Tax Expenditures for Health Care 

Eugene Steuerle * 

Ronald Hoffman 

U.S. Treasury Department 

OTA Paper 38 April 1979 

OTA Papers are circulated so that the preliminary findings of 

tax research conducted by Staff members and others associated 

with the Office of Tax Analysis may reach a wider audience. 

The views expressed are those of the authors, and do not 

reflect Treasury policy. Comments are invited, but OTA 

Papers should not be quoted without permission from the 

authors. Managing editors are Michael Kaufman and Gary

Robbins . 

Office of Tax Analysis

U.S. Treasury Department, Room 1104 

Washington, D.C. 20220 

Issued: April 1979 

* The authors are members of the Office of Tax Analysis and 

Office of the Assistant Secretary for Economic Policy, respectively. They are indebted to Charles Clotfelter, 

Joshua Greene, Clark Havighurst, Michael Kaufman, , Bridger

Mitchell, Benjamin Okner, Charles Phelps, Floyd Reeves, and 

Emil Sunley for their helpful. comments and to Amie Powell for 

her assistance in the preparation of the manuscript. 
TABLE OF CONTENTS 

I. 1 

11. HISTORY OF MEDICAL EXCLUSIONS AND DEDUCTIONS e.. 4 

.t 

IV. DISTRIBUTION OF TAX EXPENDITURES BY INCOME 

CLASS e.....................................oeee 16 

V. EFFECT OF TAX EXPENDITURES FOR HEALTH ON THE 

DEMAND AND PRICE OF MEDICAL CARE ............... 20 

VI. POLICY ALTERNATIVES ............................ 27 

VII. CONCLUSION ......................~..........oeeo 39 
TAX EXPENDITURES FOR HEALTH CARE 

I. INTRODUCTION 

Because of the renewed interest in proposals to provide 

for National Health Insurance, and because of increased 

concern over the rising cost of medical care to both 

individuals and the government, much recent. research has 

focused on equity and efficiency aspects of direct 

expenditure programs to provide medical care. Yet the 

Federal Government also helps individuals finance the 

purchase of medical aare through substantial tax subsidies. 

Over $11 billion of Federal income tax expenditures are 

provided currently through’ the exclusion or deduction from 

the income tax base of payments for certain medical expenses, 

including premiums for insurance. L/ These tax expenditures 

are the principal programs of government assistance for the 

purchase of medical care by the non-aged, non-poor 

population. 

-1/ This paper does not treat other indirect tax subsidies 

such as deductions for charitable contributions to health or 

medical institutions, tax exemption of interest on hospital

bonds, expensing of removal of architectural and transportation barriers to the handicapped, and the non-taxability of 

social security and public assistance payments for medical 

car e. 
-2-

Specifically, the tax system subsidizes the purchase of 

medical care by means of provisions permitting (1) employer 

contributions for health insurance premiums or other medical 

payments for employees to be excluded from taxable income: -2/ 

and (2) certain medical expenses to be deducted from adjusted 

gross income on individual income tax returns. In general, 

payments by employers for medical insurance or other medical 

care of employees are deducted as a cost of.businese; at the 

same time, these payments are excludable from the gross 

income of employees. In addition, individuals are allowed 

itemized deductions for 50 percent of the amount paid for 

health insurance premiums, up to a maximum of $150, and for 

other medical care expenses (including the remaining amount 

of health insurance premiums) which exceed three percent of 

the taxpayer's adjusted gross income (AGI). Expenditures for 

drugs and medicines may be counted in this three percent 

floor only to the extent that they separately exceed one 

percent of AGI. 

This paper will examine these tax expenditures, their 

impact on the Federal budget and their effects on price and 

demand for medical care. Section I1 provides a brief history 

--is paper, the terms "exclusiontt or "employee 

exclusion" will be used as an abbreviated reference to the 

exclusion from taxation by employees of employer

contributions to health plans. 
-3-

of tax law changes leading to the present exclusion and 

deduction. Section I11 presents estimates of revenue loss 

from these tax expenditures and some evidence on their 

increasing cost over time. Section IV then analyzes the 

distributional impact of these expenditures. Effects of the .. 

taxation of medical expenditures on the demand and price of 

medical care are discussed in Section V, while some policy 

alternatives are detailed in Section VL. Fhally, a summary 

is contained in Section VlI. 
-- 

-4-

11. HISTORY OF MEDICAL FXCLPSJONS AND PEPUCTTONS 

Although the exclusion from individual income taxation 

of payments to employer-provided group plans has existed 

effectively since the adoptian of the income tax, the rationale for that exemption has varied over time. At first, most 

fringe benefits of employees were not taxed non-cash compensation was not widely recognized as incqme. Of course, 

before World War 11, the income tax did not affect the majority of workers, and assignment Of value of fringe benefits 

would have served little purpose in the case of non-taxable 

workers. Moreover, a few decades ago, benefit payments under 

group health insurance were much smaller relative to income, 

both because a smaller proportion of income was spent on 

medical care and because more private payments were made by 

individuals or through individual, rather than group, policies. Internal Revenue Service rulings 3/ eventually L 

supported the exclusion by declaring that the premiums paid 

by an employer to a group insurance medical policy were not 

taxable to the employee. 

In later years, however, it came be to recognized that 

in-kind compensation was a form of wages which could be 

-3/ Special Ruling, October 26, 1943, 433CCH, Federal Tax 

Service par. 6587. 
-5-

subject to tax. By 1953, IRS rulings had become somewhat 

inconsistent. While employer payments on group policies 

remained nontaxable to employees, employer-paid premiums on 

individual policies were deemed to be income subject to tax. 

-4/ In the 1954 Code, Congress decided to make the exclusion 

uniform, and all contributions to accident or health 

insurance plans have since been allowed an exclusion from 

income by the employee. 

The tax treatment of medical expenses paid by individuals (rather than by employers) has evolved differently. No 

deduction for medical expenses existed until 1942. During 

World War 11, substantial numbers of citizens were brought 

under the income tax and t'ax burdens were raised significantly; it was felt that some relief from this heavier tax burden 

should be granted to taxpayers with extraordinary medical 

expenses. Consequently, deductions were allowed for medical 

expenses exceeding five percent of net income, with a maximum 

deduction of $2,500 for families. The maximum deduction was 

raised several times and finally eliminated in 1965. 

Changes were also made in the five percent floor. The 

1951 Act and subsequent provisions effectively eliminated any 

floor for the medical expenses of the aged or for taxpayers 

-4/ Rev. RUl. 210, CB 1953-2, p. 114 

-1 
-6-

taking care of aged dependent parents. However, in 1965 the 

Social Security Amendments provided substantial amounts of 

medical care for the aged and at the same time required all 

taxpayers, including the aged, again to be subject to the 

same floor for itemized medical deductions. 5/ 

In 1954, another major change was made when the five 

percent floor (by now based on adjusted gross income) was 

lowered to three percent, and an additional one percent floor 

was applied to expenses for drugs before those expenses could 

be counted toward the overall three percent floor. A major 

justification for both actions was that deductions should be 

allowed for all "extraordinary" expenses. While a five 

percent floor was consider'ed too high to cover all 

extraordinary expenses, a one percent floor was considered 

necessary to exclude ordinary drug expenses. 

Besides the one percent floor on drugs, another separate 

calculation was required when the Social Security Amendments 

of 1965 allowed a deduction for part of the expenses of 

insurance policies without regard 'to the overall floor. -6/ 

-3/ The change was made effective beginning in 1967. 

-6/ A deduction was allowed for one-half of insurance 

premiums, not to exceed $150. Any remaining insurance 

premiums were to be subject to the three percent floor. 
-7-

The rationale for this allowance was that the normal 

deduction favored those who could self-ins,ure against 

variable expenses, while those who stabilized their outlays 

through purchase of insurance would be less likely to benefit 

from the deduction. 

In 1978, the Carter Administration proposed that medical 

and casualty losses be deductible only to the extent that, 

when combined, they exceeded ten percent of adjusted gross 

income. All medical expenses, including health insurance 

premiums and drug expenses would be subject to this same 

floor. Thus there would be no separate allowance for half of 

insurance premiums nor would there be a separate one percent 

floor for drugs. The House of Representatives accepted the 

simplification -aspects of this proposal, but the suggested 

ten percent floor was kept at three percent, and casualty 

losses were not folded into the medical deduction. The 

Senate rejected the House provision and no change was made in 

the final Act. -7/ 

, - 3 

While the floor for itemized 3medical'expenditures has 

declined to three percent and remained there fqr over two 

decades, the proportion of income spent on medical 

-7/ The Revenue Act of 1978. 
-8-

expenditures has risen. Table I shows health expenditures 

from 1950 to 1976 and compares this data to adjusted gross 

income of households. During this period, total health 

expenditures, both public and private, -8/ have risen from 5.9 

percent to 12.6 percent of ad.justed gross Income, -9/ while 

private expenditures have risen from 4.5 percent to around 7 

percent. What at one time may have been an extraordinary 

expenditure may now be only ordinary. Tn fact, this increase 

in percent of income spent on health expenditures was a major 

argument for the Carter Administration's proposal to increase 

the floor on combined medical and casualty deductions to ten 

percent. Other arguments related to the small percentage 

(about 25 percent) of taxpayers benefitting from the medical 

deduction, and to the simplification possible if fewer 

taxpayers were required to maintain medical records. 

Opponents of the change, on the other hand, argued that it 

would be unfair to raise the floor at a time when medical 

expenses were becoming move burdensome. Apparently, 

Congress, in maintaining the three percent floor, has shifted 

-

-est imates of total pub1 ic and pr ivate heai th 

expenditures, see Gibson and .Fisher (1978) 

-

9/ As a percent of GNP, health expenditures are about nine 

percent. 
-9-

Table 1 

ti ::Ad$~rted ti Health Rxpenditurer a8 

Year t: Health Expenditures I/ 8: Crorr 1: 1 Percentage of ACI 

t: Total Publ4.c t It Income It Total Public t 

a; and Private : Private :: (ACI) 2/:: rnd Privrte : Private 

(. .. ...$ b$~l$onr...... ..I 

1950 12.0 9.0 202.1 s. 9 4. s 

1955 17.3 12.9 273.9 6.3 4.7 

-1960 25.9 19.s 346.1 7.5 5.6 

1965 38.9 29.4 466.4 8.3 6.3 

1966 42.1 31.3

1967 47.9 32.0 

S08.9 

543..6 

8.3 

8.9 

6.2 

s. 9 

1968 53.8 33.7 595.6 9.0 5.7 

1969 60.6 37.7 644.7 9.4 5.8 

1970 69.2 43.8 677.3 10.2 6.5 

1971 77.2 48.4 

1972 86.7 53.2

1973 95.4 58.7

1974 106.3 64.8

1075 123.7 71.3

197G 141.0 80.8 

719.9 

793.2 

887.5 

963.1 

1,008.3 

1,118.7 

10.7 

10.9 

10.7 

11.0 

12.3 

12.6 

6.7 

6.7 

6.6 

6.7 

7.1 

7.2 

Office of the Secretary of the Trearury

Office of Tax Anrlyslr 

-1/ Health expenditure estimates are for fiscal years. Source: Gibson and 

Fisher ($9781. 

-2/ Source: U.S. Department of Commerce, Bureau of Economic Analysis. 
-10-

from a standard which allowed deductions for "extraordinary" 

expenditures to one in which deductions are allowed for 

expenses which are more than a "moderate" proportion of 

income. This shift makes the personal deduction more 

consistent with the employer exclusion in which all payments 

for medical expenses or insurance are non-taxable to the 

employee. 
-11- * 

111. REVENUE COST OF TAX EXPENDITURES FOR HEALTH: 1968 -

1979 

For fiscal 1979, Federal income tax expenditures for 

health care will be over $11 billion. Seventy-four percent 

of this total is for the employee exclusion of employer 

contributions, while 26 percent is for individual deductions. 

These tax expenditures cover about 5 percent of total public 

and private health care expenditures and about 9 percent of 

private expenditures. Like Medicare and Medicaid, these 

subsidies are non-taxable and are of even more value to 

individuals than an equivalent increase in before-tax income. 

The tax expenditure estimate of $11 billion relates to 

the Federal income tax alone. There is a further tax 

expenditure cost of about $2 billion to States with income 

taxes. In addition, social security tax revenues are reduced 

by about another $4 billion, although this revenue reduction 

does not properly constitute a tax expenditure. -10/ I n

total, Federal and State revenues are reduced by about $17 

billion because of these tax expenditures. 

-lo/ Since social security operates at least in part as an 

insurance scheme, the reduced taxes are reflected in reduced 

benefit payments later. 
-12-

Most workers currently benefit from the exclusion of 

employer payments. According to the latest data from the 

Social Security Administration (Yohalem, $975), in 1975 about 

58.2 million workers or 72 percent of all wage and salary 

workers, were covered by some type of health care insurance 

financed by employer-paid premiums. 

Treasury estimates show the Federal income tax 

expenditure cost of this exclusion to have grown from $1.1 

billion in 1968 to $8.3 billion in 1979, or at a rate of 

about 20 percent a year. (See Table 2). While changes in the 

Treasury method of estimation do not allow exact 

comparisons, there clearly was a sharp rise in lost revenue 

during these years. This rise can be traced primarily to two 

factors: (1) the increase in cost of medical insurance, and 

(2) the growth in use of nontaxable fringe benefits as a 

means 05 payment for work. The increased use of insurance 

may itself have led to increased costs of medical care, in 

turn raising the cost of medical insurance. And, although 

there may have been increased use of group insurance policies 

in abdence of the exclusion, there is little doubt that the 

exclusion acts as an incentive for workers and employers to 

receive their compensation in non-taxable health benefits 

rather than taxable wages. Since the government pays part of 

the cost through reduced tax collections, the employee faces 
-- -- 

-13-

a lower after-tax price �or his health insurance. The 

employer may also share in this benefit since he can provide 

an increase in after-tax compensation more cheaply through 

extra insurance than through direct wages. 

Compared to the exclusibn, fewer taxpayers benefit from 

the itemized deduction of medical expenses on individual 

income tax returns. Still, by 1978, 20 million tax returns 

are estimated to have claimed itemized deductions of $14.4 

billion for medical care expenses. The estimated revenue 

cost of this tax expenditure has grown from about $1.5 

billion in 1968 to $2.9 billion in 1979 or at a rate of about 

7 percent per year. This lower growth rate for the deduction 

as compared to the exclusion can be traced to two 

principal factors (besides changes in methods of estimation). 

First, the increased use of employer-provided insurance over 

these years has meant that a lower proportion of total 

medical expenditures were being paid out-of-pocket. Second, 

the size of the standard deduction (currently called the 

"zero bracket amount") has increased greatly during this 

period. For instance, for joint returns before 1970, the 

minimum amount of the standard deduction was $200, plus $100 

for each exemption -11/ (other than age and blindness). By 

-11/ Or, for certain taxpayers, the deduction equaled 10 

percent of adjusted gross income, if greater. 
-14-

1979, the minimum amount (and the maximum amount) of zero 

bracket amount (standard deduction) for joint returns had 

risen to $3,400, regardless of income, and the number of 

taxpayers itemizing deductions had fallen correspondingly. 
-15-

Table 2 

* 

Major Federal Income Tax Expenditures for Health Care 

($ millions) 

a 

Fiscal : Exclusion of Employer : 

Year : Contributions for Medical: 

.

: Insurance Premiums and : 

Medical Care' . 1979 8,255 

1978 7,105

1977 5,560 

1976 4,490 

1975 3,275 

1974 2,940 

1973 2,500

1972 2,000 

1971 1,450 

1970 1,450

1969 1,400 

1968 1,100 

Aver age Annual 

Growth Rate (20 %) ' 

Deductibility of : 

Medical Expenses on: Total 

Individual Income : 

Tax Returns 

2,890 11,145 

2,785 9,890 

2.t 556 8,116 

2,315 6,805 

2,315 5,590 

2,125 5,065 

1,900 4,400

1,900 3,900 

1,700 3,150 

1,700 3,150

1,600 3,000 

1,500 2,600 

'( 7 %) (13 %) 

-*/ Excludes deductibility of charitable contributions (health) , tax exemption of interest on hospital bonds, expensing of removal 

of architectural and transportation barriers to the handicapped, 

and non-taxability of social security and public assistance 

payments for medical care. 
-16-

IV DISTRIBUTION OF TAX EXPENDITURES BY INCOME CLASS 

Table 3 shows the latest Treasury estimates of the 

distribution among income classes of tax expenditures from 

the exclusion of employer payments for health care. The 

numbers are highly tentative and are based upon some simple 

assumptions about the distribution of employer-provided 

health insurance among employees. Because marginal tax rates 

are higher in higher income classes, a dollar of tax-free 

health insurance is worth more (i.e., the tax expenditure 

cost is greater) to taxpayers at higher income levels. Below 

tax-exempt levels of income, of course, there is no employee 

gain from the tax expenditure. 

' Table 3 

Distribution of Tax Expenditure for Employer

Payments for Health Care 

Fiscal Year 1977 

($000) . Tax xpen 1 ure ($ millions) 

0 - 5 $ 91 

5 - 10 49 4 

10 - 15 814 

15 - 20 1,028 

20 - 30 ' 1,547

30 - 50 882 

50 - 100 456 

100 - 200 178 

200 and over 70 

TOTAL $ 5,560 

Source: U.S. Treasury Department. Information is contained 

in a news release from Senator Muskie's Office, "Muskie News" 

(February, 1978), Appendix, p. 4. 
-17-

By using a 50,000 sample of individual tax returns and 

the Treasury Tax Model, the distribution of tax expenditure 

benefits can be determined with more detail and accuracy for 

itemized deductions. Table 4 demonstrates that the average 

tax expenditure per return with itemized medical deductions 

increases as income increases (column 9). This increase is 

the result of several factors, including higher marginal tax 

rates and greater medical expenditures at higher income 

levels. Moreover, if the average tax expenditure is 

calculated across all taxpayers in the income class, rather 

than just itemizers, the tax expenditure is still of greater 

expected value in higher income classes (column 6). 

It is somewhat surprising that the regressiveness of the 

deduction is not tempered more by the 3 percent floor which 

applies to most itemized medical expenses. A percentage 

floor decreases the probability that a high income person can 

itemize medical expenses in excess of the floor. For 

instance, a person with $20,000 of adjusted gross income can 

itemize expenses (subject to the floor) in excess of $600, 

while a person with $100,000 of adjusted gross income can 

itemize expenses only in excess of $3,000. However, while 

increases in income do reduce the probability of itemizing 

deductions in excess of the floor, the average deduction 

increases significantly in higher income classes (column 13) . 
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-- -- 

-19-

In fact, the increase is so large that the average deduction 

across all returns itemizers and nonitemizers alike 

still increases with income (column 5). This result may 

occur because of significant price and income elasticities of 

demand, a greater ability of high-income persons to actually 

pay off large medical bills, increased amounts of 

self-insurance as income rises, or a combination of all these 

factors. Whatever the cause, the effect of the medical 

deduction on tax liabilities is a regressive redistribution 

of tax burdens. -

12/

-12/ The liability effect is clearly regressive. However, 

the incidence effect may be different and can depend upon 

such factors as political feedbacks. See Buchanin and Pauly

(1970). 
-20-

V. EFFECT OF TAX EXPENDITURES FOR HEALTH ON THE DEMAND AND 

PRICE OF MEDICAL CARE 

Generally, employers are indifferent between a dollar 

paid in the form of a fringe benefit and a dollar paid as a 

cash wage. Both amount to a dollar of cost to the employer, 

and both are tax deductible as ordinary and necessary costs 

of doing business. 

However, to the employee, income paid in the form of 

cash wages is fully taxable, whereas income in the form of 

employer-paid health insurance premiums is exempted from 

Federal income tax, State income tax and social security tax. 

Thus, employees are inclined to accept a larger share of 

their compensation in the form of health insurance than they 

would if the income in-kind was taxable. As Section I11 

indicated, this has contributed to the growth in the use of 

the employer exclusion. 

Since the exclusion provision reduces the price 

employees must pay for health insurance, -

13/ it is also

likely to increase the demand for health insurance; improved 

-13/ A turther consequence of the exclusion is the inducement 

for groups to be employer based, rather than to form around 

other organizations. Employees with employer-based group

health insurance are often faced with the loss of their 

health insurance if they lose or change their job. Thus, 

these employees may be vulnerable to increase health 

insurance costs at a time when they can least afford it. 
-- 

-- 

-21-

insurance coverage in turn increases the demand for health 

care. Improved coverage may be reflected in a reduction of 

the deductible amount, a reduction of the coinsurance amount 

-14/ or inclusion of previously uncovered services. Since tax

rates are higher in higher income brackets, the price 

reduction and the price incentive to increase the quantity 

of services demanded increases with income. 

The effect of allowing itemized deductions for health 

care expenses may be analyzed along the same lines. The 

deduction for health insurance premiums has much the same 

effect as the exclusion: it reduces the after-tax price of 

health insurance or health care, and the reduction is of 

greater value at higher income levels. The major difference 

is that the exclusion is available regardless of whether the 

taxpayer itemizes deductions or takes the standard deduction, 

whereas the personal deduction for health insurance premiums 

must be itemized. For the majority of taxpayers who do not 

itemize, there is no price reduction. 

The requirement that medica1,expenses exceed three 

percent of AGI before qualifying as a deduction (except for 

50 percent of health insurance premiums up to $150) is 

- "coinsurance" or "copayment" amount is the 

percentage of the total bill (after any deductible that might

apply) which must be paid by the insured person. 
-22-

similar to a deductible clause in an insurance policy 

(Mitchell and Vogel, 1975) Customarily, private insurance 

deductibles are specified in dollar terms (e.g., $100 per 

year per family member) rather than as a percentage of 

income. Specifying the deductible as a percentage of income 

results in a higher deductible amount at higher income 

levels. Of course, the smaller the deductible, the larger 

the share paid by the government. 

According to Newhouse, et. al. (1974) a small deductible 

(e.g., between $50 and $100 per year, per family) should have 

little effect on the demand for hospitalization; i.e., the 

effect of insurance would 'be about the same with or without 

such a deductible. The cost of an average hospital stay cost 

was about $1,000 in 1975 (and has increased since then) and, 

thus, would easily exceed a small deductible. 

For ambulatory and other non-hospital services, however, 

a moderate size deductible is likely to influence demand 

markedly. As the authors point out, the median individual 

visits a physician about twice a year at a cost of about $40. 

At this level of cost, there is a good chance that the 

recipient of medical care would pay the cost out-of-pocket 

because the deductible would not be exceeded. 
-23-

While the three percent floor is roughly analogous to a 

deductible in an insurance policy, the exclusion of employer 

premiums and the deduction of all expenses above three 

percent are both analogous to a copayment rate. The marginal 

tax rate determines the proportion of the last dollar of 

medical expense paid by the government; thus, the copayment 

rate equals one minus the taxpayer's marginal tax rate. 

Again, the tax incentive for increased use .of medical 

services is greater the higher the taxpayer's taxable income. 

The exact effect of these tax subsidies on the overall 

demand for health services is thus based in large part upon 

the subsidy rate on marginal expenditures. As noted, on 

average the Federal income tax ,expenditures of about $11 

billion alone cover approximately 9 percent of total private 

expenditures for health care. At the margin, however, the 

reduction in price is much greater than 9 percent. The 

marginal price reduction is equal to the taxpayers' marginal 

tax rate -- about 22 percent for the average employee and 

about 25 percent for the average itemizer. If we also take 

into account State income taxes arid social security taxes, 

the price reduction climbs to about 29 percent .for itemizers 

and 35 percent for employees. -15/ Since demand is based 

-15/ This example assumes that the incidence of the employee portion of social security taxes falls on the employee,

while, for the employer portion, the incidence rests half on 

the employee and half on the employer. 
-24-

primarily upon marginal price, the impact of the tax expenditures upon the demand of medical services i6 greater than 

the price reduction averaged across all expenditures would 

indicate. 

Whether increased demand for medical services will 

actually lead to an increase in the quantity purchased will 

depend primarly upon the elasticities -16/ 0.f demand and

supply. In general, the more elastic either supply or 

demand, the more likely will the tax subsidy increase the 

amount of medical care provided in the economy. Often the 

demand for health care is viewed to be inelastic. However, 

elasticity at the margin maybe higher for controllable 

expenses or non-catastrophic events than for uncontrollable 

or catastrophic occurances. That is, demand for some minimal 

health care or insurance maybe inelastic, but the demand for 

additional health care or insurance may be much more elastic. 

Because tax subsidies act to increase the demand for 

medical care, they also tend to increase its market price. A 

subsidy creates a wedge between the market price received by 

-16/ The elasticity of demand (or supply) may be defined 

roughly as the tendency of demand (or supply) for medical 

goods to change as the price of those goods changes. More 

precisely, the elasticity of Y with respect to X is the 

percentage change in Y that accompanies a percentage change

in X. 
-25-

the seller and the net cost to the buyer. Increases in price 

result in the tax subsidy (or the wedge) being shared with 

the providers of medical care; thus, the greater the increase 

in market price, the less the tax subsidy reduces the net 

cost of medical care to taxpayers. 

Generally, the more inelastic the demand for medical 

care, the lower is the increase in market price as a 

proportion of the subsidy. On the other hand, to the extent 

that supply is inelastic, the opposite case holds: tax 

subsidies are reflected more in increases in price. 

Insurance complicates considerably the demand side of the 

medical marketplace. Phelps (1976b) argues that the demand 

for health insurance is relatively elastic (compared to most 

estimates of the demand for medical care). Tax subsidies 

then lead to increased insurance coverage, and increased 

coverage, in turn, leads to lower copayment rates on medical 

goods actually purchased. Newhouse (1978) suggests that, 

once a large proportion of the population faces trivially 

small copayment rates, the demand side of the market ceases 

to exert an independent restraint 'on the market, and medical 

care price changes, over time, are determined by events 

exogenous to normal market operations. 
-26-

In any case, while the tax subsidies may be intended to 

subsidize only the demanders of health care, in fact, both 

the demanders and providers are subsidized. To make matters 

worse, market price increases probably apply fairly uniformly 

to many types of purchase of medical care, while the value of 

the tax subsidies increases with the taxpayer's income. 

Thus, even if the tax subsidy results in a net price (after 

subsidy) decrease to the average taxpayer, -it may still 

result in a net price increase for low- and moderate-income 

taxpayers who receive only a small price subsidy. -17/ For

those who do not receive any subsidy, a net price increase is 

almost certain. 

17/ IA similar argument with respect to the exclusion from 

taxable income of net imputed rent of owner-occupied homes,

together with the personal deduction of mortgage interest and 

property taxes, has been made by Schreiber (1978). Homeowners with low marginal tax rates may actually pay higher

prices net of tax due to the existing tax deduction. 
-27-

VI. Policy Alternatives 

The tax treatment of medical expenses can be changed 

both directly by legal changes in the exclusion and 

deduction, and indirectly through changes in other health 

programs. This section discusses briefly some commonly 

proposed changes in health policy as they affect tax 

expenditures for health care. 

Limitation of the Exclusion of Employer Contributions. 

One commonly suggested policy alternative is to treat some or 

all employer contributions as income to employees. Revenue 

gain from such a change might then be available for direct 

Federal expenditures for medical care, e.g. , national health 

insurance. If employees include as income all employer 

payments for health care and insurance, some personal 

deduction might be maintained; in that case, the value of 

employer-prov ided health insurance and other employer 

payments for health care would be added to other personal 

medical expenditures and would be subject to the same 

limitation or floor (e.g., the current 3 percent AGI 

limitation) that applies to those expenditures., 

Whether the treatment of employer payments as taxable 

income can be justified depends in part upon the principle of 

equity under which the income tax base is defined. Under 
-- 

-28-

current law, the implied principle underlying the employee 

exclusion of employer payments is that the base for 

individual income taxation should be exclusive of all medical 

expenses. Under this principle, equal income status is 

defined as equal ability to purchase non-medical goods; if 

all medical expenses are viewed as both unwanted and 

unavoidable, then the well-being of a person can be 

approximated by his income after payment of. all medical 

expenses. Thus employer payments of medical insurance and 

care are excluded from income subject to tax. 

Inclusion of employer payments, on the other hand, would 

result in a consistent rule being applied to all medical 

payments, no matter whethe'r they were paid by the employer or 

by the taxpayer. If a floor for itemizations were 

maintained, the implied principle of the current exclusion of 

employer payments would be abandoned in favor of a principle 

of deductibility that only "extraordinary" deductions should 

be allowed. 

In addition to considerations of tax 'equity ,and revenue 

loss, other arguments to limit the exclusion are based upon 

the objective of'improving the efficiency and competitiveness 

of the medical care market. More economical less wasteful 

-- coverage might be gained by requiring employer paid health 

plans to meet certain standards to qualify for the exclusion. 
-29-

And the standards might be designed to give employees more 

choice and, hence, more of an economic incentive to choose 

less costly plans (Enthoven, 1979). 

Including employer payments in income would require some 

arbitrary administrative rules. Because employees vary in 

occupation and age, there are market differentials in the 

prices that they face for private insurance.. To charge them 

equally for employer-provided insurance may not always 

reflect the relative market value of the insurance that they 

receive, although similar valuation problems apply as well to 

other taxable fringe benefits. Alternatively, to calculate 

the value of the insurance for each employee separately would 

impose additional administrative burdens upon employers. The 

final alternative of disallowing the exclusion to the 

employer, i.e., making the payments taxable to the employer, 

would also bring about a unfavorable result, for the 

employer's expense is clearly a cost of doing business, and 

the employer's marginal tax rate is not a good proxy for the 

employee's marginal tax rate. 

Changing Deduction Floors. Tax expenditures could be 

decreased or increased by changing the floor for itemized 

deductions. An increased floor seems to be in line with a 

measure of ability to pay which allows adjustments to income 
-30-

only for extraordinary or above average medical expenses. As 

noted in Section TI, the proportion of individuals' incomes 

spent on medical expenditures has increased in recent years. 

Taken as a percent of total adjusted gross income, both total 

and private expenditures for medical care have risen, and 

this is the primary rationale usually given for increasing 

the floor. Increasing the floor for medical deductions from 

three to ten percent and folding in the separate allowance 

for one-half of insurance premiums, -18/ as proposed in 1978, 

would have decreased the number of taxpayers itemizing 

medical expenses by over 80 percent. 

\ 

On the other hand, as already noted, the inherent logic 

of the current employee ex'clusion of employer payments 

implies that a deduction should be allowed to all taxpayers 

for all medical expenses. To carry that logic to its extreme 

would require both elimination of the floor and an allowance 

for medical deductions to taxpayers who do not itemize. 

Following the same logic to a lesser extent, a case can be 

made for not increasing the floor if the employee exclusion 

is not changed. The higher the fl'oor, thd greater is the 

relative tax on those who buy their own insurance or 

self-insure and do not receive insurance through an employer. 

-'-Casualty losses were also folded into the medical 

deduction under this proposal. 
-31-

The question of self-insurance deserves mention in this 

context. The allowance of a separate deduction for half of 

insurance expenses (up to $150) was enacted in 1965 partly 

because of objections from the insurance industry that the 

deductible amount or floor gave individuals an incentive to 

. 

I. 

self-insure. &ince medical expenditures varied, it was 

argued, a person would be more likely to have expenses above 

the floor in some years if he did not even .out the 

expenditures over the years through insurance. -19/ The 

adoption of a higher floor would also reduce the tax benefit 

of those who self-insure since, at least in certain 

expenditure ranges, no tax subsidy would be available. 

Additionally, if individuals are risk averse and risk 

aversion increases with the size of the risk, then it is less 

likely that individuals will self-insure for extraordinary 

expenses than for ordinary expenses. Thus, with a higher 

floor, not only would fewer non-insured expenses be 

subsidized, but there may be fewer individuals who would be 

willing to self-insure for the expenses that remained 

eligible for the subsidy. 

-19/ The merit of this argument is debatable. At least for 

very high medical expenses, only the very wealthy can 

realistically self-insure. Since most families have a strong 

incentive to purchase insurance for catastrophic events, and 

most taxpayers do not itemize, repeal of the separate 

deduction may have little impact on insurance coverage. 
-- -- 

-32-

Converting the Personal Deduction to a Personal Credit. 

A credit could be offered against medical expenses, and the 

current deduction could be eliminated (or allowed only for 

expenses in excess of the credit). Depending on the extent 

to which the credit covers costs, such a proposal could be 

designed as part of a program of national health insurance, b 

or it could be much more limited in scope. In some national 

health insurance schemes, the credit serves as a device to 

provide catastrophic coverage, while other coverage is 

provided through other means. 

Converting the deduction to a credit implies a change in 

the purpose to which the tax expenditure is directed. A 

deduction is allowed primarily to define the tax base, i.e., 

to classify individuals with equal ability to pay taxes. 

Thus, a taxpayer with $25,000 of income and $5,000 of 

deductible medical expenses is treated as having equal 

ability to pay as a taxpayer with $20,000 of income and no 

deductible medical expenses, all other things being equal. 

At the same time, since the value of a deduction increases 

with income, it provides a greater price ‘subsidy to those at 

higher income levels. A credit, on the other hand, may be 

viewed as a payment from the government to subsidize the cost 

of some item in this case, medical care rather than to 

adjust the measure of income subject to tax. A credit 

usually provides an equal level of price subsidy for all 
-33-

subsidized expenditures at various income levels and marginal 

tax rates. -20/ Because the purpose of the credit is usually 

unrelated to the goal of defining the tax base, it is often 

designed to be available to taxpayers who do not itemize and 

tQnontaxable persons, -21/ as well.

The cost (i.e., revenue loss) of a credit would depend 

upon the type of proposal that is made. As.sume that a 

personal credit is adopted in lieu of the personal deduction, 

that there is no increase in price of or demand for health 

care, and that a credit is available for all private medical 

expenses. Each one percent of credit would then cost about 

$1 billion in 1978, with an offset of around $150 million due 

to the elimination of the 'current tax expenditure for 

personal deductions and a reduction in the use of 

employer-provided insurance. 

To lessen the cost of a credit, both a deductible amount 

and a copayment rate could be applied to the credit. These 

-20/ Thus we have such terms as "refundable tax credits," 

even though there is no tax against which'the credits are 

taken. In effect a refundable tax credit is an expenditure

administered along with the income tax. 

-21/ Sunley (1977) argues that, if one could separate involuntary and voluntary medical expenses, then one might want to 

allow a deduction for involuntary expenses since they reduce 

ability to pay, but to credit (subsidize) the voluntary 

expenses. 
-3 4-

changes would not only lead to a decrease in the cost of the 

credit, but they also would limit the increase in demand 

caused by the government subsidization of health care. 

To target a credit moat to those in need, a deductible 

amount should be based on income. -22/ Thus, as with the

current medical deduction, only expenses in excess of a given 

percentage of income would be eligible for .the credit. The 

alternative to a variable deductible amount is a flat 

deductible amount. A flat deductible, however, is not well 

targeted to those most in need of assistance, nor does it 

take into account that demand may increase somewhat with 

income. Moreover, parameters in the Tax Code are not indexed 

for increases in income, whether real or inflationary. Over 

time, a credit with a fixed dollar deductible could lead to a 

larger and larger proportion of total medical expenses being 

paid out of public funds. Assuming more than pure 

inflationary growth in the total amount of medical 

expenditures, an increase in public share would occur even 

with a flat dollar deductible indexed for inflation. 

- result of varying the deductible with income is 

that, for certain persons there is an implicit tax rate on 

increased earnings due to the increase in the amount of 

expenses not eligible for the credit. For instance, if the 

credit were to equal 100 percent of all expenses in excess of 

10 percent of adjusted gross income, thhen, for a person with 

$1,500 in medical expenses and $10,000 in adjusted gross

income, an extra dollar of earnings reduces the credit by ten 

cents (from $500 to $499.90). 
-35-

National Health Insurance. This paper is concerned with 

tax expenditures rather than national health insurance (NHI) . . However, adoption of a NHI plan would have substantial 

effects on existing tax expenditures for health care even 

without a change in the laws'allowing the exclusion and the 

deduction. The principal change comes about because of the 

substitution of sources of payment for medical care. If 

employer payments increase, so do tax expenditures due to the 

exclusion. If government payments substitute �or employer 

payments, tax expenditures due to the exclusion go down. On 

the other hand, increases in employer or government payments 

for medical care both may lead to decreases in direct 

payments by persons and, therefore, to decreases in the use 

of the itemized deduction for medical expense. Because the 

size of the tax expenditure for the employee exclusion is 

much larger than the tax expenditure due to the personal 

deduction, the change in total tax expenditures for most NHI 

proposals is primarily determined by the change in 

expenditures of employers. 

Table 5 shows the change in tax expenditures and other 

changes in income tax collections due to adoption of selected 

prototype plans for national health insurance. Since the 

amount of direct patient payments decline in all cases, there 
-36-

is a decrease in the use of the personal itemized deduction 

for medical expenses. Public plans which require increased 

employer payments raise the tax expenditure cost of the 

exclusion, while plans which primarily increase government 

payments decrease the amount of that exclusion. 

Any NHI plan might be accompanied by any of the three 

previously mentioned options: elimination .of the exclusion, 

disallowance of the deduction, or a credit in lieu of a 

deduction. To the extent that NHI replaces excludable 

employer payments, elimination of the employee exclusion of 

employer payments may not result in a large increase in 

taxable income. A proposal for eliminating the exclusion 

might properly be based on' the argument that all 

extraordinary costs already would be covered by NHI and that 

tax-exempt NHI coverage would be approximately equal for all 

citizens. However, it would be inconsistent if taxable 

income would include payments for medical insurance and 

services from employers but not from the government. 

Furthermore, the problem of attributing the market value of 

employer-paid insurance premiums to each employee would 

remain. 

Disallowing the itemized personal deduction might also 

be justified if national health insurance covered all 
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-38-

extraordinary costs. Still, the more coverage provided by 

NHI, the less the possibility that out-of-pocket health 

expenditures would exceed three percent of adjusted gross 

income. Thus, while eliminating the deduction might be 

justified, the revenue effect is of less significance because 

fewer taxpayers would exceed’ the floor. 

Finally, a tax credit might very well .be the form in 

which insurance for catastrophic events is offered under NHI. 

Depending upon the size of the credit, the personal deduction 

might or might not be eliminated. If not eliminated, it 

would only be allowed for expenses in excess of those not 

covered by the credit. If the credit is large enough, 

however, there may be no Cases in which expenses would exceed 

a floor, and, thus, no need for the deduction. 
-39-

VII. CONCLUSION 

Tax expenditures for medical care form a large and 

growing part of the Federal budget. Employer payments for 

medical care have always been exempted from income taxation, 

-. 

and an increasing proportion of total private medical 

payments are exempted from tax because of the increase in 

coverage provided by employers. The personal deduction was 

first allowed in 1942 and has been expanded since then to 

cover expenses which might be considered quite ordinary 

today. 

For 1979 Federal income tax expenditures for medical 

care will exceed $11 billion and will comprise about 5 

percent of total expenditures for medical care and about 9 

percent of private expenditures. State income tax and social 

security tax collections are also reduced by another $6 

billion. While not as large as direct expenditure programs 

such as Medicare and Medicaid, these tax expenditures do have 

an impact upon the demand and price of medical care. At the 

margin, these expenditures often reduce price by 29 to 35 

percent. 

Practically all policies connected with medical care 

affect the amount of tax expenditures for medical care. 
-40-

Direct expenditures may change tax expenditures even if the 

laws affecting the exclusion and deduction are unchanged. 

The design and choice of tax expenditure policy is dependent 

upon the extent to which medical exclusions and deductions 

are to be made equally available to all persons, the amount -. of ordinary expenditures which are to be disallowed a 

deduction, and the extent to which other public expenditures 

are used to offset costs of health care. 
-- 

-41-

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i