Issue Brief

November 2001

The Intersection of Health Policy and Tax Policy

When we think about public policy regarding health care it isn't usually the tax writers who come to mind, but in the arena of American health care, tax policy is an extremely powerful force.  In fact, at the national level most of the major decisions about health care funding and health care financing are developed in the tax-writing committees of the Congress.  (There is no Health Care committee in either the House or the Senate.)  The purpose of this newsletter is to discuss some of the ways in which health policy is influenced by tax policy. 

Because the topic is so broad and complex this newsletter is devoted primarily to the influence of tax policy on health care as it directly affects the individual.  There are other provisions of tax law granting tax-exempt status for many Minnesota health care organizations.  These provisions have also had a profound effect on health care but we will not address them in this newsletter.

I.  Background
From the large programs of Medicare, Social Security, and Medicaid, to the small amounts in personal tax deductions individuals receive because they are over 65 or legally blind; tax policy and its developers play a major role in the financing and structure of the American health care system. 

Over the last two decades we have seen a great deal of public discussion on the big programs of Medicare and Medicaid, particularly as budget battles have unfolded in Washington.  We are all familiar with the recent push to add a prescription drug benefit to the Medicare program and the numerous arguments that have been made for and against this effort.  At the end of the day, the substance of these arguments always comes down to cost.  How much will the government have to spend to change these programs? 

While we are all familiar with the costs of Medicare and Medicaid and continually see newspaper stories containing detailed numbers about the affect of one proposal versus another, we almost never think about the cost in lost revenues of a tax break for various health programs.  (There are people who argue that tax breaks are not costs because they just aren't taking money to begin with.  While that view may be a legitimate ideological position, for purposes of determining the federal budget any change in tax policy that results in lower revenues must be counted  -- just as a loss of income must be counted in determining an individual family's budget.)  In the federal budget system these revenue losses are referred to as tax expenditures.

According to the most recent report from the House Ways and Means Committee, 2000 Green Book, an estimated $624 billion will be used for health care for individuals through the tax code in the year 2001 and an estimated $3.6 trillion dollars will be lost to tax expenditures on health care over the next five years.  By contrast, the amount of money the federal government will spend on Medicare in 2001 is estimated at $216 billion and the estimate for the next five years is $1.2 trillion.  We are giving health care three times as much money through the tax code as we are in Medicare program payments.

While most policymakers don't recommend getting rid of these special tax treatments, the amount of money they represent has a real effect on the delivery of health care in our country so it is useful to step back and review them from time to time.

II. The Programs Involved
The kinds of tax breaks involved fall into two categories: exclusions and deductions.  Exclusions are items that are not counted as income when determining how much an individual makes for income tax purposes.  Deductions are amounts that are subtracted from a person's total income when deciding how much of that income should be subject to taxation.

A third kind of tax break that is frequently discussed is a tax credit.  Although there have been several proposals to provide tax credits for health purposes -- one of the most recent being the President's proposal to provide a tax credit for the uninsured -- at the moment there are no tax credits in the code for health care.  

A. Exclusion of Employer Share of Health Insurance Premiums and Health Care
By far the largest single health care item benefiting individuals is the exclusion from taxable income of employer contributions to health insurance.   Basically what this provision says, is that the amount of money your employer contributes to pay for your health insurance cannot be counted as part of your income for tax purposes.  While the value of this provision might seem obvious to most of us, it has not always been accepted and still comes under attack from time to time. 

In 1943 the Internal Revenue Service (IRS) ruled that the amount of money an employer paid for group health insurance policies for its employees was not taxable to the employees.  In 1953, however, the IRS ruled that employer contributions to individual health insurance policies were taxable to the individuals who received the coverage.  That ruling was reversed the following year in Section 106 of the Internal Revenue Code. 

Although there are periodic attacks on this tax preference, it has remained in place now for almost fifty years with only one exception.  In 1978, Congress added a provision to tax the benefits of highly paid employees who were covered by a self-insured plan that discriminates against lower-paid employees.  Congress has consistently said that employers must provide equal access to benefits throughout their pay structure to qualify for tax preferences.  The result of this has been that most employer-financed health insurance plans do not discriminate in the provisions of health benefits among employees.

The tax break that this exclusion provides is very large ($359.5 billion in 2001) and has resulted in widespread access to health coverage for working people.  In spite of the fact that we continue to have a serious problem with the uninsured, the vast majority of Americans under age 65 receive health insurance either as a consequence of their own employment or as dependents in a family member's employment-based coverage.   According to a recent analysis, 75% of all workers under age 65 are covered by employment-based health insurance. 

B.  Other Special Breaks for Employer Provided Health Benefits
In keeping with recent changes in the way our society deals with retirement benefits, there has been an effort in some areas to use the exclusion provided in employer sponsored health plans for shifting to a different type of health coverage.  These new plans can generally be classified as defined contribution health plans as opposed to defined benefit systems.

In the traditional defined benefit systems, individuals (or their employers) make their contributions to an insurance plan and if they get sick their bills are paid regardless of whether the bills exceed the contribution or not.  In the newer defined contribution system, a specific sum of money is set aside, to be used in conjunction with a high deductible or catastrophic health insurance plan, and that is all there is.  The benefit is limited by the amount of the contribution; hence, the term defined contribution system. 

In a defined contribution system, if the high deductible or other health costs exceed the contribution outside of the catastrophic coverage, they will have to be paid by the employee out of his or her own funds, usually in after-tax dollars.  On the other hand, if health costs can be held down below the amount set aside, the employee will be able to keep the excess funds in the account.  Proponents of these plans argue that they make the consumer more careful about health spending and may reduce the costs of health care overall.  The purest example of a defined contribution system for health care is the Medical Savings Account (MSA).

The main argument for this policy is to shift more of the responsibility for every day health care costs from the employer to employees.  This shift can have both positive and negative ramifications.  It has been the subject of heated political debates in the last few years and will continue to be debated over the next several years I am sure.

1.     Cafeteria Plans
Cafeteria plans are flexible spending accounts that, while they aren't exactly defined contribution plans, have some of the features of defined contribution plans.  The most significant similarity is that the employee can choose how much of his or her benefit is devoted to health care.

According to the IRS, "a cafeteria plan is a written plan that allows employees to choose between receiving cash and certain qualified benefits which are usually untaxable."   Although cafeteria plans cannot include MSAs, they can include other health benefits, adoption assistance, dependent and child-care assistance and retirement benefits such as 401k plans.  This gives employees the opportunity to decide the allocation of their compensation among various benefits within certain limits.  For instance, one person may choose to devote more money to health insurance coverage while another may choose to spend more on childcare and less on health care.  These plans are strictly regulated to ensure that they do not discriminate in favor of highly paid employees to the detriment of lower paid workers.

Cafeteria plans have grown significantly as part of the compensation plans for larger employers over the last several years.  In 1986 they were available to 5% of the employees at large and medium-sized firms and in 1997 they were available to 52% of the employees of similar firms.  Smaller firms generally do not offer cafeteria plans because they usually have less generous fringe benefit packages.

Like any income exclusion, the exclusion from gross income for cafeteria plan benefits can lead to disparities in the tax system.  These disparities can work in several ways though, and they will continue to be studied by tax analysts, health experts, and benefit managers as times change.  For now, we know that this flexibility would likely not be available to people if they could not exclude the value of these benefits from taxable income.

2.    Medical Savings Accounts
The most recent change toward defined contribution health benefits in the tax code occurred with the introduction of a pilot program for medical savings accounts (MSAs) in 1996.  An MSA is a tax-exempt account similar to an individual retirement arrangement (IRA) established to allow individuals to save their money, tax-free to use for eligible medical expenses.  It is set up as a tax-exempt trust or custodial account with a financial institution.  It must be used in conjunction with a High Deductible Health Plan and only employees of small companies or self-employed individuals are allowed to establish MSAs.

The Health Insurance Portability and Accountability Act of 1996 (HIPAA) included provisions authorizing up to 750,000 "tax-qualified" MSAs over a four-year period beginning in 1997.  Last year Congress renamed the accounts after Congressman Archer and extended the pilot project for Archer MSA's until December 31, 20002.  There is currently a bill in the House, the Medical Savings Account Availability Act, authored by Congressmen Thomas and Lipinski, which would make these accounts permanent.

Within limits, contributions to an MSA are deductible for eligible individuals and are excludable from income and employment taxes if made by the employer.  At this point, only 100,000 "tax-qualified" MSAs have been opened since 1996 and critics maintain that Congress put too many restrictions on them to make them profitable for insurers to market and consumers to buy.  Even though MSA use has been very limited, there continue to be pressures to expand their availability to more workers. 

The bill offered by Congressmen Thomas and Lipinski removes many of the current constraints on MSA use.  It allows any size company to offer MSAs and it also allows individuals to purchase MSAs.   It allows MSAs to be offered under cafeteria plans in an effort to expand the number of consumers that can be reached by MSAs and to treat them more like other health plans.  It allows both employers and employees to contribute to an MSA and it expands the size of the market in which an MSA can be offered.

C.  Special Treatment of Individuals Apart from the Workplace
In addition to all the special tax deductions and exclusions that are provided for health care and health-related expenses to employees, there are special breaks in the tax code for individuals outside of the workplace.  The most commonly known of these is the deduction for medical expenses allowed individuals on their personal tax returns.  Under the tax code there is a floor for medical expenses that individuals are expected to cover on their own, but any expenses over that floor (currently set at 7.5% of adjusted gross income) are fully deductible on individual tax returns.  This year that deduction is expected to be worth $29.5 billion and over the next five years it is estimated to be worth $167.7 billion to American taxpayers.

Further, individuals who are self-employed were allowed to deduct 60% of their health insurance expenses from gross income for the year 2000 and will be able to deduct 100% of their health insurance expenses starting in 2003.  This subsidy will be worth $7.2 billion in 2001 and $60.9 billion over the next five years.

And finally there is a special extra tax deduction available to all people who are blind or over 65 regardless of their income or employment status and a small tax credit for the elderly and disabled.  These provisions yield an extra $12.1 billion this year and $65.5 billion over the next five years to help these people deal with the extra expenses they incur due to their conditions.   

III.  New Proposal and Future Changes
As you can see there is a great deal of money going into the American health care system indirectly through the tax code.  Many of these provisions such as the deductibility of excessive medical expenses are part of a long tradition and unlikely to change in the future.  Others are frequently challenged by policy experts and budgeteers.

One of the most frequently discussed health provisions is the exclusion of employer-provided benefits from employee income.  This exclusion is challenged by some economists who argue that it has contributed to the high cost of health insurance and medical care by increasing the demand for health insurance.  It is also challenged by tax purists, who object to it on philosophical grounds, and budgeteers because -- at $2.042 trillion over the next five years -- it is a very lucrative source of revenue. Most political decision makers, however, are neither economists nor tax purists and they regularly give these challenges short shrift.  

In another direction, there continues to be debate about the role of flexible spending accounts (i.e. cafeteria plans) in the system.  Minnesota has been a cradle of innovation for new ways to use flexible spending accounts.  Many Minnesota based companies are developing new products based around defined contribution principles and flexible spending accounts.

A recent study done at the Division of Health Services Research and Policy in the University of Minnesota School of Public Health showed that flexible spending accounts are used mainly by high-income and highly educated workers.  This study was done in Minnesota and results in other parts of the country may differ, but the authors of the study wonder if providing a special tax benefit that is only used by one segment of the workforce is an equitable use of the tax code.

And last, but not least, there is an ongoing and spirited partisan disagreement about the appropriate role for MSAs in the health care system.  This conversation will no doubt be continued when the current concern about our terrorism crisis eases a little and the tax-writing committees return to their normal agendas.

In conclusion, although there are many challenges to some of the tax provisions that have been adopted over the years to help people pay their health care costs, it is unlikely that these provisions will disappear.  Rather, it seems that the tax code may be used more extensively in the future to add to the variety of mechanisms we currently use to meet our health care financing needs.