Under current law, employer-provided health insurance coverage is excluded from employees' income for determining their federal income taxes. Exclusions also apply to federal employment taxes (Social Security, Medicare, and unemployment taxes) and to state income and payroll taxes as well. Considering the average cost of employment-based insurance, now around $4,750 a year for single coverage and $12,700 for family coverage, these exclusions result in significant tax savings for many workers. Because employment-based health insurance covers more than three-fifths of the population under the age of 65, the exclusions also result in considerable revenue loss to the government. Ending the exclusions could raise several hundred billion dollars a year, depending on exactly what would be repealed and how workers and employers adjust. Revenue effects of this magnitude make the exclusions a tempting target for policy makers and other advocates who seek to raise revenues without explicitly raising tax rates. The federal income tax exclusion—the focus of this report—has been targeted for other reasons as well. Because it reduces the after-tax cost of insurance to the worker in ways that are not transparent, it likely results in people with insurance obtaining more coverage than they otherwise would. Not being explicitly capped or limited in some other manner, it does little to restrict the generosity of the insurance or annual premium increases. These attributes contribute to what many economists argue is a welfare (or efficiency) loss from excess health insurance for those with coverage. These attributes also contribute to rising health care costs and spending throughout the country. In addition, the federal income tax exclusion often is criticized as unfair because the workers' tax savings depend on their marginal tax rate. High-income workers generally have greater savings than middle-income workers, and the latter usually have more than low-income workers. When these tax savings are viewed simply as an economic subsidy, this pattern strikes many people as wasteful and inequitable. These three assertions about the income tax exclusion—that the revenues could help to reduce the deficit, that it contributes to inefficiency and rising health care costs, and that higher-income taxpayers unfairly get greater tax savings—are the principal arguments put forth for repeal. Each is discussed in this report. Before turning to them, however, the report discusses the scope and origins of the exclusion, both of which are more complex than is generally recognized. The income tax exclusion has been in the tax code for more than 50 years, and its repeal could have unintended consequences unless policy makers understand what transactions it covers and what role it has had in the development of employment-based insurance. A discussion of the scope and origins will also reveal some of the uncertainties repeal would raise for both tax and health care policy. Limited to these topics, the report does not address all issues that might be raised about the exclusion. A comprehensive analysis would be difficult because of limited knowledge about who actually pays for employer-provided health insurance and how workers value insurance at different ages and income levels. While there is general understanding about these matters—it is reasonable to assume that much of the employer contribution is actually borne by workers through reduced wages—that is unlikely to be sufficient, and could be misleading, for drawing conclusions applicable to the diversity of employment arrangements throughout the country. For legislation, differences among types of employers (by size and industry, for example) and types of workers (by gender, family status, and income) often are important. The statutory provision allowing an income tax exclusion for employer-provided health insurance is short but complex. It covers more than health insurance (and health plans that often are described as insurance) and applies to most but not all workers, including members of the workers' families. How other forms of coverage would be affected by repeal of the exclusion for health insurance might be considered. In order to understand the tax issue the exclusion resolves, it should be considered along with another exclusion applying to benefits. When employees receive something of value from their employer, the general presumption under an income tax is that it will be taxable. Whether taxes will actually be paid depends on the deductions and credits a taxpayer might claim, but at least the starting position is that whatever is received should be taken into account for the purpose of determining an employee's tax liability. This rule is reflected in Section 61(a) of the Internal Revenue Code, which provides that all forms of income from whatever source are taxable unless there is an express exception. With respect to employer-provided health insurance, there are two exceptions that are relevant, an exclusion for coverage and an exclusion for benefits received. These exceptions reflect two different tax questions that arise with this insurance, whether the provision of coverage by itself should be taxable (regardless of whether the taxpayer actually uses insurance benefits) and whether the insurance benefits used should be taxable (regardless of whether the taxpayer paid for the coverage). Proposals to end the exclusion for employer-provided health insurance involve the former question and not the latter, but there are interactions that might be noted. In addition, because the exclusion for coverage applies to more than health insurance as it is commonly understood, this section of the report also discusses whether it might be appropriate to retain the exclusion for some purposes. The exclusion for coverage can be found in Section 106(a) of the Code: General rule—Except as otherwise provided in this section, gross income of an employee does not include employer-provided coverage under an accident or health plan. The provision allows employees to exclude (that is, leave out of their income tax calculations) employer-paid premiums or contributions to a trust or other fund for their accident or health plan. There is an equivalent exclusion for employment taxes elsewhere in the Code that pertains to both employees and the employer. The term accident or health plan includes not only health insurance but also accidental death and dismemberment insurance, short-term and long-term disability coverage, and coverage through reimbursement arrangements such as health care flexible spending accounts (FSAs) and health reimbursement accounts (HRAs). Although usually described as an employee exclusion, the provision applies as well to coverage of a spouse and dependents of the employee, whether prior to or after the latter's death. Coverage of former employees is also included. The exclusion applies to both insured and self-insured plans. An insured plan typically involves the purchase of coverage from a commercial carrier, while under a self-insured plan the employer retains the financial risk. In addition, the exclusion applies to coverage employees obtain separately in the individual insurance market, provided employers pay the premiums directly (list-billing) or reimburse employees under a secure arrangement that does not allow reimbursements to be diverted to another purpose. Individual market insurance is not common with this exclusion. Finally, the exclusion applies to employee-paid premiums under premium conversion plans. Under these arrangements, which must be set up by employers, employees reduce their taxable wages in exchange for their employers using the money to pay health insurance. From an accounting perspective, the premiums are no longer considered to be paid by the employees. Section 106(a) does not apply to self-employed individuals because they are not considered employees under the Code. However, under current law, they can obtain roughly the same income tax savings from the above-the-line deduction authorized under Section 162(l). Exclusions for benefits received can be found in Sections 105(b) and 104(a)(3). Section 105(b) allows taxpayers to exclude benefits they receive from employer-financed accident or health plans. It applies to benefits for their spouse or dependents as well. The exclusion is limited to expenses for medical care as defined in Section 213(d), except to the extent they were claimed as an itemized deduction in a prior year. Thus, the exclusion does not apply to disability benefits attributable to employer payments since these benefits need not be spent on medical care. In contrast, Section 104(a)(3) allows taxpayers to exclude amounts received through accident or health plans except for amounts financed by an employer. The taxpayers themselves might pay for this insurance, but that is not necessary; the only requirement is that the employer not pay. The exclusion here is not limited to expenses for medical care, as is the exclusion in Section 105(b). Thus, it might include disability benefits. Section 104(a)(3) applies to individual and group policies, including employment-based plans. If both employers and employees pay for the coverage, the benefits might have to be apportioned to determine their tax treatment. This is not necessary for medical expenses from health insurance, which would be excluded under either Section 105(b) or Section 104(a)(3). However, disability benefits attributable to employer payments would be taxable since they are not covered by Section 105(b). Those attributable to employee payments would be exempt under Section 104(a)(3). Self-insured plans covering highly compensated employees must comply with nondiscrimination rules. If they do not, the Section 105(b) exclusion may be limited for these employees. The nondiscrimination rules do not apply to insured plans. Self-employed people are covered by Section 104(a)(3), not Section 105(b). If Section 106(a) were repealed, employer-paid coverage under accident and health plans would become taxable to employees for the federal income tax. States would likely adopt the same treatment, as they do for most income tax provisions. Repealing 106(a) would not by itself end the exclusions for employment taxes, but most proposals would abolish those as well, if only to obtain additional revenue for to help reduce the federal deficit. However, repealing Section 106(a) would also affect disability insurance and health care reimbursement arrangements, among other employer benefit plans. These possible changes have not received much attention, and they might not be what is intended. Consideration might be given to retaining the exclusion for these benefits, though, as will be seen, doing so may raise other complications. Employer-paid disability insurance may be needed to prevent the adverse selection that occurs when employees purchase coverage themselves.