, the exclusion also tends to reduce the progressivity

of the income tax. Because tax benefits from the exclusion of

income depend on a taxpayer's marginal tax rate, upper-income

taxpayers with employer-provided health plans benefit more from

the exclusion than do other workers. For example, the hypothetical employee in the 40 percent marginal tax bracket, whose

employer contributes $500 a year to a health plan, receives $200

in tax savings from the exclusion. Another worker with the same

health benefits but with a marginal tax rate of only 20 percent

saves only $100. The exclusion also benefits upper-income taxpayers more than others to the extent that upper-income employees

the minimum tax. It also limits the deduction of investment

interest to the amount of investment income.

9. U.S. Bureau of the Census, Survey of Income and Expenditures,

1977 (Census, SIE, 1977).
work for organizations that provide more generous health insurance

packages.

Effect on Health Insurance Coverage

Although estimating the effect of the exclusion on health

insurance coverage is difficult, the available evidence suggests

it has been substantial. Many studies indicate that the demand

for health insurance appears to be sensitive to the cost of coverage even after taking other factors such as the cost of care into

account. 0 The exclusion is a prime factor in lowering the cost

of coverage, although other elements such as the development of

employer-provided group coverage have also played a role.H with

the exclusion, employees receiving employer-paid health benefits

can obtain these benefits for significantly less money than they

would if the benefits were taxable income. An employee in the 25

percent marginal tax bracket, for example, receives $1 in aftertax benefits from each dollar in employer-paid group health

benefits, as opposed to 75c£ of income if the contributions were

taxable. Because of the savings from the exclusion, employers can

lower their compensation costs and increase the after-tax income

10. See, for example, Charles E. Phelps, Demand for Health Insurance; A Theoretical and Empirical Investigation, Report No.

R-1054-OEO (Rand Corporation, July 1973). According to

Phelps, a 1 percent decrease in the cost of health insurance

coverage (holding constant a number of other variables,

including the cost of medical care) will result on average in

a 0.6 to 0.7 percent rise in the extent of coverage.

11. Employer-provided group health insurance has significantly

lowered the cost of insurance by allowing major savings in

administrative costs. Several studies have found that

administrative costs for private group health insurance plans

are generally less than 15 percent of total plan outlays, as

compared with 45 percent or more for individual health insurance policies. See, for example, Bridger M. Mitchell and

Ronald J. Vogel, "Health and Taxes: An Assessment of the

Medical Deduction," Southern Economic Journal, vol. 41 (April

1975), pp. 660-72 at p. 664; and Marjorie S. Mueller, "Private Health Insurance Plans in 1976: An Evaluation," Social

Security Bulletin, vol. 41 (September 1978), p. 10.

10
of their employees at the same time by replacing direct wage and

salary payments with a smaller amount of employer-paid health

benefits. Thus, the exclusion gives employers, as well as

employees, a strong incentive to provide employer-paid health

insurance benef its• * 2

Although the exclusion appears to have encouraged the spread

of health insurance, it has not resulted in universal coverage.

Many employers still have no health plans for their employees, and

the high cost of individual coverage has kept many low- and

moderate-income individuals from buying health insurance on their

own." Although some of these individuals qualify for coverage

under government programs, such as Medicaid and Medicare, many do

not. As of 1976, more than 16 percent of all persons with annual

incomes under $10,000 had neither private health insurance nor

access to government-provided coverage or care (see Table 2).^

12. Between 1950 and 1974, the share of workers with hospitalization insurance rose from 48.6 percent to 69.6 percent, while

the share of workers with coverage for regular medical

expenses increased from 16.4 percent to 66.5 percent.

Similar increases were also reported for other tax-subsidized, employer-provided fringe benefits. See Alfred M.

Skolnik, "Twenty-Five Years of Employee Benefit Plans,"

Social Security Bulletin, vol. 39 (September 1976), p. 6.

13. The tax code does provide some limited assistance to persons

with individual-paid health insurance through the medical

expense deduction, which is discussed in the next chapter.

However, the extent of support is quite limited: only half

of the first $300 of premiums, plus the remaining premiums to

the extent that allowable out-of-pocket medical costs exceed

3 percent of adjusted gross income, can be deducted. Furthermore, the subsidy is available only to taxpayers who

itemize their deductions. Thus, the large majority of lowand moderate-income taxpayers for whom the standard deduction

(now called the "zero bracket amount") exceeds all itemized

deductible expenses receive no specific tax reduction when

they purchase health insurance themselves.

14. For a further analysis of current gaps in health insurance

coverage in the United States, see CBO, Profile of Health

Care Coverage; The Haves and Have-Nots, Background Paper

(March 1979).

11
TABLE 2. HEALTH INSURANCE COVERAGE IN THE UNITED STATES BY

INCOME LEVEL: 1976

Income Level

(in Dollars)

Less than 5,000

5,000- 9,999

10,000-14,999

15,000-19,999

20,000-29,999

30,000 and Over

All Incomes

Total

Population

with

Coverage

23,111,792

35,392,435

40,581,681

34,953,210

37,441,287

18,510,910

189,991,307

Population

without

Coverage

4,873,123

7,021,263

4,106,319

2,507,093

2,068,800

949,477

21,526,075

Percent Total

of Population

without

Coverage

17.4

16.6

9.2

6.7

5.2

4.9

10.0

SOURCE: Census, SIE, 1977, as adjusted by CBO for under-reporting

of public health insurance.

Another important feature of the exclusion as a means of promoting coverage is that it imposes no requirements as to the type

of health insurance coverage required for tax savings. All

employer contributions to an employee's health or accident plan

qualify for the exclusion, although health plans administered by a

firm for its own employees must satisfy certain nondiscrimination

standards for the benefits provided to be tax-exempt. ^ Thus,

15. Under current tax regulations, payments from a fully selfadministered plan can be excluded from taxable income only if

the following standards are met: the plan must not discriminate in favor of "highly compensated individuals," defined as

the top five company officers, stockholders with 10 percent

or more of company shares, and the top 25 percent of all

employees besides officers and stockholders; and the plan

must benefit 70 percent or more of all employees (80 percent

or more if 70 percent or more employees are eligible to participate). The law allows firms to exclude employees under

12
employees with very different types of coverage will all receive

tax savings to the extent their premiums are paid by their

employers. -^

Effect on Medical Spending

The exclusion of employers1 health contributions from taxable

income generates higher medical spending, to the extent it brings

about greater health insurance coverage. Coverage, in turn, tends

to stimulate medical spending in at least three ways. First,

because it lowers the out-of-pocket cost of health care, it

encourages consumers to seek care. Second, it reduces patients1

awareness of and sensitivity to the difference in price among

providers. Third, by lowering the risk of nonpayment, insurance

promotes unconstrained use of costly forms of care. When insurance covers the full cost of care, as is true for inpatient

hospital care under many current plans, doctors in particular have

little incentive to restrain costs. On the contrary, they are

encouraged to order more tests and use more services, because the

gains from saving money are small while the risks in potential

malpractice liability for deferring services are great. The

cumulative effect of these patterns, many analysts believe,

contributes significantly to inflation in the medical sector.^'

25 years of age, part-time and seasonal workers, workers with

less than three years of service, nonresident alien employees, and employees covered by an agreement between employee

representatives and the employer (for example, workers

covered by a labor union plan). See Internal Revenue Code,

Section 105(h), 1979. In 1978, the Carter Administration

proposed that these same requirements be applied to all

employer-group health insurance plans. However, the Congress

did not follow this recommendation.

16. For further discussion of the problems in coverage resulting

from the current exclusion, see Alain C. Enthoven, "ConsumerCentered vs. Job-Centered Health Insurance," Harvard Business

Review, vol. 57 (January-February 1979), pp. 141-52.

17. See Joseph P. Newhouse, "The Structure of Health Insurance

and the Erosion of Competition in the Medical Marketplace,"

in Federal Trade Commission, Competition in the Health Care

13
The employer exclusion is especially likely to raise medical

spending, because it encourages employees to choose the most expensive type of coverage offered. This is particularly true for

employees in firms that pay the entire premium cost.l° The tax

law gives employers some incentive to choose cost-minimizing

plans, since the employer's deduction for business expenses

eliminates only part of the difference in cost between more and

less expensive health policies. For employees, however, the

exclusion does not have this effect, because all employer contributions, no matter how large, are excluded from taxable income.

Because the most expensive coverage generally eliminates all

or most out-of-pocket medical payments, the effect of the exclusion on medical expenditures is invisible to many workers. Costs

do emerge, however—often as higher prices or larger premiums.

The resulting costs for medical care fall particularly hard on

those least able to afford them, since persons with low to moderate incomes are the ones most likely to be uninsured. All

persons, however, end up paying more by devoting larger shares of

their incomes to medical care.

Low Visibility and Controllability of Expenditures

Most direct federal expenditure programs require annual

appropriations that are subject to normal Congressional review.

Because the employer exclusion is a permanent provision of the tax

code, however, it is not subject to regular review and the revenue

Sector; Past, Present, and Future (March 1978), pp. 270-87;

and Martin Feldstein and Amy Taylor, The Rapid Rise in

Hospital Costs, Report to the Council on Wage and Price

Stability (January 1977). In many instances, the increase in

services represents a real rise in quality. In some cases,

however, it may not, and it is often hard to determine when

additional services represent better care as well as higher

costs.

18. During 1978, more than 61 percent of the employees with new

group health coverage were enrolled in plans for which

employers paid the entire cost. See Health Insurance

Institute, New Group Health Insurance Policies Issued in 1978

(Washington, 1979).

14
losses it generates go largely unobserved. In addition, revenue

losses from the exclusion cannot be controlled, because they

result from automatic entitlements for individual taxpayers. This

feature is shared by the two major federal expenditure programs

for health care, Medicare and Medicaid. Most direct spending

programs, however, are subject to greater control.

ALTERNATIVES TO THE CURRENT EXCLUSION

By changing the exclusion or replacing it with another means

for subsidizing health insurance, some of its disadvantages could

be alleviated. In this section, three alternatives to the current

provision are analyzed: limiting the amount of employer contributions that qualify for the exclusion; converting the exclusion to

a limited tax credit for employer contributions to employee health

plans; and restricting the exclusion to contributions for plans

with specific features designed to contain medical costs.

Limiting the Exclusion to a Fixed-Dollar Amount

If curbing the inflationary effects of the exclusion is of

primary concern to the Congress, one way to achieve this goal

would be to limit the amount of tax-free employer contributions to

employees1 health insurance plans. A restriction of this sort

would induce employees to request plans with premiums that did not

go above the ceiling, since employer contributions above the limit

would represent taxable income to employees. If the ceiling were

sufficiently low, workers would be encouraged to seek plans with

built-in features that keep premiums low and discourage excessive

medical spending. These plans generally involve either the use of

copayments and deductibles or membership in prepaid health plans

such as health maintenance organizations (HMOs). Copayments and

deductibles both require patients to pay part of the cost for all

insured services, whereas HMOs have internal incentives to

conserve on medical services.

Limiting the amount of tax-free employer health contributions

could have a number of benefits. First, revenue losses from the

exclusion would grow less rapidly, although actual tax revenues

would increase only if employer health contributions were converted into taxable wages rather than other tax-free benefits.

Second, the difference in subsidies received by taxpayers at dif15
ferent income levels would diminish, since the exclusion would

shield less income from tax. Third, limiting the exclusion would

make tax policy more consistent with current federal initiatives

to contain medical spending. This would be especially true if the

ceiling were set at or below the level of a health plan with costcontaining features, such as deductibles and coinsurance, or the

cost of membership in a prepaid health plan. Fourth, the restriction might heighten the visibility of the exclusion, since employees and legislators would know how much income the exclusion could

shield from tax.

Limiting the exclusion would have certain disadvantages, however. It could, for example, be complicated to administer. Firms

making health insurance contributions over the ceiling would have

to report the amounts they paid for health insurance for their

employees. Doing so could create some difficulties, because the

insurance is normally purchased as a package item and its cost

depends not only on the number of employees and their family

status, but also on the age mix of workers and possibly other

factors as well. 19 in addition, the IRS would have to add

health insurance contributions to the list of business expenses

for which firms are audited. Another problem with imposing a

limit is that it might not always have the desired incentive

effects on health insurance coverage. If a single ceiling were

established, employees in states where health insurance costs were

relatively low might be able to obtain extensive coverage taxfree. This problem could be overcome by establishing different

ceilings in different states or metropolitan areas. Setting

multiple ceilings, however, would further complicate the administration of the exclusion unless a readily available price, such as

the average cost of a federally qualified HMO in an area, were

used to set the ceiling.

A further problem with limiting the exclusion is that it

could add to financial burdens on low- and moderate-income families. With a less generous exclusion, employer contributions for

19. In practice, employers would probably solve this problem by

imputing the average cost of insurance to each covered

worker, perhaps with different contributions for those with

and without dependents. The Federal Employees Health

Benefits Plan, for example, follows this approach.

16
health insurance might decrease. This decrease in

contributionscould, in turn, bring about gaps in coverage for some

employees unless a viable prepaid health plan existed in the area

and employer contributions covered the cost of membership. If

gaps in coverage did arise, low-income workers would be most

adversely affected, since they would find it most difficult to

purchase supplementary coverage or to pay directly for services

themselves.

Finally, placing a fixed-dollar limit on the exclusion would

not eliminate the exclusion's other weaknesses, such as the uncontrollability of expenditures and the concentration of tax benefits

among the affluent. To correct these problems, the exclusion

would have to be changed still further.

Replacing the Exclusion with a Limited Tax Credit

Another option would be to replace the current exclusion with

a limited tax credit. Under this option, all employer contributions for employees1 health plans would be taxable income to the

employees. At the same time, employees would be allowed a limited

tax credit for these benefits, such as 20 percent of the first

$600 in employer contributions.

Replacing the exclusion with a limited tax credit would have

important advantages. Like the ceiling described earlier, the tax

credit would limit tax subsidies for employer contributions to a

maximum dollar amount. Thus, the credit would weaken the incentives to acquire extensive health insurance coverage now created

by the exclusion, thereby encouraging employees to choose less

comprehensive—and presumably, more cost-containing—health insurance. The tax credit approach, however, might also make employees

more aware of the cost of their health insurance than would a

fixed-dollar ceiling on the exclusion, because they would have to

report as taxable income the full amount of the employers' contributions. This increased awareness could, in turn, result in

greater pressure on health-care providers to hold down medical

costs. In addition, the tax-credit approach would eliminate the

regressivity of tax savings from the exclusion, because employees

at all income levels would receive the same rate of subsidy for

each dollar of employer-provided health insurance contributions

below the maximum qualifying amount for the credit. With the

existing exclusion, by contrast, tax subsidies per dollar of

17
employer contribution rise with taxable income, because the rate

of subsidy equals the taxpayer's marginal tax rate.

The tax-credit approach would also have disadvantages,

however. First, each firm offering employer-subsidized health

benefits would have to calculate and report the amount of

contributions it provides for each employee. As mentioned before,

this would create a problem for firms, since employers would have

to decide whether to report equal contributions for all employees

or to differentiate contributions based on an employee's age,

family size, or other characteristics. In addition, the duty to

report employer contributions would require the IRS to monitor

this activity. Second, and perhaps more important, converting the

exclusion to a tax credit would not eliminate the basic problems

caused by using a tax provision, rather than a direct expenditure

program, to subsidize health insurance. Thus, federal subsidies

for employer health contributions would remain largely invisible,

although a fixed-dollar ceiling on the amount subject to the

credit would tend to limit the size of revenue losses. Replacing

the exclusion with a tax credit would also do nothing to provide

benefits to persons without employer-subsidized group health plans

who do not itemize their deductions. To assist these persons, the

credit would have to be applicable to individual payments for

health insurance.TM This could be done very simply, although it

would allow some taxpayers to claim both a tax credit and a deduction for part of their health insurance payments unless the

current rules for deducting health insurance premiums through the

medical expense deduction were also changed.

Limiting the Exclusion to Plans with Certain Features

A third option for changing the exclusion would be to limit

tax-free employer contributions to those for plans with particular

features designed to make patients and health-care providers more

sensitive to costs. Some analysts, for example, have urged that

employer contributions be channeled into policies with substantial

20. A bill embodying this principle has been introduced in the

present Congress by Representative Paul S. Trible. See

"Congressman Paul Trible Introduces Health Insurance Tax

Credit Bill," Congressional Record, June 18, 1979, pp.

H-4688-4690.

18
requirements for coinsurance and deductibles, on the assumption

that the absence of these provisions has generated inflation in

the medical sector. *•*- Other analysts have recommended requiring

employers to offer employees a choice of health-care plans and to

provide the same contribution to each one, in order to increase

the attractiveness of prepaid medical plans and to encourage price

competition among insurers and health-care providers.^2 This last

option has sometimes been paired with the idea of requiring all

plans to contain a minimum set of benefits as a way of assuring

that all employees have an adequate level of coverage.23 gy -£t_

self, such a requirement would tend to increase spending, although

it would improve coverage for many employees. If coupled with a

ceiling on tax-free employer health contributions, however, it

could prevent employees from escaping cost-containment measures by

eliminating coverage for such items as catastrophic medical

expenses.

Mandating Cost Sharing in Tax-Subsidized Policies. Requiring

subsidized health plans to contain cost-sharing provisions such as

deductibles and coinsurance could help to restrain medical costs

21. See, for example, Feldstein and Taylor, The Rapid Rise of

Hospital Costs. Representative James R. Jones of Oklahoma

has introduced a bill to this effect that would limit the

exclusion to employers1 payments for HMOs and to plans with a

coinsurance rate of 25 percent for all hospital expenses up

to a maximum out-of-pocket expense of $2,000 or 15 percent of

adjusted gross income. See "A Bill to Limit the Business

Deduction Available for Health Insurance Premiums," H.R.

3943.

22. See, for example, Enthoven, "Consumer-Centered vs. JobCentered Health Insurance." Several bills incorporating this

approach have been introduced during the 96th Congress.

These include the "Health Cost Restraint Act of 1979," H.R.

5740, introduced by Chairman Al Ullman of the House Committee

on Ways and Means; and the "Health Incentives Reform Act of

1979," S. 1968, introduced by Senator David Durenberger of

Minnesota.

23. See S. 1590, "Comprehensive Health Care Reform Act," introduced by Senator Richard Schweiker of Pennsylvania.

19
by reducing the use of medical services. In particular, advocates

of this option believe that cost sharing for hospital services

would generate large savings in medical expenditures, since

hospital care represents the largest source of spending increases

in the medical sector. Numerous studies have shown that the

demand for medical care is sensitive to the price of care as

perceived by the patient. Thus, cost-sharing provisions should

lead to lower utilization by increasing the out-of-pocket costs

consumers pay for insured services.

Although mandatory cost sharing has strong theoretical appeal

as a cost-saving measure, the overall savings from this approach

could be fairly small. First, cost sharing is not likely to have

much impact on the prices of individual services. When care is

needed, patients are not very sensitive to cost differentials

among health-care providers. Even with cost sharing, health

insurance is likely to dilute sharply the price differentials

among health-care providers. Second, although the demand for some

services is fairly sensitive to price, the responsiveness of

demand specifically for hospital care—the largest and most

rapidly growing component of medical outlays—is rather low.^4

Thus, cost sharing may not have much impact on the utilization for

a large segment of medical services. It could, however, expose

many patients—particularly those with low and moderate incomes—

to a great deal of financial risk. Third, because of the risks

created by cost sharing, some workers might choose to supplement

their health coverage with policies that filled the gaps in their

employer-provided plans, even if they had to pay the premiums with

after-tax dollars. If these plans provide first-dollar coverage,

they would eliminate whatever deterrents to utilization were

created by cost sharing in the employerfs policy, since these

supplementary plans would eliminate the need for patients to bear

any cost at the time care is received. If a sizable number of

workers chose to supplement their basic employer policies in this

way, the net effects of cost sharing on employer-provided insurance could ultimately be negligible. A recent study by several

24. CBO's review of recent studies of the demand for medical care

indicates that decreasing the extent of coverage for hospital

care from 100 percent to 75 percent would reduce the volume

of hospital admissions by 7 percent at most and would reduce

total hospital bills by about 17 percent.

20
Rand Corporation economists suggests that the chance of such

massive supplementation would be small,25 -p^g experience with

Medicare, however, suggests otherwise, and the steady rise in

medical costs makes it more rather than less likely for widespread

supplementation to occur.^"

Mandatory Choice of Plans with Equal Contributions up to a

Ceiling* Requiring employers to offer a choice of health-care

plans, including at least one option for comprehensive, prepaid

care such as HMOs provide, and giving equal employer contributions

for each, is another proposal that could help contain medical

spending. This proposal would encourage insurers and health-care

providers to compete, because employees would have to pay higher

premiums for more expensive health plans. In addition, the

requirement that employees be given the option of joining an HMO

or similar organization, when one exists in the vicinity, could

encourage the growth of HMOs, particularly if the definition of

25. See Emmet B. Keeler and others, "The Demand for Supplementary

Health Insurance, or Do Deductibles Matter?" Journal of

Political Economy, vol. 85 (August 1977), pp. 789-801.

26. The likelihood of massive supplementation would be reduced if

cost-sharing requirements were made flexible, so that persons

with different preferences about copayments and deductibles

could have some choice about the services to which the payments should apply. This kind of flexibility could be

achieved if, instead of limiting the exclusion to contributions for plans with particular cost-sharing features, the

restriction involved an overall premium limit but stipulated

that certain kinds of coverage, such as coverage against

catastrophic expenses, must be provided. In this case,

employees would have some choice of how the premium limits

were to be reached—through deductibles, copayments, or the

elimination of coverage for less commonly insured services

such as dental care. At the same time, employees would not

be able to avoid making some change in coverage that would

provide incentives to reduce utilization*

21
HMO were made somewhat flexible.^7 Several studies have shown

that HMOs can generate significant cost savings and help lower

prices where they exist.TM Mandating that employees be given the

option of joining an HMO could thus increase the possibility for

cost savings*

One problem with requiring that employees be given a choice

of health plans is that the current "overinsurance" might not be

eliminated unless firms set their contributions at the level of

one of the less extensive plans« This approach, however, could

bring about significant gaps in coverage for low- and moderateincome employees, unless the premiums equalled the cost of a

comprehensive prepaid health care plan. For that reason, most

proposals of this type would set the ceiling for employer contributions at or about this level. "

The success of this option also depends heavily on the

availability of alternative health-care plans. Although these

27. Current law already requires that employers with more than 25

employees make available membership in a federally qualified

HMO if one exists nearby. This provision has not been

veryeffective at encouraging HMO membership, however, because

few HMOs have been willing to go through all the steps

required to become federally qualified.

28. See, for example, Clifton R. Gaus and others, "Contrast in

HMO and Fee-for-Service Performance," Social Security Bulletin, vol. 39 (May 1976), pp. 3-14; Harold Luft, "How Do

Health Maintenance Organizations Achieve Their Savings?", New

England Journal of Medicine, June 15, 1978; and John K.

Iglehart, "HMOs are Alive and Well in the Twin Cities

Region," National Journal, July 22, 1978, pp. 1160-65.

29. See, for example, "Health Cost Restraint Act of 1979," H.R.

5740, introduced by Representative Ullman; "Health Incentives

Reform Act of 1979," S. 1485, introduced by Senator

Durenberger; and "Comprehensive Health Care Reform Act," S.

1590, introduced by Senator Schweiker.

22
have developed in some areas, their growth has been slow in

others.30 Thus, without more rapid growth of prepaid health

plans, savings from this option could be very small.

30. See Enthoven, "Consumer-Centered vs. Job-Centered Health

Insurance," and "Health Care Costs," National Journal, May

26, 1979, pp. 885-89.

23

CHAPTER III. THE MEDICAL EXPENSE DEDUCTION

The second largest of the tax expenditures for medical care

is the itemized deduction for out-of-pocket medical expenses.

This provision is expected to reduce federal revenues by about

$3.1 billion in fiscal year 1980.x

The medical expense deduction actually consists of two

separate deductions: one for health insurance premiums, and one

for so-called "extraordinary" medical expenses—that is, out-ofpocket expenditures that exceed what is thought to be a "normal"

percentage of household income. Under the health insurance

portion, taxpayers may deduct one-half of all health insurance

premiums, with a maximum deduction of $150. The deduction for

extraordinary medical outlays allows taxpayers to deduct most

types ,of medical expenditures, the combined value of which exceeds

3 percent of adjusted gross income. All payments for medical

services, including any remaining health insurance premiums and

all expenditures for drugs and medicines that exceed 1 percent of

adjusted gross income, may be counted toward this total.

LEGISLATIVE HISTORY

The medical expense deduction was introduced into the tax

code in 1942, when taxpayers were allowed to deduct from taxable

income all medical expenses over 5 percent of net income, with a

maximum deduction of $1,250 for single taxpayers and $2,500 for

couples filing joint returns. Since that time, the threshold, or

minimum level, of deductible expenses has been lowered, while the

ceiling on deductible expenses has been raised. In 1948, the

minimum was changed to 5 percent of adjusted gross income and the

ceiling on the deduction was raised to $1,250 per exemption, with

a maximum deduction of $2,500 for single taxpayers and $5,000 for

those filing joint returns. In 1951, the 5 percent floor was

eliminated for taxpayers 65 and older.

1. See CBO, Five-Year Budget Projections, Fiscal Years 1980-1984;

Tax Expenditures, Table 1.

25
In 1954, ceilings on the deduction for taxpayers were doubled

and the minimum level of deductible expenses was lowered to the

present level of 3 percent, on grounds that the previous 5 percent

threshold "does not allow the deduction of all extraordinary

medical expenses."^ in addition, a 1 percent minimum for out-ofpocket expenses for drugs and medicines was introduced for all

taxpayers, and taxpayers 65 and older were allowed to deduct all

health insurance premiums without limit. In 1961, the ceilings on

the deduction were raised again, while in 1964 the limitation on

deductible drug expenses was eliminated for taxpayers 65 and

older. In 1967, the 3 percent floor for deductible pharmaceuticals was restored for taxpayers 65 and older, but the other

ceilings on the deduction were removed. In addition, the deduction for health insurance was changed so that all taxpayers could

deduct half of the first $300 of health insurance premiums without

regard to any limitation. This was done in part because the basic

deduction was said to discourage individuals from purchasing

health insurance.^

In 1978, an attempt was made to simplify the deduction and

eliminate the separate subsidy for health insurance premiums now

provided by Section 213(b). A proposal included in the House

version of the Revenue Act of 1978 would have eliminated both

the separate deductibility of health insurance premiums and the

1 percent floor on deductions for drug and medicine purchases.

Deductible drug expenses would have been limited, however, to

prescription drugs and insulin.^ The net effect of this change

would have been to make health insurance premiums deductible only

to the extent that out-of-pocket medical expenses exceeded 3

percent of adjusted gross income. The Senate version of the bill,

however, did not include these changes, and they were deleted

2. See Internal Revenue Code of 1954, House Committee Report,

U.S. Congressional and Administrative News, pp. 4054-55, and

Senate Committee Report, same volume, p. 4666.

3. See Social Security Amendments of 1965, Report of the House

Ways and Means Committee on H.R. 6675, 89th Cong., 1st sess.

(1965), p. 137.

4. See H.R. 13511, Sec. 112, as passed by the U.S. House of

Representatives on August 10, 1978.

26
from the final version of the act.^ Thus, the medical deduction

remains basically as it was following passage of the Social

Security Act Amendments of 1965.

DISTRIBUTION OF TAX SAVINGS

The distribution of tax savings from the deduction as a whole

is displayed in Table 3. Table 4 shows savings from the deduction

for extraordinary medical expenses in particular. As the tables

indicate, the average tax saving from both portions of the deduction increases with taxpayers1 income. At 1978 income levels,

taxpayers with expanded incomes between $5,000 to $10,000 who

claimed the deduction saved about $98 on average from the two

parts. For taxpayers with expanded incomes between $50,000 and

$100,000, the average saving was more than $300. Taxpayers at the

upper end of the income scale also received a disproportionate

share of the total savings from the part of the deduction for

extraordinary medical expenses. For example, at 1978 income

levels, the Treasury Department's tax model estimates that taxpayers with expanded incomes over $50,000 accounted for 4.9 percent of all itemized medical expenses and 6.4 percent of the

deductible amounts. These taxpayers, however, received 14.5

percent of the savings from this part of the deduction.

The concentration of tax savings among upper-income taxpayers

comes about for two reasons. First, the proportion of taxpayers

itemizing their deductions rises sharply as income increases.

Second, tax savings depend on taxpayers1 marginal tax rates,

which, in turn, depend on their incomes. Taxpayers with higher

taxable incomes face higher marginal tax rates. Thus, they receive proportionately higher subsidies for each dollar of deductible expenses. Taxpayers in the 50 percent bracket, for example,

receive a tax saving of 50<£ for each dollar of deductible expenses, while taxpayers in the 20 percent marginal rate bracket

save only 204 f°r each dollar of deductible outlays.

The increase in benefits produced by the rising rate of

subsidy is offset, to some extent, because the floor for the

5. See Conference Report on H.R. 13511, 95th Cong., 1st sess.,

October 15, 1978, p. 201.

27
TABLE 3. DISTRIBUTION BY INCOME LEVEL OF TAX SAVINGS FROM THE

MEDICAL EXPENSE DEDUCTION

Number of Returns with

Expanded

Income

Class (in

Dollars)

Less than 5,000

5,000- 10,000

10,000- 15,000

15,000- 20,000

20,000- 30,000

30,000- 50,000

50,000-100,000

100,000-200,000

200,000

and over

All Returns

Either

Medical

Expense

Deductiona

(in

Thousands)

309

1,650

2,978

3,425

5,424

3,408

856

162

42

18,253

Separate

Deduction for

Health

Insurance

Premiums

(in

Thousands)

238

1,382

2,529

2,975

4,900

3,215

819

156

40

16,255

Separate

Deduction

for Extraordinary

Medical

Expenses"

(in

Thousands)

282

1,472

2,261

2,291

2,918

1,299

205

22

3

10,754

Percent of

All Returns

in Income

Class with

Medical

Deduction

1.4

8.8

21.5

29.5

41.9

58.8

60.5

61.2

65.1

20.4

(continued)

SOURCE: Treasury Department tax model, 1979 tax law at 1978

income levels•

a. All returns with either a deduction for insurance premiums,

a deduction for extraordinary medical expenses, or both.

b. Qualifying medical expenses over 3 percent of adjusted gross

income.

28
Table 3. (continued)

Total Tax

Savings

from the

Deduction

for Taxpayers

in the Individual Income Class0

(in Millions

of Dollars)

10.0

162.8

350.8

415.1

685.1

541.3

251.4

105.8

27.5

2,549.8

Average

Tax

Increase per

Claimant

if the

Deduction

Were Repealed^

(in Dollars)

64

103

117

122

127

162

310

748

829

143

Percent of

Tax Savings

from the

Deduction

Received by

Taxpayers

in the

Indicated

Income

Class

0.4

6.4

13.8

16.3

26.9

21.2

9.9

4.1

1.1

100.0

Percent of

All Tax

Re turns

Filed With

Expanded

Income in

Income

Class

26.2

21.7

16.0

13.1

14.6

6.5

1.5

0.3

0.1

100.0

c. Calculated as the increase in taxes resulting from repeal of

the deduction under 1979 law at 1978 income levels.

d. Estimate for calendar year 1979 at 1978 income levels.

29
TABLE 4. DISTRIBUTION OF TAX SAVINGS FROM THE DEDUCTION FOR EXTRAORDINARY

MEDICAL EXPENSES3

Number of

Returns

Claiming

the Deduction

Expanded for ExtraIncome ordinary MediClass (in cal Expenses

Dollars) (in Thousands)

Less than 5,000 282

5,000 - 10,000 1,472

10,000 - 15,000 2,261

15,000 - 20,000 2,291

20,000 - 30,000 2,918

30,000 - 50,000 1,299

50,000 -100,000 205

100,000 -200,000 22

200,000 and over 3

All returns 10,754

Aggregate Tax

Savings for

Taxpayers in

the Indicated

Income Classb

(in Millions

of Dollars)

10.0

144.2

306.1

352.1

548.5

410 5

203.2

95.8

25.1

2,094.3

Percent of

Aggregate

Tax Savings

Received by

Taxpayers in

the Indicated

Income Class

0.4

6.9

14.6

16.8

26.2

19.6

9.7

4.6

1.2

100.0

Average Tax

Increase per

Claimant

if the

Deduction

Were

Repealed0

(in Dollars)

71

104

135

156

190

327

1,130

5,333

11,669

202

SOURCE: Treasury Department tax model, 1979 tax law at 1978 income levels.

a. The deduction for qualifying medical expenses above 3 percent of adjusted

gross income.

b. Calculated as the increase in tax liabilities resulting from repeal of the

deduction for qualifying medical expenses above 3 percent of adjusted gross

income.

c. Estimate for 1979 law at 1978 income levels.

deduction—3 percent of adjusted gross income—rises as income

increases. The data indicate, though, that tax savings from the

deduction are still concentrated disproportionately among the more

affluent.

30
ANALYSIS

Tax Subsidy or Ability-to-Pay Provision?

The medical expense deduction has often been characterized as

promoting taxation on the basis of a taxpayer's ability to pay.

For the most part, this description rests on the assumption that

medical care is largely involuntary, so that medical expenses

reduce a family's "discretionary" or spendable income. Since

discretionary income forms the basis of a taxpayer's ability to

pay, and since the income tax is intended to reflect the abilityto-pay criterion, this assumption suggests that the medical

expense deduction represents part of the "normative" tax code,

rather than a subsidy grafted onto it.^

Although some tax analysts accept this view of the deduction,

most do not. Most tax experts now consider the medical expense

deduction as a tax expenditure that subsidizes a select group of

taxpayers whose out-of-pocket expenditures for health insurance

and medical care satisfy the statutory requirement for deductibility. One reason for this view is that more than two-thirds of all

medical expenditures are now covered by health insurance or

government health programs, with 90 percent of the U.S. population

having either one type of coverage or both.' Thus, the bulk of

all medical expenditures are covered by insurance, leaving the

medical expense deduction to subsidize the cost of those expenditures that are not covered. The range of deductible items is

nevertheless quite broad. For example, the medical deduction can

be used to subsidize the cost of cosmetic surgery, expensive rest

6. See William D. Andrews, "Personal Deductions in an Ideal

Income Tax," Harvard Law Review, vol. 86 (December 1972), pp.

333-37.

7. During 1978, about 67 percent of all personal health care

expenditures (medical outlays less payments for research) were

provided by private insurers, the federal government, and

other third-party payors. See Robert M. Gibson, "National

Health Expenditures, Fiscal Year 1978," Health Care Financing

Review, Vol. 1 (Summer 1979), pp. 7-8. See also CBO, Profile

of Health Care Coverage, p. 1.

31
cures, and elaborate medical equipment in the home—items generally excluded from insurance coverage—to the extent their cost

exceeds 3 percent of adjusted gross income.°

Problems with the Deduction as Tax Subsidy

If the medical deduction is viewed as a tax subsidy, it can be

criticized for a number of shortcomings.

Perverse Distributional Pattern of Benefits. In general, the

need for subsidies is considered greatest among families with the

lowest incomes and decreases as income increases. Benefits

provided by the medical expense deduction, however, tend to

increase with income, because the percentage rate of subsidy

equals the taxpayer's marginal tax rate. This holds true even

though the floor for the deduction for extraordinary medical

expenses is set at 3 percent of adjusted gross income and, thus,

increases with taxpayer income (see Tables 3 and 4). Furthermore,

because tax savings are available only to taxpayers who itemize

their deductions, the medical expense deduction provides no

benefits to the roughly 72 percent of all taxpayers who do not

itemize deductions—although many taxpayers with very high out-ofpocket medical expenditures do use the deduction. For some lowincome taxpayers, this gap in coverage does not present a problem,

because other government programs such as Medicare and Medicaid

provide significant subsidies for medical care. Nevertheless,

between 4.4 and 4.9 million persons in households with incomes

below $5,000 have no form of public or private health care coverage. For these persons, and for many households with incomes

between $5,000 and $15,000 and only limited health insurance

coverage, neither the medical expense deduction nor any direct

8. See, for example, Henri C. Pusker, "The Changing Scope of

Medical Expense Deductions," Taxes, vol. 57 (June 1979), pp.

347-353. Note, however, that current law limits the deductibility of capital expenditures for health care, such as the

cost of installing an elevator, to the difference between the

cost as installed and the resulting increase to the value of

the property where the item is installed.

9. These estimates are based on figures in CBO, Profile of Health

Care Coverage, Table 4, p. 16.

32
expenditure government assistance program provides significant

protection against high medical expenses.

Low Rates of Subsidy. Because the subsidies provided by the

deduction depend on the taxpayer's marginal tax rate, rates of

subsidy per dollar of qualifying expenditures are relatively low.

Marginal tax rates under the federal income tax range from 14 to

70 percent. Moreover, two-thirds of all tax returns for calendar

year 1978 had marginal tax rates of 30 percent or less. At these

levels, few taxpayers receive even a 50 percent reimbursement for

their deductible expenses. Thus, the deduction provides few

households with much coverage against large, uninsured medical

expenses.

The Time Lapse Between Expenses and "Reimbursement." Another

problem with the deduction as a subsidy, or reimbursement, for

extraordinary medical expenses is that the full tax saving from

the deduction may not come until long after the expenses are

incurred. Under current tax laws, any taxpayer with extraordinary

medical expenses can obtain some tax savings soon after the

expenses are incurred by reducing the amount of income tax withheld.^ The withholding system, however, cannot immediately

compensate for large medical expenses, because negative withholding is not allowed and tax savings from additional deductions are

normally spread over the entire tax year. A taxpayer with large

expenses early in the year may be able to recover most of that

within a few months. If outlays come later, substantial reimbursement cannot come until the year's tax return is filed and a

refund is received. ^

Other Problems with the Medical Deduction

In addition to the problems associated with its role as a tax

subsidy, the current medical expense deduction has other

disadvantages.

10. The tax laws permit taxpayers with itemized deductions to

claim extra withholding exemptions.

11. See General Accounting Office, "Inequities in the Federal

Withholding Tax System," Report to the Congress by the

Comptroller General of the United States (December 2, 1977).

33
High Rates of Error by Taxpayers* The medical expense deduction is one of the most important sources of taxpayer error in the

tax code. A study conducted by the IRS of tax returns for 1973,

for example, indicated that more than 75 percent of the 13,600

returns examined contained some type of mistake in calculating the

medical expense deduction—a higher rate of error than for any

other item surveyed. Another IRS survey of tax returns filed

during 1977 revealed that the medical deduction was among the five

tax code items with the highest error rates.^

The errors involved in claiming the deduction generally fall

into two categories: issues of definition and problems of computation. Issues of definition arise because it is often difficult

to distinguish "medical" from "nonmedical" expenses. For example,

taxpayers may usually deduct the cost of travel to a warmer

climate prescribed by a physician, but not the cost of food and

lodging while there." Computational difficulties result because

the tax code requires separating actual medical expenses from

payments toward health insurance premiums and keeping separate

account of drug purchases. Although the tax form simplifies the

procedure by breaking it down into steps, the entire operation

remains very complex. In addition, the current tax form complicates matters by requiring the taxpayer to combine the health

insurance deduction calculated on one line with the deduction for

extraordinary medical expenses, which is calculated several lines

below. The IRS studies cited earlier suggest that the error rate

might be substantially less if the two deduction items were listed

instead as separate deductions.

Low Visibility and Controllability of Expenditures. Tax

losses resulting from the medical expense deduction suffer from

low visibility in much the same way as those caused by the

employer exclusion discussed in Chapter II. Because the deduction

12. See letter from IRS Commissioner Jerome Kurtz to John S.

Nolan, December 27, 1977, distributed at the American Law

Institute-American Bar Association Conference on Federal

Income Tax Simplification, Warrenton, Virginia, January 4-7,

1978.

13. For more discussion, see Richard Goode, The Individual Income

Tax, revised ed. (Brookings Institution, 1976), pp. 158-59.

34
is a permanent part of the tax code, the revenue losses it creates

are not subject to regular Congressional review. Thus, the visibility of expenditures from the deduction is much less than that

of most direct expenditure programs. In addition, revenue losses

from the deduction are uncontrollable, because the deduction

creates open-ended, individual entitlements to tax savings.

Upward Effect on Medical Spending. By offsetting a portion

of out-of-pocket medical expenses and the cost of individual-paid

health insurance, the deduction encourages additional medical

spending. Taxpayers benefiting from the deduction have less

incentive to economize on medical services or to consider price in

choosing providers, because each dollar of deductible expenses is

subsidized. Thus, taxpayers are encouraged to increase medical

expenditures. Similarly, the subsidy for individual-paid health

insurance gives additional incentives to acquire more extensive

coverage. This added coverage, in turn, further stimulates

medical spending because insurance itself lowers the out-of-pocket

medical care.

The overall effect of the deduction on medical spending is

probably small, because few taxpayers receive a sizable percentage

of out-of-pocket expenses from the deduction and most: would still

have health insurance even without the savings the deduction

provides. Nevertheless, the subsidies provided by the deduction

may have some effect on upper-income taxpayers, for whom the

deduction can provide significant reductions in the cost of

elective, uninsured care.

Interaction of the Deduction with Health Insurance

As indicated earlier, the medical deduction helps to reimburse the cost of uninsured services, while health insurance

reduces the amount of medical expenses qualifying for the medical

deduction. Where outlays for necessary uninsured services are

concerned, the ability of the deduction to subsidize uninsured

medical expenses promotes taxation on the basis of taxpayers'

ability to pay. However, the deduction can also subsidize the

cost of elective medical items not generally covered by insurance,

such as cosmetic surgery and elaborate physical examinations. In

these cases, the deduction serves more to promote consumption of

medical care than to fill important gaps left by private health

insurance. In addition, the benefits are often provided to those

35
who can afford care in their own right rather than to those who

would not have care available without the deduction.

ALTERNATIVES TO THE PRESENT DEDUCTION

If the Congress wishes to change the present deduction, many

options are available. One possibility, for example, would be to

revive Section 112 of the House version of the Revenue Act of

1978. This would have eliminated both the separate deduction for

insurance premiums and the 1 percent floor on drug and medicine

purchases.^ These changes would simplify the deduction and

reduce its inflationary consequences. At the same time, they

would revive any disincentives to acquiring health insurance

that might have existed under the law before 1965. Perhaps more

important, these changes would broaden the current disparities

between taxpayers with and without employer-subsidized plans.

This last point is worth mentioning, because the separate

deduction of premiums is the only subsidy for health insurance

available to many persons with individual-paid health plans.^

More far-reaching alternatives than simplifying the deduction

could also be considered. For example, to provide taxpayers at

all income levels with the same rate of subsidy, the deduction

could be converted to a "refundable" or "nonrefundable" flat-rate

tax credit. A refundable credit would make subsidies available to

nontaxpayers and to persons whose taxable incomes were less than

the amount of the credit. A non-refundable credit, however, would

13. Implementing this proposal would have reduced federal revenues by about $16 million in fiscal year 1979 and $43 million

in fiscal year 1980, according to estimates by the Joint

Committee on Taxation. By contrast, eliminating only the

separate deduction for health insurance premiums and instead

counting all premium payments toward the deduction for extraordinary expenditures would raise federal revenues by about

$236 million at 1978 income levels, largely because the floor

on deductible drug expenses would be retained.

14. Without the separate deduction, individual payments for

health insurance premiums would be deductible only to the

extent that qualifying out-of-pocket medical expenditures

exceeded 3 percent of adjusted gross income.

36
make savings available only to persons with net taxable incomes.

To reduce the cost of the deduction and eliminate subsidies for

out-of-pocket medical expenses normally incurred by taxpayers at

various income levels, the current floor for expenses that qualify

for the deduction could be set at a higher percentage of adjusted

gross income than the current 3 percent level. Alternatively, it

could be changed to a fixed dollar amount based on family size and

composition. Finally, the federal government could provide, or

require all U.S. residents to have, catastrophic health insurance.

Three specific alternatives are explained here: changing the

deduction to a tax credit, raising the floor for deductible

expenses, and replacing the deduction with government-financed

catastrophic health insurance.

Changing the Deduction to a Tax Credit for Extraordinary Medical

Expenses

Changing the medical expense deduction to a tax credit for

extraordinary medical expenses could eliminate many of the present

distributional inequities in the deduction. A nonrefundable tax

credit would make subsidies available to all net taxpayers,

including those who do not itemize deductions, while a refundable

credit would provide benefits to households with incomes too low

to incur positive tax liabilities as well. Changing the deduction

to a tax credit would also eliminate the tendency for benefits to

rise with taxpayer income, especially if the credit involved a

fixed percentage of all qualifying expenditures and the credit

itself were not taxable. *••* Table 5 indicates the changes in tax

liabilities that would result from converting the medical deduction to a 25 percent refundable tax credit for medical expenses

above 3 percent of adjusted gross income.

Replacing the deduction with a tax credit would have some

disadvantages. First, revenue losses from the credit could be

much higher than for the deduction if the rate of credit were at

all sizable, because many more taxpayers could become entitled to

15. If the credit were made taxable, the subsidy would become

progressive—that is, higher-income taxpayers would receive

lower subsidy rates—since the tax paid on the credit would

be higher for taxpayers in higher marginal tax brackets.

37
TABLE 5. EFFECT ON TAX LIABILITIES OF REPLACING THE DEDUCTION

FOR EXTRAORDINARY MEDICAL EXPENSES WITH A REFUNDABLE

25 PERCENT TAX CREDIT FOR MEDICAL EXPENSES ABOVE 3

PERCENT OF ADJUSTED GROSS INCOME: BY INCOME CLASS

Taxpayers Experiencing a Tax Decrease

Expanded

Income

Class (in

Dollars)

Less than 5,000

5,000- 9,999

10,000- 14,999

15,000- 19,999

20,000- 29,999

30,000- 49,999

50,000- 99,999

100,000-199,999

200,000 and ovei

All Incomes

Number

of Returns ( in

Thousands)

2,053

1,885

1,154

648

251

15

1

a

r »

6,007

Percent

of Total

Re turns

in Income

Class

8.9

9.8

8.1

5.6

1.9

a

a

a

a

6.8

Amount ( in

Millions of

Dollars)

-191

-371

-223

-97

-57

-6

a

a

a

-945

Average

Decrease

(in

Dollars)

-95

-197

-193

-150

-226

-385

-647

-365

-6,309

-157

(continued)

SOURCE: Treasury Department tax model, 1979 tax law at 1978

income levels.

38
Table 5. (continued)

Taxpayers Experiencing a Tax Increase

Number of

Re turns ( in

Thousands)

17

632

1,617

1,914

2,748

1,248

179

18

2

8,375

Total

Returns

in

Income

Class

a

3.3

11.4

16.5

21.3

21.9

13.4

6.8

3.1

9.5

Amount

(in

Millions

of

Dollars)

0

14

66

120

276

273

140

66

19

975

Average

Increase

(in

Dollars)

27

23

41

63

101

219

783

3,665

9,377

116

Net Tax

Change

(in

Millions

of

Dollars)

-190

-356

-157

23

219

. 267

140

66

19

30

Less than 0.5.

39
the tax savings.1" Remedying this problem would require either

setting a low rate of tax credit or limiting the credit to a much

smaller set of medical expenditures, such as all outlays over 10

or 15 percent of adjusted gross income. Second, with more taxpayers entitled to tax savings, the demand for health care might

rise, thereby contributing to inflation. In addition, some

families would experience tax increases. Furthermore, establishing a tax credit for medical expenses would also require the

Congress to decide whether the resulting tax savings should themselves be taxed. This is a difficult question to resolve, since

some federal tax subsidies (the targeted employment tax credit,

for example) are taxed, while others (such as the investment tax

credit) are not.

Besides these drawbacks, changing the deduction to a tax

credit would leave many other problems of the present deduction

intact. For example, moving to a tax credit would do nothing to

shorten the time lag in receiving benefits, since reimbursements

would still be limited either to increased withholding exemptions

or to refunds after tax returns are filed. Adopting a credit

would also leave the visibility problem unsolved, since the benefits would still result from permanent provisions in the tax law

and hence would not be subject to regular review. Likewise,

controllability would remain a problem, because the benefits would

still be entitlements. Furthermore, the change would not simplify

the job of claiming and administering benefits. If anything,

moving to a tax credit could increase the difficulties for both

taxpayers and the IRS, since taxpayers would have to calculate a

tax credit in addition to the total of their medical outlays, and

the IRS would have many more returns to check for medical expense

claims.

16. The Treasury Department's tax model suggests otherwise (see

Table 5). However, the figures on which the model's estimate

is based do not include the medical expenses of persons who

do not file tax returns, although medical expenses are

imputed for persons who file returns but do not now claim the

medical expense deduction. Since many non-filers are elderly

persons with low taxable incomes and high medical expenses,

the Treasury's approach may underestimate the volume of

medical expenses among nontaxpayers who might file returns to

40
Raising the Threshold for Subsidized Medical Outlays

Another way of changing the medical deduction would be to

raise the threshold or floor for subsidized expenses from 3

percent of adjusted gross income to some higher level such as 5

percent. This change could be instituted either by itself or

along with changing the deduction to a tax credit. Raising the

threshold for subsidized medical expenses could help remedy the

distribution problem of the tax subsidy. The deduction, however,

might then no longer subsidize all "extraordinary" expenses, since

the average household appears to spend about 3.9 percent of its

income for out-of-pocket medical expenses.1' Raising the threshold would also lower the cost of the tax provision. For example,

keeping the subsidy a deduction but returning the threshold for

deductible expenses to its pre-1954 level of 5 percent of adjusted

gross income would reduce revenue losses by about $765 million at

1978 income levels (see Table 6).

Raising the minimum for subsidized expenses, like changing

the deduction to a tax credit, would not eliminate all the disadvantages of the present medical deduction. For example, a

deduction or tax credit with a higher floor would still mean

significant delays for taxpayers in claiming benefits. Moreover,

revenue losses would be neither more visible nor more controllable. In addition, raising the floor would do nothing to change

the tendency of subsidies to rise with taxable income. A higher

threshold would, however, reduce the effective rate of subsidy as

a whole, since a smaller fraction of medical outlays would qualify

claim a refundable tax credit for high medical expenses.

This, in turn, could lead to an underestimate of the loss in

revenues from converting the medical expense deduction to a

refundable tax credit.

17. This figure was obtained by multiplying a recent estimate of

medical expenditures as a percent of adjusted gross income

(7.2 percent) by the estimated percentage of total consumer

medical expenditures represented by out-of-pocket payments in

1976 (54 percent). See Steuerle and Hoffman, "Tax Expenditures for Health Care," p. 9; and Marjorie S. Carroll, "Private Health Insurance Plans in 1976: An Evaluation," Social

Security Bulletin, vol. 41 (September 1978), p. 14.

41
TABLE 6. EFFECT ON TAX LIABILITIES OF RAISING THE MINIMUM DEDUCTION FOR EXTRAORDINARY MEDICAL EXPENSES

TO 5 PERCENT OF ADJUSTED GROSS INCOME: BY INCOME CLASS

Expanded

Income

Class (in

Thousands)

Less than 5,000

5,000- 10,000

10,000- 15,000

15,000- 20,000

20,000- 30,000

30,000- 50,000

50,000-100,000

100,000-200,000

200,000 and over

All Returns

Decrease in

Number of Taxpayers Claiming Medical

Deduction

(in Thousands)

5

123

316

374

523

150

23

2

1

1,516

Number of

Taxpayers

Experiencing

Tax Increase

(in Thousands)

66

1,220

2,155

2,252

2,890

1,296

204

22

3

10,108

Taxpayers

Experiencing

a Tax Increase as a

Percent of all

Taxpayers in

Income Class

0.3

6.3

15.2

19.5

22.4

22.7

15.2

8.3

4.6

11.4

Aggregate

Increase in

Tax Liabilities to All

Households in

Income Class

(in Millions

of Dollars)

1

28

83

125

235

195

71

20

8

765

Average Increase in Taxes

to Households

in Income Class

Experiencing

an Increase

(in Dollars)

12

23

39

55

81

151

347

914

2,184

76

SOURCE: Treasury Department tax model, 1979 tax law at 1978 income levels.
for tax benefits. Thus, many taxpayers would find themselves with

higher tax liabilities.

To minimize the effect of a higher floor for taxpayers with

very high out-of-pocket medical expenses, the new minimum could be

paired with special credits for medical expenses above a still

higher fraction of adjusted gross income. For example, taxpayers

with large medical outlays could be given a tax credit for medical

expenses above a secondary minimum, such as 10 percent of adjusted

gross income, in addition to a deduction for all medical expenses

above 5 percent of adjusted gross income. Adding such a credit to

a higher basic threshold would, of course, increase the cost of

the deduction. For example, a nonrefundable 25 percent tax credit

for itemized medical expenses above 10 percent of adjusted gross

income would raise the cost of a deduction with a floor of 5

percent by about $429 million at 1978 income levels, according to

the Treasury Department's tax model. A refundable tax credit with

the same provisions, by contrast, would increase the cost by $967

million.18

Replacing or Supplementing the Deduction with a Direct Expenditure

Program Providing Catastrophic Health Insurance

A third option for changing the medical deduction would be to

supplement or replace the deduction with government-provided

insurance against catastrophic health expenses—outlays exceeding

either a certain dollar amount or a certain fraction, such as 10

percent, of household income.-^ The sharp rise in medical costs

during the last few years has given increasing impetus to the

drive for a catastrophic health insurance program, and bills to

establish catastrophic health coverage have been introduced both

in the present and in previous sessions of Congress.20

18. Treasury Department tax model, 1979 tax law at 1978 income

levels.

19. This section provides only a brief analysis of catastrophic

health insurance as an alternative to the medical expense

deduction. For a more general analysis see Congressional

Budget Office, Catastrophic Health Insurance, Budget Issue

Paper (January 1977).

20. See the following bills that were introduced in the first

session of the 96th Congress: "Catastrophic Health Insurance

43
A catastrophic health insurance program could cost several

times as much as the current medical expense deduction, in large

part because many more persons would be eligible for subsidies. *

Such a program would, however, cover many low- and moderate-income

households that do not now benefit from the deduction and cannot

qualify for direct assistance programs such as Medicaid and

Medicare. In addition, catastrophic health insurance would target

federal expenditures on a small but particularly important portion

of all medical outlays. Thus, a much higher percentage of catastrophic medical costs could be reimbursed than is now possible

with the medical expense deduction. Such a program would also

greatly improve the visibility of federal subsidies for extraordinary medical expenses.

One distinct problem with catastrophic health insurance—and

for that matter, with a generous tax credit for catastrophic

health expenditures—is that it could increase total medical

expenditures, whether the insurance was provided by the federal

government or by employers. Both approaches would reimburse all

or nearly all medical expenditures above the level established in

the legislation. Thus, neither patients nor health-care providers

would have much incentive to avoid unnecessary or marginally

valuable services once the specified level of expenditures was

reached. Another potential drawback is that revenue losses from

the employer exclusion (see Chapter II) would increase if the

system were created through mandatory employer-paid coverage.^2

Revenue losses from the exclusion would decrease, however, if

coverage resulted from a government-funded program, since

employers would not have to provide insurance against catastrophic

expenses through their own policies.

and Medical Assistance Reform Act," S. 350, introduced by

Senators Russell Long and Abraham Ribicoff; "Catastrophic

Health Insurance and Medicare Improvements Act of 1979," S.

748, introduced by Senators Robert Dole, John Danforth, and

Pete Domenici; and "A Bill to Amend the Social Security Act,"

S. 760, introduced by Senator Long.

21. See, for example, CBO, Catastrophic Health Insurance.

22. This approach might require low-wage firms to be subsidized

to prevent layoffs from occurring.

44
Perhaps the biggest effect catastrophic health insurance

would have on the deduction is that it would change the character

of the deduction. Under catastrophic health insurance, the

medical deduction would no longer serve as a tax offset for all

above-average out-of-pocket medical expenses. Instead, the deduction would subsidize only those expenses between 3 percent of

adjusted gross income and the level at which catastrophic health

insurance took effect. With catastrophic health insurance, the

medical deduction would become something of a supplementary health

insurance plan, providing more limited support for expenditures

too low to qualify as catastrophic but high enough to exceed what

is considered a normal level of outlays. Thus, the role of the

deduction as a supplement to health insurance coverage might

become more evident if catastrophic health insurance were introduced.

45

CHAPTER IV. TAX-EXEMPT FINANCING FOR PRIVATE HOSPITAL PROJECTS

The third major tax expenditure for health care results

from the use of tax-exempt bonds to finance capital projects

undertaken by hospitals and other private medical institutions.

These bonds are commonly issued by state or local development

authorities on behalf of public or private institutions serving

designated functions. Thus, they are to a considerable extent

subject to state or local government control, although they

create federal revenue losses and are subject to some federal

restrictions. Under Section 103 of the Internal Revenue Code,

tax-exempt bonds may be issued for tax-exempt hospitals to cover

the cost of construction, remodeling, and other capital

projects. Proprietary (for-profit) hospitals may also benefit

from tax-exempt bonds under the so-called "small issue"

exemption in Section 103 for industrial revenue bonds. In

fiscal year 1980, these bonds could cost the federal treasury

about $400 million in foregone revenues.^

1. See, for example, Internal Revenue Code Section 103.

2. This revenue estimate should be regarded as tentative,

because it relies heavily on five assumptions. First, more

than $15.4 billion in tax-exempt hospital bonds are expected

to be outstanding by 1980 based on estimates of bond issues

and refundings from 1971 (the first year these bonds were

issued in any significant volume) through the third quarter

of 1979. Second, tax-exempt financing is assumed to generate no additional capital spending by hospitals (if additional spending is generated, the revenue loss would be

higher). Third, tax-exempt financing is assumed to displace

primarily taxable financing from other sources rather than

consumption, saving, or other tax-exempt financing. This

displacement of taxable issues results from a chain reaction

among investors in which each investor moves down a rung on

a ladder of securities ranging from fully taxed at the top

to tax-exempt. The net result is equivalent to having taxexempt issues displace fully taxable ones in the market,

even though no individual investor moves directly from tax47
Although tax-exempt hospital bonds do not result in so

large a tax expenditure as the medical expense deduction or the

employer exclusion, they are important because of their role in

financing hospital construction. Between 1976 and 1978, these

bonds provided between one-third and one-half of all funds for

hospital construction in the United States. In 1979, more than

half the funding for construction could come from tax-exempt

bonds (see Table 7).^ Studies also indicate that tax-exempt

bonds are important in financing construction at private, as

well as public, hospitals. An annual survey of hospital construction activities by the American Hospital Association, for

example, indicated that, among responding hospitals, tax-exempt

bonds funded 47.5 percent of all construction at short-term nonfederal hospitals and 49.2 percent of the construction undertaken at short-term private not-for-profit hospitals during

1977.^ These levels all represent a sharp increase from the

proportion of funds provided by tax-exempt bonds before 1975.

exempt: to fully taxable investments. The fourth assumption

is that the interest rate on displaced taxable investments

averages 9 percent. This is probably a conservative estimate, given current market rates on commercial loans and

high-grade corporate bonds. Finally, the marginal tax rate

of the average net purchaser of tax-exempt securities is

assumed to equal 30 percent, based on Treasury Department

studies.

If 95 percent of the financing displaced by tax-exempt bonds

is taxable and the remaining sum is tax-exempt, these

assumptions imply that the annual revenue loss to the

federal government from tax-exempt hospital bonds would be

about $395 million ($15.4 billion x 0.95 x 0.30 x 0.09 =

$395.3 million.) The revenue loss would increase further

with the issuance of additional tax-exempt hospital bonds

during 1980.

3. See also Hospital Financing Study Group and IGF, Inc.,

"Recent Trends in Financing Health Facility Construction,"

August 1978.

4. See "Sources of Funding for Construction," Hospitals, vol.

53 (February 16, 1979), pp. 63-71, reprinted in AHA Research

Capsule No. 29.

48
TABLE 7. TAX-EXEMPT BONDS AS A SHARE OF TOTAL HOSPITAL CONSTRUCTION FUNDING, 1971-1979, IN MILLIONS OF DOLLARS

Volume of

Tax-Exempt

Hospital

Year Bonds Issued3

1971

1972

1973

1974

1975

1976

1977

1978C

1979

SOURCES:

262.0

525.0

610.6

1,282.4

1,959.0

2,725.6

4,731.5

3,121.8

3,153.5d

Volume of

Net

Net Proceeds as

Proceeds

a Percent

Bonds Net Used for of all

of Refund- Hospital Hospital

ings Construction^3 Construction

262.0

525.0

610.6

1,282.4

1,861.1

2,453.4

2,971.4

2,338.7

3,106.7d

222.7

446.2

519.0

1,090.0

1,581.9

2,085.0

2,525.7

1,987.9

2,640.7d

The Bond Buyer; ICF, Incorporated; Hospital

Study Group; American

Bureau of the Census,

New Construction Put

C 307 8-5 (May 1978) and

Hospital Association;

Construction Reports,

5.8

10.7

12.5

24.5

31.9

39.5

50.3

38.5

52. Oe

Financing

and U.S.

Volume of

in Place, Series C30, Nos.

C30-79-8 (August 1979)•

a. Excludes some small issues not reported by The Bond Buyer*

b. Funds available after excluding refinancing issues and

assumed non-construction uses of funds. ICF, Inc. estimates

that, on average, only about 85 percent of all tax-exempt

bond proceeds are available for construction purposes.

c. Includes some issues for nursing homes.

d. Annual estimate based on first nine months.

e. Estimate based on projections of annual construction for the

first eight months of 1979.

49
The History of Federal Subsidies for Hospital Construction

The large increase in the proportion of funds provided by

tax-exempt bonds has coincided with a substantial reduction in

direct federal government subsidies since the mid-1970s. Before

1974, direct expenditure programs were far more important than

tax-exempt bonds in financing hospital projects, because large

subsidies were available through the Hill-Burton program for

hospital construction.^ In 1974, however, the authority for

funding loans, grants, and loan guarantee projects was shifted

to a new program, created in Title XVI of the Public Health

Service Act, by the passage of the National Health Planning and

Resources Development Act (Public Law 93-641). This legislation imposed tight new restrictions on the development of new

hospital facilities, in part because of a belief that existing

federal programs had promoted inflation in the health-care

sector.'

The use of funds under the Title XVI program has been

limited by the failure of states to satisfy the health-planning

requirements set out in Title XV of the act and by the failure

of the Department of Health, Education, and Welfare (HEW) to

issue final regulations. In addition, Congressional funding for

the entire Title XVI program, including projects at state and

local government hospitals, has been limited to an increase in

federal loan authority of $250 million in 1977, none of which

had been allocated as of September 1979. At present, loans and

grants are being made primarily to allow medical facilities to

5. The Hill-Burton program, established in 1946, provided

significant subsidies for constructing hospitals in many

parts of the United States where hospital facilities were

limited.

6. For a detailed analysis of this act, see Kay Cavalier, "The

National Health Planning and Resources Development Act—Summary of Existing Law and Its Implementation," Congressional

Research Service, No. 77-50 ED. (1977).

7. See the National Health Planning and Resource Development

Act, P.L. 93-641, Section 2(a)(2), 42 U.S.C. §300K (a)(2)

(1975),

50
correct safety hazards and to avoid noncompliance with licensing

or accreditation requirements. Most other payments are limited

to developing facilities for ambulatory patient care and to converting inpatient facilities to outpatient use.

The one direct federal expenditure subsidy for general

hospital construction now readily available is the provision of

mortgage insurance through the Section 242 program administered

by the Department of Housing and Urban Development (HUD). (At

the time of publication of this paper, however, very few

hospitals were taking advantage of the financing available under

Section 242.) Hospitals in rural areas (places with populations

under 10,000) with no other sources of funds can obtain

low-interest, long-term loans through the Farmers Home

Administration (FmHA) of the Department of Agriculture. In

addition, the Appalachian Regional Commission and the Department

of Commerce's Economic Development Administration (EDA) will

provide limited subsidies to medical institutions in areas that

qualify for assistance from these agencies. Apart from these

programs, however, most direct federal subsidies for medical

capital projects have been eliminated. Thus, tax-exempt bonds

have become the major largely unrestricted government program

for subsidizing capital projects at private hospitals and

medical facilities.

LEGISLATIVE HISTORY AND MECHANICS

Before 1968, any hospital project in the United States

could theoretically use tax-exempt bonds to finance capital projects, because the tax code did not prohibit the use of industrial development bonds for nonexempt, for-profit institutions

and organizations. Before that year, any hospital that successfully applied to a state or local industrial development bond

(IDB) authority empowered to issue hospital bonds could have

tax-exempt bonds issued on its behalf. In addition, in states

where IDB authorities did not exist, or where they were not permitted to issue bonds for hospital projects, tax-exempt hospitals could, in theory, issue these securities themselves if they

complied with the requirements of IRS Revenue Ruling 63-20.

This ruling allowed institutions to issue tax-free bonds "on

behalf of" state or local governments if title to the financed

51
project would pass to a state or local government upon

completion of the project and if certain other conditions were

met.8

In 1968, the rules regarding tax-exempt bonds were changed

by the addition of Section 103(b) to the Internal Revenue Code.

Under this provision, taxable institutions, which include proprietary medical institutions, were prohibited from issuing more

than $5 million in tax-exempt bonds during any six-year period.

No new restrictions, however, were imposed on the use of taxfree bonds by tax-exempt hospitals.

Under current law, not-for-profit hospitals thus have a

variety of ways to obtain tax-exempt financing for projects.

Using sections 103(a) and (b) of the Internal Revenue Code and

Revenue Ruling 63-20, these hospitals may still issue bonds

themselves, "on behalf of" state and local governments, according to the terms stated above. In at least 47 states, however,

state or local government tax-exempt financing authorities are

authorized to issue tax-exempt bonds for private hospitals. *-®

8. See Revenue Ruling 63-20, IRS Cumulative Bulletin, 1963,

vol. 1, p. 24.

9. See Section 103(b)(6). The $5 million limit was increased

to $10 million by the Revenue Act of 1978.

10. As of November 1979, only two states—Alaska and Hawaii—

did not have statutes authorizing this type of financing.

In Missouri, however, this type of financing was withheld

until recently because the statute authorizing it had been

challenged as unconstitutional. The statute has since been

upheld, and bonds were issued earlier this year. The state

of Washington statute for hospital bond financing has been

under similar attack; that case, however, had not yet been

decided when this paper was published. Sources for the

above information: Blyth, Eastman, Dillon Health Care

Funding, Inc., "A Brief Introduction to Health Care Capital

Financing Alternatives," paper presented at the National

Health Policy Forum, September 11, 1978; and conversations

with bond financing staff at Kidder-Peabody, Inc. and staff

at The Bond Buyer.

52
This option, which avoids the need to place title in a state or

local government, is now the predominant form in which

tax-exempt hospital bonds are issued. For proprietary

hospitals, tax-exempt financing is limited to small issues not

exceeding $10 million. Thus, tax-exempt bonds are available

primarily for use by tax-exempt, nonprofit institutions.

ANALYSIS

Are Federal Subsidies for Hospital Construction Needed Under

Present Conditions?

In analyzing tax-exempt hospital bonds, a critical question

is whether federal subsidies for hospital construction are still

needed. In the past, government subsidies to private, not-forprofit hospitals have been justified because of a shortage of

hospital beds in many parts of the United States, particularly

rural areas. A growing number of researchers, however, have

come to believe that the United States now has an excess of

hospital beds. Several studies have appeared arguing that

hospital bed occupancy levels, which have averaged 75 percent

for the nation as a whole during recent years, could generally

be raised to 80 or 85 percent without lowering the quality of

medical care. ^ There is also information to suggest that

current hospital utilization is excessive, implying that hospital bed capacity could be reduced still further without

impairing the quality of care. Established HMOs, for example,

generally use 30 to 50 percent fewer hospital days and only half

the number of hospital beds as do fee-for-sevice providers for

similar groups of patients. ^ In addition, many researchers

have found that areas with more hospital beds per capita have

11. See, for example, Walter McClure, Reducing Excess Hospital

Capacity (Excelsior, Minn.: InterStudy, October 1976); and

National Academy of Sciences, Institute of Medicine,

Controlling the Supply of Hospital Beds (Washington:

October 1976).

12. See McClure, Reducing Excess Hospital Capacity*

53
higher rates of hospital utilization,^ suggesting that the

supply of hospital beds to some extent creates its own demand.

Although many parts of the United States are considered

deficient in health care resources, most recent studies have

identified shortages of medical personnel—doctors and nurses—

as the reason.-^ Thus, the consensus of available research

would suggest that the United States as a whole has an excess of

hospital beds. Individual areas, however, may well have shortages of hospital beds or other capital equipment. Current

health-planning regulations would allow subsidies to be targeted

to hospitals in these areas, since the regulations require virtually all hospital projects to undergo review before being

built.^ There is some question, however, whether these rules

are working in the desired way. This issue will be discussed

further in the next section.

Special Problems with Tax-Exempt Bonds as a Subsidy

Although hospital subsidies in general have been questioned

because of the number of unoccupied hospital beds, the current

tax-exempt bond provisions have some special difficulties as a

way of subsidizing hospital projects. Some of these difficulties deserve particular mention.

13. McClure, Reducing Excess Hospital Capacity, contains a

review of the liteature on this subject.

14. See General Accounting Office, "Progress and Problems in

Improving the Availability of Primary Care Providers in

Underserved Areas," HRD 77-135, August 22, 1978; U.S.

Department of Health, Education, and Welfare, Report to the

Congress on the Status of Health Professions Research in

the United States, HRA 78-93, (August 1978); and Institute

of Medicine, Manpower Policy for Primary Health Care

(National Academy of Sciences, May 1978).

15. For a discussion of recent trends in federal health planning activities, see Cavalier, "National Health Planning

and Resources Development Act," and Congresssional Research

Service, "Health Planning Amendments," Issue Brief No.

IB78010 (1977).

54
High Cost of Delivering Funds to Hospitals* Tax-exempt

bonds are sometimes considered an efficient way of delivering

funds to hospitals because financing can often be arranged much

more quickly than would be possible if hospitals had to apply

directly to a federal agency for support. These savings in

time, however, come at a price: a much smaller percentage of

the total subsidy goes to the intended beneficiaries—hospitals. Most studies of tax-exempt bonds show that the federal

government loses more in tax revenues than the issuing institutions receive in interest savings. Most of the difference

accrues to bond purchasers, who receive a higher yield on taxexempt issues than they need to be willing to purchase the

bonds. (The extra yield arises because the interest rate for

tax-free bonds is set by the marginal bond buyer who, as a rule,

is in a lower tax bracket and thus requires a higher yield than

other purchasers to find tax-free bonds attractive.) The

remaining difference goes to compensate bond underwriters,

lawyers, and others (including state bond-issuing authorities)

whose services are needed to arrange for tax-exempt financing.

Although no estimates of the difference between interest rate

savings and federal revenue losses are available specifically

for tax-exempt hospital bonds, estimates for tax-exempt bonds in

general put the excess at 25 to 50 percent of total revenue

losses.1° This amount is far more than the approximately 2 to 3

percent of all funds allocated to administrative costs under the

Hill-Burton program during 1969 and 1970, the last two years of

extensive loan guarantee activities. *•'

16. The Senate Budget Committee estimates that it costs the

federal government $1 to provide 75$ of interest savings to

institutions issuing tax-exempt bonds. See Senate Budget

Committee, Tax Expenditures, 95th Cong., 2nd Sess., 1978,

p. 182. Other analysts report higher estimates of the lost

subsidy. George F. Break and Joseph A. Pechman, in Federal

Tax Reform; The Impossible Dream? (Brookings Institution,

1975), p. 54, estimate the differential between revenue

losses and interest savings at 25 to 30 percent. Richard

Goode, in The Individual Income Tax, revised ed. (Brookings

Institution, 1976), p. 136, suggests that the differential

may run from 33 to 50 percent of all revenue losses.

17. See Appendix to the Budget of the United States Government,

1971, p. 386, and 1972, p. 402.

55
Difficulty of Targeting Funds to Needed Projects* A second

problem with tax-exempt bonds is that the savings they yield are

hard to target on needed projects. On the one hand, tax-exempt

funds are available only to hospitals that can sell tax-exempt

bonds. This restriction prevents subsidizing some worthy projects, because hospitals with a large proportion of uninsured,

low-income patients often have trouble selling bonds. On the

other hand, tax-exempt bonds can be used to finance projects

that, objectively, may be unnecessary. All states, in accordance with the Health Planning and Resources Development Act,

have extensive health-planning systems, and hospital projects

cannot be begun without state-issued certificates of need.

These regulatory mechanisms, however, appear to have important

weaknesses,. In some states, for example, planning agencies are

dominated by industry representatives, and some have been overruled by the actions of the state legislature. •*•" Moreover,

according to several studies, the certificate-of-need program

has not lowered costs or restrained the growth of hospital

capital projects, although there has been some decrease in construction of new beds and an offsetting rise in other capital

expenditures.^ These findings are not conclusive, but since

the certificate-of-need process is the primary means for preventing unnecessary hospital projects from receiving tax-exempt

financing, the evidence suggests that tax-exempt bonds may still

subsidize some projects of doubtful need.

Creation of Tax Inequities. A third problem with taxexempt bonds as a subsidy for hospital projects is that they

introduce distortions and inequities into the tax code. Because

tax-exempt bonds provide a way of sheltering income from tax,

18. See Elizabeth Wehr, "Health Planning Bills: Committees Back

Off, Decide Not to Force Hospital Closings Now," Congressional Quarterly, June 17, 1978, pp. 1540-1543.

19. See David S. Salkever and Thomas W. Bice, Hospital Certificate-of-Need Controls (Washington, D.C.: American Enterprise Institute for Public Policy Research, 1979), especially Chap. 4. See also Frank Sloan and Bruce Steinwald,

"Effects of Regulation on Hospital Cost and Input Use,"

paper presented at the Annual Meeting of the American

Economic Association, Chicago, Illinois, August 29, 1978.

56
their use enables taxpayers with equal incomes to pay different

amounts of income tax. Tax-exempt bonds also reduce the

progressivity of the income tax, because tax savings rise with

taxpayer income, and tax-exempt bondholdings among individuals

are concentrated among taxpayers with high incomes.

Low Visibility and Controllability of Expenditures. A

fourth problem with tax-exempt bonds is that, as with the

employer exclusion and the medical expense deduction, the

expenditures they create have low visibility and controllability. As tax expenditures, revenue losses from tax-exempt bonds

have low visibility, because they do not appear in budgetary

outlay totals. Moreover, because the tax savings result from a

permanent part of the tax code, revenue losses from tax-exempt

bonds do not require formal Congressional approval each year and

are thus uncontrollable.

Other Considerations

Tax-exempt bonds provide federal subsidies without requiring hospitals to submit plans for federal review and possible

disapproval. To qualify for tax-exempt financing, however, the

projects generally require the approval of several state and

local authorities. In addition, federal health planning regulations require most projects to qualify for a certificate-of-need

from the relevant state health planning and development agency

(SHPDA).20 Thus, hospitals using tax-exempt financing face not

an absence of red tape, but a different set of hurdles for

receiving federal subsidies. Many financial analysts, however,

believe that these obstacles can be circumvented more quickly

than would be the case with a direct expenditure program to

subsidize hospital construction.

Another point to consider in evaluating tax-exempt hospital

bonds is their effect on total medical spending. Tax-exempt

bonds are often thought to reduce medical costs by allowing

20. For an explanation of the certificate-of-need program, see

Cavalier, "National Health Planning and Resources Development Act," pp. 23-24. Note, however, that some states have

since revised their certificate-of-need statutes to comply

with the standards set forth by HEW.

57
institutions to finance capital projects at below-market

interest rates. They can, however, also raise medical spending

in certain situations. If construction subsidies lead to new

facilities or equipment, for example, the resulting increase in

resources may generate more and longer hospital stays and

greater use of medical services.21 Expenditures can also increase if the subsidies provided are too small to offset the

higher cost of new construction.

Whatever upward effects tax-exempt bonds have on total

medical spending probably result in large part from the role of

third-party payments in financing hospital care. As discussed

in Chapter II, third-party payers (government assistance programs, private insurance companies, and philanthropies) altogether finance more than 90 percent of all hospital costs, and a

very large proportion of these payors provide full or nearly

full coverage for hospital charges.^2 xhis method of reimbursement assures that cost-increasing capital projects can be financed. Thus, it gives hospitals no incentive to avoid capital

projects that increase average costs. In other markets, where

insurance is not as prevalent, the resulting rise in prices and

loss of customers would tend to limit costly capital projects.

In the hospital sector, where insurance coverage is widespread,

the same incentives to avoid cost-increasing developments do not

occur.

POLICY OPTIONS FOR TAX-EXEMPT HOSPITAL BONDS

The Congress has many choices with respect to tax-exempt

hospital bonds. Three options are explored here: maintaining

21. This phenomenon—the tendency of increased supply to stimulate use—is sometimes called the "Roemer effect" in the

health-care literature. See Milton I. Roemer, "Bed Supply

and Hospital Utilization: A Natural Experiment," Hospitals, vol. 35 (November 1, 1961), pp. 36-42.

22. In calendar year 1978, third-party payers contributed about

90 percent of all hospital costs. See Robert M. Gibson,

"National Health Expenditures, 1978," Health Care Financing

Review, vol. 1 (Summer 1979), p. 8.

58
existing law, eliminating the use of tax-exempt bonds for

hospital projects, and continuing to allow tax-exempt hospital

bonds to be issued but requiring that they be so-called "general

obligation" issues of the governmental unit issuing them.

Maintaining Current Law

Maintaining current law would preserve the existing tax

subsidy for hospital construction. This subsidy, as indicated

earlier, is relatively free from burdensome federal rules and

restrictions. In particular, it avoids the need to obtain advance approval of the subsidy from a federal agency. Costly and

time-consuming delays are thus minimized.

Maintaining current law does have certain disadvantages.

Present shortcomings in health-planning activities make it hard

to target the subsidy on worthwhile projects. At the same time,

some hospitals cannot benefit from the subsidy because their

patient mix gives them a poor credit rating. Another problem

with the bonds is that they create inequities in tax treatment

between similarly situated persons and give rise to relatively

inefficient subsidies with little visibility and no control on

actual expenditures.

The first of these problems—poor targeting—could be

relieved by improving the effectiveness of the current health

planning process. The second set of problems cannot be remedied

so easily. This last set of problems applies equally to all

tax-exempt bond subsidies, however. Thus, they would not justify singling out tax-exempt hospital bonds for special limitations unless the Congress feels that federal subsidies for hospital construction should be curtailed.

Eliminating Tax-Exempt Bonds for Hospital Projects

Eliminating the use of tax-exempt bonds for hospital

projects would make tax policy more consistent with direct

expenditure programs for hospital construction, which have been

cut back sharply in recent years. This approach would reduce

revenue losses and remove the incentive provided by tax-exempt

financing for further additions to the nation's hospital capacity. In addition, it would reduce the number of opportunities

for sheltering income from tax. Doing away with tax-exempt

bonds for hospital construction might also lower interest costs

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to state and local governments for public projects, because

hospital bonds would not be adding to the supply of tax-exempt

issues.^ Eliminating tax-exempt financing could thus reduce,

albeit very slightly, the cost of building schools, highways,

and sewer facilities.

One problem with eliminating tax-exempt hospital bonds altogether is that few other sources of subsidized funds exist for

hospitals with genuine need for new facilities. As indicated

earlier, direct federal subsidies for capital projects at private hospitals are largely unavailable. The only exceptions are

the Section 242 mortgage insurance program run by HUD and the

more specialized programs for hospitals in areas that qualify

for EDA, FmHA, and regional agency assistance. To reestablish

direct expenditure subsidies for private general hospitals, HEW

would have to issue regulations for implementing the subsidy

program under Title XVI of the Public Health Service Act, and

states without health-facilities plans would have to develop

them. Neither of these actions seems imminent, although a

number of states have prepared health-facilities plans during

the last year. Direct expenditure subsidies could also be provided if the standards for providing them under Title XVI were

modified. Modifying these rules, however, could undermine the

incentives for states to limit the growth of hospital facilities

through health planning—a move many health experts would

oppose.24 Thus, without further activity by HEW and the states,

eliminating tax-exempt hospital bonds could remove the last

major source of federal subsidies for private general hospitals.

23. See George E. Peterson, "Tax-Exempt Financing of Housing

Investment: Capital Market Impacts and Costs to the

Treasury" (The Urban Institute, 1978), p. 18. Peterson has

estimated that, for additional amounts of tax-exempt bonds

up to about $10 billion, each $1 billion of tax-exempt

bonds raises the interest rate for tax-exempt issues in

general by 0.04 to 0.07 percentage points.

24. See Linda Demkovich, "Health Planning Agencies Face Threat

from Deregulators," National Journal, vol. 11 (April 28,

1979) pp. 687-90; and Elizabeth Wehr, "Controversy Downplayed as Health Planning Law Comes Up for Renewal," Congressional Quarterly, vol. 37 (March 24, 1979), pp. 521-23,

538.

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Limiting Tax-Exempt Hospital Bonds to General Obligation Issues

If the Congress wants to retain tax-exempt financing but

improve its targeting toward hospital projects, one option would

be to limit tax exemption to bonds that are general obligations

of the issuing government—meaning they are backed by that

government's full faith and credit.

At present, most tax-exempt hospital bonds are revenue

bonds, meaning that hospital revenues are the only security for

the payment of principal and interest.25 Because state and

local governments bear no financial responsibility for the

issues, they have no incentive to limit them. Thus, the number

of hospital issues is controlled largely by the market for taxexempt bonds and by the ability of state health planning

agencies to screen out "unnecessary" capital projects. As

indicated earlier, the past effects of these agencies have not

been great.26

If hospital bonds were general obligation issues, the

number of hospitals receiving such tax-exempt funding would

probably decrease. Bond markets tend to limit the amount of

money a state or local agency can borrow on its own behalf.

Thus, making hospital bonds general obligation issues would

force them to compete with other public projects for a limited

supply of government-backed, tax-exempt funding. Under these

circumstances, state and local governments would probably scrutinize hospital projects more carefully and grant funding for

fewer projects. This reduction, in turn, might decrease the

number and size of private hospital projects. Ultimately, the

effect of this approach could be to encourage the use of taxexempt hospital financing only for projects with the greatest

apparent public benefits. At the same time, it would maintain

25. According to figures compiled from The Daily Bond Buyer by

Kidder-Peabody, Inc., less than 20 percent of the taxexempt hospital bonds issued in the last three years (1976

through 1978) were general obligation bonds.

26. See Salkever and Bice, Hospital Certificate-of-Need Controls; and Sloan and Steinwald, "Effects of Regulation on

Hospital Costs and Input Use."

61
the availability of tax-exempt financing for private hospital

projects.

Limiting tax-exempt hospital bonds to general obligation

issues would have certain drawbacks. For example, competition

among projects may not always mean that the most worthwhile

project will receive the funds. Bond-issuing authorities are

political entities, and the criteria used to select projects

will not necessarily coincide with objective standards of need.

In addition, jurisdictions that normally receive especially high

ratings for their general obligation bonds will be given an

artificial advantage in the competition for funds, even though

the hospital projects being financed may not be as necessary and

as financially sound as those from weaker jurisdictions.

Another problem with this option is that many states have

statutory or constitutional prohibitions against using state

debt-issuing authority for private-sector projects. Other

states authorize their tax-exempt bond authorities to issue

revenue bonds for hospital projects, but not general obligation

bonds. In all these states, limiting the use of tax-exempt

hospital bonds to general obligation issues would preclude

hospitals from obtaining tax-exempt financing. If this option

were chosen, therefore, it would probably be desirable to delay

the effective date for a few years after enactment. This would

give states time to reconsider existing prohibitions against

providing government backing for capital projects at private

hospitals and to modify these restrictions if they so desired.

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U.S. GOVERNMENT PRINTING OFFICE : 1980 0 - 61-467